Description

I. THESIS

Combimatrix (Symbol: CBMX) is a small biotech company that is undervalued by the market and has catalyst in place to realize its intrinsic value in the near term (~6months or less).   Management is open, downside is limited, and the upside is potentially large (100-200%+).

II. OVERVIEW

Bruin821 has a write-up on this idea from Oct 6, 2008 http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/3428

The story has not changed much with respect to products/market potential/etc. and I invite you to refer to that write-up for a discussion on the business. What has changed is the stock is down over 50% from Bruin's initial write-up, despite the fact the CBMX story is likely coming to fruition in the near-term.

Here is a recent presentation explaining the company:

http://www.combimatrix.com/cbmx_presentation_files/CBMX-9-09.pdf

Akumar@combimatrix.com is the CEO's email address. My experience speaking with Dr. Kumar has been overwhelmingly positive. He is remarkably accessible and transparent about the direction of the company.

III. ASSETS

III.1  Cash & Contingencies

III.1.a December 31, 2009 expected net cash balance

The company doesn't appear to be interesting after glancing at the balance sheet, however, closer inspection of the company's contingent claims suggest otherwise.   In 2005 the company won a lawsuit against National Union Fire Insurance relating to its director's and officers' insurance policy and was awarded a $32.1 million judgment by the US District Court.  It was later awarded an additional $3.6 million by the court for attorneys' fees and has continued to earn interest since this time.

National Union appealed, at which point the court required it to post an appellate bond of $39.2 million with the court.  This means that the creditworthiness of National Union is not an issue and the only thing standing between CombiMatrix and the current value of the judgment is the 9^th Circuit Court.  It appears very unlikely that the ruling will be overturned based on our legal due diligence: the decision was a bench verdict by a federal judge, and there were $0 dollars in punitive damages so the appeal theory is very weak (see below for a detailed discussion)

All briefs have been submitted to the court by both parties and only the oral hearing and verdict remain, meaning that a disbursement of the funds could happen soon. A decision is expected to be finalized by Q4 2009 (http://investor.combimatrix.com/releasedetail.cfm?ReleaseID=390998).

The current date is set for November 2, 2009, however, the defense has filed for an extension. http://finance.yahoo.com/news/CombiMatrix-Announces-Hearing-pz-4105810275.html?x=0&.v=1

It is very possible that the date is extended, but if a new date is scheduled, it should be on December 6, 7, or 8^th, which is when all the needed participants from the courthouse will be together again. If it does get extended to early December, a decision COULD be made before the holidays.

The $36mm lawsuit money and $10mm supplement represent $46mm.  After the estimated 20% lawyer fee we are left with ~30mm plus the $10mm supplemental (which I estimate they will likely settle for 7-8mm to expedite the process).

Add back the $11mm cash balance on June 30, 2009 and the company is sitting on nearly $6.24 in cash as of December 31, 2009 ($11(cash balance)+$36*(1-20%)(lawsuit proceeds after fee)+$7mm(estimated settlement for supplemental)=46.8/7.5s/o=$6.24/s) in cash per share (based on 7.5mm outstanding).

If we assume $3mm in cash burn for Q4 (based on previous burn and management guidance) and ~$9mm in l/t liabilities at December 31, 2009, we are left with a net cash balance of ~$4.64/s (($46.8mm-12mm)/7.5mm s/o).

III.1.b. How do we handicap the lawsuit?

Obviously, a huge portion of the cash balance relies on winning the lawsuit, which will be decided in the next few months.

Before we start, here are the respective documents from PACER that are relevant to the analysis:

Finding of Fact and Conclusions

http://www.scribd.com/doc/21649961

Appeal

http://www.scribd.com/doc/21649936

Amended Judgment 052208

http://www.scribd.com/doc/21649932

I encourage others to have their lawyers do their own due diligence, however, our own legal due diligence, the due diligence of another independent party, and the company's lawyers have all come to the same general conclusion: There is approximately a 95% chance of victory for CBMX (and this is likely a conservative estimate).

Legal due diligence (lawyer's opinion):

"One of the most common reasons for overturning a verdict is because of mishandling of the jury.  Having a bench trial eliminates this possibility, because the judge acts as the factfinder as well as the trier of fact.  

