Sink or swim

These are some of the filters that might ordinarily be applied when assessing a growth company’s investment case. Used together, they should give rise to several sound buying opportunities, and may even reduce the level of risk within a portfolio of shares.

That said, such an approach will also rule out many smaller businesses that don’t or can’t meet the most rigorous underwriting standards. Often, this will insulate investors from unsuccessful or even disastrous purchases. Still, for those willing and able to raise the stakes, digging for rubies in the small-cap rubble could well be worth the wager. So-called ‘penny stocks’ can present the chance to diversify across niche, weird and wacky markets, and to buy into blue-sky concepts that could one day be profitable.

Within this feature, we consider a range of the more unusual companies listed on London’s Alternative Investment Market (Aim), with market capitalisations of between £40m and £250m. Why Aim? Simply put, the junior market’s listing rules are less stringent – enabling fledgling, high-growth and high-hope ventures to go public.

Using counterintuitive screening criteria, we identify red flags that would normally be offputting – such as zero sales, blow-the-roof-off broker estimates and high cash burn. Naturally, several stocks falling into the first two categories stem from the biotech and resources sectors, where there can be long trial and exploration periods prior to first sale or product commercialisation. Where we can’t invoke the normal yardsticks to measure these companies, we have to use new valuation methods to pick through potential advantages and disadvantages. In this world, the ‘buy’ and ‘sell’ dichotomy fails to reflect the enhanced risk-reward situation. In several cases, these investments are almost binary: ‘sink’ or ‘swim’.

Pre-revenue stocks

A company on your watch-list releases full-year results. It contains a smorgasbord of superlatives, boasts huge potential and a growing position in an enormous addressable market. You’re hooked. That is, until you reach the income statement. For all its promise, this business has no revenues. How to proceed? Below, we look at eight pre-revenue stocks, and offer a view on their future viability.

Atlantis Resources

With a name redolent – if hopefully unprophetic – of our sink-or-swim framework, Atlantis Resources (ARL) finds itself firmly in the pre-revenue category.

The group finances, constructs and operates large-scale tidal power projects around the world, and supplies tidal turbines and subsea connection equipment. It has more than 1,000 megawatts of tidal capacity in development, including the world’s largest tidal array project, MeyGen, off coastline near John O’Groats. In December, Atlantis struck a deal to acquire the Uskmouth power station in Wales from SIMEC Energy – part of the GFG Alliance, an international group of energy, mining and engineering businesses. Structured as a reverse takeover, the deal will result in Atlantis’s name changing to SIMEC Atlantis Energy.

As Atlantis points out, “the moon is a reliable counterparty”, and tides could provide 20 per cent of Britain’s energy needs. Investors will have to wait until any of this translates into a top line for Atlantis, which despite reporting revenues in the past made no sales in the half-year to June 2017. But as a small cap making waves in the energy sector, the group is worth a deeper look.

Sink:

• Atlantis has a relatively high cash burn rate – that’s before considering a recently announced £20m share placing. The proceeds will go towards the working capital requirements of the enlarged group following the Uskmouth deal. Investors have paid up until now, but the appetite could dwindle if major injections are needed with revenues yet to appear. That’s particularly true while Atlantis is also tapping the debt market – having issued a five-year bond last July with an 8 per cent coupon.

Swim:

• The MeyGen development is making good progress, with construction of the first 6MW turbine recently completed. The project, which has 392MW of future development capacity, is now in its 25 years operations phase.
• The SIMEC-Uskmouth deal is expected to be the first of many acquisitions from the GFG Alliance, which will create “a diversified renewable energy company of scale”. MeyGen could also act as a showcase for other tidal projects.
• Management has a revenue generation plan in place, including – but not limited to – selling parts of its stakes in various projects and the sale, servicing and licensing of its technology to other project developers.

It’s possible Atlantis may require further cash from investors, but with MeyGen progressing well and the diversification and growth prospects presented by the SIMEC deal, we’re happy to be blue-sky (or blue-water) dreamers on this one. Swim.

