Working alongside surgeons in the operating room as an implantable device rep, I often find myself adopting their operating room clichés. "Dilution is the solution to pollution," is an adage used by docs in the O.R. that refers to the copious application of sterile water into an open wound in order to dilute bacteria and minimize risk of post-operative infection.
In the world of surgery, dilution is always a good thing. To the contrary, in the world of small cap biopharma stock investing, dilution is not always viewed the same way. Investors loathe stock dilution as it diminishes their stake in company ownership and oftentimes is seen as corporate mismanagement or a harbinger of financial difficulty ahead.
In some cases this may be true; however, two shining small cap biopharma companies, Antares Pharma (NASDAQ:ATRS) and Pluristem Therapeutics (NASDAQ:PSTI), who have recently engaged in subsequent offerings of shares to raise capital, are making savvy development decisions early on in order to guarantee long term investors a substantially higher upside in the future.
Antares and Pluristem are two small cap biopharma companies on the verge of tremendous breakout growth. Each of these companies boasts superior pipelines of new game-changing products in clinical stage development and exhibit iron clad balance sheets and upcoming FDA catalysts for many years out to boot. Despite both of these companies returning more than stellar gains for their investors during recent months, they have suddenly become the subject of much scrutiny and lambasting by retail investors over their decisions to raise capital through the issuance of additional common stock.
Indeed, the dilution of stock has somewhat delayed rapid near term stock price appreciation; yet, I ask the critics to consider 2 things. Firstly, that many successful biotech companies who have experienced exponential stock price appreciation over the years have done the same thing during their early stages of growth. Consider Onyx Pharmaceuticals (NASDAQ:ONXX) as just one example. Secondly, by raising additional capital through an offering, both of these stocks have deftly avoided forced partnerships and license deals that could have a much worse dilution effect in the long term.
In August of 2009 Onyx Pharmaceuticals , a biopharmaceutical company that engages in the development and commercialization of therapies that target the molecular mechanisms that cause cancer, announced a plan to issue 4.6 million new shares in order to raise capital to fund ongoing product development and to keep the company financially secure for an additional number of years. Around the time they announced the new offering, ONXX was trading in the neighborhood of $30/share. Below is a quote from an article written by Raymond Chung, Seeking Alpha contributor, in August 2009 regarding investors' reactions to the new ONXX offering:
The euphoria from the company's recent successful Phase 2 breast cancer results were quickly forgotten, as the stock plunged more than 20 percent in two days. Investors were taken aback as why a company with more than $450 million in cash would need an additional $370 million. Visions of a buyout by Bayer AG, its 50/50 Nexavar (approved for kidney and liver cancer) collaborator were replaced with images of a potentially large and dilutive acquisition. It didn't matter that earnings were much better than expected, especially since previous investor criticism has focused on the company not dropping enough sales down to the bottom line. (August 2009).
Raymond accurately depicts the mood of investors at the time of the company's announcement; they felt betrayed and were instantly convinced it was time to jump ship. Much to the chagrin of the investors who bailed, from 1999 until present the stock has steadily climbed, and as of Oct 2012, ONXX is currently trading in the range of $89-$93 per share. To a short term investor or trader, ONXX may not be the best stock to use as a comparison as it did take almost three years for the stock to soar to the extent that it has, with its largest jump occurring just recently in June 2012 after good news surfaced from the FDA.
Nevertheless, the company has succeeded and those long term investors who waited patiently through the hype are now being nicely rewarded with a triple-bagger. Something more to consider, would ONXX have made it through the additional three years while waiting response from the FDA had they not raised the additional capital when they had the chance? Was the management's dilution of stock in 2009 a gross managerial misstep that showed disregard for their loyal retail investors, or was it in fact a savvy and opportunistic business development decision? I side with the latter.
Even the brightest and most respected retail traders will argue that there is rarely a good excuse for a company to dilute shareholder equity. They'll speculate as to why the company was unable to raise funds through deep pocketed angel investors who want to be a part of the next game changing medical breakthrough, or why they were unable to successfully negotiate partnerships with larger pharma companies who can offer them milestone payments and royalties on future product developments/earnings. What these traders are oftentimes overlooking is the fact that the decision to force a partnership or license agreement with a bigger player early on can actually lead to a much worse dilution effect compared to holding out and "going-it alone".
Consider the lucrative future earnings potential of Antares Pharma's Vibex MTX product. Vibex MTX is making great strides in developmental studies as it progresses nicely towards FDA filing and approval. Assuming a conservative 15% market share by 2015 in a market of over 2 million patients, a profit margin of 54%, and a timely ability to save the health care system time and money, Antares Pharma is conservatively projected by some analysts to earn over $400M in 2015 with Vibex MTX alone, assuming commercial launch sometime in 2014. Now consider the future earnings potential for Antares Pharma's Vibex MTX should they consider to license it out.
Assume they will receive a generous $5M milestone payment upon approval along with an annual royalty of 8% earnings. ATRS investors would now be looking at diluted earnings of only $37M in 2015 from Vibex MTX. Now take the present value of 2015-2020 expected future cash flows from Vibex MTX assuming they raise enough cash to "go it alone" and compare it to the present value of 2015-2020 expected future cash flows "licensed out scenario" assuming a 1 time milestone payment of $5MIL and annual royalties of $32MIL (8%). We're now looking at a dilution effect of over $1billion in earnings should Antares Pharma decide to succumb to short term pressures and license out their crown jewel Vibex MTX product.
In conclusion, dilution of shareholder equity is a necessary evil in the case of Antares Pharma and Pluristem Therapeutics. Both companies simply have too much to lose by letting go of their future cash cows. The timing is right to take advantage of the markets' readiness to supply them with enough capital to make it through to market launch of their most potent products. Thus far, both companies have shown their investors better than average pps appreciation and their stocks have demonstrated continued resistance to downward pressure.
Disclosure: I am long ATRS, PSTI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.