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CTSO: Q2 Product Sales Beat Big. New Catalysts Come Online. Moving PT to $15/share

By Brian Marckx, CFA



Q2 2018 Update: Product Sales Beat Big. More Upward Estimate Revisions As New Catalysts Come Online. …

CytoSorbents (NASDAQ:CTSO) reported financial results for their second quarter ending June 30th and provided a business update. Relative to the financials, it was a very strong quarter for product sales which set a new record high, jumping 18% from Q1 and almost 73% yoy. Product sales were also well ahead of our estimate and given the steeper than anticipated growth rate and new catalysts coming online, we have again made upward revisions to our forecasts. Germany remains the main market, accounting for 62% of product sales in Q2, although product sales in other countries also continues to grow. Product margin, at 74%, remains elevated and is expected to move higher following the impending opening of a new, higher capacity, manufacturing facility.

These trends, in addition to improvement in operating loss, are expected to continue. Management continues to guide for operating income (ex non-cash and clinical trial expenses) to move into the black (for the first time) on a quarterly basis during 2018. CTSO has noted that they estimate this is achievable at a quarterly product revenue run-rate of approximately $5.5M - while we had previously forecasted Q4 sales of approximately $5.3M (i.e. $200k less than CTSO's op loss b/e revenue number), our upwardly revised estimates following the stronger than expected Q2 now puts our Q4 product sales number at almost $5.7M.

Growth of the direct sales force, onboarding of additional third-party distribution and increased activity from CTSO’s partners have all contributed to adoption and utilization of CytoSorb and the resultant product sales growth. So has increased use in a variety of indications. Importantly, management noted that they are seeing demand-pull from the market - indicating that awareness of CytoSorb over the last few years has reached a point where education in sales process has become easier. That trend, as we have noted in the past, will undoubtedly continue and benefit from continued increase in utilization (CytoSorb has now been used in more than 47k human treatments vs. 27 one-year prior), more reports of clinical successes and the awareness-related benefits of the ongoing REMOVE and REFRESH II clinical studies.

Much of the growth is coming from CTSO direct sales efforts. Headcount of the direct sales team increased by 75% since early 2017 and resulted in direct product sales growing 82% yoy through the first half of 2018. Direct sales accounted for 76% of product sales in 1H 2018, up from 72% in the prior year – the proportional increase in direct sales likely contributed to the ~750 basis point widening in product margin over the same period.

As we have stated in recent prior updates, while we reiterate the potential for short-term volatility in product sales, we think the additional history of regular growth should provide ever-increasing confidence of the robustness of the fundamentals of the source and ‘quality’ of these revenues in the context of long-term prospects. Re-orders from existing customers, initial orders from new customers, accounts and territories, use of CytoSorb for additional indications and ramping utilization numbers are all common themes that management cites in relation to the source of product sales growth. Bulk orders and inventory-stocking are not.

We continue to like near and long-term prospects for product sales growth, the latter particularly so in the context of potential eventual entry into the U.S. market as well as other potential catalysts that have yet to make any impact. Among the latter are new product launches, such as HemoDefend (U.S. FDA trial anticipated to begin early-2019), label expansion (including recently for OUS use in bilirubin and myoglobin removal) and potential new partnerships and government grants.

Q2 total revenue was $5.8M, up 61% yoy and 17% sequentially. Product revenue was $5.3M (vs. $4.8M E), up 73% yoy and +18% from Q1 '18. Grant income remains robust and was $509k (vs $529k E) in Q2. While we expect additional (and near-term) opportunities to score future grants, the yet-to-be billed portion of CTSO’s current grant contracts is still significant. Of the remaining ~$2.2M available under their current roster, we model ~$1.1M to be billed during this year (and most of the remainder in 2019).

Relative to product sales, much of the recent growth has been attributed to improved reimbursement in Germany. And while Germany has been a significant contributor to revenue, that market may still remain relatively untapped given their significant population and large hospital network. Management has indicated that adoption in that country has been brisk and aided by strong support by certain KOLs. One hospital in Germany already generates over $1M in product sales for CTSO. With over 400 mid-to-large hospitals in the country, we think there is considerable near-term upside from that market.

