Investors' Ultimatum

November 1, 2002
Bryan M. Armstrong

Bryan M. Armstrong, CFA, is executive vice-president of Ashton Partners.

Pharmaceutical Executive

Pharmaceutical Executive, Pharmaceutical Executive-11-01-2002,

A new mentality is sweeping Wall Street, leaving many companies shell-shocked. The US equity market's worst performance since the crash of the late '80s has many looking for scapegoats. In response, institutional investors are focusing more intently on the underlying earnings power of each company in their portfolio. They are scrutinizing business models with an eye toward a company's ability to generate future cash flows.

A new mentality is sweeping Wall Street, leaving many companies shell-shocked. The US equity market's worst performance since the crash of the late '80s has many looking for scapegoats. In response, institutional investors are focusing more intently on the underlying earnings power of each company in their portfolio. They are scrutinizing business models with an eye toward a company's ability to generate future cash flows.

The effect of that change is most pronounced for small-cap growth companies, particularly in the biotechnology, pharmaceutical, and medical device sectors. In the past, the perceived value of life science companies was rooted in innovation, not business models. In today's tumultuous marketplace, such companies have no choice but to align their business models and investment stories with Wall Street's new standards.

Unfortunately, the reality is that many life science companies still continue to talk grandly of the potential for blockbuster drugs or revolutionary technologies. Such stories fall on deaf ears. This article examines the disconnect between life science companies and Wall Street and provides specific guidelines to improve investor communications. Companies that are able and willing to explain how their initiatives translate into future cash flows will be the clear winners in the valuation race.

At first glance, it seems reasonable to leave the interpretation of a stock's value to investors. But the lack of adequate information flow between life science companies and institutional investors makes that an increasingly difficult proposition. Life science management continues to profile its company's scientific or technological prowess with almost no reference to the underlying business model, and investors are frustrated.

It's What You Say

The reality is that communications plays a critical role in the valuation process, especially during uncertain market conditions. Investors value companies based on projected future cash flow, which requires that companies convey a great variety of information.

Because past performance is considered a poor predictor of future performance, investors rely heavily on qualitative information that links corporate strategy and future cash flows. That qualitative evidence is the "missing link" for many esoteric, complex life science stories. Without it, investors will simply turn to more easily understood and valued alternatives.

Institutional investors seem to have presented life science companies with an ultimatum: either help us assess the return and risk profile of your business with relevant, accurate, and transparent financial disclosure or risk being significantly undervalued.

"The price companies pay for secrecy is more suspicion from a potential investor, explains Frank Boriello, MD, PhD, BB Biotech AG/Bellevue Asset Management. "It's a trade-off. If a company wants to keep something out of the public domain, there will always be an increase in risk."

Failing to comply with the demand has been devastating for some companies. The life science sector as a whole has underperformed relative to the overall market. During the past 12 months, the S&P Small Cap Biotechnology and Pharmaceutical Index has fallen more than 35 percent, compared with a 29 percent downturn for the broader S&P 500 Index, a -24 percent for the NYSE Composite, and a -21 percent for the Dow Jones Industrial Average.

Wall Street's frustration in valuing profitable life science companies can be narrowed to three common problems:

Failure to Communicate

Different perceptions. Many companies overlook the fact that an investor's perception of a company's ability to execute may be substantially different than that of management. The perceptual gap widens when companies fail to make information available, and the result is a high level of uncertainty. Although investors typically use mathematical equations such as the weighted average cost of capital (WACC) and the capital asset pricing model (CAPM) to determine a company's cost of capital, the single greatest factor influencing that critical input is uncertainty. A high level of uncertainty and a high cost of capital bring a low valuation.

Consider a small-cap life science company that signs a potentially lucrative partnership with a large pharma player. To avoid unduly raising investors' expectations, management decides not to disclose details of the transaction. Yet, to the detriment of all stakeholders, the deal adds very little to the company's valuation because investors are unable to quantify its financial impact.

"Sometimes companies strike deals in which they are unable to, or do not want to, disclose the exact terms. How are we supposed to know whether to put a royalty of 3 percent or 20 percent on it?" asks Boriello. "That becomes an uncertainty."

The flow of cash flow. Wall Street investors expect companies to reinvest cash flows in their business if new projects yield a higher return than the cost of capital. If expected returns fall short, cash flows should be returned to shareholders through a dividend or stock repurchase.

But profitable small-cap life science companies rarely return cash flows to investors despite the fact that many are having difficulty finding value-enhancing projects. Consequently, cash sits as excess surplus on the balance sheet, hampering return on investment comparisons and casting a negative perception on the company's future growth potential. Additionally, if the money is not being invested in the underlying business, it likely is being invested in money market accounts or marketable securities. In effect, companies play quasi-asset managers with investors' capital. That is a tough pill for Wall Street professionals to swallow.

Lack of detail. The most egregious and common problem stems from management oversimplifying the company's financial condition by communicating only revenue and earnings per share (EPS). Although those are popular metrics, there are many others even more critical to investors' analysis.

