AusBiotech’s latest industry survey found that Australian life sciences companies attracted well over $2 billion of capital in the 18 months to May this year. The phenomenal success of a handful of biotech companies has spurred investors’ optimism in the sector with some making huge profits. However, in our experience biotechnology companies remain an extremely risky investment proposition with most failing to deliver shareholders any return on their capital over the long term.
The vast majority of Australian listed biotech companies are single-asset, capital intensive businesses with no or limited revenue. These companies are intrinsically hard to value and their fortunes can rise and fall on regulatory decisions or trial results.
Access to capital
When assessing a company preparing to float it is useful to consider its reasons for listing. In the case of biotech companies, the equity market provides access to capital when other avenues are often incredibly limited. Among equity markets globally, Australia is a popular destination for biotech companies to float through an initial public offering (IPO) or a back-door listing on account of favourable listing requirements relative to offshore exchanges.
In a typical biotech scenario, the company develops an idea for a product, raises capital to fund that idea and then commences clinical trials – usually a multi-year process. Investors are essentially “buying hope” in the idea and the company’s shares may rally if this hope is shared. But at this stage, business is likely to be generating little if any revenue and is highly unlikely to pay dividends. Also, the majority of investors in these companies lack the in-depth medical knowledge to make informed investment decisions.
Binary outcomes
Biotech businesses eventually reach their decision day which will deliver a binary outcome for the company and its shareholders. The potential downside is massive. The outcome could be a response from the US Food and Drug Administration (FDA) either approving or denying the company’s application to market its drug or the results of clinical trials. The scenario is akin to a gambler putting all their chips on red at the casino; they will either win or lose. When the outcome is negative, the impact on the company’s share price is generally swift and catastrophic.
With little or no revenue and an asset that is yet to be commercialised, biotech companies are notoriously difficult to value. When comparing two companies, each with a market capitalisation of $200 million, one a biotech company and the other an industrial company, the differences are stark. The investor faces a greater challenge valuing the biotech business with a speculative idea and no cash than the industrial company generating sales with clear drivers of supply and demand.
The prolonged period leading up to and even subsequent to the commercialisation of the company’s product (if it receives approval) is frequently capital intensive with biotech companies often compelled to tap the market to fund ongoing and costly clinical trials.
Pharmaxis is an example of a biotech business that has sought capital from the market numerous times to fund clinical trials and commercialise its assets. The pharmaceutical research company has a portfolio of assets in various stages of development and approval, including a drug to treat patients with cystic fibrosis, which is yet to be approved in the US.
Since it listed in 2003, the company has undertaken five capital raisings. Notably, in 2007 the company issued new shares at $3.90 each raising $50 million, and in 2009 raised $47 million issuing new shares at $2.35 each. Long-term investors in these capital raisings have suffered losses, with Pharmaxis shares failing to trade above 50 cents a share since early 2013, largely on the back of the failure to receive approval in the US for its lead product, Bronchitol.
Understanding is imperative
Before making the decision to invest in a biotech business, it is critical to first understand the dynamics of the sector and the technology it is seeking to commercialise.
In late 2013 we took a position in Sirtex Medical – a decision driven in part by the fact that the company was already generating cash flow, unlike most biotechs. The company’s primary product is a targeted radiation treatment for patients in the late stages of liver cancer. In 2013 Sirtex announced it was undertaking a study to determine if this device could be used to treat patients at an earlier stage of their disease and thus extend the patient’s life. If the device’s use could be extended, it would significantly increase Sirtex’s addressable market and drive business growth.
Prior to the preliminary findings of the study being announced, we sold out of Sirtex as we felt we lacked the requisite specialist medical knowledge about the device to assess the likely outcome of the study. Without this insight, we had no competitive investment advantage. In March 2015, the company announced the preliminary findings of its study were mixed. Sirtex shares plummeted 55 per cent on the day to $17.53 a share, eroding approximately $1 billion of shareholder wealth. Sirtex’s share price has subsequently recovered, a testament to the management team and depth of trials underway. In essence, Sirtex is not a one-trick pony.
Historically, we have had a mixed track record investing in biotechnology businesses. While there are certainly success stories, they are extremely rare and in our experience the vast majority of companies in the sector are inherently risky. Even if a company eventually achieves the necessary regulatory approval to commercialise its technology, it will frequently take a lot longer and cost more than originally forecast, clouding investors’ visibility of the business and its outlook.