By Brian Marckx, CFA
Fiscal Q2 2017, Operational Update
Zecotek (TSX:ZMS.V) (OTC:ZMSPF) reported financial results for their fiscal 2017 second quarter ending January 31, 2017. Revenue was just $6k for the quarter and $214k through the first six months of the year – down 99% and 75% from the respective prior-year comparable periods. While disappointing, highly variable revenue has been and will likely continue to be the norm for Zecotek for at least the near-term. On the more positive front, the company has been able to diversify (to an extent) sources of revenue and currently carries more than $2.2M in customer deposits that should eventually be booked as revenue. Relative to Hamamatsu, almost $1.6M of LFS crystals orders has still yet to be fulfilled.
As we have noted previously, we think the drawn out process of recognizing the Hamamatsu-related deferred revenue (i.e. previous orders which Hamamatsu has yet to take possession of) relates mostly to dragging feet of Hamamatsu. And ZMS has more recently begun to spread its wings with more than just anecdotal evidence that the company is making a more determined effort to branch out to other customer channels. And while complete speculation on our part, the drawn-out delay with Hamamatsu and ZMS’s additional sales and marketing efforts to the likes of Chinese PET manufacturers, UC Davis, U.S.-based medical imaging manufacturers, U.S. homeland security and more recently "a world leader in the area of level, switching and pressure measurement for the process industry", among others, may be related. While we expect Hamamatsu to remain an important customer channel, LFS crystals orders from non-Hamamatsu customers is what we expect to be driving an eventual inflection in revenue.
And despite the yoy dive in revenue, operating loss actually improved as operating expenses came down as compared to 2016. Operating loss was $1.3M and $2.5M in the three and six months ending January 31, 2017, compared to $1.9M and $3.0M in the comparable year-earlier periods.
Meanwhile, cash used in operating activities was $1.1M and $2.2M in Q2 and 1H 2017, compared to $1.7M and $2.1M in the prior year periods. ZMS exited fiscal Q2 with $420k in cash and equivalents. Subsequent to Q2 quarter-end, the company raised an additional $377k (gross) via the sale of 1.255M common shares (@ $0.30/share) with 100% warrant coverage. Additional financing could possibly become available from the recently announced potential equity investments in the Imaging and Display segments as well as, possibly, from grant funding (which we discuss in more detail below). Operational Update
The recent highlight on the operational front relates to an agreement with Shanghai EBO Optoelectronics Company whereby ZMS will supply the Shanghai-based company with “over $21M worth of scintillation crystals
over the next three years.” The supply agreement will continue after the initial three year term on a yearly basis. Per ZMS’s press releases, EBO is the largest crystal array producer and supplier in China. EBO will sell ZMS’s crystals particularly to meet growing demand of the Chinese PET scanner market. The agreement further stipulates that EBO will be the exclusive distributor for the LFS crystals for the Chinese PET market and will only use LFS crystals in arrays for that application.
While ZMS will use its existing facilities for the initial supply under this agreement, they indicated that they will look to expand capabilities in the future in order to increase their operational and production capacity. Crystals supplied to EBO will be used meet the company’s obligations under the previously announced MOU with a Chinese OEM PET manufacturer. As a reminder, that MOU (when executed) calls for supplying crystals/arrays for up to 200 PET scanners over the next five years. While there was no timetable offered on when this supply agreement is expected to ramp or when meaningful related revenue will begin to be generated, ZMS did note in their March 21 press release that the Chinese OEM has resumed purchasing LFS crystals in array form through EBO and that ZMS and EBO are working on a schedule to meet the Chinese OEM’s production plan.
Another recent development relates to the company’s Display Systems
division. While Imaging Systems (i.e. related to the LFS crystals) has and will likely continue to represent the majority of the potential upside value of the company, the Display Systems business has shown growing promise as an additional value driver. Much of this promise relates to the 3D display program. It appears that at least some investors have taken notice based on the March 2017 announcement of a potential $10M financing (on a ‘best-efforts’ basis) in return for an equity stake in Zecotek Display Systems.
