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Seven steps to healthy profits

Megan Boxall explains how to take the risk out of investing in Aim's young medical companies
Seven steps to healthy profits

There’s a lot of money to be made in British healthcare, just ask Jonathon Milner. The Cambridge scientist retained a 28 per cent stake in his £58m antibody catalogue business when he listed it on London’s junior market in 2005. Thirteen years and an eight-fold share price increase later and Abcam (ABC) is one of Aim’s biggest companies. Mr Milner – who has made regular share sales in the last few years – now owns 10 per cent of the group, a stake that is worth £250m. 

But Abcam hasn’t always been a star. Panmure Gordon analyst Julie Simmonds remembers the scepticism in the city when the company – which had only recently progressed from selling antibodies out of an ice bucket in the laboratories of Cambridge University – announced its IPO. Even the Investors Chronicle failed to foresee the growth to come, describing the group as “fairly priced” at 280p following its first set of financial results (at the time of writing, its share price is 1,323p).

And Abcam isn’t the only Aim-traded healthcare company that took time to get investors on board. Hutchison China Meditech’s (HCM) share price crashed 85 per cent in its first two years on Aim, while Advanced Medical Solutions (AMS) was listed for nearly two decades before its value began to climb. Today, these companies are among Aim’s biggest and their growth has outpaced the wider market by more than 200 per cent in the last five years. If Aim’s medical success stories teach us anything, it’s that investing in small- and mid-cap British healthcare requires patience.

Over the long term, medicine has the potential to be incredibly lucrative: barriers to entry are high, demographic dynamics are favourable and demand is never going to disappear. But short-term sentiment can shift nerve-jinglingly quickly, which is why healthcare investors are best off taking a long-term view – when they’re on to a winner. But picking that winner is not easy. A lack of tangible metrics, the risk of all-out failure and the huge variety of companies complicates healthcare on Aim and makes it hard to separate the next generation of Abcams from the companies on the road to collapse. We’re here to help.

 

 

1. Identify the potential

In 1983 James Gusella and his team at Massachusetts General Hospital identified the gene that is responsible for the progressive, neurological condition Huntington’s Disease – it was the first time an illness had been definitively linked to a single part of a human’s genetic code. The potential from this nugget of science was extraordinary: if genetic missives can be identified as the single cause of certain diseases, that information can be used to treat or cure some of the planet’s deadliest diseases. It took almost 35 years, but in late 2017 US-based Spark Therapeutics (Nasdaq:ONCE) became the first pharmaceutical company to launch a cure (for blindness) which works by replacing a patient’s mutated gene.

Meanwhile, Huntington’s is no longer the only disease that can be traced back to a single gene. Rapid improvements in the efficiency of genetic profiling alongside an increase in data sharing means scientists have now identified the genes that cause Parkinson’s, Cystic Fibrosis, Duchenne Muscular Dystrophy and many other illnesses. Doctors are also testing the potential of rejigging healthy parts of a patient’s body (such as the immune system) so they are better prepared to fight non-genetic diseases such as cancer.

But questions have been raised regarding the commercial opportunities for these exciting new treatments. Unlike most pharmaceutical products, they only need to be taken once, meaning returns on the exorbitant drug development investment are likely to be low. To cover the costs, these gene therapies are expected to carry lofty price tags, thus lowering the potential market size. Such concerns prompted British pharma giant GlaxoSmithKline (GSK) to sell its rare disease unit (which included a lot of early-stage gene therapies) in April 2018, a move that David Brown from healthcare analytics group GlobalData, attributed to "a lack of confidence in sustaining a profitable business model in the realm of curing rare disease”.

And yet there is no denying genetics is one of the hottest topics in medicine with massive potential rewards. Moreover, a lack of willingness by large pharma companies to invest in early-stage treatments could be an opportunity for smaller, nimble biotech specialists to procure novel treatments with a view to selling or partnering them with a large pharma company. On Aim, Silence Therapeutics (SLN), MaxCyte (MXCT) and MidaTech (MTPH) fit the bill. Their own products may be a long way from launch, but these companies all boast novel patented technologies that have the potential to identify and help develop new genetic treatments for large global pharmaceuticals. As the gene editing market gathers momentum, they are well placed.

