Ultimate Lessons From JP Morgan Healthcare Conference 2016

The end of the JP Morgan Healthcare Conference invites reflection on lessons for investing. The legions of investors populating the Union Square hotels - almost all white, male, and wearing pale blue neckties - will face challenges finding value in the health care sector's long bull market. Bears have already come out of hibernation in the larger US stock market's first two weeks of 2016. They wait to pounce on the health care sector.

Investors could have thrown a dart at the universe of stocks and funds in the large-cap health care sector after 2010 and come away winners. The bull case made sense up until mid-2015. Consider the price trajectory of one very broad health care ETF, iShares Nasdaq Biotechnology ETF (ticker IBB).

iShares Nasdaq Biotechnology ETF (IBB) from Yahoo Finance

Here we see the 5-year price chart for IBB from Yahoo Finance as of January 19, 2016. Its valuation peaked in July 2015. Note that Amgen (ticker AMGN) is one of the top ten holdings. That one stock is off its 52-week high by about 17% even though Motley Fool reports that Amgen had phenomenal things to say about itself at the JP Morgan Healthcare Conference. Of course, a sector's performance is more than the financial health (pun intended) of one of its widely-held leaders.

The health care sector's long-term performance is very much dependent on the Affordable Care Act (ACA). FactCheck noted in 2014 that the ACA may be contributing to a moderation in the growth rate of per-capita health care spending. The per-capita growth since at least the 1990s has driven the profitability of drug makers and insurers, so any moderation means the sector's companies must seek more customers (i.e., plan enrollees) to sustain their earnings growth. The Economist noted in 2015 that more people are enrolled in health insurance plans even as costs per patient decline. The tradeoff of more customers for less costly coverage was always the grand bargain that the health care sector expected from the ACA to maintain its financial success.

Several CBO reports note that federal health spending continues to grow. We can find one cause for this hidden in FactCheck's 2012 discussion of cuts to growth in Medicare spending. The estimated $716B in growth savings designed to prolong the Medicare trust fund's life covers the issuance of Treasury bonds the trust fund will own. The Treasury's borrowing through such bond issuance will subsidize the ACA health plan exchanges for years. The CBO's March 2015 baseline update on the ACA's fiscal effects shows just how expensive those subsidies will become. The estimated net cost of ACA coverage, including exchange subsidies, totals over $1.2T by 2025. That total more than overtakes the original estimate of $716B Medicare savings. The ACA's effects on health care affordability are an unsustainable burden on the federal government's finances.

The ACA exchanges themselves are facing financial trouble. Premiums from healthier people are not offsetting the tax credits for poorer and sicker people. Twelve of the ACA cooperative health plans have now closed. Insolvent entities cannot continue to operate, and their closure means the surviving eleven co-ops will face more financial stress as sicker people enter their risk pools. The ACA risk corridors are underfunded. Insurers' premiums did not keep up with cost increases for those risk corridors, so either a federal bailout replenishes them or insurers raise their premiums even more. Insurers participating in ACA exchanges are facing unprofitable growth. The ACA's rules and structures force every participant in the health care sector's revenue chain - individual plan subscribers, insurers, and government transfer payment programs - to participate in an increasingly insolvent regime. The financial implications of a collapse in support for the health care sector's revenues would be disastrous for investors.

Watching The Big Short before the JP Morgan conference began offered an indirect lesson in the warning signs of an overheated sector. Only a handful of major investors anticipated the housing market's crash through 2008 by watching how adjustable-rate mortgage rates destroyed the value of pooled securities. The canary in the coal mine to watch is always whether a payment stream is sufficient to support asset valuations. Health care payments are a convoluted jumble of insurance premiums and government reimbursements. Collapsing intermediaries will obstruct such payment streams and endanger the valuation of any security tied to the health care sector. Investors will eventually have an opportunity to make their own big short in health care, much like the home mortgage big short. Analysts can someday decide which short is bigger.

Full disclosure: No positions in any securities mentioned.

CytoSorbents Continues Despite Disappointing Financials

CytoSorbents Corporation (ticker CTSO) has a brand new approach to removing blood impurities in critically ill patients. Hemoperfusion is one of several extracorporeal methods that capture and remove potential threats from blood. IBISWorld thinks the total blood dialysis market is quite large, and the revenues of publicly traded dialysis leaders are indeed sizeable. A simple glance at the financials of dialysis market leaders Eli Lilly (ticker LLY), Baxter International (ticker BAX), and Fresenius Medical Care (ticker FMS) shows how difficult it will be for Cytosorbents to make headway.

