Successfully developing and commercializing next-generation medicine is incredibly difficult and expensive, and while some companies have the financial firepower to cross the finish line, many biotech stocks will run short on cash before then.
In this clip from The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes and contributor Todd Campbell explain why cash and equivalents can be the most important thing that investors need to know before buying biotech stocks.
A full transcript follows the video.
This podcast was recorded on Sept. 7, 2016.
Kristine Harjes: Our next lesson is something that applies to all sectors, beyond just healthcare. That is cash and equivalents. This elevator pitch here -- it's basically the very top line on your balance sheet. It's the most liquid thing on the balance sheet. It means everything that can be converted to cash immediately. That could be actual cash, but it could also be your bank accounts and Treasury bills or government bonds that have a maturity date of three months or less. It could be money market holdings. There are a whole bunch of things that fall into this category. But the thing to remember is that it's your cash and things that are equivalent. It's things that are pretty much cash, because you could turn them into cash so quickly.
Todd Campbell: Right. Not only is it the top line of the balance sheet, but it should be top of mind for investors. I don't think there's a stock that I invest in that I haven't taken a look at the balance sheet to evaluate how much liquid money they have available to them. That's really what we're talking about when we're talking about cash and equivalents. We're talking about the money they can free up within 90 days or less and be able to use to take action, either paying debt, paying costs associated with running their business, whatever. Cash and equivalents is must-know news for any stock, but it really comes into play and is of particular interest is for healthcare investors.
Harjes: Absolutely. One of the reasons that this matters is so much to healthcare, and why were talking about it on any of the shows it's because of cash burn and biotech. If you're a company that doesn't have a product on the market, you need to watch how much money you're spending every single quarter really, really closely. The change in balance of your cash from quarter to quarter is explained in the statement of cash flow. Cash burn is basically how much that balance is decreasing. This is really important, because it can be used to calculate your runway, which is cash balance divided by cash burn. Say you have a million dollars in cash on the books, and you're spending $500,000 a year. That means you have a runway of two years before you're out of money. This can make or break a company.
Campbell: This is a huge issue for biotechnology companies. Previously, we were talking about the complexity associated with developing many drugs, biologics especially. That complexity equals cost. Developing drugs is very expensive. There's so much failure in drug development. 90% of drugs that have begun trials in humans have ended up being discarded rather than making their way to pharmacy shelves. The failure rate is incredibly high, the cost is incredibly high. So, when you have a brand-new biotechnology company that's going out there, they're not only investing big money, but they're investing it over the course of a number of years as they conduct phase 1 trials, and phase 2 trials, and phase 3 trials, and try to convince the FDA to get to the market. Then, of course, they have to spend for marketing, and the feet on the ground to build up awareness for that medicine.
There are so many costs that are associated before you can begin generating commercial revenue from a drug. Historically, the way that biotechnology companies have gotten that funding is going out to venture capitalist or angel investors, and then eventually they've gone public and issued shares. By keeping a very close eye on cash burn, people can get a very good indication of whether or not it's likely that the funding will run out before trials are completed that could actually get the drug to the market. Thus, that would force these companies to go out and either to a dilutive offering, to dilute your ownership by selling more shares in the marketplace, or they'd have to go to banks or private lenders and borrow money at interest rates that may not be favorable. So, you have to keep a close eye on the quarterly cash burn, and make sure you don't end up investing in a company that's going to run out of money too quickly.
Harjes: Right. And the devil is kind of in the details here, because cash can come from a variety of different places. You can have, say, a milestone payment coming in from a partner company. So, definitely, you want to dig in and figure out where that cash is coming from, and the different places that they hold the cash that is on the balance sheet. I'll give one example here.
This is not a company that is of concern to me, but it is an interesting point to note, and we talk about it all the time -- Gilead Sciences (NASDAQ:GILD). Their press release for the second quarter claims that they have $24.6 billion in cash, cash equivalence, and marketable securities. But if you actually look on the balance sheet and start breaking it down, their total cash and short-term investments line item is $8.8 billion. That is composed of $6.5 billion in cash and cash equivalents, plus another $2.6 billion in short-term investments. That is a big way off, that $8.8 billion, from the $24.6 billion in the press release. And the difference there lies in, they have $15.9 billion in long-term marketable securities. So, whether or not that counts as a cash equivalent or not, it could go either way. My point here in telling this story is that you want to stay consistent when you're defining your metrics, just for the purpose of comparison, and you also do want to actually look at the balance sheet and figure out, where is their cash? Where is it coming from? Where is it going out to on a quarter-to-quarter basis?
Campbell: Yeah, doing that will help to protect you from a lot of risk. This is a risky enough industry to be investing in on its own, we don't need to encourage even more risk. The street is littered with biotechnology companies that burned through their cash too quickly, and that caused significant problem for investors. I can think of two right off the top of my head. Dendreon was one, they developed a prostate cancer drug called Provenge. The other more recent one would be, of course, MannKind, which developed an inhalable version of insulin, but they spent so much money, their cash burn was so much greater than the revenue they generated off of that drug, or have to this point.
Harjes: So, those are two examples of companies that historically, in the past, have run into these issues. Are there any on your watch list that you think might be in jeopardy of running out of cash soon?
Campbell: A lot of attention in the past year or so was focused on companies that are developing drugs to treat Duchenne muscular dystrophy, which is a muscle-wasting disease that unfortunately shortens patients' lives. There's a massive need for new drugs to address this condition. Two companies that are working on those drugs are Sarepta Therapeutics and PTC Therapeutics. Those two companies have drugs that work in very novel and unique ways. However, developing those drugs has been incredibly expensive, and both of those companies have raised my eyebrows in terms of what their cash outflow has been relative to what they actually have on their books.
Harjes: Right. So, the lesson here is, if you're looking to give yourself a little bit more safety in your biotech investments, keep an eye on that cash burn.
Kristine Harjes owns shares of Gilead Sciences. Todd Campbell owns shares of Gilead Sciences. The Motley Fool owns shares of and recommends Gilead Sciences. The Motley Fool has the following options: short October 2016 $85 calls on Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.