No one would dispute that competitive boundaries in global agribusiness are changing rapidly. Refer to the statements last week by AWB Managing Director Mr Trevor Flugge, and Wesfarmers Chairman Mr Harry Perkins.

Both leaders commented on the need for agribusiness to build economies of scale and scope, suggesting that it would not be impossible to imagine a Wesfarmers Dalgety in the future which had merged with Pivot or the AWB or Elders. Mr Flugge was quoted as saying you could build yourself a major Australian-based global agribusiness trading and services company, which could compete with ConAgra or Cargill. Ten years ago I think that ambition would have been beyond us.

Looking forward, Rabobank sees agribusiness based on science and technology, operating in coordinated value chains, where clusters of firms cooperate along a chain, from genetics to consumer purchase point, to deliver a specific food or fibre or health attribute. Competition is already between value chains, not between firms.

Rabobank entered the Australian market in 1994 because we saw opportunities in Australia’s competitive advantage in food production. We finance farmers as well as handlers and early and late stage processors of agricultural products. And we have a strong commitment to the competitiveness of the industries in which we operate and the integrity of food and fibre production as viable and sustainable economic activities.

We see the power along value chains evolving to either end – to genetics at the production end, and to brands at the consumption end. What’s driving this is a quiet revolution in the composition of the food we eat in developing economies, away from a-specific low functional food towards highly specific functional food.

All of this involves a paradigm shift in our thinking about genetics, food and health. It’s a paradigm shift from function to outcome. For example, if you’re a canola producer, you’re no longer in the grains industry, you’re in the high stearate or low saturated fatty acids edible oils business – you’re in the food ingredients business.

The changes around us are exciting, full of potential, intimidating and difficult to interpret. It’s been a momentous year for biotech and food related issues in Australia and globally, which the following developments richly illustrate:

• Cargill and Monsanto announcing their global biotechnology and feed joint venture Renessen
• The decision by Australian health ministers in December 98 that all genetically modified food be labelled, and the debate around how to define what is substantially equivalent food
• The March 99 first Australian Consensus Conference on biotechnology in Canberra, organised in response to Australian consumers wanting more information and debate about gene technology
• The establishment of the (interim) Australian Office of the Gene Technology Regulator last month
• The media images of environmentalists destroying genetically modified crops in the UK
• The increasing phenomenon of large supermarket companies declaring GMO-free supply chains or conducting GMO audits of food products or requesting their suppliers to conduct audits

And that list doesn’t even begin to scratch the surface around the blurring areas of food, fibre and health.

Biotechnology or gene technology is extremely emotive issues, eliciting diametrically opposed views. That’s why an open, informed debate where scientific and non-scientific people respect each other’s views is critical.

What biotechnology does is continue the process of selective breeding which humans have employed in animals since around 18,000BC and in plants since around 10,000BC, to increase the availability and quality of our food supply. As a scientific discipline it has enormous potential to relieve human disease, hunger and pollution.

No one group of stakeholders is any less important along a biotechnology food chain than another, but my comments today relate especially to the providers and caretakers along our food chains – the scientists and farmers – and to the financiers of food – banks and investors.

The way biotechnology is impacting our food and fibre chains poses significant challenges to us all.

The combined effects of these forces lead to increasing volatility in commodity markets, manifested in price, production and consumption patterns, which in turn increases the importance of managing risk for all players along the food and fibre value chains.

Take the global grains sector. As it consolidates and integrates, underpinned by increasing sophistication in science, technology and information management, declining prices are leading to increased competition. Grains processors are vertically integrating to protect their sources of supply, traders and marketers are moving into areas of the production chain which increase their margins, developers of genetic and seed material are forming strategic alliances. Direct trade between farmers and end users is increasingly common. And superior returns are being captured by chains of firms, not just by sole operators.

The way businesses create sustainable superior returns because of the nature and position of the value chains in which they operate is especially true of biotech companies.

The primary aim of modern biotechnology (apart from making great beer, wine and cheese!) is to make a living cell perform a specific useful task in a predictable and controlled way.

