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Thursday, May 21, 2015

Solid First Quarter Results And Outlook From OxySure Systems

By Jason Napodano, CFA & Nisha Hirani, MD

On May 19, 2015, OxySure Systems, Inc. (OXYS) reported financial results for the first quarter of 2015. Revenues in the quarter totaled $0.62 million, which was a 75% increase from the same time period in 2014. Results were slightly above our expectations. This was the 11th consecutive quarter of year-over-year revenue growth for OxySure.

Total replacement cartridges as a percentage of the Model 615 installed base as of March 31, 2015 was 45%, up from 39% as of March 31, 2014. The fully burdened gross margin on the revenues was up approximately 4%, from 46.2% in the quarter as compared to 42.3% during the prior period in 2014. Gross profit was $0.29 million for the first quarter of 2015, an increase of 92% from $0.15 million for the first quarter of 2014.

Sales and marketing, R&D, and G&A expenses all increased substantially in the first quarter of 2015. Selling, general and administrative expenses for the first quarter were $1.3 million compared to $0.44 million for the first quarter of 2014. One of management’s goals for 2015 was to start the process of increasing awareness about the company, its products and technologies, and thus it has implemented some significant online marketing and television campaigns (note a current campaign on CNBC).

Sales and marketing expenses increased to $0.46 million during the first quarter of 2015 from $87k during the first quarter of 2014, as OxySure has significantly expanded its sales and marketing, branding, and investor relations efforts. OxySure has been doing some direct to consumer marketing of both the company and Model 615 in efforts to increase awareness and sales. Management believes that these efforts have been effective today, and the company plans to continue to spend on advertising and promotion. Other general and administrative expenses increased by approximately 80% to $0.62 million for the quarter primarily due to increases personnel costs around the company’s expanding sales staff.

OxySure spent $0.21 million on R&D efforts in the quarter, as compared to only approximately $1.5k in the first quarter of 2014, largely to support the company’s ongoing work with the U.S. military to develop a battlefield ready version of the device for U.S. Special Forces. As per management, it has made significant progress in regards to the hand held oxygen unit for military combat use and HALO jumps.

Net loss in the first quarter of 2015 was $1.34 million, or $0.05 per share, as compared to $0.38 million, or $0.01 per share, during the first quarter of 2014; however, we note a large portion of loss in the quarter was non-cash. Throughout 2014, the company paid off all outstanding capital lease obligations, making them the full owner of all equipment related to the Model 615 manufacturing and production, and the company also extinguished both its long-term debt.

OxySure exited the first quarter of 2015 with $0.1 million in cash on the books. In January 2015, the company signed an agreement toraise up to $1.575 million through private placement issuance of new equity to an existing accredited, institutional investor. Under terms of the agreement, the financing comprises three tranches of $525,000 and each tranche consists of a 525 units, with each unit consisting of one share of Series B Convertible Preferred Stock and 1,818 warrants at an exercise price of $1.20 per share. The Series B shares have a par value of $1,000 and are convertible at $0.55 per share. To close the first tranche of the financing, OxySure issued 525 units of Series B Convertible Preferred Stock. Under terms of the agreement, the investor has the option to subscribe for the second and third tranche at any time over the twelve-month period expiring December 31, 2015. The company has the right to close additional tranches if the stock trades above $1.05 per share for 10 consecutive trading days, with >25,000 VWAP, for tranche two and above $1.30 per share for 10 consecutive trading days, with >25,000 VWAP, for tranche three. The company has also received the fourth of five economic incentives in the amount of $52k from the Frisco Economic Development Corporation, and OxySure expects to receive the last incentive during the fourth quarter of 2015 to bring the total incentives up to $243k (not including landlord incentives totaling $324k).

Actual cash burn in the first quarter of 2015 was approximately $1 million, which was higher than expected. Since sales and marketing, R&D, and G&A expenses were all increased substantially in the first quarter of 2015, we believe that OxySure will need additional cash to fund its operations. We believe that as new reps are trained, they will start to generate additional revenue, which will help to offset the increased costs starting in the second quarter. Additionally, we think that potential strategy acquisitions will present an opportunity for the company to close the second and third tranche of the financing above, or enter into new financings to help fund operations to potential cash flow breakeven in the next year or two.

…Distribution Expansion Continues…

Recently, OxySure has exhibited its products at several key tradeshows, and plans to exhibit its products at several other tradeshows throughout 2015 including the National Association of School Nurses (NASN) in Philadelphia in June and the International Medical Trade Fair & Conference (FIME) in Miami in August. As per management, OxySure continues to secure marquee customers in various industries, such as Dolese; Lee Lewis Construction and Chatham Worth in the construction industry; Spectrum Resource in the agriculture industry; and Intercontinental Hong Kong in the hospitality industry.

OxySure has also made a significant effort over the past several months to expand its U.S. distribution footprint. We believe this is paramount to driving sales of the Model 615 in the coming years. After all, municipalities, office buildings, shopping centers, hospitals, or schools cannot buy the Model 615 device if they do not know about it! In this regard, we are very pleased to see the company adding both territory sales managers and inking new distribution agreements.

