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Biotech's recent examples of why turnover can be an ominous sign

Monday, 25-August-2014

One of the biggest tricks of being an investor in publicly traded companies is that you usually only get to view them at arm’s length.  It is your job to take the small snippets of information that companies feed to the public, and try to connect the dots to paint your own picture of the company’s overall health.  Another way of putting this is that information is asymmetrical.  People on the inside who work at these companies have a lot of information to base their actions upon, and you the investor on the outside have very little on which to base yours.  Given this disadvantage, you are usually better off taking a cautious and skeptical approach.


While most investors spend plenty of time parsing every word of press releases and conference calls, keep in mind keep that any knowledge gleaned from those is based on what companies are telling you.  Sometimes a more accurate picture of what is going on is told by how people there are actually voting with their feet.  I’m talking about staff turnover.  It is one of the least appreciated pieces of corporate intelligence, yet might actually be one of the most predictive of future results.  People swap jobs all the time for many reasons, but as an investor, you do not have the luxury of simply assuming everything is fine.  Staff turnover events are something that should be researched closely and taken seriously.


Nowhere is this more important than with smaller biotech companies.  Given the binary nature of biotechs, investors rightfully view many of them as lottery tickets.  Either they are going to pay off big, or fall flat on their face.  While investors have the benefit of diversifying and placing many bets, keep in mind that employees do not.  They are married to just one fate.  That is why it generally pays to take extra heed if employees at a firm you follow suddenly start placing their bets elsewhere.  Furthermore, if this is taking place in front of an important milestone, your skepticism radar should be on full alert.  When employees do not want to stick around for the payoff from good news, maybe it means there is none to be had.


This dynamic was illustrated well by two examples over just the last month.  Unusual staff turnover happened in the months leading up to a regulatory setback for AcelRx (Nasdaq: ACRX) and just days ahead of a poor trial outcome for Kindred Biosciences (Nasdaq: KIN).  While it might just be dumb luck that both of them turned out to have bad outcomes, going back over their stories and some of the red flags that cropped up might be instructive for when you come across similar cases in the future. 


Key staff departures at AcelRx as they discussed their product approval with FDA.


AcelRx is a small biotech company that has been developing Zalviso, a combination of the opioid analgesic sufentanil and a savvy technological device that patients can use to self-administer the drug under the tongue while in the hospital for post-operative pain.  The goal is to replace IV PCA treatments like morphine that are more invasive, prone to error, and keep patients tethered to their beds.  FDA accepted the company’s regulatory application for this product in December of 2013 and set a July 27, 2014 PDUFA goal for their decision.  Aside from Zalviso, AcelRx has no other marketed products and earns no revenue.


Staff turnover red flags started cropping up on this one in the spring.  The company lost their Chief of Clinical Affairs in March, their Chief Financial Officer also in March, and their Chief Commercial Officer in June.  As you visualize this on the below timeline, you might not be surprised to learn that the company was ultimately hit with a complete response letter (less politely known as a rejection) by FDA on their decision date.

Interestingly, all three of these people had only been at AcelRx for a relatively short time:  1.5 years for the Chief of Clinical Affairs, 3.5 years for the CFO, and only 9 months for the Chief Commercial Officer.  While the company put on a good face after all of these departures, saying things like they happened so the people could be closer to family or to take a larger role at another company, the history here probably goes to show that you cannot necessarily take such explanations at face value.  Let me point out a few things that should have weighed heavily on a skeptical investor’s mind in this case.


First, for a small biotech company, reaching a first product approval is a huge achievement and usually serves as an inflection point.  Some people spend their entire careers never getting there, but for those who do, the payoff can be significant.  Therefore, put yourself in the shoes of those who have this milestone in sight.  Not only is there professional fulfillment that comes with it, but also stock and options that have not vested, and likely visions of bonuses and pay raises once an approval happens.  Why would you walk away from those things if you thought an inflection was just around the corner?  Maybe one person would make that decision, but for three to do it in succession does not sound right.


