Newly profitable small-cap biotechnology company DUSA Pharmaceuticals (DUSA) is an investment with fantastic return opportunities. With rapidly increasing sales and its greater than 80% gross margin leading to even more rapidly growing profits, investors may want to join in the chant: D-U-S-A! D-U-S-A! DUSA is an integrated dermatological biotechnology company whose main products treat the common skin condition actinic keratoses (AK), precancerous lesions caused by sun exposure. AKs are responsible for more than 8 million visit to dermatologists and other skin care physicians annually. This figure is significantly higher than 2003’s 5.2 million visits. It is estimated that the direct costs of AK are greater than $1 billion annually.
Levulan PDT is used to treat non-hyperkeratoic AK of the face or scalp. AKs are precancerous lesions caused by sun exposure. Levulan PDT is applied with DUSA’s Kerastick. Exposure to DUSA’s BLU-U light source converts the application into the drug actually responsible for treating AK. The mechanism of activity of this procedure is actually very interesting; I suggest reading about it on other Seeking Alpha articles such as this one. The current treatments of AK aside from DUSA’s include freezing with liquid nitrogen, surgery, laser therapy, and topical creams. Liquid nitrogen therapy suffers from poor reimbursement from health insurers. Topical creams have poor compliance issues because they leave the patient’s face with white splotches resembling a "pizza." DUSA has what seems to be a superior treatment to the competition, with the principal disadvantages being a slight sensitivity and recommendation to avoid direct sunlight on the affected areas for a few days.
DUSA turned a profit in the fourth quarter of 2010, making the full year profitable. This represents the first profitable year for in DUSA history. Sales, however, have increased at a compound annual growth rate of nearly 30% since 2004. DUSA currently has less than a 5% market share, so with the significant advantages of its Levulan PDT treatment over other care options, this 30% growth rate could easily continue for a number of years into the future.
DUSA sells the BLU-U light source nearly at cost, deriving its profits principally from the sale of Levulan Kerastick. This is like Gilette giving away the razors so that they can sell you the higher margin razor blades available only from them. And indeed, the net margin on sales of the Levulan Kerastick is high. In 2009 the margin on Levulan Kerastick was 84%; DUSA increased this to an 87% margin in 2010. The BLU-U device had a 17% margin in 2009, and only 3% margin in 2010. Since the Levulan Kerastick has far more sales than the BLU-U, the combined margin was 80% for 2009 and 83% in 2010.
Using this information, I set out to make a projection for sales and earnings for the next 5 years. 30% sales growth seems fantastic, but this is certainly achievable for a small cap biotech with a product gaining rapid acceptance. Still, I wanted to see what earnings would be under a variety of situations. I generated a table of these possibilities with annual sales growth in 5% increments from 10 to 30%. In each case I assumed that the increased sales would have an 80% gross margin, equal to the gross margin for 2009 and slightly less than that of 2010. In the scenario with 30% annual sales growth, DUSA earnings per share would amount to $2.92 in 2015. Applying a market multiple P/E of 15 would give a share price of nearly $44. This would represent a nearly 50% annual gains for the next 5 years. Less optimistic growth scenarios still show large increases in earnings.
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Is this a reasonable projection? One way to evaluate it is to calculate what the market share would be under the fastest growth rate. DUSA currently has about $36 million in sales, which is just 3.6% of the market of AK treatment. This market is estimated to be growing 10% per year, so the 2015 market can be estimated at about $1.6 billion. Under the most optimistic growth rate in the table above, DUSA would have $135 million in sales, which would still be just 8.4% of the total market. Greater than 30% growth is clearly possible from the total market for AK treatment.
A much more cautious approach might say that 30% annual growth in unsustainable for 5 years. Even fast growing companies rarely grow that fast. And as the company grows, they might have to give out additional discounts and have a lower gross margin for increased sales. So I made another table in the same style, but in this case the increased sales have only a 60% gross margin. In this case, with reduced gross margins, even a 20% annual growth rate – well below the historical sales growth of the last 6 years – would represent $1.26 in earnings in 2015. A P/E of 15 would give a stock price of about $19 per share, which would represent 28% annual growth for the next 5 years.
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Now, I’m not predicting that the price of DUSA stock will go up to $44, or even $19, in the next 5 years. To me these represent reasonable – but optimistic – upside potentials. Even aside from the vagaries of predicting 5 years into the future, there are some risks to DUSA itself. First, the majority of DUSA revenues and profits come from this one product line (Levulan Kerastick, with BLU-U light source). It is vulnerable to competition as well as patent issues. The patent protecting the use of Levulan Kerastick with BLU-U for the treatment of AKs is scheduled to expire in June 2019. A competitor of Levulan Kerastick is Metvixia, currently owned by Galderma, a large private dermatology company with significantly larger resources than DUSA. In a fun twist, DUSA receives royalties on sales of Metvixia, but these royalties are not nearly as profitable for the company as sales of its own products.
DUSA is a high growth, newly profitable biotechnology company. Like many other small biotechnology companies, it is highly dependent on one product and vulnerable to the introduction of competing products as well as the loss of patent protection. However, this fast growth gives investors the potential for large gains. What’s a reasonable price for an investor to pay for this growth? With an annual sales growth of 30%, leading to even faster earnings growth, many investors would pay a P/E of 30 for a PEG ratio around 1. Because DUSA just turned profitable, I think this is one of the cases where forward earnings are more useful than prior year results. Until 1st quarter earnings are reported, I think a forward P/E of about 18 is reasonable, and I’ll use the 25% sales growth number to be a little more conservative. This gives a buy price around $6.50. With a current share price around $5.50, there is a nice margin of safety if the earnings projections are not met. Of course, a small biotech company with a profitable product and fast growth is likely to be appealing to larger companies in search of growth. One of these might buy DUSA at 4-5 times revenues, or about $6.75 to $8.50 in 2011 – an additional reason not to buy additional shares above $6.50, at least until the next earnings report shows their growth in 2011.
Disclosure: I am long DUSA.
