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Oculus Innovative Sciences (NASDAQ:OCLS) and NovaBay Pharmaceuticals (NYSEMKT:NBY) offer investors potential short-term returns well over 100%. I expect Oculus in particular to perform even better than some of my recent picks. For example:

  • Neuralstem (NYSEMKT:CUR) was trading at $.68 when I published my article, and within 3 days it hit $1.96.
  • Opko (NYSE:OPK) was trading at $4.18 when my article was published and is currently trading at $7.60.
  • 8 weeks ago I published an article on MusclePharm (OTCQB:MSLP), when the stock was trading at $4.07. MusclePharm is now trading at over $11.

Oculus and NovaBay are solving an unmet medical need

Oculus and NovaBay have developed next-generation antimicrobial compounds that kill deadly superbugs like Staph, E. coli, and MRSA. But more importantly, these new antimicrobials do not perpetuate the growing problem of antibiotic resistance, nor do they produce the side effects generated by traditional antibiotics. The profit potential for NovaBay's and Oculus's high margin products goes into the billions of dollars. With numerous catalysts coming up this year, either company's share price could more than double.

Traditional antibiotics are losing efficacy

Bacterial and parasitic diseases have become the second leading causes of death worldwide, according to a report on antibiotic research released Sept. 17th by the London School of Economics. Hospital acquired infections are the fourth leading cause of death. These untreatable infections are costing the healthcare systems billions of dollars annually.

With the emergence of drug-resistant "superbugs," like Methicillin-resistant Staphylococcus aureus (MRSA), traditional antibiotics such as penicillin and its derivatives just aren't working sufficiently. But, the big pharmaceutical companies are not investing much in developing new antibiotics because they just aren't that profitable. Without a new generation of antibiotics and antimicrobials, we could revert back to the pre-antibiotic days where simple wounds caused death.

Only 3 Big Pharma companies are developing new antibiotics

Today, there are only three big pharmaceutical companies with active antibiotic R&D programs: GlaxoSmithKline (NYSE:GSK), AstraZeneca (NYSE:AZN), and Sanofi (NYSE:SNY). That's down from 20 large pharmaceutical companies in 1990, according to the Infectious Diseases Society of America.

GlaxoSmithKline has two new antibiotics in the pipeline, while AstraZeneca is partnering with other companies. Last year, AstraZeneca licensed a new antibiotic in development from Forrest Laboratories (NYSE:FRX). The drug has shown some promise against a number of infections and multi-drug-resistant pathogens, including MRSA. The company recently boosted its capabilities with a new facility in Boston, which demonstrates a $100 million investment in antibacterial research. Also, Sanofi recently decided to fund antibiotic research through an agreement with privately held Rib-X, from New Haven, Connecticut.

These three large pharmaceutical companies are the last ones standing. Given the trend, I would not be surprised if these companies eventually phased out their antibiotic research programs and simply acquired companies like Oculus and NovaBay. It's just not worth it anymore for these large pharmaceutical companies to develop a new antibiotic that is almost obsolete by the time the product is launched.

Microcap biotechs are providing solutions

Oculus and NovaBay have developed antimicrobial products that not only can save countless lives, but could save billions of dollars in healthcare costs. These products should be well received, given the current trend for dramatic healthcare cost reductions. I will discuss each company in detail, including my preferences in terms of investment opportunity.

NovaBay: positive clinical data will drive shares higher

NovaBay Pharmaceuticals is a clinical-stage biotechnology company focused on developing anti-infective compounds. These compounds are being developed to treat bacteria, fungi, and viruses. NovaBay's lead product, NVC-422, operates by mimicking the body's own disease defense mechanisms, obviating the normal resistance that traditional antibiotics generate.

NovaBay's big win has been with the treatment of impetigo and its lucrative partnership with Galderma. Impetigo is a highly contagious skin infection that mostly affects infants and children. It is caused by Staphylococcus aureus, including MRSA (methicillin-resistant Staphylococcus aureus), Streptococcus pyogenes, or both.

