Four Small-Cap Growth Names with Different Value Drivers: Keay Nakae


keay82It's important to take the emotion out of investing. Keay Nakae, senior research analyst with Ascendiant Capital Markets, looks at micro- and small-cap biotech stocks from an engineer's perspective: It's all about the data. In this interview with The Life Sciences Report, Nakae reports on four companies with upcoming catalysts that potentially position them for significant growth—and the ability to grab investors' attention.

The Life Sciences Report: You have a very interesting background. You earned your master's degree in business administration at the Anderson School of Management at UCLA, but you are also an electronic engineer, with an advanced degree from California Polytechnic State University in San Luis Obispo. You've also had significant experience in industry, where you were part of a team that developed the Affinity pacemaker at St. Jude Medical Inc. (STJ:NYSE). Engineers look at the world in a very disciplined, problem-solving fashion. You have been a sellside analyst now for more than a dozen years, and have been recognized by Forbes as one of America's Best Analysts. Can you tell me how your experience has shaped your methods as a sellside analyst?

Keay Nakae: My prior work history has been cumulative in terms of my ability to be an effective analyst. At each stop along the way, I've had a certain set of tools that I was able to further develop, which, collectively, I use in my current job.

Starting with my engineering background, I have a certain, very logical way of problem solving and thinking about things. But equally important is the fact that, having worked for a company that was developing a product, I understand all the steps along the way: product design, developing the prototype, fixing what's wrong and improving the product to the point where it can be handed off for manufacturing and go to the market. Being part of that process has been very valuable in knowing what questions to ask.

After being an engineer and then graduating from business school, I shifted careers and worked in corporate finance, which requires a whole different set of skills. But again, this has been very valuable to me as an analyst in terms of determining valuations. I understand how tradeoffs are made in determining which products in the development pipeline are advanced with additional funding and focus, and why other products are shuffled back or simply abandoned due to their perceived future values.

TLSR: Keay, how does your critical analytical process fit into analysis of micro- and small-cap biotech stocks? Does the discipline that you brought from business school, engineering and industry make it easier for you to see value drivers, or the lack of value drivers, in very small companies that often have just one product in development?

KN: For companies that fit the micro- and small-cap criteria, I focus on the game plan. A drug developer must, obviously, have a good compound, but it also must have a good game plan for advancing that molecule through the required clinical steps to create value. More often than not, the design of clinical studies can go a long way toward creating perceived value along the road to commercialization.

If a smaller company has fewer resources, limited funding and less experience, trial design may not be up to the standards found in larger companies. Poor decisions about clinical trial design can have very negative ramifications down the road. If a company makes good trial design decisions on the front end, it may take a little bit longer to complete the process, but positive results could bolster value creation as a product moves to the next phase of clinical development.

TLSR: I'm going to ask this next question specifically because you follow both micro-cap and small-cap stocks. Micro-cap names may not be very reactive to catalysts, even though the catalysts might be very positive. Many micro-cap biotech and specialty pharma stocks have significantly lagged this two-year biotech bull market. I'm wondering if you can venture an opinion as to why these micro caps are not following the lead of small-, mid- and large-cap biotech stocks.

KN: The lag time has to do with both the micro caps' investor base, and also with what their future funding requirements are going to be.

Let's say you have a company working on a product, and let's say it has some positive preclinical data. The developer is still going to have to go through phase 1, phase 2 and phase 3 studies, so we know the pathway required to get that drug approved. But at step one the developer is still a long way off, and there is a lot of work that needs to be funded. The market knows that the company is going to need additional capital. In most cases it is too early to talk about partnering at this stage, so the developer has to go it alone. Hence, the need at some point to raise additional cash, which means further dilution, which represents an overhang on the stock.

TLSR: Another issue has to be the fact that institutional investors can't own these micro-cap stocks. As an analyst, do you have to cultivate the small hedge fund manager for these types of names?

KN: There are different investors for every type of company at every stage of development. To your point, the larger mutual funds obviously have restrictions on what they can buy in terms of market cap, liquidity, and possibly profitability. Liquidity is always an issue at any stage. If you make an investment and you want to get out of it, can you do that? That's obviously a key concern or criteria for anybody investing in any stock.

