CEMI: Record YTD Revenue, Margin Improvement Should Soon Follow

By Brian Marckx, CFA

NASDAQ:CEMI

READ THE FULL CEMI RESEARCH REPORT

Q3 2018: Record YTD revenue, margins take a hit but should begin to rebound…

Chembio (NASDAQ:CEMI) reported financial results for their third quarter ending September 30, 2018. Q3 made it three-for-three with us substantially underestimating product and total revenue every quarter so far in 2018. Product and total sales increased 28% yoy and 24% in Q3 and by 46% and 43% YTD. While it is unclear exactly what is catalyzing product revenue or where we’re missing, recently secured contracts (such as that with Bio-Manghinos) and international tenders (including the $15.8M tender from Ethiopia) are undoubtedly significant contributors to the record YTD revenue. For context of how relatively strong 2018 has been, revenue through the first nine months is greater than only three of the last the last 12 full fiscal years and is 19% higher than the prior best through Q3.

However, with a greater percentage of product sales originating from OUS, including from (typically low-margin) aid tenders, a lower proportion of revenue is flowing through to gross income. Product revenue from North America, which includes direct sales via CEMI’s sales force (and distribution partners) and which we estimate carry healthier margins (at least, in general), accounted for just 10% of the YTD total. This is down from 20% in the same period in 2017 and from 37% and 30% in fiscal 2017 and 2016, respectively.

The good news is that there are several anticipated near-term margin-related catalysts including imminent commencement of CEMI’s new automated manufacturing line, initial production in Malaysia, lower reader production costs and launch of DPP HIV-Syphilis in the U.S.


View Exhibit I

Production of the DPP tests is expected to begin on CEMI’s new automated line (in New York) in Q4’18. Meanwhile, CEMI anticipates site inspection of their Malaysian production facility in December. If all goes well, manufacturing will begin there next year and bring down production and shipping costs of certain tests sold overseas. And with the recent acquisition of OpTricon, cost of CEMI’s quantitative readers will also come down. And finally, DPP HIV-Syphilis, which we continue to believe could eventually prove to be one CEMI’s most successful products, could receive FDA approval and launch in the coming months (or even weeks). As a reminder, the PMA package seeking FDA approval was filed in in Q1’18.

Product Sales Up 28% yoy, 15% qoq
Q3 product sales were $7.9M, up 28% yoy, up 15% sequentially and 19% higher (~$1.3M) than our $6.6M estimate. Similar to the first two quarters of the year, the majority of revenue related to sales in Africa and Latin America, which accounted for 39% and 40% of product revenue, respectively.

Through the first nine months, total product revenue increased 46%, or $6.7M, while revenue from Africa and Latin America increased 279% ($5.1) and 35% ($2.4), respectively. While specific sources of product revenue were not disclosed, much of the growth in Africa is coming from the $15.8M Ethiopian tender and growth in Latin America from the recent $8.5M Bio-Manghinos (for Brazil’s Ministry of Health) order. We think this highlights what is behind product margins falling to just 14% in Q3 and to an average of 21% YTD. For comparison, product margins were 34% and 33% in the comparable prior-year periods and averaged low-to-mid 30% over the last four fiscal years. The good news, as noted, is that margins should improve.

And, with a newly-won contract from Bio-Manghinos for $10.5M (for the production of DPP® HIV and DPP® Leishmania assays), we think revenue should remain relatively elevated. In addition, ~$11.5M of the Ethiopian tender is expected to be recognized during 2019 and 2020. Other potential revenue catalysts going into 2019, in addition to U.S. DPP HIV-Syphilis, include DPP Ebola (which was recently granted U.S. Emergency Use), DPP Zika (in several areas of the world), one or more DPP Dengue assay launches (including stand-alone Dengue, Dengue/Zika/Chikungunya Authorization), a DPP fever panel and revenue via opTricon.

Additional tenders (initial UNICEF Zika could be worth up to $4.9M and CEMI recently applied for a second UNICEF RFP), increasing demand for HIV self-testing and potential meaningful contribution from collaboration agreements (such as with AZN, LumiraDx and, most recently, FIND for HCV rapid test development) could also contribute. As it relates specifically to the collaboration with AstraZenecas, a CE Mark application was filed for a (yet-to-be disclosed) POC DPP test to detect a certain biomarker (we may know more details in the coming weeks/months with CE Marking).

