FOOL ON THE HILL
Bargain Bin Biotechs: Deals or Dogs?

Though flush with cash from the biotech financing boom, some companies are now selling close to or below net cash per share. There's a reason: Their business prospects are poor and their cash burn high. But one biotech tool maker is growing sales. It's risky, but worth watching.

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By Tom Jacobs (TMF Tom9)
May 23, 2002

In more stable times (when are those?), companies rarely go public without a few years of solid business performance to show investors. Think Microsoft (Nasdaq: MSFT) in business for years and profitable before its IPO.

But in a strong bull market -- particularly its late stages such as we saw in 1999-2000 -- many development-stage unprofitable companies jump at the chance to sell stock to fuel their growth to hoped-for profitability. This can be through an initial public offering (IPO), or, if the company is already public, by selling more shares. Capitalism is not pretty, of course, and the recent boom's end left many companies unable to use even their newly raised cash to their advantage. Bankruptcy lawyers, twiddling their thumbs throughout the 1990s, are now the profit centers of many firms.

So when the boom ends, many of these companies find themselves with oodles of cash but still years to profitability. When their stocks get hammered as investors move their money to companies with more of a profit history, the stock prices approach or even drop below cash per share. Are they deals?

It depends. There's usually a reason they're selling for close to or less than cash: The market expects them to continue to burn through it, with little or no prospect of future profits. Call it the winnowing-out process, or just Darwin on Wall Street. In the boom, optimism reigns, and in the following bear market, only the strong survive. Now that the markets are less friendly, will a company be able to raise any more cash? Or will the only option be the neighborhood loan shark, providing terms that will be more curse than blessing?

Biotech boom and bust
Take companies using or making shiny new biotechnology, companies either in the biotech (or genomic, proteomic) tools business or using them to boost health care through drugs, diagnostics, and the like. (And you can join our great community of investors sharing biotech information on our Biotechnology discussion board.) Many benefited from the 1999-2000 boom in which the public markets were willing to finance these companies' development. That willingness collapsed after March 2000 and has only recently returned, with a surprising number of small biotech IPOs in the past few months. Biotech booms come and go, and for now, if you aren't cash flow positive -- and biotech drug makers typically must survive 10 or more years of cash burn until they even think of having a drug on the market -- you won't have an easy time selling new shares, or convertible debt, or even stuffing a PIPE (private investment in public equity).

Take CuraGen
Consider unprofitable, development-stage biopharmaceutical hopeful CuraGen (Nasdaq: CRGN), whose shares closed yesterday at $7.95, a 19% discount to its $9.79 cash per share. Should you exclaim, "What a deal!"?

Not so fast, Buffett Jr. On closer inspection, wearing those cartoon Coke-bottle glasses, you see that CuraGen has $6.63 a share in net cash, which is (cash plus short- and long- term investments) minus (short and long term debt + preferred shares) all divided by average shares outstanding. So actually, the shares sell for 20% more than net cash per share.

Still not bad, you say. The company has proprietary technology and a sweet deal with Bayer AG that should yield significant revenues, but the trouble is that it's not bringing in a lot of cash right now. In fact, so darned little that CuraGen burned through $68 million in cash in the last 12 months. With $324 million in net cash and with revenues at current levels, CuraGen will need to find new sources of capital in 4.8 years. That's why it's selling for only 20% more than net cash.

Selling for net cash
I ran a screen on biotech companies selling for equal to or less than 110% of cash and with a share price greater than $1. Thirteen companies showed up, and I computed net cash per share for them:

                Price Cash/       Net Cash
Company    5/22 Close Share    %    Share   %
Pharmacyclics   $4.90 $8.15  -40%  $8.15 -40%
Precis Pharm.    3.10  5.00  -38%   4.35 -29%
Maxim Pharm.     4.19  5.36  -22%   5.24 -20%
CuraGen          7.95  9.80  -19%   6.63  20%
Alexion Pharm.  15.75 18.81  -16%  11.98  31%
Zymogenetics    10.55 12.28  -14%  12.28 -14%
Arena Pharm.     7.50  8.10   -7%   8.07  -7%
Celera Genomics 13.90 14.54   -4%  14.07  -1%
Nanogen          3.20  3.14    2%   3.00   7%
Incyte Genomics  7.67  7.36    4%   4.68  64%
Cell Genesys    14.61 13.88    5%  12.19  20%
Aclara Bio.      2.30  2.15    7%   2.14   7%
Caliper Tech.    7.57  6.88   10%   6.65  14%

True, this is a rough cut, because there is debt and then there is debt. For each company, you would need to investigate further the nature of debt (convertible bonds, preferred shares, etc.), its terms, and so on. But Alexion Pharmaceuticals (Nasdaq: ALXN), Incyte Genomics (Nasdaq: INCY), and Cell Genesys (Nasdaq: CEGE)don't look as good on a net cash per share basis as they did on pure cash per share.

Burning through the cash
And what about cash burn and survival term?

