FNCH - Finch Therapeutics: Why This Finch Could Fly - An Asymmetric Risk/Reward Opportunity

2023-04-03 08:43:08 ET

Summary

• Finch Therapeutics recently made the decision to discontinue the company's Phase 3 trial, lay off 95% of its workforce, and pursue the next path to maximize value for shareholders.
• As of now, the company has a market cap of $16 million with a cash position of over $43 million and has cut costs dramatically, decreasing the cash burn rate.
• Finch also has approximately $48 million in property, plant, and equipment listed on the balance sheet and currently trades at a negative enterprise value.
• I estimate that Finch's intellectual property, cash, and other assets combined are far greater than the cost of liquidating the whole company.
• While there is much uncertainty, the recent decline in the share price presents an asymmetric risk/reward opportunity for patient investors.

Investment Thesis

Finch Therapeutics ( FNCH ) is a microbiome technology company which currently has a negative enterprise value, due to the fact that the market capitalization of the company is smaller than the company's cash position. This is not uncommon in the world of biotechnology companies today, but Finch Therapeutics stands out for several reasons.

While Finch was previously burning cash at a high rate, after the recent layoffs of 95% of staff and the discontinuation of their Phase 3 trial for treating c. difficile, the company seems to be in cash-preservation mode as it figures out the next step to maximize value for shareholders. The stock trades at a small fraction of the company's book value, with over $43 million in cash and $48 million in property, plant, and equipment listed on the balance sheet as of February 28th, 2023.

Recently, the company made the decision to discontinue its Phase 3 trial and lay off 95% of its workforce, suggesting that management is prepping for a sale/liquidation or merger somewhere down the line. It is an uncertain road ahead, but the cash position is much larger than the current market capitalization, and with a smaller cash burn rate going forward, more value can be realized for patient shareholders.

In addition to physical assets and cash, Finch has a considerable number of patents (over 50) and intellectual property as well, which carries additional hidden value beyond what is observable on the balance sheet. I estimate that Finch's physical assets alone could be worth anywhere from $1.75 to $1.90 per share at the conservative end, and possibly more should a liquidation or major deal occur some time in the future to realize the true value of the company's intellectual property.

Introduction

Finch Therapeutics is a stock which caught my attention after I noticed that prominent value investor Seth Klarman had bought around $1 million worth of the company's shares in Q3 2022. I thought that it seemed highly unusual for a value investor of such a high caliber to be buying such a small, speculative company, but the size of the position was somewhat telling. This prompted me to dig a little deeper and do my own research into what Finch was working on.

At the time, Finch Therapeutics had a promising Phase 3 clinical trial of CP101 in Recurrent C. difficile Infection, dubbed PRISM4. Quite recently, in January 2023 the company made the abrupt decision to discontinue the Phase 3 trial and lay off 95% of its workforce. This begged the question, just what is management doing and what is the next step for the company?

The Phase 3 trial was on schedule and going very well with no serious adverse events reported, so there is some uncertainty as to why the company would make this decision and what the immediate result would be for the company's share price. Since January 31st, 2023, FNCH has fallen approximately 33% as the market is unsure of what the possible outcomes for the company will be now that their Phase 3 trial has been discontinued. In this article, I will outline the value proposition of the company, explain the asymmetric risk/reward opportunity, and explore several different possible outcomes for the stock.

Down, But Not Out

While Finch has abruptly discontinued the PRISM4 trial, there are many other avenues that the company could explore to create value for shareholders. Apart from the sheer cash position, as well as property, plant, and equipment listed on the balance sheet, Finch has over 50 patents and additional intellectual property, which are collectively more difficult to assign value to.

Touching on the topic of risk a bit, it is worth mentioning that the company is currently involved in a patent litigation against Ferring and Rebiotix, which seems to be turning a corner. As of last month, the court " adopted Finch's proposed definitions for seven out of the eight terms at issue, broadly rejecting Ferring and Rebiotix’s arguments for those terms." It seems as though Finch has a high likelihood of winning the patent infringement lawsuit, but this will not be known until next year.

