Implant Sciences: Diluted And Deluded

| About: Implant Sciences (IMSCQ)

Implant Sciences (IMSC.PK) makes devices to detect trace amounts of explosives and narcotics. It's current price is triple its 52-week low, despite financials that have been miserable for the life of the company, and a history of no successful products. It has been the subject of several promotional articles on Seeking Alpha, as well as an article I wrote documenting bankruptcy risk and price-pumping coverage by paid sponsors.

Implant recently released its annual report, providing more detail into its operations and financial condition. The report gives insight into the role stock dilution, in the form of warrants and other convertibles, plays in undermining the common investor. Unless otherwise stated, all quotes and financials in this article come from Implant Sciences annual report for fiscal year 2012.

The annual report says that Implant sells almost entirely to developing countries such as Nigeria and China. For the fiscal year 2012, it depended on one customer for 33% of its revenue. Its reliance on poor countries is out of necessity, since it has been unable to keep its government contracts:

...we have experienced a decline in government contract revenue during the year ended June 30, 2012 and have recorded no revenues from government contracts, due to the expiration of several contracts and our inability to secure new contracts.

Implant has changed its business several times in recent years (its name comes from a former medical business). It has never been profitable, has an accumulated deficit of $120 million as of June 2012, with average losses of $15 million per year. It has negative cash flows from operations. It has a working capital deficit of $33 million. The 10-K says its auditors have "substantial doubt" about its ability to survive. The company says it will run out of money within a year: "we will require additional capital in the third quarter of fiscal 2013" and failure to raise the capital "could require us to file for protection under bankruptcy laws."

The report says the company's finances are impairing its ability to make its product:

We rely on a single contract manufacturer …. From time to time in fiscal 2012, this manufacturer has limited the number of detectors it would manufacture due to our inability to pay for the detectors on a timely basis.

Revenue declined 50% last year, as the company sold 56% fewer products. Its current market capitalization is a little over $50 million. That makes it more expensive than Facebook, Google, and Apple, based on the price-to-sales ratio. No other price ratio is useable, since they are all negative.

As noted in my previous article, Implant has fed investors with a barrage of press releases and paid sponsorship (AKA "analyst coverage"). The company issues a press release when it sells a single unit, or hires one new sales manager. What it never mentions anywhere but in small print is that it depends on a single lender to avoid bankruptcy.

Teetering on the edge of bankruptcy is only half the risk. The other half makes the investment unwise even if the business succeeds. DMRJ Group, which holds all of Implant's debt, has deals allowing it to extract virtually all the company's assets at the expense of the common shareholder.

According to the annual report, as of September 25th, the company owed DMRJ $37 million, including interest. Its revenue in the last three years totals less than $14 million. So, its debt is more than double its revenue of the last three years combined. All the debt is due in March (recently re-negotiated from September 2012). All the company's assets are pledged to DMRJ to secure the debt: "If we are unable to repay these amounts as required...DMRJ may seize our assets."

There are currently 39 million shares outstanding, for a market capitalization of $51 million. However, the annual report reveals that convertibles and options, held mostly by DMRJ, amount to around 70 million additional shares if exercised. The fully diluted market cap of this Pink Sheet penny stock with declining sales and bankruptcy warnings is roughly $135 million. In other words, the current shareholders can only claim around 35% of any future earnings:

DMRJ, our secured lender, has the right to acquire up to 65,075,874 shares of our common stock upon the conversion of two promissory notes, the conversion of preferred stock and the exercise of a warrant. Our directors and executive officers own, or have the right to exercise options within 60 days to acquire, up to 9,169,196 shares of our common stock.

How can this play out?

Scenario #1. Implant develops a great product with high demand. It will take time to ramp up production from numbers currently so pitiful that the company issues a press release when it sells a single unit. It will have to compete with much larger companies (Morpho Detection, Smiths Detection, and NucTech), and underbid to establish itself. This rosiest of scenarios doesn't let it go from a company with average revenue of $4 million to one that can erase $37 million in debt by March. In the possible world where Implant has a competitive product, DMRJ will be able to seize it and leave the common shareholder with nothing, and the 10-K says so:

...these stockholders could have...absolute control over the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets....

Scenario #2. Same as above, but DMRJ doesn't seize all the company's assets. Instead, the company issues 70 million more shares to meet the conversion of all the preferred stock, warrants, etc. it has issued. Today's investor promptly sees his stake reduced to 35% of today's value. And, in the event DMRJ cashes out that massive position, a torrent of selling.

Scenario #3. History repeats. Implant continues to lose money, and the warnings of its auditors and management come true. Implant goes bankrupt. By then, DMRJ has sold a large portion of its stock, much of which it converted at $0.08 per share, at considerable profit due to the currently heightened price.

The most recent hype included DMRJ Group itself. In early September, $12 million of the line of credit from DMRJ was swapped for a note that could be converted into preferred stock that could be converted into common stock at $1.09. Implant and DMRJ described this as proof of the lender's commitment to Implant. In the press release, David Levy of DMRJ said:

Renegotiating a portion of our line of credit with Implant Sciences into a term loan that is convertible into equity in the Company clearly shows our confidence in the continued success of Implant Sciences.

Implant CEO Glenn Bolduc said: "This transaction is a first step in positioning us to materially improve our balance sheet and strength as a publicly traded company."

How the exchange signals confidence or improves the balance sheet is obscure. Debt was not reduced, merely reconfigured with more options for DMRJ. Implant has to pay 15% on the preferred shares. Nothing was converted to common stock. Furthermore, DMRJ reserved the right to undo the deal. DMRJ can force Implant to buy back the preferred stock, if Implant does not i) have at least one product approved by Transportation Security Administration by the end of this year, or ii) achieve revenues of at least $7,500,000 per fiscal quarter, commencing with fiscal quarter ending in 2013 (Implant has never had that much revenue in a year). While David Levy was talking about confidence, he was busily checking the exits (and paying himself 15%).

The bottom line is that Implant Sciences is a zombie company being propped up by DMRJ Group, in order to milk shareholders. There is no way for the ordinary, trusting investor to profit. The story told in company press releases is radically different from the one disclosed in the small print.

Disclosure: I am short IMSC.PK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.