Burn Baby, Burn - Why Cash Flow is So Important...

By Marc Lichtenfeld

While you might love to sing along to "Disco Inferno" on the dance floor, investors in unprofitable companies hate the word "burn."

You see, it's usually preceded by the word "cash" -- as in "cash burn" -- and it often refers to the amount of cash the company is spending on a quarterly or yearly basis.

For larger, well established companies, cash burn is usually not an issue. They tend to have plenty of reserves, and many times the unprofitable quarter or year is an aberration.

But for smaller companies -- particularly in the biotech space, which sometimes come public before they even have any revenue -- cash burn is a topic investors need to pay close attention to.

Regular readers of mine know that I’m obsessed with cash flow. Obviously, if a company has no revenue, the cash flow will be extremely negative. However, if a company has enough cash to last for a while, that's not the end of the world. As long as it has enough time to land lucrative partnership deals or bring a product to market, it should be just fine.

For example, little known Lexicon Pharmaceuticals (Nasdaq: LXRX) generated just $1.8 million in revenue in 2011 and lost $116 million. However, it has $318 million in cash and investments and five product candidates that could land a partnership with a big drug company, potentially bringing in millions of dollars. Additionally, the company expects to burn through less than $100 million in 2012, giving Lexicon at least two and a half years to bring in more money.

The problem arises when a company does not have such a long runway. This is of concern because the way a company usually raises money is by selling more stock, which dilutes shareholders.

For example, if you own 1,000 shares of a company with 1 million shares outstanding, you own 0.1% of the company. If it raises money by selling 250,000 shares, you now own 0.08% of the company.

Let's look at a real example from last week. Celldex Therapeutics (Nasdaq: CLDX) has a very promising drug for brain cancer. Thursday, the company said it will sell 10.5 million shares at $3.85 in order to raise $40 million. Before the offering, the company had 44.2 million shares outstanding, so existing shareholders were diluted by 24%.

The stock closed at $4.36 before the announcement and opened at $3.88 after.

Because shareholders get diluted, stocks usually fall when the company announces it's going to sell stock. Even the fear of a company having to sell stock can keep the stock price from going up.

Avanir Pharmaceuticals (Nasdaq: AVNR) is a company burning cash at a rapid rate. Despite having just $75 million in cash, the company expects operating expenses to be around $90 million.

So in other words, the company has less than a year of cash left. No wonder the stock is trading more than 40% below its 52-week high.

When I screen for stocks using the stock screening system I created, I always look for companies with positive cash flow. If the company can't generate cash by running its business, I'm not interested.

However, when I select healthcare stocks in particular, I will sometimes pick companies that are burning cash. Generally, my rule is this: I want a company that has at least two years worth of cash left. That's plenty of time for some positive developments to occur.

On the rare occasion where there is less than two years of cash, I need a strong catalyst that can lift the stock significantly higher before the company raises money.

For example, let's say there’s a stock trading at $2. I know they need to raise money, but they have clinical trial data coming out. If my assumptions are that the stock could move to $4 on the data and then slide down to $3 if they announce a capital raise, then it's worth buying it now at $2.

Those situations don't occur too frequently, however. So when analyzing unprofitable companies, be sure you have a clear understanding of how much cash the company has and how much it's using.