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Expert Financial Analysis and Reporting

NovaBay: Topline Data from Two Phase IIb Trials Presents an Asymmetric Investment Opportunity in 2013 (NBY, $1.24)


NovaBay (NBY) is focused on the development of novel anti-microbial products that are topically applied as gels, liquid solutions and instillates. By replicating the mechanism of action used by the body's innate immune system, NovaBay has created products that hold the potential to treat bacteria and microbes resistant to currently used drugs and as importantly to avoid the emergence of resistant microbes. Central to the analysis of NovaBay's products is an
understanding of antibiotic resistance. NovaBay's CEO Ron Najafi has just posted on his Chairman's Blog on the Company's website one of the best articles on antibiotic resistance that I have read. It puts this growing health crisis in perspective. I would urge you to read that blog before proceeding with this note; it puts my comments in more perspective.

The Company's lead product in development is auriclosene, previously known as NVC-422. This molecule is being developed for dermatological applications as a gel formulation in partnership with Galderma, one of the premier dermatology companies in the world. It is also being developed by NovaBay as an eyedrop for adenoviral and bacterial conjunctivitis and as a liquid instillate for treating urinary catheter blockage and encrustation. NBY has also begun marketing a related product, NeutroPhase, through a series of global partnerships. This is a proprietary wound cleansing solution composed of pure hypochlorous acid which was cleared by the FDA through the 510(k) regulatory process. For a more in-depth overview of these products, their clinical development programs and commercial potential, I would refer you to three articles that I have written and are available on my website. Later in this report I discuss my estimates for the net present value of the impetigo and adenoviral
conjunctivitis indications. The underlying methodology for these estimates is detailed in my initiation report on the company published on October 30, 2012.

I have written in prior reports that I believe that antibiotics development is in the rapid process of changing from an ignored area for Wall Street investors to one that may evoke the same keen interest as cancer drug development. I see the passage of the GAIN Act in October 2012 as the tipping point. The implications for companies involved in antibiotics and anti-microbial development are profound. I believe that the FDA will move toward more reasonable requirements for clinical trials that will make it easier to gain new indications for existing drugs and make it quicker and easier to bring new drugs to the market. I also believe that it will be easier for NovaBay and its peers to justify and achieve premium price points needed to realize a satisfactory return on research investments. I believe this is particularly true of NovaBay's product portfolio since its first-in-class antimicrobials are the only new anti-infectives that do not give rise to resistance.


NovaBay's Technology Base

Most large pharmaceutical and biotechnology firms have avoided antibiotics for much of the past two decades. I would refer you to Mr. Najafi's blog for a detailed explanation as to why this occurred. As a consequence, big companies de-emphasized the area allowing small biotechnology companies like Nova Bay to take the lead in building strong antibiotic and anti-microbial pipelines. NovaBay has taken a unique approach that is focused on the development of novel, topically applied, non-systemic anti-infectives.

NBY's technology base stems from an understanding of the action of neutrophils (white blood cells) in the body. When a pathogen breaches the skin barrier and causes an infection, the body's innate immune system is the first line of defense. It spearheads this attack with neutrophils that surround and ingest the pathogens. The neutrophil then produces chlorine based molecules, such as hypochlorous acid (HOCl) that act to kill the pathogen as well as inactivate toxins produced by the bacterium. Unlike antibiotics and other antimicrobial agents, pathogens have not been able to evolve resistance to this mode of action used by neutrophils despite hundreds of millions of years of effort. This is in sharp contrast to antibiotics which can be rendered ineffective by bacterial resistance in a few years.

NovaBay's technology is based on an understanding of molecules that neutrophils produce. It is specifically focused on hypochlorous acid (HOCl) and its derivative molecules, N-chlorotaurine (NCT) and N,N-dichlorotaurine (NNDCT). In the neutrophil, all three of these molecules are very short lived and are produced close to the ingested microbe so that they can act before they decompose; however, they are not candidates for drugs because their short half-life makes them incompatible with the shelf life necessary for commercialization. NovaBay has discovered how to stabilize these molecules thereby providing a long shelf-life and allowing for their use in drugs that can be delivered topically as solutions and gels for the treatment of diseases caused by infectious pathogens.


Investment Overview

Although NovaBay is a small company as judged by its $50 million market capitalization, it has a broad pipeline that is based on developing auriclosene for three separate indications, impetigo; viral and bacterial conjunctivitis; and urinary blockage and encrustation (UCBE) While the molecule is the same, the disease states are quite different as are the formulations: auriclosene for impetigo uses a topical gel, for viral conjunctivitis it is an eye drop and for urinary encrustation and blockade, it is a liquid instillate. Each of these opportunities offers a unique commercialization opportunity.

This year will be a very big year for clinical events as the company will be reporting phase IIb results for auriclosene in the treatment of impetigo in the second half of 2013. It will also be reporting phase IIb results for auriclosene in adenoviral conjunctivitis in the second half of 2013. Results for the second part of a phase II trial of auriclosene in UCBE could be released in 2Q, 2013. The two valuation driving events of 2013 will be the topline data for auriclosene in impetigo and adenoviral conjunctivitis.

In the following sections, I summarize projections from my initiation report of October 30, 2012 that peg the net present value of auriclosene in impetigo and related indications as somewhere between $70 and $118 million on a pretax basis. If we take the mid-point of this range of $94 million and tax affect this at a 40% rate, the value of this asset is about $1.40 per share. Using similar methodology, I peg the adenoviral conjunctivitis value as $6.60 per share. The methodology underlying these estimates is detailed in my initiation report.