Judge Gutierrez (original trial judge) is relatively new at this, which means that there's more of a chance he would make a mistake rather than a more seasoned judge.  So I combed over the document very carefully to find any mistakes of law and application that might give grounds for an appeal.

Appellate courts give a LOT of deference to a lower court's findings of fact.  Once a court determines each party's "story" of what happened, that's pretty much set in stone and you can't go back and attempt to change that through an appeal.  So what's in the record as having transpired is the official story.  Appellate courts do however overturn decisions if the lower court got the law wrong or didn't apply the law to the facts correctly.

After combing through the legal precedents the judge is relying on, it seemed correct, and the case isn't very complex, nor does it rely on obscure laws.  So I would not think that the Court of Appeals would reverse the District Court over this.

Furthermore, the application of the law was straightforward and correct, and thus wouldn't be a grounds for appeal.

Now on to the actually appeal: 

The good news for CMBX is that California has insurance laws that are generally friendly to the insured.  

I think this case really hinges on whether CMBX had to get approval with National Union prior to settling the underlying litigation, and whether the bad faith ruling holds up.  The stuff in here whether CMBX was covered or not under the policy is largely irrelevant in my opinion because most courts will find that this type of litigation IS covered under these insurance policies, and the appeals court likely will not overturn this ruling by the district court that there is coverage.  Thus, all the arguments made in the appeal over whether there is coverage or not because of the language of the policy or because Montgomery (the officer) did something bad at his old job at Nano or his new job at CMBX, these probably don't matter much.

So safely assuming that coverage exists, the questions the appeals court will focus on is whether: (1) CMBX had to obtain approval for their settlement; and (2) whether (1) even matters at all because the district court can rely on bad faith as grounds for awarding the entire judgment amount.  

Addressing (2) first, the district court's factual findings about NU's conduct is pretty damning in my opinion.  They clearly didn't do a good job and you can see in the appeal that their attorneys even go as far as to admit they might have been negligent (which I think is a bad strategy, to admit any sort of guilt, because it's not like there's really a clear line between negligence, gross (or really bad) negligence, and willfully bad conduct). But then again, I think the district court did a poor job of articulating exactly how NU acted in bad faith, and how NU's bad faith led to the $30mm+ loss incurred by CMBX.  It's one thing to lose a case, but it's another to lose it because of your insurance company.  I don't think CMBX can really prove that that NU's bad faith is the cause of it's loss.  I really think the bad faith argument is up in the air, and I wouldn't rely on it if you needed it to win the case.  So let's move on to (1).

(1) Did CMBX have to obtain approval for its settlement?  This is really just he-said/she-said back and forth here by the parties.  The Defense argues in their appeal that yes, CMBX had to get approval; while the district court and the plaintiff state that because NU never replied to them at all, they decided to act on their own out of necessity.  I think the appeals court would defer to the district court's finding here that CMBX acted reasonably given the circumstances and the lack of communication from NU.  It's just one of those things where the plaintiff says one thing and the defense says another, and the district court comes out on the side of the plaintiff, so that's where the weight of the evidence lies.  Once the lower court sides with the plaintiff's side of the story, there's inertia in the plaintiff's favor, and the appeals court won't go against it, because it's not really their job to re-examine the facts of the case.  Instead, the job of the appeals court is to determine whether the district court erred in matters of identifying the correct law, and correctly applying it.  

So all in all, this really isn't a bad appeal.  They do their best to chop at the weak points of the district court's decision.  Sidley's appellate practice group is really formidable, so I'd never count them out.  But in my opinion I don't think this will be a successful appeal.  

I think the chance of a successful appeal is miniscule.  I wouldn't be able to really quantify it, but conservatively I'd say it's less than 5%."

Cash and Contingencies Valuation

Likely case (95%+ chance):

12/31/2009 net cash balance of ~$4.64 (supplemental money would likely be disbursed in 3-6 months)

Worst case (5% chance);

12/31/2009 expected net cash balance of ~$0.

 III.2 Operating Assets:

 Description

1)  CMDX laboratory (creates diagnostic products)

We visited the lab facilities at the beginning of August 2009 and were highly impressed (Amit Kumar is happy to arrange for shareholder tours of the CMDX facility in Irvine, CA, just email or call). The lab churns out a variety of diagnostics, but its primary value is in the top 4 tests (they have 12 tests in total): Prenatal/PostnatalScan, Her2Scan, HemeScan, and ProstateScan. See the previous write up on CBMX or the company's website for more details http://www.cmdiagnostics.com/testmenu.htm. Benchmark Capital analyst Derek Tall, PhD. (dtaller@benchmarkcap.com) also has some great DCF type analysis.