The most relevant comparison should be between CytoSorbents and Fresenius because their product lines are both specific to the blood dialysis market. Here's a basic comparison, from the latest available reporting periods.

CTSO
Gross revenue (ttm): $3.9M
Profit margin: -284.9%
ROE: -127.6%
EPS: -$0.69

FMS
Gross revenue (ttm): $17.1B
Profit margin: 6.12%
ROE: 12.2%
EPS: $1.72

It's not even close. Fresenius is by far the more successful company. I'm not sure why CytoSorbents even went public in the first place, or why their executive team's compensation is so high, given their very poor financial performance. They have almost doubled their gross revenue each year since 2012 but their negative net income grows even larger. That's just plain embarrassing.

I had some hope that a deeper look into CytoSorbents would reveal something worth seeing. I just can't see past those very disappointing top line and bottom line results over several years. The retained earnings were over -$130M by the end of September 2015, and that's a huge negative hole for a small company fighting into a mature market with high regulatory barriers. I don't think I need to take this any farther. It is obvious that CTSO does not deserve to be anywhere near my own money.

Full disclosure: No position in CTSO or any other stocks mentioned at this time.

The Haiku of Finance for 03/10/15

Biotech blowoff
ZIRP and health care spending growth
Drive pricey forecast

Biotech Blowoff Beats Even Dot-Com Madness

Annual health tech fests like the JPMorgan Health Care Conference, Biotech Showcase, and One Med Forum came and went this year in San Francisco.  The star performers in this sector no doubt have a lot to brag about.  They will also have a lot of explaining to do when the biotech and health care sectors eventually crash.

The NASDAQ Biotechnology Index (NBI) has only been around since November 1993.  It does not have as much history with the United States business cycle as the S&P 500.  Retail investors did not need to pick stocks in this sector to compensate for whatever they lost in the 1990s dot-com crash.  The iShares Nasdaq Biotechnology ETF (ticker IBB) was priced at $95.32 at inception on Feb. 12, 2001.  It now stands at $341.43, a healthy gain for anyone who held it through the financial crisis and didn't get spooked when it dropped into the high 50s in March 2009.

Consider that IBB's P/E of 24 signals a valuation far out of whack with what the health care sector of the economy can deliver in the future.  IBB's components are large-cap stocks heavily weighted towards pharmaceuticals.  Specialty drug makers have received an unsustainably large portion of prescription spending in recent years.  The health insurance coverage that sustains all prescription spending is now heavily dependent on ACA subsidies.  Anecdotes about the Affordable Care Act pale in comparison to the government's National Health Expenditure (NHE) data, which show how further projected increases in health care spending through 2023 are strongly driven by ACA coverage expansion.

Continued ACA subsidies, like all other federal discretionary spending, depend very much on the US government's ability to borrow at low interest rates indefinitely.  That is unsustainable.  Any upward movement in interest rates would explode the federal government's interest costs on sovereign debt and immediately crowd out discretionary programs.  The likely effects on politically popular entitlements like ACA handouts would include inflation indexing.  Uncle Sam is an expert practitioner at artificially understating inflation to save on CPI-based entitlement costs.  The end of endless cheap borrowing will bring the end of meaningful ACA subsidies and Medicare reimbursements.  The health care and biotech sectors will not escape that banquet of consequences.

Full disclosure:  No position in IBB at this time.  No position in other health care or biotech stocks at this time.  One small private equity position in one medical device startup.

Launch Opportunities for Biotech Startups in Surviving and Conquering Disease

I attended two recent public lectures that opened my eyes to disruptive opportunities in the health care sector.  The first was Dr. Diana Schwarzbein's presentation at the Commonwealth Club on the "Survival of the Smartest," where she expounded on her findings in The Schwarzbein Principle linking nutrition and endocrinology.  The second was Dr. Nevan Krogan's talk at the local Umpqua Bank branch on mapping the human genome.  Their wisdom can drive capital into enterprises that benefit human health.