Helpful regulation may be less groundbreaking than the potential for gene editing cures, but it's also an interesting consideration for investors assessing the market potential of a company. For example, the US Food and Drug Administration (FDA) is currently hoping to clamp down on the unregulated allergy medicines market in the US with a view to promoting novel, long acting treatments such as those currently being developed by Allergy Therapeutics (AGY).

Forthcoming regulatory changes could also boost the potential returns in antibiotics – a market in dire need of extra funding if humans hope to fight the rise of the superbug. Drug resistant bacteria is a growing problem because a lack of investment means no new class of antibiotic has been launched for three decades. The small returns under the current pricing structure means pharma companies are not willing to invest in the sector, but that could all change now that the World Health Organisation has put antibiotic resistance on its watch list of the biggest threats to human health. A potential boon to companies such as Summit Therapeutics (SUMM), Motif Bio (MTFB) and Eco Animal Health (EAH) which already operate in the antibiotics space.

 

2. Target the opportunity

In the UK, children with adrenal insufficiency – a hormone affliction that can be life threatening – are treated with steroids. Because no child-friendly portions exist, parents must guess the appropriate dosage by crushing the pills between two spoons and separating some of the powder. It is a practice Martin Whitaker, chief executive of Diurnal (DNL) describes as “archaic”. But for Diurnal, a lack of investment in this illness has provided an excellent opportunity. The group has recently completed the development of a new drug to treat adrenal insufficiency which is in the process of being rolled out across Europe.

Rare diseases are attractive for small- and mid-sized pharma companies because the doctors who diagnose and suggest treatments are specialists from a small cluster of universities and research centres. There are also rarely any competitors (Mr Whitaker is confident Diurnal’s drug will be chosen above the steroid/teaspoon combination) and patients are often desperate to try new treatments. Diurnal is not the only Aim-traded British group seeking to capitalise on the opportunity in the rare disease space: Amryt (AMYT), ImmuPharma (IMM) and MidaTech are also developing drugs in areas of unmet clinical need.

At the other end of the spectrum, respiration, infection and emergency care boast enormous patient populations and therefore offer a big market opportunity. But, unsurprisingly, that potential has not been missed by global pharmaceutical giants, many of which have big portfolios of drugs to treat these types of illnesses. Competition is therefore tough and commercial opportunities harder to grasp for the smaller player. Still, Synairgen (SNG), Verona (VRP) and Faron Pharmaceuticals (FARN) are among a number of Aim-traded groups giving it a shot.

One area of medicine in which big populations can be very attractive is animal health. Demographic trends are putting pressure on farmers who are increasingly using nutritional supplements, drugs and genetics to improve the productivity of their livestock. Benchmark (BMK) has operations in all three of those product areas and specialises in the aquaculture market, which is growing rapidly alongside human demand for fish.

 

3. Stay focused

Losing sight of the original goal can have negative consequences for company growth, as investors in E-Therapeutics (ETX) and Redx (REDX) found to their cost. Both companies began life as early-stage, drug discovery vehicles before attempting to focus on the clinical development of a small number of specialist drugs. Without the management know-how or funds in place, both companies collapsed.

Another red flag for prospective healthcare investors is the rate of cash burn. Out of the 80 Aim-traded healthcare companies, 11 currently have less cash on the balance sheet than they burnt through in the most recent financial year, suggesting that they are likely to have to tap the market again soon. That is particularly concerning for companies that only have drugs in the very earliest stages of development – 4D Pharma (DDDD) and Tiziana Life Sciences (TILS) spring to mind – and therefore have many years of investment ahead of them.

Look for companies with adequate funds (maybe they have recently completed a fundraising round or have an alternative source of capital) and experienced management who will keep the company on track.

 

4. Don’t fail

Earlier this year, the drugs being developed by ImmuPharma, Summit Therapeutics and Faron joined healthcare’s least loved league table: medicines that have failed a pivotal clinical trial. The share prices of all three companies fell more than three-quarters on the back of the news as investors' hopes of an imminent drug launch were dashed. This binary nature of clinical trials is one of the main difficulties with healthcare investment. Drugs trials either pass or fail – anticipating their outcome is almost impossible.