In terms of new personnel, the company appointed Clark Hood in September 2014 to position of Vice President, Resuscitation Sales Worldwide. Mr. Hood has over 25 years of experience in healthcare, medical devices and emergency medical equipment, and specifically in sales and sales management. Prior to joining OxySure, Mr. Hood spent over 16 years with Cardiac Science, a global medical device manufacturer of automated external defibrillation (AED) products and management services in over 100 countries. In December 2014, OxySure signed an exclusive contract with Cliff Meidl, a two-time U.S. Olympian and prolific speaker and passionate advocate for safety, CPR, emergency preparedness, and leadership topics in the safety industry. Mr. Meidl will become a spokesperson for the Model 615 device and help market and promote the product throughout his various endeavors in 2015, which in the past included appearances on Oprah and NBC’s “Today Show”, as well as at various medical conferences including the American Heart Association annual meeting.

In January 2015, the company announced several new staff additions. Key hires included Kathryn Jayne to the position of Director, Regulatory Affairs & Quality Assurance, Richard Bryant to the position of Manufacturing Manager, and Richard Marcus to the position of Engineer, Innovation Solutions Group. The company also made several new staff additions to the U.S. sales force, including hiring new territory sales managers in Chicago, IL, Phoenix, AZ, Atlanta, GA, Pittsburg, PA, Michigan, Colorado, and the Dallas-Fort Worth, TX region. The new reps are coming in with significant commercial sales experience in the emergency medicine and/or the healthcare industry. We are anticipating a significant ramp in direct sales by the company in 2015 thanks to the expanded promotion effort. The company’s goal is to have 30 full-time and/or independent representatives in place by the end of 2015, and currently has six in place.

OxySure currently is looking at over a dozen potential cities and major metropolitan areas to join the company, and these include cities in Florida, California, Missouri, Minnesota, as well as other areas in Texas, and along the East Coast. The most recent class of territory managers completed training in April 2015 and should start contributing to second quarter sales. The next class of reps is scheduled for early June 2015 training. We think it is realistic that each of these representatives can generate up to $500,000 in revenues for the company per annum, but we don’t expect these reps to be at that run rate immediately, instead it will take at least 3 to 6 months to ramp up to this, and the $500,000 per annum will be achieved over time. OxySure has also implemented a new customer relationship management (CRM) software platform for its sales team to utilize.

Besides hiring internal sales representatives and territory managers, OxySure is inking new distribution agreements all over the U.S. In December 2014, the company signed a distribution agreement with Cardiac Life, a Rochester, NY distributor of AEDs. Management at OxySure believes that Cardiac Life gives the company strong representation in the northeast. By adding OxySure to its product portfolio, Cardiac Life can now offer a unique and proprietary resuscitation product to their existing and new customers. In January 2015, the company inked a deal with Cardio Partner Resources, an Illinois-based distributor of AED’s and other medical devices throughout the Midwest.

The company signed two more distribution agreements in February 2015. The first was with Chris Gardner and Associates, a Connecticut-based authorized distributor of automated external defibrillators (AEDs) for companies such as Cardiac Science, HeartSine, Philips Medical, Physio-Control, and Zoll. The company is headed up by Chris Gardner, a former EMT and EMS Instructor and American Heart Association BLS (Basic Life Support) Instructor. OxySure’s Model 615 will fit in nicely with the company’s current suite of AED products and gives OxySure its first distribution agreement for the Northeast. Later in February, OxySure signed an agreement with Stop Heart Attack, an Alabama-based distributor of AEDs and other emergency response products. The deal gives OxySure its first key distribution agreement for the Southeast.

In March 2015, OxySure signed its first distribution agreement in California, with Menlo Park-based Health Education Services. Health Education Services (HES), founded in 1979, focuses on turn-key implementation of Philips automated external defibrillator (AED) programs as well improving safety, health, and quality of life by providing services, classes, and consulting for medical practitioners as well as the general community. Founder & Managing Partner, Julianne Brawner, brings over 18 years of AED experience to the table.

Oxysure signed a distribution agreement with New Jersey Team Lifein April 2015, which has three locations throughout the state. OxySure’s Model 615 is a great compliment to Team Life’s existing AED installed base. TEAM LIFE has emergency health and safety training experience in the United States as well throughout the world, and offers hundreds of training courses per year. The TEAM LIFE sales division distributes CARDIAC SCIENCE brand AEDs, first aid kits, emergency medical equipment, and teaching supplies for CPR classes. Jim Schatzle, Founder & President, has over 30 years of experience in the Emergency Medical Services as an EMT, Firefighter, and Paramedic.

International expansion remains a primary focus for OxySure. For instance, in the U.S., an individual suffering a medical emergency can generally expect first responders to arrive within 5-15 minutes of the initial call for help. However, in some areas overseas, it may take upwards of 45 minutes to 1 hour before first responders are able to arrive due to insufficient infrastructure or poor traffic conditions. Thus, the value proposition offered by the Model 615 product is likely to resonate even more with individuals in certain overseas communities.

The company recently expanded its distribution footprint into Chile,Hong Kong and Macau, and Singapore. The order from Pacific Medical Systems, Ltd for Hong Kong and Macau, for example, came with a minimum commitment of 11,800 units over the first three years. These deals typically also include ancillary orders of other OxySure products like the wall mounts, travel bags, and replacement cartridges and masks. The deal with HTM Medico Pte Ltd in Singapore requires an annual minimum purchase commitment of 1,250 units of Model 615, valuing the contract at $1.3 million in the first 5 years. We remind investors that in September 2014, the company signed a $2.46 million, 3-year, 18,000 minimum unit contract with Ajad Medical to be the company’s exclusive distributor in Saudi Arabia. We continue to believe there is potential for rapid uptake in overseas markets.

