Champions Oncology Trades At A Sufficient Discount To R&D Capacity
Summary
- CSBR runs a PDX bank. PDXs are mice models of human derived tumors.
- The company offers services to bio and pharma companies in pre clinical treatment testing. Its test have high predictive power for human results, without the associated cost.
- CSBR has grown revenues and pre R&D income consistently. Today, the company operates at break even, and dedicates $10 million yearly to R&D.
- Management has been conservative, avoiding debt, share issuance, acquisitions and cutting unprofitable projects early.
- Although R&D capacity is not income, the multiple on this earnings measure is low enough in my opinion.
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Champions Oncology (NASDAQ:CSBR) runs a PDX bank, and offers oncology treatment testing services for bio and pharma companies.
The company operates in the stages previous to human testing, where operations are less expensive and much more recurring. It does not run the same risks as a company trying to develop a treatment, rather it offers services to those companies.
Interestingly, CSBR is operating at break even, but most importantly, it is able to self finance $10 million in yearly R&D expenses. Its management has shown signs of conservatism and efficient use of resources.
I believe the current discount to self generated funds to R&D is promising, and that the company's stock is an opportunity.
Note: Unless otherwise stated, all information has been obtained from CSBR's filings with the SEC.
Business description
Xenograft bank: CSBR is a xenograft bank. Xenografts are a transplant from one animal tissue into another. Specifically, CSBR has a library of human tumor tissues, and the ability to implant that tissue into mice, which can then be used to test treatments before testing on humans.
For a fraction of human testing cost, bio and pharma companies can gain information that has sufficient predictive power over possible results for humans. The companies then decide whether or not to continue with the much more expensive clinical trials.
So if a pharma company is developing a drug against colon cancer, it can ask CSBR to run tests on mice with human colon cancer. Furthermore, CSBR can provide the company with different types of colon cancer, and different characteristics of the original human patient (age, gender, habits, race, etc.). It would be impossible to replicate that with humans.
Service, not treatment development: Treatment development works like an option. It has a range of outcomes where it is worth nothing, and a range of outcomes where it is worth a lot. This makes investing in treatment development (or micro cap bio/pharma) a tremendously risky business, only suitable for big companies or very informed investors.
However, CSBR is not in the business of treatment development, but rather in that of services to treatment developers. In the gold rush analogy, CSBR sells picks and shovels. The company has been growing revenues consistently, which makes its risk profile very different from that of a one shot treatment company.
Good size and relatively small competition: According to InsightAce Analytics, the current preclinical model market (which includes other solutions) generates $1 billion in yearly revenue, positioning CSBR with a 5% market share. The company still competes with much bigger names like Charles River (CRL) and Crown Bioscience.
However, CSBR's bank size is not bad. The company claims on its 10-K to have 1,500 models. Crown claims 2,500, the cancer model finder has 4,500 xenograft models registered and Charles River claimed 500 models in 2020.
SaaS and drug development: CSBR also has small SaaS and drug development segments that are in nascent stages. The SaaS segment aims to use CSBR's gene database plus other databases to provide researchers with computational models. The drug development segment aims to develop preclinical drugs and then either partner or sell the drug to a bigger company to continue with clinical trials. These segments are very small though.
High gross margins: Like most technology businesses, CSBR enjoys a substantial gross margin. The recent decrease in gross margins was caused by the SaaS segment (more on this later).
Improving efficiency relations: I always like companies to show either a stagnant or even decreasing SG&A to revenues ratio. This shows that management is improving efficiencies, and that the company generates more money from new business than what it costs to create that business.
In the case of CSBR, I also add SG&A to R&D, because R&D spending should prove a much more durable moat creator than SG&A spending.
Conservative capital allocation: Because CSBR is still a growth company in a nascent industry, managers have to be extremely careful. It would be too easy to embark on glorious dreams of future TAM and over invest. Some investors are also attracted by these 'growth at all cost' companies and the stock price increases for a while to later collapse.
Fortunately, CSBR has shown several signs of being conservative. The company has not issued a significant number of shares since it reached operational break even in 2018. It carries no debt whatsoever and has $9 million in cash reserves as of 2Q23 (October 2022).
Furthermore, management has shown that it can cut back on spending when a project puts operational break even at risk. For example, the SaaS segment (a product called Lumin) is growing slowly, and has not performed as expected. Management commented on the company's 2Q23 earnings call that it would decrease spending on the segment, in order to protect margins. This indicates they are not stubborn.
Risks
Thinly traded: CSBR's average volume has been 25 thousand shares, that imply a traded volume of $100 thousand per day. Thinly traded stocks can become very volatile when there is a surprising event. In this case, if the company disclosed a negative event, selling pressure may not find buying volume and prices could move down quickly.
Technology moves fast: Although CSBR has shown more than a decade of consistent top line growth, and seems to have a competitive PDX bank, technologies could change quickly. The company will need to continue investing in R&D, and other technologies or competitors may steal its market. This is not a mature business selling to slowly changing consumers.
Valuation
Self-financed R&D capacity: For technological and growth companies, I prefer to use self-financed growth capacity as a better gauge of business performance. Because CSBR is a technology business, I believe R&D is the growth engine. However, because technology is risky, I want the business to finance R&D expenses sustainably, without recurring to debt or dilution.
CSBR has shown the capacity to consistently grow that R&D capacity, here proxied as pre-tax income minus R&D expenses. The company would have been operationally profitable since 2018 if it had cut back on R&D expenditure.
R&D capacity is not net income: Of course, I am not delusional, and I know that R&D is not net income, nor FCF, for several reasons.
First, R&D is in part investment and in part expense. If these companies do not invest consistently, they lose market share. So a portion of R&D is pure business maintenance expenditure. Second, R&D capacity is pretax, and therefore should be discounted for income taxes if I wished to consider it as net income. Finally, the cash used in R&D is gone, and will not come back, that is another reason to be conservative and self-finance R&D.
Therefore I require a much better R&D capacity yield than I require a net income yield. Say for example that I would be comfortable with an 8% yield on a company growing net income as CSBR grows R&D capacity. I should require at least double that yield, of 16%, for R&D capacity.
How much does R&D affect future business: This is a difficult topic, but one that is important to determine the return on the R&D expense. If CSBR had capitalized R&D expenses between FY16 and FY21 it would have gross 'research assets' of $30 million. In that same period it generated pre R&D operating income of $10 million, not that bad a return.
Further, the correlation between past R&D expenditure and gross profit is strong. That means, if past R&D expenditure increased, future gross profit increased as well.
CSBR's yield on R&D capacity: With current R&D capacity of $10.5 million, and the company trading at a market cap of $55 million, CSBR offers an R&D capacity yield of 19%, or conversely a multiple just above 5x.
Conclusions
CSBR trades at an attractive yield to R&D capacity. Of course, R&D is not the same as net income. Net income can be distributed, while R&D is invested.
However, CSBR has shown that it can invest these funds profitably, and more importantly, in a conservative fashion. The company is not financially leveraged, and has not made big facility investments. Management has been quick in slowing down unprofitable endeavors that could affect margins.
Although the company has shown stagnation periods like 2019, 2020, and may enter into a new one in 2023, I believe it has potential and consider CSBR a buy.
Of course, this is a risky proposition, because the company is small, it is thinly traded and operates in a fast-changing, volatile environment.
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Disclosure: I/we have a beneficial long position in the shares of CSBR either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.