Three small biotechs worth examining

The rush of money into biotechs has put three small stocks in focus.

Summary: New capital raisings in the biotech sector have reached their highest levels for more than four years, and the first float since 2010 is being earmarked for the second quarter. The sector is building momentum again, and this article puts three small cap biotechs under the investment microscope.
Key take-out: While biotech stocks on the S&P/ASX Small Ordinaries have shed 10% on average since the start of the year, there are a number of individuals stocks that have a promising prognosis.
Key beneficiaries: General investors. Category: Growth.

Don’t be fooled by the recent slump in junior biotech stocks, as that isn’t much of a gauge on investor interest in the sector.

If anything, there are more reasons to believe that sentiment towards the high-risk high-reward sector is on the up-and-up, even as biotech stocks on the S&P/ASX Small Ordinaries have shed 10% on average since the start of the year versus a 5% gain on the small cap benchmark.

What is a better measure of market appetite for biotech investments is capital raisings, as the amount of money given to our listed drug developers through the sale of new shares has spiked to a 4½-year high of $213.5 million in current quarter.

This would actually be a record amount if equity raisings by sector giant CSL are excluded, according to data compiled from Bloomberg.

While it is true that 80% of the total amount raised in the first three months of the year is attributed to market darling Mesoblast, the capital injection into other biotech hopefuls still represents around a six-fold increase compared to the previous quarter and to the same period last year.

The number of capital raisings also matches the previous record of eight that was set in the fourth-quarter of 2010, although biotechs only managed to secure $16.8 million in new capital back then.

The only piece missing from the upbeat prognosis for the industry is an initial public offer (IPO). A successful float will fire up the sector.

Investors might not have to wait long however. Home-grown stem cell company Regeneus is looking to list by June this year through a $25 million to $30 million IPO.

Excluding back-door listings and medical device companies, Regeneus could be the first true-blue Australian biotech IPO since CBio (now called Invion) three years ago.

The company, which is backed by the Sherman family, is hoping to mimic the success of fellow stem cell treatment developer Mesoblast, and Macquarie Bank is rumored to be in the running to be the lead manager for the Regeneus IPO.

The irony might not be lost on some that Macquarie issued a damning report that was blamed for a sharp sell-off in Mesoblast’s share price from its record peak back in 2011.

There is another reason why investors might like to include some biotech stocks into their portfolio. The earnings outlook for the sector is generally removed from the macro environment, and I see that as a big positive considering how markets have behaved following the controversial bailout of Cyprus.

This might surprise you, but small biotechs are not the most volatile section of the market. They rank behind energy and the mining-laden materials sector.

Biotechs are still a high-risk sector by any measure though, and the difficulty in understanding the science behind the technology is an added barrier for most investors.

But picking the right drug or medical device developer can make a big difference to your portfolio, and it pays to do your homework. To get you started, experts highlight three of their top picks for 2013 that are worth watching.

Universal Biosensors (UBI)

The painful 15% plunge in Universal Biosensors’ share price over the last two days to 65 cents should be seen as a buying opportunity.

Investors were spooked by a voluntary US recall of glucose testing devices by LifeScan, a Johnson & Johnson company that has licensed Universal Biosensors’ technology.

However, the sell-off looks like an over-reaction as analysts are unlikely to downgrade their valuation on the stock by much, if at all.

“There will only be a bit of disruption, but it will only be measured in the hundreds of thousands of dollars for UBI,” said WilsonHTM Investment Group analyst Shane Storey.

“That works out to only 2% to 3% [of total revenue].”

However, the $122 million market cap stock has been struggling to gain traction with the market and another deal with Siemens to develop a diagnostic for coagulation testing has done little to lift the stock. Even prior to Tuesday’s fall it had already tumbled by 17% since the start of the year.

An equity raising last year has sapped some enthusiasm for the stock, and investors are also shying away due to the lack of transparency on sales of Universal Biosensors’ test strips, which are used with the device.

Sales of these consumables are the main game for Universal Biosensors, as the company gets around one cent a strip in royalties, plus a margin on the strips manufactured by the company at its Melbourne facility. But sales of the strip are outside the control of Universal Biosensors as this is handled by LifeScan.