On April 2, 2014, OxySure announced CE Mark approval in Europe for the Model 615 device. We expect that management will begin to roll-out the device to the thirteen EEA member states throughout 2015. As OxySure signs new exclusive agreements for large countries like Germany, France, and Italy, these minimum orders will be significant revenues to OxySure. Above we noted the size and terms of the distribution agreement in Saudi Arabia, a country with a population of around 30 million. Italy, for example, has a population twice that size. The population of Germany (~81 million) is ten-times that of Hong Kong and Macau (~8 million). The population of France (~66 million) is ten-times that of Singapore (~6 million). It is for this reason that we believe international Model 615 sales could skyrocket in the coming years. A minimum commitment from a distributor in Germany alone could be north of $1 million in upfront revenues to OxySure. Oxysure is also in discussions with other distributors in South Korea, Singapore, as well as Latin America. As per management, the plan is to negotiate an exclusive with an overseas distributor in exchange for a minimum sales commitment (usually two to three years out).

Attractive Valuation

OxySure believes it can double its sales in 2015 through signing new distribution agreements in emerging markets, launching the product around Europe, and continuing to focus on “at risk” and “established” markets in the United States. For 2015, we do not quite model a double from 2014 revenues. Instead, we are conservatively modeling revenues up 61% to $3.9 million. However, we note that our model for 2015 and beyond is expected to change dramatically as the company expands its distribution by making strategy acquisitions. For example, we would not be surprised to see the Estill Medical merger back on the table at some point in 2015. We also see several other markets, including wound care, diagnostics, and respiratory emergency products fitting nicely into the company’s platform. Management expects to add new products to its catalog during 2015, with an emphasis on products that compliment the existing portfolio that currently target the following responder and pre-responder markets: emergency; resuscitation; trauma; short-duration oxygen market; and the pre-hospital medical emergency market. As per management, OxySure will be announcing a new add-on product in the next couple of weeks as well as an announcement in the near term regarding OxySure’s participation in a “major global act.” We look forward to hearing the news and learning more about what the near future holds for OxySure.

We think OxySure can eventually get total revenues to the $10 million mark in a few years through a combination of organic growth and M&A activities. The current market capitalization is only $19 million, meaning OxySure is trading at roughly 4.8 times our projected 2015 revenues. By 2016, with an estimated $5.5 million in revenues, we believe OxySure can post breakeven operations. Our target is $1.75 per share, which is a market capitalization of $50 million. Given our projected 61% revenue growth for 2015, we believe this is a fair target.

Tuesday, May 19, 2015

Vericel Is Too Cheap To Ignore

By Jason Napodano, CFA

On May 14, 2015, Vericel Corporation (VCEL) reported financial results for the first quarter ending March 31, 2015. This was the third full quarter of operations for the company's recently acquired Cell Therapy & Regenerative Medicine ("CTRM") business.

Revenues: Total revenues for the quarter were approximately $10.8 million, and were comprised of approximately $7.1 million of net sales of Carticel® implants and surgical kits, $3.6 million of net sales of Epicel® grafts and biopsy kits, and $0.1 million in sales from Marrow Donation, LLC. Although the company did not own these products for the first quarter 2014, management noted that the year-over-year growth of both Carticel and Epicel was approximately 4%. Revenues came in slightly below our expectations, as we expected total revenues of $11.2 million (consensus was $11.1 million), based on $8.3 million in Carticel sales and $2.8 million in Epicel sales.

Management did not provide guidance for 2015 on the earnings call. Instead, management chose to provide revenue breakdown percentages by quarter for the last several years. This was no doubt done because both Carticel and Epicel have some seasonality to them and management did not want to let the sequential drop in Carticel sales in the first quarter 2015 from the very strong fourth quarter 2014 spook investors.

For example, Carticel, an elective surgery product, has historically seen strong uptake at the end of the year when insurance deductibles have likely been met and yearly flex spending accounts need to be used up before they expire. Over the past several years, one-third of Carticel sales typically are generated in the fourth quarter. The first and third quarters of the year are the weakest, with sales accounting for around 21-22% of the total year for each quarter. Epicel sales are strongest over the winter months due to the use of things like electric blankets, space heaters, and fireplaces / wood-burning ovens. Management noted that roughly 56% of Epicel sales are generated in the first and fourth quarters of the year, split equally between the two quarters, with the third quarter being the weakest at only 20% of the total year.


We have made some adjustments to our model based on the results from the first quarter and updated seasonality guidance. Importantly, despite seasonality, management believes they can achieve year-over-year sales growth in both Carticel and Epicel throughout 2015. We think the 4% growth seen with Carticel is a good baseline for the upcoming quarters. As such, for 2015, we see Carticel sales ramping slowly throughout the year, posting total sales of $34.9 million. We have accounted for the seasonality and slower summer months in our model, which results in a sequential decline between the second and third quarter 2015, and model the fourth quarter 2015 to be up just over 4% from the very strong fourth quarter 2014.