2)  Government contracts/misc.

The company has other products as well.  One is the Influenza Detection system, which works with technology similar to that of the cancer-screening tests.  This product line got a big boost with the outbreak of the H1N1 Swine Flu, which the system is able to detect.   When the swine flu broke out earlier this year, the FDA issued the Emergency Use Authorization which approved two tests developed by other companies for immediate use to detect the H1N1 strain.  CombiMatrix's flu detection system is far more complex, accurate and comprehensive, and thus also more expensive.  This makes it more appropriate in research settings, where it has already been used.   But if the swine flu gets really bad (as CEO Amit Kumar describes it, "more pathogenic and communicable") then this cost will not be as important and CombiMatrix's test will likely be adopted. 

In fact, just recently the Brooke Army Medical Center announced they are using the CBMX technology http://finance.yahoo.com/news/BAMC-to-Use-CombiMatrix-pz-3792138748.html?x=0&.v=1. Moreover, in early April the Ontario Agency for Health Protection and Promotion verified CombiMatrix's Influenza-Detection system. Ultimately, these tests may help guard against H5N1 bird flu outbreaks. As public  health ministries become accustomed to CombiMatrix's technology, there is a possibility that CBMX could win a large contract anywhere from $10m to $100m could be awarded to CombiMatrix based on an average cost of the CBMX's 'in-house' oligo array automated system, which costs around $200-300k per unit plus additional fees for customizable chips. Governments may want to use this platform for military use or civilian outbreaks and so the size of any potential contract is highly variable. Regardless, US Army/Canadian validation is a step towards drawing investment from more government agencies. Already, China has expressed some interest and Canada has been interested since its outbreak of severe acute respiratory syndrome (SARS) in 2003. Additionally, in March 2009, NASA awarded CombiMatrix $858,000 from NASA over three years for the Company's semiconductor microarray that can be used in automated genetic analyses suitable for use in satellites. Later this year, the Company plans to launch a cell phone-sized array reader that can monitor genetic changes to bacteria as researchers circle the Earth. Beyond government contracts, academia and other research laboratories are potential buyers of CombiMatrix's platform technology that enables 'in-house' customizable array services. Sales to these institutions represented about one-third of total revenue on average.

Valuation:

Specialty diagnostic companies are typically valued on a P/S ratio. The following are a list of comparables, their estimated 2009, and associated p/s ratios.

Consensus revenue estimates for CBMX 2009 are $6.6mm (2 estimates), which translates into a value of $21.12mm based on the industry average p/s ratio. Comps analysis lowballs the true value of the current operating assets, as the analysis disregards 2 important facts: 1) BRLI and NeoGenomics have lower p/s due to their low margin lab-service revenue, and  2) the growth profile of CBMX's revenue is much higher relative to its peers.

With respect to 2): Bruin has a nice outline of the market potential and various ways one can think about the CMDX lab value. In reality, the lab in its entirety is hard to value precisely, but various estimates from management, DCF analysis, and industry insiders put it north of $100mm in the current market environment.

A recent transaction justifies the claim of ">$100mm." Just recently, EXAS sold the IP for an unfinished test that is similar to the CBMX PP test for $18.5mm and our test is arguably better. In addition, there are plenty of OTC/Pink companies in the space with no revenues, teetering cash balances, and undeveloped tests, which have market caps of >$50mm. EXAS for example, has a 92mm market cap, competes in the exact same space, has no revenue, and is burning money. Another example is Vermillion, Inc. (vrml.q), which went from being bankrupt to a 108mm market cap company and they have ONE test. We have twelve, which are already deriving revenue and saving lives--go figure.

