Initiating Coverage of Interleukin Genetics at Outperform - Analyst Blog

Brian Marckx, CFA

We have initiated coverage of Interleukin Genetics (ILIU) with an Outperform rating and $1.60 price target. See below for a free copy of our 18-page report on the company.

BUSINESS

Interleukin Genetics, Inc. (ILIU) develops genetic tests focused on personal health. Through applied genetics research and scientific collaborations the company has made significant progress in understanding how genetic make-up can affect an individual’s predisposition and risk of suffering from certain disease. Interleukin’s research has specifically focused on a form of genetic variation called single nucleotide polymorphisms (SNP) and how it can have an impact on a person’s health. The company has applied this knowledge in development of genetic tests focused on areas such as weight management, cardiovascular health and periodontal disease. Interleukin sells its Inherent Health line of tests, which launched in 2009, to the consumer market and maintains a CLIA-certified lab at its headquarters in Waltham, Massachusetts where consumers send test samples for processing.

The vast majority of Interleukin’s past revenue came through licensing and contract research agreements with Alticor Inc., parent company of Amway Global. Under these agreements Alticor funded a portion of product development and made equity investments and in return was given rights to market the company’s genetic tests under their own brand name (Gensona). In 2008 Interleukin began peeling off these licensing deals with Alticor (Interleukin retained all the intellectual property related to the tests) and the remainder concluded in 2009, concurrent with the mid-2009 launch of the company’s Inherent Health brand.

The company is now in somewhat of a transition mode and finally poised to reap the rewards of significant R&D expenditures incurred over the last few years associated with development of their recently commercialized genetic tests. While Amway Global acts as a key distribution partner, Interleukin continues to seek additional sales channels and broaden the customer audience for their tests. Following the launch of the Inherent Health line, Interleukin began to dedicate more resources towards sales and marketing via e-commerce, distribution agreements, publication of clinical studies, and presentations at industry and scientific conferences. A March 2010 presentation made at a major medical conference significantly benefitted sales of the weight management test, the company’s flagship product.

Interleukin continues with development of other genetic tests, including a very high potential new version of a test for periodontal disease which could launch around mid-2012 and be supported by broad dental insurance reimbursement.

OUTLOOK

SIGNIFICANT NEAR-TERM MILESTONES

• PST Study Results: On the Q4 2010 conference call Interleukin management noted that enrollment for the 4,000-patient University of Michigan / Renaissance Health study had begun and initial samples had been processed. According to management’s current expectations, enrollment will be completed later in 2011 and study results will be available in Q1 2012. If all goes as planned, the test will launch later in Q2 2012 and be supported by nationwide dental insurance reimbursement.

• Publish Weight Management Test Trial Data: Stanford University researchers are expected to resubmit the weight management test study results for publication in the near-term, supported with data from a confirmation study. Interleukin believes this confirmation data will provide requisite support to pass a peer review panel and result in publication in a medical journal.

o Larger Weight Loss Clinics: Some of the larger weight loss clinics also want to see confirmation data before considering integrating Interleukin’s weight management test into their programs. If and when the data is published, the hope is that these clinics will become significant customers/distributors of the weight management test.

o Retail Consumer Interest: The March 2010 presentation of the initial study results sparked a small media frenzy, in-turn generating significant interest in the weight management test. Publication in a medical journal may ignite a second round of attention and additional retail consumer interest in the test.

• OA Test Development: Interleukin will look to publish additional data from studies on the association between interleukin gene variation and osteoarthritis. The next step will be to bring in a partner for development of an OA genetic test.

FINANCIAL OUTLOOK

Our financial outlook for Interleukin is based on some recent trends in revenue, expenses and cash flow and incorporates assumptions relative to the outcome of certain events, including the milestones listed above. There is a significant level of uncertainty as to the eventual outcome of these potentially highly influential events which creates substantial risk that our outlook could differ from reality.

