Echelon Target Maintained 1.25 Buy If you would like a well considered opinion... Here is the update from Doug Loe, Echelon:
" Event: QC-based sterilization platform developer TSO3 reported FQ119 data for the March- end period. Financial data were mixed in our view, with recurring revenue still exceeding unit sales revenue during what we would still consider to be a launch period for the firm’s leading ozone/hydrogen peroxide-based low-temperature sterilization platform VP4, but with our model assuming that units placed with hospital clients in the quarter (nine in total, four of which generated tangible revenue) represents a near-term floor and not a ceiling for levels of unit sales traction that we believe TSO3 can achieve in coming quarters.
TOS-TSX: $0.33
$1.25 Target
Target Return: 279%
Valuation: NPV (30% disc rate), 20x EPS, 12.5x EV/ EBITDA (F2021 ests)
TSO3 Inc.
FQ119 Results Reveal Measured Progress On Placing VP4 Systems, But Expect Pace To Accelerate Through 2019h 2019 - BUY
Bottom line: We will get into a few quarterly specifics below, but our investment thesis still assumes that VP4’s suite of technological benefits (load capacity, load-specific infusion of sterilant gas, cost per cycle) can on their own drive VP4 adoption in the 30,000-unit global low-temperature sterilization market, even before considering the differentiated FDA claims that the device has on effectively sterilizing flexible multichannel endoscopes and duoden-oscopes. The FDA clearly cares about this capability, and we expect US client hospitals to in time see the value in having access to scope-sterilizing capabilities. We are thus maintaining our BUY rating and one-year PT of $1.25 on TOS, with our valuation still based on NPV and multiples of our F2020 EBITDA/EPS forecasts.
Recurring revenue ticking up nicely while unit sales growth traction reflects seasonality rather than placement intensity: Of the consolidated revenue reported at $0.96M (company reports in USD, and as such our discussion of all dollar amounts below refer to the use of the USD currency as such, unless otherwise specified), we observed that the revenue contribution was more skewed to recurring revenue than it was to unit-related capital sales.
On that note, sales of the firm’s lead Sterizone VP4 sterilizer were $252,000 in the quarter, while accessories, consumables and service revenue contributed to $0.114M/$0.437M/ $0.157M or cumulatively $0.708M of revenue, as compared to FQ118 at $0/$0.172M/ $0.083M and no sterilizer sales recorded in FQ118. As we have noted earlier, the cumulative proportion of recurring revenue has outpaced unit sales for the first time in the firm’s financial history, an observation that we expect to continue in the mid-to-longer term as well.
Separately, seasonality on device placement was also at play, with the view that Q4 tends to be the strongest of all other quarters, given dynamics related to sales force compensation (with the aim to close sales by year end for recognition on related sales compensation metrics) as well as annual hospital capital equipment purchasing cycle. That said, we do not assume that such seasonality should substantially impact TSO3’s unit sales traction during what is still an early adopter phase of VP4’s innovation curve, and we thus expect most financial periods to experience sequential unit sales ramp at least through F2021.
Focus on aggressive unit pricing strategy in placement of devices and encouraging incremental recurring revenue growth: Average selling price of the devices are anticipated by us to be $63,000 after adjusting for the number of VP4 systems that were placed at negligible cost to client hospitals, though presumably with commitments on consumables purchases that over time should offset modest returns on capital cost itself. TSO3 (TOS-TSX) | 7 May 2019
Management disclosed that of nine VP4 systems shipped in the quarter, five were placed without deriving any upfront revenue on the systems themselves, and so total revenue generated from capitals ales of US$0.25M, which TSO3 does specifically indicate in its MD&A, corresponds to an average selling price for the other revenue-generating VP4 systems palced in the quarter at US$63,000 as indicated above. Even at heavily discounted price levels (our model assumes near-term VP4 selling price will be at or near US$75,000, and we previously assumed a transfer price to Getinge of US$110,000 per system), the selling price is still roughly double the cost to reacquire Getinge AB (GETI.B-STO, NR) inventory, which was US$33,000 per system. In the near-term, we endorse TSO3’s decision to sacrifice upfront capital revenue in order to drive consumables revenue during our forecast period, but our endorsement of this strategy does have a fuse, and we look forward to TSO3 adopting a revenue model commensurate with its peers once legacy Getinge VP4 finished goods inventory is placed.
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Looking forward, we observed the firm has received 14 purchase orders or commitment indications, and thus FQ219 is on pace to exceed FQ119 performance both on VP4 placements and on consolidated revenue, independent of recurring consumables revenue that should continue to climb as installed base climbs in parallel. To date 75 sterilizers have been installed at end-user locations, 7 that have been shipped but not installed, 28 pending open purchase orders or commitment indications. All metrics are still modest in our view when considering annual low temperature sterilizer turnover that we believe is up to 3,000 systems annually worldwide, but for now we are more positive about the directionality of VP4 placements than in market share analysis as such.
