The Best Business Model in Biotech

Source: Isis Pharmaceuticals via Facebook.

Biotech stocks are absolutely on fire. This is in part thanks to a growing U.S. economy and record U.S. stock market highs, since investors usually have a greater appetite for risk when the economy and stock market are on track. However, a substantial amount of credit is due to the biotech stocks themselves, which have remained innovative and had their valuations driven higher by investors following improved drug development prospects.

From small-cap clinical-stage biotech stocks all the way to the megacap biotech names, the results have been largely the same: big gains that have left the S&P 500 in the dust over the last four years.

But as investors, we also know full-well that stocks don't go up in a straight line. At some point -- it could be next week, next month, or three years from now, no one really knows for sure -- the biotech sector will hit a brick wall, and its pumped up valuations will be challenged. For investors, this means the best strategy is to latch onto companies with the best possible business models in biotech.

Source: Isis Pharmaceuticals via Facebook.

Three components to the best business model in biotech What's the best business model in biotech look like? The way I see it, there are three major components.

First, a biotech company needs to be able to grow organically. There's nothing wrong with acquiring new drugs or drug development pipelines (as I'll discuss a bit more below), but the bread and butter growth for a biotech company has to come from within. Demonstrating the ability to develop and commercialize therapies internally builds rapport with physicians and consumers, validates a biotech company's drug development platform, and helps the company in question maintain strong pricing power on its branded drugs.

Source: Amgen via Flickr.

Amgen , for example, lacked this internal growth engine during the 2000s, with its top-line growth generally in the low-to-mid single-digits. However, with 10 novel compounds, many of which were internally developed, expected to yield late-stage results between 2014 and 2016, Amgen has the capacity to deliver ample new revenue streams and alleviate any intermediary concerns about patent exclusivity losses. Unsurprisingly, its stock has tripled in price since 2011.

Secondly, a biotech company has to be willing to collaborate. Although some biotech companies do develop blockbuster drugs internally, some of the most promising new therapies were developed in collaboration with Big Pharma or another biotech company. Collaborating on drug development can help improve the effectiveness and/or safety of a drug, reduce expenses for both companies, and overall is just a smart way to utilize the strengths of both companies involved.

Isis Pharmaceuticals , for instance, relies on its antisense drug development platform to produce clinical trial-ready compounds at a quicker and cheaper pace than traditional drug developers. Unfortunately, its three-dozen compound deep pipeline would cost a small fortune to study in clinical trials. That's why roughly two-thirds of Isis Pharmaceuticals' pipeline is partnered across roughly one dozen companies. Sure, Isis will have to share its revenue if these partnered drugs make it to pharmacy shelves, but it helps reduce the company's expense burden, and also provides it with upfront cash and milestone opportunities that it can use to fund additional research and development.

Finally, the best business model in biotech requires a knack for occasionally making acquisitions that rapidly boost the profitability of a business. As mentioned above, buying other drugs and pipelines aren't necessarily a bad thing -- but it shouldn't be the only source of pipeline and product growth. If it is, there could be serious growth concerns over the long run. However, the best business models will have an eye out for the best acquisitions to make.

Source: Gilead Sciences.

Take Gilead Sciences . The company has developed a pretty impressive lineup of HIV/AIDS therapies, as well as cardiovascular compounds internally. But it was Gilead's $11 billion purchase of Pharmasset in 2011 that really changed the company's outlook. The goal of the purchase was to acquire PSI-7977, which would go on to be known later as sofosbuvir and then Sovaldi. Sovaldi-based therapies have changed the landscape for hepatitis C patients and given them a chance at an effective cure.

In its first year on the market, Sovaldi produced $10.3 billion in sales. Sovaldi has since ceded space to Harvoni (a once-daily pill that combines Sovaldi with ledipasvir) in the most common type of HCV, genotype 1, and sales of Harvoni in the first quarter totaled $3.58 billion. Overall, hindsight shows Pharmasset was a brilliant acquisition for Gilead.

What company combines these three traits?There are probably around a half-dozen companies that could fit the bill for best business model in biotech based on the above three components. However, I'm going to give my personal nod to Celgene as the best balance among the three.

Celgene's claim to fame has been its ability to grow organically, which isn't as easy to find in the biotech sector as you'd think. The recently-approved anti-inflammatory drug Otezla could provide Celgene with up to $2 billion in peak annual sales, while blood cancer drug Revlimid has been an absolute star, generating $5 billion in revenue in 2014 and projected to deliver $7 billion by 2017.

Celgene has been able to keep up its impressive growth rate by expanding the label indications of its drugs. For instance, Revlimid's ability to move into follicular lymphoma could be a means to move Revlimid's already-impressive sales even higher.

Source: Celgene.

Celgene has also dabbled in the acquisition department from time to time. Purchasing Abraxis BioScience in 2010 brought cancer drug Abraxane into the fold. Abraxane generated just $315 million in sales for Abraxis in 2009, but delivered $848 million for Celgene in 2014. By 2017, Celgene projects Abraxane will be a $1.5 billion to $2 billion cancer drug with the possibility of growing label indications. Like Gilead's Pharmasset acquisition, the purchase of Abraxis has worked out really well for Celgene.

Lastly, Celgene boasts close to 30 collaborative partnerships, ranging from immunology to cancer treatments. Celgene's management team understands that it may not have all the answers internally, and it's not afraid to spend on upfront and milestone fees in order be a part of some of the most potentially groundbreaking experimental treatments that other biotech companies have to offer.

Celgene's business model gives it the potential to grow by the high single-digits or low double-digits for what I believe could be a decade to come. By those standards, Celgene might make for an attractive long-term investment in biotech.

The article The Best Business Model in Biotech originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool owns shares of and recommends Gilead Sciences and Apple. It also recommends Celgene and Isis Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.