With Carticel, management is undertaking the following initiatives to drive growth:

- Firstly, the company has greatly increased its promotional efforts around the product, and even implemented a peer-to-peer marketing program that kicked off in April 2015. This was a web-based national meeting with approximately 500 orthopedic surgeons and clinical support staff. According to management, the program was very well received and created a renewed interest in the product. We expect this program to continue in 2015, as well as expand to training sessions where experienced Carticel surgeons and assist their fellow physicians in gaining comfort with the product. Within the orthopedic segment, Vericel is focusing on military surgeons with Carticel. This makes sense to us, as the ideal Carticel candidate is a younger and more active patient. Management's goal is to reach a total of 1,000 healthcare providers in the coming quarters.
- The second key initiative is adding to the Carticel sales force. For example, for the first time since Vericel acquired CTRM, all 21 sales territories for Carticel are now filled. Management even commented on the first quarter call that additional sales territories will be added in 2015 based on area profitability.
- Beyond marketing and promotional programs to drive unit growth, management is also looking at the opportunity to continue to raise the Carticel price, as well as make process improvements on the manufacturing progress and order flow. On the pricing front, Vericel raised the price of Carticel by 7% in January 2015. We discuss the process improvements in greater detail below when we analyze the gross margin line.


With Epicel, the story is similar, with growth coming from increased promotional efforts, an increased sales force, increasing volume, and expanding the patient population through an HDE amendment.

- In terms of the increased promotional effort, Vericel has increased the number of Epicel sales staff to four sales representatives. We remind investors that under Sanofi-US, Epicel was being promoted by only one sales representative. That's right - one! Vericel increased that number to three in 2014, and now has increased it to four as of May 2015, with plans to add more reps in 2015 as the product grows. There are approximately 120 major burn centers in the U.S. were a product like Epicel is used. Almost 50% of Epicel use comes from only a handful of these centers. Each year there are between 2,000 and 2,500 patients that might qualify for the product. Current penetration of Epicel is only around 6%, so if management can drive uptake and awareness with a new promotional campaign we think the return on investment will be quite handsome.

- The call detail with Epicel is interesting. Management is targeting centers that have previously used Epicel, between 2010 and 2013, but did not use the product - for whatever reason - in 2014. Vericel is going back to these centers and re-introducing the product. The barrier to use is low because the surgeons likely already have experience with the product, and thus management considers this "low hanging fruit" with respect to driving uptake. In time, once this segment has been effectively targeted, management will start promoting Epicel to surgeons at centers that have never used the product before.

- The final aspect of the Epicel growth plan is to expand the product label to include pediatric patients. The current label includes only adult use, even though Epicel has significant pediatric use since approved in 2007. In fact, management noted that around one-third of Epicel commercial use is in patients less than 21 years old, and about 30-40% of the historic clinical data are in pediatric patients. The reason Vericel wants to expand the label to include pediatric patients is because Epicel is a product marketed under a Humanitarian Device Exemption (HDE). Previously, the U.S. FDA placed profit restrictions on products under a Humanitarian Use Device (HUD), limiting the profits that can be obtained through commercial sale by selling the price roughly equal to the cost to produce. That is not the case anymore. Vericel only needs to collect and package existing data on the use of Epicel in a pediatric population and present the application to the FDA for review via an HDE supplement. Management has already submitted a pre-meeting briefing package to the FDA. After that meeting, assuming positive outcome, Vericel will file an amendment to the HDE to request a waiver of the profit restriction clause. Turnaround on that submission is 75 days. If all goes well, the price of Epicel (and profits from the product sales) will be going up by the end of the year.

In terms of Epicel sales, for 2015 we think Vericel will see significant year-over-year growth acceleration for the product. Even with seasonality baked into our forecast, we see Epicel doing $13.4 million in sales in 2015, growing to $17.5 million in 2017. We believe our 2017 estimate can be easily beat if the pediatric amendment to the HDE is approved by the FDA.

Gross margin: Gross margin was 48.1% in the first quarter 2015. This was below the fourth quarter 2014, seasonally the strongest quarter, but still up nicely from the 42.7% in the third quarter and the -13.0% margin in the second quarter. Expansion of the gross margin is a key metric in helping Vericel achieve profitability for the newly acquired CTRM business. As we've noted in previous reports, the CTRM business was under-managed and neglected at Sanofi-US, rolled up within a significantly larger organization. Costs were high, efficiency was low; there was no P&L oversight. The first thing that management did to improve the gross margin, specifically with respect to Carticel, was to change the compensation package for the sales force to remove the incentive to have a biopsy done when it is unlikely it will lead to an implant.

For example, approximately 1,000 orthopedic surgeons performed biopsies for Carticel in 2013; however, only 422 surgeons actually implanted the product. That means 60% of the time Sanofi booked cost with no revenue offset. For instance, when the surgeon takes the biopsy the cells are sent to the Cambridge facility where they are expanded. They are then cryopreserved while the company waits for the Carticel order. No order means the company experienced wasted cost. Management tells us approximately 50% of the total cost of goods on Carticel is the first-pass expansion process on the cells.

We believe the low implant-to-biopsy ratio was due to two reasons: poor incentivizing and lack of understanding from the surgeon on the ideal Carticel candidate. Both of these fall on the sales reps. Specifically, Sanofi was incentivizing sales reps on biopsies instead of implants. Vericel management recently put an end to that practice.

Now, sales reps will be incentivized on implants, which makes sense because this is when the company actually books revenue. Physicians will also be educated on the ideal Carticel patient so that biopsies are only taken if there is a strong intent that it will result in an implant. On the fourth quarter conference call management noted that the implant-to-biopsy ratio improved to 38% in the fourth quarter 2014, up from 34% when Vericel acquired the business from Sanofi-US. This number was not given (we asked) first quarter, management only commented that they are "on track" with maintaining the improvements noted last year.