The common link between the two talks was the relationship between diseases and the body's natural pathways.  Dr. Schwarzbein's work has identified the chemical building blocks in foods that enable the body's "building" hormones.  Dietary changes that support the body's cell repair ability can mitigate long-term diseases.  Dr. Krogan described the large-scale data collection effort for disease as the next health care revolution.  Malfunctioning protein complexes occur in disease states, and mapping the mutations in cell function pathways enables precision medicine.

I am not a physician, biochemist, or nutritionist.  It is beyond my professional skill as a financial analyst to describe how chemical changes affect cells.  The medical community's attention to the interaction of chemistry and genetics is enough to signal that biotech entrepreneurs should offer disruptive solutions.  The channels for these solutions abound.  The Silicon Valley Health Institute's speaker series is probably a good forum for startups to show early adopters their latest ideas.  The Gladstone Institutes link scientific investigators to emerging research; startups should look there for research validating their business models.  The California Institute for Quantitative Biosciences (QB3) operates Bay Area incubators for promising startups.  I believe venture investors would look very favorably on a startup with a QB3 pedigree.

The combined effect of these two talks reminded me that the San Francisco Bay Area is ground zero for biotech innovation.  Scaling entrepreneurs need to hang out with endocrinologists, biochemists, and gene therapy specialists at major medical research centers.  I once connected with the California Institute for Regenerative Medicine on behalf of a health care startup in my own portfolio.  I would do so more often with other entrepreneurs who seek my wisdom, if I owned an equity stake in their enterprises.

Derma Sciences Puts Honey Into Wound Care

I first noticed Derma Sciences a few years ago when they garnered some notice for marketing a honey-based topical wound application.  I'm checking up on their progress.  I don't know why they put their management bios on the investors relations page but I have to deal with it.  Their CEO has a background in managing life sciences companies with two acquisitions.  That's good, and the rest of the management team has bench strength in life sciences.

Derma Sciences offers other products besides the honey wound treatment I first noticed.  I'm not knowledgeable enough on the scientific qualities of their other products to evaluate their effectiveness.  It's good to have patents, but I have questions.  Do any of their anti-microbial applications cause allergic reactions?  Is there enough supply of honey and other inputs to support projected sales growth?  I admit that I don't have the answers at this time.

The share price has seen a dramatic run-up since the beginning of 2011.  The high price is odd in light of their financial performance.  They have experienced continuing annual net losses, although they announced record revenue for 2013.  Their retained earnings likewise experience continued annual declines, indicating their bottom-line results are not adding value despite the rise in the share price since 2011.  I like honey, especially the organic varieties found in San Francisco boutique markets, but I can't understand Derma Sciences' prospects well enough to include it in my portfolio.

Full disclosure:  No position in Derma Sciences at this time.

Stellar Biotechnologies Makes KLH Applications

Stellar Biotechnologies (KLH.V / SBOTF) makes targeted therapeutics from keyhole limpet hemocyanin (KLH).  This protein is cultivated from mollusks called keyhole limpets in some kind of aquaculture.  The CEO is a scientist who invented the extraction method this company uses, and he formerly ran an aquaculture company.  I can't think of a more appropriate combination of scientific and business backgrounds.

I am impressed that a single source of protein enables multiple products in vaccine carriers and test kits.  Vaccine carriers typically have cold change storage requirements, so it will be interesting to know the shelf life of a KLH-based product.  I am further intrigued that this business model does not depend on the success of one specific vaccine because the basic protein can be adapted to the needs of multiple vaccines.

Stellar's success depends on executing licensing agreements rather than clinical trials.  I searched SEDAR for their financial statements because I didn't see anything useful in EDGAR.  Their annual statement for the year ending August 31, 2013 showed almost US$7.9M in cash on hand, and annual losses of almost -US14.9M.  They still have to raise significant amounts of money because their increasingly negative retained earnings shows them going farther in the hole every year since 2011.

I think their technology holds promise, but they need to execute some licenses.  Negligible revenue for a company that has been publicly traded for almost four years makes me wonder whether vaccine makers are getting Stellar's value proposition.  BTW, other companies (such as biosyn) also market KLH products.  Stellar must show the market some major clients to prove it has something worthwhile.

Full disclosure:  No position in Stellar Biotechnologies at this time.  

