Description

OVERVIEW

Founded in 1996, Cepheid (CPHD) is a manufacturer of real-time PCR thermocyclers, instruments that genetically confirm the identity of unknown substances. CPHD’s stock price closed on November 7 at $4.10, and with 30.9 million diluted shares, the company has a market capitalization of $127 million. CPHD has $21 million in cash on its balance sheet and a burn rate of $18 million per year; the company will need to raise capital within the next twelve months. Total revenues for the last twelve months, including government grants, were $13.2 million. Management aggressively estimates 2003 revenue of $23 million, which implies the company enjoys a market capitalization of 5.5 times next year’s potential revenues. The company is on target to lose $19 million of net income this year.

It appears that the excessive valuation is due to misleading statements by both management and analysts about a potential contract with the United States Postal Service (USPS). Management originally communicated that the contract would be signed in September of 2002, and then they revised their estimate to December 2002, and now they are unable to predict any timeframe. Management has also guided investors to expect more than $27 million of gross profit during the first contract year. It appears that the actual amount is closer to $2 million.

The remainder of CPHD’s revenue opportunities are unquantifiable, even by management. All end-markets are addressed by profitable and more established manufacturers, such as Roche, Applied Biosystems, Perkin Elmer, and Idaho Technology. Each has a significantly greater installed base than CPHD.

Recently, CPHD fired more than 20% of the R&D staff in order to trim its cash burn by $875,000 per quarter. This reduction does not seem like the type of action taken by a high-growth company on the cusp of significant product development and revenue growth.

The CEO lives in Illinois full-time, even though the company is based in California.

CPHD will require additional funding sometime in 2003. Raising capital will present a significant challenge after the delay of the USPS contract and the realization that it will not provide any meaningful profit to Cepheid.

DETAILS

Markets and Products

PCR (polymerase chain reaction) involves the amplification and identification of very small amounts of DNA or RNA. CPHD manufactures real-time PCR thermocyclers, as well as the corresponding consumable tubes and reagents, which are the instruments used to generate many copies of the genetic material and render its identity. Although PCR has been around since 1983, the first widespread real-time use began in 1996. Real-time PCR involves more analysis than traditional PCR, and the cyclers are at least three times as expensive. The "thermo" aspect of the cycler involves repeatedly heating and cooling the sample to generate numerous replications. Up to 30 replications can occur before enough of the DNA is present to identify.

There are four end-markets for real-time PCR: government agencies, clinical settings, academic laboratories, and large food manufacturers and agribusiness corporations. The government agencies include the Department of Defense and USAMRIID (US Army Medical Research Institute of Infectious Diseases). Clinical uses include hospitals testing for the presence of disease in patients, which requires FDA approval of the tests. Academic research involves performing genomic and other investigations requiring DNA analysis. The food and agribusiness market consists of organizations such as the United States Department of Agriculture, which tests agricultural products, as well as corporations that produce and process food products that are required to be sample tested for disease. CPHD has placed limited quantities of instruments into the government and academic settings. It is awaiting its first FDA approval of a joint-venture clinical test for Group B Streptococcus (GBS), scheduled for early 2003; the company cannot estimate the market size of this product. And as of last December, CPHD stated that it had not assessed the food and agribusiness market or its potential clients.

Competitors of CPHD include 1) Idaho Technology, a private company that has developed 4 of the 7 PCR test chemistries and is the United States government’s largest supplier of real-time PCR instruments, 2) Roche’s Molecular Diagnostics and Applied Sciences divisions, which have annual revenues of $976mm, more than 130 patents related to the PCR process, a leading real-time LightCycler market share, and which CPHD pays clinical royalties to, 3) Applied Biosystems, with DNA synthesis and PCR product revenue of $253 million in fiscal 2001 and which CPHD pays non-clinical royalties to, and 4) Perkin Elmer’s life sciences division, with 2001 revenues of $346 million, which makes the industry standard Model 7700. In contrast to CPHD, all of its competitors are profitable.