"A drug developer must, obviously, have a good compound, but it also must have a good game plan for advancing that molecule through the required clinical steps to create value."

Typically companies start small, with very focused types of investors, and move up the chain as they gain success and create value. From the company's perspective, it's important to keep the doors open, allowing it to continue to work on its compound. Financing may be more expensive on the front end, but the company has to have funding to keep working. Hopefully, as the company continues to create value and achieve successes in human clinical trials, smarter hedge funds will then want to invest. Maybe the company can even do a financing without using a banker. With continued clinical success, the company can reach a position where it is able to conduct a larger financing with traditional mutual funds as investors, and/or enter into licensing agreements with bigger companies.

TLSR: I've been reading some of your research. Can you throw out a name that you like?

KN: We can start with a couple of names. One is Synthetic Biologics Inc. (SYN:NYSE.MKT). This company has a number of different products, some legacy products, and others more recently acquired. Deep in the company pipeline is a monoclonal antibody collaboration with Intrexon Corp. (XON:NYSE), which is very intriguing.

With regard to near-term opportunities, Synthetic Biologics has a legacy product to address multiple sclerosis (MS). Obviously, that's a big market and the focus of a lot of drug development. The company has a very simple solution, which is to take a form of the female hormone estrogen, which it is calling Trimesta (estriol), and co-administer it with a commonly used MS drug. Currently, Trimesta is being evaluated with Copaxone (glatiramer acetate) to see what the additional benefit is. The company is near completion of its two-year follow-up in this phase 2 MS study.

What I like about this study is that it has an industry-standard primary endpoint, which is a two-year follow-up for relapsing-remitting MS patients. The last patient follow-up should occur in January 2014, and we should see the top-line results reported a few months later. If we get a good result, it's going to be well accepted because of the solid trial design.

TLSR: Keay, Clostridium difficile (C. difficile) infection has been a trendy topic among investors. Synthetic Biologics has an interesting approach to the infection. Could that be a value driver here?

KN: Yes. The second compound in Synthetic Biologics' pipeline, which we think could be the most interesting, is another oral product, SYN-004 (beta-lactamase), for C. difficile. It's an enzyme, and the concept is very simple.

C. difficile is a quite common hospital-acquired infection. A whole class of antibiotics, the beta-lactams, are administered intravenously (IV) when patients are admitted to hospitals. But what tends to happen is that these antibiotics make their way into the gastrointestinal (GI) tract and wipe out some of the natural flora—the "good" bacteria—that exist there. That creates an opportunistic environment for C. difficile, which is also naturally present—but it can cause significant problems for a patient. By using the enzyme SYN-004, which would be co-administered with the IV antibiotic, clinicians could protect the "good" bacteria in the GI tract from the beta-lactam antibiotic, thereby preventing C. difficile from taking over and causing its symptoms. It is a very interesting concept, and could be a low-cost prophylactic approach to treating this problem.

TLSR: This company has the estriol hormone, Trimesta; the beta-lactamase SYN-004; and a monoclonal antibody targeting the Bordetella pertussis toxin, which causes whooping cough. This is a lot for a company with a $70M market cap. How does the company manage all of this activity?

KN: The company stock has benefited from a change in focus and a partnership with Intrexon—more specifically with Intrexon's chairman and CEO R. J. Kirk.

A few years ago, Synthetic Biologics was known as Adeona Pharmaceuticals Inc. and, other than Trimesta, had a less-interesting development pipeline. A key transformational event occurred in Q4/11, when Adeona signed its first collaboration agreement with Intrexon, which prompted the company to shift its focus and change its name. R. J. Kirk now has a significant stake in Synthetic Biologics, and that relationship has allowed the company better access to investors who have been successful investing in R.J. Kirk and his ideas and companies.

As the company moves forward, and with top-line results with Trimesta expected no later than mid-2014, I think we will see creation of value and potential licensing opportunities. Because of the trial design, with its well-established and accepted endpoint, positive data could open some doors for licensing.

TLSR: Do you suspect that Teva Pharmaceutical Industries Ltd. (TEVA:NASDAQ) might be the ideal partner, considering that the phase 2 trial is studying the combination of Trimesta with Teva's Copaxone?

