Dealing with developing stage biotech companies is a speculative approach to investing as many names will bust. Potential is the name of the game, so many investors get easily excited about the possibilities of having the next Gilead in their portfolio. As the Biotechnology sector (IBB) performance in March showed, this is a volatile industry. Ultimately, science and human capital behind a compound will determine the success of a candidate. However, as an investor, one must keep an eye on some easily observable, yet vital, company features so not to get burned.
The number of shares issued is a number that is, at times, overlooked. With developing stage names especially, shares outstanding are a significant figure because a company’s equity is used as a form of currency. To raise additional funds, developing stage companies will dilute current structure, thereby shrinking the value of your investment. Debt, the less popular option of funding, holds more of a cost and as a result considered riskier.
The most updated shares outstanding number can be found on the first (or second) page of a 10K or 10Q company filing.
Indirectly, shares outstanding affect a company’s market cap, defined as market price X shares outstanding, which many investors use a valuation measure. So, not only will an investor see his investment diminish with greater issued shares, but a company will see an inflated market cap.
Navidea (NAVB) is a diagnostics company developing imaging agents to identify presence and status of disease. Navidea has about 150M shares outstanding, a relatively high number when comparing with peers and taking into consideration the company’s market cap is just over $200M. With loss from quarterly operations at $8.5M, Navidea is still unable to sustain operations with incoming revenues meaning the risk of further dilution exists in future.
In addition to the basic shares outstanding number, investors must keep in mind dilutive securities that have yet to be exercised but remain outstanding. These include convertible securities (such as convertible debt), warrants and options. When in the money, these securities can be exercised and dilute a company structure.
It’s important to keep an eye on the number of common shares each of these dilutive securities can be converted to and at what exercisable price. In Navidea’s example, dilutive securities could add a potential 22M shares to the shares outstanding figure. This is not an immediate risk as the majority of the listed dilutive securities are out of the money. However, if the price of NAVB nears the high $2 range, many of the dilutive securities become in the money.
From a financial & technical point of view, Navidea is not compelling. The company will not be able to cover operating expenses through their Lymphoseek product anytime soon meaning that additional funding will be needed. Navidea boasts an already high shares outstanding figure and has further dilutive securities. Like mentioned above, the science may overcome all these challenges if Navidea’s neurology programs are successful. However, that is bet I am unwilling to wager.
Reverse Stock Splits
A reverse stock split reduces the total number of outstanding shares. This corporate action involves the company dividing its current shares and increasing share price by a proportionate amount so fundamental market cap does not change. Investors must be careful of reverse stock splits as it’s a way companies may continue to dilute while concealing the large shares outstanding figure. Due to this rollback of shares, companies generally come under selling pressure when announcing a reverse split.
On the other hand, having a low number of shares outstanding and low float (number of tradable shares not held by insiders) is a trait to look for. A low float indicates that insiders ownership is high, thus providing a vote of confidence in the company with skin in the game. Additionally, a low float would indicate high volatility when demand for the stock rises and vice versa. A perfect example would be Tekmira’s (TKMR) action in 2014.
Tekmira has 22M shares outstanding and a float of 10M shares. Averaging 683,000 shares in volume daily, about 7% of Tekmira’s tradable shares were exchanging hands daily. When the RNAi enthusiasm hit, Tekmira saw a huge run to $30 (three fold in price) in a matter of one quarter. The tide turned just as quickly though, due to the low float number, when the company fell back to $10 range.
Neurotrope (NTRP), a company developing diagnostics and treatments targeting Alzheimer’s Disease, has a public float of just 2.7M shares and 22M shares outstanding. In other words, just like the Tekmira example, a positive catalyst could fuel a huge rally in Neurotrope since approximately 15% of company shares are tradable.
Development stage companies do not run profitable operations, thus being financed is crucial. When a company runs low on funds, dilution takes place, in which not one investor benefits. Generally, it would be ideal to find companies with enough cash to last at least the next 12 months as anything lower is in risk of imminent dilution.
The most up to date cash balance can be found as the first listed asset on the balance sheet. The burn rate depicts how much cash a company goes through during a specified period. This figure is found on the Cash Flow Statement under “Net Cash Used by Operating Activities” (below).
Neurotrope reported a cash balance of $12.6M as of May 2014 and operating cash burn of approximately $1.6M/quarter. Investors must keep in mind that this cash burn figure will fluctuate (usually higher) as a company undergoes clinical trial costs. Assuming a quarterly burn rate of $2M going forward, Neurotrope has a run rate of approximately 6 quarters lasting until Q1 2016. This gives investors a safe margin before facing further risks of dilution.
Dilution Risk Posing as Negative Catalyst
The need for additional funding can initiate selling pressure on a stock even when other aspects of operations are going as planned. Synergy Pharma (SGYP) announced positive top line results from their phase II irritable bowel syndrome study. Yet, the company has fallen nearly 20% since their announcement because of looming dilution risk.
Synergy has $70M in cash and a quarterly burn rate of roughly $20M. This burn rate figure is expected to further increase with the company expecting to initiate phase III for the successful study in the second half of 2014. Consequently, dilution has become an immediate risk. Having less than 12 months of funding has been a dreadful experience for Synergy shareholders.
The right leadership can be what distinguishes a success from a failure, especially in health care where making the wrong decision can cripple a company. Unfortunately, many investors, including myself, have learned this the hard way. Having the right people at the top executing the corporate strategy is essential. Specifically, I prefer when those of influence have had past success in a similar field.
David Johnson, currently CEO of Alliqua (ALQA), was President of ConvaTec, Bristol-Myers Squibb’s wound care division. Under his tenure, ConvaTec grew revenues from $600M to approximately $1.7B. In 2008, ConvaTec was acquired for $4.1B by Nordic Capital Fund. Johnson’s strategy at ConvaTec was to grow the top line through product developments, primarily from smaller acquisitions.
At his current role, Johnson operates Alliqua, an emerging wound care company looking to grow their product portfolio through strategic acquisitions. Johnson’s proven success with ConvaTec acts as assurance that he can repeat his success with Alliqua.
Having notable leadership validates early stage companies. Being a developing company, investors need endorsements since corporate histories tend not to be nonexistent. For Alliqua, a strong management team received the backing of Celgene, with the big-pharma announcing a 20% stake in Alliqua.
Striking huge returns in health care will require lots of research and even more luck. Investing in these fields is speculative by nature, so ensuring proper due diligence can assist in minimizing losses. Above are some of the features, with examples, I believe every health care & biotech investors must be aware of.