Real-time thermocyclers range in price from $27,000-$130,000. The differences largely include the optics detection system (lenses, laser quality, etc.), as well as the speed and capacity of testing. The largest market share goes to Applied Biosystems, Roche and Perkin Elmer, which manufacture high-end, high-throughput laboratory equipment. Their machines run 96 batch tests at a time, and run in as little as 30 minutes. All of the 96 tests need to be searching for the same genetic element(s), such as anthrax. These machines tend to be large and industrial, ranging in price from $55,000 to $130,000. Idaho and CPHD make smaller machines that run 16 tests for CPHD’s SmartCycler (priced at $27,000) and 32 tests for Idaho’s Rapid cycler (priced at $45,000), but run as quickly as the larger ones, in as little as 30 minutes. Part of the allure of the small machines is that their portable size allows researchers and government agencies to use them out in the field.

CPHD claims that its product is superior to Idaho because it has 16 different heaters to run 16 different protocols at one time. Basically, each DNA reproduces optimally at a certain temperature and a certain speed. For example, if the Post Office wants to test for anthrax and meningitis at the same time, the CPHD SmartCycler could multiply the anthrax DNA at one temperature and the meningitis DNA at another temperature, both at the same time. The Idaho machine, however, could only heat all of its 32 tests at the same temperature. Interestingly, CPHD has recently begun marketing its cycler as capable of running 96 tests at a time by simply adding on capacity. It had previously boasted its niche status, yet now wants it both ways as a competitor to the much more efficient and dominant batch systems. Apparently CPHD has decided that the market opportunity in the crowded world of Roche, Applied Biosystems, and Perkin Elmer is a much more attractive one to place on a PowerPoint slide. On another note of competitive differences, CPHD touts its test sensitivity, which can identify anthrax as diluted as 30 spores per microliter. The Idaho tests are more sensitive, however, to as few as 4 spores per microliter.

The market for real-time PCR thermocyclers was $310 million in 2001, with an average price per cycler of $50,000. These figures imply approximately 6,200 thermocyclers were sold in 2001, of which CPHD sold less than 500, largely covered by government grants. The vast majority of the industry’s thermocyclers are sold into academic laboratories, which use the larger, industrial machines. CPHD and Idaho are going after the biodefense market and field operations applications such as the Army and Department of Agriculture. These users require smaller, more versatile and transportable machines. Both are also seeking FDA approval for clinical applications, estimated to be granted in 2003. However, management provides no guidance for potential revenues, and it is difficult to estimate the potential adoption of a technology that is expensive and often almost redundant to what is currently in place.

It should be noted that Idaho, Roche and Applied Biosystems have developed valuable patents, and are currently generating royalty revenues from them. Up to 20% of any potential CPHD revenue in the future will be paid out as royalties to these three companies. This seems to make CPHD’s most recent gross margin guidance of 50-70% quite impossible; it represents a significant increase from its current gross margin of approximately 22%.

United States Postal Service Contract

During the fall of 2001, CPHD’s stock price traded up from $1.50 to $8.19 within 18 trading days on speculation that its PCR detection units would help government agencies, including the United States Postal Service (USPS), to identify anthrax rapidly and easily. Since then, CPHD’s stock price has been volatile, trading up on meaningless promotion - either by the company or the press - and trading back down in short order. Articles such as those written by Gene Marcial in BusinessWeek on September 23, 2002 simply add fuel to the fire. Marcial referenced an analyst expecting CPHD’s stock price to leap to $9.50 by year-end 2002 due to an expected contract with the USPS by December. [Management has subsequently stated that a contract is not going to occur within this timeframe. Additionally, the research firm intends to seek investment banking services from CPHD, and the research analyst may receive compensation based on the firm’s investment banking revenues.] The idealized USPS contract is the only reason that CPHD has the market valuation it does, and as it turns out, the contract at best will generate very low margin profits of almost no significance to Cepheid’s valuation.

CPHD is part of a team coordinated by Northrop Grumman that is competing for the United States Post Office Emergency Preparedness contract for detection devices. Before its third quarter earnings call, CPHD management and Wall Street analysts were touting revenue estimates of $25-40 million from the USPS during 2003. On the call, they reduced the estimate to $14-23 million. It is almost a certainty that this estimate will not materialize either.

A March 6, 2002 USPS report outlines the need for 2,000 biodetection systems in 292 mail facilities around the country. Each system will include a real-time PCR thermocycler, which retails for $27,000 in CPHD’s case. In addition to these 2,000 instruments sold to the government, analysts expect a large revenue opportunity from the consumable tests that are used throughout every day to test for anthrax. Of course, this is the favorite razor-razorblade model. Management points to Wall Street analyst projections as a guideline for investors. One analyst concedes that CPHD will only maintain a 10% markup on the instrument, so at 2,000 machines with a cost of $12,000 per machine, CPHD will derive $13,200 per machine, or $26.4 million in revenue and $2.4 million in gross profit.