In the event that the impetigo trial is positive and the higher risk adenoviral conjunctivitis trial disappoints, I think that stock could trade at $2.00 or so by early next year. This is based on a value for the impetigo indication of $1.40 per share and additional value for the potential of the urology indication and the commercial promise of NeutroPhase. The home run or asymmetric investment opportunity arises if both the adenoviral conjunctivitis and impetigo trials are successful. I think this could potentially result in a stock of $7.00+ by yearend or early 2014. If both trials fail and lead to stopping the clinical programs, I think the downside is probably in the $0.25 to $0.35 price range.

While we are waiting for phase IIb results in adenoviral conjunctivitis and impetigo, there appears to be no issue with financing. The company raised $8.2 million of equity in 4Q, 2012 and ended the year with $16.8 million of cash and accounts receivables of almost $1 million. Since the receivables are from NovaBay's corporate partners, they will surely be collected in Q1, 2013, effectively providing the company with nearly $18 million to start this year. I expect the burn rate to increase from $6.5 million in 2012 to about $8.0 million in 2013 so that the company has about two years of cash. Financing needs in 2014 will be dependent on the success of the adenoviral conjunctivitis trial. If successful, I think this could lead to a major partnering deal with an upfront milestone of $25 to $50 million. I that trial fails, I think that the company would need to finance in 2014.


The Dermatology Opportunity

The impetigo and associated dermatological applications for auriclosene are partnered with Galderma, one of the largest dermatology companies in the world. It is responsible for all costs related to clinical development and commercialization. I believe if the impetigo trial is successful that Galderma will need to do a confirmatory trial and this could result in approval in 2016.

Based on the available clinical data and the validation provided by the Galderma partnership, I believe that the chances for success are good in the impetigo indication. An open label phase II trial resulted in encouraging data. This alone would make NovaBay an attractive investment. In my initiation report, I estimated the royalty stream for the period 2016 through 2028 and then discounted this royalty stream to arrive at a net present value. Using a discount rate of 10%, the net present pretax value of the royalty stream is $118 million which compares to the current market capitalization of $50 million. Using a discount rate of 15% produces a net present pretax value of $70 million.


The Adenoviral Conjunctivitis Opportunity

The trial in adenoviral conjunctivitis is the home run opportunity for NovaBay, but there is greater uncertainty. NovaBay is now conducting a phase IIb trial that began in May 2012 and could report topline results in 4Q, 2013 or 1Q, 2014. I am cautious on the potential for success in this trial. The product was previously licensed to Alcon which conducted a phase IIa proof of concept trial. The trial had design issues that affected enrollment and Alcon stopped the trial at a time when only 81 patients were available for evaluation with 42 on NVC-422 and 39 on control. In this limited sample size, the trial did not meet the rather herculean primary endpoint that Novartis applied to this trial after they acquired Alcon. However, ultimately Novartis made the strategic decision to end virtually all internal and external anti-infective drug development and returned the program to NovaBay.

NovaBay has carefully analyzed the data and found some encouragement from analyses of critical sub-sets. There was a particularly positive signal in a subset of 30 patients with epidemic keratoconjunctivitis or EKC. Many forms of viral conjunctivitis resolve on their own, but it is EKC that usually drives a patient to a physician; it is also highly contagious so that infections can spread quickly between family members or members of a group and is the only form of the illness that is sight threatening. NovaBay decided that a new phase IIb/III trial would have a reasonable chance of success.

If this trial is successful, NovaBay could probably partner this product in quick order. I would expect that the terms of the deal, including the upfront payment could be substantial, perhaps on the order of $25 to $50 million. Bear in mind, the current market capitalization is only $50 million. I believe that if this first trial is successful, NovaBay's partner would have to do a second confirmatory trial to gain approval. If both trials are successful, I think marketing in the US and Europe could start in 2016. There is some chance that Brazil might approve the product on the basis of one trial that would result in marketing in 2015.

Currently, NovaBay controls all worldwide rights. I am assuming that this product will be partnered and in the initiation report on NovaBay, I calculated the net present value of the royalty stream assuming partnership terms similar to that achieved with the Galderma partnership: the royalty starts at 10% and escalates to 30% on sales above $300 million. Using a discount rate of 10%, the net present pretax value of the royalty stream is $786. Using a discount rate of 15% produces a net present pretax value of $530 million.


The Urology Opportunity

The urology indication is somewhat further behind and the commercial potential is less clear. My preliminary judgment is that this is another significant commercial opportunity. The company may be able to commercialize this product on its own if the trials in auriclosene in impetigo and adenoviral conjunctivitis are successful. This could result in partnering milestones that would allow NovaBay to develop and commercialize the urology indication on its own for the US market, while finding a marketing partner for ex-US territories.

NovaBay could form its own sales force to market the product in the US. About 80% of potential sales are concentrated in 50 clinical sites so that a small sales force of 20 sales reps could reach most of the market. The cost per rep would be about $200,000 and the gross margin would be about 95% at peak sales. This allows for the calculation of operating income. Discounting this stream of operating profits at a 10% discount rate results in a net present pretax value of $499 million and at a 15% discount rate it would have a net present pretax value of $353 million.

I assume that international sales will reach the same level as US sales and that the product will be partnered at a royalty rate of 15%. Discounting the resultant royalty stream at 10% results in a net present pretax value of $89 million and at a 15% discount rate is $63 million.


The NeutroPhase Opportunity

NeutroPhase has been approved via the 505-b-2 regulatory route and should be marketed in the US in 2013. NovaBay's strategy is to manufacture the product in the US and supply it at a transfer price to partners in the US and abroad. The company has announced a partnership with Pioneer Pharma for distribution in China and Southeast Asia. It is negotiating other deals in the US, Europe, Middle East, North Africa and other areas of the world. Although NeutroPhase is a very good product, physicians are generally satisfied with existing products and the potential is limited in the US and other markets, at least in the near term. I am estimating $1.4 million of sales in 2013 and $10.6 million by 2017.

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