The business model for unprofitable health-care companies has generally been pretty straightforward:
- Do an IPO to get some cash.
- Use the cash to fund research, which hopefully increases the value of the company.
- Do a secondary offering -- diluting shareholders, but with a smaller piece of a larger pie, no one complains too much.
- Rinse and repeat.
It works pretty well until you throw a bear market into the mix. When the value of companies drops even though they haven't had any bad news, the secondary-offering step becomes very costly for current shareholders, since it requires more dilution to get the same amount of cash.
Not everyone is having that problem
Instead of destroying shareholder value, Exelixis was able to grab cash by licensing out a pair of drugs in development to Bristol-Myers Squibb
Timing is everything
Some companies don't really have to worry about the ups and downs of their stock prices through this bear market. They're flush with cash because they made timely decisions before the market dropped.
Running out of time
A recent report from the Biotechnology Industry Organization (BIO) said 30% of small biotechnology companies have less than six months of cash remaining. Fortunately, most Fools won't have to worry about that. As long as you're not bottom-fishing in the penny stocks, you're probably OK. Here's a big hint: If the company is trading for more than cash on hand, that's a good indication that a lot more due diligence is needed.
But it's not just penny-stock biotechs that might need to sell their souls to stay alive. Some health-care companies with products to sell might be on the hook if the economy and the stock market don't turn around soon.
For instance, at the end of the third quarter, Hansen Medical -- which has a catheter-guiding robot on the market, but isn't yet cash-flow positive -- had a little more than $45 million in the bank. It used up that much cash through operations over the previous 12 months. Unless hospitals suddenly have a change of heart and start buying big-ticket items in large numbers, Hansen is going to need to get a hold of more cash sooner rather than later. However, since it’s currently trading at less than half its IPO price, now doesn't seem like the best time to do that secondary offering -- though it did raise more than $39 million in the second quarter last year, when the price was about three times today's level.
So what's the take-home message here? Investors have to go beyond the science and look at the financials of the companies before they invest. While many drug companies will make it through this bear market, just like they did the last, investors need to be careful. It might be wiser to invest in companies with stashes of cash that are well-poised to do the buying instead of the selling.
Vertex Pharmaceuticals, Hansen Medical, and Exelixis are Motley Fool Rule Breakers picks. Find out why by grabbing a 30-day trial subscription. You'll get access to all our back issues and the most recent picks.
Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. Johnson & Johnson and GlaxoSmithKline are Income Investor picks. The Fool owns shares of Exelixis. The Fool has a disclosure policy.