In a previous Phase II clinical study, NVC-422 was shown to be safe and well tolerated by impetigo patients. NVC-422 also demonstrated a clinical response rate of 92% and a microbiological response rate of 95% at the same dosage used in the current Phase IIb study.

The company recently announced the continuation of its Phase IIb clinical trial for NVC-422 (its impetigo treatment) into South Africa. The goal here is to reproduce earlier tests that proved the product efficient and evaluate two different dosage regimens. In my opinion, given the excellent results in the previous study, I expect the Phase IIb results to be good also. Positive results could easily double the share price.

NovaBay's conjunctivitis trial

Not all clinical trials have gone well for NovaBay. Last year the company announced what I thought were negative results for its conjunctivitis trial. NovaBay's partner, Alcon (NYSE:ACL) promptly jumped ship and discontinued its partnership with NovaBay.

NovaBay claimed the results weren't so bad and is now attempting to produce better results with a new conjunctivitis trial. If NovaBay can get good results with this new trial, NovaBay shares should soar. This is a huge market addressing an unmet medical need, and in my opinion, this is the trial to watch.

NovaBay dependent on the Galderma partnership

Since NovaBay is still in the clinical stage, its primary source of income is a result of licensing and collaboration payments. The company has yet to generate meaningful revenue as a result of product sales. NovaBay's primary source of funding is coming from Galderma, as well as dilutional capital raises, and if Galderma were to pull out, shareholders could be hurt. But if NovaBay continues to demonstrate positive clinical data with impetigo, I believe Galderma will stay the course.

What's the risk?

The biggest risks for NovaBay revolve around clinical trial results. If either the conjunctivitis or impetigo trials produce negative results, NovaBay may become a penny stock. Another longer-term risk involves more dilution, which could happen considering that NovaBay has yet to generate sufficient revenue through product sales. Finally, if Galderma were to discontinue the partnership (not likely at this point), dilution could become a serious problem for shareholders.

What's the trade?

NovaBay is currently trading at $1.53, with a $55 million market capitalization. NovaBay looks undervalued when compared with Tetraphase (NASDAQ:TTPH), which just completed its IPO, which valued the company at $140 million. (Tetraphase is also focused on preventing and healing drug-resistant infections).

But NovaBay is not sufficiently undervalued for me to take a large position. Clinical results will probably not be reported until later this year, and the share price could drift lower before that time. My strategy is to buy shares on major dips (if that opportunity arises) providing there is no negative news driving the shares lower.

Oculus: undervalued with great fundamentals

In my opinion, Oculus presents the best short-term investment opportunity given its compelling fundamentals, near-term catalysts, and severe undervaluation ($20 million compared to NovaBay's $51 million valuation and Tetraphase's $140 million valuation). Oculus is the only one of these companies that is generating significant revenue through product sales.

Oculus provides a solution to antibiotic resistance

Oculus is a commercial healthcare company that designs, produces and sells a new generation of antimicrobial products. Oculus is selling products in multiple markets including dermatology, acne, wound care and animal healthcare. The company's products are sold in 21 countries including the United States, Europe, India, China, and Mexico.

Oculus has developed a chemical compound called Microcyn that kills viruses, bacteria, and fungi. To date, over four million patients have used Microcyn without a report of a single serious adverse event.

The beauty of Microcyn is that it mimics the body's natural immune system's response to an infection. Within 30 seconds, it kills Staph, E. coli, and even MRSA. Many infections that are unresponsive to normal antibiotic treatments are eradicated with Microcyn.

Not only does Microcyn decrease treatment cost and reduce patient suffering, but just like NovaBay's product, it provides a solution to the growing problem of antibiotic resistance. It also gives doctors a way to treat many difficult wounds like diabetic foot ulcers that Johnson & Johnson's (JNJ) Neosporin can't handle.

