Investing in biotech stocks can provide true binary opportunities. While larger companies have more diversified drug portfolios, small-cap companies often need to bet their futures on a single candidate.
If the drug succeeds, small-cap biotech stocks easily become multi-baggers. If the drug fails, downside of 80% or more is possible.
If this massive downside potential frightens you, it likely frightens scores of other investors. It's one of the many reasons why small-cap biotech stocks have sizable inefficiencies when it comes to accurately pricing their shares.
In fact, the small-cap biotech space is one of the least efficient corners of the market. In addition to the possibility of losing one's entire investment, here are some other factors that contibute to mispricings:
- Complex, opaque regulatory processes.
- Esoteric products and use-cases.
- Limited coverage and liquidity.
The factors above typically scare off 99% of institutional and retail investors. But if you're willing to do the work, great bargains can be had. Foamix Pharmaceuticals (FOMX, Financial) is an ideal example.
Promising drug candidates
While Foamix has some interesting early-stage candidates, the only ones that matter are FMX101 and FMX103.
FMX101 is a topical foam meant to treat moderate-to-severe acne. The active ingredient is an antibiotic called minocyclin.
Importantly, Foamix did not invent minocyclin. Discovered in 1961, minocyclin is the 229th most-prescribed medication in the U.S. with more than 2 million prescriptions.
What Foamix did invent was the foam vehicle in which the minocylin is delivered.
Currently, the vast majority of minocylin prescriptions are for broad-spectrum pills. When you take an antibiotic pill, your body doesn't know exactly where you intend for it to be distributed, so it gets spread throughout, limiting its effectiveness and contributing to antibiotic resistance.
Foamix's patented foam system allows users to apply the minocyclin directly to their skin for acne treatment. Based on Phase III clinical results, FMX101 is just as effective as other treatments, though it is both easier to use and less likely to contribute to antibiotic resistance.
In March, the FDA accepted the company's new drug application (NDA). By October, it will announce whether the drug is formally approved and ready to be sold.
While the clinical results look promising, the drug appears to have merely an average chance of being approved. Historically, around 85% of drug candidates have made it from an NDA filing to being approved. Therefore, we will assume that the upcoming sales projections only have an 85% chance of occuring.
To value Foamix, it is necessary to forecast the potential sales of FMX101. From there, apply a range of price-sales multiples to estimate the company's future value.
In a 2017 report, Credit Suisse (CS, Financial) said it was confident that, if approved, FMX101 could take a good chunk of the $3.7 billion acne market. "Acne is the most common skin condition in the U.S.," their report said. "It affects 650 million people worldwide and about 50 million people in the US alone."
Credit Suisse ultimately concluded that peak sales could exceed $450 million. Meanwhile, Cowen believes peak sales could hit $350 million.
These esimates make a lot of sense. Since 2015, four new acne drugs have entered the market. In their first years, revenues ranged from $100 million to $200 million each. FMX101 is especially well positioned considering it can take market share from other topicals as well as orally ingested minocyclin (considering it's an optimized version of the same drug).
Even if FMX101 is moderately successful, $200 million in peak sales would be very conservative.
Foamix's other Phase III candidate, FMX103, is a very similar drug. It contains the same active drug (minocyclin) and the same vehicle (Foamix's proprietary foam), although the concentration of minocyclin is slightly different in order to treat moderate-to-severe rosacea, a close cousin of acne.
Because the drug and use-case are so similar, there's a high chance that if FMX101 is approved, FMX103 will also be approved. An NDA filing should come within the next few months, meaning an approval could come as early as December 2019, but more likely in the first quarter of 2020.
Credit Suisse said that it believes peak sales for FMX103 could range between $120 million and $190 million. In March of 2019, Cowen released a research note saying peak sales could be as high as $350 million.
While some topical formulations for rosacea have garned peak sales of $200 million or more, the most recent drug (Finacea foam) hit only $70 million. FMX103 has advantages, but a $100 million peak sales estimate seems more reasonable versus Credit Suisse and Cowen's rosier projections.
What are shares worth?
Joseph Edelman, portfolio manager at Perceptive Advisors and widely regarded as the greatest biotech investor of all time, typically places a 3x peak sales multiple on potential drug candidates, although in some cases he has applied multiples of 6x or more.
Using a conservative peak sales estimates of $200 million for FMX101 and $100 million for FMX103, and a peak sales multiple of 3x, Foamix has a potential valuation of $900 million.
Using an 85% chance of approval for each drug provides a risk-adjusted valuation of $765 million. With a current market capitalization of just $200 million, there could easily be 300% of upside.
Note, however, that this is a completely binary situation. If the drugs fail to gain approval, Foamix stock likely has 80% downside risk, or more. The multi-bagger upside, however, more than compensates for the risk.
Investors should know for sure by the end of 2019, when Foamix could have two approved topical drugs with large market potentials.
Most investors will stick to the sidelines regardless of the risk-adjusted upside simply because the downside potential is large. That, however, is the type of behavior that makes small-cap biotech stocks like Foamix such a bargain.
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