Morphosys is the only company I am familiar with that systematically breaks each and every one of these rules. It does not have any drugs on the market and is not expected to have any in the foreseeable future, yet it is profitable. It is involved in drug discovery which is associated with a high attrition rate, yet statistically, there is a very high chance that it will have commercial revenues at some point in the future. It is involved in one the fastest growing segments in the industry, but can be regarded as a conservative holding since it will never be dependent on a limited number of binary events. And finally, it has no need to raise cash in the coming decade in order to support its activities, as its costs are covered by other companies.

Morphosys has developed a unique technology for discovering and producing monoclonal antibodies. The technology, called HuCAL (Human Combinatorial Antibody Library) basically mimics the immune system, as it scans a vast repertoire of antibodies and identifies the ideal ones for a given target. This approach represents a shift from the traditional approach of developing antibodies, because it does not involve animal immunization.

The classic way of developing antibodies involves immunizing an animal (typically a mouse) with the target of choice and utilizing the animal’s capability to produce antibodies against the specific target. Morphosys’ solution bypasses the need of immunization, as the entire process of screening and selecting the antibodies takes place on the scientist’s bench. Although most of the antibodies on the market were developed through animal immunization, the “artificial” approach is well accepted and going forward, the industry will probably see plenty of drugs based on both approaches. At the end of the day, the only thing that matters is the ability to generate an antibody and get it approved, which can be achieved by both avenues, and in some cases, screening technologies have a clear advantage over the immunization. Morphosys’ technology is not the only screening technology out there, but it is certainly considered one of the best, if not the industry’s leading screening system, as underscored by this long list of collaborators.

Morphosys’ platform is the basis for three business segments, each representing a different risk profile and market potential: (i) Research and diagnostics, (ii) partnered pipeline and (iii) Proprietary Pipeline. It is the combination of these segments which makes Morphosys such a unique investment opportunity.

Research and diagnostics

The research and diagnostics division was built primarily by acquisitions and is currently serving research labs and diagnostic companies around the world. Of the three divisions, this one can be seen as the most “traditional”, as it has a relatively low growth rate and commercial potential. On the other hand, the research and diagnostics division is considered very safe, as it is independent of clinical results. In 2008, after several years of losses, the division finally became profitable, despite a sequential decrease in revenues, down 7% to $18.2M. The company expects the unit to grow 10% in 2009 and to maintain a modest level of profitability in the near future.

Morphosys is trying to reshape this division by focusing more on antibodies for diagnostics. The market of diagnostics, albeit much smaller than that of drugs, is expected to experience strong growth in the coming decades as part of the trend towards personalized medicine. Antibodies have an important role in the field and are well entrenched in the market, due to their high specificity and ease of use. Morphosys is addressing the market for antibodies for diagnostics, estimated at several billions of dollars annually, by licensing its platform to diagnostic companies. It is currently involved in over 20 projects, some of which are expected to mature into commercial products. Last year, Morphosys announced that Sweden based Phadia would use an antibody developed by Morphosys in one of its tests for auto-immune diseases. The financial potential of such projects is relatively small, but unlike therapeutics, diagnostic products represent a fast route to market and limited regulatory risk. Without a doubt, the big potential for Morphosys lies in its partnered therapeutic pipeline.

Partnered Pipeline

The partnered pipeline segment is Morphosys’ cash cow, responsible for the vast majority of revenue and profit. The capability to discover and screen antibodies is now very common in the industry and in research labs, but only a small number of companies mastered this technique and created an efficient platform that can feed a vast number of projects. Morphosys is considered one of the four horsemen of antibody discovery, along with Medarex (MEDX), Cambridge Antibody Technology, now part of AstraZeneca (AZN), and Abgenix, which is now part of Amgen (AMGN). Medarex and Abgenix have developed immunization-based platforms whereas CAT and Morphosys have developed screening platforms that do not require animal immunization.

The universal and highly adaptable nature of the HuCAL platform enables Morphosys to be actively involved in tens of projects every year. Typically, Morphosys licenses its technology to pharmaceutical companies and develops anywhere between several to tens of development programs, each program revolves around a single target. The typical deal structure entails an initial licensing fee, full cost reimbursement by the partner, milestone payments of $12-16 million per program and mid single digit royalties on sales. Each program by itself may be modest in size, but considering the fact that Morphosys currently has 55 partnered programs, three of which already in clinical testing, the overall value is obvious.

Morphosys has agreements with a large number of partners, including some of the largest pharma companies, but in 2007, the company decided to focus most of its research activity on one collaboration by inking a transformative deal with Novartis (NVS). The deal, one of largest ever deals in the pharmaceutical industry was a ten year collaboration which includes more than a hundred new programs. In return to full, but not exclusive access to Morphosys’ technology, Novartis committed to pay $600 million over the course of ten years on top of the standard milestone and royalties on future sales. Although Morphosys is not limited with respect to partnering with other companies, Morphosys does not intend to sign additional broad discovery deals. Therefore, going forward, the Novartis collaboration will account for the vast majority of Morphosys’ activity, and will unofficially turn it into Novartis’ antibody division.

In 2009, the company expects 20 new programs to commence, primarily with Novartis, as well as the advancement of 4 antibodies to clinical testing by its partners. Looking ahead to the coming decade, Morphosys believes it will be involved in a “triple digit number” of programs. Based on present collaborations, Morphosys could cumulatively be involved in as much as 180 programs, an exceptional number by any standard. Most of the programs will not be financed by Morphosys, which will carry the cost only for programs it pursues independently or co-develops with partners.

Suffice it to say, the vast majority of these programs will fail to reach the market. In drug development only a minority of drugs prove both effective and safe, with approval rates traditionally in the single digit range, depending on the indication. Luckily for Morphosys, antibodies are thought to have better success rates due to their excellent safety profile and the ability to identify patients who would derive benefit from the treatment. According to several retrospective analyses, antibodies have a ~3 fold higher approval rates in indications such as oncology and autoimmune diseases, making Morphosys’ prospects even better.

The company tried to illustrate this in one of its presentations last year (see figure), by applying its internal statistics and historical approval rates for antibodies in order to predict the number of programs that will get approved. According to its analysis, which should be regarded as an extreme form of forward looking statement, the company will eventually see more than 17 (!) drug approvals. Investors would gladly settle for half of that number. Assuming average peak sales of $500 million per antibody per year, ten years of peak sales and a royalty rate of 5%, the cumulative value of Morphosys partnered pipeline could reach $4.25B, spread over fifteen years.