And while maybe not a near-term catalyst, a program that could potentially hold tremendous upside value is CEMI’s cancer diagnostic. While this has been somewhat of an ‘under-the-radar’ program (our wording and characterization) with only scant details disclosed publicly, indications are that this is progressing and with promising results. In fact, management noted on the Q2 call in August that their cancer test has completed development “with excellent analytical performance” – the test is now in the validation phase. So far, we know that it is built on the DPP platform and is a multiplex test for cancer which uses just a finger-prick worth of blood and can deliver results in 15 minutes. While we do not have nearly enough information about the test and initial results to include it in our model, given that early, accurate and non-invasive cancer diagnosis could have multi billion-dollar potential, this will be a program that we will be eager to know more about.


View Exhibit II

Total Sales Up 24%, +8% qoq
Total sales, which includes license and grant revenue, were $9.4M, up 24% yoy and 8% sequentially. Approximately $300k of the $1.3M in R&D, milestone and grant revenue in Q3 relates to the initial $5.9M BARDA Zika grant. We estimate that ~$1.7M remains under the grant, which was awarded in August 2016. As a reminder, the grant relates to the development of a DPP Zika assay and subsequent EUA, 510(k) FDA clearance and eventual CLIA waiver. To-date, the assay has received FDA EUA (as of 9/27/17), in addition to CE Mark and approval from Brazilian regulators (ANVISA). Upon successful completion of the DPP Zika grant, CEMI may be eligible to receive a follow-on $7.3M grant related to the development Zika/Dengue/Chikungunya Combination Assay (a similar assay was submitted for ANVISA approval in Q3’18).

CEMI has made very rapid progress on their $2.9M (total) product development agreement with AstraZeneca. On the Q2 call in August, management noted that assay development had completed and validation and verification was ongoing. Just three months later, the initial regulatory approval application had been made. On the Q3 call in November CEMI disclosed that an application for CE Mark had been filed and that they now have their eyes set on FDA 510(k) clearance. As CE Marking is typically a relatively expedited process, it is possible this test could be cleared for sale in Europe (and other parts of the world that accept CE Mark) by current year-end or shortly afterwards. At that point, we’ll know exactly what the biomarker is that the assay tests for – and a better idea of the potential market opportunity for the product. As we hypothesized in prior updates, while neither the assay or target application were disclosed, given a mutual relationship with Genisphere’s technology, we think it may relate to oncological companion diagnostics.


View Exhibit III

CEMI continues to draw outside interest for their expertise, technology and proven success in bringing high-potential diagnostics through the regulatory process(es) and to commercialization. The most recent collaboration came in July 2018 when CEMI announced an agreement with FIND for the potential development of a rapid HCV test (CEMI and FIND already have an ongoing collaboration for a DPP fever panel). CEMI is one of three companies that FIND chose to participate in their HCV RFP – the test selected for development will be announced in December. This could be a win for CEMI – and represent incremental revenue that otherwise may have never materialized. That’s because CEMI has had a DPP HCV program in the past – but that was essentially mothballed way back in 2011 (based on our notes, the program was halted based on questions of economic feasibility of rapid HCV testing). So, if CEMI’s DPP HCV test is chosen to move forward with FIND, it could eventually result in a new source of revenue (that may not have happened otherwise). Also, if successful, we think it might also potentially lead to development of a combination HCV test, such as HIV/HCV.

CEMI also recently penned a collaboration agreement with LumiraDx, a privately-held UK organization with a focus on diagnostics – and founded by executives from major diagnostics companies (including Alere). LumiraDx chose CEMI to help them develop POC infectious disease assays. CEMI will receive milestone-based funding and upon commercialization, will sell reagents to LumiraDx as well as receive a royalty on sales.

Given limited disclosures as to specifics of the tests under development related to these collaborations, it is difficult to handicap the probability of ‘success’ (in terms of both product development and commercialization) or potential contribution to CEMI. But, our model will be updated accordingly as CEMI provides future updates. Until then, we think investors should view these as representing option-like value – with potential upside (potentially significantly so, although tough to estimate right now) and effectively no downside. We should know fairly soon about the AZN test.

Margin
Product and gross margin were 14% and 28% in Q3, compared to 34% and 46% in the prior-year period. Through the first nine months of the year, product and gross margin were 20% and 35%, compared to 34% and 47% in the prior year. YTD product and gross margins were negatively impacted by a greater mix of sales to markets with lower selling prices – which, generally, refers to international tenders – and more specifically, likely means the Ethiopian tender was a significant contributor to depressed for the last two consecutive quarters. For context, product and gross margins over the three prior years were 37%/43% (2015), 31%/47% (2016) and 33%/46% (2017).