Wounds treated with Microcyn have demonstrated a reduction in healing time by up to 60%. Microcyn increases the oxygen content at the wound site within 30 seconds and maintains that oxygen level for up to 36 hours. More oxygen means faster healing.

Microcyn also reduces chronic inflammation by inhibiting the release of histamines by the mast cells. This also speeds healing time and reduces itch and pain.

I have spoken with a number of physicians who are using Microcyn in their daily practice as well as in the surgical suite (surgeons have a high regard for this product). From all accounts, Microcyn appears to be the safest and most effective antimicrobial on the market, and some believe it could become the new standard of care for anti-invectives.

What is Oculus worth?

Oculus currently has a market capitalization of $20 million. This is an extremely low valuation for a company at such an advanced stage of development. Most $20 million biotech companies have no revenue, no FDA clearances, and very little cash. Many of them have products that are marginal at best. Oculus on the other hand looks great from a fundamental perspective. For example:

  • The company currently has a revenue run rate of about $18 million.
  • Oculus is growing revenue at 30% to 40% annually, and achieving margins of over 70%.
  • Oculus has consistently beaten guidance for the last several quarters.
  • The company is getting close to reaching profitability with EBITDAS losses of only $235,000 for the first six months of the current fiscal year.
  • Oculus has 7 FDA clearances and more on the way.
  • The company just received an expanded label claim for the company's CE Mark in Europe.
  • Numerous physicians endorse the Oculus products, including Dr. Adam Landsman from Harvard Medical School.

Oculus is trading just above one times revenue, well below fair value. In my opinion, given the positive fundamentals, the company should be trading for at least three times revenue. In order to keep my estimates conservative, I will base my calculations on two times annual revenue, which would give Oculus a current valuation of $36 million. But keep in mind that this valuation excludes the value of this summer's Ruthigen IPO or FDA approval of its scar reduction product. (Just to put things in perspective, Opko is trading at 62 times annual revenue). At two times annual revenue, the Oculus share price would be $5.45, which is still below fair value because of upcoming catalysts.

Three near-term catalysts should drive shares higher

While Oculus shares could easily rise 100% without a catalyst, any of the following catalysts should take the Oculus share price above $10.

Number 1: Oculus is planning an IPO for its division, Ruthigen Incorporated, a medical drug subsidiary addressing the surgical market. If all goes according to schedule, this could happen as early as Q3 of this year and Ruthigen should retain a Nasdaq listing at that time. Just the announcement of an IPO filing, which in a best case scenario could happen in the next 30 days, should cause Oculus shares to surge.

Number 2: By early May, Oculus should be announcing topline clinical data for the company's scar reduction trial. This is a $6.2 billion market, which addresses an unmet medical need, and positive data will add value to the Oculus share price.

Number 3: The company should be receiving notification from the FDA regarding its 510K application for scar reduction. I anticipate this happening as early as mid-July of this year. A positive FDA decision would be extremely good for shareholders. Also, a mid-July approval would mean Oculus could begin selling the new product in August of this year.

Keep in mind that we only need one of these catalysts in order to move the Oculus share price. If all three events are positive, share price appreciation will be significant.

Once Oculus reaches profitability, the game changes completely

One of the reasons Oculus has been trading at such a low valuation is that the company has yet to be profitable. But Oculus is getting close, and once the company reports its first profitable quarter and gives guidance for future profitable quarters, a whole new level of investors will begin buying. At that point we could easily see Oculus valued at over $100 million, given the fact that it is selling products with multibillion-dollar total addressable markets. If Oculus can maintain 30% to 40% annual revenue growth once it is profitable, we should see a share price of over $20.

Oculus fundamentals are the best in the company's history

As is often the case, there is considerable irony here; Oculus is now performing better than it ever has, yet the share price is near an all-time low. If you want to see a clear example of market irrationality, just take a look at these numbers:

2007 key statistics:

  • Revenue: $2 million
  • Total number of Oculus products: 4
  • FDA clearances: 2
  • Market capitalization: $136 million
  • Share price: $80.36 (split-adjusted)

Compare that to the current numbers:

  • Annual revenue run rate: $18 million
  • Total number of Oculus products: over 100
  • FDA clearances: 7
  • Market capitalization: $20 million
  • Share price: $3.08 (split-adjusted)

This is actually an ideal situation for investors, where fundamentals improve and the share price declines. We don't often see opportunities like this, especially with such obvious mispricing.