Bluejay Mining

The potential of Greenland’s mining industry was only recently unveiled due to climate change. Into those warming ice sheets strides Bluejay Mining (JAY), which aims to take its Dundas project in the north-west of the country – the highest-grade mineral sand ilmenite deposit in the world – into production in 2019. If it launches successfully, Dundas could bring Bluejay its first revenue stream – stemming from the relatively simple resource of a raised beach area on the icy island’s coast. The group also has copper, zinc and nickel projects in Finland and is considering how best to manage this portfolio.

Sink:

• Bluejay hasn’t yet commercialised its mining projects, but its price-to-book ratio now represents a significant premium to its two-year historic average. This might be offputting for those yet to be convinced by Bluejay’s ability to make a commercial success of a mine in a far-flung corner of the globe.
• We are still awaiting Bluejay’s preliminary feasibility study, which is due in the coming months and will feed into the final feasibility report later this year. Much is riding on the results of these investigations, which will offer some clarity on the project’s economics. Anything short of the heady promise to date could dash investor enthusiasm.

Swim:

• Bluejay has access to vast resources, so much so that in April it could casually upgrade Dundas’ estimated resource by 400 per cent, to 96m tonnes with 6.9 per cent grade ilmenite in situ. A shallow marine area is also being explored.
• While its focus is Dundas, Bluejay has options elsewhere in Greenland, including Disko-Nuussuaq, a high-grade nickel-copper-platinum prospect.
• Bluejay’s cash position looks strong for now. In February, the group successfully raised £17m – reflecting investors’ willingness to pay up. Last week it responded to media speculation about a potential fundraising, confirming there are no current plans for one while it still has over £15m in cash. That’s not to say fresh equity won’t be needed in future.
• Following Greenland’s national election in April, a new coalition government is in charge – one that supports the country’s mining industry and seeks to make Greenland an attractive destination for foreign investment.   

If Dundas and other projects prove successful and start generating revenues, this could fund expansion into larger metals markets. Bluejay’s shares have risen more than 60 per cent in the past year, reflecting enthusiasm for a company with undoubtedly exciting prospects. But were mining this easy in such an inhospitable part of the world, we think others would have fared better in Greenland to date. Sink.

EVR Holdings

Farewell to the days of missing your favourite live act. Thanks to EVR Holdings (EVRH), it’s now possible to watch live performances at home with a virtual reality (VR) headset. The group creates VR music content via its flagship app MelodyVR,  offering dedicated ‘jump spots’, so that users have different vantage points. MelodyVR spent a long time in the testing stages, explaining the lack of sales so far. Nevertheless, investors have been happy to buy into a vision; EVR’s shares are up over 1,000 per cent since its 2016 IPO. Encouragingly, MelodyVR officially launched in the US and the UK last month and revenues are expected for 2018.

Sink:

• According to broker Investec’s recent forecasts, pre-tax losses will widen from £6.2m in 2017 to £12.3m in 2019, narrowing the following year and swinging to a profit in 2021. Such cash burn could force a dilutive return to the market.
• EVR is reliant on a buoyant VR hardware market, and good user experience. These factors are out of its control. So far, MelodyVR is available on Facebook’s Oculus Go device and Samsung’s Gear VR headset, with more platforms expected. As such, EVR is reliant on third-parties’ marketing of the VR concept. What if it fails to take off?

Swim:

• While it flags EVR’s “execution risk”, Investec expects revenues of £24.4m for 2019, with a huge uptick to £96.6m for 2020.
• Investec also notes that low capital expenditure requirements and negative working capital suggest strong free cash flow. Net cash was £12m in December, and the group raised £25m in April, its fourth equity placing since IPO.
• The potential market is huge – PwC’s ‘Global Entertainment and Media Outlook 2017-21’, reckons there will be 257m VR headsets in the global market by 2021, with revenues forecast to rise at 80 per cent a year to $15bn.
• EVR could become an acquisition target. British VR has already proved an attractive investment; Japan’s SoftBank injected $500m into Improbable, a developer of large-scale simulated world, in May 2017.
• EVR has deals in place with major hardware developers, music labels and rights holders, which creates a handy barrier to entry. Of course, a larger rival could try to muscle in, although Investec believes VR competitors are more production- and hardware-focused.
• At last count, chairman and chief executive Anthony Matchett had a 13 per cent position, while chief operating officer Steven Hancock held 10 per cent.

