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ZMS.V: European PET OEM Supply Contract Could Be Worth $10M+ Per Year

By Brian Marckx, CFA


Fiscal Q4 2017, Operational Update….

Zecotek (TSX:ZMS.V) (OTC:ZMSPF) reported financial results for their fiscal 2017 fourth quarter and full year ending July 31, 2017.  While revenue continues to disappoint, we remain optimistic that the company will soon begin to generate additional sales of their LFS crystals and other (Imaging-segment) products given the recent headway that they have made in building their customer footprint, particularly as it relates to China and more recently, Europe.  In addition, slightly more than one-half of the $2.5M Hamamatsu order remains outstanding.  Zecotek also made substantive progress towards monetizing development work from their Display business during calendar 2017, most notably of which included partnering with two auto manufacturers for use of the company’s 3D display technology for use in heads-up display functionality.     

Q4 and full-year revenue of $42k and $467k were down by 89% (from $363k) and 69% (from $1.49M) from the prior-year comparable periods.  Approximately 77% of the revenue in fiscal 2017 relates to Hamamatsu.  

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. But, ZMS has more recently made a much more determined effort to not rely so heavily on Hamamatsu for its ultimate success by spreading their wings and branching out other customer channels.  These include an unnamed European PET OEM (Philips Healthcare?), two European auto manufacturers, EBO Optoelectronics, Chinese PET manufacturers, UC Davis, a U.S.-based medical neuroPET manufacturer and homeland security, among others.  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.  ZMS could also potentially generate initial revenue from its Display segment - which represents another possible incremental revenue driver.     

And despite the significant decline in revenue in fiscal 2017, operating loss and cash burn have actually moderately improved as a result of tempered spend from cost-containment efforts.  Operating loss was $4.9M in 2017, down from $5.2M in the prior year.  Meanwhile, cash burn (i.e. cash used in operating activities, excluding changes in working capital) was $4.74M in 2017, almost $500k less than the $5.24M in cash used during 2016. 

Cash balance was $862k at July 31st.  Zecotek continues to successfully raise operating capital when needed and last week announced that they “arranged for a non-brokered private placement of 10,000,000 units of the Company at a price of $0.30 per unit for gross proceeds of $3,000,000.”  Units consist of one share of common and one warrant – the warrants have a $0.43 exercise price and expire in two years.  The press release did not indicate when this financing is expected to close.  And while most of the recent capital raises have been on the piecemeal side, we think larger and more attractively priced deals should come with additional substantive progress in expanding the customer base, and perhaps more importantly, in delivering initial larger-sized orders to some of the current customers (or even just announcement of formal contract terms and identification of some of the customers, such as the European PET OEM).        

Operational Update: European PET OEM, Zecotek China Biz Development Director, U.S. LFS Order, Display Systems HUD Technology… 
There have been a number of noteworthy developments, on multiple fronts, over the last several months.  While much of the recent operational progress relates to photonics in China, there has been forward movement in other areas as well including the recent announcement that a major European PET OEM selected the LFS crystals for a new line of PET/CT scanners and, as it relates to the company’s Display Systems unit, a collaboration with (at least) two European auto manufacturers (including a joint-development agreement in July) in the development of next-generation heads-up display technology.  And while we had not heard much in the way of U.S.-related business development activities lately, that changed when on August 16th ZMS announced that a (unnamed) U.S.-based manufacturer of a novel neuroPET scanner placed an order for the company’s LFS crystals.  Additional detail on ZMS’ recent operational progress follows…   

Perhaps the most exciting recent news was that “a well-established life sciences OEM based in Europe has selected its patented Lutetium Fine Silicate (LFS) scintillation crystals for a new line of high resolution positron emission tomography (PET)/ computed tomography (CT) medical imaging devices.”  While it is unclear what exactly needs to happen before ZMS would begin shipping meaningful LFS quantities to this unnamed OEM, the late-October 2017 press release indicates that discussions about a long-term supply agreement are ongoing, which could be worth in excess of $10M annually to Zecotek.  We have no insight as to the identity of this European OEM although we think it would not be unreasonable to speculate that it could be Philips Healthcare given that the two companies settled a patent infringement lawsuit in December 2014.  As a reminder, Zecotek brought the lawsuit in February 2012 claiming that Saint-Gobain infringed on a Zecotek-owned patent covering their LFS scintillation crystals and accused Philips of using these crystals in their PET scanners.  While terms of the settlement remain private, we have long speculated that it might include a source/supply agreement of ZMS’s crystals to Philips for future PET scanners.  If Philips, which is one of the leading PET scanner manufacturers in the world, is indeed the counterparty to this supply agreement, this could result in a major source of revenue for Zecotek.  We hope Zecotek is soon allowed to reveal the name of the OEM customer and certainly hope that meaningful LFS crystals sales result from this.     

