Description

Rockley Photonics is a busted SPAC, with the share price trading more than 70% below its 2021 high. Even worse, the company is pre-revenue and burning more than $100mm in cash a year. This company arguably shouldn’t be public, but that doesn’t mean it isn’t an attractive investment at the current share price. 

Rockley is developing photonics (laser) technology that should leapfrog the current wireless health sensor technology that everyone is wearing on their wrists today. Existing biomarker sensor technology is LED-based technology, while Rockley’s proprietary photonics technology is 1,000x more accurate and could allow for additional applications such as alcohol monitoring, glucose monitoring, lactate monitoring, carbon monoxide, blood pressure, hydration, etc. Put simply, Rockley offers fitness enthusiasts and patients the equivalent of a testing lab on a wearable chip, except the testing is continuous and non-invasive.

Besides the change in sentiment related to SPACs, Rockley’s shares have been especially pressured in December due to tax loss selling and due to a revenue forecast change announced during the holidays related to a tertiary business in China that should have very little impact on either free cash flow or intrinsic value.

The Company
Rockley was founded in 2013 by its current CEO, Dr. Andrew Rickman, who is one of the pioneers of the silicon photonics industry. He founded the first company to commercialize silicon photonics, Bookham, which was backed by Intel and Cisco and eventually went public on the Nasdaq. Bookham’s name was changed to Oclaro which was eventually acquired by Lumentum. He then founded a second company, Koturo, which was sold to Mellanox in 2013, which Nvidia in turn acquired. After selling Koturo to Mellanox in 2013, he started Rockley.

Most of the top management team are people with highly technical backgrounds similar to that of Dr. Rickman. At the time of filing for the SPAC merger, the company had 82 P.h.D.s and 156 engineers working for the company.

Before the SPAC acquisition of Rockley, Rockley had raised $390 million and was valued by SC Health, the SPAC acquirer, at an enterprise value of $1.2 billion. In conjunction with the offering, $150mm was raised in a PIPE which included participation by Medtronic.

As the merger approached in August, the climate surrounding SPAC mergers changed for the worse. When the SPAC business combination was announced in the spring of 2021, SC Health shareholders were given the option to approve the transaction and, if they chose, to redeem the shares. Unfortunately, there was a surprisingly high level of redemptions in the runup to the acquisition close, so the cash that Rockley had available was $145mm at the close on August 11th, versus an expectation when the acquisition was proposed of $283mm in cash. Since the merger, management has not sold any shares, but this should be unsurprising as they are subject to a six-month lock-up agreement.

One of the primary reasons Rockley decided to go public was to gain credibility with prospective customers and investors due to the regulatory scrutiny required as a public company. Rockley currently has 11 agreements with various consumer electronics companies, including Apple, that represent >60% of the smartphone and wearables market. Of those 11 future customers, management used just four to form the basis of its projection of over $1bn in sales by 2024 at the time of its merger in summer 2021. Rockley first began developing a business relationship with Apple in 2017, and Apple apparently is paying them $80mm to fund engineering efforts to develop a sensor for their next generation of smartwatches which are being rolled out in 2023. In addition, Rockley has formed agreements with 5 MedTech companies, including Medtronic, to develop clinical products which the FDA might eventually approve and to fast-track the launch of unapproved-by-the-FDA medical grade products. Besides Medtronic, Applied Materials is also an investor.

The Marketing Opportunity for Rockley
Rockley Photonics has been developing proprietary sensor technology for use in wearables, smartwatches, and medical devices. The sensor technology compresses the sensing capabilities of a tabletop clinical spectrometer into a wearable chip that can be carried on one’s wrist. Traditionally when you shrink an instrument, the performance declines as less light goes into the device. However, the technology architecture Rockley has developed allows for an improvement in performance vs. a lab spectrometer. 

Compared to existing LED-based sensors currently in use, Rockley’s photonics-based sensors are supposed to provide a 1,000x improvement in accuracy and one million times better resolution. Rockley’s photonic sensor also enables the measurement of numerous biomarkers which LED-based sensors cannot measure, such as hydration, blood pressure, core body temperature, lactate, and glucose.

The technology is being designed to work anywhere on the body with a reasonable level of blood perfusion. Perfusion happens when oxygenated blood is delivered to the various tissues of the body from the heart. Besides a sensor on the wrist, you could get a measurement by placing your finger on a smartphone or placing a smart patch on your chest.

