The Contrarian: Fashionable genes are too expensive
By Christopher Byron
Red Herring
October 1, 2001
This article is from the September 15, 2001, issue of Red Herring magazine.
It's a mania that predates the Internet. Over the last two decades, dozens of biotechnology companies have been taken public by venture capitalists eager to shed their financing obligations onto public shareholders. The VCs' only challenge was to convince those shareholders that rising multiples would forever make refinancings possible. A major beneficiary of that theory: biotech superstock Human Genome Sciences (Nasdaq: HGSI) (HGS).
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So how's the company doing? On July 26, HGS released its latest quarterly financial results -- the latest bath of red ink in what has become six straight years of annual losses. Not to worry, say supporters, for HGS is a "genomics" company -- the promise of biotech. Indeed, the company's media-savvy chairman, William Haseltine, has become a poster boy for the entire genomics industry.
Genomics is the analysis of the structure and function of genes. Companies like HGS create databases that they license out to drug companies in search of drug "targets"; a genomics company might also isolate those targets and develop drugs itself.
But a major payoff for HGS's database remains elusive. While five companies made use of it in the past eight years -- bringing in a shade over $5 million in fees in HGS's June quarter -- those agreements ended June 30, without a single renewal. HGS would have investors believe that it prefers to lose partners because the company can now keep the benefits of its database to itself.
But the true value of the database is in question. HGS has claimed that the database contains information on as many as 100,000 genes. Yet the five companies continue to maintain just 460 drug-research projects based on approximately 280 genes, suggesting that they regarded the rest of the database as not worth much of anything. Indeed, only one company -- GlaxoSmithKline (NYSE: GSK) -- has even gotten to the point of testing an actual drug derived from the database.
HIDDEN COST
You can't really tell what this database has cost shareholders, but it's been a lot. Accounting rules require research and development costs to be expensed rather than capitalized, and the entire cost of the database has simply been dumped into HGS's accumulated deficit, which by now exceeds $400 million.
At first blush, the $1.7 billion in cash on the company's books seems enough to prevent a cash squeeze. And HGS does have five drugs in various stages of clinical testing. But operating losses are running at more than $40 million per quarter, and they're rising rapidly. A year from now, those losses could be approaching $100 million a quarter, as spending on developing new drugs siphons the cash away.
Some investors have decided they don't like the odds anymore: the stock has been lurching downward from its high of $116 in March 2000 and by late September had fallen to just over $30.
Still, it's hardly inexpensive. Many biotechnology companies lack both cash flow and earnings, so the only fair valuation principle that puts biotechnology stocks on an apples-to-apples basis is market value as a multiple of book value. Consider Millennium Pharmaceuticals (Nasdaq: MLNM), which already has a drug on the market, yet sells for a lower multiple (2.5 times book) than does HGS (2.9 times book).
In a sense, HGS is just a hugely expensive money market fund with an enormous premium representing a bet that the company will come up with profitable drugs before the money runs out. After all, nearly all HGS's assets -- and 100 percent of its equity -- consist of nothing but the proceeds from an adroitly timed stock sale last year that raised net cash of $913 million, plus a private placement of convertible debt that raised $510 million more.
The bottom line is that no premium bet of any sort makes sense if the cash supporting that premium drains away. And every day that the company waits to replenish its cash with a fresh financing will make it that much more difficult -- and more expensive -- to do so. |
