New Mandate Will Help Sell Veriteq's FDA-Approved Microchip

| About: VeriTeQ Corp. (VTEQ)

Editor's Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.

Most companies are trying to sell products, but very few companies have the government mandating purchases in their product category. Veriteq (OTCPK:VTEQ) found itself in this enviable position just a few months ago and will continue to enjoy this luck for the near-term future. Because of an FDA ruling with an initial compliance deadline of October 2014, Veriteq will begin to enjoy mandated demand for its niche industry before October 2014 and has forecasted revenue of $239 million - many multiples of its current market capitalization - with 61% gross profit margins. Because of the immediate nature of Veriteq's first-to-market business, I have bought shares and am very optimistic about the first three quarters of 2014. Below, I discuss my investment rationale and the real risks of Veriteq failing to accomplish its revenue goals.

To summarize so far, Veriteq is the exclusive provider of the world's first FDA-cleared RFID device for on demand identification of medical devices that are implanted inside the human body. In other words, Veriteq sells a tiny $500 RFID chip that goes inside artificial joints and breast implants so they can be scanned by a doctor - even after decades of being inside the body. Doctors scan Veriteq's radio microchips from outside the body using Veriteq's hand-held scanner.

Veriteq's RFID microchips and hand-held readers are fully FDA approved. Its microchips are installed within medical devices so that manufacturing information can be recalled on demand, passively, through the skin using radio waves, in the event of an emergency like a product failure. Patients often lose product warranty cards, making paper-based identification unreliable in urgent medical situations. Veriteq's RFID microchip can never be lost, as it is implanted inside the medical device itself and always accessible from the hand-held reader at the point of care.

You might be wondering why a would doctor need to scan a device years after surgery. In France in 2010, a manufacturer of breast implants named PIP used industrial-grade silicone instead of medical-grade in its implants. As a result, PIP implants had double the rupture rate versus other implants, and patients grew very concerned that they may have had PIP's implants inside of their bodies. Unfortunately, many of these patients had no idea who the manufacturers of their implants were, did not have their product or warranty cards, and their plastic surgeons did not have records. This uncertainty lead to understandable panic among patients.

FDA Steps In

In response to growing concern about product failures and anonymous medical devices in the U.S., the FDA proposed a rule on July 10, 2012, requiring medical device manufacturers to adopt a uniform identification system for their products. On September 20, 2013, the FDA finalized this rule reflected in § 801.50 requiring medical device makers to comply with its Unique Device Identification system (UDI). This FDA Final Rule for UDI requires manufacturers to disclose the product's lot or batch number, expiration date, and manufacturing date, as well as link this information through the product's UDI number to a searchable database administered by the government. Rapid access to data like a serial number could be potentially lifesaving in the event of a product recall or when an adverse event report is issued by the FDA.

No personally identifiable patient information will be stored in this database. UDI numbers will simply serve as a way to retrieve manufacturing details in the event of emergencies like product defects or recalls. Many other countries are joining the FDA by creating similar systems, such as England's statute expected to pass legislative approval by late 2014.

The FDA has scheduled deadlines for UDI compliance.

  • Class III medical devices (high risk) by October 2014
  • Class II medical devices (moderate risk) by October 2016
  • Class I medical devices (low risk) by October 2018

Catalyst: October 2014 Deadline

I benefit as a shareholder from a near-term catalyst of Class III medical device manufacturers scrambling to comply with a new government mandate by October 2014. At the moment, Veriteq provides the only product that can satisfy the FDA's demands for certain products.
"We believe we are the only product today that has the ability to meet the Direct Mark mandate of the UDI legislation," said CEO Scott Silverman. "We believe we are uniquely positioned with our FDA cleared technology and have an early mover advantage to give major medical device manufacturers the ability to comply with the Direct Mark requirement."

The FDA classifies breast implants and artificial joints as Class III medical devices, and they therefore must comply with FDA Final Rule for UDI by October 2014. Veriteq forecasts breast implants accounting for 66% of its revenues during the next five years, with artificial joints accounting for 22%.