The benefit of these products should be self-evident. It allows for health monitoring for fitness freaks and health optimizers. It also provides early warning signs for the onsets of disease, much like the current set of wearables people are using only better, faster, more robust, and more accurate. For doctors and hospitals, it allows patients to be discharged early and monitored remotely. Rockley’s technology matches up well with an increasing consumer focus on preventative health, the proliferation of wearable technology, and patients increasingly turning to Covid-driven at-home health monitoring to avoid in-person visits to the hospital or doctor’s office. According to Gartner, the smartwatch and wearable markets are expected to grow at a CAGR of 20% through 2024:

Below are the three areas of product focus for Rockley:

1. Consumer Wearables: The immediate focus is on the wearables ($7bn TAM) and smartphone ($23bn TAM) markets. Rockley will be offering a basic module, which includes blood oxygen, hydration, heart rate & heart rate variability, core body temperature, breathing rate, and blood pressure. At the same time, Rockley will be offering an advanced module that includes the functionality of the basic module plus alcohol, glucose, carbon monoxide, and lactate monitoring.
   
   

2. Medical Grade Devices: In parallel with Rockley’s wearables and smartphone sensors, management is also working on MedTech applications ($18bn TAM) to allow for early detection of diabetes, heart disease, and other major diseases. Clinical biomarker sensors would involve upgrading Rockley’s chips to double the number of sensors, thereby significantly enhancing the capabilities of the chips. Besides continuous glucose monitoring, Rockley’s clinical sensors should detect several other important chemicals in the blood such as albumin, urea, and creatinine. Several weeks ago, the company released a white paper demonstrating the efficacy of its sensors in measuring core body temperature more accurately than conventional measuring devices such as a tongue thermometer. 

   
   Because it would require extensive testing on the part of its MedTech partners to obtain FDA approval, Rockley management is not expecting FDA-approved clinical sensor revenues until 2025 at the earliest. Rockley’s advantage here is that its sensor technology allows for health monitoring outside the clinic or the hospital and offers testing solutions to the average patient which are more accessible and more cost-effective than using bulky, high-cost medical lab equipment. 

As a result of the strong data that has come out with some of the human trials with its medtech partners, at the last quarterly earnings call management announced that it is now planning to launch medical grade sensors which are not approved by the FDA as early as late 2022. While these sensors cannot be used to formulate a diagnosis, they can be used for alerting medical professionals that something might be off due to one or more biomarkers moving outside of an expected range. In my view, this line of business could add significantly to Rockley’s revenues and profits by 2024, yet management didn’t change its forecast after announcing that this launch would not be fast-tracked. Instead, Andrew Rickman said that its original 2024 forecast was now “de-risked.”

3. Long-term: Management believes there are several other areas of long-term opportunity which its technology platform will be useful for, including the production of optical transceivers for data center connectivity, machine vision applications for robotic and automotive LIDAR, and package optics for computer connectivity. These sectors are likely to have more competition from other silicon photonics companies, and I frankly think the company is better off just focusing on its health sensor business.

Competition
Rockley’s sensors should represent a giant leap over current technology with biomarker capabilities that will be unmatched (see table below). Moreover, it appears that the company has built an extensive moat around its technology and its process to keep competition from duplicating its sensors.

I am not aware of any company trying to develop photonic biosensors at the present moment. Moreover, management believes it would take hundreds of millions of dollars and up to 5 years to replicate Rockley’s progress for a well-financed, strategically focused competitor. The following factors should keep competitors at bay for awhile: 

• Rockley has spent over $300mm in R&D over seven years of continuous specialization to create a new technology that unlocks new use cases. This doesn’t prevent future competition, but it does create a capital and time-based hurdle that probably provides Rockley with a 3-5 year head start on a well-financed, would-be direct competitor (which currently doesn’t exist).
  
  

• Rockley employs a highly specialized, highly experienced, and highly regarded technical team with deep silicon photonics experience.
  
  

• The company has end-to-end control over its photonics and electronics designs, its co-packaging technology to put electronics and photonics together, and its proprietary algorithms and software to run the chips and measure the individual biomarkers. This control is purposeful to protect Rockley’s proprietary know-how, trade secrets, and information, generally making it more difficult for another company to replicate its processes.
  
  

• Rockley has been issued 157 patents with 305 pending patent applications, covering numerous relevant technology domains. Even with the money, the time, and a great management team, any competitor would face a significant IP hurdle to compete with Rockley effectively.

Today, Rockley’s potential photonics competitors are not working on biomarker sensors; instead, they focus their research and development efforts on data communications and Lidar applications. Thus, outside of Rockley, there are simply no photonics companies currently that have the platform to pursue Rockley’s target market.

