Jason Napodano Positions For 2014: Biotech M&A Growth Trend To Continue

by: BioNap

This is the sixth piece in Seeking Alpha's Positioning for 2014 series. This year we have once again asked experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.

Jason Napodano, CFA, is the Managing Director and Senior Biotechnology Analyst for Zacks Investment Research. Jason has been with Zacks since 2003. Prior to Zacks, Jason worked as an equity analyst for Eastover Capital and as a research scientist for TechLab, Inc. Jason possesses a B.S. in Biochemistry from Virginia Tech, and an M.B.A. from Wake Forest University. He is also a Chartered Financial Analyst (CFA).

Seeking Alpha's Abby Carmel and George Moriarty recently spoke with Jason to discuss the general outlook for biotech and evaluate individual investing opportunities that present themselves as we begin the new year.

SA Editors (SA): For our readers' benefit, can you provide a quick background on the areas you focus on within biotech?

Jason Napodano (JN): I am a small-cap biotech analyst with a focus on cardiology, central nervous system disorders, pain, metabolic disorders, regenerative medicine, and wound care. I tend to focus on stocks that are flying (well) below the radar of most institutional and retail investors.

There is a bias that exists by investors leading most to shy away from small- and micro-cap stocks, specifically ones that trade on the OTC Market. This, coupled with a lack of good quality fundamental research offered by traditional Wall Street investment banks, often leads to an information and valuation arbitrage opportunity. For example, many stocks I cover have solid fundamentals but struggle to attract investors to their story given their small size or lack of national listing (many trade on the OTC exchange or outside the U.S.). In other cases, investors may be aware of the strong fundamental story emerging, but struggle with how to accurately value small-cap biotechnology companies that may be losing money and years away from profitability.

My strengths lie in a background in biochemistry and molecular biology, having worked for a small private biotechnology company for four years, and in financial modeling and valuation. I spend days sifting through dozens of small-cap biotech stocks searching for the right combination of improving fundamentals and attractive valuation. I believe these are interesting stocks for readers of Seeking Alpha because of a potential high rate of returns that can be achieved by successfully finding an undiscovered gem.

(SA): Broadly speaking, biotech had a great year, with ^NBI rallying 50+%. What do you see as the potential catalysts for a continued rally?

(JN): I think the FDA has been more cooperative than in the past. I see lots of companies pursuing things like Special Protocol Assessments, Orphan Drug designations, Priority Reviews, and Breakthrough Therapy designations. Investors tend to like visibility, and a friendlier FDA certainly helps to not only drive confidence but increase positive outcomes in the sector.

M&A has always been a key driving factor for biotech stocks, and 2013 was a good year from an M&A standpoint. Data on the first three quarters of 2013 shows a solid pick-up in M&A activity for the sector, and that drives interest and investment by investors.

(SA): And what are the risks facing the sector?

(JN): Certainly a global or U.S. economic slowdown would hurt biotech stocks in 2014. Biotech stocks are high-beta, so if the market turns south in 2014, I would expect biotech stocks, which had a great 2013, to be one of the first places investors look to protect profits. Another major risk would be a significant drug recall or safety issue. Major drug recalls, like the Vioxx withdrawal in late 2004, had ripple effects on the biotech market in early 2005.

(SA): Drilling down a bit more now, what are the sub-sectors you're focused on for 2014?

(JN): Several regenerative medicine stocks may finally be coming of age. Every year investors tend to wonder if this is the year stem cell stocks perform well. I think you have to be selective and focus on stocks with near-term catalysts and plenty of cash on the books, but there are names within regenerative medicine I like. Specifically Neuralstem, Inc. (NYSEMKT:CUR). Neuralstem had a great 2013 (+130%), and I expect the run to continue in 2014. Investors can read about why I like Neuralstem in this article I wrote for the healthcare research website, PropThink, back in November 2013.

I think the wound care market is in for big changes in 2014. I highlighted a number of changes on the horizon in this article I did for Seeking Alpha in October 2013. I'm keeping an eye on Cytomedix, Inc. (CMXI) for a potential breakout in 2014. Investors can read my article on why I believe changes to the CMS reimbursement policy are positive for the company here. I also really like ULURU, Inc. (OTCQB:ULUR). It fits the model that I noted in the opening paragraph about having good fundamentals but largely being ignored due to listing (it's OTC) and country of origin (Australia). A summary of why I like ULURU can be found in this article I wrote for Seeking Alpha in November 2013. I'd also point to Avita Medical (OTCQX:AVMXY) as another potential breakout name for 2014. I simply love their autologous cell harvesting and delivery kit for the treatment of complicated skin defects called ReCell. Check out my thoughts on ReCell and how it is in my view the best and only product I would consider for my children should they ever suffer a severe burn or scald.