Biotech companies are in the business of understanding the collection of chemical coding systems, or genes, and looking for ways to change the instructions from those genes to achieve a desired outcome. Biotechnology in agribusiness allows us to lower inputs, increase sustainability, increase the quality of nutrition, differentiate what were once commodity markets and develop new products.

On the "input trait" side of plant biotechnology, that outcome might include herbicide tolerant crops, insect resistant crops, virus resistant crops, fungus resistant crops, bacteria resistant crops, or crops with altered agronomic properties such as altered flowering times, sterility, drought or salt or cold tolerance, yield increase, oil and fat content, lysine content, altered fibre strength or altered nitrogen metabolism.

On the "output trait" side of plant biotechnology, that outcome might include vaccines against disease, genetically altered traits for sweetness, flavour, colour, water content or hydrogenation process, carbohydrate metabolism, protein metabolism, speedier reproductive cycles and increased antioxidant vitamin content.

Relative to our population, Australia has a fine heritage of scientific intellectual capital and early stage biotech R&D. We account for 2% of global activity in plant biotechnology, which is impressive given our population base, and we’re good at it. Our universities contain world leading research programs and we have the Cooperative Research Centre structure to underpin collaboration among government, science and industry on new commercial projects.

We also have some high profile biotech successes. Cochlear, who have developed a leading bionic ear. ForBio, specialising in forest biotechnology who are patenting gene sequences for eucalypts and pines. Biota who have developed the Relenza antiviral for flu, marketed by Glaxo Wellcome in Australia and Europe. CSIRO, whose wealth of innovation is staggering, including cotton plants with inbuilt resistance to heliothis, potatoes resistant to Potato Leaf Roll Virus, and wheat with important market traits such as freezing characteristics and noodle qualities.

However because of the size of investment funds available in Australia for agribusiness biotechnology, and our tax regime relating to R&D, we don’t have that successful track record in commercialising biotech to match our wealth of innovation.

We have the scientific brain pool for agricultural biotech, and our producers are commonly acknowledged as world leaders in sustainable agriculture, but we do not yet have the most conducive environment for funding and commercialising innovation. We are well on the way, but we’re not there yet. Our financial commitment pales compared to countries like Israel which has devoted USD$3 billion to biotechnology development.

The science of biotechnology might be complex, but the key drivers for biotech companies are actually quite simple. They are:

• Research and development pipelines, including intellectual capital
• Product portfolios
• Management quality.
• Comparative Industries for Biotechnology

Comparative industry analysis helps to understand the value drivers of biotechnology. The three most obvious "related" industries are chemicals, pharmaceutical’s, and the information technology and telco industries (IT&T).

In the pharmaceutical industry, the timeframe for developing "blockbuster drugs" is getting longer, yet the incremental gains are getting smaller and the time taken until replicas or substitutes come into the market is decreasing. Like the Australian swimming team preparing for the Olympics, it’s not whether you can shave 2 seconds off the world record, its whether you can shave off 2 tenths of a second!

Consequently, many players in the pharmaceutical industry can’t afford to fund commercialisation of their research unless they operate in a niche market as part of a greater alliance of R&D functions, testing functions, regulatory functions, manufacturing, distribution and retail functions. Partnership is not an option for pharma and biotech companies; it’s a necessity.

As a result there is a high degree of M&A activity in all these industries, driven less by funding requirements and more by the need to sustain that umbilical cord of R&D innovation. Partnership is not an option among the pharmaceutical community; it’s a necessity.

The same is true of the relationship between farmers and scientists, and farmers, scientists and bankers in relation to agricultural biotechnology. Partnership is not an option; it’s a necessity. Australian farmers have already been early adopters of gene technology, particularly in relation to cotton and livestock genetics. That part of our equation is strong, but we need to strengthen the finance function to support our scientists and producers in commercialising agricultural biotechnology.

Think about investor perceptions of biotechnology in relation to Internet stocks. You could argue that Internet stocks are just as speculative as biotech stocks but have done a sensational job of marketing themselves to the public.

The questions here are: could science market itself more successfully to investors, producers and consumers? Are financiers failing to comprehensively understand and support scientific innovation to market?

