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A time-tested strategy for producing outstanding returns is to unearth under-priced stocks (i.e., value stocks) that have been left for dead by Mr. Market. While this strategy is oft-espoused by the greats such as Benjamin Graham, Warren Buffett, amongst others, it does have its perils for retail investors lacking complete knowledge of a company and its underlying securities. For example, a stock may appear to be undervalued based on some type of fundamental analysis, yet the company itself may contain hidden dangers that threaten to sink the stock. Indeed, this is likely the reason why it's been historically difficult for the vast majority of retail investors to beat the broader indices when picking so-called "value stocks."

In this article, I discuss a biotechnology company, Omeros Corporation (NASDAQ:OMER) that, at first glance, appears to be an excellent value stock, but a more careful analysis shows that the company is more of a value trap, and should thus be avoided by retail investors for the time being.

Omeros Corporation

Drug Candidate Pipeline

Omeros is a Seattle-based biopharmaceutical company that is developing and commercializing drugs targeted for indications such as inflammation, coagulopathies and disorders of the central nervous system. The company's most advanced clinical candidate is OMS302, which is indicated for lens replacement surgery, and has completed two successful Phase III clinical trials thus far. Given that OMS302 showed statistically significant superiority over placebo in the maintenance of intraoperative mydriasis and reduction of postoperative pain after intraocular lens replacement procedures, Omeros plans on filing a NDA with the FDA and a MAA with the EMA for OMS302 in the first half of 2013. The company is expecting a commercial launch in the first half of 2014. Additionally, Omeros has successfully completed an initial Phase III trial for OMS103HP, a product indicated to reduce pain during arthroscopic surgery. According to the company, OMS103HP should be ready to enter a second, pivotal Phase III trial later this year.

Coming down the pike, Omeros has three other drug candidates (OMS201, PPAR Addiction, and PDE1) currently in Phase I and II trials, as well as three new INDs under review with the FDA. As it stands, Omeros could have one product approved by the FDA and EMA in early 2014, another drug (OMS103HP) well into a pivotal Phase III trial, and a robust pipeline of other candidate drugs entering clinical trials. Overall, such a productive drug candidate pipeline is a rare find amongst biotechs in general, and is the primary reason why OMER looks to be grossly undervalued at current levels.

Commercialization and Marketing Plans

Unlike most other developmental-stage biotechs, Omeros has decided to retain worldwide manufacturing, marketing and distribution rights for all of its drug candidates. Simply put, this means that Omeros must transition from a clinically-oriented company into a commercial operation. To do so, Omeros must build a sales force and marketing team from scratch. While this strategy does enable Omeros to retain all profits from its drugs, it does require the company to spend a significant amount of capital for expertise it's currently lacking. And this strategy may detract from Omeros's core competency of drug development in the future, as the management will no doubt have to invest a significant amount of attention into the commercial wing of the company. Given that the commercial activities involved in bringing a new drug to market can be extremely cumbersome, the vast majority of developmental biotechs prefer to partner with a big pharma for the commercial launch of their first FDA approved drug (see e.g., Belviq, ARNA). As such, I find the lack of interest in finding a big pharma partner for the potential commercial launch of OMS302 puzzling.

Fundamental and Technical Analysis

As of December 31, 2012, Omeros had cash and cash equivalents and short-term investments of $22.4 million. The company is currently burning approximately $3.0 million a month in cash, due in large part to the anticipated commercial launch of OMS302 in 2014. To meet its significant financial obligations going forward, Omeros must rely on its $60 million at-the-market equity facility with MLV & Co. LLC, and a $40 million committed equity line financing facility with Azimuth Opportunity Ltd. Although Omeros does have enough funding to float the company for at least two years, this funding is largely dilutive in nature, and is a major reason why the stock continues to slide.

The technical aspects of the stock, however, suggest that OMER is ready for a positive turnaround. Specifically, the RSI sits at a whopping 22.9, and OMER is trading -49% below its SMA200. In other words, OMER is technically oversold at this point. Even so, I would caution investors from taking a position here, as the technicals have favored the buyside for weeks, yet the stock has continued to slide based on the overarching fundamentals (i.e., dilution, lack of partnering, high cash burn rate, etc.). Based on the problematic fundamentals, shorts have taken a large position in the stock, with approximately 12% of the float being short. With more dilution on the way to cover the commercial launch of OMS302, I see no reason to believe a short squeeze is imminent, despite the already substantial short position.

Conclusion

Omeros Corporation has one drug (OMS302) that should be approved by the FDA later this year, and another (OMS103HP) that is deep into the clinical trial process. As we saw last year, investors often award companies with newly approved FDA drugs by radically re-valuing the company's market cap (e.g., ARNA, AMRN, VVUS, etc.). And given that Omeros's market is a paltry $106 million at the time of writing this article, one could easily fathom that an FDA approval for OMS302 should result in a similar re-valuing scenario for OMER, making OMER an attractive value stock at current levels. However, I believe a dramatic revaluation will fail to occur for OMER even if OMS302 receives a positive nod from the FDA.

Firstly, OMS302 is a combination of two FDA-approved drugs that are readily available in generic form. Specifically, OMS is a mixture of ketorolac, an anti-inflammatory agent (NSAID), and phenylephrine, a mydriatic (pupil dilating) agent. Given the widespread use of these two drugs in lens replacement surgery already, it's difficult to understand from an investor standpoint what OMS302 can hope to accomplish in terms of market size or valuation. Simply put, doctors can just prescribe a cheaper generic combination of the two drugs in the same ratio as OMS302. Interestingly enough, Omeros itself hasn't placed any market valuations on OMS302, perhaps due to this very issue. As a result, I doubt the market will be enthusiastic about OMER post-FDA approval of OMS302.

Secondly, the company is relying heavily upon dilutive financing for the commercial launch of OMS302, and the continual development of the rest of the company's pipeline. With a cash burn rate of $3 million per month and an uncertain market size for OMS302, I believe OMER will continue to sink to new lows as dilution continues, despite the positive technical indicators and the possible catalyst of an FDA approval. In conclusion, OMER is much more likely to be a value trap for the reasons discussed here, and should not be viewed as a so-called bio-run up play. Any appreciation in PPS will likely be met with a well-timed round of dilution.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Is This Biotech A Value Stock Or Value Trap?