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ZMS.V: Zecotek In Strongest Capital Position In Years. Imaging China Investment Could Jumpstart Sales

03/01/2018
By Brian Marckx, CFA

OTC:ZMSPF
TSX:ZMS.V

Over the course of just a few days in late-January, Zecotek (TSX:ZMS.V) (OTC:ZMSPF) announced closing of two significant equity-related financings that, in aggregate, raised almost $10M in new capital for the company.  The funds are expected to be used for general operating activities as well as to advance certain previously announced strategic growth objectives, including to ramp production and sales of the company’s LFS crystals in China.

On January 25th Zecotek announced closing of a $4.8M (gross) equity raise via the sale of 16.1M common shares @ $0.30 each.  Included was 100% warrant coverage (2yrs, $0.43 strike).

Then on January 31st they announced closing of a $5M (net) financing via the sale of 6.67% equity interest in newly formed subsidiary, Zecotek Imaging China Ltd.  The transaction implicitly values Zecotek Imaging China at $75M (which also implies ZMS shares are significantly undervalued).  While the identity of the purchaser was not disclosed (only noting that it is “an industrial business group based in China, which has also made a significant investment in the recently announced non-brokered private placement”) we think it could be Shanghai Creation Investment Management Company (SCI).  As a reminder, Zecotek announced in October 2016 that they reached an agreement with SCI to invest $5M for an equity stake (of up to 10%) in Zecotek Imaging Systems.      

The $5M cash infusion should provide a sizeable backstop in facilitating initial meaningful sales in China.  But, benefits of this partnership could extend well-beyond the new operating capital.  Partnering with a China-domiciled organization not only brings expertise and knowledge of the local business environment, it also presumably provides for greater efficiencies (as well as potentially addressing any legal mandates related to foreign companies doing business in China).  

The press release indicates that the investment affords Zecotek greater control over LFS crystals production and related costs – also, perhaps implying that at least some of delay in initiating LFS crystals sales (including to satisfy PET OEM orders) was related to production or supply (or some other) issues associated with EBO Optoelectronics.  Nonetheless, we are hopeful that this partnership, additional production capacity and cash infusion will accelerate the pace of LFS crystals sales.  

Fiscal Q1 2018 Results

Fiscal Q1 2018 (ending Oct 31, 2017) revenue of $189k, while not overly significant, was slightly better than our $104k estimate and was 4.5x the $42k in revenue posted in Q4 2017.  And, 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 and sales and production capabilities, particularly as it relates to China and more recently, Europe.  

In addition, one-half (i.e. $1.25M) of the $2.5M Hamamatsu order still 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.

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 to other customer channels and geographies.  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 revenue contracting since 2016, falling by more than $1M to $467k in 2017, that impact did not run through the rest of the income statement.  In fact, 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, and was $1.03M (i.e. $4.1M annualized run-rate) in Q1 2018.  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 used during 2016, and was just $1.03M (i.e. $4.1M annualized run-rate) in the most recent quarter. 

Cash balance was $286k as of October 31, 2017.  We mentioned in our update in early January, that while the company had largely relied on piecemeal-type capital raises in the past, that we felt larger and more attractively priced deals would 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).  Just a few weeks later the company announced closing of two deals that, in aggregate, raised almost $10M in additional capital.  

Similar to how the $5M outside equity investment in Imaging China is expected to help jumpstart crystals sales in that country, additional capital could come from selling off a small equity interest in Zecotek Display systems in order to facilitate product development in that business segment.  In fact, in March 2017 Zecotek announced that they were looking for a $10M investment (on a ‘best-efforts’ basis) in return for an equity stake in Zecotek Display Systems – although there has not been a recent status update on this.  Zecotek noted that the proposed $10M equity financing (if consummated) will be used to complete integration of their 3D technology for automotive applications.
  
Outlook

Revenue has been challenging to accurately forecast.  While we think revenue may continue to be variable over the near-term, the recent customer engagements, continued broadening of the customer base and what we think is a more deliberate spreading of ZMS’s wings towards opportunities outside of Hamamatsu has us encouraged that sales will trend towards more consistency.  More importantly, however, will be if ZMS can steepen the revenue curve.  As the customer base grows, so do the potential shots on goal and opportunities to grow revenue.  

The news in late October 2017 that a major European PET/CT OEM adopted the company’s LFS crystals for a new line of scanners was particularly exciting for a couple of reasons.  First, Europe is a more seamless market to work in as compared to China, which is the other territory where we think Zecotek has near-term revenue-inflection potential.  Secondly, we think European PET OEM could be Philips – and if that is the case, the supply agreement could be related to the terms of the lawsuit settlement – which would suggest binding contract terms.  And in addition, ZMS believes this relationship could be worth in excess of $10M in revenue per year to the company.  While our model now includes assumed contribution from this relationship, we will not model anywhere near $10M annually unless and until there is more substantive information about the binding nature of the agreement or until there is a reasonable history of meaningful sales to this channel.  This is now the relationship which we are most eager to hear updates about.  

