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What exactly is a biotech company and how does it differ from a standard pharmaceutical concern? It’s important to first point out that the chief difference is in the approach that each uses to develop their respective drugs. Biotechs use “biotechnology” to manufacture drugs, which involves the manipulation of microorganisms (such as bacteria) or biological substances (like enzymes) to perform a specific process. Biotech drugmakers essentially use those microorganisms or highly complex proteins from genetically-modified living cells as components in medications to treat various diseases and conditions, from cancer to rheumatoid arthritis to multiple sclerosis. By contrast, conventional pharmas rely on a chemical-based synthetic process to develop small-molecule drugs.

Unlike pharmas, biotechs focus primarily on research and development, beginning with the discovery of novel compounds, which then get ushered into the clinic for further testing. Indeed, the discovery and development process is often more lengthy, difficult, and costly for biotechs than it is for their standard chemical-based counterparts. For this reason, R&D expenses tend to be very large for biotechs. In many cases, they operate at a loss for an extended period of time, as their R&D costs well outpace their top lines, which are typically driven by milestone payments received through collaborations with larger, more established biotechs, universities, or even pharmaceutical companies.

If a compound successfully progresses through the final stage of testing, a biotech firm may at that point strengthen its marketing and sales capabilities to prepare for commercial launch upon receiving FDA approval. Alternatively, it can partner up with another company that agrees to handle those costly functions in exchange for a portion of sales.

Like biotechs, pharmaceutical companies conduct R&D studies, too. But depending on the size of their resources, they generally have greater flexibility to either carry out those functions entirely in-house or license drugs from other entities, including biotechs, for additional development and potential sale. What’s more, pharmas usually generate sales from products they already have on the market. Thus, their top lines tend to be more substantial compared to biotechs. So, while R&D costs might be sizable, sales and marketing expenses are particularly hefty for pharmas, which are key to spurring sales and maximizing profitable returns.

Generic competition is another major area that sets apart biotechs from conventional pharmas. Barriers to entry are, no doubt, much higher for generics of biotech drugs than for those of chemical-based pharmaceuticals, given the complexity, length of time, and expense of developing such meds. Whereas standard pharmaceutical outfits regularly face the threat of generic copycats entering the market once patents expire on their brandname products, biotechs have been spared this problem, until recently. That’s because the U.S. FDA has lacked procedures or guidelines for granting approval to “biosimilars”, or generic versions of branded biotech therapeutics.

But this appears to be changing. The healthcare reform bill, which was signed into law in March, 2010, included an amendment to create an abbreviated approval pathway for allowing low-cost generic biotech meds to enter the market. For a biosimilar to get the green light, its composition must be shown to be nearly the same, or “interchangeable”, with the original FDA-approved biotech treatment. (Note that it can never be identical to the original drug since no two living cells are exactly the same.) Creating generics of standard pharmaceuticals is far less complicated, on the other hand, as small-molecule medicines from chemical-based compounds are simpler to replicate.

The biggest bone of contention, though, has been the issue of data exclusivity—the time period between FDA approval of a biologic (or biotech drug) and the submission of a filing for a biosimilar from a competitor. It is a means of providing patent protection to the innovator for its safety and efficacy data, precluding rivals from coming on the scene. The biotech industry has suggested that data exclusivity on new biologics should be as long as 14 years, to properly give a company the chance to recover development costs, while providing an incentive to innovate. Opponents, namely makers of biosimilars, instead have argued that a shorter data exclusivity term, such as seven years, would not only help lower prescription drug costs, but increase access to patients. Under the current healthcare reform law, data exclusivity is for 12 years.Conversely, for standard pharmaceuticals, it is only about five years. That permits cheaper replicas to make their way to the market more quickly.

From an investment perspective, several things should be kept in mind. First, whereas most conventional pharmaceutical concerns tend to be profitable, it is fairly common to see biotechs operating at a loss, with the exception of a few well-established ones such as Amgen (AMGN) and Genzyme (GENZ). Next, investors should realize that biotechs have a greater degree of risk associated with them versus their chemical-based cousins. Indeed, stock price movement for biotechs is highly sensitive to company-specific R&D-related events. Clinical trial failures or delays, competition, and regulatory obstacles can cause sharp dips in the price of a biotech issue. If a biotech is unable to recover from a setback, investors could be left with a worthless stock. On the flip side, shareholders could reap huge rewards if a biotech’s treatment successfully reaches the market. Pharma equities, however, are considered to be somewhat less volatile, with stock price action predominantly dictated by profit performance.

Investors certainly have a plethora of pharmaceutical and biotech companies from which to choose. Pharma names include Abbott Laboratories (ABT), Eli Lilly & Co. (LLY), Merck & Co. (MRK) and Pfizer (PFE - Free Pfizer Stock Report). On the biotech side are Human Genome Sciences (HGSI), Incyte Corp. (INCY), United Therapeutics (UTHR), and Vertex Pharmaceuticals (VRTX), among others. As with any industry, making selections depends on an individual’s investment strategy, taking into account time frame and risk tolerance. It’s up to the investor to decide where to place bets.

At the time of this writing, the author did not have positions in any of the companies mentioned.