CGNH: Q1 2011 Results - No Material Surprises Relative to Our Estimates - Analyst Blog

Brian Marckx, CFA

Q1 2011 Results – No Material Surprises Relative to Our Estimates
 
CardioGenics (CGNH) filed their 10-Q for the period ending January 31, 2011 on March 17, 2011. Results were generally in-line with our expectations with no meaningful surprises. Operating loss was $461k, slightly better than our $515k loss estimate. The difference mostly attributable to $157k in investment tax credits received during the quarter (accounted for as a reduction to R&D expense), partially offset by higher than estimated ($297k A vs. $250k E) G&A expenses. All of the company's investment tax credits have now been exhausted. Net loss and EPS came in at $503k and ($0.01) versus our estimates of $511k and ($0.01).
 
Cash flow from operations was ($262k) but stripping out the $157k investment tax credit and $115k received from share subscriptions (both carried as receivables), neither of which are not fundamental to the operations of the business, cash used in operations was $534k, which is very much in-line with our expected ~$180k per month burn rate. $298k was raised through stock issuance during the quarter. CardioGenics exited Q1 2011 with $1.87 million in cash and equivalents (compared to $1.84 million at 10/31/2010). We continue to expect the rate of cash burn to increase up at least until the magnetic beads launch and for the company to remain cash flow negative throughout 2011.         
 
 
OUTLOOK
 
Based on what we believe are material competitive advantages and the dynamics of the respective markets where CardioGenics will compete, we feel the company's products will be well received. This assumption, however, necessitates that a number of things happen as planned.
 
Significant unknowns remain, many of which can severely impact the success of the business. We have communicated extensively with management and have used our best judgment gained through extensive due diligence in determining the likely outcome of the major lingering questions. While we feel comfortable with our conclusions, until there is more certainty to some of these unknowns there is a risk that some of our assumptions will be proven inaccurate which could be detrimental to the success of the company. Despite this, from an investment (i.e. – risk/return) standpoint, we feel these questions are more than mitigated by the tremendous potential of the company's products to rapidly ramp revenue and earnings and achieve positive cash flow.   
 
Competitive Advantages
As we have detailed, the POC IVD market is dominated by only a few very large players which can make entry into the market difficult, despite the QLCA incorporating what we believe may be a superior technology. The benefits of superior sensitivity of the machine may not be realized or evident until after many years and customers may be hesitant to switch from what they believe is an acceptable product so marketing for this claim early on (assuming clinical trials confirm this hypothesis) may not prove to be overly persuasive. We expect CardioGenics to address this competitive headwind by offering their products at a significant discount relative to competitors' offerings. With what we expect to be relatively low production costs we expect CardioGenics to be able to compete very aggressively on price. By offering the QLCA machine for free (through a lease agreement where the customer agrees to purchase a predetermined amount of tests) and under pricing competitors' tests the idea is that the company will be able to gain a toe-hold in the market. This toe-hold can hopefully then be expanded to a foot-hold as the installed base grows. And despite under pricing the competition, we still expect gross margins on the tests to CardioGenics (after distributor royalties are paid) to be around 90%.
 
Clearly the company also has potentially tremendous advantages with its beads product; a 4 – 7 fold increase in sensitivity at a fraction of the cost of competitors' beads and marketed by a top-three distributor. Price should again provide a way into the market but we think the qualitative advantage of the beads will also provide a CardioGenics with meaningful differentiation over the competition which we think can benefit sales immediately upon launch.    Based on these advantages we think CardioGenics can compete very well in the magnetic bead market and claim as much as 5% market share within a few years after launch. Based on our model we believe CardioGenics can achieve profitability by late 2012 on just the contribution from bead sales (and test development milestone payments).     
 
CardioGenics being almost exclusively a research company provides an advantage from a risk and capital perspective. This allows the company to keep capex and operating assets to a minimum and significantly reduces their financial exposure to declining sales and cash flow in any given year. And while outsourcing most other major functions other than R&D typically means sacrificing gross margins, most companies would be envious of their expected 90%+ in this category.  
 
