Oculus Innovative Sciences: The Cheapest Stock Available In An Active Dermatology Sector And A New Player In Atopic Dermatitis

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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