Trius (TSRX) completed an equity offering on Friday, January 19 in which it sold 6.3 million shares at $4.465. I assume that the Green Shoe of 945,000 shares will be exercised and, if so, net proceeds to Trius will be $31.9 million. I calculate that the number of shares outstanding at the end of 1Q, 2013 will be about 46.2 million and that the cash position at the end of 1Q, 2013 will be $84 million, which equates to roughly two years of cash burn. At the closing price of $4.90 on Friday, the market capitalization is $226 million.
I think that management made a good decision. With the cash position firmed up, investors won't be worrying about an equity offering after the release of phase III data on its second phase III trial on which topline data is expected in 1Q, 2013. If the data is positive like the first trial as I expect, there is no overhang from an equity offering and there is a clear path forward to submission of the NDA with probable approval in mid-2014. The $226 million market capitalization seems modest when viewed against these fundamentals.
There will likely be a partnering deal if the data is positive. A further benefit of the offering is that the strong balance sheet gives an enhanced bargaining position for Trius. They aren't desperate to get cash from a deal. They will be bargaining from strength and the terms are likely to be better. I think that a partnering deal for commercial rights in Europe and possibly some rights in the US might bring in an upfront payment of $50 million or possibly much more bringing year end cash to $96 million plus. In addition, a partner would likely pick up a big part of the costs of developing tedizolid in pneumonia, bacteremia and other indications thus reducing the $12 million quarterly burn rate.
The stock closed at $5.23 on Thursday, January 28th, and after the announcement that the deal was done at $4.465, the stock subsequently closed at $4.90 on Friday, which was encouraging. This equity offering has done a lot of de-risking of Trius for the remainder of 2013. The one major worry is that the second phase III trial will fail. However, if the data is positive as I expect, it seems like there will be clear sailing for the rest of the year. Investors can look forward to no more capital raises, a partnering deal and submission of the NDA. There will be a strong wind at the company's back for the balance of the year. I see the stock trading up into the $7+ area in 2013 with the terms of the partnering deal being the major determining factor. Investors will then begin to focus on the potential for tedizolid after approval, which I expect in mid-2014.
I think that this offering surprised Wall Street as most investors expected the company to issue shares after the announcement of topline data from its second phase III trial that is expected sometime in 1Q, 2013. This was based on the assumption that the data would be positive and the stock would react positively.
So why did the company choose to do the deal prior to the announcement of topline data? Some message board chatter suggested that the company somehow had lost confidence or knew that the data in the second trial would be disappointing and the stock would plunge. I reject this idea because the trial is blinded and management cannot know the results. Moreover, if management did somehow know that the results were negative, this would be a material event that would require the issuance of an 8-K.
Why move before the announcement of data? The major challenge to an emerging company like Trius is demonstrating in well controlled trials that its product is safe and effective and to also create the clinical and economic reason for hospital formularies to pay for it. Nearly as important as the clinical data is the maintenance of a strong cash position. Small biotechnology companies live in a hostile environment for raising equity through traditional share offerings. There is a feeling among some investors that issuing equity and creating more shares dilutes current shareholders and is bad. I find many managements afraid to issue shares because they fear that investors will see the offering as dilutive and sell their shares and some hedge funds routinely short into announced deals.
Managements usually wait for some catalyst that they anticipate will drive the stock higher and finance at that time. There are risks with this strategy beyond the obvious one that the event (usually clinical trial results) is disappointing. The first is that investors expect companies to do this and the stock often trades down even in the face of positive data. The second risk is that the company may allow its cash balances to decline to the point that investors know that it has to finance, and this can result in buyers in the deal exacting harsh terms.
Trius has a relatively high current quarterly cash burn rate that averaged $12 million in the first three quarters of 2012. Trius has been aggressive in keeping its cash balance strong, but this is a big enough burn rate that if the company is not careful, it could find itself in the position of having to finance at a time of weakness. The company has kept its cash position substantially above the one year of cash burn at which investors usually perceive weakness.
The company raised about $52 million in 1Q, 2012 bringing its cash balance at the end of the quarter to $97 million. In August 2012, it signed up for a committed equity financing facility from Terrapin Opportunity Fund for a total commitment of $25 million. It executed a drawdown on this facility of $3.4 million in September and another of $5.0 million in December. If well executed, an equity line facility is an efficient and unobtrusive way of raising capital and I think that management felt this might be the best way to raise capital and could possibly avoid the disruption and significant discounts that come with a public offering. However, these drawdowns were not well executed and resulted in noticeable pressure on the stock that caught the attention of investors who then began to fear that subsequent drawdowns would also result in stock pressure. The equity line facility became a cloud over the stock.
