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

I recently began consulting for a company that I believe has the potential to become a market leader in wound care and beyond; Oculus Innovative Sciences, (OCLS). Oculus has developed a chemical compound called Microcyn that kills viruses, bacteria, and fungus, and provides physicians with a solution to the growing problem of antibiotic resistance. I've been using this product for years, and have found it to be extremely effective. Here's a brief history of the company:

In January of 2007, Oculus became a public company trading at about $8 per share. Investors were optimistic about the company's future and soon bid the shares up to $11. At that point, Oculus had about $2 million in annual revenue, one product, and not much of a track record.

Now, four years later Oculus has shown impressive revenue growth ($9.7 million in fiscal 2011), released over 50 new products, formed partnerships, a number of which are paying 30% royalties, and yet the shares are trading at around $1. Oculus is in a much stronger position now than it was four years ago, yet the share price reflects a company that has failed on all levels.

It's ironic that at the time of the IPO in 2007, Oculus was nowhere near profitability, and now that it is close to becoming profitable, the share price is 90% lower than the $11 peak. In reality, Oculus has performed like a champion. There certainly could be stumbling blocks in the future, but thus far management has proven its ability to grow the company at a fairly rapid clip.

Let's take a look at some of Oculus's accomplishments:

Number 1: Product revenue growth from $95,000 in 2004, to $9,754,000 in 2011. The revenue performance over the last four fiscal years is impressive:

  • Fiscal 2008 revenue: $3,335,000
  • Fiscal 2009 revenue $5,358,000, a 60% increase
  • Fiscal 2010 revenue $7,364,000, a 37% increase
  • Fiscal 2011 revenue: $9,754,000, a 32% increase

Number 2: Lucrative partnerships in which Oculus receives 30% royalties while the partners incur all marketing and distribution costs.

Number 3: Product line growth from 1 product in 2004 to over 50 products SKUs in 2011.

Number 4: Projections of 30% to 35% product revenue growth going forward.

Number 5: Flat expenses while growing revenue.

Number 6: Guidance beat for the last six quarters.

Number 7: A business model which consistently produces 70% to 80% margins for product revenue.

Number 8: Products that have treated over 3.5 million patients with no adverse side effects.

Number 9: A clinical trial in which patients treated with Microcyn alone achieved a 93.3% success rate compared to 56.3% for patients treated with the gold standard of care: Levofloxacin plus saline.

Number 10: Seven FDA clearances and more pending.

With all those accomplishments, why is the share price so low? Well, for one thing Wall Street is just not aware of this company. Also, Investors are impatient. They feel things should be moving along faster, and the growth rate should be even higher. Investors complain about the seasonality of Oculus's revenue: huge growth one quarter, minor growth the next. They believe that since Oculus has yet to turn a profit, it never will. These are all reasonable concerns. As with all speculative stocks, there is risk here. But with risk, comes opportunity. With Oculus, the fundamentals have improved, and the share price has plunged, which creates opportunity for investors.

Most companies go through long and erratic periods of revenue growth before reaching profitability; (AMZN) was unprofitable for years before it turned the corner, as was Netflix (NFLX), Apple (AAPL), and Microsoft (MSFT). They all had to pay their dues.

Oculus needs $4 million per quarter in revenues in order to reach EBIDA break even, and the company reported $3.7 million for the third quarter of 2011. It is getting close. If revenues continue to ramp at the current rate, at some point Oculus should become profitable. Once that happens, the share price should rise significantly.

What can we expect going forward? As Oculus introduces new products and forms more partnerships, it should be able to keep its cost structure low while growing revenue at 30% to 35% annually. Once Oculus has several partners who are performing as well as Innovacyn (the veterinary partner), the revenue potential for Oculus becomes huge. The beauty of the Oculus business model is that it is easily duplicated, simply by finding capable partners. And, the company's strategy of passing costs on to its partners is what allows Oculus to achieve such high margins.

What is the ultimate revenue potential for Oculus? The best approach is to look at the total addressable market for all Oculus products:

  • Wound care: $4 billion
  • Veterinary: $1 billion
  • Urinary tract infection: $1.1 billion
  • Ventilator associated pneumonia: $380 million
  • Allergy: $6 billion
  • Dermatology: $3.3 billion
  • Acne: $2.8 billion

Total addressable market: $18.58 billion.