While there are no direct competitors in the silicon photonics biomarker space, that doesn’t mean that there aren’t indirect competitors trying to attack this market from other, non-photonic directions. Several companies are trying to develop non-invasive or minimally invasive biomarker monitoring, but none are trying to put many different biomarkers on one device. Instead, most are pursuing a specific biomarker. For example, Abbott and Dexcom offer clinical continuous glucose monitoring that uses a patch with a tiny pinprick that goes into the skin. Another company, Withings, has a clinical product called ScanWatch with a built-in ECG that monitors atrial fibrillation.

My conclusion is that Rockley should have a monopoly in the multiple-biomarkers-on-a-wearable-chip space for years.

Financials

As of September 30th, the company had $125mm of cash on its balance sheet. Management has said that the company should have enough cash to launch its wearables line and get to a place where they are generating positive free cash flow. However, I have my doubts. During the Q3 call, management announced that it had signed an equity line of credit agreement of up to $50mm with Lincoln Park Capital. I suspect management wants to raise more capital besides that, but it’s probably difficult to do at the current share price.

Management’s three-year forecast at the time of the summer 2021 merger can be seen in the two tables below. They were expecting a quick ramp to $1.1 billion in revenue by 2024 based on an assumption of 21% penetration in the wearables market and 1.9% penetration in the smartphone market among the 4 customers with whom Rockley had already developed supply agreements at the time of the merger.

Since the merger, there have been three developments that should affect this forecast, two positively and one negatively:

1. Rockley expanded the number of contracted customers from 4 contracted customers to 11 contracted customers. Many of these new contracted customers are likely to be smaller customers than the original 4. Instead of raising its forecast when these contracted customer wins were announced at the end of Q3, management claimed that these new customers de-risked their original forecast.
   
   

2. Rockley announced that its medtech partners are ramping up much more quickly than they had originally anticipated at the time of the merger, and there are now contracts with 5 medical device companies, 2 of which are large medtech companies, one of them being Medtronic. Rockley expects to begin shipping product at the end of 2022 for medtech launches that should occur in 2023. Again, management did not raise its forecast, claiming that these revenues also de-risked the original forecast.
   
   

3. On December 21, in the midst of an already illiquid holiday market, Rockley announced that the U.S. government was prohibiting Rockley from selling data communication-related IP to its joint venture in China, Hengtong Rockley Technology Co. Apparently Hengtong Rockley had generated some revenues with Huawei, and for that reason the sale was prohibited. This announcement has absolutely nothing to do with the health sensor business. Rockley’s data communications technology is tertiary for the company. However, in conjunction with this announcement, the 2021 revenue forecast was reduced from $27.5mm to $7-$8mm and the 2022 revenue forecast was reduced from $78.6mm to $25-$30mm with these IP revenues going away. Besides these revenues being non-strategic in nature, these revenues were also very low margin. The cash flow impact from these revenues not happening are quite low. The 2023 and 2024 revenue forecast remained unchanged, and the company’s health sensor related forecast remained unchanged. Upon the announcement, BofA downgraded the company from Buy to Neutral and reduced its target price from $14 to $6, and the share price declined by another 15%.

These three announcements, when combined, should have increased intrinsic value. Nevertheless, ever since the original merger, the share price has continually declined.

Valuation
Cowen is placing a $22 price target on the company based on a 5x sales multiple applied to a 2024 revenue forecast of $861mm discounted back by 10%, which seems reasonable enough. That would also be more than a quadruple from the current share price.

Cowen also looked at comparable SPACs, semiconductor companies, and medical device companies to develop a comparable valuation for Rockley, but I don’t really see any usefulness in looking at comps. I think the best comp might normally be a semiconductor company like Nvidia, but Nvidia is absurdly valued currently (in my opinion).

I am estimating Rockley’s intrinsic value to be $15.03 based on looking at a best, base, and worst case scenario for the company, with the base case being management’s 2024 forecast and the worst case being a 100% loss. Unlike Cowen, I am using a 20% discount rate on the shares, given the high level of business risk involved.

Rockley also comes with some free options, in my opinion. One free option is that Rockley could develop one or more medical devices that the FDA approves, each of which could turn into multi-billion dollar market opportunities. For example, Dexcom (DXCM), a company that is singularly focused on clinical continuous glucose monitors, currently has a market cap of $55 billion. Also, Congress is considering requiring that automakers include alcohol sensors in all automobiles sold in the United States by 2026 in the infrastructure bill, and Rockley has the best alcohol sensor technology in the world. This is also a multi-billion dollar market opportunity. None of these options are included in the company’s 2024 forecast.

Catalyst

- Acquisition

- Successful product launches

- Dissipation of tax-loss selling