The problem with these numbers is twofold: 1) even if these numbers are borne out, it is not meaningful to CPHD’s valuation, and 2) sources in the government have privately said that the project has been cut by more than half and has been delayed due to continued pilot testing. The current estimate is for 800 systems, or an implied $960,000 of gross profit dollars to CPHD. The entire contract was to result in one large payment to Cepheid. Now, it seems that the pilot phase will continue through at least the summer of 2003, with less than $800,000 of revenue in this phase, according to the USPS. As for the consumable element, analysts become very excited at calculating the opportunity of 12 tests per day per machine at $7 per test at a gross margin of 40%. In this estimation, the gross profit dollars would be almost $25 million per year. However, sources say that these same anthrax tests are sold to other agencies of the government currently for less than $4.50! At $4.50, the gross margin to CPHD would be approximately $0.30 each, or 7%. Furthermore, the source said that 12 tests per day would be prohibitively expensive in terms of equipment and energy. Nonetheless, using 12 tests per day and assuming a gross margin of 7% instead of 40%, and using 800 systems instead of 2,000, the gross profit dollar opportunity becomes slightly more than $1 million per year. So, instead of a potential $27+ million first year gross profit opportunity, the reality is closer to $2 million.

On a final note, CPHD had anticipated developing the consumable’s biological contents itself, seen as the largest profit center of the contract. The company’s third quarter earnings release, however, announces that Applied Biosystems will supply the contents, resulting in CPHD providing only a very low margin plastic shell.

Finally, there are large liability issues that must be addressed by CPHD before any contract is signed. The USPS does not want to indemnify the manufacturers from damages that result from equipment malfunctioning (i.e., unnecessary cleanup costs, worker overtime or lost time, etc.).

Other Comments

After announcing an increase in its sales force in July, CPHD recently announced “progress” on a staff realignment. These efforts, which were never previously announced publicly, consisted of terminating 25 full-time positions (mostly engineers) and 14 contractors. The lifeblood of the company has been its engineers, but obviously the company needs to sacrifice product development in order to burn $875,000 less per quarter, which is the estimated savings from the employee reduction.

On August 1, 2002, the company sold 4 million shares of stock at $2.65 in a public offering. Its closing share price on that day was $3.00.

Management is very promotional, issuing numerous press releases and meeting with dozens of investors during visits to New York. The previous CEO, Tom Gutshall, was replaced in April by John Bishop. Even though CPHD is based in California, Bishop lives in Illinois full-time. Nonetheless, Bishop is the best hope that investors have in realizing any profit from buying shares at these price levels. Bishop was previously the CEO of Vysis, a clinical diagnostics company sold to Abbott Laboratories in December 2001 at a valuation of more than 11x sales. Vysis, however, was a diagnostics company that had enjoyed a significant relationship with Abbott before being acquired. Cepheid has clearly illustrated that it is incapable of efficiently developing or manufacturing the diagnostic reagents required for the USPS system, relying instead on those of Applied Biosystems.

CONCLUSION

Because management’s credibility appears to be severely lacking in its statements surrounding the USPS contract, it is very difficult to believe in anything it says about the company’s other market opportunities. It is very clear that the academic and clinical settings are dominated by much larger and profitable competitors. In addition, the government and food markets are dominated by Idaho technologies, which has over 7,000 installed cyclers vs. CPHD’s 894, largely sold under government grants.

With $21 million of cash on the balance sheet currently, and at a burn rate of $4.5 million per quarter, the company will require additional funding sometime in 2003. By that time, it should be apparent that the USPS contract will fall far short of management’s guidance and “street” expectations, and investors will no longer buy the rest of the story.

Catalyst

Cepheid requires further funding within twelve months. The company's current valuation is supported by a much exaggerated potential contract with the United States Postal Service (USPS). By the time Cepheid raises capital, it should be apparent that the USPS contract will fall far short of management’s guidance and “street” expectations, and investors will no longer buy the rest of management's pie-in-the-sky story.