Given the complexities and variables when analyzing total addressable markets, there is considerable room for error. In order to be conservative, I will reduce my estimate of $18.58 billion to a total addressable market of $10 billion, which in my opinion is probably a more reasonable number.

Oculus will not be able to capture all of this total addressable market. Some products will be more successful than others, so let's assume Oculus can only capture 10%. That brings total product sales to $1 billion, annually. At a 30% royalty rate, Oculus would receive $300 million from its partners. As Oculus grows, its cost structure will grow also, so of that $300 million, let's assume a 30% profit margin, which would give Oculus $90 million as its GAAP profit.

With 30 million shares outstanding, and a profit of $90 million, the earnings-per-share is $3.00. How does this relate to share price? With a PE of 14, and earnings of $3.00 per share, the share price would be $42, assuming 30 million shares outstanding.

I realize $42 per share assumes a best case scenario. It is more likely things do not go as planned, and revenue turns out to be less than what I projected. There are always unexpected costs, and some of the addressable markets will turn out to be less lucrative than expected. Also, there is always the looming specter of future competitive products. Big Pharma's R&D departments are not sitting idle. Let's assume revenue turns out to be half of what I projected. That would give us an EPS of $1.50, and a share price of $21.

If Oculus is able to carry on as it has, successfully growing product revenue at 35% per year, earnings of $1.50 per share is not unrealistic. It all comes down to whether or not management can continue to execute as it has in the past.

So far, management has done a good job. Investors need to keep in mind that this company started with nothing but an idea. Hoji Alimi, the CEO, spent 4 1/2 years in the lab developing the product to its current level of stability, safety and efficacy. He then began hiring the management team and built the company to its current level of $9.7 million a year in revenue. It took some real talent to pull that off. I know, because I have been involved in startups for most of my life, and this level of achievement is neither easy nor common.

Let me give you an example of a company in which management proved not to be capable. In 2001, a Silicon Valley venture capitalist introduced me to a company that was the market leader in VoIP technology. In other words, it was the first company to successfully do what Skype is now doing. I invested, and within two years the company went bankrupt, and Skype took over the VoIP market. My company had the technology, it was just as good as Skype's, but management did not have the talent to successfully develop it. They completely dropped the ball. Investors often overlook management's abilities, or lack thereof, and focus entirely on the product or technology. That's never enough. For a company to succeed, it also needs extremely capable management.

Most of the principals within Oculus are major shareholders, either in the form of common shares or options. The bulk of their potential net worth is tied up in this company, so they are all financially motivated to create a successful outcome.

After many hours of meetings and conference calls with Hoji Alimi, Bob Miller, Jim Schutz, and Dan McFadden, I have a clear picture of just how good these guys are. They form a solid team which combines experience, intelligence, creativity, discipline, and the willingness to do the hard work. They certainly have the ability to bring this company to the level of a long-term successful enterprise.

Another thing to keep in mind is that Oculus would make a perfect acquisition for Johnson & Johnson (JNJ), Merck (MRK), or Pfizer (PFE) But I like Johnson & Johnson, partly because my first company was sold to Johnson & Johnson, but also because Johnson & Johnson has been on an acquisition binge over the last couple of years. Management has picked up 11 new companies, and it appears Johnson and Johnson is continuing on this path. The company is sitting on $30 billion in cash, some of which would be better used buying a company like Oculus.

Oculus' line of products would be a perfect complement to Johnson & Johnson's existing portfolio. Johnson & Johnson has the low cost over-the-counter antiseptic market covered with Neosporin, but it really has no high-end products that equal the efficacy and more importantly, safety, of the Oculus products.

If Oculus continues on its current path, a $21 share price is possible. But with a current share price of around $1, if Oculus hits $10 again, it will go down as a very good trade. Whether Oculus succeeds as a standalone company, or it is bought out by a bigger company, shareholders stand to benefit.

Disclosure: I am long OCLS.

Additional Disclosure: John Ford is a general business consultant for Oculus Innovative Sciences and a shareholder. For disclaimer and SEC rule 17 b disclosure information, please click here

Source: $10 Billion Market Opportunity For Oculus