Expansion of the geographic and distribution footprint as well as increasing commercial use in a growing number of ‘indications’ have also benefitted product revenue. In July CTSO's announced distribution to several more countries, bringing the total to 53 countries. CytoSorb has been used for a host of conditions in commercial clinical practice and clinical studies, including more than 60 investigator-initiated studies. The new indication for removal of bilirubin and myoglobin could have the effect of further expanding use. While CE Mark meant that clinicians had wide discretion in what conditions to employ CytoSorb, this new label expansion adds credence for use in these specific indications. Additionally, per management's comments on the Q2 call, there is a reimbursement benefit related to on-label (as opposed to, previous, off-label) use for these conditions.

Meanwhile, grant income continues to help subsidize R&D as well as providing additional validation of CTSO’s technology (particularly given the list of contracts has continually grown). The recent label expansion of CytoSorb for the removal of myoglobin, for example, appears to be a direct extension of the rhabdomyolysis clinical study funded by a grant from the USAF. We think CTSO will continue to look to monetize the successes of these grant-funded studies with further label extensions and in the development of new technologies (such as HemoDefend). That could provide additional optionality in terms of commercial programs that CTSO could pursue and, potentially, with the consummation of additional commercialization partnerships.

The last three most recent grant awards are funded by the United States Army Medical Research Acquisition Activity (USAMRAA), including two in May and one in September 2017. This includes funding of up to $999k over two years ($519k of which has been paid to-date) for a phase II contract related to the development of HemoDefend in enabling universal plasma. The other one awarded in May is a phase I contract which will pay up to $719k over four years ($143k of which has been paid to-date) and relates to novel hemoadsorptive therapies for severe burn injuries. Then in September ‘17 a phase II SBIR contract worth up to $1M over 29 months ($168k paid to-date) was awarded – this relates to the development of potassium binding sorbents to be used in the treatment of traumatic injury and acute kidney injury – this contract follows the related phase I grant that CTSO scored in July 2016.

Product margin, at 74% was up from 65% in Q2 '17, flat from Q1 of this year and second best in history. Product margin continues to come in ahead of what we had anticipated - we have made some upward adjustments to product margin estimates following Q2 results. While production volumes (in addition to direct vs distributor sales mix, pricing increases and certain non-manufacturing efficiencies) have already contributed to widening of product margins (which have expanded 600 basis points over the last two years), the impending opening of a new manufacturing facility is expected to create even greater economies of scale. The facility, which has production capacity to handle ~$80M worth of product sales, came online in Q2 and is expected to account for all of CTSO's production by the end of this month. Product margins, which management continues to guide to eventually eclipse 80%, are expected to benefit immediately following commencement of production at this new site.

Operating expenses were $8.2M in the most recent period and up considerably from both Q2 '17 ($4.4M) and Q1 '18 ($6.5M). However, excluding stock compensation (which can increase when the stock price rises), which was almost $2.1M in the most recent quarter (vs. ~$800k in Q2 '17 and $500k in Q1 '18), the increases are more muted. In fact, on a % of product sales basis, operating expenses ex-stock comp in Q2 '18 (116%) was lower than both comparable periods (Q2 '17: 119%, Q1 '18: 134%). The comparisons and metrics are meaningful, in our opinion, particularly in the context of the viability of management achieving their guidance of reaching a point of operating income break-even (as defined earlier) in the very near term.

R&D expense through the first half of 2018 is 2.5x that of the prior-year period - with much of the increase related to REFRESH II activities. We model R&D expense to steepen again with anticipation of ramping REFRESH 2 enrollment.

Cash used in operating activities was $3.3M and $5.5M ($2.3M and $5.0M, ex-changes in working capital) in the three and six months ending 6/30/18, compared to $1.9M and $3.9M ($1.6M and $3.1M, ex-changes in working capital) in the comparable prior-year periods. Cash balance was just over $25M at Q2 ’18 quarter end. In March CTSO restructured terms of their $10M loan (principal of which would have begun to amortize), which is interest-only for 18 months (or for 24 months upon drawing the available $5M “B” tranche) – this will provide a little bit more runway and, per our estimates, get CTSO to at (or nearly at) a point of GAAP operating profitability by the time principal begins payback.

Operational Update: New Liver Disease Indication, REFRESH 2 Protocol Update, REMOVE Ramping Enrollment, HemoDefend FDA Program...