VR is still in its relative infancy in terms of mass-market adoption, and so it’s difficult to predict whether it will be the next big form of entertainment. In turn, we can’t know for sure whether consumers will be willing to pay for EVR’s virtual concerts as opposed to the real thing. But for now we’re cautiously optimistic. Swim.

4D Pharma

If the good bacteria in the body can be harnessed, it has the potential to be used to treat a wide range of illnesses. That’s the thinking behind 4D Pharma’s (DDDD) proprietary MicroRX platform, which has produced seven potential drugs to date, and which 4D is trialling in animal and human studies.

Sink:

• 4D’s drugs are highly experimental and have only undergone very early stage trials. Risks associated with development are therefore very high and it is likely to be a long (and expensive) road to commercialisation and first revenues.
• Operating cash outflows hit £16m in 2017, up from £10m in the prior year thanks to a big uptick in research and development costs.
• Its market capitalisation is supported by the potential for clinical success and could therefore collapse if trials were to fail.
• Operating cash outflows hit £16m in 2017, up from £10m in the prior year thanks to a big uptick in research and development costs.
• Its market capitalisation is supported by the potential for clinical success and could therefore collapse if trials were to fail.

Swim:

• 4D boasts a wide product pipeline, covering autoimmune illness, respiratory disease and oncology.
• With a novel platform for drug discovery, 4D could be a takeover target for a large pharma company if it proves its efficacy.
• Supportive institutional shareholders have contributed to multiple placings.

4D Pharma joined Aim in 2014 at the height of the biotech boom, when investors were excited by the potential of a novel platform for identifying new drug candidates. But four years on and 4D has made very little progress. Only three medicines have reached human studies and they’re still in the very earliest stages of development. And yet the group has burnt through the £17m raised at IPO and raised money four times since. True, it may eventually become a takeover target for a large pharma company, but we don’t think that potential outcome is worth waiting for. Sink.

Motif Bio

Motif Bio (MTFB) acquired the rights to its novel antibiotic, Iclaprim, with the sole purpose of completing clinical trials and launching it in the US. After initially struggling to raise money – which forced Motif to list on Nasdaq in addition to Aim – Iclaprim has finally completed clinical trials and is now being reviewed by regulators.

Sink:

• Antibiotics are cheap drugs, so Motif Bio may struggle to make a decent return on its investment – Iclaprim’s clinical trials cost more than $70m in the past three years.
• As the clinical trial only proved that Iclaprim performed as well as (but not better) than the current standard of care for hospital-acquired infection, Motif Bio may have a hard time persuading physicians to prescribe it.
• US healthcare is a difficult market to navigate.

Swim:

• As drug-resistant bacteria become a growing problem in global healthcare, new antibiotics are in high demand. Iclaprim has the potential to be the first novel antibiotic launched in 30 years.
• The regulators should grant approval within the next few months, which would provide investors with a major share price catalyst.
• Motif Bio has debt facilities to fund the commercial operations and further clinical studies to expand Iclaprim’s label.
• The company successfully raised £10m last month to strengthen its balance sheet and fund near-term regulatory investments.

Motif Bio has done well to raise money, complete clinical trials and submit Iclaprim to US regulators. But shareholders haven’t truly felt the benefits – the share price is still trailing its pre-Nasdaq levels despite positive trial results. Approval and launch would bring in Motif’s first revenues, but the costs of commercial operations and follow-up trials means the company is likely to be lossmaking for some time. The best outcome for Motif Bio would be a takeover by a big pharma company, but considering antibiotics aren’t currently a commercially attractive part of the pharma market, that doesn’t look particularly likely. Sink.

