The Biotech Boneyard

Revenue matters for biotechs too
 

By: Clark Dean

During COVID, biotech companies rode high on a wave of hype and stratospheric valuations. It was a time when every pipette wielder fancied themselves a potential Moderna, and investors were throwing money at any lab coat in sight.
 
But, as we explored in our recent article, “The Quality of New Entrants,” the recent IPOs and SPACs from the biotech and pharmaceutical sector were mostly unprofitable and were, in large part, responsible for dragging down the overall quality metrics of the small-cap sector. With the biotech sector down roughly 50% from its 2021 all-time high, investors should have perhaps adopted the mantra “trust the financials” instead of the mantra “trust the science.” 
 
We wanted to do a deep dive on this unusual sector, as it plays such a big role in the small-cap index and in the decline of the quality of that index, to see if we could figure out ways to separate winners from losers.
 
To start with perhaps our most glib observation, biotech companies with headquarters outside of California (30% of biotech companies) and the Acela Corridor (40% of biotech companies) have a rather horrible track record, with all due apologies to your buddy’s Miami-based biotech startup.
 
Figure 1: Regional Return Indices Biotech & Pharmaceuticals, 1996–2023

Source: Capital IQ. Monthly market-weighted returns.
 
On a more serious note, there is a major difference between biotech and pharma companies that generate revenue and those that do not. Simply separating companies into those with over $10 million of revenue and those with under $10 million revenue, which we label no-revenue companies, identifies a shocking divergence in performance.
 
Figure 2: Return Indices for Revenue vs No-Revenue Biotech and Pharmaceuticals, 1996–2023

Source: Capital IQ. Monthly market-weighted returns.
 
While the companies with revenue returned 10.4% annualized since 1996, companies with no revenue compounded at -9.3%. And this divergence has been equally eye-popping in the past 10 years.
 
Figure 3: Return Indices for Revenue vs No-Revenue Biotech and Pharmaceuticals, 2013–2023

Source: Capital IQ. Monthly market-weighted returns.
 
The returns in the biotech and pharmaceutical sector are coming from companies that have revenue. So the initial take would be that there is no compelling reason to invest in companies not yet generating revenue. But surely there must be some winners here. The superstars of today had to start somewhere.
 
With this in mind, we did a deeper analysis of the no-revenue companies with over $50 million of market cap to see if there were any factors that could be used to pick out any diamonds in the rough. We could not use traditional metrics, so we tried metrics focused on spending as a proxy for scale and cash balances as a proxy for quality. We defined spending as operating cash burn plus capex. Rather than a traditional definition of total enterprise value, which includes cash, we just used total debt and market cap to calculate enterprise value.
 
TEV/spending and TEV/cash both spread returns. This is perhaps not surprising, as they are both a form of a value metric. Low valuations relative to either spending (scale) or cash (runway) are predictive of higher returns.
 
Figure 4: “Value” Metrics in No-Revenue Biotech and Pharmaceuticals

Source: Capital IQ. Monthly market-weighted returns. Data from 1996–2023. Quintile 1 has the lowest valuations relative to fundamentals.
 
But even successfully spreading returns is of little help. Only the lowest valuation quintile peaks above negative returns and then just barely.
 
We also looked at years of cash remaining, measured as cash/total annual spending. According to EY, 29% of biotechs have less than one year of cash left available. Perhaps companies with more time to succeed do better. Below we show the return by years of cash available. The companies in quintile 1 average 4 months of cash, the companies in quintile 2 average just under a year, and the companies in quintiles 3, 4 and 5 average 1.5, 2.4 and 4.9 years respectively.
 
Figure 5: Returns by Quintiles of Years of Cash Remaining

Source: Capital IQ. Monthly market-weighted returns. Data from 1996–2023.
 
Clearly, investors punish companies with insufficient cash, and negative returns are heavily concentrated in those companies with less than a year of cash on hand. Companies with runway to succeed do not do well on average but fare far better than the larger universe’s compounded annual return of -9.3%.
 
The final factor we examined was the trailing three-month return, or momentum. Typically, past returns exhibit at least a weak predictive tendency for future returns. In this case, however, the opposite was true. Strong trailing returns are a terrible indicator for positive returns going forward (-27.6%). High returns are followed by significant underperformance. No-revenue companies with the lowest previous returns (quintile 1) showed a tendency to mean revert, with a 5.5% forward return.
 
Figure 6: Returns by Momentum Quintile

Source: Capital IQ. Monthly market-weighted returns. Data from 1996–2023.
 
It seems that there is but one savior for biotechs with no revenue: get to revenue. This is of course the goal of any company and what biotech investors are betting on. As the COVID hangover continues, more and more of these biotech and pharmaceutical companies are running out of cash, seeing their valuations shatter. History has shown us that making this revenue bet early does not pay off. In our data, under 2% of these companies get to revenue within a year, and even then their returns are worse, not better, than the rest of the companies.