Here is another example of the inherent value of the CBMX tests:

This comes from an analyst report speaking about the value of Hemescan:

"From a marketing perspective, there are 15,110 new patien ts diagnosed with CLL and an overall prevalence of >60,000 patients in the U.S. alone. We estimate that with partner Clarient, CombiMatrix could achieve 5% market share in the next two or three years, representing the 3k of the roughly 5k patients that die each year from CLL. These patients, if treated in academic institutions, are often likely to be the low hanging fruit to help this test gain traction in the market. Although HemeScan usage has doubled in the past year, by our estimates, we assume conservatively a 50% growth rate declining to a 2% terminal growth rate despite the fact that molecular diagnostic companies like Myriad have been able to maintain >50% annual growth rates even as sales have escalated to >$300m per annum revenue. We believe these estimates are highly conservative because they do not depend on broadening the application to MDS and ALL patients, who comprise an additional ~100k patients in the U.S."

 It is really hard to say what the current operating assets are worth, as the analysis above suggest a single test could be worth $33mm under conservative assumptions. However, to play it ultra-safe, I think $20mm is a high margin-of-safety estimate for the value of the CMDX lab and the government contract business. This translates into $2.67/s.

III.3 CCA (Comprehensive Cancer Array)

This is where things get really interesting.  The latest technology from Combimatrix blows our minds - they call it the comprehensive cancer screening test (CCA).  To put it in non-mad-scientist terms, here is how we would explain it:  The test takes a drop of blood and puts it on a microchip.  The microchip then detects if you have a certain DNA sequences that can determine if you have a variety of cancers.  With obvious benefits to just about everyone, the market potential for such a product is enormous. Here is a presentation on the CCA http://play.rbn.com/play.asx?url=shareholder/shareholder/wmdemand/hostedfiles/33597cmbx.wmv&proto=mms?mswmext=.asx and here is another

http://files.shareholder.com/downloads/CBMX/707481876x0x293882/d18a0c51-4d10-4533-99c1-22c382e2136a/CBMX_DX_RX_Presentation.pdf

The projected launch for CCA continues to be mid-2010 and management disclosed that it is evaluating technology that could accelerate launch to as soon as Q1, 2010. CombiMatrix intends to complete CCA study protocols in the current quarter and to complete CCA studies in the first half of next year in time to support product launch. Larger clinical studies are anticipated after launch. We estimate that the CCA's total addressable market could be up to $12-$15 billion at $250- $300 per test.

Estimated the value of the CCA asset is difficult, but the potential is absolutely mind-blowing and the test would revolutionize medicine.

We are not the only people who think CCA might be interesting. Illumina recently announced an agreement with CBMX, such that CBMX will provide certain products for sale with Illumina products and applications.

http://biz.yahoo.com/e/091005/cbmx8-k.html

The 8-k is extremely vague and both companies are very tight-lipped about releasing any details, although the CEO has reiterated that more details will come forward when the time is appropriate.

We don't see how a minimum purchase agreement with one of the largest players in the industry can be a bad. This is speculative, but we believe it is likely that this recently announced partnership is associated with the CCA technology. In fact, Illumina has been quite clear in their own conference calls and presentations that they intend to be a leader in cancer diagnostics-CBMX's technology and resources would be a perfect fit.

Valuation

Certainly not worth 0, but potentially worth many multiples of the current stock price based on the projected market size of $15B.

III.4 Leuchemix

http://www.combimatrix.com/leuchemix_index.htm

CMBX also owns a 1/3 stake in a company called Leuchemix, which is developing a leukemia drug.  Recent test results indicate the drug is both effective and well tolerated by patients. Assuming phase 1 is completed and looks good, and Phase II is completed and looks good also (hopefully by 2Q 2010), then CBMX will partner the drug with a big pharma company to support the phase 3 costs.  The value of the compound will be dependent on the data, which will directly correlate with the size and structure of the partnership.  In the past 5 years or so, there have been two or three deals with pharma and biotech companies that have been anywhere from 500 MM to 2 Billion dollars.  These deals are usually structured as some money upfront, money to support the trial, and then money to be paid upon achievement of milestones and then royalties.  With a drug, there is always a chance of failure, despite what the previous data looks like.  However, the phase 1 data looks good so far, and if phase 2 looks good as well, the valuation will be driven by how good. If it looks great, then CBMX can easily achieve the several hundred million dollar valuation. If it looks bad, then it could be worth nothing.  And it could be anywhere in between.  When Leuchemix does 40 patients, and all 40 respond, then the sky is the limit on valuation. If none respond, then  it's zero.  If 10% respond, then it might be worth 20 million, etc.   If half respond, then it would be worth a few hundred million.

