The real-money, all-public, back-crackin', rule-smackin' Rule Breaker Port hasn't held a short sale position since late 1999, when we closed out Trump Hotels & Casino Resorts (NYSE: DJT). What's wrong with us?
Shorting stocks is not for everyone, but it does have a place in our risk-embracing strategy. When we short a stock, we're betting that the share price will fall, and if we're correct, we'll actually make money on the stock's decline. Late last year, the incomparable and usually incorruptible Brian Lund said, "Let's Short Something!" We haven't done so yet, but for more information on shorting stocks, see that column or the Fool's FAQ, because we might short somethin' soon.
When we do short, we aim to short companies that have very limited or "closed" business situations; ideally, the companies also have weak cash-to-debt positions, lack profits, and have recently indicated that business is weakening. Lo and behold...
Last week, DNA chip technology producer Affymetrix (Nasdaq: AFFX) announced that its second-quarter results would not meet expectations due to weakened demand for its GeneChip product line and further weakness in its spotted array instrumentation business.
Let's back up.
An estimated 30,000 to 100,000 genes -- the number is fiercely debated -- exist in each human cell. Scientists of genomic medicine want to know each gene's function and how and why that function is turned on or off ("expressed") in certain tissues and diseases. Affymetrix designs and manufactures products that tell researchers if a particular gene is present in a given sample to help them determine the gene's function and expression. Products that make this possible are often lumped together under the umbrella term "biochips." These include DNA arrays, microarrays, spotted arrays, gene chips, and probe arrays. Without the aid of these recent inventions, biotechnology could drown in too much information without a good way to interpret it.
Offering several products, Affymetrix is a pioneer and leader in the biochip field. It earned $200.8 million in revenue in 2000, up from $52 million in 1998. Customers include Pfizer (NYSE: PFE), Merck (NYSE: MRK), GlaxoSmithKline (NYSE: GSK), Eli Lilly (NYSE: LLY), Gene Logic (Nasdaq: GLGC), and several other pharmaceutical and biotech firms, along with several universities and not-for-profits. Gene Logic and the large pharmaceuticals are its biggest customers, but reduced spending by the pharmaceuticals resulted in weaker second-quarter sales. Consolidation in the pharmaceutical industry, and in biotechs, is making companies more hesitant to spend, and, in the end, leads to fewer individual clients for Affymetrix.
Second-quarter revenue at Affymetrix is expected to land between $44 million and $50 million. Revenue the previous four quarters, starting with the most recent, was $54 million, $59 million, $55 million, and $45 million, so the current quarter's revenue will be in a range not seen for four quarters. Affymetrix stated that it does not expect further weakness in its overall business, but results will be "sporadic" for at least the next two to three quarters -- which we interpret to mean "not great."
Impressive business, but limited market
Affymetrix has accomplished a great deal and it has our respect and admiration for that. Heck, most of the major pharmaceutical companies are already "Affy" clients. But that's precisely part of the reason we're considering it as a short. The company's blazing heyday may have already burned down to a smolder -- the days when it was signing new clients left and right, stomping through an industry devoid of much competition, and growing revenue like a young whipper-snapper. Those days. They seem gone.
These days, few large clients remain to be landed. Competition is emerging from the likes of Corning (NYSE: GLW), Agilent Technologies (NYSE: A), and Motorola (NYSE: MOT), and Affy's revenue is flat to down. Most importantly, though, is that we believe Affymetrix is operating in a closed situation. Despite its claims that someday it will sell GeneChips to consumers, for now and for the near future its customers are limited to companies and universities that are engrossed in science. That's great -- what an important market! It's life-changing! But the revenue potential is limited.
Corning estimates that the biochip market will be a $1 billion industry in 2005. Affymetrix already has $200 million in annual sales and is still valued at $1.3 billion. Profit expectations for 2002 continue to decline, and the company's cash balance -- at $423 million -- is not much larger than its $375 million in long-term debt. Furthermore, the trend in technology businesses calls for product prices to decline as products mature and as more competition arises. (The company's competitive advantage is patents, but competitors are working around those.) Put the pieces together, and we have a simple formula for a short:
- Limited market size, much of which is already captured
- A profitless operation that is incurring losses, holds not much more cash than debt, and has slowing sales growth
- Increasing competition and the likelihood for declining product prices
- An aggressive market value of $1.3 billion, which we'd hope to see decline to a still-healthy $600 million if we shorted the stock
Last October, Tom Jacobs devoted an entire column to biochips and another to the potential at Affymetrix. Those are must-read columns if you're considering this company, long or short, and before Tom continues our discussion of Affymetrix on Wednesday. Until that column, please share your thoughts on the company and what's right and wrong with our thinking. Should we short Affymetrix? We aim to decide on Wednesday.
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Jeff Fischer is somewhat short at five feet, eight inches tall. Of the companies mentioned, he owns shares of Pfizer. You can view his other holdings in his online portfolio. The Fool has a full disclosure policy.
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