Products' Status
The analyzer and Troponin I test are now expected to enter head-to-head field trials in May 2011. FDA trials are expected to begin in Q3 2011. Obviously CardioGenics felt the bench study data was compelling enough to move forward with field trials and Dr. Gawad has extensive experience working on cardiac diagnostic test products and bringing several of those through FDA approval and to market, including a currently marketed test for Troponin I. For these reasons we feel comfortable in the chances of these products performing has hoped in FDA trials. We note however, that FDA turnaround time on 501(k) applications can be highly variable, so further delays to our updated projected launch date (1H 2012) is certainly possible.    
 
Development of CardioGenics' paramagnetic beads has been drawn out longer than initially anticipated. While we now model a launch during fiscal Q3 2011 (ending July 31, 2011), since management has not provided more specifics on development, we have no reliable information to indicate when the beads could begin generating revenue.
 
Viability of a commercial product and launch timelines of the beads are potentially the most influential unkowns and depending on the outcome, could have a significant impact on our near-to-mid term financial forecast for the company. This is evidenced by bead sales accounting for 100% of our forecasted revenue and cash flow for the company in 2011, 89% in 2012 and 78% in 2013.          
 
Visibility on the timelines or chances for eventual commercialization of the companies other tests (PAI-1, HFRS, HFGR) is even more clouded as development for these products is still in relatively early stages. Eventual commercialization of these tests will help fuel long-term growth for CardioGenics but failure to hit our launch timelines by as much as one year should have only minimal financial impact over the next several years as we model beads and Troponin I tests to account for 72% of revenue and cash flow in 2014. Longer-term, these products could offer huge upside to the company as there is no currently marketed test for two of the three tests (PAI-1 and HFGR) and we believe the HFRS test incorporates at least one novel marker. Unfortunately though, this also adds to the uncertainty relative to development timelines and cost as well as the probability of getting them to market. Our current “best-guess” (which is incorporated in our model) is that the PAI-1 test launches in 2H 2013, the HFRS in 1H 2014 and the HFGR in late 2015.   
 
Loose Ends
CardioGenics has a number of other unknowns, aside from those related to development and commercialization of the pipeline. Among the most significant is that a distribution partner has yet to be established for the QLCA and tests. This is somewhat mitigated by the recent disclosure that CardioGenics has retained an outside firm to aid in establishing partnerships. Anecdotally we believe the company is looking for a well established player in the market and a deal is expected to be in place by the time the machine and Troponin I test receive FDA approval. The specific partner and the terms of the distribution agreement can have an impact on revenue, margins, cash flow and units placed so until a deal gets done and the terms are disclosed, our model will reflect what we believe to be reasonable assumptions relative to a distribution partner based on industry standards. One of our assumptions is that CardioGenics will receive $1 million in milestone payments upon submission of each test to the FDA from its distribution partner. The milestones are typically paid out over several years which we have also incorporated into our financial forecast.
 
Another remaining loose end is additional financing – if, when, how much, from whom and what kind all remain unanswered. The only thing we are confident of is that the company will need more money before the QLCA and Troponin I test launch. CardioGenics has demonstrated that they have the ability to raise capital when needed and we have no reason to believe they will fail to do so in the future.  
 
 
Financial Forecast
R&D expenses and cash burn will be dramatically higher in 2011 relative to 2010 as the QLCA trials finally get underway. We look for the beads to launch in Q3 2011 and model net loss and EPS of $2.85 million and (-$0.05 EPS) in fiscal 2011 (October 31, 2011).   
 
We currently expect the QLCA and Troponin test to launch in Q2 2012 and also assume the company begins collecting milestone payments for the Troponin I and PAI-1 tests from its distribution partner during 2012. We model 2012 revenue of $6.78 million. Operating expenses will remain elevated during the year as a result of ongoing R&D and regulatory activities but we think the company can post positive income for the full year. We look for net income and EPS of $1.79 million and $0.03 in 2012. 
 