I think management came to view this equity line as not being right for them and they decided against drawing down the remaining $16+ million from the facility. They appeared to lose confidence in the ability of Terrapin to execute drawdowns without pressuring the stock. Management still needed to bolster cash positions and its only viable option was a public offering, but the next question was when to do it. Why do an equity offering now rather than wait for the second phase III trial results?
I think there were two reasons for moving quickly. The first is that the company did follow the usual strategy of doing an equity financing after the successful completion of the first phase III trial. However, investors had anticipated an equity deal, and despite the positive trial results, the financing issue was dominant and the stock traded down. Management feared a repeat after the release of the second phase III trial results.
The other concern for management is the chaotic political situation in Washington in which raising the debt ceiling is in question. While the odds seem very high that the debt ceiling will be raised, we have to admit that politicians from parties are extremely dysfunctional and that some turn of events could lead to no increase in the debt ceiling. This could create utter chaos in the capital markets and might lead to a position in which the company would have about $52 million of cash on its balance sheet at the end of 1Q, 2013, which is barely a year of cash burn. The company might still be perceived as financially weak and a financing might not be doable only so at very onerous prices. Management did not want to run this risk.
My View on Equity Offerings in General
There is more often than not a kneejerk reaction to equity offerings that essentially can be summarized as believing that any issuance of shares dilutes existing shareholders and is unequivocally bad. This creates a problem for emerging biotechnology companies that must spend great amounts of money researching and developing their products for years before they are approved and come to market thus incurring large negative cash flows for several years. They have no choice but to raise money on a periodic basis. If everyone were to accept the argument that equity offerings are dilutive and therefore bad, the ultimate outcome would be that a biotech company would either partner its product or simply operate until it runs out of money and then shut its doors. The latter is obviously absurd.
To be a little more precise, biotech companies might also have the option of seeking someone to acquire them, but this is a relatively rare event. They could also try to fund themselves through grants. For the purist non-diluters out there, this is really the only true form on non-dilutive financing, but grants are usually not available to a company and almost never can be more than a supplemental source of funding.
Partnering is looked at as good because it is assumed that not issuing shares is non-dilutive. However, I think that partnering can be a highly dilutive form of financing as the licensor may lose much, usually more than half, of future profits to its partner and runs the risk of losing control of the development of its drug to a less committed partner. I have seen a lot of biotechnology companies suffer severe economic damage as a partner lost interest when clinical development difficulties arose as they so often do during development.
Let me suggest that investors take a balanced view on financing a biotechnology company. The first thing to understand is that options other than grants result in other investors now having a call on the company's future profits either because new shares are issued or future profits must now be shared with a partner. However, existing shareholders can benefit because without these new stakeholders the company would fail and the value of all shares is zero. The new money invested can provide great benefit for existing shareholders as it allows the completion of programs that can pay high rewards. Think back to Amgen (AMGN) and Epogen. If Amgen had not partnered Epogen with Johnson & Johnson (JNJ) and raised money through timely secondary offerings, there would undoubtedly be no Amgen today.
Going into almost any emerging biotechnology investment, the investor has to understand the reason why management is bringing new stakeholders into the company. There are situations where partnering or electing not to raise money through public offerings can be bad. Conversely, share offerings and partnering can sometimes be good. It is all about the use of the proceeds and the timing. An equity offering is good if ultimately the return on investment to existing shareholders is increased (even though there are more shares) through allowing clinical development to continue or finish and to commercialize a new product. The goal of any company is to issue the fewest number of shares possible and retain as much control of future profits as possible.
Failing to issue shares to allow for the development of a promising product can be catastrophic. Investors have to consider equity offerings in the context of timing and reason. Based on this line of reasoning, I see the Trius offering of January 19th as a positive for existing shareholders. In my mind, managements must be first judged on their choice of products to develop and their clinical development plans. This is the science part. However, how management elects to finance its operations is almost as important. Some managements are very good and some are not so good. I think Trius management is very good financially.
Disclosure: I am long TSRX.