We believe that Finch has made significant progress towards restructuring the business to maximize value for shareholders through our robust intellectual property estate, including by continuing to support the advancement of our microbiome technology through partnerships and collaborations... As part of our restructuring, we have significantly decreased costs by reducing vendor and employee expenses, extending our expected cash runway into 2025. We expect this will support company operations well beyond our anticipated jury trial with Ferring and Rebiotix, which is scheduled for May 2024, over what we believe is their ongoing unauthorized use of our intellectual property. In addition to these recent developments, we continue to pursue partnerships with leading research institutions to explore new opportunities for our microbiome technology to address a variety of important unmet clinical needs."

Source: Mark Smith, PhD, Chief Executive Officer of Finch Therapeutics

Which new opportunities are there left to explore? For starters, the University of Minnesota is currently conducting investigator-initiated trials using Finch's exclusively licensed technology, which are being funded and conducted independently from Finch. This is another important thing to consider, as Finch could benefit from these trials at a future date without having to fund the trials directly.

The therapeutic areas that these trials cover range from inflammatory bowel disease, oncology, and autism spectrum disorder, to several others. While the PRISM4 trial for treating c. difficile is in the rear-view mirror, there is still hope for the company's technology in treating other diseases and disorders. This could prove to be quite valuable in the long-term, should another party express interest in Finch's assets on the back of some good data in the treatment of other diseases. Research in the emerging field of the microbiome is just starting to gain traction, and Finch has played an important role so far.

In addition, Finch has announced that the company has created a biorepository with "thousands of stool samples collected from study participants and thousands of bacterial isolates derived from healthy donors " - something that the company intends to license in the near future. There is considerable value in this biorepository which has yet to be unlocked, although the exact monetary value is difficult to determine. For all current considerations, I will not attempt to define exact value of the biorepository or the company's patents.

This presents with three initial things to consider:

• Finch has dramatically decreased costs and the cash burn rate by discontinuing the PRISM4 Phase 3 trial and laying off 95% of its workforce.
• Finch has a high likelihood of winning the patent infringement lawsuit against Ferring and Rebiotix which will conclude in 2024.
• Finch has over 50 patents, and thousands of stool samples and bacterial isolates which could be licensed for future research applications or sold.

Another thing to consider is the company's debt situation - in terms of the company's debt, Finch has repaid all of their obligations to Hercules Capital ( HTGC ) as of January 2023, which totaled around $16.2 million. Judging by this and the initial considerations listed above, it stands to reason that Finch's management has set the stage for a sale of the company, potential liquidation, or a merger of some kind down the road.

Asymmetry - High Upside, Minimal Downside

Finch is an excellent example of an overlooked stock which exhibits asymmetric risk/reward characteristics. The company currently has a negative enterprise value (EV = -$1.8 million) due to the fact that the market capitalization of the company is smaller than the company's cash position. In theory, if the company were to liquidate today, the cash position would be more than sufficient to cover the company's remaining liabilities and pay out shareholders with a surplus. I estimate that as of February 28th, 2023, Finch had around $0.90 per share in cash. This means that Finch is currently trading for less than two fifths of its cash position. Book value has decreased around 15% since last December, but the stock trades at a steep discount to book value and the risk of deterioration has been largely priced in. Recently, the stock has experienced a brutal bear market and has the propensity to trade as low as one fifth of current book value on given days, citing price action over the last six months with 52 week lows hitting approximately $0.30.

The current situation concerning Finch Therapeutics may not look like a value investment at first glance, but to me this looks like it could be a classic 'Dhandho' investment - a term coined by legendary value investor Mohnish Pabrai which equates to a framework of low risk, high uncertainty investing . The mantra that coincides with this strategy is "Heads I win; Tails, I don't lose much."