The Chinese PET OEM relationship could be home run but we think it is prudent to forego modeling any significant related contribution until, at least, the MOU turns into a formal contract (if it ever does).  And if it reaches that point and with additional clarity on potential scheduling of follow-on orders, there may be an opportunity to make an informed estimate related to potential future sales through this channel.    

The recent $5M equity investment by an industrial business group based in China (which might be SCI) should provide a sizeable backstop in facilitating initial meaningful sales in China.  But, benefits of this partnership could extend well-beyond the new operating capital.  Partnering with a China-domiciled organization not only brings expertise and knowledge of the local business environment, it also presumably provides for greater efficiencies (as well as potentially addressing any legal mandates related to foreign companies doing business in China).  

The press release indicates that the investment affords Zecotek greater control over LFS crystals production and related costs – also, perhaps implying that at least some of delay in initiating LFS crystals sales (including to satisfy PET OEM orders) was related to production or supply (or some other) issues associated with EBO Optoelectronics.  Nonetheless, we are hopeful that this partnership, additional production capacity and cash infusion will accelerate the pace of LFS crystals sales.  

Nonetheless, we view the establishment of Zecotek China and initial orders from EBO Optoelectronics as substantive progress towards entry into the Chinese market.  The recent hiring of an experienced (and native) director of business development is also encouraging as it relates to the potential of this segment to gain traction.  As such and given that we have yet to incorporate meaningful revenue related to these relationships, our model could prove highly conservative.  We will be eagerly awaiting updates on progress of towards consummation of the MOU (including refurbishment of the scanning areas at the hospitals which has been implicated as the bottleneck) as well as additional orders from EBO related to the $21M supply agreement.

The recent stream of news related to progress towards tapping the Chinese market has been heartening as it relates to the potential for the revenue curve to significantly steepen, despite the fact that it has yet to amount to much in the way of sales to-date.  We think at least a substantive portion of the delay in recognition of meaningful revenue from this country is policy/regulation-related and as such, are hopeful that clearing of administrative hurdles are only time dependent and will be a gating factor that will soon resolve and result in much more significant revenue.     

Near-term could see recognition of more of the outstanding Hamamatsu orders, some of which may be dependent on finalization of module specifications from PET OEM customers.  And ZMS could see additional interest for their LFS crystals from manufacturers of small and next-gen Time-of-Flight PET scanners as well as in applications such as pre-clinical pharmaceutical research for drug development.  The recent LFS order from a U.S. neuroPET manufacturer is a clear positive, although time will tell if this relationship bears significant fruit.   Israel, via ZMS’s distribution agreement with RAM N.S. Technologies, adds another potential near-term shot on goal.  And while a formal supply relationship with Philips has yet to be penned, that possibility remains open and, if it happens, could be a needle-mover for ZMS.  

And other recent revenue opportunities could be in homeland security, radiation detection and (as it relates to the Display segment) in 3D HUD.  The agreements to develop a radiation detection unit with a radiation safety and homeland security OEM as well as the partnerships major European auto manufacturers in the development of a 3D HUD system sounds encouraging – although, as noted, the potential revenue opportunities related to both of these is currently unclear.  Consummation of the outside equity investment in Imaging China may be a harbinger for a similar deal for Zecotek Display Systems – which would be used to complete integration of their 3D technology for automotive applications – and could result in another future revenue stream.  

We model fiscal 2018 revenue of $2.4M, with much of our estimate weighted towards the second half of the year based on assumed contribution from the European PET OEM.  We look for revenue to grow to $6.4M in 2019.  But, as noted, we have not incorporated contribution related to supplying crystals to the China PET OEM contract and are modeling only a fraction of the (indicated) $10M+ annual sales potential related to the European PET OEM.  If the China contract is triggered and/or European PET OEM crystals sales ramp faster than our assumptions, our model will likely prove conservative and possibly highly conservative, particularly in the out-years.  Consummation of an equity investment in Display Systems could also positively influence our outlook and related projections.  Our model is subject to updating.  Model revisions could also affect our price target.  As it is now, our DCF methodology calculates fair value of Zecotek at $1.00/share or approximately $143M.  Based on the recent $5M investment for 6.67% interest in Imaging China, floor value is a minimum of $70M, or $0.49/share (which would conservatively assume the ex-China imaging segment plus Zecotek Display is worthless).

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