A classic "zombie stock" is one that usually is operating on next to nothing and that may be dead and not even know it. A "biotech zombie" is a different animal altogether. In this article we'll take you through the gruesome nature of these stocks and how to watch out for these "living dead" investments.

The Creation of a Biotech Stock and a Monster
A biotech company is usually started by a grant from a local government, a foundation, a university, a wealthy backer or by a venture capitalist investment group. The time frame before investors can expect to see returns often runs in the range of five to 12 years and investors almost always buy into these stocks with the understanding that the payoff has to initially come from either a partnership with a major drug company or an already public biotech company. The real payout will come as the company gets closer to developing a treatment for whatever ailment is targeted. The costs are massive to bring actual products to market and very few ever make it there entirely on their own (if it all). (To keep reading about biotech companies, see The Ups And Downs Of Biotechnology and Using DCF In Biotech Valuation.)

Let's discuss the most common scenario for creating a publicly traded biotech zombie, using the fake company XYZ BIOTECH.

XYZ BIOTECH decides to go public with a robust business plan and some initial strong pre-clinical lab tests. Overall, it's a healthy company with no signs of future monsterism.

Note: The most common areas for biotech research include cancer, diabetes, AIDS, staph, sepsis, Alzheimer's, skin disease, viral influenza, avian flu and sexual dysfunction.

In order to get a strong interest from the start, startup biotech companies tend to attack more common "target" diseases. There is just too much capital required to get a product developed that would treat an ailment that only affects a few hundred - or even a few thousand - people each year. The growing monster must target the greatest number of people possible if it is to survive.

Chasing Its Goals, Dragging Behind
Now that the monster has been created and is heading toward a target group, it must sustain itself. Biotech zombies will never have genuine revenues, but they may show some revenues on the balance sheet because of interest income, grant payments and study partner funding. (To learn more about the balance sheet, see Breaking Down The Balance Sheet, Reading The Balance Sheet and Testing Balance Sheet Strength.)

Now, let's say that at some point down the road, usually after the zombie company has spent 50% or more of its initial public offering (IPO) cash and/or partner grant cash, XYZ BIOTECH drops the ball and issues a news release stating that its star treatment (its lead candidate) has failed to meet primary endpoints. The zombie's heart is failing.

Failing to meet its goals means that the robust indications and wonder cure are just not what the previous hype indicated. The XYZ zombie will say it is still evaluating data, and that it is evaluating its molecules for other indications; but, for all practical purposes, the hopes of reaching the major target are gone. At this point, the biotech zombie usually loses its big-buck partner and, as a result, all future financial backing. Therefore, it must decide what it will do going forward.

At this point, XYZ will likely scale down operations, reign in spending and usually send some employees and contracts pink slips. For whatever reason, most of the companies that fall into this scenario usually have between $50 to $150 million in net cash after subtracting intangibles from the hard assets, and then after subtracting their various liabilities. But although the zombie has been battered, it's still alive and continues to stumble along after it's goal.

The FDA Promotes Further Zombie-ism
If XYZ's candidate is granted a Food and Drug Administration (FDA) "orphan drug" designation, which is given if the candidate would have been a treatment for a condition where no treatment currently exists, the increased attention received from the FDA's designation would cause it to become a full zombie even faster. When the FDA gives an orphan drug designation, it generally requires more data and more tests, which is something a partner company or capitalist backer is not looking to support. (To learn more, read What does it mean to have orphan drug status?)

It is important to know that the biotech zombie pattern is not usually a result of an FDA request for more data, unless it was for a candidate that Wall Street and analysts thought was a virtual shoe-in. Those zombie companies fall into different categories of biotech investing because they will still have intermittent volatility in their shares whenever they issue pertinent press releases and updates. A true biotech zombie will usually have only one major candidate or a couple fledgling projects. These zombies will stay listed as public companies, but they basically go into a coma and usually will not show any sign of life for a very long time. (To learn more, see Measuring The Medicine Makers.)

The exception to this FDA zombie creation revolves around a previously unknown or under-the-radar micro-cap stock that claims to have a possible treatment for a new "hot" disease of the day. This working zombie will be spurred ahead of the pack as a positive answer to the negative public government warnings or disease scare. For example, consider the avian flu, small pox, anthrax, e.coli, and the like. Often, the companies who worked with these diseases weren't on the map until the temporary phenomenon occurs.

Is a zombie a fraud?
Many of these biotech zombies get labeled as hucksters or frauds, but in many cases it is simply a true a failure in a larger scale testing phase that turns them to zombies. Sometimes it boils down to the FDA making a completely unexpected call. Listening to the subsequent conference calls will provide the best signal of this. If a biotech company is not legitimate, it quickly becomes evident because there are too many public opinion posts and too many online message boards where investors can get information. The end result will usually be a long steady decline for the companies that are run by management that doesn't get it. (To keep reading about this subject, see Conference Call Basics, Evaluating A Company's Management and Putting Management Under The Microscope.)

Resurrecting the Zombie
There are ways to identify some biotech zombies that may have a shot at life. This is a purely speculative strategy, but many zombies have seen a rebirth in the past. For any company to come back to life, it must have adequate cash (more than it needs to survive a year or two). It also has to have or hire a solid chief science officer, or it has to have a stellar team that has been behind other successful discovery projects. This is why watching for press releases from biotech zombie stocks can be very important. And, if you can get past all the groaning and mumbling, you may find new life in an old zombie.

Usually the earnings releases on zombie stocks don't matter - with the exception of any new guidance on evaluating molecules. However, these releases may also be used as a guide to make sure the company isn't increasing its cash burn rates. In some cases you will see a top scientist leave one of the bigger biotech companies or some of the special project areas of a "Big Pharma" drug company to work on the zombie. If and when this occurs, you at least have a potential biotech zombie that has a shot of recovering. These companies will often trade under a stated book value for certain periods of time.

End Zone
When running screens for these biotech zombies that have a shot at reanimation, there are several things to look for on the balance sheets. Zombies in the U.S. or Canada will almost never have a market cap of more than US$300 million by nature. If the zombie company you are researching still has "current" revenues or forward revenues expected, then it may be worth keeping the potential screen (if the revenues are under $10 million annually). If these factors aren't in play, the zombie is either be dead or it is still an active company that hasn't become a zombie. If the zombie has no cash and the company has a high burn rate, then cut it out of consideration. If, however, the zombie has ample cash and a low burn rate, then keep watching this groaner, new life may not be far away.

To read more about investing monsters, witches and voodoo, see Haunting Wall Street: The Halloween Terminology Of Investing and The Ghouls And Monsters On Wall Street.

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