While we expect revenue mix (including product vs grant revenue and international, particularly EM tenders, vs U.S. sales) will continue to move margin around, some of the more significant influences may be recognition of the remainder of the Ethiopian HIV STAT-PAK tender (i.e. big, relatively low-margin) and automated and expanded manufacturing (including in NY and Malaysia-based manufacturing). We also expect the opTricon acquisition – which means CEMI now owns the proprietary quant reader – will benefit gross margins as they no longer pay mark-up on the devices. Interestingly, these readers may also generate revenue for CEMI as disclosures suggest there is an active market (beyond CEMI themselves) for these products.

As it relates automating the New York-based manufacturing, CEMI took delivery of their initial automated production line in the summer and, as of the Q3 call, expects to go live with that line before current year-end. This equipment, which will provide for the first (of an expected more to come) tranche of moving from manual to automated production, will be used for the DPP assays manufacture. Indications are that CEMI will continue to bring more of its manufacturing under automated processes – which should further reduce COGS, benefit margins and expand overall manufacturing capacity. Next-up, per comments on the call, is to automate the lateral flow products – including SureCheck, which is sold in the U.S. and Europe (the latter for self-testing) and STAT-PAK, which is sold in Africa. Management anticipates that the related equipment will be delivered in 1H’19 and, following validation, the automated lines will be up and running later that same year.

Meanwhile, CEMI anticipates site inspection of their Malaysian production facility in December. If all goes well, manufacturing will begin there next year and bring down production and shipping costs of certain tests sold overseas.


View Exhibit IV

Our Outlook
The company has been deliberate in finding ways to grow all of their product lines, diversify their revenue base and increase shots on goal. They have shown an ability to deliver on this strategy. Bringing sales functions in-house which included hiring experienced sales executives to manage the America’s and EMEA regions and recruiting international sales directors tasked with increasing sales of the company’s products in each of their respective regions (Latin America, Africa and Asia/Pacific) has paid major dividends. This deliberate move to lessen (or potentially eliminate) the company’s historic reliance on a small handful of third-party companies and governmental organizations in regulatory affairs, marketing and distribution has already been transformational.

CEMI has indicated that they will continue with what has worked – including additional layering of their US sales capabilities. MTMC could generate needle-moving contribution, particularly once DPP HIV/Syph launches. Other recent “wins” relative to regaining control of their destiny include the addition of Dr. Christine Rousseau, resurgence of U.S. lateral flow sales, OTC HIV segment growth, new Bio-Manguinhos contracts and commercialization agreements, acquiring RVR (providing direct commercial and manufacturing access to large SE Asia markets), the large Ethiopian tender, AstraZeneca development collaboration, acquiring OpTricon and more.

As it relates specifically to opTricon, the acquisition not only offers margin enhancement on the readers, but also provides a tangible European base of operations (the facility will act as CEMI’s European HQ) and offers more flexibility in product development and potentially as well in partnering and collaboration arrangements.

The outside collaborations are just the latest iteration of CEMI building their business from the inside, out. AZN was the first of what could be many deals to follow. LumiraDx came to CEMI not just for their technology but also their expertise and success in developing high-potential products and bringing them through regulatory (FDA as well as a host of other countries) and to commercialization. Expect this could be a resume builder and attract additional attention.

Revenue
We now look for 2018 revenue of $32.5M, implying growth of 36% from 2017. We have product sales growing 38%. Going into 2019, DPP HIV/Syphilis could make an initial contribution (assuming FDA approval). Africa and Asia have begun to make much significant contributions – which we think continue to grow.

Given the limited disclosures relative to AZN and LumiraDx collaborations and front-end nature of the HCV FIND agreement, it is currently difficult to handicap the probability of ‘success’ (in terms of both product development and commercialization) or potential contribution to CEMI. DPP Cancer could also hold tremendous potential but is not at a point where we think it can be reasonably modeled. We also do not yet model any assumed future outside collaborations or acquisitions. Our model will be updated accordingly as CEMI provides future updates. Until then, we think investors should view these as representing option-like value – with potential upside (potentially significantly so, although tough to estimate right now) and effectively no downside.

Valuation
OSUR trades at 4.6x consensus 2018 sales and 4.2x consensus 2019 sales. Based on our estimated CEMI 2018 revenue of $32.5M and 2019 revenue of $40.0M, CEMI is valued at approximately $9.50/share. This is adjusted downward from $13.75 – the change is a combination of contracting sales multiples, some slight downward adjustments and higher share count.

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