Mast Therapeutics Moving MST-188 To Phase 3 Trials

Mast Therapeutics (MSTX) has continued to make progress since the last time I checked them out in February 2013.  I need to clarify one hurdle they must surpass to be competitive.  I had mentioned the per-pill dosage cost in my last article as a comparable price point of a competing product.  Their drug MST-188 is injectable as an acute treatment, so comparing it to pills would not be an apples-to-apples analogy.  

It's good that they're trying to apply MST-188 to other ailments besides sickle cell anemia.  This potentially gives them fallback options if the Phase 3 trials for sickle-cell patients are not productive.  Oh BTW, they still have a page on ANX-514 but I don't see any recent developments with that drug.  

Note their 10-Q for November 4, 2013.  Their expenses for the MST-188 clinical studies are increasing.  Their SGA expenses are increasing even though they're not selling anything.  I did mention in my last blog post on this company that they would need a lot more cash to conduct their trials.  They priced an SPO in June 2014 but I do not see a follow-up press release on when they closed the fundraising round.  I will continue to check up on Mast Therapeutics as it moves forward. 

Full disclosure:  No position in MSTX at this time.  

Pluristem Therapeutics Moving Somewhere

I had to check out Pluristem Therapeutics (PSTI) just to see what's going on in biotech.  I have to remind myself that other sectors exist besides the ones I usually review.  This one develops placental cell therapy solutions.  I don't know enough about biology to determine whether this technology works.  Their bioreactor process looks like it's scalable to large-volume production but I'm not sure how to assess the size of their potential market.

Their product must be competitive on a price per dose basis with other treatments (injection, radiation, oral doses, etc.) for inflamed tissues.  I evaluate progress in biotech companies when their announced milestones for successful trials and regulatory approvals move the share price.  Alternatively, a private company meeting these milestones will be able to successfully raise capital at higher valuations.  Let's review their press releases and compare them to the stock's movements over at Yahoo Finance.  Pluristem announced several clinical trial results in 2010 and yet the stock didn't move appreciably beyond a buck and a half.  The stock finally started to move up in early 2011, and that year they announced several iterations of positive data along with FDA orphan drug status.

This company started 2003 with a much higher valuation than they have today.  Such a steep decline in a decade makes me wonder who was so optimistic about them in 2003.  They did a shelf registration in January 2011 so maybe something really was different back then.  Whatever.  I don't have the patience to dig through decade-old financial statements.  They're still publicly traded but they experience persistent net losses since 2011.  That lack of performance is enough for me not to have Pluristem in my portfolio.

Full disclosure:  No position in PSTI at this time.  

Bluechiip (BCT.AX) Putting MEMS and RFID Together

Bluechiip (BCT.AX) is a tech company in an often-overlooked niche.  They are developing a next-generation RFID electronic marking system that can identify samples stored in extreme environments.  Their chip-based record solves problems that more primitive technologies cause for biobank records.

The bluechiip team is split along lines typical of a tech startup.  The CEO is experienced in establishing commercial relationships and the chief technologist created bluechiip's proprietary tech.  The rest of the team knows MEMS and product engineering but they need someone with experience in the biobank market.

RFID chips that can sense temperature have been around for several years and competitors exist.  BioTillion's BoxMapper coupled with RURO's FreezerPro ColdTrack is one such example.  Research Elemnts' Cryo Element combines barcodes with RFID.  One key to success for bluechiip will be to demonstrate that their RFID reader can display a medical sample's record without requiring the sample's removal from its cryostorage container, thus eliminating the chance of thawing.  I don't know whether their reader and chip have the same price points as competitors.  If they cost more, they need to store and display more data than a barcode to be desirable.

One thing working for bluechiip is that customers who adopt their reader/chip solution will have switching costs of returning to less effective record methods or converting to a competitor's RFID solution.  This can give them a competitive advantage if they sign up a major biobank as an early adopter.  Committing to record-keeping infrastructure is just like most major IT decisions.  One you have a company-wide solution, it's difficult (but not impossible) to change it.

I noticed something interesting in my background research on medical RFID platforms that use MEMS technologies.  A lot of them operate from Australia, just like bluechiip.  Bluechiip may be on to something.  I'm not ready to invest in them because I need to see them capture some market share to prove that their concept works for clients.  Let's see where they are at the end of 2013.

Full disclosure:  No position in BCT.AX (or other companies mentioned) at this time.

