Michael Brush
WASGINGTON: With biotechnology exchange traded funds down as much as 20% from their highs last year, it’s now tempting to shop for bargains.
That makes sense, as long as you look among quality companies with earnings and robust pipelines, such as Vertex Pharmaceuticals VRTX and BioMarin Pharmaceutical BMRN
But it’s better to avoid cash-hungry biotech companies with dire funding needs. Shares of such companies are well below their highs, so any funding will be much more dilutive than before the selloff. This means any funding-related stock declines could be big, and the rebounds skimpy.
The “at risk” companies are in the small-cap and mid-cap — “smid-cap” — zone with market caps of $5 billion or less. Some of the best biotech winners are in this zone, but you need to shop carefully.
“Be wary of smid-caps that need to raise money over next 12 months,” cautions Jefferies biotech analyst Michael Yee. “If the market remains challenged, companies that need cash may be forced to raise at lower prices with little choice.”
Yee and his team regularly share screens for these “at risk” companies with clients. The screens are good at predicting trouble. To find the most vulnerable names, the Jefferies analysts take cash levels and divide them by estimated 12-month losses. They get that by annualizing the losses in the most recent quarter. This produces a cash-to-annualized loss ratio, or what I will call a risk ratio. Ratios of less than one suggest the company will have to raise cash in less than a year — which means the pressure is on. The lower the ratio, the higher the risk.
One of those screens last November identified several companies that indeed soon raised capital — to the detriment of shareholders.
• MannKind MNKD which has an inhaled insulin product called Afrezza, topped the list of risky companies in the November Jefferies screen. It had cash of $11 million and annualized losses of $94 million, for a very troubling risk ratio of 0.1. Then on Dec. 19, MannKind issued 26.7 million shares to raise $40 million, which tanked MannKind’s shares by 32%. The stock fell to $1.15 from $1.70, and it has not fully recovered.
• Omeros OMER which is developing an anti-inflammation drug for cataract surgery, ranked high for risk in early November. It had cash of $61 million and annualized losses of $156 million, for a cash-to-loss ratio of 0.4. That made it the fifth-riskiest company of the 50 with risk ratios below one. Omeros did a $210 million convertible debt offering Nov. 8. The stock slumped 25% to $12 from $16, and it still hasn’t fully recovered.
• Axovant Sciences AXON which is developing dementia drugs, ranked high with a risk ratio of 0.7. Its stock fell 10% on outsized volume on Dec. 14 after it announced a capital increase. It has since recovered.
Given that this screen can identify potential landmines, it makes sense to revisit it for an update. I cite six vulnerable biotech companies from the most recent screen, below.
Biotech’s troubles
Before we go there, it’s important to understand why the biotech sector probably won’t be off to the races any time soon. That’s because a strong biotech rally would help these companies by reducing the dilution risk.
1. One reason is that we are late in the economic cycle. Investors are less likely to get excited about riskier names like early-stage biotech.
2. The second is Washington, D.C. With the Democrats in control of the House, expect a lot more drug-price-control proposals in the headlines.
One dramatic example from Vermont Sen. Bernie Sanders would let the Department of Health and Human Services throw out drug patents to green-light generic versions of drugs — if those drugs are priced higher in the U.S. than in Canada, the U.K., Germany, France and Japan. Eviscerating patent law is certainly a novel approach. Presidential contender and Massachusetts Sen. Elizabeth Warren will no doubt campaign hard for drug-price controls. And it’s not just the Democrats. President Trump announced a plan in October to lower some U.S. drug prices by linking them to international prices.
Because of risks like those, Baird analyst Brian Skorney says he has a hard time getting excited about biotech. He has a neutral rating on the sector. You have to give Skorney credit. It’s rare to see sell-side analysts be so openly negative on the sectors they cover. (Skorney and Baird analyst Michael Ulz do cite Vertex and BioMarin as favorites for 2019.)
I’m not predicting these stocks will fall. But they look risky given their funding needs, lower stock prices and cautious outlook for biotech. Cash positions and quarterly losses, below, are as of the third quarter, the most recent data.
1. MannKind’s $40 million capital increase in December didn’t get it out of the woods. It now has $51 million in cash. But given the $96 million annualized loss, it has a risk ratio of 0.5. That makes it one of the top 10 riskiest companies in the Jefferies screen. Afrezza sales are ramping up. And MannKind may net more milestone and royalty payments from partner United Therapeutics. But the bears are not convinced. The short interest remains elevated. The company did not respond to a request for comment.
2. Ironwood Pharmaceuticals IRWD which develops therapies for gastrointestinal disorders, has $312 million in cash and $696 million in annualized losses, for a risk ratio of 0.4. That makes it the fifth-riskiest company in the Jefferies screen. Ironwood has a product on the market for irritable bowel syndrome called Linzess. But sales aren’t high enough to offset funding needs. Ironwood also has several shots on goal, including a possible therapy for acid reflux in Phase III development. And some of the best biotech investors, identified by a system I use for analyzing biotech stocks in my stock letter, Brush Up on Stocks, have substantial positions in this name. This is a positive. The company did not respond to a request for comment.
3. BeyondSpring BYSI just announced a “promising” meeting with the Food and Drug Administration (FDA) to map out a drug application path for its lead cancer drug, Plinabulin. The Dec. 27 news had no lasting impact on the stock — and looming funding needs could be to blame. With cash of $22 million against annualized losses of $48 million, BeyondSpring has a risk ratio of 0.5. That puts it among the top 10 riskiest biotech stocks, by this measure. The company did not respond to a request for comment.
4. Aerie Pharmaceuticals AERI develops treatments for glaucoma and other eye diseases. It has $236 million in cash and annualized losses of $340 million, for a risk ratio of 0.7. One product on the market, called Rhopressa, reduces pressure in the eye. It might get approval in Europe before year-end. But none of this will be enough to reduce the need for a dilutive capital increase before then. This company also has a bullish ownership profile. Aerie Pharmaceuticals declined to comment.
5. Aveo Pharmaceuticals AVEO has $29 million in cash but annualized losses of $88 million. This gives it a risk ratio of 0.3, the worst in the Jefferies screen. Aveo has a promising cancer drug called tivozanib in Phase III development. It thinks it can submit a new drug application by May. But that won’t be soon enough to stave off the cash crunch. The company says it has enough cash to “fund planned operations into the third quarter of 2019.”
6. Myovant Sciences MYOV reports $154 million in cash against annualized losses of $264 million, for a risk ratio of 0.6. Myovant has a drug called Relugolix that may treat uterine fibroids, endometriosis and prostate cancer by regulating hormones. It has another product for female infertility. None of those are far enough along to hit the market soon. On the plus side, Myovant also has a good ownership profile. The company did not respond to a request for comment.
Houdini exit
Not all biotech companies in a tight corner financially end up worse for the wear. Like Houdini, some get out of the jam clean — and in a way that helps investors.
Coherus BioSciences CHRS looked problematic back in November, given its risk ratio of 0.5. But on Jan. 7, it announced a $75 million senior secured credit facility agreement with Healthcare Royalty Partners. Investors rejoiced, at least in part because this is debt, which doesn’t dilute shareholders like a stock offering does. They sent the stock up 40% over the next week.
Courtesy: (marketwatch.com)