"Pandora’s box" and "Frankenstein" are some of the critical analogies you hear about biotechnology. It’s true; there’s very much an element of "expect the unexpected". Rumelt, a respected US strategy expert, whose research has demonstrated that firm factors are five times more influential in creating sustained profitability that industry factors, describes the unexpected as the "Honda Factor". He says:

"In 1977 my MBA final exam on the Honda Motorcycle case asked, "Should Honda enter the global automobile business?"

"It was a give away question. Anyone who answered ‘yes’ flunked the exam. Because markets were saturated; efficient competitors existed in Japan, the US and Europe; Honda had little or no experience in automobiles; and they had no distribution system.

Eight years later in 1985, my wife drove a Honda!"

Well to use an ‘80s analogy for a 21st century phenomenon, financing biotechnology is about financing the unexpected - taking a risk that the Honda miracle will come true.

In Biotech, Vg Is the R&D Pipeline or The Portfolio of Real Options

So what are the funding options for a potential "biotech Honda"?

As we know, firms exist to create value. The value in a biotech firm is the present value of current assets, plus the future value of growth opportunities embedded in the firm’s R&D pipeline:

Vf = Va + Vg

Biotech pipelines are complicated and high-risk entities. They are less pipelines than they are flows of concepts where public research agencies and private companies cooperate to fund R&D, test a product, submit it for regulatory approval. Eventually with the consumers’ blessing the product might generate sales revenue.

Examples of potential "Honda’s" embedded in food R&D pipelines would include:

• tomatoes, carrots and cucumbers with enhanced beta carotene
• potatoes with vaccines for hepatitis B, cholera and diabetes
• bananas with genetically in-built malarial vaccine
• rice-based food which would allow diabetes sufferers to avoid insulin injections
• lycopene-enhanced tomato which could be used in tomato and pasta sauces (lycopene is an antioxidant carotenoid which may reduce the risk of cancer)
• milk-derived products which could prevent diarrhoea using bovine anti-E.coli immunoglobulins.

Return on investment for biotech companies is typically not derived from a single successful product or trait, but from the performance of ongoing sequences of commercial products across a portfolio of research disciplines.

Because of their higher risk profile, biotechnology companies tend to be highly capitalised with low debt. Most of their cash flows are ploughed back into R&D. Australia’s high capital gains tax can act as a disincentive for investment into new biotech businesses. Local sources of venture capital for Australian biotech firms are limited and there are few incentives for US pension funds, a major source of international venture capital, to invest in Australia. Since mid 1996 the research and development concessional tax incentive was reduced from 150% to 125% which, combined with a relatively immature local capital market for biotechnology, also hinders investment.

So there is a lot of pressure on biotech companies in relation to their financing. One effect of this pressure for funding is that companies end up performing contract research for larger, better-financed pharma or life science companies, handing over the proprietorial right to that research or technology to the contracting company who bring the product to market. The drawback is that biotech firms may unwittingly position themselves in a vicious cycle: they are unable to move beyond being a successful research house, end up with no commercialisation, marketing or distribution capabilities, and therefore have less to offer an investor.

What are the various sources of financing for biotech companies? Here is an overview.

The sweetest source is financing from internal cash flows, which generates the most control over an investment. But biotech companies tend to be small, often with negative cash flows, or a short-term positive cash reserve, which might only last 12 months or so. This generally forces them to seek external funding, and there are several generic choices from debt or equity.

The first option is to find an individual willing to place private equity or venture capital – a biotech "sugar daddy" if you like.

The next option is to attract venture capital administered by a firm, which specialises in high-risk category investments. Such companies often take an influential role in the management of the firm they are investing in, so that they can influence the time horizon and structure of the revenue streams flowing from their investment.

A third option is to seek investment from institutional investors or pension funds, such as the Rabo/Gresham Food and Agri Fund and the Gresham Technology Fund.

A fourth option is to attract investment from an R&D syndicate. The commercialisation of research or technology is carried out for a partnership of high net worth individuals by a biotech company via a licensing agreement over technology. In return they receive tax concessions and can leverage the investment.