How much money does this mean? I benefit as a shareholder by not having to guess how much money Veriteq plans to make from new FDA Final Rule for UDI compliance orders and its other operations. Veriteq publicly forecasts $18.5 million in revenue for fiscal 2014 - more than its current market capitalization - with 53% gross profit margins. When the Class II device deadline of October 2016 arrives, Veriteq forecasts $58.1 million in annual revenue with 61% gross profit margins. Finally, by the time the Class I deadline of October 2018 arrives, Veriteq forecasts $70.2 million in annual revenue with 63% gross profit margins.

Overall, with just $6 million of easily serviceable debt, I believe shares are uniquely undervalued given this near-term catalyst of the FDA's Class I compliance deadline this October. Veriteq's technology was cleared by the FDA in 2004 and is covered by dozens of U.S. patents, providing a strong barrier to entry against would-be competitors. Veriteq has experience delivering shareholder value, selling a RFID device five years ago to Stanley Black & Decker for $47.9 million. Veriteq's CEO was additionally responsible for leading a former company to a NASDAQ uplisting and has 15 years executive experience with technology companies. Silverman personally owns 5,462,770 shares of Veriteq common stock, squarely aligning his interests with shareholders like me.

My investment rationale is simple: the current market capitalization of Veriteq is a fraction of its forecasted revenue this year, not to mention the next five years. However, there is a serious risk surrounding this forecast, and I will analyze this risk below.

RFID Privacy Concerns

Briefly, because RFID technology often accompanies questions about privacy, I wanted to answer reader's questions regarding Veriteq's products. I had privacy questions myself. The following corporate statement helped to clarify this topic.

Veriteq's Q.I.S.T. is the only FDA cleared UDI on the market that can give an implantable medical device manufacturer and healthcare provider the ability to retrieve UDI information about an implantable medical device in vivo, on demand, at the point of care, from outside the body. Currently, Veriteq knows of no other companies that can offer this type of solution to the medical device community.

Veriteq places the highest priority on patient privacy and confidentiality. Our RFID technologies are passive in nature and inaccessible without the proper equipment, which is only available to doctors, hospitals and manufacturers of implantable medical devices. The databases that store any device or treatment data collected from our technologies are maintained by our clients in healthcare institutions and/or medical device manufacturers, all of which observe the strict guidelines published by HIPAA and follow the same information security protocols that are currently in place in the various hospitals, surgical centers and oncology practices that use our technologies.

No personal patient identification data is ever captured, stored or recorded.

Risk Analysis: Revenue Forecast

The main risk for this investment is Veriteq's revenue forecast. Given Veriteq's small current market capitalization, if Veriteq accomplishes anything close to its forecasted $239 million with 61% gross profit margins during the next five years, current shareholders will have nothing to worry about and plenty to be happy about. However, if Veriteq has grossly overestimated its revenue potential and misses this mark entirely, say $100 million or less, then its current market capitalization is probably fair, although any further disappointment would undercut the current market capitalization.

What are the risks of Veriteq failing to accomplish its goal?

First, I want to identify the size of Veriteq's addressable market. Most people know that plastic surgery is growing in popularity. Indeed, cosmetic surgeries in the U.S. totaled 14.6 million in 2012, a 5% increase over the prior year, and breast augmentation is the most popular form of cosmetic surgery. There are approximately 3 million breast augmentation surgeries performed worldwide every year, although the FDA acknowledges that unreported surgeries could increase this total by 2-7 million. The American Society of Plastic Surgeons officially reports that U.S. surgeons performed 286,000 breast augmentation surgeries in 2012.

Now, Veriteq has forecasted $11.5 million in breast implant revenue in 2014. If I assume 50% of manufacturers buy Veriteq's product, no market growth whatsoever and no sales outside the U.S., Veriteq's forecasted $11.5 million in breast implant revenue calculates to $80.42 in revenue per procedure ($11.5M/50%/286000). Recall that Veriteq's microchip ultimately retails for $500 per procedure, so I find this forecast to be attainable at a 50% adoption rate.

However, and even though full UDI compliance is mandated, 50% adoption is not guaranteed. Of course, 100% adoption is possible, as Veriteq has no direct competitors (in fact, the FDA considers its microchip a predicate device, meaning other manufacturers wishing to enter this industry will be measured against its device). However, adoption at less than 50% is possible, and as we will see, the key risk is a low adoption rate.