As a reminder, the Display Systems division has had several projects in late stages including development of a working prototype of a 32-inch 3D display which does not require the use of 3D glasses. The display is protected by both U.S. and Australian patents. It can simultaneously project high resolution 3D and 2D images on the same screen with separate views for multiple users. Zecotek has previously noted that they were in discussions with certain major electronics companies to co-develop an OLED/LED (organic light emitting diode) based, flat screen, glasses-free, true 3D HD television.More recently
, the Display Systems segment has been working with automotive manufacturers in the design on novel heads-up display (HUD)
technologies. HUD projects an image (graphic below is an example with no relation to ZMS’ technology) on, in front of or around the windshield, eliminating the need for the driver to remove his eyes from the road to check the speedometer, navigation and other information. In December 2016 ZMS announced that they are working with a major (unnamed) European automobile manufacturer to integrate their 3D display technology into a HUD and entertainment console. Then in March 2017 the company announced another European auto manufacturer expressed interest in their technology.
Zecotek notes that the auto manufacturers’ interest in their technology relates to the fact that, unlike other HUD systems, their 3D display does not require eye tracking and allows for more views than traditional HUD technology. Drawbacks of eye tracking include additional costs and potentially lower reliability. While ZMS’ press releases announcing the arrangements with the European auto manufacturers did not provide specifics in terms of near-term milestones, the December ’16 press release did note that initial testing of the technology showed it “is well suited for the application in the automobile industry”. Additionally, ZMS noted that any news on a possible agreement will be released in early 2017. Zecotek noted that a proposed $10M equity financing (announced in March, discussed below) into Display Systems (if consummated) will be used to complete integration of their 3D technology for automotive applications – while we are unsure if this means there has been additional progress related to the agreement with the initial European auto manufacturer since it was announced in December, it certainly suggests that that may be the case. As such, we will be interested to hear any updates on this program.
Equity Investments in Imaging and Display Segments (on best-efforts basis)
Additional liquidity could materialize upon close of a recently announced agreement with Shanghai Creation Investment Management Company (SCI). In October ’16 ZMS announced SCI was initially expected to invest $5M in return for an equity stake (10% maximum) in Zecotek Imaging Systems (i.e. division developing LFS crystals, MAPT and other imaging-related products and components). Zecotek’s October 20th press release announcing the agreement noted that final valuation was contingent upon execution of the MOU with the Chinese PET OEM. As a reminder, terms of that agreement call for the MOU to convert into a contract upon installation of the first PET scanner incorporating Zecotek’s LFS crystals in a hospital in Shanghai.
While Zecotek has yet to disclose whether the MOU has been executed, in mid-March 2017 they announced that the proposed $5M investment has since been increased to $15M. While it is unclear if the maximum equity stake remains at 10%, the implication is that that may still be the case as ZMS mentions that the increase in financing is due to improved valuation of the Imaging Systems division and growing demand for the LFS crystals by the Chinese PET OEM industry.
The March press release further mentions a (as we alluded to above) $10M financing for an equity stake (% was not disclosed) in Zecotek Display Systems – funds for which will be used to complete the integration of their 3D technology for automotive applications.
If and when finalized and closed (the financings are being done on a ‘best-efforts’ basis), Zecotek expects to use proceeds from the Imaging Systems investment towards building requisite operational infrastructure, including adding China-based representatives, to facilitate execution of the Chinese PET OEM contract, which calls for as many as 200 systems to be built with ZMS’s crystals over the next five years.
Zecotek also notes that SCI (“one of the most active investment funds and IPO consulting companies in China”), upon consummation of the agreement and initial investment, will be directly involved in initiating operations in China. And finally, SCI is also expected to be involved in helping ZMS apply for grant funding from the local Chinese government authority. ZMS expects to seek up to $3M to be used in establishing a manufacturing facility to grow LFS crystals – providing the benefits of a local supply to the Chinese OEM as well as additional capacity to BOET, ZMS’s current supplier.
Interestingly, SCI highlights China Aotai Medical on its website as one of its success stories (link… http://bit.ly/2gZ3DnA and use Google Translate). Chengdu, China based Aotai is billed as designing and developing “the world’s most advanced MRI systems”. As such, it appears, SCI has direct experience with working with Chinese-based advanced imaging organizations which may suggest they could be an ideal partner for ZMS and their China PET programs.
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