SCIE: Q2 Results – Initial Revenue From Pentax! (SCIE)

SCIE: Q2 Results – Initial Revenue From Pentax!

Brian Marckx, CFA

Q2 Results

SpectraScience (SCIE) filed their 10-Q for the second quarter ending 6/30/2012 on August 14th. Revenue came in at the $310k level that management guided to in early July and represented initial orders under the distribution agreement with Pentax (see below for a reminder on the Pentax deal).

Q2 gross margin was a relatively beefy 35% compared to our 8% estimate. SCIE did not disclose the revenue product mix (WavSTAT consoles versus forceps) although we suspect the difference in actual versus our estimated GM is a higher percentage of sales coming from forceps (which carry ~40% GM) than from WavSTAT consoles (sold ~ at cost) compared to what we had estimated.

Q2 operating expenses were $1.07 million, well below our $1.47 million estimate on lower R&D expense. Operating income came in at ($964k) significantly better than our ($1,448k) number on the better GM and lower op expenses.

Net loss and EPS were ($5.5) million and ($0.05). The net loss includes $4.6 million in "other" expense, which is mostly non-cash and related to change in fair value of derivatives and amortization of the recently issued debt and warrants.

Cash
SpectraScience exited Q2 with $185k in cash and equivalents, down from $1.0 million at the end of Q1. Cash used in operations in Q2 was $820k, down from $1.1 million in Q1. At the end of Q2 there was $2.3 million in convertible debt set to mature from July through September – all of which is convertible into common at $0.0573 per share. Subsequent to Q2 $600k of this was converted into common – we think it's safe to assume the remaining $1.7 million will also convert. SCIE will need to raise more capital, however.

At the annual shareholder meeting in July, shareholders voted to increase total capital stock from 225 million shares to 325 million shares, including an increase of common shares from 175 million to 275 million. Per the July 2012 business update call that SCIE held, management hopes to execute a two-stage financing; the first a smaller (~$1.5 million) raise in the very near which would likely be similar in form to recent raises (i.e. – OID convertibles) which would get the initial commercialization off the ground and the second, a larger (management didn't offer a number) raise sometime around the fall of this year through the sale of common stock which, by that time, would hopefully have significant institutional interest.

As a reminder, in December 2011 SCIE retained investment bank, Laidlaw & Co. to raise up to $20 million in capital over the next two years – to-date they've raised just under 10% of this amount. We expect the capital raising efforts to benefit from the recent progress SCIE's made, including with bringing on Pentax as well as the initial revenue in Q2.

Maintaining Outlook / Recommendation

We have made no material adjustments to our model following Q2 results and are maintaining our outlook and Outperform rating.

SCIE Lands Major Distributor (from our 7/10/12 update)

SpectraScience nailed down the large distributor that they've been hoping to land. Effective June 15th SpectraScience entered into an agreement with Pentax Europe GmbH, a European subsidiary of Tokyo-based optical giant Hoya Corporation, for a five year deal to be the exclusive distributor of WavSTAT for colon cancer in Europe as well as parts of the Middle East and Africa. In total, the distribution agreement covers 23 countries.

The agreement includes minimum annual purchase quotas of the WavSTAT instrument and forceps in each of the designated countries. Details of the minimum purchase agreement are confidential.

Pentax, through its Pentax Medical division, is one of the largest and most respected worldwide providers of gastroenterology devices including a variety of gastroscopes, colonoscopes, endoscopes, sigmoidoscopes and confocal laser microscopes. While (as we noted in our initiation report on SCIE) Pentax is considered a direct competitor to SpectraScience, they offer a leading line of cutting edge endoscopes which are compatible with SpectraScience's forceps which provides Pentax with a potentially valuable and appealing extension to their product portfolio. It also helps to further differentiate and expand their product offerings relative to major competitors including the likes of Olympus, Mauna Kea, and Fujinon. Pentax brings a very substantial distribution reach and potentially very valuable customer contacts, relationships, and experience in international markets that dwarf SpectraScience's current capabilities. And with initial expected gross margins on sales of the forceps to Pentax at around a healthy 40+% (and expected to grow with higher production), this deal with Pentax appears like it could be a big win for SCIE (and a nice addition for Pentax).

An initial focus for SCIE and Pentax Europe will be the Netherlands' new colon cancer screening program which management talked about on the March 27th investor call. SCIE is positioning to supply WavSTAT systems under this program, which is expected to significantly increase the demand for colonoscopies to such an extent that there may not be a sufficient number of physician specialists handle the patient flow. During 2012 hospitals in the Netherlands will train nurse endoscopists to perform colonoscopies – SCIE sees this as a potential opportunity to supply WavSTAT under this program as it provides a non-subjective diagnosis without the need for interpretation by a specialist.

Business Update Call 7-9-2012 (from our 7/10/12 update)

Management held a business update call on July 9th. Highlights included;

• Pentax Already Marketing WavSTAT – WavSTAT for the colon cancer application is already included in Pentax's trade show and industry conference marketing materials in Europe. It will also be included in Pentax's booth at the United European Gastroenterology Week in Amsterdam in October.

• Sell WavSTAT At Cost, Profit From Forceps – SCIE will sell the WavSTAT console to Pentax at cost and expects sales of the forceps to Pentax to generate initial gross margin in the 40% – 50% range. As we've indicated since initiating coverage of SCIE, this is consistent with our model in which we assume the console (i.e. – "razor") is sold at cost and initial gross margin of the forceps (i.e. – the "razor blade") is just under 40% (slightly more conservative than management). Similarly, Pentax will sell the console to the end-user customers at cost and profit from the sale of the forceps (the recurring revenue stream).

• U.S. Approval – the expectation continues to be that a supplement to the original PMA is viable path to gain regulatory approval to market the current model (WavSTAT4) in the U.S. In order to do so SpectraScience needed to make user interface improvements which required changes to the software. Management noted that the software updates are being completed but could not offer any potential timelines on when they might be finalized and a regulatory package completed.

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