SCIE: PENTAX Deal, Biz Update Call

Brian Marckx, CFA

SCIE Lands Major Distributor, Books $310k In Initial Sales

SpectraScience Inc. (SCIE) nailed down the large distributor that they’ve been hoping to land. Effective June 15th SpectraScience entered into an agreement with Pentax Europe GmbH, a European subsidiary of Tokyo-based optical giant Pentax Ricoh Imaging Co., for a five year deal to be the exclusive distributor of WavSTAT for colon cancer in Europe as well as parts of the Middle East and Africa. In total, the distribution agreement covers 23 countries.

The agreement, which includes minimum annual purchase quotas of the WavSTAT instrument and forceps in each of the designated countries, provides that SCIE will sell WavSTAT and the forceps to Pentax for $30k per device and $825 per five-pack, respectively. Details of the minimum purchase agreement are confidential.

Pentax, through its Pentax Medical division, is one of the largest and most respected worldwide providers of gastroenterology devices including a variety of gastroscopes, colonoscopes, endoscopes, sigmoidoscopes and confocal laser microscopes. While (as we noted in our initiation report on SCIE) Pentax is considered a direct competitor to SpectraScience, they offer a leading line of cutting edge endoscopes which are compatible with SpectraScience’s forceps which provides Pentax with a potentially valuable and appealing extension to their product portfolio. It also helps to further differentiate and expand their product offerings relative to major competitors including the likes of Olympus, Mauna Kea, and Fujinon. Pentax brings a very substantial distribution reach and potentially very valuable customer contacts, relationships, and experience in international markets that dwarf SpectraScience’s current capabilities. And with initial expected gross margins on sales of the forceps to Pentax at around a healthy 40+% (and expected to grow with higher production), this deal with Pentax appears like it could be a big win for SCIE (and a nice addition for Pentax).

An initial focus for SCIE and Pentax Europe will be the Netherlands’ new colon cancer screening program which management talked about on the March 27th investor call. SCIE is positioning to supply WavSTAT systems under this program, which is expected to significantly increase the demand for colonoscopies to such an extent that there may not be a sufficient number of physician specialists handle the patient flow. During 2012 hospitals in the Netherlands will train nurse endoscopists to perform colonoscopies – SCIE sees this as a potential opportunity to supply WavSTAT under this program as it provides a non-subjective diagnosis without the need for interpretation by a specialist.

$310K In Initial Sales Booked In Q2….
Subsequent to the announced distribution agreement, SpectraScience noted that they began shipments to Pentax just prior to Q2 quarter end (June 30, 2012) and that they expect to book $310K of revenue in the second quarter. On the 7/9 business update call management noted that Pentax already has customers for each of the units purchased and these customer orders came from France, Germany, the Netherlands and the UK (indicating that there’s customer and geographic diversification beyond just the Netherlands’ screening program, an obvious positive).

We have adjusted our Q2 2012 revenue estimate from $155k prior to the revenue pre-announcement to $310k. We have made no other material changes to our model. We are also maintaining our Outperform rating and $0.35/share price target on SCIE.

Business Update Call 7-9-2012

Management held a business update call on July 9th. Highlights included;

  • Pentax Already Marketing WavSTAT – WavSTAT for the colon cancer application is already included in Pentax’s trade show and industry conference marketing materials in Europe. It will also be included in Pentax’s booth at the United European Gastroenterology Week in Amsterdam in October.
  • Sell WavSTAT At Cost, Profit From Forceps – SCIE will sell the WavSTAT console to Pentax at cost and expects sales of the forceps to Pentax to generate initial gross margin in the 40% – 50% range. As we’ve indicated since initiating coverage of SCIE, this is consistent with our model in which we assume the console (i.e. – “razor”) is sold at cost and initial gross margin of the forceps (i.e. – the “razor blade”) is just under 40% (slightly more conservative than management). Similarly, Pentax will sell the console to the end-user customers at cost and profit from the sale of the forceps (the recurring revenue stream).
  • Additional Financing – cash position remains tight and will getter even tighter barring imminent financing given the expectation of increased burn rate as a result of inventory building and related expenses (sales training, trade shows, presentations, market evaluations, etc.) to support the initial commercialization. The annual shareholder meeting on Friday will include a vote to increase total capital stock from 225 million shares to 325 million shares, including an increase of common shares from 175 million to 275 million. Management hopes to execute a two-stage financing; the first a smaller (~$1.5 million) raise in the very near which would likely be similar in form to recent raises (i.e. – OID convertibles) which would get the initial commercialization off the ground and the second, a larger (management didn’t offer a number) raise sometime around the fall of this year through the sale of common stock which, by that time, would hopefully have significant institutional interest. As our model had already included assumed regular sale of equity/convertible securities, we have made no changes to our modeled outstanding share count. Aside from a couple of hiccups (such as the slight delay in getting a large distributor on board and related goose egg for revenue in Q1) management has clearly done a good job of delivering on its strategy over the last several quarters, highlighted by the distribution agreement with Pentax. Assuming management continues to hit the general milestones that they’ve outlined, including expected sequential sales growth over at least the next two quarters (and presumably longer and almost indefinitely on a y-o-y basis), this should resonate positively with investors and generate additional interest from the institutional audience.
  • U.S. Approval – the expectation continues to be that a supplement to the original PMA is viable path to gain regulatory approval to market the current model (WavSTAT4) in the U.S. In order to do so SpectraScience needed to make user interface improvements which required changes to the software. Management noted that the software updates are being completed but could not offer any potential timelines on when they might be finalized and a regulatory package completed.

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