FOOL ON THE HILL: An Investment Opinion
When the FDA Says No

Shareholders of fledgling biotech drug maker Cell Pathways watched the stock collapse this week when the FDA rejected the company's application to market cancer drug Aptosyn. Investors who examined the depth of the company's drug candidate pipeline, and whether it had cash or alliances with big drug makers to survive hard knocks, would have known the risks.

By Tom Jacobs (TMF Tom9)
September 29, 2000

Shareholders in young biopharmaceutical hopeful Cell Pathways (Nasdaq: CLPA) got their wind knocked out on Monday when the FDA did not approve the company's Aptosyn cancer drug. The action deflated the stock from $30 to $9.31, or 69%, and to $7.94 at yesterday's close.

But for investors who looked, the warnings were clear: The company has a thin drug pipeline and lacks alliances with big drug makers.

Drug company investors, hear this: Someday, sometime, your company will have a product that either fails during human trials or garners the FDA's booby prize. It's like having teenagers. Someday they -- or you! -- are going to stumble. You need to have the resources to pick up and move on.

To invest in a drug company, you need to know two things at a minimum:

1. Does the company have enough drug candidates in its pipeline to compensate for clinical failure or FDA rejection of one or more?

2. If currently unprofitable, does the company have enough cash and big drug maker partners to survive bad news?

How deep is the pipeline?
You can usually find a company's drug candidate pipeline on its website, which often has a link right on the home page. For example, Genentech's (NYSE: DNA) pipeline has charts showing drug candidate progress in clinical trials. For biotechnology drug companies, you can also go to Recombinant Capital's website clinical trial database, type in the company name, and view a summary of a company's works in progress.

Without knowing a company's drug pipeline, you can't make an informed investment decision. No buts. And even if you do find information, you still need to compare pipelines of several companies to pick the better investment. A valuable tool is Fool ElricSeven's Biotech Pipeline Evaluation, available from Soapbox.com. (By the way, ElricSeven's real name is Greg Carlin, and he will be one of the instructors in The Motley Fool's Biotechnology Online Investing Seminar, trying to help you separate the winners from the losers in the brave new world of biotechnology investing.)

Cell Pathways' pipeline is barely sufficient
Cell Pathways' pipeline contains Aptosyn for four different conditions: Four drugs in one. The FDA must approve the drug for each intended use. This week's rejection was for colon polyps, and it may suggest trouble for other applications. The company is also testing CP461, a cancer drug, but it's between Phase I and II trials, which means at least three to five years from approval and marketing -- if the trials produce positive results.

So Cell Pathways is not a one-hit wonder, and it doesn't have a lot of cushion. We still need to know whether it has a cash margin of safety or whether it's a fool's paradise.

How much cash?
A company needs cash for expensive development and testing of a drug -- especially if the FDA disapproves and wants more trial data. For a Pfizer (NYSE: PFE), Merck (NYSE: MRK), or Johnson & Johnson (NYSE: JNJ), money is generally no object. A quick check of any of their financials reveals that cash and cash equivalents significantly outpace liabilities and can fund many trials. Even if cash-strapped, big drug makers can access capital markets that are only too happy to provide mountains of cash at favorable rates.

Burn, baby, burn
But unprofitable development-stage companies are burning through cash while they research and develop what they hope are their profitable future products. You must know how long a company can survive while spending at a certain rate.

Of course, a young company with great science and promising products -- but insufficient current revenues -- can often secure funding in the public markets by selling stock or convertible bonds, for example. This year has been a bonanza -- some would say hysteria -- that way. But the market's love for biotech stocks comes and goes like teen music stars. A company could hit hard times just when biotechs lose favor. Then money's scarcer than a pay phone in the desert. You either sell yourself cheap to a big drug maker or go bankrupt. Shareholders lose.

To calculate a back-of-the-envelope burn rate, take the company's latest 10-Q and find the income statement (statement of operations). Multiply the net loss times four to get an annual net loss figure. (If your company is profitable, pass Go, collect $200. This section isn't for you.) Then, to calculate how long the company can survive without further financing, skip to the balance sheet. Add the cash to cash equivalents, and divide by the annual net loss figure.

Let's take Cell Pathways. Last quarter's net loss of $7.153 million multiplied by four equals a burn rate of $28.6 million per year. Divide the $35.4 million in cash and cash equivalents by the burn rate, and you have a survival term of 1.24 years. That leaves little or no margin of error for drug candidate failure or FDA rejection and new testing.

That's skating on thin ice for a development-stage company. No wonder the stock price fell through.

Alliances
We should still look further, because an unprofitable development-stage drug company may have revenues from alliances with big drug makers. Alliances offer joint benefits: The larger company spreads its risks by outsourcing some research and development, and the smaller partner gains drug development funding and often the promise of a strong, worldwide sales force to help fulfill the financial potential of a drug. A company's 10-K and website will provide details. Another good source is Recombinant Capital's biotech alliance database. Type in the company name and see a list of deals and value.

ReCap's database shows that Cell Pathways has a few partners, including big drug maker such as Eli Lilly (NYSE: LLY). But it doesn't show any financial terms. The latest 10-Q says nothing.

A year and a quarter of cash? No existing alliance revenue? Not the place for a Foolish investor's money.

Tools, not guarantees
These tools don't guarantee investing success, of course, but may help prevent unwarranted risks. A Foolish investor who applied a few simple tests would likely have been nursing lattes -- not double Johnny Walkers -- this week.

Your Turn:
When is an unprofitable development-stage biotech company a good risk or a casino? You'll find Fools talking on the Biotechnology discussion board.

Related Links:

  • Biotechnology Online Investing Seminar
  • Clinical Trials and the FDA, Fool Specials, 4/5/00
  • Biotech Reports from Soapbox.com