Description

Lattice Biologics develops, manufactures, and markets biologics products, specifically in the area of regenerative medicine. The business has gone through a dramatic turnaround over the last few years, with the business having gone from losing $3 million in EBITDA in 2016 to modest profitability and strong growth with expanding margins. Management has now put the company on a solid growth trajectory with extremely rapid 130%+ revenue growth in recent quarters, and guidance for another 40% growth over the next year as well. With operating leverage in the business, this further growth should drive margin expansion and meaningful profitability in 2020.

The share price has declined from around $0.30 per share in 2016 to $0.025 at present. Although the business has undergone a substantial turnaround with improved profitability and a strong growth trajectory, this has largely been overlooked by the market and the share price continues to languish near all-time lows, thus creating a compelling investment opportunity. I believe the company is worth at least $0.06 per share, which implies around 12x my 2020 EBITDA estimate.

The company’s size and liquidity make it more suitable for personal accounts. Shares trade as LBL on the Toronto Venture Exchange in Canada and LBLTF on OTC Markets in the US.

Business Overview

Historically, Lattice Biologics' core product has been demineralized bone scaffold. This has been the majority of revenues over the last few years, and in 2019 specifically, 100% of the revenues have been derived from these products.

The company also offers a variety of other products, including: amniotic fluid based products, demineralized bone matrix putty (DBM), and acellular dermal matrix (ADM).

The company has historically targeted a very wide range of applications for their products, including orthopedics, neurological/spine, oral reconstructions, breast reconstructions, etc. Integral to the company's turnaround, however, is that they've increasingly narrowed their focus on the higher margin dental market -- and based on the financial performance, this strategy appears to be paying off.

Grafting / Allografts

Lattice's products are used in grafting procedures. Bone, for example, generally has the ability to regenerate, but requires some sort of scaffold to do so. The bone graft is then reabsorbed and replaced as the natural bone heals over time.

Lattice's products are more specifically used in allograft procedures. An allograft is the transplantation of tissues and cells from one individual to another of the same species. Allografts are typically used when there is an insufficient amount of tissue/cells available to use from a person's own body. These tissues are typically obtained from tissue banks, which in turn receive donated tissue from deceased people.

Allografts have apparently been used in medical procedures for over 150 years, and there are around 1.5 million allografts in the US each year. It's estimated that around 1/3rd of all bone graft procedures in the US use allografts.

Acellular Demineralized Bone Scaffold

The original business was demineralized bone scaffold for orthopedic, neurological, trauma, and other reconstructive procedures. Over the past several years, however, they've replaced their lower margin (unprofitable) business with higher margin revenues in the dental market, and this is now the bulk of sales. Demineralized bone scaffold is often used specifically in dental implant procedures. In this market they sell their demineralized allograft powder to dental distributors under private label agreements.

To produce the bone scaffold products, the company takes human cortical bone and demineralizes it through a proprietary process. The end product assists with fusion, acts as a biologic plate, or can be used in conjunction with a hardware plate system. The product can also be easily sized using scissors, and can withhold sutures.

Amniotic Fluid Based Products

The company has also developed two amniotic fluid based products -- AmnioBoost and AmnioBlast. Fluids are taken from healthy caesarean deliveries and processed to remove contaminants. The fluid can then be further processed to super concentrate the cytokines and stem cells naturally found in the amniotic fluid. There are a number of applications for this stem cell based technology, but the company is specifically scaling it up for the dental allograft market, where they can leverage their existing dental distributor relationships.

Lattice had their first commercial sales in November 2016 (for a different end market I believe), but the company has recently been working out some logistical issues for them to address the dental market. The MD&A indicates that "development efforts in regards to shipping constraints" have concluded, and that they "expect revenue from the AmnioBoost line to rise rapidly and further drive top line growth."

Other Products

The company has other products/technologies that are also complementary to the dental allograft market: acellular dermal matrix, amniotic membrane, demineralized bone matrix putty, and cancellous demineralized bone matrix sponges. As they are not contributing any revenues at the moment I don't want to dwell too much on them, but you can find descriptions of these technologies in their filings. Management believe that they need to enhance inventory levels in order to address this market, and they specifically write in the MD&A that "as these inventory levels rise throughout 2019, these ancillary products are expected to further drive top line sales."

History and Valuation

The business was originally formed under the name International Biologics in 2007. The business was then acquired by Guy Cook, the current CEO, in the fall of 2013 using a newly formed company, Lattice Biologics. The business was acquired for around $6 million, including the assumption of liabilities. Cook had previously grown Bacterin International, another publicly traded company to over $30 million in revenues in 2012. Lattice Biologics was then brought public in late 2017 via a reverse merger.

In 2016 the company had $3.8 million in revenues, but gross margins were thin in the low 20s and the business was losing $3 million a year. Since that time, revenues have shrank as they replaced unprofitable legacy contracts with higher margin business, so although revenues have declined to an estimated $2.3 million in 2019 (and $1.9 million in the TTM) that $3 million loss has been turned into modest profitability -- I am expecting around $250k CAD in adj EBITDA in 2019.

Gross margins have expanded from the low 20s three years ago to 50% in 2018 and 55% in the TTM. Management provided a revenue forecast for 2020 in their most recent press release of 3.0 - 3.5 million, which implies around 40% growth. Given the operating leverage in the business, I expect this further growth to drive EBITDA to around $900k CAD for the full year.

The balance sheet is likely the largest factor that has kept potential investors away. The company has net debt of around $5.3 M CAD -- around 1/3rd of which is owed to an officer for deferring salary. Management has stated that they are working with creditors to convert certain debt balances to equity for working capital purposes. I am not as concerned as the market, however, and expect that management should be able to convert a portion of their debt at a large premium to the current share price.

Most importantly, management has very significant ownership at 40%, and so they are well incented to preserve equity value; the CEO owns 31% of the company and the CFO owns 9%. Secondly, the business is actually doing quite well now and is profitable with a solid growth trajectory. In 2017 they had some debt settlements at $0.15 and in 2018 they settled some more at $0.10. Note that the Venture exchange won't even allow settlements below $0.05 per share without special permission. Given the strength in the business, I think management should be able to convert a decent portion of the debt to equity at $0.05 - 0.10 per share, which would be quite positive IMO considering the current share price is only $0.025.

If we assume $900k CAD in EBITDA in 2020, that puts the valuation at 8.5x EBITDA. Should the company convert $3 million CAD in debt at $0.05 per share, for example, that would drop the valuation to 6.8x EBITDA. $3 million CAD converted at $0.10 per share, on the other hand, would drop it further to 6.0x EBITDA.

I believe that the company is worth around $0.06 per share. This works out to a valuation of around 12x EBITDA and 2.6x revenues, assuming no debt conversions. Should the company maintain their growth trajectory and margin expansion, however, I think investors are more likely to start looking at revenue multiples, which could drive further upside -- regenerative medicine businesses are often highly valued with a number of companies having been acquired in the 4-7x revenues range (TEI Biosciences, Transplant Technologies, Surgical Biologics, Osiris Therapeutics).

Risks

• The company may not be able to convert their debt to equity on favorable terms.
• Current success that the company is experiencing with bone scaffold for the dental market could be ephemeral due to competition or otherwise.
• New product launches planned for the dental markets may fail or not even occur at all.

Catalyst

• Strong Q4 results with another quarter of 100%+ growth and modest profitability expected
• Strong 2020 results with ~40% revenue growth expected and meaningfully higher EBITDA
• Favorable debt conversions