KN: Teva's Copaxone is going off patent, and Synthetic Biologics does have a patent issued for the combination therapy of Trimesta with Copaxone. Partnership would logically be a direction that Teva might be interested in, and a positive phase 2 outcome on a hard, well-accepted endpoint would likely result in advancement of Trimesta + Copaxone into phase 3 studies. But at the same time, I believe we could also see other pharmas thinking about how synergistic Trimesta could be with one of their new oral medications. While Copaxone is a very commonly used drug, the big excitement in MS today comes from new, orally bioavailable drugs, specifically the new drug from Biogen Idec Inc. (BIIB:NASDAQ), Tecfidera (dimethyl fumarate). Since Trimesta is also administered orally, I think a positive phase 2 result will definitely lead to more development of Synthetic Biologics' compound.

TLSR: It's interesting that you say that because Copaxone is an injectable, and one of the value propositions for Trimesta is that it can be given orally. Theoretically, if the patient could be on all oral medications, that would be a better situation. Why do you imagine that Trimesta is being developed with Copaxone?

KN: At the time this phase 2 study was being designed and commenced enrollment, Copaxone was the standard of care that Trimesta needed to be compared against.

TLSR: Could you mention another name?

KN: We also cover companies in the cell therapy area. One company with a number of important catalysts coming up is Cytori Therapeutics Inc. (CYTX:NASDAQ). [Editor's Note: Cytori Therapeutics will be one of the presenting companies at the upcoming Stem Cell Meeting on the Mesa, taking place in La Jolla, Calif., Oct. 14–16.]

"There are different investors for every type of company at every stage of development."

Cytori has an autologous (using the patient's own cells or tissues) approach. The company runs a sample of adipose tissue obtained from a liposuction-like extraction procedure through its device, the Celution System, which concentrates the cells of interest. The processed material is called adipose-derived stem and regenerative cells (ADRCs), which are injected back into the patient. The company has generated a decent amount of clinical patient data thus far, and is now focusing on two areas. The first is cardiovascular disease, where Cytori is currently conducting a clinical study in the U.S. to evaluate the ability of its cell therapy product to treat patients with chronic ischemic heart disease. That particular phase 2 study, called ATHENA (NCT01556022) is currently enrolling patients, and we expect to see top-line results reported in the middle of 2014.

Cytori's other opportunity is using the same cell therapy approach to treat patients who have experienced thermal burns as a result of radiation exposure. In this particular case, the company has been granted a development contract from the Biomedical Advanced Research and Development Authority (BARDA), which is under the U.S. Department of Health and Human Services. BARDA is looking for new technologies and therapies that could be available to the U.S. in case of a nuclear event. The company is currently doing work under phase 1 of the contract, which provides the company $4.7M to complete a number of tasks, the most significant of which is a preclinical evaluation of the product. That work is expected to be complete in Q1/14, and at that point the company will show the results to BARDA. The hope is that Cytori will then qualify to move into the more significant second phase of the contract, which would provide the company with up to $56M in additional funding to conduct a pivotal study in the U.S. with the goal of having the therapy receive FDA premarket approval (PMA).

Hence, Cytori has two pretty significant, upcoming catalysts: a decision on whether it will move into the second phase of the BARDA contract, and the top-line results from its ATHENA study, evaluating its product in chronic ischemic heart disease.

TLSR: I note that the final data collection for the ATHENA study will be December 2013. We're just a couple of months from that now. How long is the follow-up?

KN: ATHENA is effectively a pilot study, so its primary endpoint will be evaluated at six months follow-up.

TLSR: This company is creating value with its research and the BARDA contract for the thermal and radiation burns. My question goes to how this is going to be monetized. My understanding is that Cytori sells or leases the Celution device, and then it sells the consumables, the supplies. That doesn't sound like a tremendous value generator for the amount of research going on here. Your thoughts?

KN: The work that the company has done to date has generated positive results in a number of areas, but there are a couple of key hindrances. One, the Celution product is not yet FDA-approved here in the U.S., and even where it is commercially sold outside the U.S., there is a lack of reimbursement. That is hindering any kind of rapid acceleration in revenue growth for Cytori. The product is sold and used outside the U.S., but primarily the system is used to conduct clinical research. That's the case in Japan and, to some extent, in Europe.