If things get "difficult" in 2014, I'd point investors to two quality specialty pharmaceutical names I like for 2014, Pozen (NASDAQ:POZN) and Depomed (NASDAQ:DEPO). Pozen has a U.S. PDUFA date in April 2014 for its safer-aspirin product, PA-325/40. The company has plenty of cash, even after it distributed $1.75 per share to investors on December 31, 2013 (more info). I pounded the table on Pozen for PropThink back in May 2013 and the shares have nearly doubled since that time. With respect to Depomed, I think that management is doing an outstanding job in creating shareholder value. I analyzed the management effectiveness for Seeking Alpha readers back in November 2013, and in December 2013 reviewed the company's most recent product acquisition in CAMBIA. Depomed is executing nicely and with still roughly $270 million in cash, the stock is cheap.

(SA): You have covered Organovo (NYSEMKT:ONVO) previously, and 3D printing remains alluring to retail investors. What do our readers need to know to succeed in this space?

(JN): Avoid it. There's too much hype in the stock and too much risk for this investment to make sense for retail investors right now. Organovo is a very interesting company with almost science-fiction like technology. Unfortunately, the valuation is completely ridiculous because of the hype around 3D printing and I don't see how investing in this name at today's valuation makes sense. Public Enemy said it best in 1988: Don't Believe the Hype.

(SA): In your recent piece on 4 Bold Biotech Calls, you included an M&A prediction. What level of M&A activity do you expect in the year ahead?

(JN): Pegging an exact level is a little above my pay-grade, but I think the trend seen in 2013 - double-digit growth over 2012 - will continue. In my "4 Bold Biotech Calls For 2014" article I predict that Avita Medical will get acquired.

I have a pretty focused coverage list, but if you twisted my arm to predict a few more deals, I'd point to Acadia Pharmaceuticals (NASDAQ:ACAD), Cynapsus Therapeutics (CYNAF), and Tonix Pharmaceuticals (NASDAQ:TNXP) as three names in CNS/neurology that could get scooped up at some point.

Acadia is developing pimavanserin for the treatment of Parkinson's disease psychosis (PDP). I wrote an article for Seeking Alpha in November 2013 predicting that pimavanserin will be a blockbuster drug. I think big pharma will be very interested in pimavanserin once we get closer to the NDA filing. I also think Cynapsus is undervalued and would be a great pick-up for a specialty pharmaceutical company with an eye on Parkinson's disease. My recent article on Cynapsus for Seeking Alpha outlines why I like the company. Personally, I think Acadia wants to remain independent and commercialize pimavanserin in the U.S. themselves. If they do, they should look to acquire Cynapsus to give their reps a second product to promote to Parkinson's disease and movement disorder doctors. That would be great for me because I wouldn't have to do any additional work getting to know the combined story!

It may be a little early for someone to acquire Tonix Pharmaceuticals in 2014. The company still has some work to do to complete a Phase 2b clinical trial with TNX-102SL, a sublingual low-dose formulation of cyclobenzaprine for the treatment of fibromyalgia, but given the size of this market and the data we've seen to date on the drug, it is certainly a possibility in 2015 or 2016. We told investors that it was "Time To Buy Tonix" back in November 2013. So far, we're up a cool 120%.

(SA): Now let's get into some specific names. What is your favorite long opportunity for 2014?

(JN): Well, I like a lot of the names I mentioned above. I also like GlassesOff (OTCQB:GLSO) and LabStyle Innovations (NASDAQ:DRIO).

GlassesOff has developed a smartphone application that looks to reverse and prevent the need for reading glasses in adults that have begun or are nearing presbyopia. We like GlassesOff because of the size of the market and the fact that the application seems to work - at least in the limited number of subjects tested to date. Our article from December 2013 highlights why we like the stock.

Sticking with the smartphone based application for medical needs theme; I think Labstyle Innovations is interesting. The market seems unimpressed with the concept of merging a glucometer, lancing mechanism, and smartphone application all-in-one, but Dario (the application) is pretty neat, and we think the company will gain better traction licensing the software than the market valuation implies. So far my call on LabStyle has been a poor one, but investors can still read my thoughts from a November 2013 article for Seeking Alpha.

One riskier name worth considering is DARA Biosciences (DARA). DARA's near-term future may hinge upon a decision from the U.S. FDA on whether or not to grant the company Orphan Drug status on KRN5500, a pain drug for chemotherapy-induced peripheral neuropathy. We wrote in December 2013 that a positive outcome in this regard would be "game-changer" for the company.

