Seeking Alpha
Deep value, special situations
Profile| Send Message|
( followers)  

(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

I recently established a position in BioZone Pharmaceuticals (BZNE.OB) based on the company's undervaluation, its patented QuSomes technology, and the fact that Opko (NYSE:OPK) and Dr. Phillip Frost have taken a 25% position in BioZone. (All of my Dr. Frost investments have provided large returns.) BioZone's strong patent portfolio, multibillion-dollar addressable markets, and current revenue stream, make it an ideal asymmetrical trade, with large upside potential, and limited downside risk.

BioZone's new generation of drug delivery.

BioZone has developed a new method of drug delivery, QuSomes that provides improved efficacy, reduced side effects, and lower costs. This technology will allow BioZone to reformulate and sell certain FDA approved drugs at a reduced cost, which should help BioZone capture a large percentage of these drug markets. BioZone's initial 3 drug targets are large, with total addressable markets exceeding $7 billion annually.

Why is this technology needed?

With insoluble drugs, a solvent needs to be added in order to break down the drug and deliver it into a patient's system. Without the solvent, the drug is rendered ineffective. But the current generations of solvents are expensive, difficult to produce, and produce severe side effects. BioZone has invented a second-generation solvent, QuSomes, which eliminates all these problems.

I thought the best way to understand BioZone's technology and business model was to speak directly with Dr. Brian Keller, the inventor of QuSomes technology. Here are some excerpts from that interview:

Q: What's the advantage of your QuSomes delivery technology?

QuSomes have several advantages over their predecessors. They are less expensive, easier to make and more versatile. We can make old drugs new, safer, and less expensive. Since this technology allows injectable drugs to circulate for a longer period of time in the bloodstream, we can often use smaller drug doses, which reduces the side effects and increases the safety profile. This method of delivery allows the drug to get to hard to reach tissues, deeper into the patient's system, which means that smaller doses can achieve greater efficacy. With our technology, the patient can get smaller doses, less frequently, which increases efficacy and improves results, or patient outcomes.

Historically our company was involved with drug delivery using phospholipid-based liposomes. But there are problems with liposomes; they are unstable, the ingredients are expensive, and are difficult to formulate with, so I developed a new generation of liposomes. I used a completely different lipid than a commercially available phospholipid, and that technology is patented and proprietary to us. We own the patents.

I designed a new lipid that functions better than phospholipids. Our proprietary liposomes are less expensive, easier to formulate with, and more stable. The second-generation is a lot more versatile, and adaptable to more drug products.

Q: Could you elaborate on your QuSomes delivery technology?

In short form, QuSomes are a second generation liposome technology that use our patented, proprietary lipid to form stable liposomes. QuSomes encapsulate active ingredients and drugs thereby rendering them hydrophobic molecules and enhancing their membrane penetration capabilities. I might add, first generation liposomes, made with phospholipids, were very successful commercially but have some inherent problems that we were able to solve with this second generation.

Q: Can I think of your technology as millions of microscopic balloons that are filled with an FDA approved drug, then delivered into a patient's system where they circulate and dissolve at an appropriate rate?

Yes that's a good way to look at it. They are 1/50th the size of a strand of hair.

Q: What are your first market opportunities?

In addition to currently using this technology in some over-the-counter drug products, one of the first prescription applications is voriconazole, which is a first-line therapy for systemic fungal infections. This is primarily used in people who have acquired a fungal infection due to immunosuppression. Cancer and AIDS patients fall into this category. It's available orally and as an injectable, and there are two I.V. products on the market, the brand VFEND and Sandoz's generic product. I believe our formulation is superior to the current formulations because it doesn't contain the solvent cyclodextrin. Cyclodextrin has problems, and we have a better alternative. Also, our formulation is easier and less expensive to manufacture, and it provides superior drug solubility.

Q: What are the problems with cyclodextrin?

Cyclodextrins are problematic in several ways. First they are difficult to manufacture and as a result, relatively expensive. But more importantly they do cause side effects, which are often confused with the drug substance. The side effects include nausea, vomiting, tinnitus and general intolerance of the drug. This causes the drug to be discontinued and another drug started, something that pharmaceutical companies would like to avoid.

Q: Doesn't your solvent also create side effects?

Our solvent, being in low concentrations, is virtually side effect free.

Q: How do you know this?

In several different instances we have demonstrated the safety profile in animal trials.

Q: Are there any other advantages to your approach?

Our product is easier and less expensive to manufacture.

Q: Can any other pharmaceutical company do what you are doing?