A final equity option available for biotech companies is to go public, raising equity from the capital market although there are high transaction costs and long lead times attached to going public.

Once biotech firms reach the market with a product they still face significant risks to their funding base. Regulatory risk for example. Take the case of Australian biotech company Biota, which developed the Relenza, antiviral for flu. Their share price soared on the promise of selling Relenza to the American market. Unfortunately the company’s application for registration was rejected by the USFDA earlier this year, and their share price plummeted overnight, wiping out a significant part of the company’s market value.

So financing the present value of assets in place and the future growth options for a biotech firm is typically risky or difficult for several reasons:

• Product development is scientific or very technical in nature and information asymmetry may exist between developers and financiers.
• Firm size for biotech companies tends to be small – there is often a trade-off between a flexible structure, which promotes innovation and a robust revenue stream.
• Time to market is long and unpredictable.
• Control over manufacturing and marketing rights is crucial to the long-term viability of the firm, but not easily developed. Hence the great deal of M&A activity once firms hit their limits to critical mass.

Traditionally most banks have difficulty financing any kind of groundbreaking innovation, which by nature has a high chance of failure. Biotech financing is usually the domain of venture capitalists that have specialist skills and are more risk-tolerant than debt finance sourced from major banks.

The issues or risks which financiers struggle to price in relation to biotech are:

None of this is meant to be pessimistic, just realistic.

All of this means that biotechnology projects which have a strong early stage R&D focus but little consumer market research will have a higher probability of failing, rather than projects which have a strong consumer market research component. It’s almost like a mantra "Know your end-user customer!" "Know your value chain!"

It means that stand-alone biotech projects, which aren’t developed within an investment portfolio of projects, have less chance of success. For agricultural biotechnology, it also means that projects have to be strongly collaborative, involving researchers, producers and financiers.

Perhaps the most spectacular example of a successful biotech product which came unstuck because of lack of collaboration through it’s value chain was that of the Calgene Flavr Savr tomato.

Calgene, subsequently bought by Monsanto, first introduced Flavr Savr tomato in the US in 1994 under the MacGregor brand, but pulled it from supermarket shelves by mid 1996. The aim of the genetically engineered product was to delay softening and reduce spoilage in order to give vine-ripened tomatoes all year round improved flavour. Normally tomatoes are picked when green and hard to facilitate transportation, then sprayed with the plant hormone ethylene, which brings out their colour but not necessarily their taste.

By and large the genetically engineered tomato was successful. But the producers and distributors in the tomato value chain neglected to alter their packaging technology to accommodate soft tomatoes resulting in damage and losses of up to 30% of consignments. By the time a new generation of packaging was developed, Calgene had been forced to cease production.

If the tomato producers had worked with the retail chain directly, there might have been a different outcome for Flavr Savr tomatoes.

There are those who argue that farmers should just leave biotechnology to the experts, take a back seat to science and respond passively to scientific innovation. I don’t agree.

The future of Australian biotechnology lies in our collective ability to generate intellectual property, patents and germplasm that others want, and to maximise our skills through complementary partnerships among scientists, farmers and bankers.

Biotechnology is broader than just getting the genetics right and increasing our yields. There is scope for partnership in Australia way beyond our current activities, even though we are working from a well-established base.

Our bank invests in the sectoral knowledge of our people, as well as their financial skills. We want our people to understand the eg grains or horticultural industries almost as deeply as the people who manage those businesses.

When we weigh up credit risk for a financing opportunity, here are the non-financial things we look for in prospective clients. They are generic characteristics, but they are especially applicable to partners in biotechnology value chains:

• How well do you manage change
• How well do you understand your value chain(s) and the value drivers for your business
• How well do you understand the growth options in your business
• How do you access and manage knowledge

Whether you take a pro-active and partnership approach to the scientific opportunities in your value chain, so that input supply, agronomic and biotech companies seek you out to do business with you.

For our rural clients, we don’t expect farmers to be scientists, but we do expect them to recognise a good one if they are for hire! We expect our rural clients to be good at negotiating, and we expect them to be able to access and manage information.