What really amplifies this mispricing is the fact that the Ruthigen IPO alone could give investors at least a 3X return from today's share price.

Oculus fundamentals get even better after the Ruthigen IPO

Oculus fundamentals will improve even more after the Ruthigen IPO, for the following reasons:

One: Ruthigen will be licensing product technology from Oculus, which will result in an upfront payment to Oculus, milestone payments, and licensing fees for Oculus. This will add substantially to Oculus's bottom line.

Two: Oculus's expenses will be significantly reduced, primarily based on reduced headcount, and regulatory and clinical trial costs.

I estimate that as a result of these benefits, Oculus will become profitable shortly after the IPO.

What is Ruthigen worth?

In order to calculate the value of Ruthigen, I began by looking at Ruthigen's $4.8 billion total addressable market, time to commercialization, and expected clinical trial results. I based my estimate on the assumption of early market penetration, an analysis of comparable companies, and operating profitability of over 20%.

This gave me a present value for Ruthigen of $120 million, in line with Tetraphase's $140 million IPO valuation.

Tetraphase IPO bodes well for Ruthigen

Tetraphase just concluded a very successful IPO, which should benefit Ruthigen. Tetraphase and Ruthigen are focused on preventing drug-resistant infections, however each company is using a different approach. The success of Tetraphase's IPO demonstrates the tremendous appetite that investors have for biotechs in general, and especially companies that are finding ways to successfully treat and prevent drug-resistant infections.

How much will the IPO add to Oculus's share price?

In order to keep things simple, I'm assuming that after the IPO, Oculus will maintain a 50% ownership in Ruthigen. Whatever valuation the market gives Ruthigen, 50% of that will be added to Oculus's inherent value, which should be reflected in the Oculus share price. If the market incorporates Ruthigen's total value into the Oculus share price, the numbers look like this:

Worst-case: Ruthigen is valued at $40 million, $20 million of which is owned by Oculus. This would add $3.07 to the Oculus share price.

Most probable: Ruthigen is valued at $80 million, $40 million of which is owned by Oculus. This would add $6.14 to the Oculus share price.

Best case: Ruthigen is valued at $120 million, $60 million of which is owned by Oculus. This would add $9.23 to the Oculus share price.

Right now the market is assigning zero value to the Ruthigen IPO. That's wrong. The market value potentially attributed to Ruthigen could be more than Oculus is valued in today's market. Right now Oculus owns 100% of Ruthigen, so the fact that the market is assigning none of Ruthigen's value to the Oculus share price is an example of market mispricing at its best.

With 6.6 million shares outstanding, Oculus is worth at least $5.45 (2 times revenue) without Ruthigen. When we add the value of Ruthigen, that brings the Oculus share price to somewhere between $8.52 and $14.68.

Here's why I believe the Ruthigen IPO will be successful

The IPO market has been on fire over the last few months, and I expect that to continue unless the economy experiences another recession, which is highly unlikely. Investors are generating exceptional returns on their IPO investments and are hungry for more. I believe the IPO will be successful for the following reasons:

  • Ruthigen is addressing a huge market: $4.8 billion in the United States, and in the future, some percentage of the $23 billion worldwide market.
  • Ruthigen's products are backed by a strong patent portfolio.
  • Ruthigen has developed the latest generation of antimicrobials, which should provide even better efficacy and safety data than Oculus's original formulation, which showed phenomenal results as demonstrated in the FDA Phase II clinical studies.
  • Ruthigen has a great business model. For a relatively small investment, $100 per patient, Ruthigen believes it can significantly decrease surgical infections, which in turn can save billions of dollars in healthcare costs. Let's say that an average surgical infection ends up costing the healthcare system thousands of dollars per patient. If Ruthigen can eliminate a large percentage of these infections for a cost of $100 per patient, I believe healthcare providers will embrace this product. Companies like Ruthigen that can demonstrate significant healthcare cost reductions will be well received by Wall Street as well, given the focus of our current administration.