The Haiku of Finance for 03/26/13

Show me a pipeline
Energy or biotech
It must make money

Report From 3rd Annual New Paradigms to Fund Life Science Innovation Conference

I sure do get lucky sometimes.  Last week JP Morgan held its famed health care conference in San Francisco.  I didn't get invited to that one but I scored something just as valuable.  I got to sit through several sessions of the 3rd Annual New Paradigms to Fund Life Science Innovation Conference at the Marines Memorial Club.  I didn't have time to attend the entire conference due to my meeting schedule but I enjoyed the funding panels.  My synopsis is below, with my own special insights in italics.

The panel on "Government Investing Opportunities to Fund Life Science Innovation" had experts from the National Institutes of Health and National Cancer Institute.  They put real teeth in the old saying, "I'm from the government and I'm here to help."  The NIH maintains a free biobank for research and uses its grant program to leverage other government resources in gene therapy, cell therapy, and production assistance.  The NCI manages an active portfolio of about 50 SBIR (Small Business Innovation Research) grants and also offers bridge financing and regulatory assistance.  The advantage of government agency SBIR grants is that they are non-dilutive funding that doesn't take IP away from a developer.  NCI even sponsors an investor forum matching successful Phase 1-2 startups with investors who will fast-track their product.  Hey, last year they held it in Santa Clara, so I ought to see if I can attend this year.

The panelists had a consensus on how biotechs execute successful fundraising.  Startups should have a good team, IP amenable to protection, and an explanation of how the proposed product meets an unmet market need.  My own interpretation of "good team" encompasses someone who is scientifically qualified to invent a device or discover a drug, plus a capable executive with serial entrepreneur experience.  Several years ago when I first started studying startups, I noticed the successful ones had teams with both scientific and managerial skills.  That insight comes in handy when making investments, and one panelist observed that academic researchers have little understanding of commercialization or manufacturing. This is why the best business schools create partnerships between their MBA candidates and their own university research labs.  These partnerships create business models for commercializing the lab researchers' tech and are favorites to win business plan competitions.  

NIH gives startups guidance prior to submitting their SBIR grant request.  I'm thrilled to see government agencies focus their grant funding on the successful commercialization of a product rather than just keeping startups alive.  Heaven help us if the SBIR process turns into a make-work program for unemployed scientists.  The panel mentioned the "numbers game" aspect of successful grant funding, with only 15% of grant applications getting funded, so startups need to work hard on their grant applications.  One panelist mentioned that DOD grant makers are risk-averse, so having a strong relationship with DOD is the key to getting their research grants.

I learned a new acronym from this panel:  STTR, i.e. Small Business Technology Transfer, a program for fast-tracking the commercialization of federally funded research.  I also learned that many biotech startups are "virtual" but many grants require much work to be done internally.  Hmmm, that places virtuals at a disadvantage because they outsource things like clinical trials.  The government's workaround is to have the startup directly expense on their budget some functions outsourced to contract research organizations.  Startups who outsource functions must write deliverables into those contracts and enforce non-payment for lack of progress.

One panelist mentioned HHS's Biomedical Advanced Research and Development authority (BARDA) as a funding source with the caveat that its mindset favors the military's "quad chart" briefing system.  That makes sense to me if BARDA's mission is to fast-track biological warfare countermeasures that must support interagency efforts with DOD.  The takeaway is that startups must learn to summarize their value proposition in one slide with a picture of their drug or device, its costs, and their deliverables.

The panel noted that SBDC-funded consultants can help walk startups through grant writing.  Startups must frame their investment pitch in a way that non-expert angels and family offices understand, and SBIR grant success gives credibility as a form of peer-reviewed validation.  The NIH panelist noted the impact of leaner federal budgets, with the expectation that a sequester would reduce its budget by 8.2%.  NIH would likely cut current grants, reduce actual contract awards to 90% of their authorized level, and reduce the number of years for a contract to run.  The panel also said that startups can increase their chance of successful grant funding by having more preliminary data.

The next panel had an interesting title:  "Patient Advocacy Group and Passion Capital."  I had this mental image of hot nurses making out passionately with their patients, but alas that wasn't discussed today.  The panelists did mention what their organizations do:  The Thiel Foundation funds innovation capital for radical early-stage startups; the Cystic Fibrosis Foundation does venture philanthropy to de-risk new treatment methods for their typical patients; FasterCures is a think tank that coordinates venture philanthropy funders and develops new financial instruments.