Back at the manufacturing facility, cells will be cryopreserved before first-pass expansion, pulling out significant cost of waste from the process if an implant is never ordered. As noted above, we believe Carticel was a neglected asset at Sanofi. They obviously never did this sort of process optimization. The changes that Vericel management has made to the Carticel process, from point of sale to manufacturing, should lead to dramatic margin improvement throughout 2015. That means a business that was already throwing off cash at the end of 2014 will start throwing off more cash in 2015. Ultimately, we believe gross margin approach 60%. Raising the price of both products, Carticel based on demand and Epicel based on the amended label, will certainly help, but the added benefits of increased scale and reducing waste will really drive home operating margin expansion in our view.

Net Loss / Income: Operating loss in the first quarter totaled $4.6 million, driven by $4.4 million in R&D and $5.5 million in SG&A. R&D expense should begin to decline in the coming quarter as the Phase 2b ixCELL-DCM study with ixmyelocel-T completed enrollment in January 2015. Ultimately, we think R&D costs may have peaked last quarter because the ixCELL-DCM study will offer data in the first quarter of 2016. If the data are strong, we expect Vericel to seek a licensing agreement with a larger organization that will likely handle the cost Phase 3 trial and commercialization of the product. If the data are not good, we expect management at Vericel to kill the product. Either way, R&D for 2016 will go down. As far as SG&A, management is making hires to expand the sales force for both Carticel and Epicel. As a result, costs are going up. However, management noted that new sales reps and expanding the promotional effort will only be undertaken on a profitable nature, so we think the SG&A run-rate for the first quarter 2015 is a good basis for what to expect the remainder of the year, and we still think the entire company can approach operating cash flow breakeven levels in 2016.

Net loss for the first quarter 2015 was $4.9 million, or $0.20 per share. As noted above, we believe 2015 will be the last year of sizable R&D expense at Vericel. It is possible that the company will need to conduct another Phase 3 trial in the U.S. with MACI in 2016, but the cost of this program will be far less than the Phase 2b ixCELL-DCM or Phase 3 REVIVE-CLI studies that the old Aastrom initiated. It is clear to us that Vericel is keenly focused on the CTRM business and driving the company to profitability with its existing resources.

Cash & Profits: As of December 31, 2014, Vericel Corp. reported cash and investments of approximately $25.9 million. Operating and investing burn for the first quarter 2015 was $4.5 million. We remind investors that the company raised gross proceeds of approximately $40.3 million in September 2014 through a public offering of common stock. On the company's fourth quarter call, management stated that they expect to be able to achieve cash flow positive operations with the existing cash balance. Based on our financial model, which forecasts cash flow positive operations around the middle of 2016, we believe the stated goal is achievable with still an estimated $12+ million in cash on hand.

As noted above, the company's goal is to report data from the Phase 2b ixCELL-DCM study in the first quarter 2016. If the data are positive, we believe the company will move quickly to secure a development and commercialization partnership for the drug. This will likely come with a sizable upfront payment, meaningful potential development, regulatory, and commercialization milestones, and royalties on product sales. This could be a potential game-changer for Vericel, as an influx of non-dilutive cash in 2016, coupled with the existing commercial business turning cash flow positive, will allow management to enter into additional M&A or licensing transactions to significantly expand the commercial business in 2017 and beyond. A failure of the Phase 2b ixCELL-DCM study means the R&D line drops likely greater than 50% next year and the commercial operation has 100% of management's attention going forward. We see the outcome of this trial as a win / no big deal type event.

The Pipeline: MACI™ (matrix-induced autologous chondrocyte implant) is a third-generation autologous chondrocyte implant product currently marketed for the treatment of focal chondral cartilage defects in the knee in the European Union since 1998. According to Vericel, the advantage of MACI™ is that it delivers the efficacy of Carticel®, with a dramatic improvement in ease of use for the physician and a reduced rehabilitation protocol for the patient. The implant procedure for MACI™ is much less invasive and thus results in a meaningful reduction in the post-operative recovery time for the patient. Specifically, the implant procedure involves only a mini-arthrotomy or arthroscopic delivery, eliminating the need for a periosteum harvest and sutures.

Management's goal is to bring MACI to the market in the U.S., as well as reintroduce the product in Europe. To us, MACI™ looks like represents a potential replacement product for Carticel® as well as an opportunity to expand the market for autologous cartilage repair products. Currently, Vericel has halted sales of MACI™ in Europe, and the company has a three year window in which to reintroduce the product without having to file for a new application. There are reimbursement challenges in Europe; however, the company believes that there are a number of countries where the product has great potential and thus they will continue to investigate the best path forward in that regard.

As far as gaining approval for MACI™ in the U.S., the company is continuing to engage with the FDA to determine the path forward. Management is not certain whether the study that got MACI™ approved in Europe is going to be sufficient to gain approval in the U.S. However, if another study is required, it is likely to be a smaller confirmatory study. With that said, nothing will be known for sure until Vericel has a chance to sit down with the FDA and determine the steps necessary to get MACI™ approved. This is scheduled to happen in the second quarter 2015.