For 2013 and 2014 we model revenue to begin to show dramatic growth, which is mostly predicated on beads and Troponin I test revenue significantly ramping beginning in late 2013. Based on our assumptions, the company should begin to gain significant operating leverage during this period as revenue growth substantially outstrips that of operating expenses, resulting in the company becoming cash flow positive for the full fiscal year 2013. 2013 and 2014 also include revenue contribution from the PAI-1 test (and HFRS test for 2014) but, as noted above, we believe a failure to get either product to market will not prevent the company from generating positive cash flow as early as 2013. We model net income and EPS of $9.66 million and $0.14 and $27.37 million and $0.39 in 2013 and 2014, respectively. CardioGenics is carrying significant net operating loss carryforwards which should eliminate any effective income taxes during the first few years of profitability.  
 
Longer Term
Longer term CardioGenics has indicated that they expect to expand their testing menu beyond the cardiovascular setting and into other disease areas such as infectious disease, cancer, thyroid and diabetes. Professional POC testing of many of these are expected to grow in the mid-to-high single digit rate over the next five years which could bode well for CardioGenics. An expanded and more diverse testing menu would also provide the company with more competitive firepower. However, we do not expect CardioGenics to dedicate much time or resources to expanding their testing menu until after their cardiovascular diseases tests have been commercialized, which means the fruits of a larger menu may not be realized until near the end of this decade.
 
 
RECOMMENDATION / VALUATION
 
We believe the QL Care Analyzer, which incorporates the sensitivity of lab analyzers with the speed and ease of use of POC machines, will be well received in the professional POC IVD testing market. Led by an acclaimed cardiologist with two decades of experience in developing and gaining FDA approval of several cardiac marker tests, CardioGenics' initial tests will target their area of expertise – cardiac markers. Cardiac markers are also the fastest growing segment in POC IVD testing due to the need for quicker tests in order for emergency physicians and cardiologists to make informed decisions within one-hour of the onset of a cardiac event. We believe the QLCA will close the sensitivity gap between POC and lab analyzers and offer healthcare providers faster results (15 minutes versus 3 - 4 hours) without sacrificing sensitivity, the latter which has been a significant impediment in the further adoption of POC testing.   
 
Unlike many development-stage companies with a better mousetrap which have unrealistic strategies to realize outsized growth and market share expectations, CardioGenics' initial plan is to just gain entry into the market as a niche player. We believe CardioGenics is uniquely positioned to gain a foothold in the rapidly growing professional POC IVD testing arena. The company's initial game plan is not to hit a walk-off home run against the handful of large companies that currently dominate the space, but instead to just get on base. Entry into the market will be gained by claiming a niche position within cardiac marker testing through offering next-generation technology at a significant discount to competitors' products, most of which use legacy technology.     
 
We expect CardioGenics to fully exploit the razor/razor-blade business model by offering the QLCA for free through a minimum test purchase agreement. Despite under-pricing the competition, sales of the test cartridges and relatively low production costs should afford CardioGenics gross margins around 90%+ (including the cost of the analyzer). By outsourcing the majority of functions other than research and development, the company carries little overhead and has minimum capex requirements – this low cost business model, along with huge margins, can result in positive net income and free cash flow in relatively short order.
 
We feel the current market value of CardioGenics under-represents the significant and numerous competitive advantages of the company's products and business model which we estimate will push the company to profitability by late 2012. While various lingering questions remain, based on extensive due diligence and numerous conversations with management, we expect satisfactory answers to the bulk of these questions to come within the next 12 months. And from an investment (i.e. – risk/return) standpoint, we feel these questions are more than mitigated by the tremendous potential of the company's products to rapidly ramp revenue and earnings and achieve positive cash flow in relatively short order.     
 
Median valuation of peers in the professional POC IVD testing space is 14x 2013 earnings. We look for CardioGenics to post EPS of $0.14 in 2013. Using the peer averages our near-term target price for CardioGenics is $2.00 per share.
 
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