Monday, 24-November-2014

Secondary equity offerings are a fact of life in biotech investing.  This is the industry where they are most common since drug development is so risky and capital-intensive.   Therefore, any smart investor needs to learn how to anticipate them, know how they affect a company’s capital structure, and decipher what this means for common stockholders going forward. 

 

Considering that secondary offerings are one of biotech’s fundamental realities, I am always surprised by how some investors are not able to handle them very well.  You know what I am talking about, right?  Whenever there is a hot stock on the move, count on at least one or two negative people to warn you of an inevitable secondary as if it was an incoming scam or the end of the world for that company.  Oftentimes the opposite is true.

 

While I understand that “secondary” and “dilution” have negative connotations in most sectors, do not allow the glass-half-empty type people to use those terms to scare you out of good biotech stocks.  I do not like to see my holdings diluted any more than the next person, but the fact is that biotech comes with both good and bad secondary offerings.  It is your job as an investor to recognize which is which, and not sweat the good ones.  

 

Like any business transaction, what it all comes down to is whether the company is making the offering from a position of strength or weakness.  Just try to remember this simple rule of thumb and the decision about how to invest around them will be much clearer.  There are three categories I try to place secondary offerings into:  

 

Good offerings that are a clear sign of strength

 

The best secondary offerings are the ones that take place right after a company has nailed an important proof of concept or de-risking event.  In those situations, an offering should be welcomed because it is simply being used to fuel the next stage of growth.  Companies are going into these offerings with the upper hand, so any dilution should be minimal and efficient.  I usually think of the additional money raised in these cases as supplementing my investment, not diluting it. 

 

A side benefit of this scenario is that it helps you to better gauge the quality of the news event that put the company here to begin with.  If the secondary goes well and easily brings in a lot of money, view it as independent verification from the market that the news event and subsequent stock move was in fact legitimate and not just out of control hype.  The stronger the secondary, the more likely the stock will continue to climb afterwards.

 

A recent example of this good scenario is what happened to Receptos (Nasdaq: RCPT) last week.  Receptos was already a solid company due to a promising multiple sclerosis program, but its prospects were significantly bolstered when it also reported positive phase 2 results from a drug in ulcerative colitis in late October.  This ulcerative colitis news moved the stock from the high $60’s to around $110.  Receptos quickly followed up by announcing a secondary offering last week.

 

They planned to raise more than $325 million (big amount = green flag).  Not only that, but there was even a market rumor that a single fund was interested in buying one-third of the deal.  It only took one day to close (short time = green flag), and Receptos ended up raising $414 million at $100 per share.  Everything about what I have just written exudes strength, which is exactly the type of situation you want to participate in.  Not surprisingly, the stock is already trading at a new high of $119 just two days later.  This is a textbook case of a good secondary that should be welcomed.

 

‘Gray area’ offerings that should give investors pause

 

The good and bad offerings are easy to analyze.  It is the ones that come from out of nowhere, and by companies that do not have any major events on the horizon, that are the most difficult to interpret.  I consider these to be “gray area” offerings that should at a minimum give you pause.  Use them as a catalyst to do more research, reevaluate your investment, and consider if the offering might in fact be a sign of hidden bad news.  In other words, try to make a judgment call about whether the offering was done out of strength or weakness, and use that as the basis for what to do with the stock.  Any hint of weakness should probably be sold.

 

The strength scenario is pretty straightforward.  I am sure you have heard the old saying in biotech “raise money when you can, not when you need to.”  If a company’s stock price has simply drifted high on no news, a raise could be a sign of prudence on management’s part.  Think of a biotech’s stock price as its cost of capital.  The higher it goes, the cheaper the cost, and the cheaper the return on investment they eventually need to turn in order to create value.  As long as you trust that the management will put the cash to good use, these offerings can typically be seen as a good thing.  

 

It is the offerings that come from out of nowhere at a traditionally middle-of-the-road stock price that should make you think twice.  Chances are those types of offerings will have the weakest pricing too, which would be another red flag.  Managements of these companies need to have a very clear explanation about “why now” and what they intend to use the additional funds for.  If they are unable to do that to your satisfaction, assume the offering is being done out of some sort of weakness.  You will not always be right about that, but I have found it is the best way to go in most cases rather than to stick around and expose yourself to the unknown.

 

Bad offerings that are clear signs of weakness and doom

 

The easiest offerings to analyze are the ones being done by wounded ducks.  I’m talking about companies that are trading at or near new lows, and then decide to do a secondary offering.  When that happens, you need to walk away, no questions asked, because you do not want to be on the same team as a company that is raising money out of clear weakness.  Such an act of desperation not only raises a million red flags about the company’s business prospects, but it also ensures that the risk-reward ratio of investing in common stock is not worth it either way since the capital structure will now be shot.

 

As I mentioned earlier, a biotech company’s stock price is its cost of capital, so when companies do offerings at low prices, that means they are raising the most expensive money possible.  Nine times out of ten, this puts a company into a polar vortex of dilution that is almost impossible to get out of.   You still might like the science, but do not forget what your job is as the investor.  When companies raise expensive money at low share prices, the price per share of the stock then becomes a less meaningful proxy for the business’s fundamentals.

 

A perfect recent example of this is Lexicon Pharmaceuticals (Nasdaq; LXRX).  Lexicon already had a bloated capital structure to begin with after doing ad nauseam financings in the past.  They had well over 500 million shares outstanding, which made it a half billion-dollar company even at just $1.00 per share.  Such a market cap at that low of a price is a telltale sign this is likely the end of the road, not a new beginning.  Sure enough, Lexicon announced last Wednesday that they planned to offer another 50 million shares of stock (and some debt as well) at a new low price.

 

The offering was clearly done out of pure weakness.  Not only does it suggest they have no realistic chance of forging a promised partnership to develop their diabetes compound, but it is just the latest salvo that has turned their common stock into a complete joke.  Think about it, even if Lexicon defies the odds and successfully develops this drug one day, what is the best-case scenario for the stock?  Those who have held it are almost never likely to earn a decent return, especially when you factor in the opportunity cost.  Why would you want to join the club?  The company is in a weak position that is not worth your money. 

 

Conclusion

 

The key takeaway I hope you will remember is that there are both good and bad secondary offerings in biotech.  Secondaries are a fact of life in this sector, so you need to learn how to analyze them without emotion.  A good rule of thumb to live by is to try to figure out if a company is making the offering from a position of strength of weakness.  Boiling it down to that cancels out a lot of noise and biases, and makes your investment decision so much easier.  Stick with the companies doing them out of strength and secondary offerings can actually be your friend.  Yes, there are good secondary offerings.