Valuation

The bottom line is that most drugs don't make it.  And there have been many failures in leukemia. The research will cost money to do phase 3 and that money will come from a partner once Leuchemix has good phase 2 data.  So CBMX needs to finish the phase 1 and show good phase 2. 

In its current stage, the entire Leuchemix project (if it were put up for sale) is probably conservatively worth $15mm in this environment where risk-taking is so low for early-stage projects. This would translate into approximately $5mm for CBMX, or $.67/s.

IV. Valuation Summary

 Baseline

Win Lawsuit

$4.64/s in "cash liquidation value"

+$2.67/s CMDX lab (but likely worth $100mm+)

=$7.31/s

Lose Lawsuit

=$2.67/s

Options

+$?/s CCA technology

+$?/s from announcement of asset sales and/or partnerships with large player like Illumina

+~$?/s 1/3 Leuchemix, which requires no additional capital infusions.

+$?/s large government contract

Valuing the CCA tech, asset sales and/or strategic partnership announcements, substantial government contracts, or leuchemix option value is difficult, but I feel confident suggesting that any one of these options, if successful, would likely be worth the current market cap of the stock. The CCA, in particular, could be worth 5-10x+ the current market cap of ~$50mm and we should see the outcome of this option fairly soon--by Q2 2010.

With the stock floating around $6.1, if we win the lawsuit (which is a very likely outcome), we essentially get paid $1.21/s to hold all these options (a VERY nice deal), and if we lose the lawsuit, we are essentially paying ~$4.21/s for the basket of options (a so-so deal).

Note on Dilution

There are an assortment of options, warrants, and convertible debt-yes, it is insane, and yes, it dilutes the value of the upside scenarios, but it is also a built-in fundraiser.

4.a Warrants

4.b $8.4mm in convert debt at $7.5, see page 13, june 30, 2009 10k for details

4.c ~2mm options @ $7.4 avg. The options are borderline ridiculous, but at least the employees certainly have incentive to get this thing going!

V. Signaling

The CEO has repeated numerous times that the stock is of CBMX is extremely undervalued. He has consistently bought stock during non-black-out dates. Here are some recent insider buys:

Moreover, the CEO has never sold a single share of stock and has purchased nearly 700k worth over the past few years.

 VI. Issues/Risks

1. Lawsuit loss

2. More dilutive capital raises (the ridiculous raise from last summer was out of necessity so they had the required negotiating power to pursue the lawsuit until the end). With plenty of capital in hand (even without lawsuit victory), there should be no need to dilute shareholders further. And one can be assured that if I see another huge option grant, there is a non-zero probability I will hire a group of UFC fighters to raid CBMX headquarters!

3. Failure of Leuchemix/CCA

4. Boy who cried wolf syndrome: CBMX has been arranging for a "strategic transaction" for over a year now. It is likely this is the final end-game, but if history is any guide with this company, something will pop-up that delays things even further!

5. Frustrated shareholder base attacks CMBX HQ and burns down the CMDX facilities.

Catalyst

VII. Catalysts

1. Bidding process has started.

A few weeks ago, the company announced (http://www.genomeweb.com/arrays/combimatrix-seeks-financial-advisor-evaluate-sale-or-partnership-options) that it has engaged multiple investment bankers to aid the company in an "effort to unlock shareholder value."  This could mean, according to CEO Amit Kumar, "the sale of all or a portion of the business."  This is the catalyst the stock needs to unlock the value in its underlying assets.   Recently, comparable companies have successfully monetized their assets in the diagnostics space. For instance LabCorp (NYSE: LH) offered $4.55 per share of Monogram Biosciences (NASDAQ: MGRM) to acquire the company in July, for a total valuation of Monogram of $155 million (including the assumption of debt).

Finally, on September 16th they announced the decision to go with Baird and Co. http://finance.yahoo.com/news/CombiMatrix-Corporation-pz-3917462384.html?x=0&.v=2

It's hard to say how the market will value the various assets owned by CBMX, but there has certainly been an increase in interest from multiple players in the industry.

We expect to see assets sales and strategic partnerships announced in the near future that will unlock the instrinsic value in the company's assets.

2. Short interest of ~260,000 share may come under pressure as positive announcements are made. The float on the stock is tightly held. We estimate that >50% is held by long-term owners who are waiting on strategic transactions that will unlock the instrinsic value of CBMX.