No other company can use our approach because they don't own this proprietary lipid. We do, and we own the patents. Other companies can manufacture this drug using cyclodextrins, but they run into the problems created by the solvent.

Q: Would you be first to market with this approach?

No, Sandoz has an I.V. and oral generic form of voriconazole; however, there are many financial models that demonstrate how a better generic generally captures 50% market share in the first 6 months.

Q: And you believe your version is better than the Sandoz version?

Yes.

Q: What is the total addressable market for voriconazole?

A: According to IMS Health the total Global market for voriconazole is $871M.

Q: What needs to be done in order to bring this product to market?

We need to conduct a toxicity study in small and large animals, which is $400,000-$500,000 and takes 90 days. We will then conduct a commercial formulization in parallel. Once this is complete we will do a bioequivalence study in about 48 healthy human volunteers. This takes about 60 days. We need another 3 months for all of the application requirements, and then it goes to the FDA. An $800,000 PDUFA fee (prescription drug user fee) is required by FDA, which gives us a 10-month guaranteed review time.

Q: So the whole process takes about 2 years.

Yes.

Q: What's the total cost before you can begin production and sales?

About $3 million.

Q: What about a partnership deal, where a partner bears all the expense?

We could do that now or at any point along the way, but the longer we can hold out, the better the terms will be for us. There are more buyers than sellers, particularly with approved drugs.

Q: What's your plan in terms of when to take on a partner?

Once we are ready to market the product, we will consider marketing and distribution partners. It will certainly be something we discuss with Dr. Frost.

Q: What else do you have in the pipeline?

We will be developing docetaxel in tandem with voriconazole. The pathway and timeline will basically be identical, but by doing both in tandem, we can save money. Docetaxel is another very insoluble drug and uses Tween 80®, another older, inefficient solvent. The use of QuSomes represents modern pharmaceutical technology that improves the solubility of docetaxel.

Part of the lesson here is that the pharmaceutical scientist doesn't have a lot of tools on the shelf for dealing with insoluble drugs, other than these harsh solvents. There's a real need for an alternative, which our lipid provides.

Q: So scientists are using these hard-core solvents, which are very toxic, because many of these drugs are not soluble in water. They have to use these aggressive solvents just to get the drug into the patient's system, but this ends up harming patients. Is this correct?

Yes, there just aren't a lot of other options other than solvents that have been around for 50 years or more.

Q: How many other drugs with large addressable markets are using these solvents?

20 or more.

Q: So your ultimate pipeline could approach 20 new products?

Yes.

Q: What is docetaxel used for, and what's the total addressable market?

Docetaxel is used for numerous cancers, including breast, non-small cell lung, stomach, head and neck, and prostate. The total addressable market globally is $2.3B according to 2011 IMS data.

Q: I would think that since you are just reformulating an existing drug, it would be easier to get FDA approval. Is this true?

Yes, there is a designated regulatory pathway at FDA for reformulating drug products, sometimes called a 'paper NDA' or a 505(b)2 application. The success rate for approval of these type of applications is quite high since we are only reformulating an already approved drug for the same intended use.

Q: With a high FDA success rate, I would think that you could begin a marketing and sales campaign before FDA approval, so that you could launch immediately following approval. Is that your strategy?

Yes, we will not wait for FDA approval to begin ramping up for sales.

Q: The reformulation business model seems particularly attractive, because the development and approval cycle is much shorter than for a new drug, and the expense is a mere fraction of a new drug development.

That's true. For roughly $3 million, you can address billion dollar markets.

Q: What's your pricing strategy for products in this reformulation category?

Since we have not incurred any of the original drug's development costs, we can come in with a 20%-30% discount to the leading brand, and still be very profitable. With better manufacturing efficiency, safety, and pricing, we should be able to take over a fair share of the market.

Q: Since there are 2 elements to your cost basis, the actual drug and the QuSome delivery technology, is your delivery technology less expensive than some of the older technologies that are being used now?

Yes, in some cases a large part of the expense is the delivery technology, and since QuSome's delivery technology is relatively inexpensive, we can lower cost that way also.

Q: Do you want to talk about any other product candidates?

There is an oral antifungal, Posaconazole (Noxafil®) which has a broad antifungal spectrum, and a great safety profile, but patients can only take it orally so they don't get enough concentration to kill the fungus. If an injectable form could be brought to market, which we believe we can do, we could probably capture a large percentage of the $4 billion injectable antifungal market.

Q: What makes you think you can develop an injectable version of Posaconazole?

We have already developed a formulation. We know that the drug is perfectly dissolved by the QuSomes.

