StreetTalk: Your Cash Ain't Nothing But Trash: Wall Street Not Embracing BioTech IPOs

Some savvy scribe once said that initial public offerings were Wall Street's version of a Christmas gift. Investors shook the boxes for weeks, admired the colorful wrapping, and wondered just what was inside. When the big day came, presents were opened and opinions were formed that could either help or haunt a new publicly traded company for months, even years. What companies didn't want was the investment equivalent of returning their "gifts" the morning after Christmas.

Brian O'Connell

Hey, it's no coincidence that the term "Black Friday" is used primarily to describe Wall Street and the post-holiday shopping season. Traders use the term to describe the epic 1929 stock market disaster, and retailers cite Black Friday — the day after Thanksgiving — as the day that can make or break their year, from a financial point of view.

Yes, I know it's only September and the holidays are months away, but I like the comparison between Christmas gifts and IPOs — particularly biotech IPOs.

Investors tend to get excited when biotech companies go public, even if it's against their better nature. A knowledgeable investor realizes the odds are against you when betting on a new biotech issue. According to Pharmaceutical Research and Manufacturers of America, FDA approves only one out of five drugs that survives to get into human clinical trials. And, of 20 select biotech IPOs reviewed by the investment firm Burrill & Co. in 2004, only four have rolled out within their initial price range.

Wait, there's more if you can take it. IPOFinancial.com reports that about 25% of life sciences firms that introduced IPOs to the market in a 52-week period from spring 2003 through spring 2004 are trading above their offering price.

Merry Christmas

The good news? For starters, the overall life sciences market outperformed the broader financial markets through the first half of the year (Table 1). That means biotech IPOs can count on some momentum going forward into the last half of the year.

There are more positive developments on the biotech IPO front. The industry entered 2004 with a strong balance sheet — about $16 billion in cash and a wide-open pipeline full of new drugs and products. With FDA approval of 25 new drugs in 2003 (up 25% from 2003), investors had good reason to look forward to a spate of new biotech IPO rollouts in 2004. Indeed, Wall Street analysts expect 2004 to be a windfall year for biotech companies, with revenue growth estimated at 20% and sales expected to reach $47 billion in 2004.

Bumps in the Road

With a firm foundation for growth, you'd think the industry would be chock full of IPO success stories so far this year. Unfortunately, that just hasn't happened.

Whether it's a perceived glut of biotech IPOs or uncertainty over — pick one — the economy, the war on terror, the presidential race, the Red Sox pitching — investors have generally shied away from new biotech issues, to the point where companies are being forced to cut the pricing of their IPO shares just to make a deal with underwriters and get out on the market.

That's exactly what happened to Acadia Pharmaceuticals, a San Diego, California-based developer of nervous system drugs, and Critical Therapeutics, a Lexington, Massachusetts-based asthma treatments developer. Both IPOs hit the market at around $7 per share despite initial pricing projections of about $14 and $13, respectively. As a result, both companies raised about one-half the cash they anticipated and now can expect a struggle to ramp up investor perceptions that each company is not yet ready for the big leagues. Fair or unfair, perception counts for a whole lot on Wall Street.

Table 1. Biotech Stocks vs. the Overall Markets

A similar fate befell Auxilium Pharmaceuticals Inc., a Norristown, Pennsylvania developer of testosterone gel. It, too, was forced to cut its pricing projections in half after lackluster interest from investors.

A big part of the problem, according to some industry observers, is that Wall Street underwriters just aren't sure how to price new biotechnology issues before they hit the market. Just like the high-profile financial analysts who couldn't valuate dot.com stocks in the late 1990s, — and who wore egg on their faces for getting the Internet bubble so spectacularly wrong — underwriters don't have a feel for the market value of biotech stocks.

Tom Jacobs, co-founder of the Complete Growth Investor, writes in a recent volume of his column, Investor's Lab, that there is an inherent conflict of interest between life sciences companies going public and their underwriters that leads to enormous gaps between where company stock prices are set and where they actually should be set. "To entice customers to this or any future deal, the underwriter needs to deliver a return. This presents an incentive to price the shares under what they might bring once available on the open market," he writes. "Imagine how happy the underwriter's clients are if they buy shares at a $20 offering price, only to watch them pop to $30 when they open for trading. Of course, it isn't that easy. Neither the underwriter nor anyone else really knows what price the new company will command on opening day, let alone the next day, week, or month. Supply and demand change from moment to moment. But at the extremes — where there is a Grand Canyon between offering price and opening day price — you have to scratch your head."

It's Jacobs view that capitalism is a "messy business" where stock markets behave irrationally and not every new company can succeed with an IPO rollout. That's especially true in a biotech market where so much is up in the air and so many investors, burnt from one heat-seeking, high-flyer that was grounded for some reason or another, are a bit reluctant to dip their toes in the biotech IPO market.