               Net Cash TTM Cash % of  Survival
Company         Cash     Burn     Cash Term
Pharmacyclics  $224 mil. -$43 mil. 19%  5.2 yrs
Precis Pharm.   132       -33      25%  4.0
Maxim Pharm.    122       -33      27%  3.3
CuraGen         324       -68      21%  4.8
Alexion Pharm.  217       -30      14%  7.2
Zymogenetics    147       -27      18%  5.4
Arena Pharm.    215       -22      10%  9.7
Celera Genomics 910       -78       9% 11.7
Nanogen          65       -33      52%  1.9 
Incyte Genomics 313       -75      24%  4.2
Cell Genesys    434       -60      14%  7.2
Aclara Bio.      76       -24      31%  3.2
Caliper Tech.   145       -30      21%  4.8

With these rates of cash burn, the only companies I would want to investigate further are tool makers with increasing revenues or drug makers with near-term prospects for approved drugs.

The criterion for tool makers is important: The 1999-2000 financing boom brought public a gazillion companies with technologies for high-throughput genomics and proteomics research. There is too much product chasing large and small drug makers, and there is no more increase in newly public companies to provide new customers. Companies will need to consolidate or go out of business. So, any tool makers that are increasing revenues in these poorer times must have products people want and be doing something right. For drug makers, they need good drug prospects either to market themselves or strike favorable partnerships, considering the enormous risks of failure. And I'm not willing to gamble on a drug maker whose whole future currently is one drug.

Rate of sales growth
Let's look at year-over-year sales increases for each company's most recent four quarters:

           % Year-Over-Year Sales Growth
              Most Recent Four Quarters      
Company          Q1   Q2   Q3   Q4
Pharmacyclics    -- -100% 1250%  0%
Precis Pharm.    --  -95   -66 -68
Maxim Pharm.    -33% -50   -30 700  
CuraGen         -16    6    22  27
Alexion Pharm.    6  -44   -18 -56
Zymogenetics    133  -77   N/A  N/A
Arena Pharm.    -22   44    52 154 
Celera Genomics  73   49    81 113
Nanogen         -23   -9    13  26
Incyte Genomics -43   -1    10  22
Cell Genesys     44  -10   -20  30
Aclara Bio.     -23   43   -44 -20
Caliper Tech.    46*  58    20  26

*$5.0 in litigation settlement payment excluded from prior year quarter.

The sales figures are so lousy for the drug makers, reflecting their dependence on one   product candidate for survival in the next few years. None merit a closer look, unless you are a drug science expert.

At first glance, it looks like Celera Genomics (NYSE: CRA) is booming, but think again. All its growth came in its bioinformatics business, which it has more or less consigned to its sibling-tracking stock, Applied Biosystems (NYSE: ABI). Like Incyte Genomics, Celera proposes to reorganize its business to focus on drug making and diagnostics, and who knows where that's going. It could strike a huge deal with a big pharmaceutical company tomorrow giving it a better shot, but I'll believe when I see it.

What about Caliper?
Another one that jumps out at me is Caliper Technologies (Nasdaq: CALP), with 46%, 58%, 20% and 26%  year-over-year sales growth for the last four quarters. Its lab-on-a-chip technology allows huge scale testing and analyzing that "miniaturizes, integrates, and automates many laboratory processes." Caliper has shifted business strategy from technology licensing to commercial sales, with the most-recent quarter showing 38% increase in product volume growth and a 287% increase in sales of high throughput system products to commercial customers.

A key feature of Caliper is its exclusive partnership with Agilent Technologies (NYSE: A), which makes and markets classy equipment to deploy Caliper testing technology and analyze its results. But this month Caliper did something quite interesting. It notified Agilent that it intended to end its exclusive collaboration agreement as of May 2003. This could be a negotiating ploy or, more likely, Caliper has prospective partners with whom it can also make money. This is all pure speculation, but if Caliper management were worried, it likely wouldn't be risking its relationship with a 30% customer.

Other risks are that Caliper currently derives 24% of revenue from sales to related-party Amphora Discovery Corp., 30% from Agilent, and 13% from one other unidentified customer. Wow. I'd want to track down more on the related-party information. Also, while Caliper has settled its patent lawsuit with Aclara Biosciences, I'll keep an eye on its lawsuit against Molecular Devices (Nasdaq: MDCC).

So, you see, there's a reason these companies are selling for close to or at a discount to cash. If you're comfortable with selling short, these companies present some possibilities. But if you prefer to go long and accept some risk, the most encouraging candidate is Caliper Technologies, which is growing sales rapidly and perhaps showing strength through its negotiations with its largest customer. I'm putting it on my watch list until I see the results of the Agilent deal and check further into the related-party transaction, where it's hard to evaluate sales prices between non-arm's length partners.

Have a most Foolish holiday weekend!

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Tom Jacobs (TMF Tom9) is waiting for Life-on-a-Chip technology. At press time, he owned no shares of companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.