By Jennifer Van Brunt


Stocks in the biotechnology sector have experienced a rough ride the last several months and their overall performance in 1997 was less than notable. In fact, the average biotech stock was trading lower on the last day of 1997 than it was on the last day of 1996. Of the 302 biotech and biotech-related stocks in BioWorld Financial Watch's universe, the average loss in share price over the course of 1997 was close to 2 percent — and that was a gain from the previous weeks, when the stocks had dipped to about 5 percent below their 1996 year-end prices. (See the graphs on p. 11 for details of biotech stock performance in 1997, as measured by the Nasdaq Biotech Index and the BioWorld Stock Indicator.)

This is in marked contrast to the previous two years, when the biotech stocks performed exceptionally well as a group. In 1996, for instance, the stocks gained 18 percent in price (on average) from year end to year end, and in 1995 they gained an average 96 percent over the course of the year.

Even though the biotech stocks may receive a nice boost this week during the annual Hambrecht & Quist Healthcare Conference in San Francisco — a traditional source of good news for the sector — they are still underperforming relative to what most analysts feel is their underlying strength. And while an apparent disparity between stock performance and company fundamentals (technology, product development, partnerships) may provide a buying opportunity for some, it doesn't help the short-term goals of those companies that wish to generate some cash reserves.

For those needs, biotech companies are once again turning to creative financing structures, as they have in previous periods when traditional sources of cash are not readily available. The most recent twist comes in the form of the royalty interest transaction that Xoma Corp. executed with New York-based Pharmaceutical Partners LLC. This type of financing structure, which has been used successfully in the entertainment and gold mining industries, allows Xoma to exchange uncertain future product royalties for immediate cash. The Berkeley, Calif., biotech firm (NASDAQ:XOMA) raised $17 million at the end of December by selling its rights to royalties from sales of the anticancer drug Rituxan to Pharmaceutical Partners, a firm composed of ex-PaineWebber employees. Xoma had licensed the exclusive rights to its anti-CD20 antibody patents to South San Francisco-based Genentech Inc. in May 1996; Genentech then sublicensed those rights to Idec Pharmaceuticals Corp., of San Diego, for use in the firms' recently approved chimeric monoclonal antibody product, Rituxan, for treating non-Hodgkin's B cell lymphoma. Together with the $3 million up-front licensing fee it received in 1996, Xoma has realized $20 million from this license. The future royalties from product sales of Rituxan now go to Pharmaceutical Partners, which is taking the risk. Of course, if the product is a real blockbuster, Xoma could lose in the long-term, but in the short-term, it's got the cash on hand to fund further development of its own core products.

Biotech companies have also turned to another financing vehicle that's worked for other industry sectors — the undervalued share transaction. This type of financing involves buying and selling options on stocks; although there are variations on the theme, in general, the structure allows a company to profit from an increase in the price of its stock without an up-front cost.

In 1997, three biotech companies arranged undervalued share transactions — Lexington, Mass.-based Interneuron Pharmaceuticals Inc. (NASDAQ:IPIC) in May, Idec Pharmaceuticals (NASDAQ:IDPH) in September and Salt Lake City-based Myriad Genetics Inc. (NASDAQ:MYGN) in October. All three biotech firms dealt with the same financial institution — SBC Warburg Dillon Read Inc., of New York. According to managing director Eric Roberts, "These transactions are well suited to companies with a market capitalization of greater than $250 million." But they also depend on an active trading volume to make the deal work correctly. "An options contract becomes less valuable if there's not active trading because the financial institution can't offset its position easily," Roberts added.

There are a number of biotech companies that fit this bill, and these days there's little doubt that their stocks are down. It should come as no surprise that SBC Warburg Dillon Read has received enormous interest from other biotech firms regarding this type of financing alternative.

