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Financial planning, Investment and Self Managed Super Fund Article
Value of Long Gestation Companies
By John Robertson
1st March 2007
This article may be out of date.
Smaller listed companies find it hard to emphasise their attractiveness to investors when their first sales have very long gestation periods.
This can tempt them to try some shortcuts.
Small biotech and mining companies have one thing in common. It can take a long time for them to prove the value of the underlying ‘discoveries’ which might eventually lead to greater shareholder wealth.
Delineation of mineral reserves, in the case of a potential miner, is one clue to value. In the case of the budding biotech, it might be the grant of new patents. However, the commercial significance of these indicators is often unclear and frequently not spelled out adequately by the companies themselves,when they announce the new reserve or the additional patent.
Without other accompanying information, thesepotential indicators of commercial progress might offer only the vaguest sense of potential future value. In some cases, the extra information might confuse rather than clarify.
There are some regulatory guideposts describing how such early stage companies should report their progress. The most stringent and longest standing are for the miners.
Originally formed in 1971, the Joint Ore Reserves Committee (JORC) is made up of representatives of the Australasian Institute of Mining and Metallurgy, the Australian Institute of Geoscientists and the Minerals Council of Australia. It provides guidance on how companies should report exploration results, mineral resources and ore reserves. These guidelines are referred to as the JORC Code.
Under the JORC Code, publicly made claims about the magnitudes of mineral finds must be vouched for by experienced and technically trained individuals who stake their reputations on their statements to investors.
Eighteen months ago, the ASX published its Code of Best Practice for Reporting by Life Science Companies. It offers guidance to biotech companies on how they should present themselves to the investing public bearing in mind some of the peculiarities of their circumstances and the need to avoid misleading their potential investors.
These regulatory efforts reflect concerns that investors are at risk if there are inconsistencies between the reporting standards of comparable companies or between how the same company might report at different times.
This is an especially significant risk when there are technical issues unlikely to be understood by the average investor without specific training.
While regulators have moved to afford greater certainty in this way, their guidelines have tended to focus on the management process, which is more easily monitored.
They have tended to ignore the primary output of interest to investors, namely, what the company might be worth at a particular point in time and how the most recent piece of information enhances or diminishes that value.
Too long to wait
Many years could elapse between verifying the initial science and completing all the human testing needed before a new drug can be taken to market. Similarly, some mines underpinning the prospects of today’s listed mining companies are the result of mineral discoveries made as long ago as the 1980s.
With this long to wait, most analysts would regard putting a formal value on a new patent or a new ore discovery as highly speculative. The most sophisticated might adopt some form of probabilistic approach to derive an expected value, but even this would be highly unusual. Generally, analysts wait for an accumulation of information, perhaps over many years, before a technically more conventional valuation is attempted.
That leaves potential investors in a quandary about whether to buy and at what price to sell a stock at this early stage. As a consequence, long gestation companies such as these are frequently treated as purely speculative. They achieve a small following, but are not regarded as part of the mainstream market.
In the normal course, such companies proceed over many years through a series of market revaluations as occasional operational and strategic milestones are passed.
The risk of things going wrong or failing to proceed as smoothly as the timeline on the project plan is likely to test the patience of ordinary investors. The occasional failure to meet deadlines often damages executive credibility which is hard to restore.
Prolonged periods of share price weakness might not be at all unusual as the company moves through cycles of disappointment and euphoria.
Company executives embarking on these long-term development opportunities are frequently (if not always) motivated to stay the course by what other companies, typically overseas, appear to be worth. They frequently eye off these companies jealously wondering when their own discoveries will lead to similar revaluations by the markets. Not only will that make them wealthier individuals, but it will also ease the task of raising fresh working and development capital for what are usually capital hungry businesses.
This becomes a source of frustration for company executives. There can be a strong temptation to highlight value in ways which circumvent the need for this lengthy history to unfold.
Biotechs: what they should say
The best practice guidelines issued by the ASX for young biotech companies highlights the information they should provide about patents they hold, including:
- title of the patent
- basic description of the subject matter covered by the patent
- PCT Number (if applicable)
- priority date
- expiry date
- status in key jurisdictions
- patent number in key jurisdictions
- filing date
- the identity of owner(s) if the company is not the owner, and the rights to the patent have been in-licensed.
The ASX suggests that the commercial significance of a patent should also be addressed, but does not proffer any substantive advice as to how this is to be accomplished.
The important question for an investor is what a new patent means for the value of a company and whether a new patent is a strategically significant addition to the business.
Case study: Norwood Abbey
Norwood Abbey is an interesting case study in the local market. It develops medical devices and procedures for administering drugs, as well as researching opportunities in human immunology. Some of its underlying science appears quite outstanding and its access to researchers with international reputations at leading institutions gives it the chance to deal with problems which belie its size and location.
According to the chairman of the company at its most recent general meeting, it had approximately 200 international patent applications outstanding with some 40 already granted. About half of these had come through in the 12 months prior to the meeting.
In this case, the share price seems to have varied inversely with the number of patents. From around 60 cents a share in late 2005, the Norwood Abbey share price followed a downward trajectory to 5 cents a share a year later.
Clearly, the magnitude of the intellectual property position alone is not necessarily a sound indicator of value.
As the Norwood Abbey chairman himself observed in describing what had happened, there were other factors at work, such as failure to deliver sales. In one case, another company preempted Norwood Abbey by bringing to market a competing product which pulled the commercial rug from under Norwood Abbey, notwithstanding the apparent quality of its intellectual property and the accumulating volume of related patents.
