Canadian Biotech Isn't Dead; Following The Money To Undervalued Equities

Includes: GILD, NVDQ
by: Nouvelle Asset Management

There's a world of biotechnology just north of the American border, a regional segment of the biotech market that in recent years has been neglected by retail and institutional investors alike. Canadian life science companies struggle to raise capital like their American counterparts, but face harsher headwinds as a direct result of a lack of venture capital, institutional investors, and market visibility in Canada. And it's not for lack of ingenuity. Canadian biotech is far from dead, and companies with promising technologies, companies that are fighting these headwinds by successfully raising capital, create substantial opportunities for the savvy investor.

Twelve years ago, at the height of venture capital activity in Canada, 1,007 Canadian biotech startups raised $5.9 billion. Last year, in 2011, 444 Canadian firms saw just $1.5B in invested capital. The dwindling investments have gotten so bad, in fact, that the Ontario government considered a 35% tax credit for angel and institutional investors.

Ernst and Young's Beyond Borders: Global Biotechnology Report 2011 demonstrates this shift. The report states that while biotechnology globally has reported solid top- and bottom-line growth, finding funding for research & development remains difficult, particularly among small innovators. Companies in Canada, Europe and the US raised $25 billion in 2010, roughly equal to the four years preceding the global financial crisis, when "money was easy." And while funding may be on the rise globally, says Ernst and Young, it's largely in the form of debt, and early backing is hard to come by:

Even as overall funding amounts held up nicely, a growing share of the total was in the form of large debt financings by mature, profitable companies...But while balance sheet restructuring and debt optimization may be worthwhile means for large companies to maximize shareholder value, they have very little to do with the question of how the financial crisis has affected the ability of emerging companies to fund innovation. What is most relevant for our analysis is what may be termed "innovation capital" - total funding minus large debt financings by mature, profitable companies. And on this front, the trend is exactly the opposite of the overall numbers. While total US capital raised increased by 15% in 2010, innovation capital actually declined by 20% over the same period.

Promising technology does not go entirely unnoticed, however. The other week, Gilead Sciences (NASDAQ:GILD) announced the purchase of YM BioSciences (YMI), an Ontario-based hematology and oncology drug developer, in a deal that valued YMI at $510M. More importantly for investors, Gilead's $2.95 per share purchase price came in at an 81% premium to the company's previous $1.63 close. The company's lead candidate and deal-driver for Gilead, CYT387, is a JAK1/2 inhibitor that demonstrated promising results in a Phase I/II trial for myelofibrosis. And the purchase was a welcome reprieve for YMI investors; shares traded below $2.00 for most of 2012 and had been relatively immobile for the second half of the year.

Similarly, back in February, Alexion Pharmaceuticals (NASDAQ:ALXN), a developer of treatments for ultra-rare diseases, acquired privately-owned and Montreal-based Enobia Pharma in a deal valued at $1.08B ($610M plus potential milestone payments). YMI and Enobia are two of a select few success stories to come out of the Canadian biotech industry since the flow of development-driving venture capital went stagnant in the last decade.

As a result, Canadian biotech companies are notoriously undercapitalized. But small, cash-strapped innovators that are able to secure funding warrant a closer look. Venture capital firms are looking for returns, and ensuring that an investment can be liquidated at a gain further down the road is thus a priority. To that end, the TSX Venture Exchange, where many Canadian biotechs make their public debut, is a poor stage for visibility and liquidity. Relisting on a larger exchange becomes a primary objective for mid-stage biotech companies and their backers; this offers an arbitrage opportunity for investors with the foresight to notice a potentially lucrative disparity.

Along that vein, Cynapsus Therapeutics (CTH.V) (CYNAF.PK), a Toronto-based drug-developer, is in the middle of a capital search, and VC backing suggests a relisting on a larger exchange in the near future. The company, in fact, is in the process of raising $6-8M in order to fund a large bio-equivalence trial. What's encouraging is that Cynapsus has already secured $2.5M of the in-process financing from a "healthcare/life science focused institutional investment group" - sounds like one of those few large investors exploring the Canadian biotech industry.

Cynapsus' lead candidate, APL-130277, is a sublingual thin-film strip reformulation of apomorphine, a common treatment for "off" episodes in patients suffering from Parkinson's Disease. While symptoms of Parkinson's disease can be mitigated with the use of dopamine stimulation and replacement, sufferers often experience "off episodes" in which they may have impaired movement and speaking capabilities, or be rendered completely immobile. Injectable apomorphine is the only available fast-acting treatment for these episodes and can return a patient to near-normalcy within 20 minutes.

If APL-130277 can demonstrate the same dopaminergic qualities as its injectable counterpart (safety and tolerability were established in early trials), then the benefits of its sublingual formulation are clear - an effective treatment without the necessity of a needle. Off episodes effect 25-50% of the 1 million Parkinson's patients in the U.S., and estimates put peak sales of APL-130277 at $600 million to $1 billion. And, Cynapsus' recent survey of neurologists illustrated considerable demand for a sublingual reformulation. APL-130277 was even recognized as one of the Top Ten Neurology Projects to Watch in 2012.

