Tuesday, February 20, 2007

Margin Rules Might Make Development Stage Biotech Financials Matter

Margin Rules Might Make Development Stage Biotech Financials MatterSocialTwist Tell-a-Friend
David Miller
February 20, 2007

For development-stage biotechnology companies, quarter-to-quarter revenues don’t matter much because these firms – by definition – don’t have significant revenues. What revenues they do have tend to be expense reimbursements from partners or amortized partnership dollars (up-front cash and milestone payments).

This makes financial analysis of these companies a relatively easy bottom line affair – you largely ignore everything but the net cash burn.

That could change for customers of TD Ameritrade (AMTD). Some time before the end of February for “original” Ameritrade customers and at an unknown date between February and June for “original” TD Waterhouse customers, the firm is changing its margin maintenance rules on biotechnology stocks. Generally, maintenance requirements will increase for those who hold development-stage biotech companies. Those who have concentrated portfolios will be the most affected.

Thanks go out to a correspondent, who wishes to remain unnamed, for alerting me to this potential change and sharing his conversations with the Ameritrade people. I made a few calls and came up with the following information.

TD Ameritrade has had significant trouble with collecting on margin calls from investors who were overly concentrated in one biotechnology stock. Not everyone has the “benefit” of my constant harangue on diversification, so there are people out there who have sunk everything into one stock only to see it detonate. Telik’s (TELK) recent 70% overnight decline is probably one of the better recent examples of this sad phenomenon.

TD Ameritrade is addressing this by changing the maintenance requirements for holders of biotechnology stocks in margin accounts. This is more than a little complicated, but I’m going to lay this out in a series of tables. If you are a TD Ameritrade customer with a margin account, I can’t urge you enough to call them and get specific guidance about your account.

It is probably best to start with the current rules:

In addition to these requirements, TD Ameritrade has placed more stringent maintenance requirements on a few hundred individual stocks. The company is changing their web site to make the list of these stocks easier to find. Currently, select the “Trade” tab on the new interface and start looking for a link named “Special Margin Requirements.” Some users will find this at the top. I found it in the small print at the bottom of the page.

The first change applicable to biotechnology investors has to do with different concentration requirements. Concentration refers to what percentage a particular stock makes up of your entire portfolio. As you can see above, normal concentration requirements kick in at 70%. For biotechnology stocks, there are now three tiers with the first one beginning at 50% instead:

This is relatively straightforward thus far. The more concentrated your portfolio, the higher your maintenance requirements will become.

The complicated part is how TD Ameritrade is going to determine the margin requirements on individual biotech stocks. They’ve decided to use a price/sales ratio, the market cap of the company divided by trailing twelve-month sales. If you don’t want to do the calculation in your head, both the TD Ameritrade site and Yahoo! Finance list the price/sales ratio.

I think this is a particularly odd choice, likely made by people with limited understanding of the sector. It creates the odd situation where, for a given revenue level, low-priced stocks – arguably those the market has voted to be the most risky – have lower margin requirements than high-priced stocks the market has voted to be less risky. It’s backwards, really. Additionally, it doesn’t even make sense from TD Ameritrade’s standpoint. A 50% loss on a $5 stock is the same as a 50% loss on a $25 stock, the only difference is the number of shares involved.

I’ve written at some length how traditional valuation metrics simply don’t apply to the biotech space. This is a perfect example of that.

Nevertheless, them’s the rules. Here is how the maintenance requirements break down according to the concentration tiers noted above and the price/sales ratios:

For people with undiversified biotechnology portfolios, the change from the current maintenance rates can be as much as 30 percentage points.

I’ve pulled a few examples from our own coverage universe to highlight how reliance on price/sales ratios create some unexpected results.

Would an objective observer determine YM Biosciences (YMI) is a lower risk than ZymoGenetics (ZGEN)? Or that Targeted Genetics (TGEN) is less risky from a “could go to zero” standpoint than Repros (RPRX)?

Of course not. TD Ameritrade has chosen a blunt quantitative instrument instead of working on a qualitative analysis of the situation in the sector.

If you are a TD Ameritrade margin customer with significant biotech holdings, call the company and ask to speak with the margin department. Have them run the numbers on your account to tell you what your maintenance call will be under the new rules. This is especially important if you are over 50% concentrated in any one stock.

I’m interested to see if other brokerages will follow suit.

Disclosure: Positions in YMI, RPRX, TGEN

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