Microbix Biosystems: Four Businesses for the Price of One
We’re the first to admit biotechnology is usually too speculative for us. A combination of no revenues and constant dilution is usually a recipe for investment failure. With Microbix Biosystems (MBX.TO, MBXBF), however, we believe we have uncovered the rare opportunity to purchase a stable business and get all the upside of a typical bio-tech along with it.
Microbix has a foundation value in its Virology franchise and three pipeline technologies that could each be worth more than the company’s current market-cap. Best of all, we believe the market is valuing Microbix on its Virology business alone, giving investors the opportunity to pick up the company’s pipeline for practically nothing. You might say Microbix is 4 businesses for the price of one.
Virology Business
Founded in 1988, Microbix began as a producer of infectious disease antigens. An antigen is any substance that produces an immune response in the body. To test someone for a disease, you need purified samples of the virus to see if it will elicit an antibody response in a fluid sample. Diagnostic testing kits use Microbix’s antigens to provide a quick and accurate diagnosis, which is especially important in controlling disease outbreaks.
Anyone who has been watching the news can appreciate the drivers of Microbix’s Virology business (though the company is not involved in Ebola). Each new disease outbreak requires more testing kits. And each outbreak usually involves a slightly different virus strain, which is a new antigen Microbix can add to its product line. Microbix’s business essentially grows itself over time.
Setting up a facility to mass-produce samples of deadly diseases is not easy. You need a lot of manufacturing and scientific expertise. And then you need to clear regulatory hurdles. This dynamic has created a favorable industry situation. The industry is essentially a duopoly – Microbix and Meridian Bioscience (NASDAQ:VIVO) are the Visa and Mastercard of the antigen niche.
Most importantly, this business generates cash that Microbix can use to develop its technology pipeline. Microbix currently has three technologies in its pipeline:
VIRUSMAX
VIRUSMAX is a technique for increasing virus yields in egg-based influenza vaccine manufacture. The process holds promise in countries that have a vaccine deficiency and would need rapid production in case of an outbreak. Microbix’s original strategy was to partner with such a country and build a national supply facility.
That was until Novartis (NYSE:NVS) sued Microbix for patent infringement in 2011. The commercialization strategy turned from the laboratory to the courtroom. Investors got a welcome surprise in January of this year, when Microbix announced they had successfully defended themselves across all claims in the suit. Microbix then turned around and sued Novartis for patent infringement in US and European courts. The case will go to trial late next year.
Urokinase
Urokinase (trade name Kinlytic®) is a natural human protein that stimulates the human body’s blood clot dissolving processes. The drug is FDA-approved and was commercialized by Abbott Laboratories (NYSE:ABT) as a treatment option for heart attacks. In 2000, the drug did over $200M in sales. By 2004, however, it was pulled from the market and divested after an FDA investigation into the drug’s manufacturing process.
Microbix purchased the drug in 2008 for pennies on the dollar from a bankrupt competitor with hopes of returning it to market. Ten years is a long time in the pharmaceutical world and new drugs have emerged to replace Urokinase. None of them, however, have the safety profile of Urokinase. There remains healthy demand in the market for this drug.
The dilemma for Microbix is they will need to build a $30M FDA-approved facility to return the drug to market. They will need a partner for financing. Microbix struck a commercialization deal with Zydus Cadila in late 2012 only to have them terminate a year later. Did they conclude the drug didn’t have much potential after conducting due diligence? Possibly, but we think it had more to do with turmoil in Zydus’ home market (India) and a poor strategic fit with their core generics business.
Microbix is in discussions with new partners for Urokinase.
LumiSort®
Last we have LumiSort, Microbix’s crown jewel. LumiSort is a technique that promises to improve the yield and quality of sexed semen production. If you are a dairy farmer, being able to preselect for female offspring, especially from your best animals, is a huge advantage. You can use half the amount of semen for artificial insemination and improve your herd economics.
The problem is the incumbent sexing technology is slow, damaging, and wasteful. The process destroys up to 70% of the input semen and yields product with 25% lower fertility than unsexed semen. It costs twice as much as unsexed semen and is a tough sell to a farmer who must part with his prized animal semen. As a result, penetration is in the low single-digits.
LumiSort hopes to improve across all dimensions of sexing technology. LumiSort works by marking undesired sex cells and destroying them with a laser. The precision laser leaves cells unharmed and allows the process to run much faster than existing technology. Microbix believes their technology will show vast improvements over the existing technology:
Source: Microbix May 2014 Investor Presentation
These projections have got the industry’s attention. To date, Microbix has signed letters of intent with semen straw distributors representing 25% of the global market.
There is a lot at stake given the size of the global semen market ($1.5 billion annually). The catch is Microbix will first have to prove the technology works. The technology uses proven techniques but combining them all in a compact machine is tricky. Microbix began work with Lathrop Engineering earlier this year to build a prototype and will have results out by mid-November.
Financials
The strategy of harvesting cash flows from their core business to develop new technologies has failed to create value thus far:
Among the missteps of the past was 2008’s “perfect storm,” when the company raised $6M in debt financing just as the capital markets froze up. This disaster stalled development of LumiSort® and caused 50% shareholder dilution as the company raised funds to stay afloat.
