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Excluding a diminishing stake among insiders, and scant ownership among financial institutions, shares of Oculus Innovative Sciences (OCLS) appear to be concentrated in the hands of unsophisticated investors who've continued to perpetuate a failing enterprise.

Since its IPO in 2007, Oculus has underperformed every major index known to passive investors, including broader market indices like the S&P 500 (SPX), and sector specific indices tracking Health Care (XLV), Biotech (XBI), Pharmaceuticals (XPH), and so on and so forth. The chart below shows Oculus' performance relative to six benchmark indices since the company first went public.

Stock Performance

click to enlarge

There are a number of takeaways from this chart. First, since Oculus does not pay a dividend, every $1 invested in Oculus's debut five years ago would leave an investor with $0.15 today, before deducting transaction costs, and accounting for the time value of money (i.e. inflation). In other words, an investor would have fared better financially by stuffing money under their cushion instead of investing in Oculus - excluding, of course, the more prudent choice of investing in a fund that tracks biotechnology, healthcare, or any other segment one might so desire.

The second takeaway is that while day-to-day, week-to-week, or even month-to-month price movement may be irrational and immaterial in the long run, the same cannot be said of an equity that performs poorly year after year.

Financial Distress

On the surface, Oculus appears to have a growing business with a bright future. Yet a deeper look reveals financial distress. Indeed, as of the last reported quarter, Oculus's book value was roughly $0.005 per share, assuming the firm's assets could be liquidated at historic cost (which is not a conservative assumption whatsoever). Working capital in the same period was $3,784MM, roughly the equivalent of Oculus's twelve month cash burn rate. Inevitably, the company will need to raise capital [again] by either issuing debt or stock in a secondary offering.

And so it has been the case since the company's inception, as investors have floated Oculus $114.5MM and counting (per a disclosure in the latest quarterly report). The problem that arises, then, is that all else being equal, dilution leads to a lower price per share. One need not look far for proof: Oculus's share count rose from 11,424,209 after the initial offering, to 28,855,729 as of January 27, 2012 (mrq), or 153% in the last half-decade. It's clear from the chart (above) that this dilution has weighed heavily on the company's stock price.

In June, Oculus drew on a $2.5MM loan, in an attempt to shy away from another capital raise with stock (which still happened less than 6 months later). The deal, however, granted the creditor a warrant for 306,612 shares of common stock (see 'Notes Payable' disclosure in 10Q). To make matters worse, the warrant has a cashless exercise feature. Debt servicing in connection with this loan will cost Oculus $0.83MM in FY2012 - a material strain on a bankroll that totaled less than $5MM as of December 31,2011.

Stock Overhang

In an attempt to stretch the dollar, Oculus has steadily increased the proportion of stock-based compensation from $1.582MM in FY2007 to $2.366MM in FY2011. But even as cash expenditures have benefited from a shift over to stock-based compensation (a non-cash item), a bigger problem now looms. There are millions of derivate securities - stock options and warrants - that create an enormous overhang and exert a downwards pressure on the price of the stock. It's the same dilution that Oculus has been attempting to avoid with secondary offerings, dressed another way.

Oculus Share Capitalization
Source: Investor Presentation

Fully diluted shares (as shown in the diagram, above) assume all warrants and stock options are exercised before a tally of the number of shares issued and outstanding is taken. Implicit in the total (44.54MM shares) is dilution to the tune of about 54%, or, all else being equal, a share price equivalent to slightly less than 2/3 of the recent quote. The immediate impact, however, can be slightly relaxed since the strike prices of several derivatives (but not all) are higher than recent quotes for Oculus's common stock. Yet it reinforces the idea of overhang, or - if you prefer - a ceiling on how high the stock can trade.

More concerning, however, is that in the aggregate, insiders own less than 5% of shares outstanding. As offering after offering diluted common holders, ownership among Oculus insiders has diminished. Notwithstanding, the last time an insider bought shares in the open market was on August 9, 2010: a whopping $35,000 worth.

And now, one of Oculus's largest owners is selling his stake (more on this, shortly). The point being is that insiders haven't a meaningful stake in the company and even as Oculus trades near all-time lows, not one officer or director of the company has had the confidence to buy shares on the open market. These actions (or lack thereof) beg the question: are management's interests aligned with those of shareholders?

Undifferentiated Product

One might be reading this and wondering where it all ends. The answer, of course, is that it ends where it all begins: Microcyn, Oculus's product platform. PharmaTracker published a very thorough analysis of the science underpinning Microcyn six months after the company went public (and yes, it's always a good idea to read opinion pieces dating back more than just the most recent quarter). Essentially, Microcyn is hypochlorous acid or, in layman's terms, a pH-neutral solution of dilute bleach.