I have spoken with a couple of investment bankers, just to get their opinion about the likelihood of a successful IPO. Both agreed that the IPO would probably go off without a hitch, the only question was one of valuation. As an Oculus shareholder, any valuation would be great, because the market is currently assigning Ruthigen a value of zero, so even a low valuation of $40 million would add significant value to Oculus's market capitalization.

What is the scar reduction product worth?

According to a 2003 report by Frost & Sullivan, it is estimated that 62 million scars are formed each year in the United States. Assuming $100 per treatment, this gives Oculus a $6.2 billion total addressable market. Since Oculus's product is addressing an unmet medical need, Oculus could ultimately capture a large percentage of this huge market. At 5% penetration, total product sales would be $310 million annually.

But it would take years to reach that level of market penetration, since the sales force will initially only be focusing on the dermatology market. With that in mind, let's assume that Oculus could reach $10 million in sales in three years. That would give us a net present value of about $6 million, which would add about $.90 to the current Oculus share price.

Reverse split should drive Oculus shares higher

I like reverse splits, because they provide me with a fairly predictable sequence of events. First, once a company announces that it's planning a reverse split, the share price declines. But here's a surprising fact: two to three months after the reverse split takes place, the share price on average rises 13% to 16%.

This is because once the stock is trading over $1, it becomes fair game for a whole new group of investors that would ignore stocks trading under $1. Also, by the time a company reaches the reverse split stage, the shares are sometimes severely undervalued creating unusual opportunity for investors.

Following the three-month marker, the share price will go one of two directions depending on the company's fundamentals. A company with strong fundamentals usually sees continued share price appreciation. Companies with weak fundamentals experience continued declines in share price and some of them go out of business completely.

The key is for investors to be cognizant of the fundamentals because reverse splits with strong company fundamentals provide an ideal investment opportunity. Such was the case with MusclePharm. After the reverse split, investors took a look at the fundamentals, which were good and getting better, and the share price went from $4 to $11.

Oculus is now in a similar situation, because the shares have been so beaten down that investors aren't even noticing just how good the company's fundamentals are. Now that the shares are trading over $1, a new group of investors will begin paying attention to the fundamentals and near-term catalysts, which should drive the share price significantly higher, as was the case with MusclePharm.

Reverse split will allow institutions to increase investment level

Oculus has attracted a handful of institutional investors, including Bank of America, UBS, Wells Fargo, CalPERS, and State Street. Now that Oculus shares are trading over $1, I believe more institutions will become buyers. Right now, most institutions just aren't aware of Oculus's improving fundamentals. As awareness grows, institutional participation should increase. Institutional investors will not ignore the upcoming IPO.

Newly issued patent adds considerable value to Oculus

A very important piece of news is being completely overlooked by investors. Oculus just announced the issuance of a new United States patent, for the use of Microcyn technology in the treatment of skin ulcers. Healing skin ulcers can be extremely difficult. In the United States, more than six million Americans each year suffer chronic wounds including arterial, diabetic, pressure and venous ulcers. From my investigation, it appears that Microcyn is one of the best antimicrobials for treating these hard to heal wounds.

This latest patent gives Oculus a total of 33 issued patents, and 113 pending. While it is beyond the scope of this article to give an exact valuation of this patent portfolio, we can come up with an approximation.

The average price paid per patent in 2012 was $374,000. That gives Oculus an approximate valuation of $12.34 million for the entire patent portfolio. If we add the value of the patents pending, the entire portfolio could be worth more than Oculus's $20 million market capitalization.