Much of the other recent highlights on the operational front relate to ZMS’ focus on the Chinese market, with the recently penned EBO Optoelectronics supply agreement already bearing fruit.  In fact, Zecotek announced that over $1M in orders for their LFS crystals have been placed since May 2017.  This includes purchase orders amounting to $1.2M for crystals that will be used in PET medical scanners as well as for radiation detection systems – ZMS noted in their July 4th press release that the majority of the order came from Shanghai EBO Optoelectronics.  

This follows the late-May announcement that three “tier 1” PET OEMs had qualified the LFS crystals for use in their products and that one of these Chinese companies had placed a $100k order (also via EBO Optoelectronics).  Relative to qualification of the crystals, ZMS’s CEO commented that, “These three tier 1 OEMs have decided that the LFS crystal has all the economical and physical characteristics needed for their long-term production of PET medical scanners.”  Zecotek also recently noted that a quality control system had been established to provide for testing and standardization of their crystals – presumably to facilitate the qualification process as well as the supply channel.   

As a reminder, in January 2017 Zecotek announced 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 and has a client list which includes the top PET OEMs in the world.  The duo are now working on a sales and marketing plan - which was enhanced with the recent hiring of a Business Development Director – discussed below.  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. 

Crystals supplied to EBO will be used to 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, 2017 press release that the Chinese OEM had 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.  It is unclear whether the aforementioned $1.2M in purchase orders relates to this particular PET OEM.        

In order to further leverage expected demand from China Zecotek announced in May 2017 that they formed “Zecotek China”, a wholly-owned subsidiary based in the Shanghai Free Trade Zone.  In addition to meeting certain commerce conditions unique to China, including having a formal presence in that country, formation of the subsidiary is also expected to provide for greater efficiency in working with EBO Optoelectronics as well as offering certain tax benefits.  ZMS made another important step as it relates to having a formal presence China (and China’s photonics industry) with the hiring of hiring of Thomas Lau as Business Development Director for Zecotek China.  Per ZMS’ press release, Mr. Lau is a native of China and has more than 20 years of experience in that country’s photonics industry in business development and executive roles.  He will work closely with EBO and be responsible for “managing an aggressive expansion strategy” for the company’s LFS crystals and other photonics products for both medical and non-medical applications.  
As a reminder, while Zecotek’s primary focus in China has always been the PET OEM market, the company indicated shortly following the formation of Zecotek China that they had already received significant interest from non-medical industries and government organizations in the country.  In June 2017 ZMS announced that they received a notice of allowance in China for its advanced formulation of its patented LFS crystals.  Then in November the company announced that the Chinese patent office issued a certificate of allowance for its solid-state Micro-channel Avalanche Photodiode/Transistor (MAPD/T) photo detector.  With the additional IP locked down, Zecotek noted that they begin commercial production in “early 2018”.  

Zecotek has previously indicated that they believe their proprietary MAPD/T photo detectors could be revolutionary in terms of replacing conventional photo multiplier tubes (see our discussion below).  And while commercial introduction of the initial MAPD/T products has been drawn out longer than anticipated, we are hopeful that progress on the patent front means that they are one meaningful step closer to finally getting the product on the market.  While eventual launch should be a significant milestone, even more substantive would be incorporation of their photo detectors in production of commercial OEM PET scanners.  This will be something we will be eager to hear future updates about.  

Zecotek’s quest to branch out to other applications apparently made further progress with the company announcing in May 2017 that they are now working with a “radiation safety and homeland security OEM” to “jointly develop a commercial radiation detection unit”.  As a reminder, in 2016 Zecotek had noted that an OEM had ordered their crystals for testing in a large cargo screening device at land crossings as well as for screening applications for smaller items such as luggage.  This recent agreement apparently resulted from the successful testing of the crystals for these applications.  While potential revenue implications are not clear, ZMS noted at the time that they were looking to have an operational prototype completed within six months (~November 2017).  The company did not provide an update on this with reporting of Q4 results, although we hope to hear more in the near future.      

Another recent development relates to the company’s Display Systems division.  While Imaging Systems (i.e. related to the LFS crystals and MAPD/T photo detectors) 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 – there has not been a recent status update on this, however.  

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 were working with a major (unnamed) European automobile manufacturer to integrate their 3D display technology into a HUD and entertainment console.  In March 2017 the company announced another European auto manufacturer expressed interest in their technology.  Then, in July 2017 ZMS announced that they signed a joint-development agreement with a leading German auto manufacturer to develop a brand-specific, 3D HUD and entertainment console noting that they “signed a contract to develop the world’s first 3D HUD system with a highly respected automobile manufacturer with a clear path to commercialization and widespread adoption”.  While Zecotek was shooting to have the initial prototype completed by 2017 year-end, they did not provide an update when they reported Q4 results.  This is another program that we will be eager to hear updates about.  

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.  Zecotek noted that the aforementioned proposed $10M equity financing of Display Systems (if consummated) will be used to complete integration of their 3D technology for automotive applications.

We cover Zecotek with a $1.00/share price target. See below for free access to our most recent report and financial model on the company.

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