Rule Breaker to Short Affymetrix
June 20, 2001

**This trade is being made under the regular portfolio policy, namely, once The Fool announces an intention to trade, that trade will be made within the next five trading days. For more detail, please read our Trading Policy.**

Affymetrix, Inc. (Nasdaq: AFFX)
3380 Central Exwy
Santa Clara, CA 95051
Tel. 888-DNA-CHIP (888-362-2447)
Fax. 408-481-9442

Closing price (6/20/01): $21.96
Average daily volume: 2.1 million shares
Daily dollar volume: $46.1 million

Market cap: $1.26 billion
12-month sales: $215.5 million
Price-to-sales ratio: 5.9

Transaction Stats:
On June 21, 2001, the RB Port shorted 1150 shares of Affymetrix at $21.61 per share.

AFFY Quote | AFFY Snapshot | AFFY Chart | AFFY Financials | AFFY Estimates

When I think of shorting stocks, I can't get out of my head Homer Simpson singing "Short Shorts." (The classic episode was "Homer the Heretic," for all of you fans.) We should have him as a singing icon in our column. It would probably only take about a zillion hours of techie time -- and mucho dinero for license fees -- but it would be classy, no doubt about it.

After all, you'd better have some humor around if you publicly admit to shorting a stock or even window-shopping at the shorting store, because you must prepare to be attacked, reviled, drawn, and quartered. But we are strong, we can take it. That's why all but one of us took one step back, leaving Jeff Fischer to take the first hits with his Monday column making the case for shorting short shares of biochip and analysis equipment maker Affymetrix (Nasdaq: AFFX). After Jeff's courageous act, I'm hoping that there are no more rotten vegetables left to hail upon me in cyberspace.

We believe that short selling is a helpful tool for an advanced investor's kit. (Thursday morning we'll run a special with plenty of resources for the Foolish shorter.) And showing you that we aren't completely gonzo with biotechnology stars in our eyes, we're willing to consider a short of a company that provides biotechnology tools.

Closed situation
My hobby horse today is one very important criterion Jeff mentioned: When we short, we think it's important to short stocks of companies whose businesses are in a closed situation.

A closed business situation means that there is a ceiling to the company's product markets. That our company is bumping its head against it, with little or no chance that it will exit a door or window and fly unfettered to other markets. In the world of biotechnology, that's the case for companies using biotechnology to improve drug discovery, and that includes biotech tool makers like Affymetrix. Some other representative names in this area are Lynx Therapeutics (Nasdaq: LYNX), Caliper Technologies (Nasdaq: CALP), Aclara Biosciences (Nasdaq: ACLA)Nanogen (Nasdaq: NGEN), Celera Genomics' (NYSE: CRA) sibling Applied Biosystems (NYSE: ABI), Beckman Coulter (NYSE: BEC), and Invitrogen (Nasdaq: IVGN).

These biotechnology tool makers sell to the same three markets: academic researchers, the 300 or so public and private companies developing biotechnology to sell to others, and about 12 big drug makers -- big pharma. (Included in the 300 are some companies using new biotechnology to try to move into the world of big pharma.) This means that there are just so many entities in the world with the money to buy DNA sequencers, biochips, lab-on-a-chip testing devices, and associated equipment such as reagents, analyzers, and other biotech whiz bangs, framuses, and whats-its. I don't see any way that this world will expand, and anyone selling to these markets simply does not have increasing possibilities. Why?

Where's the customers' cash?
For one, the money tap is turned off. We have just been through probably the biggest public-financing boom in biotechnology history. Many emerging companies, including our two holdings Celera Genomics and Human Genome Sciences (Nasdaq: HGSI), used the opportunity to obtain huge amounts of financing to come as close as possible to ensuring their survival until they reach  profitability -- to make sure they don't burn out

That boom saw dozens of development-stage companies go public, giving them the money to buy equipment and fueling a temporary boost to the tool makers. This was exactly what happened with the so-called Internet company IPO frenzy, which temporarily inflated the revenues of companies providing Internet infrastructure. For biotech companies, that world is limited -- until the next boom, if there is one. The markets can expand again for the tool makers only if biotech stock prices fly again, giving companies the ability to issue new stock for more cash or encouraging more private companies to raise capital by going public.