European Approval for Treatment of Liver Disease and Trauma
Organ failure has recently become a significant focus for CTSO and new indications are directly aligned with that goal. In mid-May CTSO announced CytoSorb received European approval for use in the reduction from the blood of elevated bilirubin and myoglobin. Elevated bilirubin is associated with chronic liver disease and failure, while elevated myoglobin, which is a symptom of severe trauma, can lead to kidney failure. While CE Mark has always meant that (at least in theory) clinicians (in areas of the world where CE Mark is accepted) had wide discretion to use CytoSorb as they saw fit (mostly for conditions in which cytokines are elevated), we think that this new approval likely does expand the overall market for the device.

Bilirubin is a by-product from the breakdown of hemoglobin. Normally, bilirubin is conjugated (i.e. processed) by the liver and then excreted. But, in people with liver disease, the liver has difficulty processing bilirubin, resulting in a toxic build-up of the substance. Elevated bilirubin is common among people with hepatitis A, alcoholism and non-alcoholic fatty liver disease (NASH) - a global market estimated at approximately 50M people.

Myoglobin, found in heart and skeletal muscles, is tasked with capturing oxygen which muscles then use for energy. But, when the body experiences trauma, myoglobin (and other substances) is released into the blood and can become elevated (i.e. rhabdomyolysis). High levels of myoglobin can be toxic - it is the kidney's job to remove it from the blood so it can be excreted in the urine. Typical treatment consists of intravenous fluids and extracorporeal therapy (i.e. dialysis). As a reminder, CytoSorb was evaluated in a clinical study funded by a grant from the U.S. military for the removal of myoglobin in patients with rhabdomyolysis. It has also been the subject of case studies for rhabdomyolysis.

These new indications mean that clinicians can use CytoSorb on-label for conditions associated with elevated cytokines, myoglobin and bilirubin. 'On-label' potentially opens up use in instances where institutional policies forbid off-label use and, per management's comments on the call, may provide reimbursement benefits. And while not mentioned specifically by CTSO, we think that having approval may also open the door to one or more commercialization partnerships focused on these indications (perhaps similar to CTSO's deal with Fresenius).

CytoSorbents believes these new indications have the potential to significantly increase the total worldwide market for their device - while we think it is too early to estimate the significance of these approvals, we think they likely do broaden the market for CytoSorb (for the reasons stated) and, perhaps more importantly, provide additional strategic options. We also think it may be a harbinger of more approvals to come - clearly CTSO has already parlayed validation from grant-funded studies into broadening the commercial market for CytoSorb - that may be a strategy that they continue to employ.

REFRESH 2 enrollment commences, although slower than expected
As a reminder, REFRESH 2 is expected to be a pivotal FDA registration study and provide primary support for a U.S. regulatory filing for use of CytoSorb during cardiac surgery. In December 2017 FDA approved the IDE. CMS approval was also required and obtained, as was central ethics committee approval. Per comments on the Q2 call (August 2nd), seven sites are actively recruiting, three more have concluded clinical trial agreements and 19 others are completing start-up activities.

As we noted in recent updates, the pace of onboarding study sites had been slower than anticipated - which hampered enrollment. The first patient was enrolled in March - but clearly there has been a headwind to increasing the pace of enrollment. CTSO had previously mentioned that part of the hold up was legacy REFRESH I sites requesting the full IDE protocol – given the similarities in the studies, the extent of the administrative boxes that needed to be checked for these sites was underestimated. And while management was hesitant to offer specifics in terms of their expectations for site onboarding, the message was (at that time) that it should begin to accelerate.

While enrollment-to-date was not disclosed on the Q2 call, clearly the message is that it is less than hoped-for. So, a protocol amendment (one that is backward compatible for patients already in the study) was submitted to FDA for approval. Complete specifics of the amendment were not publicly disclosed - although apparently it does include an increase in the age limit and modifications to baseline renal risk factors. More importantly, management indicated that it will facilitate enrollment and increase the target market (if approved) - with no compromise to any other aspects.

We hope to know more about the amendment when approved by FDA - which CTSO expects sometime in Q3. CTSO hopes to have 15 to 20 sites ready to enroll when that happens. At that time, they expect the pace of enrollment to be approximately one patient per site per month. Which implies full enrollment (n=400) by approximately September 2020. Meanwhile, since the amendment is backward-compatible, the study can continue to enroll based on the initial protocol.

Our price target has moved to $15/share. Our updated report on CTSO, which includes our financial model and valuation methodology, can be accessed via the link below

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