Biozone Pharmaceuticals (OTCQB:BZNE), an otherwise completely ignored small-cap stock, has made a quick and curious splash onto the biotech scene. As of September, billionaire Dr. Phillip Frost and associated entities including Opko Health (OPK) have purchased 25% of the 69M share float, and MusclePharm (OTCQB:MSLP) has invested an additional $2M in a bid to utilize Biozone's proprietary drug delivery technology, elaborated below. $2M is over 5.5x the amount of cash on Biozone's balance sheet last quarter, so something is going on. Whenever Frost makes a move, the obvious angle is to laud Frost's past successes in previous deals and general green market thumb. Other writers have already done that well. This piece will be more about the company itself, its challenges and prospects, financial position and possible future. While insider tracking is valuable, investments should not be made simply by following insider moves.
About Biozone Pharmaceuticals
Biozone Pharmaceuticals, through Biozone Laboratories, develops and manufacturers over the counter (OTC) drugs as well as cosmetic and beauty products for third parties. It also produces products it sells under the brand names of Glyderm and Baker Cummins. It additionally has a very small business selling raw materials used in OTC cosmetics and drug production, previously called Equachem. The company liquidated Equachem in 1Q13 and transferred operations to Biozone Labs, a move made in order to reduce SG&A. It worked, as SG&A shrunk 62% from 4Q12 to 1Q13 and even further last quarter, though this came at the expense of revenues, which have also shrunk 50% since then. The move, however, turned out to be a good one as the net loss is down 80% since the restructuring. The company now operates under a single business segment.
R&D focusing on new revenue streams
R&D increased to 3.4% of sales in 2012 from just over 1% in 2010. Management noted in its last 10-K that the firm is now heavily focused on a proprietary drug delivery technology called QuSomes, which will be discussed below. Its efforts are in the early stages and the technology is not having any material impact on operations so far.
The company also has some other interests. It owns 45% of BetaZone Laboratories, a company that engages in the development, sale and licensing of pharmaceuticals and cosmetics in Latin America. It is now being liquidated and divided among shareholders, with pro rata going to Biozone. This will help pad its balance sheet, though we won't know by how much until next earnings.
Growth Driven by QuSomes
QuSomes technology has driven the company's business historically and explains its heavy focus on skin and cosmetic products, as well as MusclePharm's $2M interest. QuSomes are a liposome developed by Biozone used to deliver a treatment or drug with greater effectiveness than applying its contents directly.
The company developed them during its R&D with Dr. Danilo Lasic. Dr. Lasic was recognized as the world's leading authority on liposomes at the time. A liposome is a tiny vesicle that can be filled with drugs or other treatments and used as a delivery device. It is made from the same material as a cell membrane. During its research efforts, Biozone discovered a self-forming liposome it named QuSomes. Liposome molecules, like QuSomes, were and still are recognized for their ability to deliver encapsulated drugs. Basically, these QuSomes could enhance solubility and efficacy of topical creams and serums. The delivery system is used in its own products but more importantly, the company also markets the technology to third parties as a way to differentiate products and enhance margin.
The potential for QuSomes elsewhere is very significant and the technology likely played a major role in attracting investors like Dr. Frost. Biozone has largely focused on the cosmetic market to date and is just starting to see opportunities elsewhere for QuSomes outside its traditional market. New uses for its patent on QuSomes could help drive the company's growth and push the shares higher.
There is discussion that QuSomes could have applications in the treatment of certain types of cancer as an oncological drug delivery platform, in the supplement market, ophthalmology and elsewhere. Success in even one area opens up broad new markets for the company.
MusclePharm Deal Highlights Interest in QuSomes
Biozone investment from MusclePharm is an interesting one. MusclePharm is evaluating QuSomes technology and believes QuSomes could improve the absorption and delivery speed of its products. MusclePharm boasts annual revenues of $67M in 2012, 83% of its current market cap, but has yet to pull a profit. Its products sell in 10,500 retail stores in 90 countries (page 1). Sales were just $3 million in 2010, so it is growing fast.
The $2M investment was made via a 10% secured convertible note. It is convertible to Biozone common stock at $0.20. The transaction also included a 10-year warrant kicker to purchase 10 million shares at $0.40/share, only 69 million shares of common stock are outstanding for Biozone. The notes were asset backed at Biozone, giving additional security to MusclePharm. The assets were not specified but it would likely include the company's manufacturing operations.
The structure of the deal, with the warrants and convertible note, makes the survival and success of BioZone in the best interest of MusclePharm. MusclePharm can keep the warrants in the money and generate a significant return on its investment by utilizing Biozone as its third party manufacturer and finding ways to employ QuSomes in its nutritional products.
This deal could drive a significant increase in volume at Biozone, bringing the company into profitability. The MusclePharm deal was likely orchestrated by Dr. Frost, who holds shares in both companies and probably saw potential for the relationship and money to be made. It strengthens two of his investments and stands to benefit all parties involved.
More on Biozone's operations
OTC cosmetics and drugs currently account for 95% of sales (see previous link, page 1). The primary business for Biozone is its third-party manufacturing operations. Third-party manufacturing sales accounted for 92% and 94% in 2011 and 2012, respectively. Total sales in 2012 were $17.2M.
