This Article Is Written By Edward Vranic and Can Also Be Found At His Blog on Seeking Alpha
REDONDO BEACH, CA / ACCESSWIRE / July 21, 2015 / Biotechnology stocks with a focus on dermatology have performed quite well in 2015. Dermatology covers a broad range of conditions from cosmetic such as wrinkle and acne care to dealing with serious medical problems like atopic dermatitis. Anacor Pharmaceuticals, Inc. (NASDAQ: ANAC) soared over 50% on July 13 after it released positive Phase 3 data on its Crisaborole Topical Ointment for atopic dermatitis while Dermira, Inc. (NASDAQ: DERM) has risen over 40% from its IPO price of $16 since last October. Dermatology gets ignored by some investors as it's rarely related to life-threatening conditions like diabetes, cancer or heart disease and there are plenty of generic drugs or other treatments available for some aspects of it. However, strong margins and favourable pricing drive this industry and plenty of large pharmaceutical companies have taken this sector seriously over the last several years as there has been a consistent wave of acquisitions. Companies with patented technology and cheap valuations will continue to be absorbed by larger players who want in on the field.
Leading the way on the acquisition front has been Valeant Pharmaceuticals International, Inc. (NYSE: VRX) which has become a leader in dermatology care through its purchases of Dow Pharmaceutical Sciences for $285 Million in 2009, Medicis Pharmaceutical for $2.6 billion in 2012 and PreCision Dermatology for $500 million in 2014. Other significant deals include GlaxoSmithKline PLC (NYSE: GSK) acquiring Stiefel Laboratories for $3.6 billion in 2009, Novartis (NYSE: NVS) acquiring Fougera Pharmaceuticals for $1.5 billion in 2012, Almirall buying Aqua Pharmaceuticals in 2013 for $402 million inclusive of milestone payments and Allergan PLC (NYSE: AGN) acquiring SkinMedica for $350 Million in 2012.
Even companies in deep financial trouble have found a suitor at reasonable valuations. Graceway Pharmaceuticals was bought out by Medicis in 2011 in a bankruptcy sale for $455 million. Graceway had $355 million in net sales in 2009 but its revenue took a huge hit as its lead product Aldara lost exclusivity and dropped from 85% of the company's total sales to just 16% in the span of a year. Even under these dire circumstances, Graceway was still purchased for 1.3 times of 2009 sales. The table below summarizes these deals along with the revenue multiple associated with each of them based on the annual revenue in the year prior to the acquisition.
The revenue multiple for these buyouts other than Graceway broadly ranges between 3 to 6 times of revenue. While the larger deals valued the companies at around 3.5x of revenue, the two smallest ones valued the companies in excess of 5.0x of revenue. Investors can benefit greatly by being on the lookout for companies in the dermatology field that are valued at a lower revenue multiple.
One company which particularly stands out is Oculus Innovative Sciences, Inc. (NASDAQ: OCLS), which produces prescription and over-the-counter products based on its Microcyn platform technology. It has a history of sales across the globe in the skin and wound care and animal health care industry, but has recently been gaining significant traction in the dermatology sector particularly in the United States where it received FDA clearance and received a new U.S. patent for the use in medical devices for the treatment of atopic dermatitis. This traction is already being seen in the financials as its Q4 results (ended March) showed that its U.S. sales increased by almost four times, growing to $412,000 for the quarter compared to $110,000 for the period ended March 2014, with the growth being due to the expanding dermatology business.
At $1.50 per share, OCLS' market cap is only $22.5 million. Considering that it has over $6 million in cash as of its fiscal year ended March 2015, its enterprise value is only $16.5 million compared to $14 million in revenue achieved for the year. OCLS is trading at a revenue multiple of 1.2x which is less than what Graceway was purchased as a distressed company with its lead product in steep decline. ANAC has added over $2.7 billion in market cap and over $60 per share in less than two weeks following the positive Phase 3 results, reflecting the bullishness investors have over its New Drug Application for atopic dermatitis in 2016. The skin disease impacts about 18 to 25 million people in the United States alone, so that bullishness can be justified.
What makes less sense is that the market is overlooking OCLS even as it is a well-funded biotech company that has recently cleared and patented medical devices for atopic dermatitis selling in the market today along with several other products that have been granted approval by the FDA through 510(k) clearances. OCLS is growing its presence in dermatology at this very moment instead of at some point in the future. OCLS can use its international revenue and $4.5 million in proceeds from the sale of Ruthigen shares to fund growth in its dermatology division until it reaches cash flow positive status. The company has stated that it expects to use existing funds to get to break even so dilution outside of the exercise of existing warrants and options are not a big risk.
ANAC's ointment will be a major force in the dermatology market and a significant help to the millions suffering from atopic dermatitis. However, it will not take 100% of this market and won't start selling until at least 2017 if all goes well from here which leaves a significant upside opportunity for OCLS. ANAC has moved over $2.7 billion in market cap since the announcement. That is more than 160 times the enterprise value for OCLS. ANAC's market cap is $6.5 billion while it achieved $15 million in revenue during Q1 2015. Annualizing this figure means the company is valued over 100 times revenue. A portfolio of strong drug candidates is going to be valued at a higher revenue multiple than a company with a portfolio of medical devices, even those with several patents and FDA clearances such as OCLS. But more than a 100x multiple for ANAC compared to a 1.2x multiple for OCLS is too severe of a difference. If investors are highly bullish for ANAC's new drug for atopic dermatitis, they should also be more bullish for OCLS' latest successes in treating this disease than what is currently being demonstrated by its low valuation and stock price.
Given the 3.0x or greater revenue multiple valuations for acquisitions in the dermatology field and 5.0x or greater for microcap companies, ANAC's multi-billion dollar move after its Phase 3 results for atopic dermatitis, OCLS' 300% revenue growth in U.S. dermatology sales and 37% in overall revenue growth for the last quarter and the company's FDA clearances and patent grants for atopic dermatitis, I believe it is reasonable to expect that the company should be trading at a 12-month trailing revenue multiple of at least 5.0x. That would lead to an expected enterprise value of $70 million and an expected market cap of $76 million, or a price of more than $5 per share for OCLS.
Disclosure: I am long OCLSW, which are warrants on OCLS expiring in 2020 at a strike price of $1.30. They act similar to call options. I believe the warrants are highly under-priced given the long time to expiry, the volatility on the stock, and the fact that the warrants are in the money. Warrants represent a leverage opportunity and a risk management tool. For instance, a purchase of warrants at $0.50 when the stock price is $1.60 will result in intrinsic value of $1.90 if the stock price doubles to $3.20. Conversely, the warrants are worthless if the stock is under $1.30 upon expiry in 2020. But warrants can also be used to manage risk because an investor can put up less capital in OCLSW for the same dollar amount of upside compared to an investment in OCLS. Owning warrants is within my risk tolerance. Investors should decide if warrants are within their risk tolerance independently of my recommendation. I have been paid for this article. I purchased OCLSW prior to any contact or relationship to the company and this article is an accurate representation of my opinion on OCLS.
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