FOOL ON THE HILL

A Visible Error in Judgment

When investing in emerging companies with a new technology, watch out for those companies that have consciously decided to take the riskiest course in order to maximize the eventual payoff. Penetrating emerging markets with a new technology inevitably takes more time and money than anticipated. As Visible Genetics has shown, managements that bet the company on immediate success will often lose that bet.

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By Zeke Ashton
July 2, 2002

Visible Genetics (Nasdaq: VGIN) was on top of the world in the spring of 2000. The company's stock had hit $100 a share in March, making Visible Genetics, for a short time at least, a billion-dollar company.

Fast-forward to the present day. In the two years since the stock's crazy run-up, Visible Genetics has succeeded in getting its product approved and to the market. In fact, the company's TruGene product remains the only Food and Drug Administration-approved DNA sequencing system for HIV, and Visible Genetics is now developing additional products for Hepatitis C and B.

Given the above, it has been an incredible disappointment for shareholders to watch their stock drop all the way down to around $2 in recent trading. How Visible Genetics managed to succeed in getting a unique and valuable product to the market only to drop in value by 97% in two years constitutes an interesting lesson for investors who target technology companies in emerging markets. What happened to Visible Genetics, and why did the shares fall so dramatically?

Founded in 1993, Vancouver, Canada-based Visible Genetics jumped into the market's favor by virtue of an early lead in one of the sexy buzzword areas of biotechnology. Pharmacogenomics is the idea that patients with different genetic characteristics can be better targeted for treatment by applying specific drugs applicable to their genetic type. No disease better exemplifies the potential for applying pharmacogenomics than HIV.

The standard weapons in the anti-HIV drug arsenal include a cocktail of protease inhibitors and reverse transcriptase inhibitors that work to suppress the virus. HIV requires frequent changes to the drug cocktail therapy because the virus replicates itself with amazing proficiency, and introduces mutations as it does so. As the virus mutates, it builds up a natural resistance to the drugs used to treat it. That's where genotyping comes in. By using genetic testing devices such as Visible Genetics' TruGene, doctors are able to identify the genetic changes in the virus to predict which drug regimen is most appropriate and to change drug therapies before viral loads begin to spike.

The clinical trial data for TruGene showed very strong evidence that genotyping improves HIV patient care. In one large European study, for example, 32% of the patients that were treated based upon genotyping had undetectable viral loads after six months, versus only 14% for those patients who received standard treatment alone.

There are an estimated 350,000 treated HIV and AIDS patients in the U.S. If every patient received a genotyping test only twice per year, that's 700,000 tests a year. At an average of $350 per test, that's a big market -- about $250 million per year. And that's just the U.S. Hence, the high hopes for Visible Genetics.

Visible Genetics' $90 million cash position entering 2001 was largely the result of two rounds of privately negotiated financings in 1999, both at prices in the low teens, and one secondary offering to the public in early 2000 (of two million shares) at $38. The three financings had raised a total of $128 million, but had of course also resulted in the dilution of the company's shares -- dilution that looked pretty bad when the stock was trading north of $50. However, the company had burned through $42 million of its cash in the year 2000, and burned another $15 million in the first quarter of 2001.

The company submitted its application for marketing approval with the FDA in September of 2000, and received regulatory approval for TruGene in Canada in July of 2001. Despite these events, the stock had dropped from the mid-$30 range down into the mid-teens by May, in tandem with the continued Nasdaq slide and impatience with the approval process in the U.S. The stock popped back above $25 upon the welcome news in September that the company had received regulatory approval in the U.S.

With a ramp-up in spending needed to build the company's sales force, market the newly approved product to doctors, and transfer the manufacturing from Pittsburgh and begin full-scale production in Atlanta, the company's $80 million in cash was looking a little meager. Nevertheless, CEO Dick Daley seemed confident that the company would not have to raise additional funds.

Essentially, the company was in a race to turn profitable before running out of cash, which it was burning at the rate of between $10 million and $15 million a quarter. After burning $20 million in the last calendar quarter of 2001, management finally bowed to the inevitable, raising $22 million in a private financing at a price of $8.34 per share. Once again, Daley professed his confidence that the cash raised would be enough to see Visible Genetics through to profitability. Once again, Daley was wrong.

On May 30, the company cancelled its scheduled conference call, dropped its revenue guidance from $32 million to $37 million to $20 million to $25 million, and announced it was considering various strategic alternatives, including the sale of the company. The press release noted that any sale of the company would likely bring only a "modest premium" to the company's share price, which dropped from over $5 in mid-May to $2.52 by the end of the day of the announcement. I started buying at under $4 on the assumption that an acquisition was likely and that the company would receive at least $5 per share in any buyout.

The classic (and most likely fatal) mistake that Dick Daley and Visible Genetics made was that they were bound and determined to be a global, fully integrated diagnostics company from the onset, and never made the moves that would have increased the company's chances to survive if things didn't go perfectly according to plan.

There were plenty of opportunities to raise money at very attractive valuations, but the company waited until it was clear that there was a risk of running dry to do it, thereby ensuring horrible terms. Say what you want about former biotech darlings like Celera Genomics (NYSE: CRA) and Human Genome Sciences (Nasdaq: HGSI), but the management of those companies raised enough cash to ensure that their outfits would be able to survive a decade or so without any further capital. They will live to play on.

When entering an emerging market with a novel product, one has to be prepared for the possibility that it will take longer than expected to reach critical mass. Unfortunately, it's clear that at every junction, the management team at Visible Genetics consciously determined to embrace risk in the hopes of high reward. Now that it's clear Visible Genetics won't survive as an independent entity, the value produced by the company will be lost to its shareholders and will likely rather accrue to the company that buys Visible Genetics at a fraction of its true value.

Dick Daley's only recourse now is to try to salvage as much value as possible for shareholders. My assumption is that for any competitor, it would be far easier and cheaper to buy rather than build. Visible Genetics has invested $50 million into research and clinical testing, has about $30 million in cash left, and still has a promising product and very valuable technology. I would estimate that Visible Genetics' value to another company would be at least $100 million. At a recent price of $2 and change, the company's market cap is only $40 million.

Unfortunately for Visible Genetics shareholders, as of this writing there still has been no deal, and the value that the company will receive in a buyout likely deteriorates a little bit for each day that passes. One can only hope that Visible Genetics doesn't blow the company's last chance to salvage whatever it can for its shareholders.

At the time of publication, Zeke Ashton owned shares of Visible Genetics. The Motley Fool is investors writing for investors.