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

Note: In addition to my regular discussion on select companies in the life science ("applied biology") space, I've included a top-down discussion and exemplification of my main categorization method. For those not interested, company-specific discussion can be found near the end of the article.

What kind of company is this?

Life science (biology) investments can be very hard to categorize. While virtually every stock I look at is correctly labeled as a healthcare or biopharmaceutical equity, this label tells me next to nothing about the expected behavior or the risk/reward of the stock. From an investment standpoint, there is a huge difference in expectation between a large pharmaceutical stock and a small one. There are also huge differences between generic and regular pharmaceutical companies, although this may not be reflected with categorization.

Some ETFs are available for investors who want to take wider "shotgun" approach to bio investing, although this method can be very problematic due to the way these funds are weighted (sometimes just by market cap). Prepackaged categorical investment products offer very little customizability, and blind investors to the actual risk/reward of the fund as a whole.

This all stems from one main problem - life science stocks are very heterogeneous investments. While petroleum equities may have a direct correlation to the price of oil, pharma stocks will generally trade in a separate little universe.

While it's still important to look at each company individually, I think that investors can perform the most important sort between life science companies with one simple question:

Does this company need to conduct clinical trials to generate consistent income?

Clinical Life Science Companies (Yes)

These would be companies that are developing or commercializing life science-based products for use in the clinical setting. Drug developers, diagnostics developers, and class III medical device companies would fit into this category. From an investment perspective, the small companies in this category are generally high risk/reward investments, and returns often take a long time to materialize because of the FDA approval process. Medium or large companies are generally considered more "stable", and they usually produce strong cash flows - therefore reducing risk of bankruptcy while reducing reward.

Examples: Celgene (CELG) ; Neurocrine Biosciences (NBIX) ; ChemoCentryx (CCXI) ; Navidea Biopharmaceuticals (NAVB)

Almost all of the life science companies that I cover are healthcare product developers in the clinical development stage, so they would fit into this "clinical life science" category. Whether it's a newly made drug or medical device designed to administer drugs more efficiently, these may need a 7-10 year window to fully complete the "clinical development" stage. Although these drugs/devices may demonstrate efficacy in the laboratory, human testing is necessary to officially demonstrate the clinical utility and safety of any product. This is why clinical trials are required for FDA approval.

Generally speaking, clinical development requires millions of dollars each year for both R&D expenses and SG&A expenses during this lengthy period. This is why it's especially disappointing to stakeholders when new drugs or devices fail to receive FDA approval after years of hard work and patience. These products are also quite vulnerable to bad clinical trial data releases, because these generally cause investors to lose faith in a company or product. This results in substantial devaluation and selling of the associated stock.

Valuation is way more tricky for clinical life science companies, and can only be calculated with big assumptions about a company's chances for FDA approval and proper commercialization. This is often done with careful analysis of available clinical/preclinical trial data, and comparison to other products in the industry.

Overall it's a scary and volatile little corner of the stock market, which is why many investors avoid developmental drug and device companies altogether. However; the risk profile changes quite a bit if the company reaches the commercialization stage. If the product launch is handled well, the company can generate substantial revenues at great profit margins, which supports the stock valuation with cash flow. While there is less potential for explosive gains, these commercial-stage companies (which are sometimes developmental/commercial hybrids) can still grow and outperform the broader market.

Industrial Life Science Companies (No)

These would be companies that are developing and commercializing life science-based products for use in various industries that don't require clinical trials and FDA approval. Most generic drug manufacturers, Class I/II medical device companies, high-tech agricultural companies, certain chemical companies, and others might be put in this loose category. The key difference with these companies is that they do not need to conduct clinical trials, which completely changes the nature of these types of stocks. For small or medium companies, the risk/reward should generally be lower compared to similar-sized companies in the clinical life science category.

Examples: Purdue Pharma (Private); MusclePharm (OTCQB:MSLP); Biozone Pharma (BZNE) Bioamber Inc. (BIOA)

Although many generic drug manufacturers can be considered quasi-clinical, these companies produce revenues and can be better evaluated by financial performance. The is also true of medical device companies that are commercializing Class I and most Class II devices, which are considered relatively "generic" and low-risk for use by clinics. Companies that develop Class III devices behave more like drug developers, and usually require clinical trials.

Unlike clinical life science companies, investors can effectively value these companies based on just financial data, near-term projections, market size, and analysis of any potential competitive edges.

To better define this industrial category, I've included discussion on two recently-discovered companies that fit quite well.

