Today we report on a Canadian pharmaceutical firm that does not develop any drugs itself. Instead, Merus Labs acquires the rights to existing drugs and outsources manufacturing and other operations. The company purchases the right to smaller, established drugs rather than new treatments. Its approach to business keeps operating costs down, and Merus’ rising revenue and cash flow give it the means to expand its line of products. But as a penny stock that relies on acquisitions to keep growing, Merus Labs faces added risk, and that risk is compounded by the highly competitive nature of the drug industry.

Merus Labs International Ltd. (symbol MSL on Toronto; www.meruslabs.com) is a Toronto-based company that acquires the rights to established drugs.

Merus mainly targets relatively small, mature products, as opposed to the newer treatments that attract the attention of larger drug firms. The company outsources its manufacturing and other operations, so it has low operating costs and few employees. By focusing on acquisitions, it also spends nothing to develop new drugs.

The company’s main products include Enablex (an overactive-bladder treatment), Sintrom (anticoagulant) and Vancocin (antibiotic). It mainly sells these drugs in Canada and Europe.

In May 2015, Merus paid Novartis Pharma $29.5 million U.S. for the rights to two more drugs: Salagen (which relieves dry mouth symptoms in cancer patients undergoing radiation therapy) and Estraderm (a hormone replacement therapy for women). In 2014, these treatments had total revenue of $10 million U.S.; this deal lets Merus make and sell them in certain European countries.

Penny stocks: Merus strategy depends on buying drugs that are off the radar of major companies

In its fiscal 2015 third quarter, which ended June 30, 2015, the company’s revenue rose 32.3%, to $9.5 million from $7.2 million a year earlier. Its two new drugs (Salagen and Estraderm) accounted for 37% of the increase.

Overall cash flow jumped 160.5%, to $6.5 million from $2.5 million. The company issued new shares to pay for its acquisitions, so cash flow per share rose at a slower pace of 40.0%, to $0.07 from $0.05.

Merus can afford to keep expanding: it ended the quarter with long-term debt of $51.1 million, which is equal to a moderate 25% of its market cap. It also held cash of $41.6 million, or $0.41 a share.

However, to keep its revenue and cash flow rising and fend off generic competition, Merus will need to buy drugs that are proven, are selling at favourable prices and have growth potential—yet are too small to interest major drug companies.

It’s been successful so far, but growth by acquisition is inherently risky—much more so than internal growth. The risk is much greater when acquiring drugs, because adding treatments that fail to grow as expected, or lose out to a competitor, can be extremely costly.

Merus Labs is okay to hold, but only for highly aggressive investors.

Inner Circle recommendation: HOLD for highly aggressive investors

For a recent report on a Canadian penny stock in a different industry that is banking heavily on an acquisition, read Canadian penny stock Madalena Energy pushes for big results in Argentina.

For our advice on the best way to avoid the risks and find the rewards with penny stocks, read 7 tips for making money with penny stocks.

Has the bad news on Valeant Pharmaceuticals made you suspicious of drug stocks?