Developing new drugs is a risky business. Only around 7% of treatments make it through the approval process. With the average cost of production per treatment amounting to more than £1bn, it's both a risky and costly process.
However, the payoff can be enormous, which is why small-cap biotech stocks like Motif Bio(LSE: MTFB) often attract plenty of attention.
Motif is developing several antibiotic treatments for niche diseases and management is planning to submit its first therapy for approval early next year.
First drug opportunity
This first drug is for patients with Acute Bacterial Skin and Skin Structure Infections (ABSSSI). The firm already has two required Phase 3 trials in ABSSSI necessary to submit a new drug application to the US Food and Drug Administration, which is planned to take place before the end of Q1 2018.
Unlike existing ABSSSI treatments, Motif's product, Iclaprim, is not toxic to the kidneys. Around 26% of ABSSSI sufferers also have kidney disease, so this is a promising development. Nearly 4m patients are diagnosed with ABSSSI every year in the US, so Iclaprim could become a blockbuster seller for the firm. If it does, investors should be well rewarded for their patience.
The total addressable market value is estimated at $2.8bn, capturing just 10% of this would see Motif's shares surge as the current market value is only £100m.
Shares in its larger rare disease treatment peer Shire(LSE: SHP) currently trade at a price-to-sales ratio of 2.9. If Motif can achieve sales of $280m, roughly £207m, the same valuation would indicate a market cap of £600m -- a gain of 500% from current levels.
Shire also looks undervalued to me. The company has recently fallen out of favour with investors due to its rising debt pile, but management is working hard to bring down these obligations, and over the long term, the company should produce steady returns for investors.
Making progress with growth
For the fiscal first quarter (July to September), Shire reported that net cash generated by operating activities doubled to $1,055m, helping to reduce its net debt by $920m, a sizable decline, although even after this reduction, the group still holds a net debt balance of $20.4bn, a net gearing ratio of 62%.
Still, the company's pricey acquisition of US firm Baxalta is paying off. For fiscal Q1 the group reported a 20% increase in adjusted earnings per share, which rose to $3.81 off the back of a 20% increase in adjusted net profit.
After recent declines, Based on broker forecasts the stock trades on a forecast P/E of 8.7 for 2017, which is cheap even after accounting for the company's debt pile. The rest of the pharmaceutical industry trades at a median forward P/E of 17. As the company continues to pay down debt and grow earnings, this valuation gap should quickly close.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended Shire. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.