Diurnal

Founded out of the University of Sheffield in 2004, Diurnal (DNL) is focused on developing therapies for the treatment of rare and chronic hormone illnesses. Its lead drug, Alkindi – for paediatric adrenal insufficiency – has been approved in Europe and is due to begin a pivotal clinical trial in the US.

Sink:

• Management has taken the higher-risk route and decided to commercialise Alkindi itself in Europe.
• High-risk and expensive clinical trials are still ongoing in the US and Europe.
• The share price is currently supported by the potential for Alkindi. Although the drug has proved its efficacy in clinical trials, management will still have to persuade individual European governments to prescribe the drug. Sales forecasts are only moderate in 2018, and losses are expected to widen until 2019. 

Swim:

• Diurnal has further drugs in clinical development in Europe and the US. Chronocort – for adult adrenal illness – is expected to be launched in Europe in 2020 and in the US the following year.
• Alkindi’s US trials are relatively low risk as the drug has already proved effective in Europe.
• A recent £10m fundraising has provided capital for the European Alkindi launch and further support for clinical trials.
• Management is open to partnerships with larger drugs companies.

Diurnal is a prime example of a biotech company that has got everything right. Venture capital funding helped the drugs through their earliest, highest-risk stages of development and Aim investors have been called upon to support the final stages of development. The group is operating in an under-served part of the global healthcare market, which means its drugs shouldn’t encounter much competition and have been given long-term patent protection.

As with all early-stage biotech companies, risks remain, but these are beginning to shift from research and development hazards to those associated with commercialisation. The long-term outlook is good thanks to the strong drugs pipeline and management’s decision to work with partners to market the drugs in the tough US healthcare market. Swim.

Verona Pharma

Verona Pharma (VER) is responsible for the development and potential commercialisation of RPL-554 – a respiratory drug that has the potential to be used in the treatment of asthma, chronic obstructive pulmonary disease (COPD) and cystic fibrosis. RPL-554 differs from most of the products currently available as it combines bronchodilation – opening the airways – and anti-inflammation to treat severely ill patients.

Sink:

• RPL-554 is still only in the second phase of development and therefore has the expensive phase three trial to come.
• Verona currently only has one drug in the clinical phase of development, meaning the future of the company is entirely dependent on the success of this drug’s clinical trials.
• The respiratory market is already incredibly crowded, which means commercialisation might be tough even if RPL-554 does gain approval.
• Revenues aren’t forecast for the foreseeable future, while losses are expected to widen until at least 2020.

Swim:

• The company is aiming to ensure the drug’s dosage and formulation are ideal before progressing to the expensive phase three trial.
• The high value of respiratory medicines means this is a popular area of specialism for big pharma companies. That could make Verona Pharma a takeover target.
• Nasdaq listing provides another potential source of capital. Indeed, the group has filed a shelf registration statement with the US’ Security and Exchange Commission – meaning it can issue up to $200m in shares over the next three years.
• Verona has clinical trials and proven efficacy in three different respiratory illnesses.

With just one drug and a great deal of development still to come, Verona remains a high-risk biotech company. The strong evidence that RPL-554 is both safe and effective makes Verona Pharma a potential takeover target for a pharma company with a big respiratory division. Swim.

OptiBiotix

The microbiome is healthcare’s “most promising and lucrative frontier”, according to consultancy Markets and Markets. Life sciences business OptiBiotix (OPTI) develops compounds to modify the human microbiome – the collective genome of the body’s microbes – to prevent and manage disease. Such compounds are used as food ingredients and supplements, but also to help manage obesity, high cholesterol and diabetes. OptiBiotix is not strictly ‘pre-revenue’; but for the year to November 2017, it reported sales of just £0.19m – down from £0.29m a year earlier.

Sink:

• Broker FinnCap notes that the early-stage nature of the company’s contracts “makes it difficult to forecast with any degree of certainty”.