 

 

But there are factors that increase the risk of failure, the most obvious being the stage of development: according to the FDA, only 25 per cent of drugs in the final stage of development achieve their target, compared with 77 per cent in the first phase. Still, mistakes at the final hurdle are infinitely more disappointing than failures at the start of testing, not to mention gut-wrenchingly expensive – it pays to make sure Phase III trials are carefully planned.

Poor planning is one of the reasons Panmure Gordon analyst Mike Mitchell began recommending investors dump ImmuPharma's shares several months before the trail failed. He warned that the group’s final phase clinical trial was far too small for the nature of the illness and in April was proved right when the drug failed to achieve its pre-stated goal, despite the fact that it had helped alleviate patient symptoms. Mr Mitchell points to management experience as an important consideration when assessing the likely outcome of a clinical trial. Inexperienced managements are more likely to make mistakes with the structure of their trials, while bosses who have had success (or failure) in the past are better placed to get it right.

Manuel Llobet at Allergy Therapeutics is a prime example. In 2014, his company failed its initial attempt to find the appropriate dosage for its new allergy medicine, Pollinex Quattro, because of a poor study structure. Back then, the group used challenge chambers (which expose patients to allergens in an artificial setting), but these are now widely regarded as inadequate for clinical trials. Allergy’s second attempt proved far more successful and the group is now on the cusp of launching a final, pivotal trial that should announce results by 2020.

But there are drugs that simply don’t work, something no amount of planning, testing or evaluation can plan for. Having experienced two sets of clinical failure at his previous company, Glyn Edwards of Summit Therapeutics crafted the Phase II trial for the company’s Duchenne Muscular Dystrophy drug with the utmost precision and an unusually large patient sample. But the drug’s mechanism of action didn’t work, forcing Summit to abandon its attempts to revolutionise Duchenne treatment. A bitter disappointment for hundreds of hopeful patients and for Summit’s investors who had to stomach a 78 per cent one-day share price fall.

 

5. Don’t be greedy

Aim-traded healthcare companies are often run by ambitious scientists – men and women who care passionately about the drugs they are developing and have visions of pioneering major medical breakthroughs. The reality is far less sunny. It is hard to carry a drug all the way through its development and even harder to make the leap to commercialisation.

Vernalis (VER) was overambitious. Management attempted to launch and sell medicines in the massive US market, but quickly found out the costs were far too great for a small company to stomach. The business is now up for sale.

David Cox from Panmure Gordon thinks Faron’s failure in the final phase of development could end up working in its favour. Faron had plans to commercialise its respiratory distress drug itself and had already raised money to expand its sales operations. Now the drug will have to be re-tested, something Dr Cox doesn’t think will be possible without the help of a partner – a company that could end up helping with commercialisation efforts as well.

Partnerships have worked wonders for infection control group Tristel (TSTL) and fish farming specialist Benchmark. Both used distributors to expand overseas before acquiring those partners and bringing the commercial operations in-house. Hutchison China MediTech also took a sensible approach to partnering. Its first two drugs were developed alongside Eli Lilly (US:LLY) and AstraZeneca (AZN) – two global behemoths – which shouldered some of early-stage risk. Chi-Med will share the financial rewards of these two medicines.

The bottom line is that drug discovery and development is a completely different business to commercial pharma. Greed entices companies to try and make the leap, but that is tough. Very few companies have succeeded. Commercial and development partnerships, such as those being pursued by MaxCyte, Verseon (VSN) and OptiBiotix (OPTI) are therefore far more sensible.

 

6. Be attractive

Transplant surgery has evolved dramatically in the 65 years since doctors first saved a life by moving an organ between two people and yet the method of transporting organs remains remarkably primitive. A harvested heart, lung, liver or kidney is placed in a plastic ice bucket and raced to an operating room where a critically ill patient and their surgical team are waiting. Lifeline Scientific is in the process of pioneering change with its safe, efficient, organ transportation device. It’s a product that targets an enormous, underserved part of the healthcare market – no wonder Lifeline Scientific was snapped up by a major healthcare company just nine years after arriving on Aim.

