The biotech sector is arguably the riskiest playing field in an inherently risky business – share market investing.  There is no such thing as a risk-free share, but as you know, some shares are riskier than others.  

Biotechs provide dramatic examples of the classic risk/reward relationship.  When a biotech company gets approval of a new drug or treatment, shares can skyrocket.  Needless to say, when a clinical trial fails, share price plunges.

In last weeks Sector Scan column here on thebull.com, analyst Steven Hing of Zodiac Securities gave us a list of five biotech shares to consider for potential investment.  His opinion is that even those shares that have seen substantial share price increases this year still have significant upside potential, provided they can deliver results on drugs and treatments in late stages of stgelopment.

From his list, we have chosen Mesoblast Limited (MSB) as a target share for further investigation.  Although MSB has the largest market cap of the shares on the list, the main reason for the choice is not the size of the company, but the size of the pipeline.

The pipeline is the number of potential products a company is working on to bring to the market.  Biotech shares with extensive pipelines are less risky than those with only one or two offerings in stgelopment.  For this reason, we have chosen Phosphagenics (POH) as a comparison share, even though its market cap is miniscule in comparison to MSB.  However, POH also has a robust pipeline.

Biotech Shares – By the Numbers

One of the many challenges in digging into many biotech shares is determining what numbers to look at.  Retail investors everywhere love to look into the favored valuation ratios like price to earnings (P/E), price to sales (P/S), and price to earnings growth (PEG.)  When you are dealing with companies that have yet to bring products to market, you have no earnings to look at.  In the absence of these valuation ratios, where do you begin to look?

No matter how promising a drug or treatment may be, it can take years before a company realises any revenue from product sales.  In the meantime, they are burning cash.  In evaluating any share of a speculative investment, cash is truly king.  The game is simple.  Does the company have enough cash on hand to cover expenses until products step in, ready to generate revenue?

Liquidity Ratios

The first sets of numbers we can look at are the liquidity ratios – the current ratio and the quick ratio.  Both these ratios measure a company’s ability to convert assets into cash, should the need arise in a short time frame.  Start-up biotech shares prefer to get funding from issuing shares and collaborating with larger pharmaceutical firms.  In some cases, venture capital is involved but traditional debt financing is not common because of the risks involved.  Startups need to have substantial cash reserves to keep operating, so one would expect liquidity ratios to be high.  Here are the numbers:

  MSB POH Sector
Current Ratio 21.01 4.0 4.3
Quick Ratio 20.95 3.27 3.8

 

MSB is highly liquid and we would expect to see they have more than adequate cash reserves.  POH is another story.  So, let us look at the cash position for each of these shares.

Cash on Hand

From the Consolidated Statement of Financial Position for our companies we compare their cash on hand for FY2010 with FY2009.

  2010 Cash on Hand 2009 Cash on Hand
MSB 32,048(m$) 16,526(m$)
POH 2,740(m$) 10,868(m$)

 

The numbers tell the story.  MSB is in a very strong position.  They almost doubled their cash reserves, year over year.  The obvious question is from where did the money come?

Checking the Statement of Cash Flows for MSB, we find they raised 26,798,338 in an equity offering.  In contrast, POH did not raise cash through an equity offering nor did they get an infusion of capital from another source.

The stark difference between these two shares – and remember, Steven Hing feels both are attractive investments – raises the question of at what point should a speculative company look to increase its cash position?  As you probably know, equity offerings dilute the value of existing shareholders and sometimes result in a drop in share price.  How much cash, then, is enough?

Expense Coverage

Analysts sometimes use a ratio called Expense Coverage Days that measures the number of days a company can continue to operate without raising additional capital.  However, cost of goods sold and accounts receivables are needed to calculate the ratio and some speculative companies have no numbers here. 

A simpler approach is to compare the company’s cash on hand against their total loss for the year.  The total loss includes everything from real operating expenses to income tax expenses and currency adjustments.  Here are the numbers:

  2010 Total Loss 2010 Cash on Hand
MSB 14,379(m$) 32,084(m$)
POH 11,275(m$) 2,740(m$)

 

Some analysts feel startup companies should have enough cash reserves to cover two years of operating expenses, at a minimum.  MSB once again shows us its sound financial position. 

At first glance, POH appears to be in a precarious position.  However, when you use total loss numbers you need to do a line-by-line review of the balance sheet to identify one-time charges or other expenditures not relevant to the comparison.  If you look at the Statement of Comprehensive Income for POH, you will find two impairment charges totaling approximately 9 million.  If you subtract those charges, their total loss for FY2010 drops to 2,166 million.  Investors interested in POH would need to search the accounting notes explanation in the financial statements to understand the nature of these charges.

With speculative biotech shares, one of the most important line item expenditures to monitor is R&D (Research and Development.)

Research and Development Expenses

In most cases, investors want to see R&D expenditures going up, not down.  However, if most of the company’s products are in late stage stgelopment, there may be no immediate need for increased R&D.  Here is a year over year comparison of the R&D expenditures for our two companies:

  2010 R&D Expense 2009 R&D Expense
MSB 7,566(m$) 7,145(m$)
POH 2,969(m$) 3,450(m$)

 

As you can see, MSB increased its R&D efforts slightly while POH showed a slight decrease.

At this point, the numbers tell us MSB represents a better investment, mostly due to its strong cash position.  However, numbers rarely tell the whole story, so to complete the picture, we need to look behind the numbers.

 

>>Back to the newsletter to view other articles – June 25th 2011

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