(SA): Alternatively, what name do you see presenting the greatest risk to investors in the year ahead?

(JN): Above you asked about Organovo. I like the technology. I was a big fan of Organovo when the stock was $2 and $3 per share. At nearly $10, I just don't see it. I'd also recommend investors avoid Osiris Therapeutics (NASDAQ:OSIR). Earlier in the year, the company decided to sell off its stem cell business in Prochymal and focus commercial operations on BioSurgery. I'm skeptical that this move will pay off. I think the changes that I outlined above in wound care that are positive for names like Cytomedix and ULURU are negative for established players like Osiris and Organogenesis (privately-held). Organogenesis, which makes Apligraf, has already taken dramatic steps to reduce costs and survive in this new environment. I predict that Osiris is heading down the same path, and that their wound care product, Grafix, will be a commercial failure.

(SA): What advice would you give to a 'do-it-yourself' biotech investor looking at opportunities in the present environment?

(JN): It's okay to be skeptical, but understand that biotech stocks trade on more than just scientific data alone. Some of the smartest scientists and critical thinkers I know are some of the worst investors because they can't seem to get over the notion that the market is at times irrational, and impending catalysts and changes in perception have more influence on where stock prices go over the near- and medium-term than scientific truths.

Investing in a change in perception is a powerful thesis in the biotech sector. I'd encourage investors not to focus specifically on fundamentals, but on the first derivative of fundamentals - the change in fundamentals. If quality is rated on a scale of 1 (worst) to 10 (best), in biotech, a stock with a fundamental rating of 2 that is heading to 3 or 4 is a better investment than a stock with a fundamental rating of 9 heading to 8 or 7. I love turnaround stories, and hate buying things that everyone else absolutely loves. Everyone absolutely loved Apple Inc. (NASDAQ:AAPL) when it hit $700 in September 2012; the fundamentals were incredible. You had to be a complete lunatic to buy Bank of America (NYSE:BAC) when it broke $5 in December 2011.

Valuation and perception is key to finding good investments in biotech. I do some pretty in-depth valuation analysis for the names I cover. I've also been a biotech analyst for fifteen years, so I have a lot of experience with "running the numbers." I'd much rather invest in a company where the market is giving it only a 5% chance to succeed where I think the odds are more like 10-20% than a stock where the market thinks the chances of success are 90% and I think it's more like 80%. The first stock is undervalued, even though the odds of success are far lower than the second stock.

Two examples: Everyone thought I was absolutely crazy to initiate coverage of Amarantus Biosciences (OTCQB:AMBS) back over the summer of 2013. The stock was trading at $0.026 per share! But I took a pretty hard look at the science behind MANF and LymPro, did some valuation work, and concluded that the stock was undervalued. The stock is up 300% from the lows because people have realized the fundamentals are improving and the valuation is attractive.

On the opposite end of the spectrum is Sarepta Therapeutics (NASDAQ:SRPT). Not a sane person in the world would have suggested in October 2013 that Amarantus has superior fundamentals to Sarepta. That's silly. Sarepta's eteplirsen looks like a miracle drug for children with Duchenne muscular dystrophy, but Sarepta's stock is down 64% from the October 2013 highs because the FDA put the brakes on the potential for companies to file an application for Accelerated Approval. Sarepta was trading on incredible high hopes and, as often happens with biotech stocks that are priced near perfection, when one thing goes wrong the re-valuation is swift and painful.

(SA): Any additional considerations you'd like to share with readers as they ponder their investing strategy in 2014 and beyond?

(JN): Besides telling them to read more articles on Seeking Alpha? I'd encourage investors to get on Twitter and start following and interacting with people that have been doing this professionally for years. Biotech investing is not easy. In fact, it's very difficult for the novice investor. There's an immense amount of free information on the web, some good and some bad, so know your source. Twitter provides direct access to a number of incredibly smart analysts, traders, and investors.

I follow 156 people on Twitter but there are hundreds more worth following, and the biotech community on Twitter is over 10,000 strong. There are lots of places to get free information outside of Twitter as well. Besides Seeking Alpha, I always keep an eye on what journalist Adam Feuerstein is saying. He's an incredible resource and often ahead of the curve. I contribute to PropThink and post on my own blog called BioNapCFA. Of course, I work for Zacks/SCR and colleagues Grant Zeng, John Tucker, and Brian Marckx author fantastic work. And if you are more of a trader than an investor, the team at BioRunUp is incredible. There are lots of other great resources, so I'd encourage readers to ask questions, delve deep, and trade wisely!

Disclosure: none.

To read other pieces from Seeking Alpha's Positioning for 2014 series, click here.