It faces stiff competition where barriers to entry are next to non-existent because of the ease of replicating the product, particularly in countries where patent law isn't rigidly upheld. For example, in Mexico, Oculus had noted that certain competitors had 'ripped off' their product design and were attempting to undercut the brand name with lower prices. The company disclosed this because historically, Mexico has accounted for the majority of Oculus's product sales. In FY2011 49% of sales were to customers in Mexico.

The FDA regulates Microcyn as a simple medical device. The agency granted Oculus's Microcyn 510(k) clearance as a product intended for the "moistening and lubricating" or "moistening and dressing" of wounds. Oculus, however, has purported that Microcyn "has anti-microbial properties" and can answer to the rise of antibiotic-resistant pathogens.

Notwithstanding, as you'll read here and here, Oculus was flagged for making unsubstantiated claims about their product without authorization from the FDA (Microcyn would need to be approved as a drug before such claims could be made). Inevitably, the claims Oculus can [legally] make with respect to their product places a tremendous burden of their salesforce, who have to convince customers that dilute bleach branded as 'Microcyn' is worth a premium to the dilute bleach that can be purchased for less, elsewhere.

Concentration Risk and Other Red Flags

In the most recent quarter, Oculus reported impressive top-line growth. A closer look at sales by geographic region revealed that growth was predominately driven by domestic sales (U.S.).

OCLS Quarterly sales by segment

Additionally, a disclosure in the filing would reveal that growth in U.S. sales was primarily driven by growth in the animal care segment, which Oculus sells to through exclusive distributor, Innovacyn, Inc., under the brand name 'Vetericyn'.

[Oculus] shares profits related to Vetericyn and Microcyn over-the-counter sales. During the three months ended December 31, 2011 and 2010, the Company recorded revenue related to these agreements in the amounts of $755,000 and $292,000, respectively.

By extrapolating the difference between Vetericyn sales in the two comparable quarters, we end up with a figure strikingly similar to the variance in sales between the quarter ended December 31, 2011 and the comparable period in 2010 (see table, above).Growth in sales in the U.S. segment was $528,000 ($1,005K - 477K), 88% of which can be attributed to growth in sales via Innovacyn. Importantly, growth in the Mexican market came in at a sluggish 8%, while Europe and the rest of the world contracted 4.5%.

Oculus's growth is almost entirely pegged to a royalty realized on sales of their product through a single distributor. This tells us that markets outside of animal care (i.e. Innovacyn) have been hesitant in adopting Microcyn, regardless of the claims Oculus's salesforce is making. Numbers don't lie: the wound care market is clearly signaling that it is not interested in using Microcyn.

With Oculus's growth in the hands of Innovacyn, there is a tremendous amount of risk concentrated in a single relationship. Innovacyn, by the way, is wholly-owned by Robert Burlingame, who was formally a director of Oculus Innovative Sciences, and was recently named in a prospectus offering the sale of up to 3.98MM shares of Oculus stock.

On September 15, 2009, we entered a commercial agreement with V&M Industries, Inc., a California corporation, to market and sell Microcyn over-the-counter liquid and gel products for animal healthcare. At the time of the 2009 transaction, V&M Industries, Inc. was wholly-owned by Robert Burlingame, who was also a director of our Company at the time of the transaction. V&M Industries, Inc. subsequently changed its name to Innovacyn, Inc.

It's interesting that V&M decided to change its name to Innovacyn, just as Burlingame resigned from Oculus's board of directors. According to the company, he also ceased being a 5% holder in 2010. In connection to a 2009 financing, Burlingame and his son became majority holders of Oculus's stock, and were granted warrants, which they've now registered in the prospectus mentioned (above).

OCLS prospectus

Warrants for the purchase of 2MM shares of Oculus stock vest at $1.13 a share. Specifically, warrants for 666,000 shares expired on March 4, 2012; warrants for an additional 1.33MM expire June 1, 2012. Indefinitely, this creates an overhang of stock painfully near current market price(s). To make matters worse, a second tranche of warrants can be exercised anytime in the next 10 weeks (if they haven't been exercised already).

It's fascinating that Burlingame's clients have been so hungry for Microcyn when the rest of the market seems rather unenthused. In general, whenever there exists such an interdependent relationship between two firms that primarily exist for one another, there's always abundant room for manipulation. The difficulty in investigating this type of notion lies with the private entity whose books are (naturally) closed.

And then for Burlingame, who would seem to have the most inside knowledge (since his firm is contributing almost entirely to the growth Oculus has seen), to be named in a prospectus is somewhat unsettling, but perhaps explains Oculus's trading since the prospectus was filed with the SEC. Though indirectly, it almost suggests that growth may be waning, even in the animal healthcare segment.

Source: Oculus: Financial Distress, Concentration Risk, And Other Red Flags