Harry Hindsight chimes in on 4D Pharma
Losing 100% on an investment is never a good feeling.
Commiserations to anyone holding shares in 4D Pharma (DDDD).
On Friday, the company’s shares were suspended. It was revealed that a creditor had chosen to put the company into administration.
The fat lady hasn’t sung just yet: a range of outcomes is possible, and existing shareholders might not lose 100% of their investment. But losing 100% of their investment appears to be, by a wide margin, the most likely outcome.
I’ve been there, done that and bought the t-shirt. I’ve lost 100% on an investment before. I’ve also owned several companies which would have resulted in a total loss, if I had not come to my senses earlier.
Fortunately, these experiences happened quite early in my investing career. I paid for my investing education in this way, and have not needed to pay for any additional tuition just yet.
But that doesn’t help you very much, if you’ve just lost 100% on DDDD. All I can say is: you will use this experience in the future.
Some former DDDD shareholders will choose not to get involved in individual stocks again. For them, that will be the right decision.
Some will abandon pharma stocks. Some will develop a greater interest in mature, profitable companies. And some will simply reduce the size of their “mad money” portfolio - the portion of their savings that they earmarked for entertainment!
But for each person, the pain of loss will help to shape their future investment strategy.
I’ve checked my archives, and I don’t think I’ve ever written a word about DDDD before. So I’m not claiming to be a guru who saw this coming.
However, there are good reasons why I’ve never written about DDDD before, which I can spot instantly:
Pharma - this is a notoriously difficult sector. Remember that even the experts often fail to predict the results from drug trials, and fail to predict whether or not a medicine will be approved. If the scientific experts can’t do it, how can a layperson?
Surviving in the investment field has a lot to do with knowing what you don’t know. I know that I can’t predict the future of medicine, so I simply stay away.
Now if somebody has been burned in DDDD but still wants to invest in the pharma space, the good news is that there are plenty of large, profitable companies they can choose from. Less exciting, but much easier to sleep at night!
Zero revenues - investing in pre-revenue companies has a lot in common with investing in lottery tickets. One or two of them will succeed and, if you’re lucky, they will pay for all the others.
DDDD’s revenues weren’t quite zero (c. £500k annually). But they were effectively zero, relative to $20m of R&D spending annually, and $7m in administrative expenses.
In its most recent results statement, the company said:
To date we have not generated significant revenue, and we do not expect to generate significant revenues from the sale of our product candidates in the near future.
There was not even the prospect of significant revenues being generated soon.
Anybody invested in a company that has effectively zero sales, and has no near-term prospect of making any sales, needs to understand the nature of the risk they are taking.
Personally, I don’t feel comfortable investing in companies that aren’t making a profit. But investing in companies that don’t even make revenue - that’s a special category of risk!
Debt/Balance sheet - for many years, I’ve suggested that investors should check the going concern statement in the annual report of their companies. It’s a simple check that only takes a minute.
“Going concern” is mentioned 27 times in the most recent annual report from 4D Pharma. The report is unambiguous in its message (I have added the bolding below):
The Directors are continuing to explore sources of finance available to the Group and have a reasonable expectation that they will be able to secure sufficient cash inflows into the Group to continue its activities for not less than 12 months from the date of approval of these accounts. They have therefore prepared the financial statements on a going concern basis.
Because the additional finance is not committed at the date of approval of these financial statements, these circumstances represent a material uncertainty as to the Group’s ability to continue as a going concern.
This is perfectly clear, and barely needs to be commented on further. Additional finance was needed, but was not yet secured. Without that additional finance, it was unclear if 4D Pharma would be able to continue in its current form.
Whenever the words “material uncertainty” and “going concern” are used in the same sentence in a UK company’s annual report, then you know there are balance sheet issues.
And unless you are certain that these issues have been or will be resolved, then I think you have to allow for the possibility that the company will be insolvent.
Near the start of my investing journey, I suffered a 100% loss from a company which had a balance sheet problem. Most investors have done this at least once in our lives.
In investing, as in every other field, the important thing is to learn from the mistake, and not do it again!
Expensive Borrowing - the loan which 4D Pharma is currently unable to repay has some interesting detail.
Last year, the company turned to a specialist lender to help pay its bills - Oxford Finance LLC.
The loan was secured against “substantially all the assets of the Group”, meaning that this lender is at the top of the queue, both against shareholders and against most other creditors, when it comes to getting their money back.
Interest was charged at 8.15% plus a spread. In addition, the lender was entitled to a final payment fee of up to 6.5%, and a stream of warrants.
Let there be no doubt: this is extraordinarily expensive borrowing for a company to accept. If these were the best terms available, then it’s yet more confirmation of the extremely risky nature of the equity.
The loan wasn’t just expensive. It was also restrictive, with a set of covenants affecting 4D Pharma’s future choices. This in particular stands out:
The loan includes a restrictive covenant that requires the Group to maintain a cash balance of at least $7.5 million if the Group does not meet the conditions of the equity event. The equity event requires the issue of equity securities and other receipt of income from other partnering transactions, in certain combinations, of at least $45 million before 1 April 2022.
If a company is paying an interest rate that’s in or near double digit territory, and with horrible covenants like this, it’s a good sign that the equity is extremely high risk.
Once bitten, twice shy
Only two weeks ago, 4D Pharma held a pre-AGM Investor Presentation, which you can view on YouTube here.
When asked during the Q&A what was the company’s greatest challenge, the CFO spoke loud and clear when he replied “obviously, it’s financing”.
He was right - and I expect that many DDDD shareholders will be more sensitive to this aspect of their investments in future.
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