Q: It sounds like there is no shortage of product candidates. Let's move on to a different topic. One of the things that distinguishes you from many biotech companies, is that you have a contract manufacturing business that is generating revenue. How does this business generate revenue?

The contract manufacturing business makes money in two ways. We formulate products and manufacture pharmaceutical and cosmetics for clients, and we license our QuSome technology products to clients.

Q: Could you give me an example?

Sure, you come to me and say you would like us to develop an antifungal cream. It's a drug product so it's going to require us to do some drug development. We're going to have to do a formulation. Our quality control lab will have to do some analytical development to determine shelf-life and stability. In addition, we have to validate our manufacturing process and our filling process to show FDA that we are in control of our processes. We have scientific tests to show that. We also have to show the FDA that once we complete manufacturing, we have adequately cleaned up our tanks, so there's no drug left over before we manufacture the next product. This is called cleaning validation, which will prove that the tank is clean. All these costs are paid for by the client upfront, and then the client pays us for each tube of antifungal cream that we manufacture and deliver.

Q: What's the cost breakdown for one tube of antifungal cream?

A typical example would be a $3.00 cost to us, which we sell to the client for $4.35, and the client sells for $30 or more.

Q: That's a pretty good markup for you. So you have a laboratory and manufacturing facility that develops the formula according to FDA standards, manufactures the product, fills it, packages it, and sells it to the client?

Yes exactly.

Q: How about another example.

Let's say a drug company comes to us because it wants a more effective delivery for a Retin-A, acne product. The client wants a product that will have a more effective skin absorption (and patent protection) so the patient only has to use it once a day rather than 2 or 3 times a day, which would allow the patient to suffer less side effects. Since our QuSome technology produces a more effective penetration into the skin, the acne could clear up even faster than with older generation formulations.

Another big advantage of the QuSome technology is that when it's applied topically, it penetrates the skin better, anchors the drug in the skin, but does not go into the bloodstream. For topical delivery, we are treating skin problems, and we don't want the drug in the bloodstream, because that can create other complications.

Q: Why doesn't the drug go into the bloodstream?

Because the QuSome molecule is lipophilic (lipid loving) it goes through the lipid environment of the skin, and because of its lipid solubility, it doesn't go back into the bloodstream which is mostly water. We've done clinical studies in animals to show that's the case. We have radiolabeled the drug, combined it with liposomes and applied it to the animal's skin. We can then determine whether or not the radiolabeled drug goes into systemic absorption. Because of the radioactive combination, this is very easy to trace and track. We look at all the tissues, and we can determine where the drug ends up beyond skin level.

Q: What are some of the other applications for drug delivery through the skin using QuSome technology?

The big markets include acne, hair growth, inflammation, fungal infections, and local anesthesia.

Q: What percentage of your products are cosmetic and what percentage are over-the-counter drugs?

It's about 50-50.

Q: Is your contract manufacturing business growing?

Yes, the business is growing, particularly on the pharmaceutical side, which can be very profitable.

Q: Couldn't you also use your manufacturing facility to develop pharmaceutical products sold under your own name?

Yes. Because there are fewer and fewer manufacturers in our space, there are more opportunities to manufacture drug products. We have considered our own generic brands. For example, we could manufacture and sell a line of BioZone's brand of prescription generic creams, lotions, gels, ointments and liquids.

Q: How can you be profitable, because the margins must be small for these generic products?

Yes the margins are small, but the volumes are huge. Because we are the original manufacturer we can be price competitive and make nice margins.

Q: Do you have an advantage, because your manufacturing facility is already paid for, and your only cost would be labor and materials?

That's the idea. Wholesalers are always looking for good prices on popular products.

Q: Could you give me an example?

Okay, let's say we develop BioZone's promethazine with codeine, a high-volume prescription cough syrup. You go into Walgreens and have your prescription filled, and unbeknownst to you, you receive BioZone's brand.

Q: And this ends up in Walgreens because you sold to the wholesaler at a better price than your competitors?

Yes.

Q: How big would this market be?

This market is also big. Based on this revenue source we could grow our business quickly.

Q: How can you beat the competition on price?

Most of the suppliers are not manufacturers, so they incur additional costs. We don't have those additional costs, so we can simply lower the price, and still make money.

(With that last question, the interview was concluded.)

My summary of this interview

After several conference calls with Dr. Keller, and much due diligence, I understand why Dr. Frost took such a large position in BioZone. Here are some key points:

Number 1: The drug reformulation path has a high success rate with the FDA. Since FDA approvals usually move a company's share price significantly higher, this provides for a high probability positive catalyst.