"A lot of companies just give you that top line projection: 'We are going to grow X percent in '03.' Obviously, more detailed information gives us a better understanding of how they plan to hit their targets, "says James King, portfolio manager for US Bancorp Asset Management. "Anything that a company can do to help the institutional investor better understand how they make money gives us more confidence in their ability to execute their strategy. When we have greater conviction, we are more inclined to buy those stocks."

Credibility is the number-one factor influencing whether investors believe a company's guidance. Therefore, life science businesses need to establish the appropriate support for how management will execute its strategy and achieve its projected goals. In the absence of credibility, support cannot exist. A guidance with only revenue and EPS is analogous to a classified advertisement-it may hit the high points but rarely will it induce an immediate sale. To complete the sale, investors must feel confident in management's credibility.

As a first step, management must go beyond seeing its company as a creator of innovative science and technology and understand what investors want to see-namely, an investment supported by underlying cash flows. For profitable small-cap life science companies, the ability to lay out their return and risk profile for institutional investors is far easier than for companies still in the venture stage. However, there is no benefit in simply demonstrating historical profits. Management must help translate industry-specific jargon to meaningful financial terms that every investor can relate to the business model.

Connect with Investors

Following are guidance principles that life science companies should adopt to ensure effective communications with investors:

Key initiatives. Support revenue projections with a detailed account of critical business initiatives. Go beyond segmenting business lines and highlight key factors that will positively affect revenue contribution, enabling investors to focus on the company's true source of value. In the absence of a key initiative guidance, investors may overly penalize a company for an initiative they do not support if they perceive that it contributes more to revenues than it actually does.

Predictable revenues. Highlight revenues that have a high probability of contributing in the future, such as backlog and recurring revenue. Investors prefer predictable revenues to risky or erratic revenues. Accordingly, they will feel more comfortable with the company's projections and apply a lower cost of capital in valuing the company.

Transparent risks. Management should increase the transparency of its strategy, especially in dealing with potential or realized pitfalls, by discussing the risk factors most likely to affect revenue-contributing initiatives. Then it must address how it intends to overcome each risk factor. Investors will assess the risk factors involved in a company's business model with or without management's help. By addressing the issues with investors upfront, the company can alleviate risks that do not apply to the company and thus earn credibility.

Clarity of impact. Articulate the timing and expected contribution of new initiatives-whether it's a new product rollout or a recently completed acquisition-to help investors assess the return and risk potential. Merely announcing a new initiative will not significantly affect the perceived value of a small-cap company. Providing clarity about its anticipated traction and associated execution points, such as incremental revenue opportunities and annual cost savings, will help ensure that investors are appropriately assessing its progress.

Market opportunity. Determine the total addressable market opportunity for speculative business initiatives, then provide realistic best-case and worst-case scenarios for the opportunity. Steer away from sounding like the next Microsoft when discussing potentially large but speculative market opportunities. Instead, provide a well-thought-out strategy for seizing the low-hanging fruit that will earn credibility with investors.

Balance sheet. Highlight relevant balance sheet items that matter most to the success of the business, such as inventory turnover ratios, days sales outstanding (DSOs), and property, plant, and equipment (PP&E). In many cases, that tells investors how much the company is investing to support its growth. Investors use both the income statement and the balance sheet in computing cash flows. By openly discussing the balance sheet and investments being made to support growth, the company can help investors believe in the quality of earnings.

Cash management. Discuss management's strategy in deploying its cash, including investments in the existing business-hard assets, R&D, and selling, general, and administrative (SG&A)-potential acquisitions, cash dividends, and share repurchases. Idle cash can detract from value because it returns less than the cost of capital. Being an efficient cash manager is more than just having the biggest war chest. Real credibility comes from having a solid strategy for using cash.

Investor targeting. Market the company to institutional investors that have both a predilection for, and a capacity to own, the company's stock. But don't limit the search for new investors to those that are familiar with life sciences. A sound financial business model influences institutional investors with specific strategies regardless of the industry. Generalist investors manage the largest amount of Wall Street's capital, and limiting institutional targeting programs leaves a great deal of opportunity on the table.

Unmasking the true essence of the business model will help steer companies closer to the ideals of institutional investors, who ultimately have the greatest influence on stock prices. Following are case studies that highlight a few of the previously mentioned principles.

Best Practices

The companies were selected from a review of the entire life science spectrum-biotechnology, pharmaceutical, and medical device sectors-of small-cap businesses with a market capitalization of less than $10 billion. Analysts then culled the list to identify those with strong stock price performances during the past year that were valued higher-based on price-to-earnings ratio-relative to their peer average. All three are medical device companies, which are typically more highly valued than other small-cap life science ventures because they have stronger financial communications programs. Conversely, the poor stock price performances and below-average valuations that kept many biotech and pharma companies from the final list underscores the heart of the valuation problem.