Second, as I mentioned in the opening, always keep in mind that information is asymmetrical to the investor.  When it comes to FDA reviews, companies do not just file their product application and then wait around for a final decision months later.  The process is more of a dialogue.  You can bet that the leaders within these companies have an idea about how the review is going based on questions they are receiving from FDA.  That is all the more reason why staff departures months into the process should be viewed with high skepticism.  In AcelRx’s case, it was confirmed after the fact that FDA had concerns, and was not able to even consider AcelRx’s response to them in the allotted time.  I am guessing the people who left probably had a pretty good idea of where things were headed.


Third, it is likely a telling sign how all three of these people were only at the company for a relatively short time.  Take the Chief Commercial Officer, for example, who was only there for 9 months.  Given that he was hired for the purpose of preparing for the product’s launch, it should have been red flag that he joined and then left so quickly.  Not having an approved product to commercialize would be an obvious letdown for such a role.  While it was explained that he left to become the CEO of a small medical device company, I am not sure it entirely passes the smell test.  The fact that he left only a handful of weeks before the so-called approval date was an ominous sign.  To be fair, it could have also been a truly reasonable move, but you would be taking on a lot of extra risk as an investor buying into that.  At a minimum, it is poor hiring.


A final thing to keep in mind as biotech companies face regulatory setbacks like AcelRx did is that the resolutions to these things are not measured in weeks, but in months and sometimes years.  It is only human nature that people might want to move on ahead of such setbacks in order to advance their careers.  Therefore, if you see departures happening, it pays to take them very seriously.


Kindred Biosciences locks data from a pivotal study, and then announces two resignations.


This example is interesting because, on the surface, it is actually one of the more questionable things I have seen in a while.  However, before I write about this, I would like to point out for full-disclosure that Kindred’s main competitor is Aratana Therapeutics (Nasdaq: PETX).  Aratana is based in my hometown of Kansas City, and I personally own Aratana stock and fully support them.  That does not change my opinion of what happened below though.


Founded only two years ago and taken public in December of 2013, Kindred Bio is a relatively new company.  Their goal is to be a biotech-like developer of therapeutics for the companion animal market.  While other established players like Zoetis (NYSE: ZTS) and the animal health divisions of big pharma do have companion animal products, these companies derive most of their revenue on the agricultural end of the market.  Aratana was the first dedicated “pet biotech” to go public in June of 2013, and Kindred then followed thereafter.  These companies plan to develop drugs for things like pain, inappetence, dermatitis, and cancer.


While Kindred Bio had a successful IPO and good half-year following it, things might be looking a little more questionable after they announced their first pivotal trial result last week.  The study was for a drug called CereKin, and it was being tested in dogs for osteoarthritis.  Osteoarthritis is a pretty big market (estimated to be over $250 million in the U.S. alone) so some would argue that this was a key study for them.  Given that it was Kindred’s first pivotal study out of the gate, it is also perhaps a sign of their scientific knowhow, therefore making it all the more important. 


The CereKin study result ended up being a total failure and the company says they now have decided to no longer pursue development of the drug in dogs.  However, that alone is not so surprising.  Even given the relative importance of this particular study, drug development is a risky business and studies fail all the time.  I would normally give them the benefit of the doubt on that.  However, where the story takes a truly odd turn relates to some staff turnover red flags that happened just days before this bad news was announced.  Below is a timeline of key disclosures Kindred made this month.  

As you can see, it was disclosed that the Chief Financial Officer and Chief Scientific Officer/Head of R&D were retiring right in the middle of this data being locked.  Given the unusual chain of events, here are a few things that should have weighed heavily on a skeptical investor’s mind in this case.


First, I cannot think of a worse omen for an investor than to see two staff departures announced just days before a pivotal trial result.  Honestly, it is almost beyond belief.  There are many ways to describe the timing, but I will be diplomatic and just leave it by saying it is highly abnormal.  To be fair, just as in the AcelRx example above, reasonable and perhaps true explanations were given for the departures, like family issues, but how can an investor not be swayed by the risk inherent in believing that?  Given how information is asymmetrical and Kindred clearly had the trial results in hand, to see such an announcement does not leave a reasonable person on the outside much room to expect that everything will be okay.  Such a warning sign is impossible to ignore, and as you saw, everything was clearly not okay.