Swim:

• Revenues may have taken a hit in FY2017, but OptiBiotix reported a pre-tax profit of £1.67m – up from a £1.52m loss. This improvement stemmed from a £4.1m profit on the part-disposal of SkinBiotherapeutics, which listed on Aim separately in April 2017. The group still holds a 41.9 per cent stake.
• Investors could end up with a broader, diversified investment portfolio across different parts of the market for microbiome-targeted products. OptiBiotix has various tech platforms which take different approaches to modulating the microbiome. In keeping with SkinBiotherapeutics, the idea is that these could become unique business units, which might be sold or listed separately.
• The group raised £1.5m via a placing of shares at 62p each last month – reflecting continued demand among investors. While the cash position remains strong, new opportunities have arisen which require funding.

OptiBiotix believes its deal pipeline could transform into “significant revenues” over time – but, with no forecasts to support the investment case, investors are asked to guess on the realism of this prospect. Sink.

Table 1: Pre-revenue stocks

Great (revenue) expectations

A company’s size rarely reflects its potential. Niche demand can lead to huge markets. Losses sometimes expand, but all because investment is being channelled towards top-line momentum, a trend reflected in brokers’ huge sales growth estimates. This all sounds encouraging – but are such forecasts feasible? And what else has the company got going for it? Here, we consider four small-caps with a two-year forecast compound annual growth rate of at least 50 per cent.

Seeing Machines

The World Health Organisation estimates that more than 1.3m people die in road accidents every year. Of course, these are not always caused by human error, but any safety features that can monitor and ultimately protect drivers could make a real difference. Seeing Machines (SEE) seeks to address this through its Driver Monitoring System (DMS) technology, which gauges whether drivers seem drowsy or distracted. DMS can issue a series of alerts before acting automatically to slow or stop vehicles, and is used in trucking and transport fleets, aviation and rail businesses. It’s easy to see how such products appeal – but is a revenue CAGR of 139 per cent truly feasible?

Sink:

• In May, Seeing Machines cut its sales guidance for the year to June 2018 from A$38m-A$43m (£21.5m-£24.3m) to A$30m-A$35m. The group’s manufacturing partner has faced a global shortage in certain components, creating delays in the supply chain; associated revenues are now expected to fall outside the current financial year.
• Pre-tax losses widened for the six months to December 2017, from A$14.1m to A$16.7m – largely as a result of an increase in R&D expenses from A$6.2m to A$10.5m.

Swim:

• The group’s historic growth trajectory is still impressive. Half-year revenues to December 2017 rose by a whopping 267 per cent to a record A$14.6m, buoyed largely by an almost sevenfold increase in sales within its automotive segment.
• Last month, the company’s shares climbed on the news that the European Commission is considering proposals to mandate that new vehicle models are equipped with advanced safety features like Seeing Machines’ DMS. If the European Parliament and Council approves these recommendations, SEE may well enjoy heightened demand.
• Perhaps most importantly of all, on 4 June Seeing Machines announced a programme design win with a US-based automotive original equipment manufacturer (OEM) – its largest automotive win to date. The group now expects to deliver its driver monitoring technology into multiple vehicle platforms for mass production from 2020. The deal could be worth over A$50m in revenues, with the first material production revenue expected to be recognised in the company’s 2021 financial year. We reckon this deal should drive broker upgrades.

We’re concerned by management’s recent revenue downgrade, and we’re also awaiting a new chief executive. But with sales growth set to grow – particularly in light of the latest OEM win – and legislative change potentially moving in Seeing Machines’ favour, its AI-driven technology may prove successful in the long term. Swim.

Xeros

You will have likely heard of ‘fintech’ – financial technology. You may have heard of ‘martech’ – marketing technology. But what about ‘bead tech’? This is the phrase used by analysts at Jefferies to describe Xeros’s (XSG) flagship offering.

Xeros develops plastic beads and associated technologies for the commercial laundry and tannery industries. Its products reduce the amount of water used in cleaning processes, a field of growing concern given forecasts for global water scarcity. That said, at its full-year results in April we found Xeros stuck in a spin cycle. Amid ongoing discussions with various original equipment manufacturers about commercialising its products, can it really meet lofty forecast sales CAGR of 250 per cent?