The opportunity for MACI™ in the U.S., where reimbursement procedures are already in place, is significant. MACI™ looks like a superior version of Carticel®, a product doing $40+ million in revenues for the company right now. Based on the product characteristics, we believe MACI™ could effectively double the revenue opportunity. For example, in September 2014, Vericel presented three year data from the SUMMIT Extension Study of MACI™ at the 2015 American Academy of Orthopedic Surgeons annual meeting. Two-year results from the initial Phase 3, randomized, controlled SUMMIT trial demonstrated that patients with symptomatic articular cartilage defects of the knee who were treated with MACI™ showed greater improvement over baseline compared to patients treated with microfracture (Saris D, et al. Am J Sports Med. 2014). There are some 80,000 microfracture procedures in the U.S. each year. We believe MACI™ has improved economics to Vericel as well, which should allow for greater profitability as sales ramp.

With ixmyelocel-T, the Phase 2b ixCELL-DCM program continues on plan. Full enrollment was announced in January 2015. Enrollment took place at 30+ centers. It is clear to us based on the data Vericel has generated to date that ixmyelocel-T has utility in ischemic DCM. Management was clearly excited about the potential for the drug given the large market opportunity, with an estimated 170,000 patients seeking treatment, and "sweet-spot" focus for ixmyelocel-T positioned as an alternative to LVAD or heart transplantation. Assuming enrollment is completed very soon, we expect top-line data from ixCELL-DCM in the first quarter 2016.

Assuming this data are positive, we believe Vericel will be able to partner the drug for a Phase 3 trial to start in 2016. We believe the Phase 3 trial will take a similar two years to enroll and report data, putting the potential NDA in 2018 and approval in 2019. Approximately 0.6% of the U.S. adult population is classified NYHA Class III/IV. Approximately 15% of these patients have DCM and approximately 60% are considered ischemic in nature (source: American Heart Association). This equates to a target patient population of around 170,000, consistent with the graphic shown above.

If we model 5% peak market penetration in 2024, with ixmyelocel-T priced at $75,000 per course of treatment, this equates to peak U.S. sales of $600 million. We believe sales outside the U.S. will total $400 million, bringing peak worldwide sales of ixmyelocel-T in DCM to $1.0 billion. Given the suspected commercialization price for DCM around $75,000 per treatment, a bargain compared to the$150,000+ for implantation of an LVAD, ixmyelocel-T will carry greater than 90% gross margin once commercialized. That's the beauty of having an orphan drug designation. Those impressive economics are sure to attract a pharmaceutical partner, someone with an acute interest in interventional cardiology, if the data are good.

We believe Vericel can partner for this indication for $25 to $50 million upfront, $100+ million regulatory, and $250+ million in backend milestones, plus a handsome double-digit royalty on sales. We apply a 25% discount rate and 20% probability of success to arrive at a current NPV for the program of around $35 million. Should the program fail, we believe Vericel will kill ixmyelocel-T altogether. This mean, as noted above, regardless of success of failure, Vericel should be done spending significant R&D dollars are ixmyelocel-T in 2016.

Valuation: We continue to believe that Vericel Corp. is being under-valued by the market. Above we've outlined why we think ixmyelocel-T, even with only a 20% chance at success in the current Phase 2b study, is worth $35 million in value. That's $1.20 per share. We have done a similar kind of analysis with MACI, essentially believing the product is a more desirable, larger, and more profitable version of the Carticel product that is currently on the market and expected to generate sales in 2015 of roughly $30 million. If Carticel peak sales are $45-50 million in the U.S., then MACI peak sales are likely $75-100 million. At this time we do not yet know if another Phase 3 trial is necessary, but even if Vericel does have to conduct a U.S. Phase 3 program with the product, we still think MACI has a NPV of $20 million, or $0.80 per share.

The remaining valuation comes from the existing commercial business, which we believe is worth another $100 million in value, or $4.00 per share. We arrive at this number by applying a combination of valuation multiples to our projected 2015 numbers. For example, our value for the commercial business equates to only 2x projected sales, well below the industry average 4-5x.

Vericel's current market capitalization is around $76 million. If we sum-up our valuation of $100 million for CTRM, $30 million for ixmyelocel-T, $20 million for MACI, we arrive at a target valuation of $150 million, or $6.00 per share. And we note this number does not include the $25.9 million in cash as of March 31, 2015. As a result, we would be buyers of the stock at today's price.

Income Statement:

Monday, May 18, 2015

Phase 3 Septic Shock Trial Continues At Spectral Medical

By Jason Napodano, CFA & David Bautz, PhD

Financial Update

On May 13, 2015, Spectral Medical, Inc. (TSX: EDT) announced financial results for the first quarter of 2015. All numbers are in Canadian dollars. The company reported $0.9 million in revenue for the quarter, which was in-line with our estimates. Spectral derives income from the sale of proprietary reagents (monoclonal antibodies, recombinant proteins, and calibrators), the Endotoxin Activity Assay (EAA™), and royalty revenues from license arrangements based on a percentage of end user sales of Troponin I. Net loss for the quarter was $2.3 million, or $0.01 per share, and consisted of $3.1 million in operating expenses. This compares to $4.0 million in operating expenses for the first quarter of 2014, with the decrease due almost entirely to fewer new sites being initiated in the EUPHRATES trial.