Acquisition is often the best outcome for a medical device company as these products are notoriously hard to commercialise. Their margins are nowhere near as high as those enjoyed by drugs and most companies can only afford to develop one product. It is worth looking at the areas that could be ripe for consolidation. For example, Advanced Medical Solutions (AMS), Tissue Regenix (TRX) and Collagen Solutions (COS) all operate in the wound care space, which could be attractive to a large peer such as Smith & Nephew (SN.) or ConvaTec (CTEC). Meanwhile, Omega Diagnostic (ODX) recently gained £30m of investment from a large Chinese medical equipment investor and sold its infectious diseases business.

Elsewhere in healthcare, mergers and acquisitions (M&A) are high on the agenda. In the first quarter of 2018 $34bn (£26bn) of deals were agreed in the sector, driven by “demand for innovative pipeline, need to buy in growth, strong balance sheets, cheap debt and US tax reforms,” according to analysts at Peel Hunt. The broker suggests recent share price weakness at companies such as ImmuPharma and Shield Therapeutics (STX) could make them attractive to big pharma groups hoping to bulk up their pipeline and it’s worth watching the hunger for M&A at UDG (UDG), BTG (BTG) and Abcam. The latter recently had a bid rejected by Horizon Discovery (HZD) and could be in the market for another biotech tools company.

We also think Tristel is one to watch. Its disinfectant products have become the gold standard in British hospitals, are growing quickly in Australia, and recently gained approval in the US. We wouldn’t be surprised if a large medical devices company wants to get its hands on the technology before the company grows too big.

 

7. Make money

For many investors, small-cap healthcare conjures up frightening images of highly experimental companies, attempting mind-boggling things in laboratories while guzzling cash. And it’s true, cash-generative groups are the minority on Aim’s healthcare index. But they are not totally absent.

Take Abcam as an example. When it joined Aim after just seven years of operations, it was already cash generative and profitable. In its early days, management developed a relatively simple, catalogue-based business model, which allows it to generate enormous amounts of cash from antibody development. Following in its footsteps in the antibody procurement space are Bioventix (BVXP) and Fusion Antibodies (FAB). The former develops sheep monoclonal antibodies for use in large diagnostic machines, the latter is helping pharma companies identify new drug targets. Both generated cash from operations in the 2017 financial year.

Tools and services can be a good place for investors looking for profitable healthcare companies. The same is true for the primary care market, where Clinigen (CLIN) and Alliance Pharma (APH) are quality, profitable, cash-generative companies. In other areas of the market it takes longer to begin generating profits from operations, but many of Aim’s companies are making progress. Sinclair Pharma (SPH), Collagen Solutions and Benchmark are on the verge of their first pre-tax profits after several years of investment in their commercial operations.  

 

Our top healthcare picks

From companies hoping to unlock the mysteries of cancer, to those selling animal feed that makes pigs grow quickly, Aim’s healthcare index is bursting with variety. That’s good for building a broad portfolio, but tough when it comes to separating the potential winners from companies heading for disaster. To make it easier, we’ve divided the market into five broad categories – drug discovery, tools and services, primary and emergency care, hospital equipment, and animal health – and picked out the metrics that could help identify the companies with the greatest potential.

The below tables indicate the top five companies that emerged from our screens in each of the divisions. We’ll be using this analysis in our new Alpha series in which we will be delving into the investment cases of a number of companies, taking a closer look at the science, the financial position and management team to decide whether the shares are worth a punt. There’s no doubt, healthcare on Aim comes with challenges, but investors who chose to ignore it completely could be missing out on some real gems.

