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A visit to cell.com brought to my notice an article titled, "Human Embryonic Stem Cells Derived by Somatic Cell Nuclear Transfer." The crux of the article is that embryonic stem cells can be efficiently derived from high-quality human oocytes, female gametocytes that develop into an ovum after two meiotic divisions. One thing led to another and I looked up companies involved in stem cells research and their performance. To my surprise, If I had invested $10,000 in a few stem cell companies such as Osiris Therapeutics (NASDAQ: OSIR) in June last year, my investment would now be worth almost $20,000.

This article focuses on Osiris, and tries to understand how much of it is due to fundamentals and how much of it is market sentiment, and is there any logic in investing in stem cell biotech stocks.

Stem cells

The ethics of obtaining stem cells from a human embryo has been the subject matter of debate for a long time now but there are no issues involved with obtaining stem cells from other places. While to date no patient has been treated with embryonic stem cells, adult stem cells have benefited patients for 73 medical conditions. Read more about it here and here.

As is evident from the phenomenal performance of stem cell stocks, they have been a favorite with investors at least since last one year. Year-to-date, the average return on three stocks I followed (2 are penny stocks, so I am not mentioning them here) is 17.92% and at times without the company having posted any significant news.

Osiris Therapeutics - sifting chaff from grain

Osiris (Market cap: $341.48 million), operates in two segments. The company's therapeutic segment focuses on biologic stem cell drug candidates from non-controversial and traditional source, bone marrow, while its bio-surgery segment is engaged in harnessing the ability of cells and novel constructs to promote the body's natural healing.

Osiris reported annual revenue of $11.80 million in FY 2012 and the operating loss - $11.15 million - was almost as much as the revenue, meaning thereby that the company had spent nearly $23 million on cost of revenue, selling and administrative expenses and research. Operating loss for the quarter ended March 30, 2013 was $2.76 million on revenue of $4.24 million.

On March 30, 2013, the company had roughly $30 million in cash and short term investments, meaning that barring any untoward expense, the company had adequate cash to cover its research and development activities for next three to four years.

There has been no significant news posted by the company since January 2013. However, some articles have reported with great excitement that the company registered a much smaller loss in Q4 2012 than what the market expected - EPS of -0.08 against the street expectations of -0.15, which led the stock to surge a whopping 58% in March 2013.

While reduction in loss is indeed something positive, in my opinion, it is hardly something to be so excited about. At the same time, it was also made out as if the company had reduced its costs and was well placed to achieve profitability.

That was March 2013. Since then the company has declared its Q1 2013 results. The results were on expected lines and hence no author/analyst seems to have commented upon it. In as far as reduction in costs is concerned; here is a comparative chart showing the company's expense on R&D and SG&A expenses, along with losses reported over the last four quarters.

The reduction in expenses is in R&D whereas SG&A expenses have increased. In my opinion, reduction in R&D expense is a negative indication and so is the increase in other expenses.

I would, however, pay more attention to the company's pipeline products and see if any of them holds some promise for future growth.

Osiris is involved in evaluation of mesenchymal stem cells (MSCs), which have the capacity to form highly "specialized cells types including bone, cartilage, muscle, tendon, fat and liver". Osiris, primary product, Prochymal, is in phase III clinical trials for GvHD (graft versus host disease), Crohn's Disease and acute radiation syndrome. It is also being tested for type 1 diabetes, acute myocardial infarction and pulmonary disease. The FDA has designated Prochymal as an orphan drug as well as a fast track product for the first three indications. The company's other candidate, Chondrogen, is in phase II trials for arthritis.

Risks

Stem cell therapy has its own share of risks and complications. Stem cell transplants risk depends upon several factors that include the type of blood disorder, transplant type and the patient's age and health. While some patients do not experience any problems, others may need further treatment and/or hospitalization. At times, the complications can even prove to be fatal.

Some complications that may arise include GvHD that is when stem cells from a donor are used. In this condition, the transplanted cells attack the patient's body. In other cases, there may be a graft failure, risk of organ injury, infertility, new cancers and infections.

Conclusion

Biotech is more about future growth and less about numbers. Stem cell therapy has a greater potential due to increased self renewal ability of stem cells. Its importance as a tool of modern biomedical research cannot be denied. However, that does not justify unrealistic valuations and the type of gains shown by some stem cell stocks.

Moreover, being a fairly new therapeutic area, it is likely that only a few companies, if at all, can be expected to be successful in clinical trials. Investment in stem cell companies like Osiris is best done on proper understanding of the technology and on the basis of your tolerance for risk.

Moreover, it is not as if only startups and small development stage companies are engaged in stem cell research and development. Large pharmaceutical companies like Pfizer (NYSE: PFE) have been using stem cells in their laboratories for identifying safer and effective medicines and made significant investments in human adult hematopoietic (somatic) stem cells.

I would suggest that any investment in stem cell stocks should be based on sound information regarding clinical trials and pipeline products and not on media hype. The potential is there but fundamentals and valuations are more important.

Source: Penny-Wise, Pound-Foolish Stem Cell Stocks