You see my point. This is just one more indication that Oculus as a company is tremendously undervalued. With the Ruthigen spin-off, several multibillion-dollar markets, a valuable patent portfolio, high margins, robust revenue growth, and a management team that has proven itself, Oculus provides investors with a good asymmetrical trade.

What's the risk?

Oculus shares are so undervalued right now, and the fundamentals are so strong that I don't see much downside risk, unless revenue growth suddenly plummets. While that doesn't look likely at this point, it could happen down the road, but that will not affect short-term upside potential.

We also could see negative clinical results from the scar reduction trials. But since this is just one of Oculus's many multibillion-dollar markets, any negative effect on the share price should be minimal and temporary.

The other risk for shareholders betting on the Ruthigen spinoff is that the spinoff never happens. If this hot IPO market were to suddenly shut down due to macroeconomic reasons, the IPO could be delayed indefinitely. However, in that case, Ruthigen should have no trouble attracting institutional investors for a private placement.

But keep in mind, that even without Ruthigen, Oculus is worth at least twice today's share price. That's what makes this trade so compelling.

What's the trade?

Once investors realize the value of the Ruthigen spin-off, the patent portfolio, and the other near-term catalysts, the Oculus share price should more than double. Oculus looks great from a fundamental perspective, and I have been buying shares at this level in anticipation of investors becoming aware of this extreme mispricing.

These small biotech's are all buyout candidates

Given the merger mania that has been going on lately, and the focus on reducing healthcare costs, I wouldn't be surprised to see either of these small biotech companies bought out.

They would make great acquisitions for Johnson & Johnson, Merck (NYSE:MRK), or Pfizer (NYSE:PFE) But I like Johnson & Johnson, partly because my first company was sold to Johnson & Johnson. Also, Johnson & Johnson has been on an acquisition binge over the last couple of years. Management has picked up 11 new companies, and it appears Johnson & Johnson is continuing on this path. The company is sitting on $20 billion in cash, some of which would be better used buying one of these biotech companies.

Oculus's and NovaBay's products would be a perfect complement to Johnson & Johnson's existing portfolio. Johnson & Johnson has the low cost over-the-counter antiseptic market covered with Neosporin, but it really has no high-end products that equal the efficacy and safety of these biotech's products.

Also, since GlaxoSmithKline, AstraZeneca, and Sanofi are actively pursuing solutions to the antibiotic dilemma, any of these big Pharma companies could be very interested in acquiring these companies.

High mortality rate may induce acquisitions

As antibiotics become less effective, the medical community will begin putting more pressure on Big Pharma to provide effective solutions. The high mortality rate is unacceptable and getting too large to ignore. For example, complicated abdominal infections remain extremely high. The World Society of Emergency Surgery has designed a CIA0W study in order to describe the clinical, microbiological, and management related profiles of both community and healthcare acquired abdominal infections.

The results of this study demonstrated that the overall mortality rate was 10.1%. That's extremely high, especially when you consider the costs associated with treating the patients that died, as well as the patients that simply had to be treated for serious complications. In abdominal surgeries alone, we are probably looking at billions of dollars just dealing with infection related problems that occur during and after the surgeries.

Acquisitions may be the fastest way for Big Pharma to begin solving this dilemma. Oculus and NovaBay have developed the products to the point where we know they are safe and effective. Big Pharma could take over, complete the clinical trials, and use their huge marketing machine to distribute the products worldwide.

Conclusion

Oculus and NovaBay should improve the quality of life for many generations. Their products not only kill the superbugs, but they don't perpetuate the problem of antibiotic resistance. I believe these companies are on the cutting-edge of a new medical technology, and investors who take advantage of periods of extreme undervaluation will realize substantial gains. If you missed the big run ups with Neuralstem, Opko, and MusclePharm, you have similar opportunities with Oculus and NovaBay.

For complete disclaimer and disclosure information please click here.

Disclosure: I am long OCLS, NBY, OTCQB:MSLP. 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: Oculus And NovaBay: 100% Upside Potential