Fortunately, new management took over in 2012 and worked hard to put the company back on solid footing:
- Divesting the low-margin water purification business (reducing revenues ~$1M)
- Consolidating operations, reducing the cost base 29% y/y
- Refocusing on the core business, driving double-digit organic growth
These steps brought the company back to cash flow positive for the first time since 2005 and helped shore up the balance sheet.
Valuation
The Virology business is the foundation of value for Microbix. Let’s begin by valuing just this piece. Management is aiming to grow this business to $10M in revenues over the next couple of years and we think they can get there with new Dengue fever products out next year and a recently secured $17M long-term supply contract. Microbix is also upgrading their manufacturing facilities which should support higher gross margins. Here is our projection for the Virology business going forward:
So what’s a duopolistic business with high margins and double-digit growth worth? We’d say at least 20X operating income (30X after-tax earnings).
Now even after accounting for all the dilution in the company’s capital structure, the Virology business alone will cover the current enterprise value if growth materializes as we expect:
Note: Excess cash assumes full conversions of share purchase warrants
This means you are paying little for an option on the LumiSort technology. An option that could be very valuable. If the technology delivers on its promise, much of the 200M semen straws sold per year will become a target market. Microbix already has 25% of the market onboard – if they can turn just half of these commitments into paying customers, the LumiSort franchise will be very valuable:
Source: Royalty figures taken from Microbix May 2014 Investor Presentation
Under these assumptions, the franchise would be worth $265M, or $2.60 per share on a diluted basis. This is nearly 4 times the current trading price – and this says nothing of the company’s other two technologies.
Catalysts
We see a few catalysts on the horizon that could drive MBX’s shares:
1. LumiSort® Prototype Milestone
In Mid-November, we will get the first update on the LumiSort prototype test results. The LumiSort technology will be judged across 3 dimensions: yield, speed, and fertility. Yield is the most crucial since existing technology is at a paltry 30%.
There are many forms a “successful” machine could take. Perhaps it’s slower but gives a 2X improvement in yield. Or maybe it fails on yield, but offers superior fertility. Even just a slight improvement could produce a winning machine. The incumbent competitor, Sexing Technologies, has a monopoly on the industry and was recently sued by a customer for anti-competitive conduct. The industry is desperate for a competing solution.
We feel LumiSort should not be thought of as a binary event – it works or it doesn’t – but rather a range of outcomes. We think any language in the update that implies Microbix’s patents have value will have positive impact on the share price.
2. Urokinase Partnership
The market has assigned little value to the Kinlytic franchise following the fall-out with Zydus in late 2012. Our research has shown demand for the drug still exists and the market could be in for a surprise if a new partner is announced.
3. Novartis Lawsuit
Microbix’s infringement suit against Novartis will head to trial in Texas later next year. Legal outcomes are always uncertain, but we see a lot of potential here. In 2013 alone, Novartis sold 35M doses of their Agriflu vaccine in the US. At $13/dose and a standard 5% royalty we have a potential $20M claim. Microbix is suing for treble damages (3X) so a judgment over $50M is quite realistic.
We expect Novartis to flex their muscle and try to extend court dates or pressure Microbix into a low settlement. We wouldn’t bet on the outcome but we like the idea of paying nothing for an option that could bring millions to Microbix.
Risks
Here are two key risks we see with our investment:
1) Financing
Financing has plagued the company in the past and remains the primary risk. Whether it’s paying courts bills for VIRUSMAX or funding the LumiSort prototype, Microbix may need more cash than the Virology business can generate. More financing means more dilution and the pie could be much larger by the time any technologies make it to commercialization.
2) Technical
Until the prototype is complete, LumiSort remains just an idea on paper. Even if the prototype works, there will still be years of engineering necessary to make a commercial machine. It’s possible the program fails or a superior technology comes along and renders it worthless.
Insiders
Insiders collectively own 16% of the shares outstanding, with Founder and Chairman William Gastle holding the largest stake at 7%. Current CEO Vaughn Embro-Pantalony took over in November 2012 and owns less than 1%, with another 775,000 shares through unexercised options. Insider ownership is not as high as we typically like to see but we applaud management for bringing Microbix back to profitability and putting them in a position to capitalize on their pipeline.
While we wait in the dark for news on LumiSort, there have been some insider actions that have caught our eye. First in June of this year, director Joseph Renner exercised warrants for 500,000 shares (and didn’t subsequently sell). Then, Microbix completed a private placement in August that was nearly 40% participated in by insiders. All told, insiders have increased their stake by over 25% since LumiSort development began.
Insiders wouldn’t plow $1M into this company unless they were confident about its future. And we doubt 10% growth in the Virology business would compel them to invest this sum. We were also intrigued to see Director Peter Blecher, an early founder of the LumiSort technology, be the second largest participant in the recent financing. These actions have increased our conviction in Microbix – we have rarely gone wrong following the insiders.
Conclusion
We see a lot of ways to win with Microbix and few ways to lose. You’ve got three technologies near commercialization that could each support multi-million dollar franchises. And if all these fail, you are left paying a fair price for a growing Virology business that would be an attractive investment in and of itself. Insiders have demonstrated their confidence in the company with their wallets and we think there is good reason to think Microbix’s future will be a lot different than its past.
Disclosure: Paul and Brandon are Long MBX.TO