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Evaluating Debt When Investing in Biotech by Mickael Marsali

Biotech companies pour millions of dollars into research programs every year, but the outcome is never guaranteed. The money used to fund this research can, in part, come from issuing stock or taking on debt. How much debt should be a concern for investors.

Debt itself isn’t inherently bad, but too much of it should signal to investors that the company could have trouble covering interest payments down the line, and it could also serve as a warning that if their research doesn’t work out, they may not have enough capital to move forward.

Basically, debt is a risk to investors, and while all investing is essentially a risk, it’s important to minimize risk whenever and wherever possible.

One important metric we can look to in order to assess the risk of a particular debt is “debt-to-capital ratio.” The ratio is a simple calculation that divides the total amount of debt owed by the companies shareholder equity (including total common stock and preferred stock) and it’s net debt (i.e. debt minus cash and cash-like investments.) This ratio allows us to begin assessing how able a company is equipped to handle its debt obligations.

Let’s look at three companies currently suffering from high debt-to-capital ratios, and you decide if they are worth the risk to invest in.

Stock No. 1: Merrimack Pharmaceuticals (NASDAQ:MACK)

Debt-to-capital ratio: 349%

All research is expensive, but cancer research in particular foots a huge bill. Pancreatic cancer specifically is high-risk (and also high-reward) because the failure rate is higher than in other forms of cancer which is why Merrimack Pharmaceuticals is probably making it into our number one spot as an example of high debt-to-capital ratio.

Merrimack Pharmaceuticals currently holds $258 million in long-term debt that cost the company about $19.2 million in interest just last year. The reason? A drug called Onivyde.

Onivyde is a therapy created for pancreatic cancer patients who have previously been treated with gemcitabine, and it’s sales only totaled around $4.3 million in the fourth quarter. Not a great sign for a company who’s going to also be saddled with total operating expenses of at least $245 million this year.

Right now, Merrimack’s still believes Onivyde could be an $800 million opportunity, and it might be! But it’s up to investors to decide how a win or loss for Merrimack will ultimately be a win or loss for themselves.

Stock No. 2: Amarin Corporation plc (NASDAQ:AMRN)

Debt-to-capital ratio: 212%

Up until now, the FDA has hamstrung Amarin’s ability to market all the potential benefits of Vascepa, its highly purified fish-oil pill.

Vascepa is a highly purified fish-oil pill used to treat patients with inordinately high triglyceride levelsa condition that has been associated with a higher risk of suffering a heart attack or stroke. While the goal seems noble, as with any investment decision, we have to look at the numbers.

When we look a bit closer, we see that this condition only effects a small population. Couple that with the fact that cardiovascular trials have to involve thousands of patients, and we end up with a trial that costs a lot to conduct with a limited potential for payoff.

The FDA has also been limiting Amarin’s ability to expand their customer base into moderate to high triglyceride patients. Amarin’s claims were originally challenged by the FDA, limiting their ability to get the word out about the full potential of Vascepa. Amarin has since sued the FDA, and in March they reached an agreement that finally allows them to pitch their full benefits to doctors.

As you might have guessed, Amarin’s revenue run rate last year had many investors disappointed, but they expect to see a noticeable jump now that they are properly able to market Vascepa. Sales have been at $100 million-a-year with $152 million in operating expenses in 2015. They also have about $115 million in combined short- and long-term debt. Only time will tell if the next quarter brings significant changes, otherwise, investors may start packing.

Stock No. 3: Synergy Pharmaceuticals (NASDAQ:SGYP)

Debt-to-capital ratio: 158%

Synergy Pharmaceuticals has developed plecanatide, a constipation drug. After two phase 3 studies last year, the company has demonstrated plecanatide’s effectiveness at alleviating constipation, but the space for constipation drugs is already fairly competitive. In order to be successful, the sales and marketing costs associated with their eventual commercial launch will come with a huge price tag.

They filed for approval in January, reporting a low incidence rate of diarrhea, which could mean giving current popular constipation drugs a run for their money.

Synergy Pharmaceuticals currently sits on about $112 million in cash and cash-like investments, and at the beginning of the year, they reported $151.6 million in long-term debt. However, last month they reported that some of this debt burden has been alleviated by debt holders agreeing to swap $79.7 million worth of convertible debt for 33.3 million shares at an implied price of $2.47. After the conversion, $71.5 million notes with an interest rate of 7.5% are due in 2019.

Final Thoughts

Remember, high debt is not inherently bad for every company. When looking at investing in a company with high debt-to-capital ratio, it just means you need to be more well-informed about the ongoings of the company, trends in the industry, and a better idea of the landscape of drug options for patients.

Also remember, that no amount of information will ever truly illuminate risk. Make wise investments based off of an informed decision making process. With the right eye for opportunity, that big risk could pay off in a big way.

Mickael Marsali is a Senior Consultant and founding member of Arterial Capital Management in London. To learn more about his life and career, please visit his professional website.