Fabrice Taylor: Why I'm betting this stock's price is poised to double

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Fabrice Taylor, CFA, publishes the President's Club investment letter, for which The Globe and Mail provides marketing services and receives compensation.

Investors like pure plays, companies that do one thing and one thing only. This explains why companies that have more than one line of business usually trade at a discount to their sum-of-the-parts valuation. It also explains why the shares of such companies rally when they decide to split into two or more firms.

This is what's happening at Nuvo Research Inc., and what makes this stock, backed by a $52-million cash hoard, a buy. The stock looks very cheap based on reasonable valuation methods.

Nuvo has announced its intention to split into two distinct companies, both listed on the Toronto Exchange. Investors who own Nuvo Research stock upon the split (expected early next year) will get shares in both new companies.

One company – yet to be named, but let's call it RevCo (as in revenue) – will house Nuvo's profitable specialty pharmaceuticals business. RevCo will have a suite of commercial products. The anchor product is Pennsaid 2%, a topical cream that treats joint pain. Sales of the cream are growing by double digits quarter over quarter. RevCo will also have smaller revenue from other products. RevCo, unlike the current Nuvo Research, will show profit, and, if the analysts are correct, significant growth.

The other company, which we'll call DevCo (as in development company), will house a suite of early-stage drugs/treatments with big upside should they pass their clinical trials and reach commercialization. This is the money-burning part of Nuvo that has clouded the profitability of what will become RevCo. But while it loses money, as do all development companies, DevCo will have a massive cash balance and explosive upside should even one of its products succeed.

The most advanced drug is WF10, which is being tested in Germany for treatment of allergies. WF10 had very promising early trials, but the last one proved inconclusive so the company is currently redoing that test. (Allergy trials are difficult because the weather has to co-operate.) Nuvo shares touched $10 in anticipation of the results of the last clinical trial and then retreated to $5 when it proved inconclusive.

If the new trial is positive, DevCo stock will likely surge. Allergies are a billion-dollar business, and anyone who suffers from them and who has to use pills, drops, inhalers and what have you will understand how a pharmaceutical treatment could improve their quality of life, especially given that existing allergy treatments aren't always that effective.

Here's why I think the stock looks cheap (and the market agrees, given that it's up 25 per cent since the split was announced in mid-September despite a terrible market):

RevCo's revenue in the first half of this year was about $7.8-million; about $4.2-million of that was for Pennsaid 2%.

Sales of the cream, according to the three analysts who follow the company that distributes Pennsaid 2% in the United States, are set to almost double by 2018. They are already growing at a torrid pace.

Nuvo owns a plant in Quebec that manufactures the medicine, which is running at only 50-per-cent capacity. This means it can double output without any major investment. It also means the margins on Pennsaid 2% should grow to 45 per cent as the fixed costs of the plant are spread over more revenue, according to management.

This should result in substantial earnings before interest, taxes, depreciation and amortization (see table).

Specialty pharma firms trade for as much as 13 times EBITDA. Using only 10 times, I estimate that RevCo will have a market cap of about $75-million, supported by my assumption that it will get $10-million of the cash hoard (and management doesn't dispute this) and also by the high rate of acquisitions in the industry. Big specialty pharma firms have grown by using their high-priced stock to buy smaller firms trading at lower multiples. Nuvo would be a target if its multiple failed to reach nine or 10, in the view of analysts. And if it does trade well, it will likely be an acquirer of smaller branded drugs.

Either way, the investor wins.

I use a value of $50-million for DevCo, which includes $10-million for the potential upside of a successful drug trial and $40-million of cash, which is conservative compared with other development companies. This is the "blue sky" part of the investment.

As you can see from the table, this exercise suggests the potential for $12/share of value for Nuvo.

My assumptions seem reasonable, but even if they're too aggressive, there is lots of upside. There is also limited downside. It's the perfect kind of investment for a market like this.

Disclosure: The author owns Nuvo Research shares.