A list of the types of products the firm manufactures follows. Cosmetic related products and skin care dominate the list. QuSomes accounts for a substantial portion of sales in cosmetics and pharmaceuticals. As previously stated, QuSomes are already being employed by Biozone itself, and the FDA has no regulatory jurisdiction for many of its applications. QuSomes' other potential uses are discussed below.
OTC Products: Hair conditioner and shampoo for eczema and psoriasis; external analgesics, skin protectants; anti-fungal products; topical anesthetics; nasal sprays; wound care products; acne products; cough and cold products; anti-itch products; ad skin lightening products. Most of its products are regulated by the FDA.
Cosmetic and Beauty Products: AHA and Beta Hydroxy product; instant firming serums; anti-aging products; body lotions; eye creams; moisture creams and lotions; facial scrubs; and facial masks. As a whole, these product lines fall outside of regulations from the FDA.
Dietary Supplements: Vitamins, minerals and herbal remedies and are generally products that fall outside of FDA regulation.
Proprietary Product lines Glyderm and Baker Cummins: BioZone has two lines of propriety products, Glyderm and Baker Cummins, sold under the Equalan and Baker Cummings names, respectively. It sells to wholesalers and internet retailers who sell to consumers and also resell to physician practices. These two product lines have a total of three employees and generated total sales of $886K (page 4) in 2012.
The company acquired Glyderm in 2007 from Valeant Pharmaceuticals and notes this line of products is over twenty years old and is focused on acne, skin discolorations, removal of fine lines and wrinkles and resurfacing.
The Baker Cummins line is focused on hair and scalp care. It acquired this line from Aero Pharmaceuticals in May 2011 and the brand is also over twenty years old.
Challenges for Biozone
1) Concentrated Customer Base - Most Contracts Are Short-term.
Biozone has over fifty customers it manages through two sales reps. Sixty-two percent of sales come from four customers, the top four accounted for 28%, 21%, 7% and 5%. The two largest customers are Matrixx Initiatives and Savvier LLP. Management believes if either of these customers substantially reduces their volume, the financial condition of Biozone would be impacted in a material way. Also noteworthy, the company does not have long-term agreements with its customers and works off of individual purchase orders. That said, Biozone does have an agreement with its largest customers Matrixx Initiatives that stated it is the exclusive manufacturer of certain products. There are no volume requirements associated with the contract and it has a three year term with options for annual renewals.
2) Biozone Needs to Find a Defensible Portion of the Market
There are many firms that compete in the contract manufacturing space. Perrigo (PRGO) is the largest competitor in the sector. Note that Perrigo had a gross margin of around 36% in FY12 compared to 42% at Biozone. Economies of scale enable the former to have drastically lower operating expenses, of course, whereas Biozone is not yet profitable and has an accumulated deficit of over $14M. Still, Biozone has carved out a unique position within contract manufacturing, largely focused on cosmetics and it can expand based on this. All that said, management also notes that if one of its competitors becomes more aggressive on pricing, it could cut into its market share and profitability.
Biozone's sales were headed in the right direction in 2012. That said, management did not control costs and in particular, had a significant jump in SG&A in 2012 that greatly impacted profitability. This has been dealt with by merging its business operations, as mentioned above.
At the end of 2012, Biozone needed cash to continue operations. There was also a substantial issue with Matrixx in late 2012, its largest customer, when the firm had a voluntary recall of Zicam Extreme Congestion Relief nasal gel. Biozone manufactured this and it contained Burkholderia cepacia, a potentially harmful bacteria, in a sample taken. There were no reports of illness but Matrixx did notify Biozone that it would be required to reimburse Matrixx for all costs, estimated in the $1 - $3 million range, a sum very substantial for a firm with sales of just $17 million.
In 2Q13, the last 10-Q reported sales down by over 50%, SG&A was still too high but the company did make a huge change critical to its long-term sustainability. It cut interest expenses, helping to reduce its loss from $2.2 million versus $4.3 million in 1H12. Interest expense went down from $4.5 million to under $1 million for the first half of the year.
The company was able to raise over $20M from equity financing in 2012. As of 2Q13, it had positive cash flow of over $8 million including financing activities.
Recent investments have strengthened Biozone's balance sheet. Investments have brought an increase in cash, most recently $2M from MusclePharm which is not reflected in the 2Q13 financials and also Opko Health and The Frost Gamma Investment Trust. This will help shore up the balance sheet and allow the firm to invest in growth.
Biozone is risky. Its recent restructuring and investments from major players have shored up its finances for the medium term. The firm's alignment with Dr. Frost, his firm and MusclePharm have the potential to power the company to profitability. They are rallying behind Biozone and its QuSomes technology. With these partners, QuSomes can find new markets and Biozone's manufacturing sales can expand. In particular, the deal structure with MusclePharm gives it a financial interest in Biozone's success. MusclePharm can itself use Biozone's third party manufacturing which would drive increased sales. Longer term, new uses for QuSomes can pay dividends for MusclePharma and Biozone as well as other companies it partners with going forward.