Sink:

• Xeros switched to a technology-licensing model in 2015. But after several years of commercial discussions with manufacturers, all we have is an assurance of “significant progress towards commercialising technology across all targeted applications”.
• The company may need more cash. Back in April 2017, it said it “expects cash utilisation to continue to accelerate over the coming years”. This followed a £40m placing in November 2015 and preceded a £25m placing in December 2017. Some investors might be unwilling to cough up without proof of deals being signed.

Swim:

• Broker Berenberg estimates that domestic laundry alone has an addressable market of over $1.7bn in annual royalty fees globally. Around 45 per cent of this is in China, where Xeros plans to expand.
• Meanwhile, Jefferies anticipates “multiple contracts in tanning” along with deals in laundry. The broker accepts it might now be “squeaky bum time”, but there are various ways for Xeros to deliver as hoped.

This is a real blue-sky stock. The structural drivers around water scarcity reinforce Xeros’ investment case, and assuming it will finally strike some deals, we think management now fully recognises the imperatives facing the company. Swim.

Tissue Regenix

Tissue Regenix (TRX) owns a unique cell rejuvenation technology known as the dCell, which is used in woundcare, orthopaedics and cardiology. In 2017, the group acquired its US peer CellRight, which is expected to push up revenues by more than 50 per cent in the next two years.

Sink:

• Tissue Regenix isn’t forecast to be profitable until 2020 due to rising marketing and administration costs.
• Orthopaedics and woundcare are fiercely competitive markets dominated by a small number of big companies. By entering the US, Tissue Regenix will be taking on some major players in healthcare.
• There are risks associated with clinical trials for new products and integration of CellRight.

Swim:

• So-called biosurgery products are gaining momentum in the US, while OrthoPure – the group’s latest orthopaedics product – will soon be launched in Europe.
• Two recently signed distribution deals have reduced the risks of commercial deployment in the US.
• Even excluding the potential of CellRight, underlying sales are forecast to grow at a double-digit rate as the group transforms from a research and development company to a commercial operation.

Considering the rapid growth in global healthcare requirements – driven by the challenges of an expanding and ageing population – the commercial opportunity for Tissue Regenix is enormous. The recent acquisition of CellRight has given the group a good footing to capitalise on this. Integration risks and the costs associated with marketing and continued product development mean the share price has struggled in the past year, but we think the opportunity for rapid revenue growth should spark a recovery. Swim.

Ilika

Ilika’s (IKA) shares have fallen around 40 per cent in the past 12 months. Its market capitalisation is just £16m – below our threshold, but a useful example of a small company with high forecast revenue growth. Ilika, a specialist in solid-state battery technology, has developed a type of lithium-ion battery that uses a ceramic ion conductor instead of liquid. Benefits of this include a longer lifespan, faster charging and a small size – particularly useful for devices in the internet of things (IoT) market.

Sink:

• Revenue may be forecast to grow rapidly, but this is from a very low base – sales were just £1m for the half-year to October 2017.
• The group has not yet secured licensing deals with original equipment manufacturer partners. It is working on this, but investors have waited for years for its battery technology to be commercialised.

Swim:

• House broker Liberum says Ilika’s target microbattery markets – which include medical devices, automotive sensors and industrial sensors – could see revenues of $1.7bn by 2027.
• Electric vehicles could provide an enormous boost to this market. In its half-year results to April 2018, Ilika said it had been approached by various commercial partners about collaborating to develop larger-capacity batteries for use in areas including electric vehicles.
• Ilika has two microbattery prototypes, broadening and diversifying its offering to potential customers.

The potential addressable market is certainly impressive. The forecast CAGR could well be achievable, given the aforementioned low-base; but we reckon the shares’ recent pull-back reflects waning conviction in its path to commercialisation. Sink.

Table 2: Great (revenue) expectations