SBC Warburg Dillon Read has a long history of options trading, and in fact is one of the "largest options trader in the U.S.," according to managing director David Stowell. Its predecessor firm, based in Chicago, was O'Connor Partners, which through a series of mergers and acquisitions has become part of the current conglomerate. "We dynamically hedge our option positions by trading the underlying shares in small amounts and very carefully," Stowell explained. "We're hedging our stock price risk." Which is why an active trading volume becomes an integral and important part of the formula of the undervalued share transaction.

Although the details of the individual transactions vary, all three have a similar overall structure. The biotech company buys and sells call options of its own stock with no net expense to the company. The call option that the company buys gives it the right — at expiration — to purchase from SBC Warburg Dillon Read a defined number of shares of its own stock at a specified strike price, which is above the market price of the stock when the transaction was initiated. The biotech company will probably settle this first call option in cash (the difference between the price of the stock and the option strike price), with a cap on the total proceeds it is entitled to receive. If the price of the stock at expiration closes below the strike price of this first call option, then the biotech company gets no money — but it hasn't spent any, either.

The second call option, to be sold by the biotech company, gives SBC Warburg Dillon Read the right, at option expiration, to purchase a defined (often identical) number of newly issued shares of the biotech firm's stock at a specified strike price, which again is significantly higher than the biotech's stock price at the beginning of the transaction. Should this call option be exercised, the biotech firm delivers shares to the financial institution in exchange for an amount per share equal to the strike price. Should the biotech's stock close at expiration above the strike price of the second option, SBC Warburg Dillon Read gets the shares at a discount to market. Should the biotech's stock close below the strike price, however, the company would neither deliver shares to the financial institution nor receive or spend any cash.

"This type of financing takes advantage of the volatility in stocks, and volatility is one of the biggest drivers of value [in options trading]," explained SBC Warburg Dillon Read's Roberts. And the financial institution is willing to pay for that volatility because it's more than likely that the options will be "in the money" at some point in the future, he continued. However, Roberts cautioned that the undervalued share transaction is not the right structure for every company. It's a good way for a company to raise money at a lower cost to itself (no underwriting fees, for instance, as in a public offering), but it's not an alternative for a company that is in desperate need of cash, he said.

Despite the gyrations of the stock market — and the wild ride that the biotech stocks in particular experienced in 1997 — biotech companies were able to raise a respectable amount of money in the year just past. Overall, they garnered about $5.37 billion from the public markets, private placements and other traditional sources of financing (not counting the amounts raised through milestone payments and equity investments from ongoing corporate collaborations; see the chart on p. 2 for details). This was a much better record than in 1995, when biotechs gleaned a mere $3.86 billion from the same sources, but was much lower than in 1996, when companies raised $7.55 billion.

Much of that cash raised in 1996, of course, was in the form of public stock offerings, both initial and follow-on. Biotech and biotech-related firms harvested $4.49 billion from public offerings in 1996; in contrast, they reaped only $2.38 billion in 1997. This is just a hair better than in 1995, when initial and follow-on stock offerings raised $2.16 billion.

For those firms that are planning to go public, the choices are few: They can withdraw their offerings until the markets improve or they can hang in there and hope for the best.

In fact, the general weakness of the biotech sector has already lead a number of companies to withdraw their proposed public stock offerings. The first to react to the down market was Affymetrix Inc., of Santa Clara, Calif., which pulled its follow-on stock offering (NASDAQ:AFFX) in October. But in December, Apollon Inc., based in Malvern, Pa., Centocor Diagnostics Inc., also of Malvern, Osiris Therapeutics Inc., of Baltimore, and RTP Pharma Inc., of Montreal, all postponed or withdrew their IPOs — each citing unfavorable market conditions. And SciClone Pharmaceuticals Inc., based in San Mateo, Calif., which had been planning to sell registered stock to institutional investors, pulled its offering as well.

The rest of the IPO-hopefuls that have been in registration since the fall are still in active status, however (see the chart on p. 3 for details). With any luck, some of those should be on the road before the end of January.