BioZone Pharma

Investors who follow the revered healthcare investor Philip Frost should be familiar with BioZone due to the recent licensing agreement between his flagship company, OPKO Health (OPK) and Biozone (link). In this agreement, OPKO basically obtained commercialization rights to a proprietary "QuSome" drug delivery technology developed by BioZone. However, this commercialization is limited to ophthalmological indications, meaning that OPKO can only market products that are used for diseases and complications of the eye. Because of this, BioZone can enjoy the financial benefits of an out-licensed development agreement. This can include milestone payments and royalties on future sales of products based on the QuSome technology. This also allows the company to put much-needed focus on growing its core business as a contract manufacturing organization (CMO).

The company has synergy with another industrial life science company - MusclePharm - which sells high-end nutritional products catered to athletes - aka "nutraceuticals". I first wrote about the company on Seeking Alpha in December 2012 (link), and showed investors a stock that has more than doubled in value. The financial data and situation of the company have changed, although the growth story and market opportunity remain present.

This company filed its most recently quarterly report in August 2013. Although the company's revenues have been much lower this year, the company's business prospects have recently improved with the OPKO deal, and a deal with MusclePharm. A recent $2 MM investment into BioZone by MusclePharm (link) suggests that the nutraceutical company, which is looking to improve its profit margins, will provide BioZone with high volume business. An acquisition of the CMO business is also possible given the size of the investment.

It's worth noting that the company's high fixed costs as a CMO can result in heightened profit margins if the company sees higher volumes in the future from MusclePharm and other potential sources. COGS for H1 2012 was approximately 60%, and COGS for H1 2013 was about 70%. If BioZone expanded annual sales to the $30-40 MM range with extra business from MusclePharm, COGS would probably be closer to 50%. This would put the company deep into profitable territory, with an expected $10-15 MM in annual profits.

While this possibility depends on the cooperation of MusclePharm, the company's $2 MM investment shows that the collaboration is serious.

  • Feel free to review the most recent BioZone financials for yourself (link)
  • I recently discussed both companies in an interview with The Life Sciences Report too (link)

BioAmber Inc.

Many people don't see that much potential for growth in the chemical manufacturing industry because of the sluggish performance of the bigger companies in this space (Dow is only up 8% in the last 10 years), although significant opportunity can be found in niche markets. It's often the case that small, nimble companies are leading the way into these niches through the implementation of newer technologies.

BioAmber is an environmentally-friendly chemical producer that redefines the negative imagery that is often associated with chemical-producing companies. Although the product is identical, the company finds natural methods of production that eliminate unwanted byproducts. As the government continues to impose stricter regulations on companies that produce harmful byproducts (including carbon), the market's emphasis on sustainable chemistry will increase.

The company estimates that its platform can produce chemicals with a $10 BB addressable market. A second platform, which produces chemicals based on a six carbon frame, will address a $24 BB market that is largely dominated by the petrochemical industry. With the current platform, BioAmber produces and sells succinic acid, 1,4-butanediol, and disodium succinate. These industrial chemicals are used in a huge number of everyday products - everything from paint to vinegar.

The company has a Although BioAmber has only been producing since 2010, the company has already seen interest from corporate clients, and holds strong relationships with some powerful entities that provide support. The most notable client is Mitsubishi Chemical, which has agreed to make BioAmber its sole provider of succinic acid.

Recent earnings reports from the company also point to a trend of continuing growth. In the three months ended June 30, 2013 the company produced $1.03 MM in revenues - a 70% jump relative to the same period in 2012 which generated $.61 MM. A one-time event caused a $8.6 MM loss for this quarter, although it's worth noting that the core business of the company has reached the "profitability zone".

The balance sheet has also improved ahead of a major expansionary move by the company to fund a new yeast-based production facility in Sarnia, Ontario with partner Mitsui. This replaces the E. coli based manufacturing, which was determined to be less efficient. While this expansion will likely prevent profitability in 2014, the company is well financed and should be able to open the Sarnia facility in Q4 2014. This should improve the company's scalability and efficiency significantly in 2015 and onward, although it introduces more risk into the stock.

  • Feel free to review the most recent BioAmber financials for yourself (link)

Closing Comments

Although the system isn't perfect, I think that investors should definitely know whether or not the life science company they're considering as an investment needs to undergo a lengthy clinical development stage prior to commercialization. From my observations, I've found that many individual investors don't actually know what they're getting themselves into when buying an early-stage drug developer. Some would be better off with what I call "industrial" life science companies which are generally more stable, safer, and much easier to understand.

This is not to say that investors should necessarily avoid small or medium-sized clinical life science companies. The high risk comes with a high potential for return, although investors will probably have to spend a lot more time with their due diligence. Also required is a strong stomach for the volatility of these stocks.

Source: Categorizing Biology Investments And 2 Niche Market Stock Picks