10 Small Caps to Rule Them All

Small-cap companies are absolutely one of my favorite areas to research because you can often uncover hidden gems that analysts have neglected or simply not discovered yet. They can offer the ultimate risk-vs.-reward ratio, but they are not for the faint of heart.

This 10-week series is dedicated to finding the 10 small caps to rule them all. Here are the previous five choices:

• Golden Star Resources
• BuffaloWild Wings
• Integrated Silicon Solutions
• True Religion Apparel
• Allegiant Travel

This week I want to step out of the box and highlight promising biotechnology upstart Aeterna Zentaris (Nasdaq: AEZS).

What it does
Despite its name sounding like a planet found in a bad 1980s sci-fi movie, the company deals in the serious business of oncology and endocrinology research. Don't let the company's market value of just $159 million fool you -- Aeterna Zentaris is more than just a one-trick pony.

The company has 11 prospective drugs in its pipeline at the moment; perifosine is its lead candidate for success. Perifosine, currently in phase 3 trials, has received fast-track status and has been given the designation of orphan drug as a treatment for multiple myeloma and colorectal cancer. On the endocrinology side of its business, the company's lead candidate is Solorel, an oral compound also in phase 3 trials that can be used to test for human growth hormone deficiency.

How it stacks up
As you can tell, this is where valuing a biotechnology stock can get a little sticky; especially a small startup like Aeterna Zentaris. Whereas the companies I've profiled thus far made the cut because of their strong growth yet underwhelming stock performance, Aeterna Zentaris has only one marketable product to date, Cetrotide, which is an in vitro fertilization drug administered to women to prevent premature ovulation.

Having only one drug approved by the Food and Drug Administration and receiving drug milestone payments infrequently, we need to use more creative methods to see why Aeterna Zentaris is a clear buy and its competitors aren't.

Comparing drug companies can be even more difficult than trying to compare an apple to an orange because of how many drugs they have in their pipeline as well as what the potential market will be like for drugs under development. For the sake of argument, I made an attempt to pick out biotech companies with similar market values and left out the very few drugs that have already made it to market. Instead, I feel it's more important to focus on the drugs currently in the pipeline because investors are looking toward the future with biotechs, not the past.

Based on the above figures, Aeterna Zentaris has a clear advantage. The company consistently has a steady stream of drugs in late-stage clinical trials compared to a company like Geron, which currently doesn't have a prospect past phase 2 clinical trials. Orexigen, you may notice, is batting 1,000, but considering it has only two drugs in its entire pipeline, the chances of failure go up considerably. ImmunoGen may also seem like a tempting bet, but considering that 90% of its prospects have yet to make it past phase 1 clinical trials, it languishes in comparison to Aeterna Zentaris.

How it could make you money
Another way to interpret the figures above is to consider what market value is being assigned to each company based on the drugs currently in the pipeline.

Despite having drug candidates further along in the approval process than many of its rivals, Aeterna Zentaris has the lowest market value-to-drug ratio of the bunch -- and it shouldn't. If Orexigen can muster an average current value of $70 million per prospective drug in a hypercompetitive anti-obesity drug market -- which is currently on pace to deliver more than $3 billion in sales by 2016 -- then Aeterna Zentaris certainly deserves a more realistic valuation. The multiple myeloma market alone is set to grow to $5.3 billion in sales by 2018 and makes Aeterna Zentaris look like a moderately undervalued prospect at these levels.

Another aspect worth considering in the biotech sector is whom the company is partnered with. Occasionally, companies will go it alone and research and subsequently market a drug themselves. More often, though, it's considerably more beneficial for small biotech companies to form drug pacts and share knowledge and cash in order to facilitate getting a drug to market.

For perifosine, Aeterna Zentaris has allied itself with Keryx Biopharmaceuticals (Nasdaq: KERX) and Handok. Keryx holds the licensing for perifosine in the U.S., Canada, and Mexico, Handok holds the rights in Korea, and Aeterna holds the rights everywhere else. The most important aspect of this deal is that Aeterna gets to use data collected during the phase 3 trial free of charge in order to facilitate its application of the drug in Europe with basically minimal costs. Assuming perifosine gains approval, and every test thus far has generated positive data, it's my opinion that the company should have no trouble generating massive gross margins.

Eventually I suspect the market will wake up to Aeterna Zentaris' growth prospects, and it's for that reason the company deserves a spot among the 10 small caps to rule them all.

What are your feelings on Aeterna Zentaris? Biophobic or biophilic? Let's hear your thoughts in the comments section below. Also consider adding Aeterna Zentaris as well as your own personalized portfolio of companies to the free and easy-to-use My Watchlist.