It is true that Affymetrix's GeneChip DNA arrays are not yet commodity products. They are protected by iron-clad patents -- patents that have been repeatedly tested in court. As one CEO of a bioinformatics company put it, Affymetrix owns the process for putting anything on a glass slide with photolithography (laser application, the same process used in applying stuff to semiconductors). And it charges premium prices for GeneChips.

But the GeneChip is not a sine qua non. As alternatives and competition grow, Affy's revenues will be squeezed. Jeff pointed out the heavyweight competition in biochips from new entrants Motorola (NYSE: MOT), Agilent (NYSE: A), and Corning (NYSE: GLW). However, there are already alternatives in the standard and customized array world, especially if you are willing to make the trade-off between the price of an array and its comprehensiveness (number of DNA probes and accuracy, for example). Many companies are.

No expanding pie
Biotech tool makers market their products to the deepest pockets -- big drug makers -- as ways to cut the drug development costs, whether through faster target identification, quicker drug candidate discovery, or better clinical trial testing. For example, Joshua Borger, CEO of Vertex Pharmaceuticals, has said that his company aims to lower development costs per successful drug from today's $500 million to below $250-$300 million.

But I don't think that reduced costs mean that the pie grows, and that the biggest, deepest source of cash for the tool makers, big drug makers, will increase their R&D spending. Nope, I see a zero-sum game along these lines: Better tools lower development costs per drug candidate, which means higher profits for successful drugs. But since the same biotech advances lead to drugs that can be better targeted to patients'  genetics (pharmacogenomics), it is very possible that we are moving toward a world of more drugs geared toward smaller patient markets. Sure, each will cost less to produce, but each will earn a smaller return on investment. Result? Same pie split into smaller parts, no net gain in spending on the research tools.

Since I am no economist, someone will undoubtedly point out the flaws in this argument. But I'm sticking by the story that it doesn't change the fact that Affymetrix and a host of other biotech tool makers have hit the ceiling and have nowhere to go. Affymetrix stands now at a $1.2 billion market cap. It has $50 million net cash minus debt. Its other assets amount to a little more than $100 million. It has never produced $1 in annual operating cash flow, much less free cash. Its prospects for doing so in the future seem limited.

For that reason, we don't see much value in this company, and surely far less than $1.2 billion. Hence our short.

There are always risks
Yes, Affymetrix has made some moves beyond its core GeneChip array business. It purchased bioinformatics company Neopmoprhic and formed Perlegen to move into functional genomics, but we said last October that those moves were too little, too late. I see three main risks in shorting Affymetrix:

  • Speculation will reignite and catapult the stock price of any company with a link to biotechnology.
  • A company will buy Affymetrix for a huge premium.
  • Affymetrix will develop consumer products without anyone finding out and sell them quickly for big money with no warning.

We think none of these is a real risk in the current situation, but we plan to monitor our short sale and limit our losses by covering should the stock jump appreciably above our short price.  

Our British siblings
Finally, we'd be remiss if we didn't point out that The Motley Fool UK's Rule Shaker Portfolio owns Affymetrix. Last Friday, James Carlisle pointed out the recent revenue problems with the company and stated, "Affymetrix's warning is rather more worrisome." I recommend the column for its discussion of the company's own statements on its revenue "visibility." We don't coordinate portfolios with the U.K., and we think it's great to have as many perspectives as possible on a company and on investing.  

Decision time and the nuts and bolts
There you have it. We've made our decision to short $25,000 of Affymetrix. Following The Motley Fool's portfolio trade rules, we will direct our discount broker to borrow shares within the next five trading days. Our upside goal for this short is somewhere in the region of 50%. When Affymetrix nears a $600 million market cap, or about $10.50 per share, we'll consider covering. Shorts are a short-term bet by nature, but we have no time frame for the position.

Oh, but you're wondering, what are we selling to short Affymetrix? The answer is: nothing. Since we're borrowing shares and selling them, we don't need any cash to do so. We'll be on margin to the tune of 5% of our portfolio, which is an acceptable level to us.

When we cover the short -- that is, buy the shares back and return them to the generous soul who lent them to us -- we'll have to pay. If the price is higher then, we'll have to come up with some dinero, but we'll cross that bridge when we come to it. We may soon solve our liquidity problem by introducing new cash on a regular basis. David Gardner will address this issue on Friday.

Let the games begin