TS03 Inc Trust Units TSTIF

Canaccord Very Positive but Maintaining 3.50 Target for now

[echo2]

Canadian Equity Research

5 May 2016

BUY

PRICE TARGET

Price (4-May) Ticker

C$3.50 C$2.25 TOS-TSX

Neil Maruoka, MSc, MBA | Analyst | Canaccord Genuity Corp. (Canada) | [e-mail] | 1.416.869.3073

Matt Bottomley | Associate | Canaccord Genuity Corp. (Canada) | [e-mail] | 1.416.867.2394

Company Update

Q1/16 results: We have liftoff

Investment Recommendation

TSO3 reported strong Q1/16 financial results that were ahead of our estimates on higher than expected shipments of VP4 sterilizers. We had estimated modest initial sales of VP4 under the new exclusive distribution partnership with Getinge; however, TSO3 handily beat our 15 unit estimate, shipping 25 units to Getinge in the first full quarter since the agreement was signed. In our view, this represents a critical first step towards becoming EBITDA-positive, with management building credibility on its ability to execute its plan. We believe the company is now poised to ship more than 100 VP4 units in 2016. TSO3 reported revenue of US$3.1 million for the quarter (versus our estimate of US$2.4 million), already eclipsing total revenue recorded during FY2015. For the quarter, the company reported Adj. EBITDA of (US$0.6 million), in line with our estimate of (US $0.7 million).

We would be buyers of the stock at these levels with an eye towards the continued sales ramp for VP4 in 2016 and a potential decision from the FDA on expanded claims for the sterilization of flexible endoscopes, which remains on track for this year

Investment Highlights

• Getinge minimums for 2016 will likely be higher than we originally thought. TSO3 recently indicated that the number of units ordered late last year satisfy Getinge’s contractual minimums for 2016. Although we remain uncertain as to what that minimum is, the company stated it is currently ‘in a position to assemble and deliver in excess of 100 sterilizers’ this year – and has already achieved 25 unit shipments during the first quarter.

• Contractual minimums set a valuation floor. We believe the minimums within TSO3’s distribution deal with Getinge provide downside protection to our valuation of >$2.50 per share. Further, a solid balance sheet presents additional valuation support as the company transitions to positive EBITDA and cash flow in 2017.

• Expanded claims provide upside to our forecasts. We believe the claims around the sterilization of multichannel flexible endoscopes could lead to substantial upside to our market penetration forecasts. Management was confident that the company could receive regulatory approval for the expanded claims in 2016.

Valuation

We value TSO3 based on a DCF model, using an 11.0% discount rate (previously 11.2%) and a terminal growth rate of 2.0%. We have made modest adjustments to our forecasts (which are now in USD) to include modestly higher shipments of VP4 units in 2016, while decreasing the estimate net-sales margin on sales to Getinge. As a result, our target price remains unchanged at C$3.50. Our target represents an annualized return of 55.6% and continues to support our BUY recommendation.

52-Week Range (C$):
Avg Daily Vol (000s) :
Market Cap (C$M):
Shares Out. (M) :
Implied Return to Target (%) : Net Debt (Cash) (US$M): Long-Term Debt (US$M): Website:

1.34 - 2.42 237.2 205 91.0 55.6 (22.4) 0.0 www.tso3.com

2017E 2018E

28.2 52.6 2.2 10.9

1.8 7.2 0.02 0.08

FYE Dec

Sales (US$M)

EBITDA Adj (US$M)

Net Income (US$M)

EPS Adj&Dil (C$)

2.6 2.4 2.2

2 1.8 1.6 1.4 1.2

Source: FactSet

TSO3 specializes in the R&D of innovative, high-performance medical instrument sterilization technology with high commercial potential. TSO3 has received FDA approval for STERIZONE VP4 - its hydrogen peroxide-based single-cycle low temperature sterilizer and has signed an exclusive global distribution agreement with Getinge Infection Control.

2016E

TSO3 Inc. Company Update

VP4 sales well underway

TSO3 reports a strong beat on higher than expected VP4 shipments

TSO3 reported strong Q1/16 results that were above our estimates on higher than expected sales of VP4 units in the US. For the quarter, TS03 shipped 25 STERIZONE VP4 sterilizers versus our estimate of 15 units; an impressive feat considering no units were shipped in the prior quarter, and only seven units during all of FY2015. Revenue for the quarter came in at US$3.1 million, moderately ahead of our estimate of US$2.4 million, due to the higher than expected sales volumes.