Second, it is also a red flag that Kindred Bio is experiencing turnover in such key positions so soon after forming the company and going public.  In my opinion, that is a sign that they have either rushed things, or that the company’s story is not as good as it first appeared to be.  When you are investing in a relatively new company like Kindred, presumably you are a long-term investor and plan stick with it as it grows.  If the company’s leadership is not willing to make the same commitment, where does that leave you as the investor?  A more ideal situation would be for them to have a realistic business plan, and to stick with it over time.  Staff departures are not a big deal for mature companies, but disruptions at small ones tend to have a way of multiplying themselves.  That type of turbulence is rarely a good thing.


Third, the fact that a person as important as the Chief Scientific Officer/Head of R&D decided to leave also raises many unappealing questions.  For example, after CereKin failed, the company boasted how they have an entire portfolio of other assets that are already in development.  I am guessing the Head of R&D had a lot to do with choosing that pipeline, so why is he not seeing it through?  Furthermore, there are some things about how CereKin was developed that I personally think leaves a lot to be desired.  For example, Kindred did not first run their own pilot study with the drug before sending it on to the pivotal.  Rushing things in that way adds quite an element of risk so I am not entirely buying their explanation that the study’s failure was due to chance alone, as they suggested on a conference call following it.  So if the drug was not researched as thoroughly as it maybe could have been, what does it say about his role in that decision, and does this have any implications for the other drugs in the pipeline that are already in motion? 


The bottom line with Kindred Bio is that almost never in my investing carreer have I seen departures like that announced just days before the result of an important pivotal study.  It simply raises too many questions for comfort.  Given how the unusual nature of this seems to have foretold the failure of CereKin perfectly, I would be inclined to watch this company from the sidelines for a very long time before believing that the news is not the sign of an even larger problem.


Conclusions and takeaways


Now that we have seen a couple examples of how things can go wrong, there are a few parting conclusions I think we can take from them.


  • Obviously you have to take staff departures very seriously.  This is especially the case if they happen in front of an important event like a regulatory decision or trial outcome.  Information is asymmetrical to the investor.  People on the inside who work at these companies have a lot of info to base their actions upon, and you the investor on the outside have very little on which to base yours.  Therefore, do not simply buy into what companies tell you through press releases and conference calls.  Watch closely how the people there actually vote with their feet


  • You have to research stocks very closely to find out this type of news.  One thing that is tricky about turnover is that it is not always announced like regular news.  Many departures will be hidden deep within 8-K filings, and others might not be disclosed at all.  For example, I only knew that the Chief of Clinical Affairs left AcelRx in March because it came up on a conference call (he was not what is called a “Section 16” officer).  Other times you might find out about these things only as the departing person joins a new company and a press release announces the hire.  This information will not necessarily find you, so you have to be out there actively looking for it.


  • While companies almost always provide a good explanation when departures do happen, you should view what they tell you with high skepticism.  I understand that people do have things like real family emergencies, desires to move to a different city, and other perfectly reasonable causes for moving out of a job.  However, since it is more or less impossible for you to verify those with any degree of certainty, you are usually better off assuming the worst.  Another thing to look for is if a departure is a standalone event, or looks like it might be part of a larger trend.  It might be reasonable to look past one person moving on, but a succession of departures could be a sign of a much bigger problem.


I hope this article was illustrative of some of the more glaring red flags to look out for as you come across them in the future.  While these things will not always turn out bad like they did in the two examples here, I have found that it usually is better to be safe than sorry when you are the investor on the outside looking in.

Who Am I?
Brad Loncar

I'm an individual investor from Kansas City.  My focus is on biotech stocks, but I enjoy investing in all industries. I'm an old-school, buy and hold investor who believes the best way to outperform and grow capital is to own innovative companies with good management teams over the long-term. more>>

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