Idexx Laboratories (NASDAQ: IDXX). This developer, manufacturer, and distributor of products and services for the veterinary, food, and environmental markets underscores its use of cost of capital in evaluating business decisions and communicating expected risk to investors.

Idexx's cost of capital, per the capital asset pricing model (CAPM), is derived from publicly available information. It is used to evaluate all projects and to keep business managers aware of the return that shareholders expect in return for bearing the company's explicit business risk. Given that risks vary among projects and need to be measured, that approach is built into the cash flow estimates for each project.

"We try to help investors gauge risk through adequate disclosure of risk factors related to significant projects and the rationale for the key assumptions we make when assessing the economic value that these projects will add to the business," says Idexx CEO Jonathan Ayers.

For that type of capital budgeting analysis, forecasting is critical. It is essential for a company to communicate the assumptions underlying its cash flow projections to gain credibility with the investment community. Moreover, that level of analysis forces a company to evaluate itself from the inside out, exposing both its strengths and weaknesses.

To broaden its investment appeal, the company highlights a unique competitive advantage of its overriding business model. "Investors also like our use of a 'razor/razor blade' business model," notes Ayers. "An initial product sale-in our case a laboratory instrument-is followed by ongoing sales of proprietary consumable products. Those high margin, recurring revenues are very attractive to investors."

By remaining committed to consistent fundamental performance through the careful monitoring of assets employed, productivity, and communication, Idexx continues to attract Wall Street's savviest investors.

St. Jude Medical (NYSE: STJ). The company develops, manufactures, and distributes cardiovascular medical devices. It has established credibility with the investment community and the public at large by maintaining an "open and comprehensive communication philosophy," according to Terry Shepherd, its chairman and CEO. Central to that initiative is helping investors feel comfortable with the company's growth expectations and understand the risk involved in pursuing projected goals.

The company showcases its forthright approach to financial communications in its investor presentation. St. Jude Medical segments revenue by business line and provides informative details including percentage revenue contribution, anticipated growth rate, and specific initiatives that support each segment's growth expectation. Instead of simply stating total market opportunity, St. Jude Medical goes a step further by illustrating its respective position in each of its markets.

Laura Merriam, director of investor relations, comments, "When dealing with the investment community, St. Jude Medical describes its markets, its position in its markets [market share], overall market sizes, and potential for growth."

That level of disclosure benefits the company, because investors who are disinterested or skeptical about a particular segment of the business will be less likely to inadvertently discount the value of other segments.

The company also helps investors understand the risk of its growth expectation by distinguishing between growth that assumes a steady market share and growth that assumes incremental expansion. SJM's presentation states: "Holding market share in 2003 will generate at least 8-9 percent growth. The remaining growth of 6-7 percent is anticipated to come from well-detailed new products and market share aggregation."

That effectively demonstrates to investors that well over half of its revenue contribution is predictable and low risk. Accordingly, investors will likely apply a lower overall cost of capital when computing a company's value.

Biomet (NASDAQ: BMET). As a developer and manufacturer of musculoskeletal medical devices used in surgical and non-surgical therapy, this company has differentiated itself from its peers by demonstrating a penchant for strong cash management. Despite a history of consistent financial performance, Biomet's stock came under pressure in the mid '90s. In reaction, management initiated a cash dividend program and has increased it slightly each year thereafter.

Recently, the company noticed a substantial amount of cash accumulating on its balance sheet. With the returns on that cash dropping with each interest-rate cut, management began repurchasing shares on the open market. The company has repurchased $200 million in shares since last December and plans to buy back an additional $100 million.

"We have very predictable cash flows, so it's more than adequate to fund a dividend program like we have, in addition to plowing the rest back into the company," says Greg Sasso, vice-president of corporate development and communications. "We still have in excess of $300 million in cash and marketable securities-more than enough to look at external acquisition opportunities-and we decided, because we're getting such low returns on our cash, that we would take shares off the market."

Management's ability to evaluate its return on investment alternatives, both in the market and internally, has considerably aided Biomet's credibility with investors. As a result, the company has attracted a sophisticated investor audience that understands the risks and opportunities of its business model and can appropriately value the company.

The days of trading stocks based on the irrational exuberance demonstrated in the late 1990s are long gone. A majority of Wall Street investors have returned to traditional fundamental analysis in their stock selection process.

Prescription for Success

The economic downturn brought renewed focus and attention to more disciplined investing principles, much like the 1930s when the rhetoric of Benjamin Graham, the father of "value" investing, resonated with Wall Street. Both reforms resulted from a capital market fraught with accounting gimmickry and corporate fraud.

Though human psychology suggests the capital markets will someday again fall victim to irrationality, the dramatic rise and fall of the market during the past decade has left an indelible mark on the investment community. Through their buying and selling, institutional investors are quietly reforming the way companies communicate with Wall Street.

Life science companies must help the investment community assess the return and risk profile of their business models and underlying cash flows or run the risk of being undervalued-or not valued at all. Investors have thrown down the gauntlet. The question remains, how will life science companies respond?