Every biotech company wants to discover the cure for cancer, Alzheimer's, or Wii knee. Every biotech investor hopes to catch the next Dendreon.
But let's face it -- this is a tough industry, littered with failed drugs and broken stocks.
So why do investors keep trying? When all the pieces come together, the returns are stratospheric. With some due diligence, and a bit of luck, you can succeed in this space. But most investors are too scared to try because they don't know a kinase from a double helix.
Here's a secret: You don't need an advanced degree in pharmacology to find biotech companies with a legitimate chance of hitting it big. Don't start with the science; ignore the sexy story, and look at the cold, hard cash. How does Onyx Pharmaceuticals (Nasdaq: ONXX) stack up?
Burn, baby, burn
Finite financial resources are one of the biggest problems facing biotechs. They need money, and a lot of it. Drug development is very expensive, and biotechs are notorious for quickly chewing through the cash they've raised from investors and their pharmaceutical partners. Before you look at the drug pipeline or anything else, you need to know: Does the company have enough cash to bankroll expensive research and development?
The rate at which a biotech company is depleting its cash is called its cash burn. Almost inevitably, cash levels will get uncomfortably low, and the company will have to raise additional funds, typically by issuing equity and diluting existing shareholders. The less money a company incinerates each year, the better.
A biotech company in a strong financial position will have at least three years of cash on hand. You can calculate this by dividing the company's cash balance by its trailing-12-month free cash flow.
Is Onyx Pharmaceuticals on strong financial footing? Take a look:
|
|
FY 2007 |
FY 2008 |
FY 2009 |
TTM Through June |
|---|---|---|---|---|
|
Cash and short-term investments |
$469.7 |
$418.4 |
$550.1 |
$488.3 |
|
Free cash flow |
($29.1) |
($10.0) |
$33.8 |
($6.5) |
|
Years cash on hand |
16.1 |
41.9 |
N/A |
75.1 |
Source: Capital IQ, a division of Standard & Poor's. Dollar figures in millions. FY = fiscal year. TTM = trailing 12 months. Data is current as of the latest reported fiscal quarter.
Onyx Pharmaceuticals' balance sheet looks good for now. It has $488 million cash on hand. At current spending levels, that money will last for 75.1 years.
The dilution dilemma
Because most biotechs are bleeding money, management's ability to sell the company's story and convince investors to hand over dough is critically important. However, this is a double-edged sword. The company needs the money, but getting it will dilute existing shareholders' ownership stake. That's a tough pill to swallow if you already own shares, but frankly, there's no other choice.
As a shareholder in what you think is a promising company, watching your piece of the pie shrink by 20% is still a better outcome than letting company run out of money, shut down operations, or sell off its assets on the cheap.
How well has Onyx Pharmaceuticals tapped the capital markets? Here's a visual summary of the past few years:
Data is current as of the latest reported fiscal quarter.
Follow the money
The first step toward finding a promising biotech company is not to figure out whether the science is any good, but to make sure that the company is financially healthy. Drug development is a cash-intensive business model, and the real players will have the strong balance sheets and fundraising abilities necessary to play the game. Financially strong biotechs definitely deserve your further research into their drug pipelines' potential. For each contender, you'll want to look at the competitive landscape, the timeline of drug development, and whether or not any of the company's drugs are partnered with large pharmaceutical companies like Abbott Laboratories.
Let us know what you think of the cash flow situation in the comments box below. Or, if you're ready for more research, head on over to our quotes page to view the filings directly.