WIlsonHTM points out that the quarterly growth in royalty payments from LifeScan shows that sales of the glucose test devices are going well – at least up to Tuesday’s product recall.

If Universal Biosensors can continue to show further growth in these fees in the next two quarters, the stock is likely to re-rate, particularly since the Siemen’s deal will give the company an added exposure to the $US1 billion coagulation testing market.

The stock has the potential to more than double over the next 12-months, with the average broker price target sitting at $1.61 on the stock.

Universal Biosensors is part of the Uncapped 100 Index, which means that the Uncapped service will offer ongoing coverage of the stock when the site is launched.

Osprey Medical (OSP)

The market is also yet to fully appreciate the potential upside in Osprey Medical, with the stock plunging close to 30% since hitting a record high of 69 cents at the end of January this year.

Speculation that the company is about to go cap in hand to shareholders for extra funds and scepticism that Osprey’s technology (to remove the dye that is injected into a patient undergoing a heart procedure) will be adopted by the highly conservative medical fraternity are weighing on the stock.

The dye, if it reaches the kidney, can cause severe kidney damage; but painful memories of Impedimed’s and Cellestis’ failure to gain much market acceptance for their superior technologies used to detect lymphedema and tuberculosis, respectively, are hurting sentiment towards Osprey.

However, the investment director for DMP Asset Management, Julian Mitchell, believes Osprey’s vacuum cleaning device has a much better chance at penetrating the market.

“If there is a CIN (Contrast Induced Nephropathy) event, where something has gone wrong with the patient’s kidney [following a heart operation], then the patient goes into intensive care and the hospital will have to pay for that,” he said.

“So the hospital has a very clear short-term financial advantage in paying for this product.”

But preventing a CIN event is only half the story. What is potentially a game changer is the company’s novel idea to reverse the suction on the Osprey device to pump antibiotics directly to an infected diabetic limb that is at risk of being amputated.

Mitchell estimates that the stock is worth $1 if it was proven to be successful in preventing CIN, but the upside would be multiples of that if Osprey’s device can be used to save limbs.

Investors looking to better time their entry into the $49 million market cap stock might prefer to wait for the capital raising announcement, as I suspect the company will want to shore up its bank balance as it undertakes its pivotal clinical trial to prove it product can reduce the incidences of CIN.

Any capital raising is likely to drag the stock lower. Osprey has less than $15 million in cash and could price their new share offering at around 40 cents.

Acrux (ACR)

Acrux has fallen out of investors’ good books as market adoption for its testosterone treatment, Axiron, has been slower than anticipated.

Axiron has only managed to achieve an average market share of 12% in the US after two years of sales, despite the strong benefits of its treatment over existing products.

Axiron is applied under the arm, like a deodorant, which minimises the risk of the testosterone treatment rubbing off on others – such as when grandpa hugs his grandchildren.

Other treatments usually come in a gel form that needs to be smeared liberally on the skin, and the makers of these treatments have been aggressively offering rebates to hold on to market share.

Perhaps shareholders are too impatient. Pharmaceutical giant Eli Lily, which has the exclusive right to distribute Axiron, points out that it took nearly a decade for its erectile dysfunction drug, Cialis, to gain equal market share against the incumbent, Viagra, despite the advantages of Cialis.

While that fact has so far not achieved much traction with investors, WilsonHTM estimates that those with a two-year view to the stock will make a return of close to 42% on the current price given the milestone payments Acrux is expected to receive and forecast sales.

This return is sweetened by the fact that dividends and capital gains on Acrux are tax-free because Acrux is structured as a pooled development fund.

Being part of a great Australian success story, enjoying what could be very healthy gains, and not paying tax should be enough to give any investor a buzz.

The $651 million market cap stock inched up 0.3% on Tuesday to $3.88 a share, and another 0.77% today to $3.91, but it is down 3% over the past year when the S&P/ASX 300 Pharmaceutical and Biotechnology Index is up a stunning 56%.


Brendon Lau is the editor of Uncapped and may have interests in some of the stocks mentioned in the article.


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