The company exited the first quarter of 2015 with $7.1 million in cash and cash equivalents. Subsequent to the end of the quarter, Spectral closed the “Tranche B” component of the private placement that was entered into in June 2014. The “Tranche A” component was completed in July 2014, and raised the company $13.2 million from the sale of approximately 45.1 million shares of the company for $0.293 per share. The shares were sold as follows: A) 17,064,846 shares, for aggregate proceeds of $5.0 million, were sold to Toray Industries; (b) 15,358,360 shares, for aggregate gross proceeds of $4.5 million were sold to Birch Hill Equity Partners Management Inc.; (c) 9,726,958 shares for aggregate proceeds of $2.85, were sold to other investors; (d) 2,901,022 shares, for aggregate proceeds of $0.85 million were sold to other related parties. The “Tranche B” component was comprised of additional shares to be sold to Toray, thus on April 1, 2015 Toray purchased approximately 9.0 million shares for $0.553 per share for aggregate net proceeds of $5.0 million. The same day, Birch Hill acquired approximately 2.0 million shares for $0.553 per share for aggregate gross proceeds of $1.1 million. The “Tranche B” transactions brought the company’s cash total to approximately $13.2 million. Following the private placement, Toray and Birch Hill now own approximately 22.4% and 17.3% of the company, respectively.

Business Update

Spectral is developing the Toraymyxin column for the treatment of severe sepsis. The Toraymyxin column is a polymyxin B loaded absorption column designed to reduce blood endotoxin levels in sepsis patients. Polymyxin B is an antibiotic with very high affinity for endotoxin, a component of the outer membrane of Gram-negative bacteria that is the most potent initiator of the septic response. The Toraymyxin column is approved in both Japan and Europe and has been used to safely treat over 100,000 patients.

The company trades on the Toronto stock exchange (TSX) under the ticker symbol EDT.TO, and on the U.S. OTC market under EDTXF. We initiated coverage of Spectral Medical in January 2015 (see FULL REPORT) with a Hold rating and a $0.75 price target. We have since revised that target to $1.00 per share based on a favorable update from an independent Data Safety and Monitoring Board (DSMB) on the ongoing Phase 3 EUPHRATES clinical trial and the recent securing of additional cash at favorable terms to the company.

...EUPHRATES Continues On Plan…

Spectral initiated the EUPHRATES Phase 3 clinical trial in June 2010 and had 15 sites up and running by the end of 2012. There are currently 50 hospitals eligible to enroll patients in the study throughout Canada and the U.S., thus it could be argued that the trial is taking a very long time to fully enroll. That being said, investors should keep in mind that it is quite difficult to identify septic patients who fit all the inclusion/exclusion criteria. The EUPHRATES trial is screening approximately 125 patients per week, with most patients not qualifying due to not meeting the vasopressor requirements, not having a MODS score > 9, or not having an elevated EAA score. For comparison’s sake, the PROWESS-SHOCK trial that evaluated Eli Lilly’s Xigris® was performed from 2008-2011 in 208 hospitals and screened 27,816 patients in order to enroll 1,697 (6.1% enroll-to-screen rate).

The primary outcome of the EUPHRATES trial is now 28-day all-cause mortality in patients that are in severe septic shock with EAA > 0.6 and a MODS score of > 9. As before, patients must also have at least one organ dysfunction. Since the implementation of the new exclusion criteria (MODS score ≤ 9), the composite mortality rate of the enrolled patients has increased significantly, indicative of the fact that those patients most likely to benefit from treatment with the Toraymyxin column are being properly identified and randomized into the trial.

As of May 12, 2015, 82 patients have been randomized into the trial according to the revised protocol in April 2014. The pace of enrollment is now approximately one patient every 4.2 days. The screen to enroll rate is ~1.35%.

Spectral released some very good news earlier in March 2015 when an independent Data Safety and Monitoring Board (DSMB) recommended the Phase 3 EUPHRATES clinical trial continue on as planned. The DSMB also agreed that an interim analysis be performed on the patients randomized since the last protocol amendment to include EAA > 0.6 and a MODS score of > 9. Spectral management plans to perform that analysis on these amended protocol patients enrolled through the end of the third quarter 2014. Based on the current calculated enrollment rate of one patient every 4.2 days, we estimate that approximately 116 patients will be included in this interim analysis and that it will be completed by the end of 2015.

…Handicapping the Interim Analysis...

Previously, we had conservatively estimated a 50% mortality rate for placebo treated patients and performed a power analysis based on a final enrollment of 110 patients for the interim analysis. That analysis led us to believe that there would only be a 40% probability of success for the interim analysis based on mortality rates of 50% and a 37.5% in the placebo and treated cohorts, respectively. The 12.5% absolute risk reduction was based on a Japanese study of the Toraymyxin column where the mortality rates for column-treated and placebo groups were 34.5% and 47%, respectively (Iwagami et al., 2014).

Having previously presented our conservative scenario analysis, below we present an additional, less conservative estimation of the mortality rate for the control group of patients and the likelihood of success at the interim analysis in the fourth quarter of 2015. The following references lend some support to a higher mortality rate for patients with a MOD score > 9:

 - Marshall et al., 1995: This paper originally described the MODS score and found the following correlations with intensive care unit (ICU) and hospital mortality.

Hebert et al., 1993: This study examined organ failure on day 1 of admittance to the ICU for 154 consecutive patients with sepsis syndrome. The results showed 30-day mortality of 20% in patients with less than 3 organ system failures and 70% in patients with 3 or more organ system failures.