Main Risk: Low Manufacturer Adoption Rate

To understand why Veriteq could fail to achieve a high adoption rate (i.e. failing to sell its microchip to most implant manufacturers), consider the formal language of the Direct Mark mandate of the FDA Final Rule for UDI. Below I provide the relevant quotation.

Form of a UDI when provided as a direct marking. When a device must bear a UDI as a direct marking, the UDI may be provided through either or both of the following:

(1) Easily readable plain-text;

(2) Automatic identification and data capture technology, or any alternative technology, that will provide the UDI of the device on demand.

Here we see Veriteq's true risk. All implantable medical devices are required by the FDA to have a "direct marking" by October 2014, but this direct marking can either be plain-text or technology. Veriteq hopes that manufacturers will adopt the latter - technology that will provide the UDI of the device on demand - but manufacturers are not technically required to use this technology. If they want to choose option 2, they would need to buy Veriteq's chip, but they can choose option 1 and simply print the UDI number on the device.

Although Veriteq certainly has a compelling sales pitch for all of the reasons discussed above - rupturing breast implants in France, lost warranty cards, unreliability of paper-based identification after decades, need for on demand identification during medical emergencies - manufacturers can still choose to manufacture implants without RFID technology. To be clear, its CEO publicly stated during an interview, "We believe we are the only product today that has the ability to meet the Direct Mark mandate of the UDI legislation" (emphasis mine). Yet if the majority of manufacturers or consumers continue preferring plain-text UDI over technological UDI, Veriteq will fail to achieve its revenue goals.

To provide another example, let me discuss the addressable market for artificial joints. Veriteq forecasts $5 million in artificial joint revenue for 2014. Artificial joint surgeries in the U.S. comprise 600,000 annual knee replacements, 285,000 annual total hip replacements and 60,000 annual shoulder replacements. Assuming even sluggish adoption of 10%, no market growth and no sales outside the U.S., Veriteq's forecasted $5 million in artificial joint revenue calculates to just $52.91 in revenue per procedure ($5M/10%/945000). At a retail price of $500, I also find $52.91 in revenue per procedure to be attainable. However, as I mentioned above, if manufacturers or consumers prefer plain-text UDI over technological UDI, Veriteq might fail to achieve its revenue goals in this category as well.

Additional Considerations

Now that I have identified the main risk of my investment thesis, if investors conclude (like myself) that Veriteq will accomplish at least half of its $239 million revenue goal, there are a few additional considerations. First, Veriteq does carry $6 million of debt, but forecasted cash flow exceeding $30 million annually should easily service any interest payments. Its CEO also holds 58% of common shares with a once-in-a-lifetime opportunity to generate a quarter million dollars in revenue because of a fortuitous FDA ruling, and I doubt that he would let $6 million debt get in the way of his success at this scale. Most notes do not mature until November 13, 2014, anyway, and I will almost certainly sell my shares before that date. Investors might want to consider this maturity date when planning their investment timeframe.

Second, investors should note that there are currently 9,459,373 shares of Veriteq common stock outstanding with a pending S1 awaiting SEC approval that would raise this count to 15,792,708. Retail ownership is broad with 1,001 holders of record - broad ownership typically a sign of strength. In addition to Silverman who owns 58% of shares, another notable institutional investor owning 3,125,368 shares is Hudson Bay of Vringo fame. (See my thoughts on Hudson Bay here on Seeking Alpha.) Note that Hudson Bay will debt convert a majority of its holdings through the S1 if it is approved by the SEC. Veriteq expects approval within the typical 90 day timeframe (by February 11, 2014).

From a capital structure standpoint, investors should note that there are a few tranches of out-of-the-money options and warrants: 2,633,564 options exercisable at an average $10.15 per share, 2,644,444 warrants exercisable at an average $2.84 per share, and 735,734 warrants exercisable at an average $1.90 per share. Therefore, although I am comfortable with my shares priced far below these strike levels, investors should consider whether they would be willing to endure higher fully-diluted valuations above these thresholds.

I am happy with my investment at current prices, but Veriteq is not without serious risks. Regardless, I will only have to wait a few months to find out if I my analysis is correct.

Disclosure: I am long VTEQ. 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.

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