Interleukin (OTCQB:ILIU) reported financial results for the third quarter ending September 30, 2011 on November 10th. While revenue came in slightly below our estimate, the difference was more than made up from a very strong gross margin and continued operating expense cost control. As we have noted in the past, management has done an impressive job over the last several quarters with minimizing cash burn, trimming costs and increasing efficiencies. The current quarter was no exception and despite the marginal miss on the top line, these cost and efficiency initiatives resulted in EPS beating our estimate by a penny.
Interleukin continues to make meaningful progress with completing enrollment of the PST (periodontal disease test) study - and noted on the call that their previous timeline (1H 2012) for having the study results available remains intact. The company also just announced that they initiated two clinical studies of the PST test in China. The study design is similar to the U.S. based studies and will allow Interleukin to see the predictive value of the PST test on ethnic Chinese populations - which greatly expands the ultimate target market for the product. Results from these China-based studies could also be available sometime in the first half of 2012.
Progress is also being made with completing a confirmation study for the weight management test, results from which are expected to be submitted for publication. We expect publication of the data to drive further interest in the test, especially from larger corporate customers.
Q3 revenue of $766k was about 10% less than our $855k estimate. 95% of total revenue came from genetic testing. Revenue grew 41% y-o-y but was down about 4% sequentially. While we have made some minor adjustments to our model, we continue to think revenue can grow on both an annual as well as a sequential basis. We feel it is worth noting that revenue continues to show impressive y-o-y growth, despite most, if not all, of the mainstream media hoopla surrounding the effectiveness of the weight management test having dissipated several quarters back. Management noted on the call that they are looking into additional marketing campaigns - which could potentially ignite even greater growth.
Gross Margin / Operating Expenses / EPS
Gross margin came in at a very impressive 51.6%, blowing out our 42% estimate. Gross margin continues to benefit from cost cutting and efficiencies in test processing, including lower material costs. We have made some adjustments to gross margins in our model, although relatively marginally, which, based on recent history, could end up being somewhat conservative.
Operating expenses were also better than our numbers, coming in at $1.4 million, over $300k lower than our $1.7 million estimate. This appears to be another testament to management's diligence in trimming costs where there's an opportunity to do so. We have similarly made some revisions to our estimates for operating expenses in future periods.
Q3 EPS was ($0.03) on net loss of $1.1 million, compared to our ($0.04) and $1.5 million (loss) estimates.
Interleukin exited the quarter with $1.01 million in cash and equivalents, compared to $1.71 million at 6/30/11. Cash used in operations was $906k, down slightly from the previous two quarters of the year ($1.17MM used in Q1, $1.13MM used in Q2). Cash used in operations was $3.21 million through the first nine months of 2011, significantly improved from the $4.54 million used through the first nine months of 2010.
Subsequent to Q3 quarter end (on November 9th), Interleukin drew another $2 million on their convertible credit facility with Pyxis. Pro forma for the draw, Interleukin had $3.01 million in cash and still has $1.3 million of borrowing capacity under the Pyxis credit facility - which is available through June 30, 2012. This should provide ample operating cash up until the June 30, 2012 due date but Interleukin will need to either extend the due date or refinance the debt. Management noted on the call that they are currently exploring different avenues to do so. Total borrowed on the loan (including the recent $2MM), currently stands at $13 million - the balance is convertible into Interleukin common stock at $5.68/share (i.e. - currently way out of the money).
SIGNIFICANT NEAR-TERM MILESTONES
- PST Study Results: Enrollment for the ~4,000-patient University of Michigan / Renaissance Health study is expected to be completed in early 2012 with study results available in the first half of the same year (unchanged from previous expectations. If all goes as planned, the test will launch later in 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, 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.
- 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.
- 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.
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.
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 by 1H 2012 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. We model 2011 revenue of $3.12 million, implying growth of 56% from 2010, which includes 64% growth in Q4 2011.
Interleukin expects to have data analysis completed from the University of Michigan PST test study during 1H 2012 and hopes to roll out the test with insurance reimbursement later 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 $6.90 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.
Gross margin showed sequential improvement throughout 2010 and has significantly widened through the first nine months of 2011 as a result of higher test processing volumes and lower material costs. We expect gross margins to remain above 40% from here on out. Operating expenses should also be fairly scalable 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 ($0.13), reflecting 56% revenue growth, gross margin of 49% (versus 19% in fiscal 2010) and a 4% reduction in operating expenses.
We model EPS to grow to $0.18 in 2014 on revenue of $45.6 million and benefitting from continued improvement in gross margin as well as operating expenses as a percent of revenue.
VALUATION / RECOMMENDATION
As we do not expect Interleukin to generate positive earnings in the near-term, we value the company using a multiple of our long-term EPS estimate and discount it back to the present. As there are virtually no publicly traded direct competitors to Interleukin, we value the company using the average P/E multiple of the medical research services industry which currently stands at approximately 17x.
Interleukin remains very much at the front end of what we model to be significant revenue and earnings growth for the foreseeable future. However, since this growth is predicated on the favorable outcome of a number of current “unknowns”, there remains significant risk that our estimates could differ materially from reality. To account for this risk we use an annual discount rate of 20%.
Applying a 17x multiple to our 2014 EPS estimate of $0.18 for Interleukin and using an annual discount rate of 20% values Interleukin at approximately $1.60 per share.