I will keep this a short discussion on the topic of Organovo (NYSEMKT:ONVO). Earlier in the week, I thought 3D printing companies may have further upside based on buyout potential. However, I don't think I stressed the potential downside in my analysis on Organovo.
I still believe ExOne (NASDAQ:XONE), Stratasys (NASDAQ:SSYS), and 3D Systems (NYSE:DDD) could have reasonable upside potential given their unique patent collection along with an early start advantage.
Seeking Alpha contributor, Richard Pearson, thoroughly gut Organovo for the discrepancy in valuation. The stock was grossly over-priced just like any other pump and dump. The stock collapsed in valuation overnight, and sadly I was mistaken on whatever premium Hewlett Packard may have ever had to pay on the company.
How I feel about the 3D printing industry
In general, I'm a huge optimist on 3D printing and believe that as the technology advances, the use in industrial applications may pick-up more than expected. However, the future is a very murky place, and while I try to look out from the windshield as far as I possibly can, sometimes I get hit by cloudy rain storms, making it difficult for me to come up with an accurate estimation of what may happen.
Even so, I believe that 3D Systems, Stratasys, and ExOne have both downside protection and upside potential. The aforementioned companies I mentioned in a previous article offered upside of 25% to over a 100% on the basis of patents, customers, and branding. I still believe that this will hold true for traditional 3D printing companies.
In 2014 laser sintering technologies will no longer be protected by patents (lowering barrier of entry). However, even if these patents were to expire the three aforementioned players in the space still have a significant technological lead.
ExOne focuses its R&D on these activities:
• Chemistry of binder formulation;
• Mechanics of droplet flight into beds of powder;
• Metallurgy of thermally processing metals that are printed through AM;
• Mechanics of spreading powders in a job box;
• Transfer of digital data through a series of software links, to drive a printhead; and
• Synchronization of all of the above to print ever-increasing volumes of material per unit time.
ExOne believes that the expiration of laser sintering technologies in the immediate term will have a low impact on the business:
As a result of our commitment to research and development, we also hold process patents and have applied for other patents for equipment, processes, materials and 3D printing applications. The expiration dates of our patents range from 2013 to 2029. We believe that the expiration of patents in the near term will not impact our business.
So in summary, if a company is willing to claim that it has an early start advantage in an S-1 filing that was combed thick and thin by a securities attorney, I'm pretty sure that the recent market sell-off across the basket of 3D printing companies will remain temporary for pure 3-D printing plays.
Stratasys stresses its strengths in its prospectus:
We believe that the range of more than 130 3D printing consumable materials that we offer is the widest in the industry. We consider our proprietary technology to be important to the development, manufacture, and sale of our products and seek to protect such technology through a combination of patents, trade secrets, and confidentiality agreements and other contractual arrangements with our employees, consultants, customers and others. All patents and patent applications for rapid prototyping processes and apparatuses associated with our technology were assigned to us by their inventors. We have more than 500 granted or pending patents internationally. The principal granted patents relate to our FDM systems, our PolyJet and PolyJet Matrix technologies, our 3D printing processes and our consumables, with expiration dates ranging from 2013 to 2031.
Stratasys has built up an impressive patent portfolio with patents expiring into 2031. Similar to ExOne, Stratasys has built up more of a durable advantage in its space than what investors are willing to give it credit for.
3D Systems isn't messing around either:
We regard our technology platforms and materials as proprietary and seek to protect them through copyrights, patents, trademarks and trade secrets. At December 31, 2012, we held 852 patents worldwide. At that date, we also had 208 pending patent applications worldwide, including applications covering inventions contained in our recently introduced printers. The principal issued patents covering aspects of our various technologies will expire at varying times through 2027.
3D Systems has many patents and pending patent applications that are expiring well into the future. So in other words, Hewlett Packard's recent announcement of entering into the 3D printing space may involve buyouts. Hewlett Packard will not be able to develop its own processes and technology on time to become market competitive. ExOne, 3D Systems, and Stratasys have a well-established advantage.
Organovo has significant downside
A really well thought out research report on Seeking Alpha sparked fears of an overly generous valuation across 3D printer names. This caused investors to sell Organovo, 3D Systems, Stratasys, and etc.
I largely agree with the negativity in Organovo. Long story short Organovo went public using reverse mergers. In the past reverse mergers have been used for financial fraud. Organovo's executives have been dumping stock at very high valuations.
In other words, this isn't a Steve Jobs story. The company is nowhere near close to creating a liver out of 3D printed technologies. So we can end the hype here.
R&D is expensed and does not go onto the balance sheet until the patent is sold and represented in cash. The other alternative is to buy a company outright or buy the patent itself and list the value of the patent as goodwill/intangible asset. Setting aside the discussion on accounting rules, the company does not have significant intellectual property in the space.
The research and development spending has been underwhelming. Sure, we can argue efficiency is better than wasteful spending. However, Organovo has only spent $1.5 million on research and development for the quarter. Organovo's R&D is slightly better funded than a University Campus research lab. In other words, the cash expenditure on R&D isn't indicative of a company on its way to a breakthrough in biomedical technology. The rate at which Organovo has advanced its technology has been slow; therefore investors shouldn't expect the company to fill its product pipeline with anything new in the foreseeable future.
The market for 3D liver assays (basically liver cells that can be used to test phase 1 drugs) was grossly overestimated. Richard Peterson mentions that the actual revenue potential of liver assays is approximately $2 million per year. This is based on the company selling liver assays for $1,750 and selling approximately 1,150 of these liver assays in any given year. The market size is limited because there are only so many biotechnology companies in the world that could practically use the technology. Plus, because we're talking liver assays, the market potential may actually be further limited.
Going to the same exact clinicaltrials.gov, the market for liver testing is small. Approximately, 6821 studies are currently being conducted for livers. Each liver study may use one liver assay tray, offering a market potential of 6,821 times the $1,750 market price for a single tray. This implies that the total addressable market is $12 million in a single year.
Assuming the company can capture 10% of market share in the first year, the company may generate $1.2 million in annual revenue. Assuming Organovo continues to capture market share, perhaps it can saturate 50% of the liver assay market, generating $6 million in annual revenue.
I'm still offering a very high premium when compared to the company's revenue. I offer this high premium because it's developing technologies that could further extend its annualized growth. I estimate that the company may be worth $153.96 million in market capitalization (most optimistic scenario). In other words my price target for the stock is $2.00 per share. Currently the stock is trading at $9.15 per share, implying 78% downside from current levels.
Investing into biotechnology names requires significant due diligence, and even then it may not necessarily work-out. The most optimistic case scenario is for Organovo to be bought out. But, then one must ask… why? Organovo doesn't have significant resources invested into its 3D printing technologies or its biomedical research. Any of the more well-established players in the biotechnology space may as well spend the hundreds of millions of dollars in R&D to develop their own 3D printed organ than in buying out Organovo.
Organovo has been pumped by the investment community over the years. The overly generous valuation should concern investors. In fact, investors should step back and thoroughly re-consider other plays in the 3D printing space that offer far better upside.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.