Gross margin restored to levels commonly generated while the Getinge alliance was active: Gross margin in the quarter was $0.377M/39.3% with margin related to two factors: the first being the increase in revenue garnered from consumables and from sterilizer sales traction. On the latter, this was attributed to an increase in pricing, as compared to on a wholesale basis to ex-partner Getinge previously, and validating our views that unit pricing for now remains price-insensitive. Gross margin of this magnitude (percentage basis) was also roughly in line with levels seen in 2017, prior to the Getinge handover. EBITDA loss in the quarter modestly decreased to ($2.3M) as compared to ($3.2M) in FQ418, likely related to a reduction in R&D expenses in the quarter of $0.71M as compared to $1.1M last quarter. G&A expenses were relatively consistent as well at $2.6M as compared to $2.7M last quarter.
Cash runway still valid for at least one year: On liquidity metrics, the firm exited the quarter with cash of $11.3M, and with FQ119 implied EBITDA loss as a proxy for cash runway implying the firm still has five more quarters of TSO3 (TOS-TSX) | 7 May 2019
leeway to execute on its sales strategy. Working capital sustained its surplus from last quarter, as we observed favourable increases in account receivables during the quarter. Operating cash prior to contemplating working capital surplus was ($2.347M) in the quarter, as compared to ($3.21M) in FQ418, though the prior quarter did include one-time write downs on both physical and intangible assets ($0.928M) which would have substantially increased the operating cash loss further.
Exhibit 2 – Valuation Scenarios for TSO3
NPV, discount rate 10% 20% 30% 40% 50% 60% Implied value per share $2.25 $1.60 $1.17 $0.88 $0.67 $0.51 Price/earnings multiple, F2021 10x 15x 20x 25x 30x 40x Implied share price1,2 $0.39 $0.58 $0.78 $0.97 $1.17 $1.56 EV/EBITDA multiple, F2021 5x 10x 12.5x 15x 17.5x 20x Implied share price1,2 $0.31 $0.67 $0.84 $1.02 $1.20 $1.38 One-year TSO3 target price (US$) $0.93 One-year TSO3 target price (C$) $1.25 Discounted projected share price to end-of-2019 1 Based on fully-taxed F2021 EPS (fd) forecast of US$0.05, EBITDA of US$9.4M. Valuation based on NPV (30% disc rate) 2 EV incorporates FQ119 cash of US$11.3M, LT debt of US$17.5M, fd S/O of 101.1M
Source: Forecasts/estimates — Echelon Wealth Partners Inc.
Long term debt poses minimal risk on flexibility of interest payments and meeting debt convenants: On debt, the firm exited the quarter with $17.5M in LT debt, which consists primarily of a $15M 10% convertible note and a $5M 12% term loan maturing in 2023. For now, the firm remains in line with the minimum liquidity covenant of $5M, and maintains a flexible payment structure on interest payments. Interest can also be deferred until the end of the respective terms of the two debt instruments (both in 2023, so within four years).
Interest still remains high both from regulatory agencies and OEMs on modalities that can overcome issues pertaining to scope reprocessing: As discussed on the call, there is a possibility of new AMMI standards coming out this year, though for now these claims remains unsubstantiated by us. Depending on these standards, there is also the possibility that the new standards could embrace newer sterilization technologies, including that of terminal sterilization.
Exhibit 3 — Proportion of Joint-Commission-Accredited Hospitals With Non-Compliant Findings In Relation To Infection Control Standards For Medical Equipment
2009 2010 2011 2012 2013 2014 2015 2016 28.0% 29.5% 36.1% 41.9% 46.5% 52.0% 58.7% 60.0%
Source: Jeff Wiser, AAMI (2019)
As recent as April 12th, the FDA issued yet another safety communication reminding facilities deploying endoscopes to adhere to strictly to manufacturer’s reprocessing and maintenance instructions as well as reporting adverse event data to the regulatory agency. The regulatory agency also provided more recent (and concerning statistics), with 45 reports of patient infection, 1 report of patient exposure and 159 reports of device contamination, with all events occurring from Oct/18 to Mar/19. While the agency deems these events as declining over time, the emphasis was for the need to improve the safety of reprocessed duodenoscopes.
For now the FDA’s recommendations in terms of reprocessing and maintaining duodenoscopes have not changed and does not include terminal sterilization (includes only automated endoscope reprocessors). But while we are on the topic of AERs, we also observed that one of the five AER manufacturers on file (Custom Ultrasonics) issued a device recall and advised users to stop using one of its AER models for reprocessing of all duodenoscopes. Likewise the FDA also advised facilities to reprocess duodenoscopes, save for certain duodenoscope models. The urgency of finding a resolution regarding reprocessed devices has also led to the FDA announcing the intent to hold a Healthcare Infection Control Practices Advisory Committee (HICPAC) meeting this month to enhance the safety of such devices. On the call management advised that the firm will be in attendance on that meeting, with the hopes of enhancing collaboration with end-users and OEMs, as well as embracing newer technologies in terminal sterilization.
Summary & valuation: For now, we are maintaining our BUY rating and C$1.25 price target on TOS. Our PT is derived from the average of three methodologies: NPV (30% discount rate), and multiples of our F2021 EPS and EBITDA forecasts. In our F2021 reference year, we project EBITDA/EPS of US$9.4M/US$0.05 respectively. Our EV calculation now incorporates FQ119 cash of US$11.3M, LT debt of US$17.5M, and fully-diluted S/O of 101.1M."