Drug discovery

  • Newsflow: Companies with a potential pipeline catalyst in the next six months
  • Financial backing: Those that have a second source of funding
  • Balance sheet strength: Net cash higher than annual cash burn

Name

Market cap (£m)

1-yr price change (%)

Catalyst in the next six months

Second source of funding

Net cash – annual cash burn (£m)

HUTCHISON CHINA MEDITECH (HCM)

3,150.98

56.95

Y – drug launch

Y – Commercial arm

238.06

ALLERGY THERAPEUTICS (AGY)

147.04

-9.17

Y – initiation of P3 trial

Y – Commercial arm

27.30

MAXCYTE (MXCT)

128.35

3.11

Y – deal making

Y – drug development partnerships

11.85

DIURNAL (DNL)

119.61

54.76

Y – drug approval

Y – EU drugs sales

14.00

REALM THERAPEUTICS (RLM)

45.09

27.27

Y – P2 trial read out

Y – wound care royalties

18.54

 

Tools and services

  • Quality revenue: Reliable or repeated source of sales
  • Momentum: Three-year historic revenue growth of more than 20 per cent
  • Balance sheet strength: Net cash higher than annual cash burn

Name

Market cap (£m)

1-yr price change (%)

Type of revenue

3-yr historic revenue growth (%)

Net cash – annual cash burn (£m)

HORIZON DISCOVERY (HZD)

234.82

-24.10

Commercial

45.3

14.23

OXFORD BIODYNAMICS (OBD)

195.96

75.69

Collaborative partnerships

21.5

8.03

BIOVENTIX (BVXP)

132.58

44.34

Service contracts

27.0

9.49

ERGOMED (ERGO)

93.89

5.53

Service contracts

108.4

3.23

CAMBRIDGE COGNITION (COG)

28.05

19.38

Commercial

34.8

1.24

 

Primary and emergency care

Only Clinigen hit all three of our metrics. These are our five top picks from those that hit at least one.

  • Outlook: Strong three-year forecast revenue growth
  • Cash generative: Positive operating cash flow
  • Good value: Based on enterprise value to revenue (EV:revenue)

Name

Market cap (£m)

1-yr price change (%)

Forecast 3-yr revenue growth (%)

Operating cash flow (£m)

EV/revenue

CLINIGEN (CLIN)

1070.0

2.70

13.94

46.10

3.44

ADVANCED MEDICAL SOLUTIONS (AMS)

650.7

15.47

6.92

16.97

6.28

ALLIANCE PHARMA (APH)

379.13

68.00

9.90

26.58

5.42

TISSUE REGENIX (TRX)

131.81

-28.57

73.18

-8.54

22.18

SINCLAIR PHARMA (SPH)

74.56

-55.15

21.52

-11.02

2.18

 

Hospital equipment

  • Revenue quality: Companies with more than one product
  • Low risk: Those with operations in more than one market
  • Financially stable: Cash generative

Name

Market cap (£m)

1-yr price change (%)

Number of products

Operating markets

Free cash flow yield (%)

EKF DIAGNOSTICS (EKF)

145.96

48.37

12

UK, US, Europe, China

7.04

INSPIRATION HEALTHCARE (IHC)

16.56

-8.47

20+

UK, Europe, Asia Pacific, Africa, Americas

4.71

IMMUDIAGNOSTICS SYSTEMS (IDH)

76.7

-15.81

20+

UK, Europe, USA, Brazil

2.76

SCIENTIFIC DIGITAL IMAGING (SDI)

31.82

36.54

20+

UK, Europe, America, Asia

2.03

SURGICAL INNOVATIONS (SUN)

29.35

3.45

1 + OEM contracts

UK, US, Europe

8.49

 

Animal health

With only four companies on the market, all made our top five, but not all hit every screening target

  • Revenue quality: More than one product and market
  • Financially stable: Cash generative
  • Good value: Based on enterprise value to adjusted cash profits (EV:Ebitda)

Name

Market cap (£m)

1-yr price change (%)

Quality revenue

Operating cash conversion (%)

EV:EBITDA

ECO ANIMAL HEALTH (EAH)

381.32

15.4

N – Reliant on 1 drug

94

21.4

BENCHMARK (BMK)

266.44

-45.74

Y – three operating divisions

na

26

ANIMALCARE (ANCR)

120.03

-51.52

Y – UK and European commercial sales

<100

15.5

ANPARIO (ANP)

99.22

36.19

Y – Commercial sales

<100

16.6