In making its occasional announcements as each patent was granted, Norwood Abbey had referred to its building intellectual property position, but had failed to explain its commercial significance.
Norwood Abbey is simply one example. The need for the ASX to have issued its guidelines suggests more widespread shortcomings in the way companies had been explaining their activities.
To do a proper job, a company not only needs to provide the details suggested by the ASX, but should go one or two steps further by embracing the sentiment behind the ASX guidance.
To be effective in helping potential investors, a company needs to identify what it can achieve with the latest patent that would not have been possible without the patent.
In other words, it should try to say how significant the patent was in pushing forward the commercialisation of a drug or a new device.
Is the patent simply a by-product of research, or an intrinsic part of future commercial outcomes? Alternatively, is the patent so narrow that other companies could also be obtaining just as many patents (or even fewer) which lead to commercially competitive products solving the same problems?
Companies avoiding explicit details about the commercial significance of the patents being granted by not dealing adequately with such basic questions are still implicitly inviting investors to attribute a higher value to the company. This is the hallmark of just another form of investment market titillation among companies striving for attention.
If a company fails to highlight the strategic impact of a new patent, investors could legitimately draw some unflattering conclusions:
- There might actually be little of commercial significance in the patent and it is being used as a substitute for real commercial action
- The management of the company might not understand fully the commercial significance of what they have done and are unable to provide an explanation of the impact for that reason
- The management, through arrogance or incompetence, might just simply be poor communicators.
Announcements under these circumstances become a source of additional investor uncertainty rather than comfort about commercial progress.
Miners: what they should say
The urge to titillate is also present among mining companies. Some mining companies try to highlight their intrinsic worth by putting a price on the metal content of what they have discovered based on current, and cyclically high, commodity prices.
One ASX listed company with a market capitalisation of just $23 million at the end of January claimed to have discovered copper valued at more than one billion Australian dollars.
Another company which the market also valued at $23 million at the same time cited minerals in the ground, including copper, nickel and cobalt, worth US$2.15 billion in documents it sent to investors.
The stark disparity between what the market was paying for these companies and the value attributed to what they had in the ground is undoubtedly designed to get people thinking about the share price
Care should be taken in responding to this form of enticement, however, because the suggested in-ground value grossly exaggerates what an investor should contemplate paying in these two instances.
The tactic is akin to Coles, for example, saying that it is worth $700 billion, or some 38 times its market capitalisation calculated on the aggregated value of its sales over the next 20 years based on current prices and volumes.
The supposed value of copper in the first example implies that 100% of the metal to be mined occurs miraculously in its refined state and, having been removed without cost, can be delivered at today’s market prices (through some form of perpetual derivative) whenever it might be needed in the future.
There are several things wrong with this overly simplistic (i.e. erroneous) analysis.
1. Miners never take out 100% of the minerals in the ground.
Some of the orebody might be inaccessible. Some might contain a lower than average amount of mineralisation making it uneconomic to mine. In the case of this potential copper miner, the company’s own feasibility study assumes that it will mine only 60%of the resource to which it has attached its billion dollar price tag.
2. Whatever can be exploited will come at a cost.
This company’s feasibility study assumes cash operating costs will average slightly under US$1.50 per poundof copper. If today’s prices (i.e. US$2.50 per lb) prevail over the entire eight year life of the mine, the gross cash income of the mine is likely to be just above $245 million; well short of the $1 billion headline price tag.
3. The time value of money needs to be taken into account.
This mine might come into production in 2008 with an eight year mine life. With a cost of capital in the vicinity of 12%, the present value of this income stream would be little more than $120 million (assuming that the mine proceeds are spread evenly over the eight years).
4. Capital needs to be applied up-front to bring the mine to fruition.
In this case, the capital required to get this amount of metal out of the ground is likely to be around $75 million. This needs to be deducted from the potential value of the property taking us to just under $50 million in real value.
5. Any profitable business will have to pay tax.
At 30%, this could knock another $30 million from the valuation.
Even all going well, the value of the prospective income stream might just approximate its market capitalisation. Markets work!
6. Copper prices might be lower than assumed in the years ahead.
At US$1.50 per pound they would still be at a healthy premium to historical prices. Over the 25 years prior to 2004, the average copper price was US$0.90 per lb and the previous cyclical peak was only briefly around $1.50 per lb.
Industry analysts are now suggesting that the upper end of the international copper industry cost curve sits at $1.40 to $1.50 per pound. It would be common in a cyclical industry for the market price to fall below the industry’s marginal cost of production to help clear inventories at some stage.
This suggests the possibility that market prices could be under the production costs of this company.
There is some risk of our so-called billion dollar company never making a profit. Depending on what an investor might be prepared to assume about prospective copper prices, this miner might not be worth anything.
Not enough protection
As with the biotechs, there is little or no agreement among those regulating the market about what constitutes value for miners at this early stage of development before feasibility studies have been completed and sales contracts put in place.
Generally, the regulatory constraints on Australia’s mining companies have ensured reporting regimes which minimise the extent to which company prospects can be exaggerated. To its credit, the ASX has also recognised the importance of this in the case of the life science companies and has tried to move toward a similar set of standards.
However, the protection is not watertight. It focuses on the physical attributes of the claims while neglecting their impact on value.
There will continue to be instances of overzealous promotion from time-to-time fostered by impatience about share prices. Investors will continue to be tempted to infer a higher value for the latest additional intellectual property right oraccretion in mineral resource.
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