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Wall Street BioBeat : Jul 1, 2008 ( )
The Paradox of Biotechnology Value Investing
Assessing Worth Could Be More than Just Conjecture if the Right Tools Are Used
On the surface, biotechnology and value do not have much in common. Biotech companies lack predictable cash flows and calculable margins of safety; the sector is one of the market’s most volatile. Early-stage biotech companies are really two businesses: product developers and money raisers. They convert raw material—in this case intellectual property—into marketable products after a long stepwise process of clinical trials and regulatory decisions. In order to exist for years without profits and with minimal or no revenues, these firms sell equity on a regular basis, hoping that progress in clinical development and favorable market environments will raise their stock price.
Cutting-edge IP is only one piece of a biotech success story. Not allowing the company to fall into the black holes of illiquidity and preventing poor risk management or imprudent management of the underlying assets is equally or more important during the company’s early stages.
To some, these have become attractive investments. Success stories like Genentech, Celgene, and Gilead Sciences generate spectacular gains. Further, biotech provides regularly scheduled catalysts. Clinical trial results and FDA decisions, biotech’s surrogate activists, force the market to regularly revalue these stocks.
Can stock in these companies be considered true investments and not just speculation, though? For those of us with backgrounds in the life sciences, backgrounds that may provide an edge in the due-diligence process, biotechnology may be the most appropriate addition to a portfolio.
Of course the sell side is happy to provide valuations, price targets, and buy recommendations. Analysts typically discount a peak earnings estimate years in the future at a steep but arbitrary discount rate. This layering-on of estimate on estimate gives analysts the freedom to justify any arbitrary value he or she wishes.
The idea is to find a way to apply value-investing principles in this nontraditional sector. In Value Investing: From Graham to Buffett and Beyond, Bruce Greenwald provides a three-step framework for valuation. First, value the real assets on the balance sheet. Second, determine the earnings power of the company at the moment of the calculation. Third, add a provision for growth, deeply discounted.
Biotech valuation is simpler. Since most development-stage biotech firms have no revenue, much less income, valuation is only a balance-sheet exercise. Start with the IP: if the company ceased operations and locked the patents and data in a vault, how much would another biotech or pharmaceutical company pay for those assets? Add some provision for the cash on hand and derive a valuation.
There are two situations where this valuation is something other than a guess. Type one is where the enterprise value of the company is less than zero. One can evaluate whether the value of the noncash assets is more than nothing. Type two is when the market tells us what an informed buyer would pay for a similar asset.
Each Sunday night the investment bank Rodman and Renshaw publishes a report on the state of the public biotech market, including a list of those companies whose market capitalization is less than the cash on the balance sheet. The March 1 report lists 29 public companies trading below cash, 21 of which had zero debt. These less-than-cash market caps can put a zero value on still-viable assets: e.g., a legitimate drug discovery platform, a revenue stream from collaborations, or an earlier stage pipeline of product candidates.
This “is this worth more than nothing” category yields a group of companies needing further study. In this case the margin of safety derives from the educated investor’s confidence that the asset under development is legitimately worth something. Investors able to understand the underlying science and the clinical relevance and verify the quality of the clinical trial design can assess these cases in a systematic, nonspeculative manner.
Of course, no trial or regulatory decision is entirely predictable. The prudent biotech investor will choose to handicap only a small number of the ultralow or zero-value companies that he or she finds.
An example is Medicinova, a company that in-licenses drugs from Japanese companies and develops them. On March 1, the firm had a market cap to net cash ratio of 0.58 and reportedly sufficient cash to fund its clinical trials for two years. Its two lead compounds each demonstrated proof of concept and targeted large clinical indications. Unfortunately, an ill-advised road show to test the waters and maybe raise an extra year of cash coupled with the recent market downturn dropped the share price from $8 to $3.50 over the past five months, even as additional validating clinical data was reported. Clearly the Medicinova assets are worth much more than nothing.
Sangamo Biosciences provides a good example of comparative-worth valuation. The company is developing zinc finger transcription factor technology that can be used for human therapeutics, protein manufacturing, and agriculture. It has research partnerships with Sigma-Aldrich in reagent production, Genentech and Amgen in protein manufacturing, and Dow Agrosciences in agriculture. At the same time, Sangamo retains 100% ownership in all human therapeutics programs including those in diabetic neuropathy, cancer, HIV, and stem cell amplification.
To calculate Sangamo’s worth, discounting future earnings is an exercise in futility. A comparative analysis, however, shows that a similar company was recently acquired by Merck. For analytical purposes, it is assumed that zinc finger transcription factors will be as valuable a tool for drug development in the coming decades as RNAi. Sirna, one of several companies that are developing RNAi technologies, was acquired in 2006 for $1.1 billion. The largest remaining independent RNAi company, Alnylam, has a market cap of $1.2 billion. Both Sangamo and Alnylam have drugs in mid-stage development, although Sangamo’s pipeline is broader.
To reach a comparative worth, lets consider the value of zinc finger transcription technology, in other words Sangamo’s market cap, which is $476 million. Now consider RNAi technology: $1.1 billion that Merck paid for Sirna plus a $1.2 billion market cap for Alnylam plus the market cap of several smaller RNAi companies. Sangamo’s market cap of $476 million appears cheap. Factoring in the $81 million in cash and the projected cash burn of $26 million, one can make the case for Sangamo Biosciences as a biotech value stock.
Value investors have approached biotech from other angles as well. Some have sought hidden asset, high-margin, cash flow-generating businesses buried behind losses from R&D. Over the past two years activist investors have targeted Ligand Therapeutics, NABI Biopharmaceuticals, and Protein Design Laboratories and have tried to monetize their revenue streams.
There is value to be found in biotech, but biotech is not true value investing. Still, to those of us drawn to the sector because our backgrounds in basic or clinical science may give us an edge, the principles of value investing provide a framework for investment decisions that even value-investing guru Benjamin Graham might recognize.
David Sable, M.D., is the portfolio manager of the Special Situations Life Sciences Fund. The author’s fund has long positions in Medicinova and Sangamo Biosciences. Email: DSable@ssfund.com.
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