Number 2: BioZone can deliver new drug formulations that provide better efficacy, a superior safety profile, and a lower cost. This could allow BioZone to gain a large market share for each new drug.

Number 3: Dr. Phillip Frost and his company, Opko , have purchased 17.68 million shares of BioZone stock (about 25% of the company). In my opinion they would not have taken such a large position unless BioZone's QuSomes technology was solid. I feel confident in my due diligence, but Dr. Frost and his scientific team are capable of a much higher level of scientific analysis than I could ever conduct. His large position in BioZone is a strong validation of the company's technology.

Number 4: BioZone's contract manufacturing business is near breakeven, and when we include the revenue from MusclePharm (OTCQB:MSLP), BioZone should be profitable next year. (BioZone will be manufacturing products for MusclePharm). This gives investors a high degree of downside protection.

Number 5: I estimate 2014 contract manufacturing sales to be around $20 million based on MusclePharm's business and additional new customers. The valuation for the contract manufacturing segment should be at least 2 to 3 times revenue, or $40 million to $60 million. BioZone's current $34 million valuation is too low, because it's giving BioZone's QuSome's technology and the other business segments, zero valuation.

Number 6: I like the company's plan to sell its own branded label of generic drugs, because it appears that the company will be able to underprice the competition while still maintaining a healthy profit. BioZone already has the expertise, experience, and manufacturing facility, which should make this transition relatively seamless. I recommend all investors go to the company's website and take a virtual tour of the factory.

Number 7: The reformulation model is particularly attractive because of the leverage it provides. BioZone only has to invest about $3 million to bring a new product to market, which could be worth hundreds of millions of dollars annually.

Number 8: With Opko and Dr. Frost's investment in the company, I assume Dr. Frost is offering his experience and expertise in guiding the company's development. Given his track record, this can only benefit shareholders and is one of the primary reasons I invested in BioZone.

A positive wildcard, the Opko licensing agreement

On February 24, 2012, BioZone and Opko entered into a limited licensing agreement in which Opko acquired an exclusive license to the QuSome's delivery technology for use in ophthalmological indications and nonexclusive rights for all other indications.

Opko obviously wants this technology for new drug development, and common sense tells us that Opko has already begun drug trials. Since Opko has exclusive rights for ophthalmological indications, I assume some of these drug trials would be focused on this $19.8 billion market. Why else would Opko want exclusive rights? At some point Opko or BioZone would need to announce clinical trial results for products under development because this would be material information. If Opko is developing drugs that address large markets, which I assume to be the case, positive trial results would be good for BioZone and Opko shareholders.

While we don't know the exact terms of the agreement, we can assume the royalty rate is somewhere between a 5% and 15%. If we assume a conservative rate of 5%, for every $1 billion worth of products using QuSomes that Opko sells, BioZone will receive $50 million, most of which will go straight to BioZone's bottom line. Additionally, BioZone will incur no cost in developing Opko's new products.

BioZone's balance sheet

I have calculated BioZone's current cash position by starting with the $354,000 reported on June 30, plus the $2 million MusclePharm investment, plus $1 million coming in from this asset sale ($600,000 applied immediately), and $1,050,000 paid out for settlement of this outstanding lawsuit. This leaves BioZone with approximately $1,904,000 in cash. As of June 30, 2013, BioZone's long-term debt was $2.9 million.

What's the risk?

The biggest risk is one of execution. There's no guarantee that BioZone will be able to develop and sell its own branded products. Also, even with a high success rate for reformulated drugs, there could still be obstacles in dealing with the FDA.

BioZone may conduct a $6 million financing in order to develop voriconazole and docetaxel. But in my opinion, this would be a positive event because of the leverage involved; a $6 million investment opens the door to multibillion-dollar total addressable markets. The downside is that there would be some dilution for shareholders. However, I do expect BioZone's share price to be higher by the time a financing occurs, so on a percentage basis, this could be a relatively minor event.

The other option would be a partnership, where the partner covers the drug development costs, but I believe it would be more profitable for BioZone to delay a partnership for as long as possible.

Conclusion

BioZone presents a good asymmetrical trade, large upside potential with good downside protection. The contract manufacturing segment alone is worth more than today's $34 million valuation. But the additional future revenue streams from Opko, the drug reformulation segment, and BioZone's branded generic products make BioZone tremendously undervalued. In my opinion, BioZone should be trading for more than twice today's valuation.

For disclosure and disclaimer information please click here.

Disclosure: I am long BZNE.OB. 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: Opko And Its Billionaire CEO Invested In Biozone