Fiscal 2010
Revenue in 2010 was $1.997 million, up 85% from 2009, with genetic testing revenue posting growth of 284%. The revenue growth is almost entirely attributable to a surge in sales of the weight management test following the Stanford study presentation in March 2010. This is highlighted by the relatively modest 6% revenue growth (166% genetic testing revenue growth) in Q1 (ending March 31, 2010), compared to 123% y-o-y revenue growth (328% genetic testing revenue growth) for the last three quarters of the year. While y-o-y comps have been encouraging, revenue has fallen sequentially since Q2 2010 (Q2 $573k, Q3 $545k, Q4 $511k) – which may suggest that this (at least initially) will be a relatively short-lived benefit. However, at the very least, it was enough to spark some interest from a greater number of institutional customers, including some of the larger weight loss clinics.

Net loss and EPS of $6.47 million and ($0.18) in 2010 improved significantly from 2009 when the company posted net loss and EPS of $9.18 and ($0.29). Aside from the better revenue number, 2010 results benefitted from leverage gained from higher test processing volumes, lower R&D expense as a result of completion of the research agreements with Alticor during 2009, lower advertising and administrative expenses, and the $473k QTDP grant. Our financial outlook assumes that significant opportunity remains to gain leverage in both cost of sales and operating expenses with further growth in revenue.

Revenue Outlook
Our model assumes that sequential revenue growth remains flat to modestly higher over the course of 2011, slightly benefitting from some more of the smaller weight loss clinics incorporating the weight loss test into their programs. While we have no insight into if or when publication of the weight management test studies will happen or what, if any, benefit it may have to revenue, we have to make certain assumptions – and publication of these studies is one that could have a potentially very significant impact on sales – both in the near and longer terms. Our assumption is that the studies are published towards the back half of 2011 which in-turn sparks greater interest from some of the larger weight loss clinics as well as retail customers – which results in a greater rate of revenue growth starting in late 2011 and early 2012. We model 2011 revenue of $2.46 million, implying growth of 23% from 2010, which includes 44% growth in Q4 2010. Publication of the data earlier than what we have incorporated into our model and/or greater uptake of the weight management test could prove our 2011 revenue estimates conservative.

Interleukin expects to have data analysis completed from the University of Michigan PST test study during Q1 2012 and hopes to roll out the test with insurance reimbursement in Q2 of that same year. Again, with no particular insight, it is very difficult to gauge the likelihood of hitting this timeline or the viability of Renaissance Health providing insurance coverage for the PST test. As it is now, we assume a soft launch of the PST happens sometime during the second half of 2012. For 2012 we model revenue of $7.24 million which assumes Interleukin continues to gain traction with sales of its weight management test with only an incremental contribution from the PST test. 2012 could be a real transition year for Interleukin depending on the success of the PST test launch (which is highly dependent on insurance reimbursement). Based on the enormous size of the potential market for the PST test, our revenue estimate for 2012 (and beyond) could prove extremely conservative.

Beginning in 2013 we assume most of Interleukin’s revenue growth is driven by sales of the PST test. Again, depending on the level of insurance reimbursement, these figures could be low.

EPS Outlook
Gross margin showed sequential improvement throughout 2010 as a result of higher test processing volumes and we expect this trend to continue for the foreseeable future. Operating expenses should also be fairly scalable from here on out as the bulk R&D for Interleukin’s current product line-up has already been completed and sales and distribution will continue to be outsourced.

For 2011 we look for EPS of ($0.16), reflecting 23% revenue growth, gross margin of 29% (versus 19% in fiscal 2010 and 28.6% in Q4 2010) and a 7% reduction in operating expenses.

We model EPS to grow to $0.18 in 2014 on revenue of $47.9 million and benefitting from continued improvement in gross margin as well as operating expenses as a percent of revenue.

For a free copy of the full research report, please email scr@zacks.com with ILIU as the subject.

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