1 Number All Biotech Investors Need to Watch

In the world of biotech investing, stocks can either soar or plummet depending on clinical trial results. This industry is filled with small-cap companies working toward approval from the Food and Drug Administration and spending millions of dollars on clinical development. Sadly, many run out of cash before they get the chance to commercialize their potentially lucrative drugs.

It's not easy to know when to buy and when to sell in this sector, but investors can avoid losing out by closely monitoring one number: the cash burn rate.

Before we get into how to calculate burn rate and how it relates to five up-and-coming biotech stocks -- including MannKind (MNKD 1.24%), Amarin (AMRN 2.37%), Dynavax (DVAX -0.52%), Geron (GERN 2.79%), Sarepta (SRPT 0.51%) -- let's take a quick look at a case study.

A cautionary tale
EPIX Pharmaceuticals had all the trappings of an ideal growth stock in 2006. It had just merged with Predix Pharmaceuticals and enriched its pipeline with a slew of late-stage developmental drugs for the treatment of hypertension, depression, and Alzheimer's disease.

Three years -- and millions of dollars in R&D expenses -- later, EPIX sent investors a frightening SOS in what would be its final quarterly earnings report:

To continue operations beyond August 2009, we must raise additional capital. If we are unable to obtain such additional funds, we will not be able to sustain our operations and would be required to cease operations and/or seek bankruptcy protection.

Despite getting a product to market and having three drugs in clinical trials, EPIX struggled to generate revenue and build up enough cash to keep the company going. It extinguished its Bunsen burners, auctioned off its intellectual property, and liquidated its remaining assets in 2009.

Unfortunately, the pharmaceutical and biotechnology industries are littered with stories like that of EPIX. This should be a reminder that all health care investors need to keep an eye on how much money the companies in their portfolio are spending each quarter.

How to calculate burn rate
The burn rate, sometimes referred to as negative cash flow, tells you how much money a company is spending. Companies with a high burn rate, like biotechs that don't yet have a drug on the market, typically aren't generating any revenue to offset expenses.

There are different ways to determine a company's burn rate, but a simple back-of-the-envelope approach is to add capital expenditures to the negative cash flow from operating activities. You can readily find both numbers for free on websites like Yahoo! Finance or in the financial statements of a company's SEC filings.

As an example, let's calculate the burn rate for MannKind, which is developing an inhalable insulin drug called Afrezza. Its negative cash flow was around $25 million last quarter, and it had $125,000 in capital expenditures. Given these numbers, the company's burn rate during the last quarter was about $25.1 million, or $8.4 million per month.

How much gas is left in the tank?
EPIX went bust because it didn't have enough cash left in the bank to cover its operating expenses. It looks like MannKind could be heading down the same road; it reported a total of $32 million in cash, cash equivalents, and short-term investments on its balance sheet last quarter. At this rate, the company should theoretically run low on money by the third or fourth quarter of this year.

Trying not to get burned
Cash burn is a quick way to feel the pulse of your stock, but it doesn't tell the whole story. In the case of MannKind, for instance, the company can borrow several million dollars as part of a loan agreement it has with The Mann Group. It may also issue $500 million in a variety of securities, and, while this could dilute current shareholders, this should enable the company to finish its Afrezza trials.

Let's take a look at the burn rates of some other prominent biotech companies that have drugs that have either been approved or are in clinical development:

Source: Yahoo! Finance. Cash on hand = cash, cash equivalents, and short-term investments. MRQ = most recent quarter.

Amarin seems to be in the best shape here. Its hypertriglyceridemia drug, Vascepa, was recently approved by the FDA. Amarin is still unsure if it'll market the drug independently or link up with a larger pharmaceutical company, but it has plenty of cash to keep operations going while it sorts out its commercial approach.

Dynavax's Hepatitis B vaccine is currently under review at the FDA, and the company has enough money available to carry on well past the decision date in late February. In fact, it can operate for another two and a half years at the current burn rate. If the vaccine is approved, its money can be used for commercialization. If the FDA issues a rejection, however, Dynavax may have to invest in more clinical development.

Geron can carry on for another two years based on the financial information from last quarter, but it took a massive blow when one of its four imetelstat cancer drug trials was canceled in September. The company also stated that a second trial won't progress to phase 3 trials. Shares plunged on this news, and we'll have to wait and see the results from the company's other studies to determine the future of this stock.

Sarepta seems to be the most vulnerable of the bunch in terms of cash burn, but the stock jumped almost 200% in a single day after releasing positive data from its eteplirsen Duchenne muscular dystrophy drug trial. The company has about a year of cash left based on last quarter's data, but this week's promising results may attract more investors.

Foolish roundup
Unfortunately, there is no magic formula for biotech investors to follow. A company that has a low burn rate could tank in the long term if its clinical trials fail, while a company with a high burn rate can recover with promising drug results or by triggering a milestone payment from a strategic partner. However, as part of your investment analysis, it's essential to monitor cash burn every quarter, watch for any moves that could dilute your holdings, and avoid companies that could end up in the same unfortunate situation as EPIX.