Marshall, 2001: The number of failing organ systems is correlated to mortality for patients in the ICU as follows:

Averaging the mortality rates together for patients with MOD scores from 9-20 (we have decided to exclude patients with a MOD score >20 as they are unlikely to have mean arterial pressure of >65mm Hg, which is an exclusion criteria for the trial) for both the ICU and hospital gives a composite mortality of 59%. We also estimate that patients entering the trial would average 3 failing organ systems, which gives an average mortality rate of 60%.

In order for the interim analysis to result in stopping the trial, a different statistical threshold must be achieved due to the effect of repeated significance tests on accumulating data (Armitage et al., 1969). The O’Brien-Fleming approach (O’Brien et al., 1979) is typically used for interim analyses, as it allows for the final significance level to be near the overall significance level. For example, if Spectral used a significance level of 0.005 at the interim analysis that would result in a significance level at the final analysis of 0.048, which is quite close to the 0.05 value required to show significance.

Using a 60% mortality rate for the control group, a total of 116 patients randomized 1:1, and an alpha level of 0.005, a power analysis reveals the following (all calculations performed with G*Power

1) A 28% mortality rate for the toraymyxin-treated group would give 80% power to the study. This would imply a composite mortality rate of 44% for all patients in the study, a 32% absolute risk reduction in mortality, and a 53% relative risk reduction in mortality. We consider this a very aggressive assumption.

2) A 40% mortality rate for the toraymyxin-treated group (representing a 20% absolute risk reduction and 33% relative risk reduction) would make the trial 30% powered, and imply a composite mortality rate of around 50% for all patients in the study. We consider this to be a far more realistic assumption.

Even with our “far more realistic” assumption for the control group, we feel it would be highly unlikely for the trial to be stopped early during the interim analysis given the current rate of patient enrollment into the trial as the difference in mortality rates necessary for stopping the trial is quite large. The graph below shows the statistical power assumptions for the following variables: placebo = 60%, column = 40%, p<0.005.

As investors can see, with around 116 patients, the trial is only 30% powered to succeed. However, when we adjust the assumptions to assume enrollment of 175 patients (which should take place mid 2016) and a p<0.048, we see that the statistical power is now ~ 80%.

Nevertheless, the company has already undertaken steps to beginning the U.S. PMA submission process and expects to file the first parts of the modular submission during May 2015. The company is also working on a new stand along pump designed to be used in the intensive care unit under the direction of the intensive care doctor and nurse. Management demonstrated a prototype version of the new standalone pump at the CRRT conference in San Diego in mid-February 2015. A 510K submission is targeted by the end of the first half of 2015.

…But Long-Term We Like the Concept…

Regardless of when it happens with the interim analysis, we believe the company has the right strategy with EUPHRATES given the amended protocol and previous clinical data supporting safety and efficacy of the Toraymyxin column. We are more confident in the outcome of a fully-enrolled trial, which we estimate would be approximately 175 patients with estimated mortality rates of 60% and 40% for control and treated groups, respectively. Under this scenario, we believe the trial would be fully enrolled in mid-2016 with data expected in late 2016. We continue to believe that a positive outcome to the EUPHRATES trial would cause a significant revaluation of the shares, as there are no FDA approved treatment options for sepsis and the sepsis market in the U.S. is a greater than $3 billion opportunity.

We feel that there will be ample opportunity for investors to take a position in Spectral during the year as more information is gathered in regards to the EUPHRATES trial. We recommend that investors get familiar with the Spectral story, and follow the updates when the interim analysis is performed later this year. Being familiar with the Spectral story will allow investors to invest astutely on the results of the interim analysis. If the results show that the trial did not reach necessary statistical separation with 116 patients (or however many are enrolled by the end of the third quarter), the shares may sell-off. However, because this is what we expect we would use this as a buying opportunity to invest in the name ahead of the full analysis in late 2016. On the contrary, if the interim analysis does show statistical separation in favor of the Toraymyxin column, we believe the shares are headed for a major revaluation – potentially in the order of ten-fold, and investors should immediately buy the news in anticipation of a significant run in the shares.

Valuing Spectral Medical

We are currently taking a conservative approach and modeling for the EUPHRATES trial to conclude in mid-2016. This timeframe is certainly subject to change; particularly if the interim analysis reveals more information about when the trial is likely to conclude. We understand our model is different from what Spectral management is currently guiding, as the current guidance is indicating that the Toraymyxin column could be approved as early as the first half of 2016. Instead, we model for the Toraymyxin column to be approved in 2017 and launched in 2018.

We forecast that each treatment will cost $21,000 ($10,000/column x 2 columns per patient + $200/EAA test x 5 EAA tests per patient). As of now, we are projecting peak market share of 25% in a target population of 175,000 septic patients per year to occur in 2024, with corresponding peak revenues of $1.2 billion. Given the limited treatment options available for sepsis patients and the lack of many viable sepsis treatments in late stage development, we feel that this is a fully realizable potential. However, based on our uncertainty surrounding whether the EUPHRATES results will be positive, coupled with the uncertainty regarding the timeline for the trial, we are utilizing a large discount rate and probability adjustment to derive a net present value for the company.

We assign a 25% discount rate to account for the uncertainties we have discussed, we forecast free cash flow to be 60% of gross revenues, and we assign a 50% probability of the EUPHRATES trial being successful. This gives us a net present value for the company of approximately $198 million. Spectral currently has a fully diluted share count of 197.7 million shares, which leads to a fair value of approximately $1.00 per share. Risk and visibility keep us at a ‘Hold’ rating, both of which are clearly “fixable” as the story progresses and more information is released later in 2015.

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