As for the U.S., if the company were to be successful in phase 2 of the BARDA contract, which would lead to a PMA, the U.S. government would potentially be a large customer for the product. The government would likely purchase the product, place it regionally in different hospitals and have it in place to be used in case of a nuclear event. At the same time, the hospitals could use it for non-nuclear burn patients who might come in.

Equally important is that one of the tasks in phase 1 of the BARDA contract is to demonstrate the feasibility of a next-generation version of the Celution System, which has already been completed. The next-generation system will have a much lower cost of goods, which will allow the company to move toward a business model driven much more by the economics derived from the sale of the per-procedure disposables.

TLSR: Could you mention another company?

KN: We cover another micro cap called NovaBay Pharmaceuticals Inc. (NBY:NYSE), which has a number of upcoming catalysts. This company is involved in the anti-infective area, but is not antibiotic-related. Its key product, NVC-422 (auriclosene), is a very specific compound, N,N-dichloro-2,2-dimethyltaurine. NovaBay is conducting three separate phase 2 studies in different areas. We should have the results from all three of these studies over the next year.

"Liquidity is always an issue. . .if you make an investment and you want to get out of it, can you do that?"

The company has just reported positive results from the first of these indications, in urology. Auriclosene was evaluated as an irrigation solution for people requiring longer-term use of catheters, to prevent urinary catheter blockage and encrustation. The top-line results from this randomized, double-blinded, placebo-controlled phase 2 study demonstrated that auriclosene was effective at reducing the degree of catheter encrustation and maintaining catheter patency over the course of the study. The auriclosene arm demonstrated a statistically significant reduction (p = 0.005) in the degree of encrustation compared to the control arm of saline-treated catheters. While complete catheter blockage was observed in 64% of the saline-treated catheters, this was not observed in any of the auriclosene-treated catheters (p = 0.0004).

The second opportunity is in impetigo. This application is already partnered with Galderma Laboratories L.P. (private), one of the largest dermatology companies in the world. Use of auriclosene in this indication is also in a phase 2 study, and we will probably see the top-line results in Q4/13. We believe that the positive outcome of auriclosene in the urology study bodes wells for the drug's success in the impetigo study.

The third opportunity is in ophthalmology, using auriclosene to treat viral conjunctivitis ("pink eye"). We should see the results from that phase 2 study in Q2/14. That makes three catalysts driven by phase 2 data for this company in the next nine months.

TLSR: It's an exciting time for this company, no doubt about it. Its stock has behaved rather well over the past year, up 20% over the past 52 weeks, but its market cap is just $64M. Do you think that money managers haven't really looked at NVC-422 as a serious medicinal product?

KN: I believe there are a number of reasons for the low valuation. First are the limitations on micro-cap stocks that we have already discussed. Second, there is some confusion about how NVC-422 is different from both NovaBay's other product, called NeutroPhase (hypochlorous acid), which is sold as a skin and wound disinfectant, and other anti-infective products out there that, for lack of sophistication, you might think of as simply a diluted form of chlorine bleach. Finally, there is the prior failure of NVC-422 in a viral conjunctivitis study conducted by Alcon (a division of Novartis AG [NVS:NYSE]) back in 2011.

TLSR: I imagine that pediatricians would love to be able to manage pink eye in patients who can't reenter school without being treated, or highly contagious impetigo without using antibiotics. There is a crop of young physicians today looking for alternative solutions to antibiotics. But I'm wondering if investors are thinking that NVC-422 could be easily duplicated, or that a similar product is being developed.

KN: As you know, "pink eye" can be more of a generic term for eye inflammation, or conjunctivitis that may have been caused by either a bacterium or a virus. In the prior study conducted by Alcon, while the objective was to evaluate how well NVC-422 treated viral conjunctivitis, the number of patients enrolled in that study who actually had a viral infection was low. So we didn't really learn anything because of a poor trial design on the front end. The current study has a much better design, which will ensure that patients with viral conjunctivitis are evaluated. As a result, a positive result will be much more specific and informative, and would be very helpful to NovaBay in deciding how to proceed in phase 3 studies.

TLSR: We will hear the phase 2 viral conjunctivitis result in Q2/14, right?

KN: Yes, that's probably a good timeframe.

TLSR: And there is no approved therapy for adenoviral conjunctivitis currently, correct?

KN: That's right.

TLSR: Another name, please.

