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Expert Financial Analysis and Reporting

Initiation of Coverage on NovaBay with a Buy


I have just written a new report on NovaBay (NBY) called NovaBay’s Robust Clinical Pipeline Approaches Critical Clinical Trial Results in 2013. This blog is a summary of that more in-depth report. For readers who want to understand the reasoning behind the conclusions I present here, I would suggest that you refer to that report.

Investment Thesis

NovaBay has just received approval in the US for its first product NeutroPhase and will be commercializing it throughout the world using regional partnerships. It has a much more important second product, NVC-422, which is being developed for three distinct disease indications: as a dermal gel for the skin disease impetigo, an eyedrop for viral conjunctivitis and an instillate for treating urinary catheter encrustation and blockade or UCBE.

I believe that NovaBay (NBY) is significantly undervalued at its current market capitalization of just $37 million. In this report, I highlight its four product opportunities and estimate the value of each using a discounted cash flow analysis. Their potential value based on my analysis is several times the current market capitalization.

Investors are awaiting with great interest results from a phase IIb/III impetigo trial in 2Q, 2013 and a phase IIb/III conjunctivitis trial in 3Q, 2013. Important phase II data for NVC-422 in UCBE should be reported in 1H, 2013.Clinical trial results should give investors the data needed to assess the potential for approval and commercial sales of NVC-422 in these three indications. Needless to say, 2013 is a big year for NovaBay.

The company appears to need more capital to support operations in 2013. I am expecting an equity offering of $10 million sometime later this year or in early 2013. At the current price of $1.30 and assuming 50% warrant coverage; this could increase the fully diluted share count by 11.5 million shares to 46.4 million shares. This is factored into my calculations.

This financing overhang has been and may continue to be a headwind. With its completion, the stock performance in 2013 will be determined by the phase IIb/III trial results for NVC-422 in impetigo and viral conjunctivitis. I think that it both trials are successful, the stock could trade above $5 and if both fail, it could fall to the $0.50 to $0.75 range based primarily on the potential for NeutroPhase. I think this offers a very favorable risk reward ratio.

Valuation Methodology for NovaBay

NovaBay is a complex company to understand because of the three product opportunities associated with NVC-422 and the additional opportunity of NeutroPhase; it is effectively four companies in one. Each of these has differing commercial prospects. In order to frame the potential value of each of these assets, I have started with the hypothesis that each of NVC-422 clinical trials now underway will be successful and have built a sales model for its use in impetigo, viral conjunctivitis and UCBE. I have then estimated what the resultant royalty stream or operating income stream could be over the patent life of the products. This is summarized in Table 1.

Table 1: Summary of Projections for End Market Sales, Royalties and Pretax Cash Flow for NovaBay's Four Product Assets
2015 2016 2017 2020 2028
Worldwide End Market Sales ($millions)
 Impetigo 0 5 66 264 372
 Conjunctivitis 5 18 135 606 879
 UCBE 0 0 8 110 352
Sub-total 5 23 209 980 1,603
NeutroPhase 7 10 11 14 21
Value to NovaBay ($millions)
 Impetigo 0 1 7 44 74
 Conjunctivitis 1 2 17 144 226
 UCBE (foreign) 0 0 1 8 26
Sub-total 1 3 25 196 326
Pretax cash flow
 UCBE Marketed by NBY (US) 0 0 (3) 45 155
 NeutroPhase 5 7 7 10 15

I discounted the future stream of royalties and operating cash flow to determine a net present value for each product using discount rates of 10% and 15%. This seems a reasonable range of discount rates to use as compared to current risk free bond yields of about 3%. This is shown in Table 2. Please note that all calculations of net present value are on a pretax basis.

Table 2: Estimated Pretax Net Present Value to NovaBay for Its Four Product Assets
Discount Rate 10% 15% 10% 15%
Pretax Net Present Value Net Present Value Per Share*
$ millions $ millions
 Impetigo 118 70 $2.54 $1.51
 Conjunctivitis 786 530 $16.94 $11.42
 UCBE (foreign) 89 63 $1.92 $1.36
Sub-total for NVC-422 993 663 $21.40 $14.29
Pretax cash flow
 UCBE (US) 499 353 $10.75 $7.61
 NeutroPhase 56 34 $1.21 $0.73
* The fully diluted share count is currently 34.9 million.
I am assuming that a potential equity offering will increase
fully diluted shares by 11.5 million share and result in 46.4 million
fully diluted shares which is the number used in this calculation.
Source: SmithOnStocks

I want to re-emphasize to investors that the above tables assume success in each of the clinical trials that report topline data in 2013, but there is no guarantee that any of these trials will succeed. I believe that the impetigo trial has the highest probability for success as I explain in this report. I am more cautious on the viral conjunctivitis and urinary catheter blockage and encrustation trials. NeutroPhase is in a commercialization stage and has already begun to create revenues. The probability of its achieving my projections is good in my opinion. I would urge the reader to carefully read later sections of this report which explain in greater detail the reasoning underlying the projections in tables 1 and 2.