The core principle of 'Dhandho investing' focuses on determining the true value of the business, instead of judging a company based on the movements of its stock price. It appears that downside risk in Finch, while existent, is extremely small compared to the potential upside given a liquidation, buyout, or other impactful event occurring such as a merger with a larger company.

I estimate that including potential unforeseen costs of around $10 million for Finch in a liquidation or other scenario, the company would still have upwards of $0.69 per share in cash. Property, plant, and equipment is stated on the balance sheet with a net value of $48 million, or the equivalent of around $1.00 per share. This approximate value of assets does not even include the company's patents, the biorepository of research samples, or the company's other intellectual property, which I will not attempt to value.

A more accurate book value metric could be conservatively valued at $1.90 or $2.00 per share. However, there are risks that an investor should be aware of, including continued shrinking of book value and shrinking cash position with an uncertain future burn rate over the next several quarters. While the cash burn rate is expected to come down substantially, and management has stated that the current cash position will be sufficient until 2025, there is a high amount of uncertainty regarding the future. The most disappointing outcome for the company would be that a takeover deal never materializes, or that the remaining cash burn ends up eroding shareholder value over the next couple of years without a merger/liquidation event taking place.

Maybe It's The Yuck Factor

Why does this asymmetric risk/reward opportunity exist? Another way to say this is; why does the market hate Finch so much? Maybe it's due to the fact that the company discontinued its promising Phase 3 drug trial, burning cash along the way, or that the company literally deals with stool samples and bacterial isolates, which carries a 'yuck' factor that many investors simply cannot get behind.

Let us take a step back and evaluate the company in a more logical way. Assuming that Finch never brings a drug to market, we are left with the reality of the current situation - the company is now basically a pile of cash, intellectual property, a biorepository of samples and isolates, and other property, plant, and equipment. Management has fully satisfied the company's obligations to Hercules Capital, and in my opinion, seems to be prepping for a liquidation or a sale/merger sometime in the near future. The wildcard in terms of valuation is the company's intellectual property and patents, which could add considerable value given a buyout or merger, but this is uncertain and largely unknown.

In my opinion, Finch is no longer a therapeutics company with a typical binary outcome hinging on a successful drug trial. This is more of a sum-of-the-parts situation where value is likely only realized for shareholders in the event of such a liquidation or buyout/merger. Judging the risk/reward opportunity at the current stock price, I have initiated a small position in the company and intend to hold the stock for the foreseeable future, as downside risk seems to be extremely small and the upside potential is great.

However, a very real risk to consider is that Finch might not be able to realize the full value of its intellectual property or other assets in a buyout/merger. Finch's ability to comply with regulatory requirements could also become an issue in the future, and there are continued risks regarding Finch’s intellectual property rights, which have allegedly been infringed upon in the past. Other, more market specific, risks to consider are issues with liquidity and a potential lack of market makers willing to provide depth to the order book. The stock is liquid enough for my liking, but price movements can be extremely volatile and unpredictable.

Conclusion

Finch Therapeutics is a unique investment opportunity for those following a framework of low risk, high uncertainty investing and the mindset of "Heads I win; Tails, I don't lose much." The asymmetric risk/reward opportunity is due to the fact that the company has a negative enterprise value, and has cash and additional assets which are many times greater than the current market capitalization. With the discontinuation of the company's PRISM4 Phase 3 trial for the treatment of c. difficile and the layoffs amounting to 95% of the company's workforce, costs are expected to come down dramatically as the company enters cash-preservation mode. The company's debt obligations due to Hercules Capital have been fully satisfied as of February 28th, 2023, and in my opinion, it seems that management has set the stage for a liquidation, sale, or potential merger somewhere down the line. I estimate that with cash and physical assets totaling approximately $1.90 per share, Finch's stock is potentially worth five to six times more than the last traded price. Given that the full value of the company's intellectual property can be realized, the upside potential is even greater. Judging the risk/reward opportunity, I have initiated a small position around $0.35 per share and currently view Finch Therapeutics as a Buy.

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