This panel agreed that venture philanthropy is now part of Big Pharma's ecology because it helps de-risk innovation.  Some venture-philanthropists run clinical trial networks, patient registries, and other projects that help de-risk startups beyond just funding.  VP is not for the faint of heart because investments do fail.  Great risk remains in rare and orphan diseases.  Investors must see a developmental pathway to a viable drug.  VPs can fill the gap left as VCs retreat from early stage pharma funding.  VPs can take the tech they funded to corporate partners who can fund further development pathways.  Big Pharma has stepped in to the venture space to cherry-pick promising drug ideas, partly because they are reducing their own in-house development infrastructure.

The next panel was "Crowd Funding Options:  How to Raise One Million."  Ooh, goody, one of my favorite subjects.  The panelists all have startup backgrounds themselves, seeing niches in home equity finance and donor-advised funding that they could fill.  One of the CEOs argued that crowdfunding enables private equity investors to adopt a diversification approach to a portfolio.  IMHO this is a sea-change mentality from traditional pure play approaches in PE/VC.  The advantages that VCs bring to a startup besides money include mentoring and connection with other centers of influence.  It's good that entrepreneurs can access diverse sources of capital, but they need to know that the advice they get from nickel-and-dime investors will be nearly non-existent.  The JOBS Act updates Title III general solicitation rules and opens venture investing to non-accredited investors.  Entrepreneurs must use digital media to package their pitch attractively.  There is a fraud deterrent mechanism to answer critics alleging the JOBS Act generates a criminogenic business climate:  Funds raised on a crowdfunding platform are escrowed until the startup meets its funding target, and funds are returned to donors/investors if the target goes unmet by a deadline.

There's a rule in crowdfunding:  "Expect to lose your money," because it's risk capital.  One panelist mentioned that fraud is more prevalent now in regulated finance, as per Bernard Madoff and home mortgage lending.  I wonder whether the panelists read my article on the JOBS Act from last year, because they echoed some of the themes I raised.  Crowdfunding forces transparency by enabling public chatter in social media.

Startups can prove their valuation by generating social media buzz from their prospective market, thus proving the existence of demand that will drive sales.  One suggestion was to attract heavy Twitter users to a high-profile event and get them Tweeting about your idea.  Another panelist theorized that Millennials turned off by the stock market will instead invest in crowdfunded portfolios of projects.  Entrepreneurs can "build a wave" by offering freebies to early adopters who can spark passion in a product.  Perks, rewards, and bonuses attract people.  IMHO a crowdfunding platform that enables gamefication will attract startups and investors by the truckload.

I asked my only question of the conference at this panel:  "There's talk of large brokerages looking to acquire crowdfunding portals.  What qualities will make crowdfunding portals attractive to an acquirer?"  The panel answered that big banks don't yet see the intersection of social media and finance.  Portals will prove their value by attracting capital and deal participants.  I'm hereby summarizing this value proposition:  An attractive portal turns cash flow (funding from non-accredited investors) into deal flow (IPO and acquisition candidates for investment banks).  You heard it here first at Alfidi Capital.  

The final panel I was able to attend was "Biotech's Migration Outside the USA:  Where are the Emerging Opportunities?"  I don't invest much outside the U.S. but some of the cultural insights from this panel are useful to international investors.  Returning Chinese expatriates who were educated in the West bring life science expertise back home.  "Venture tourists" can visit startups outside the U.S. but the difficulty in doing deals varies by country.  Innovation as an ecosystem is attuned to local culture and takes a long time to create.  IMHO the rule of law is indispensable, so I wouldn't go looking for innovation in junta-ruled places like Myanmar; instead show me a locale that's at least one decade removed from authoritarian governance.  The U.S.'s NIH investments in R&D infrastructure really do matter.  Once again, show me a country that has such a nationally-sponsored laboratory system in place.  Several panelists mentioned the risk aversion of many traditional Asian cultures as a deterrent to startup investing, and that educated Chinese professionals make unlikely entrepreneurs because failure is considered shameful.

I had to split for another meeting but this conference was a great deal.  I wish I could have stayed for the Biotech Idol pitches because I love hearing directly from entrepreneurs.  See you next year, biotech all-stars!