That said, Cynapsus is still a development-stage company, and as a nano-cap stock on a small exchange, inherently trades with considerable volatility. This isn't one for the risk-averse, but it's important to note that APL-130277 is being developed under section 505(b)(2) of the Federal Food, Drug and Cosmetic Act, which will allow for an approval based on bio-equivalence to the subcutaneous form of apomorphine - a cheaper, easier, and possibly quicker alternative to the standard approval process. Cynapsus currently trades on the TSX Venture with a $7.75M market capitalization, a severe undervaluation based on APL-130277's market opportunity alone. And considering the upcoming influx of capital, certainly low once cash is secured. But value proposition aside, a relisting on an American exchange creates an opportunity for an arbitrage play. When the company rolls over, it will likely list at a $25-30M valuation, a sharp disparity to its current valuation on the TSXV, and one that will allow investors to take advantage of this gap for significant returns.

These kinds of market misjudgments recently generated gains for investors who identified and acted on similar disparities. Acadia Pharmaceuticals (NASDAQ:ACAD) released positive top-line data for its lead candidate pimavanserin last month. Low expectations for the Parkinson's Disease Psychosis drug had depressed ACAD so much in 2012 that the data release prompted the stock to climb more than 150% over the course of a single trading session. Prior and widespread expectations for the drug to fail created a major opportunity for those who identified the upside possibility.

In a contrasting example of the market's inefficiency, ARIAD Pharmaceuticals (NASDAQ:ARIA) received FDA approval for its lead candidate ponatinib on December 14th. The approval was widely anticipated and ARIA was so over-valued that the FDA's decision prompted a major sell-off; ARIA fell 20% before reclaiming a small amount of those losses over the following few trading sessions. Again, a major misevaluation from the market proved lucrative for the sophisticated investor. And at its current $3.43B market capitalization, high expectations for ponatinib sales are already baked into ARIA; should sales miss estimates, shareholders are in for another ride down.

Another recent Canadian biotech success story, in terms of both financing and performance, is Novadaq Technologies (NASDAQ:NVDQ) (NDQ.TO), which relisted on the NASDAQ in March. Shares trading on the TSX, where the company had been previously listed, climbed 40% into and through the NASDAQ listing despite prior success on the Canadian exchange. Shortly after relisting on the NASDAQ in March, the company was able to pull together $40.3M in an equity financing that closed, with full exercise of its over-allotment, in April. Additionally, the company was able to secure capital without pricing the offering at a severe discount to market, a hallmark of life science companies that often results in significant short-term losses for retail investors. While Novadaq continues to burn cash, albeit minimally, revenue and shipments for its primary value-drivers are increasing, and the addition of a new product will only improve sales.

Novadaq develops and markets real-time imaging technology for use in the surgical setting and has been demonstrating consistent revenue growth through 2012. While the company has yet to turn a profit (average quarterly operating loss of $1M over the TTM), 3Q revenue grew by 39% year over year, and 12% q-t-q throughout 2012. Installations of Novadaq's imaging systems have been increasing consistently, and the company reports that the SPY Elite has been installed in 90% of the top 50 U.S. cancer hospitals. Notably for life science investors, Novadaq sells the SPY imaging system in collaboration with Intuitive Surgical (NASDAQ:ISRG), which utilizes the technology alongside its da Vinci robotic surgery system under the name FIREFLY. And, the company has commercial agreements with other industry players LifeCell, MAQUET, and Kinetic Concepts (NYSE:KCI) as well. The SPY technology, and the recent addition of the PINPOINT endoscopic fluorescence imaging system (for which NVDQ made its first sale this month), are expected to drive 2013 revenue to more than $36M, up from estimates of $23M in 2012 - a 57% increase which should narrow EPS loss to less than $0.10 in 2013.

NVDQ is up 35% YTD, but retraced some 25% from a $12 high in October when the company reported a slight earnings miss vs. consensus estimates. Nevertheless, the current price makes for a quality entrance point, as analysts recently increased price targets to $12 and $15. Following its recent financing, Novadaq has a solid balance sheet with which to execute the PINPOINT launch, and with a new product just beginning to penetrate the market, makes for a quality long-term prospect in the medical device space, particularly attractive due to its industry collaborations. Novadaq is a prime example of a Canadian firm that navigated the capital environment at the low-point of investing activity four years ago and remains a compelling story.

Interestingly, venture capitalist and Canada native Ann Hanham noticed the lack of financing for biotech firms in her home country and began a campaign to start a $300M VC fund specifically for Canadian biotechnology. Hanham, who also sits on the board of Endocyte (NASDAQ:ECYT), acts as Director of Canada for investment firm Burrill & Company and said of the opportunity for Canadian biotech:

It's huge. Canada is in the top 10% of countries on a per capita basis for research; the Canadian and provincial governments have put an enormous amount of capital into research in academic institutions. But Canada is rated in the bottom 20% in the world for commercialization of their research. That means I can come in and leverage all the federal and provincial money that's gone into academic institutions. I can get it cheaply in Canada today, and I can sell it in the world for a lot more. To me, that's a really good argument to invest in Canadian start-ups.

Disclosure: I am long GILD, CYNAF.PK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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