Description

SRLS received a buyout offer in late June from MSMB Capital for $4.25 per share, a 44% premium to today’s price. The Board has since hired Lazard to evaluate alternatives (including a sale) to enhance shareholder value and a response is expected shortly. Although skeptical of the genuineness of this offer, it triggered a strategic review which might lead to a sale of the Company sooner than expected. 

What is misunderstood?

The products business has high switching costs for the following reasons:

• Companies that incorporate SRLS controls/panels into their diagnostic test kits are highly likely to continue to use SRLS products as they are spec’d into the FDA approval documents, known as a 510k. Changing suppliers for these products requires a new 510k filing which is costly and time consuming.
• Reagents and raw materials used in discovery are also spec’d into the final manufactured product (drug, diagnostic kit, vaccine) and any deviation or substitution of these materials by the manufacturer requires a new set of FDA documents.
• In performing lab testing, three potential sources of error exist: i) the test itself; ii) the operator or iii) the control panel. In order to minimize the number of changing variables, labs are reluctant to change control panels once they find panels that work well in terms of accuracy and available supply.
• SRLS has established trust among its customers, which is paramount in the control testing business. Moreover, given the small market size for specific controls/panels, SRLS has sufficient economies of scale through its R&D which prevents new entrants to the market. 

II.   BioServices (30% of revenue):  Biobanking service used in clinical and bench research for the storage of tissue samples. 80,000 sq. ft. facility located in Maryland that stores and manages 20 million biological samples per annum. 

• This segment sells primarily to NIH, resulting in limited flexibility and pricing power. This segment also accounts for a disproportionate share of total costs and is not near as attractive an asset as SRLS’s core products business. 
• Given that it is profitable and that it is one of only a few commercial biobanks in the US, this segment has value but we believe it would be better off under a different owner, a possibility currently being explored by the Company.

Growth in SRLS’s core business

         I.        We forecast high single-digit growth in the core business

• SRLS products are a core component of the diagnostics industry, a low cost but high value add component to healthcare delivery, and which we project to grow in the high single digits in the coming years driven by utilization growth from aging baby-boomers. Management indicated that >80% of SRLS revenue is generated from the diagnostics sub-sector.
• Conversations with customers suggest that annual price increases of 2-4% are expected and generally tolerated.

         II.       New products in high-growth sub-sector

• New products gaining traction particularly by expanding into IVD (in vitro diagnostics) and molecular diagnostics controls/panels and cellular assays for which the company has invested significant R&D. This is a sub-segment within diagnostics that is forecasted to grow at a solid pace in the coming decade and should boost SRLS performance in the coming years.

Competition: 

SRLS primarily competes with its own customers who could decide to make, instead of purchase, the controls/panels for their diagnostic kits.  For most customers the R&D cost to develop these products makes it prohibitive; it is more efficient to outsource to SRLS. Customer churn is therefore minimal and the majority of SRLS’s revenue is recurring. There are also niche-within-niche segments.  Customers have highlighted SRLS’s strong products and market position in hepatitis, HIV and other infectious disease control panels.  In some areas SRLS also competes with larger companies that develop controls/panels, including Life Technologies, Bio-Rad (mostly Europe), and Millipore.

In the Bioservices division, the primary competitor is Thermo which also has a facility that primarily serves NIH and CDC. If the bioservices division is sold, Thermo would be the most logical buyer. 

2012E Financials

Above are our projected results for 2012, which will see normalization in sales to a large customer currently destocking inventory and some growth as new products introduced in recent years increasingly gain traction. Conviction in these results is driven by the competitive barriers to the core business, our own due diligence with customers and the FDA regarding volume stickiness, and overall growth in the diagnostics sub-sector. 

Historical financials are mostly misleading given the issues associated with the bankruptcy and the reorganization. 2011 results are also not reflective of normalized performance due to a number of temporary issues and one-time items (including $500k severance expense for the former CEO). We are confident these issues have been rectified and the Board is correctly focused on continuing to build a solid company if no buyout offer is sufficiently attractive. If the Company is not sold, we would expect a return of capital through a buyback or dividend. Additionally, on a recent earnings call, management implied a possible divestiture of the non-core and less attractive bioservices business. This would be a positive development, leaving management to focus on its attractive core business.  

Valuation

Applying a 14x multiple to our estimate of 2012 FCF (fully taxed) and taking in to account the excess cash, we value SRLS at ~$4.75 per share, ~ 60% higher than the current stock price. Additionally, value should be given to the ~$30M tax assets as an incremental $2-3M in cash per annum will be added to the balance sheet in the coming years due to the tax shield, which is material for a Company with a $41M EV. Given the significant operating leverage and the growth opportunities, we believe our estimate of SRLS’s value is conservative.

Other relevant points

• Bankruptcy: In March 2006, the Company filed for bankruptcy which was caused by the deliberate misstating of inventory and booking of revenue by former management. The Company emerged from bankruptcy protection under a plan of reorganization and with new management in 2007. 
• Management/Board: Joseph Nemmers was recently appointed Chairman of the Board. Our diligence on Mr. Nemmers suggests he has the leadership ability to smartly grow the business and will also act in the best interests of shareholders.  The current interim CEO is the CFO Greg Gould. If the business is not sold or broken up as a result of the strategic review, we believe the board will hire a new CEO to drive the stand-alone business to its full potential before being sold at a later stage.
• Balance sheet and loan agreement: Strong balance sheet with ~$18M cash (~$0.90 per share) and negligible debt. SRLS also has a $20M loan facility agreement that it could draw upon.

Key investment risks

• A bad acquisition with the excess cash
• Too much investment into the less profitable bioservices division
• Pricing pressure downstream of healthcare reform impacts
• Poor execution relating to personnel and sales force changes 

Catalyst

• Solid 2012 and 2013 results
• Evidence of new products gaining traction
• Buyback/dividend
• Sale of the bioservices division
• Takeout