Table 2 gives the impression of great precision that is not really the case. The reader should also be aware that all the numbers are pretax and not adjusted for taxes. I think the importance of the table is that it gives a sense of the relative importance of the business opportunities NovaBay enjoys and certainly underlines the impressive breadth of opportunities. Some key observations from table 2 are as follows:

  • The potential of NeutroPhase alone comes close to justifying the $37 million market valuation of the company.
  • If the impetigo phase IIb/III trial results are positive, it should lead investors to conclude that the NVC-422 is approvable. I believe that this this along with NeutroPhase could increase the stock price to $2.00 or more.
  • Success in the conjunctivitis indication for NVC-422 could have an enormous impact on the market valuation and could possibly drive the stock over $10. This is a homerun opportunity. The results of the phase IIb/III viral conjunctivitis trial should be reported by 3Q, 2013.
  • NovaBay has indicated that it may build a commercial sales force to market NVC-422 for the UCBE indication in the US. This is second only to the viral conjunctivitis indication in potential as a successful commercial organization creates much more value than licensing.
  • If all of these four development efforts are successful, the combined net present value on an aftertax basis is over $30 per share.

Clinical Trial Timelines Provide Important 2013 Investment Determinants

Galderma is NovaBay’s partner for NVC-422 in impetigo and is funding and conducting clinical trials. It began enrolling a phase IIb/III trial in September 2012 for NVC-422 applied as a dermal gel for the treatment of impetigo. The trial could complete enrollment of 350 patients in 2Q, 2013 with topline data available in 3Q, 2013. This is a randomized, placebo controlled trial that could support registration. I expect that most regulatory agencies will require a second supporting trial, which could be started in 2H, 2013. If both trials are successful, I think US approval could come in 2016.

NovaBay started a phase IIb/III trial in May 2012 for NVC-422 to treat viral conjunctivitis. This trial will enroll 450 patients and topline data is expected in 2H, 2013. Success in this trial could lead to a partnering deal in late 2013 or early 2014. As with the development in impetigo, I think that a second supporting trial will be needed for most regulatory agencies to grant approval. This second trial could start in late 2013 or early 2014. If both trials are successful, I think US approval could come in 2016.

A phase II trial in urinary catheter encrustation and blockade has already reported encouraging data in 20 patients. Results in additional patients will be reported in 1Q, 2013. In addition to data on more patients, this part of the trial has more substantial and meaningful endpoints. It is also using a higher concentration of drug which could improve results and possibly establish that two times a week dosing is effective. Assuming success in the clinical development program, approval in the US could come in 2017. NovaBay may commercialize NVC-422 in the US on its own.

NovaBay has just received US approval for NeutroPhase for the cleansing and treatment of wounds resulting from surgery, trauma or disease. I am expecting a US partnering deal soon and introduction in the US in 1Q, 2013. It is already partnered in China and other deals are being negotiated throughout the world.

Why Hasn’t The Stock Done Better?

One would think that with NeutroPhase beginning commercialization and the late stage trials of NVC-422 in impetigo and viral conjunctivitis that NovaBay would be valued at more than its current market capitalization of $37 million.

However, the company has not yet caught the attention of Wall Street and it is followed by only one analyst. I believe that the lack of awareness is partially a function of its complexity. NovaBay is essentially four companies in one and requires a great deal of research to understand each of its components.

Biotechnology investors have learned through hard experience that small companies sometimes exaggerate the depth and maturity of their pipelines. This innate skepticism toward small companies and the complexity of NBY’s pipeline may explain the limited investor interest. The first question asked by many investors is how can a company with the limited financial resources of NovaBay have such a broad, late stage pipeline? Something must be amiss.

There is a good explanation for the broad pipeline as the products being developed for impetigo; viral conjunctivitis and urinary encrustation are all based on different formulations of the same molecule. In addition, each of these is an infectious disease indication whose endpoints can be more quickly reached and at lesser development expense than drugs targeted at chronic diseases. Moreover, partnering deals with Galderma and Alcon have funded much of the early development costs in impetigo and viral conjunctivitis.

Tagged as + Categorized as Smith On Stocks Blog


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