KN: A name we follow that's a little different is MusclePharm Corp. (MSLP:OTCPK), which is in the nutritional supplement business. One of the reasons we like this name is that while MusclePharm is in a competitive space, it has done an amazing job of establishing a brand name that people have gravitated to. We've seen really rapid revenue growth, and we would expect that to continue for a number of reasons.

The company is introducing some new product lines, one of which is focused specifically on female athletes. Then there is the more recent collaboration with Arnold Schwarzenegger to launch a branded line of Arnold Series products. Underneath that, in terms of distribution, MusclePharm continues to make good strides in moving from what had been a larger reliance on specialty stores that sell nutritional products to selling in more big-box retailers. Most recently, it has entered into a deal with Costco Wholesale Corporation (COST:NASDAQ), and we would expect it will enter into other agreements with larger drugstore chains and retailers.

TLSR: The company has concentrated on growth. It is headed toward $100M in annual revenue this year, but what about profitability?

KN: The company has achieved critical mass on the top line, but as we look down the income statement, there is a lot of room for improvement. In terms of the gross margin, we believe that the company can improve how it sources raw materials, how it manufactures products, how it ships the product, and the degree of discounting that's required to get its products on the shelf at retailers. We expect the company to move into profitability next year and to begin leveraging the infrastructure in the middle of the income statement that it already has invested in.

TLSR: It takes real talent to achieve a $100M top line from nothing, and it also takes talent to get a product into a big-box store like Costco, which could easily become MusclePharm's biggest customer, with 400+ stores in the U.S. How much risk does this one huge customer, for which MusclePharm will have to gear up to manufacture and package an exclusive five-pound container of product, present to the company?

KN: Think of it this way. First of all, the two largest current customers aren't going anywhere—those being BodyBuilder.com and its other wholesaler Europa Sports Products. The form of the product sold at Costco, in terms of quantity, will be different than what is sold through those other outlets, which not only could make it a higher margin product, but also is a point of differentiation that allows all the channels to continue to be productive.

When you start out as an unknown, you have to beg to get retailers to handle your product because stores have a limited amount of shelf space. Whatever they put on the shelf, they need to achieve high turnover, and if the product is not moving, it will get replaced with something else. Hence, the big store is going to want to know how much effort you're going to put into promoting and advertising the product to ensure it will move.

Now that MusclePharm has achieved critical mass, it becomes a heck of lot easier to get its products on the shelf at a store like Costco. When retailers see the kind of numbers MusclePharm has been posting, they know it's a much lower risk to give the company a shot. The company has done a good job in establishing the brand, which is reflected in its sales growth, and continues to look several years forward to identify future growth drivers.

TLSR: It's been very nice meeting you and hearing your ideas, Keay. Thank you.

KN: It was great talking to you.

Keay Nakae is a senior research analyst for Ascendiant Capital Markets LLC, where he covers the healthcare industry. He has twelve years of experience as a healthcare equity research analyst and has covered small- to large-cap biotechnology, medical device and diagnostic companies that compete in areas of cardiology, gynecology, neurology, urology, oncology, diabetes, aesthetics and cardiac and spine surgery. Prior to joining Ascendiant, Nakae was a senior research analyst at Chardan Capital, Collins Stewart, CE Unterberg, Towbin and Wedbush Morgan Securities. He has made media appearances on Bloomberg, and has been quoted in The Wall Street Journal, Time, Business Week and The Los Angeles Times. He has also been recognized by Forbes magazine in its annual survey of America's Best Analysts. Before becoming an equity research analyst, Nakae worked at Atlantic Richfield Co. in corporate finance and portfolio management positions, and at St. Jude Medical as a member of the research and development engineering team responsible for the Affinity pacemaker. He earned a master's degree in business administration from UCLA's Anderson School of Management, and holds master's and bachelor's degrees in electronic engineering from Cal Poly. Nakae is a Chartered Financial Analyst (CFA) and member of the CFA Institute. He maintains FINRA Series 7, 16, and 66, 86, and 87 securities registrations.

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1) George S. Mack conducted this interview for The Life Sciences Report and provides services to The Life Sciences Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Life Sciences Report: MusclePharm Corp., Synthetic Biologics Inc. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Keay Nakae: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Cytori Therapeutics Inc. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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