(Note: Effective Jan 1/16, TSO3 has changed its functional and reporting currency from Canadian to US dollars. Our previous CAD estimates shown herein have been translated to USD using the average exchange rate for the quarter).

As previously disclosed, TSO3 received an order last November from its partner Getinge that would satisfy the minimum order requirements under its distribution agreement. Revenue for Q1/16 has already eclipsed total revenue recorded during FY2015, and management continues to assert that the company is in a position to assemble and deliver in excess of 100 sterilizers during 2016.

Figure 1: Q1/16 financial results vs. estimates

Q1 '16A Q1 '16E [1] Q1 '16E 2016E $000's Fiscal YE Dec/31 (USD) (USD) (CAD) (USD)
Total Revenue	$ 3,071	$ 2,375 $ 3,279 $ 14,446
Research & Development Selling, General and Admin	$ 606 $ 1,385	$ 522 $ 716 $ 2,498 $ 1,421 $ 1,950 $ 6,945
Adj. EBITDA	$ (578)	$ (651) $ (884) $ (2,245)
Adj. EBITDA Margin Depreciation & Amortization Interest expense (income) Other	nmf $ 77 $ (30) (1,588)	nmf $ 146 $ $ (22) $ $- nmf nmf 200 $ 308 (30) $ (120)
Total Expenses	$ 1,961	$ 1,921 $ 2,636 $ 9,322
EBT EBT Margin Income Taxes	$ 707 23.0% 58	$ (775) $ (1,179) $ (1,668) nmf nmf nmf --
Net Income	$ 649	$ (775) $ (1,179) $ (1,668)
Net Margin Weighted average shares o/s	nmf 91,007	nmf nmf nmf 91,000 91,000 91,000
EPS	$ 0.01	$ (0.01) $ (0.01) $ (0.02)
[1] Our previously published estimates have been converted to USD using the average USD/CAD exchange rate of 0.7288 during Q1/16.

Source: Company Reports, Canaccord Genuity estimates

For the quarter, TSO3 reported Adj. EBITDA of ($0.6) million, in line with our estimate of ($0.7) million. Although the number of VP4 units shipped was moderately higher than our estimates, the company’s financial results were slightly offset by the strengthening CAD and a lower than expected net revenue margin on sales to Getinge (relative to our estimates). We had originally assumed that TSO3 could sell its VP4 units to Getinge at 80% of the retail sales price, but have revised our estimate down to ~75% following review of the company’s Q1 revenue and unit sales volumes.

Buy Target Price C$3.50 | 5 May 2016

2

Biomedical Devices and Services 2

TSO3 Inc. Company Update

Both SG&A and R&D were in line with our estimates, which we believe will continue to see moderate increases over the next few quarters as the company continues to ramp-up its production in order to satisfy Getinge purchase orders.

TSO3 reported net income of $0.6 million, or $0.01 per share, compared to our estimate of ($0.8 million), or ($0.01) per share; however, excluding a one-time gain of $1.6 million as a result of the company converting its CAD cash into USD (in order to achieve a natural hedge with its USD operations), net-income would have been consistent with our estimate at ($0.9 million), or ($0.01) per share.

Updates to our estimates

TSO3 has previously indicated that it is in a position to deliver more than 100 VP4 units this year, without disclosing the actual minimums within the Getinge contract. We had previously updated our estimates to include 85 unit sales in 2016; however, after TSO3’s strong Q1 performance, we have revised our 2016 estimate to assume 100 units will be shipped this year.

In addition, based on $3.0 million of equipment sales on 25 units shipped during the quarter, we have also revised our forecasts to assume TSO3 sells VP4 sterilizers to Getinge for ~75% of the estimated $150,000 retail sales price. Finally, our estimates are now shown in USD in order to be consistent with how TSO3 will report its financial results going forward.

As a result, we are increasing our estimated 2016 unit sales from 85 to 100 units, which is partially offset by a decrease to our assumed net-revenue margin to Getinge. The net impact of these changes is an increase in our full-year revenue estimate from $13.2 million to $14.4 million and an increase to our full-year Adj. EBITDA forecast from ($2.4 million) to ($2.2 million). We have not made any other adjustments to forecasted unit sales beyond 2016.

Figure 2: 2016: Old vs. new estimates

Source: Company Reports, Canaccord Genuity estimates ($ in 000)

After updating our estimates for the above noted changes, our target remains at C$3.50. Our current valuation utilizes a marginally lower discount rate of 11.0% (down from 11.2%) to account for slightly lower execution risk now that sales to Getinge are officially underway....