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CTSO: Q3: Another Solid Quarter. Financials In-Line, REFRESH II Enrollment Accelerating

By Brian Marckx, CFA



Q3 2018 Update: Another Solid Quarter. Financials In-Line, REFRESH II Enrollment Accelerating…

CytoSorbents (NASDAQ:CTSO) reported financial results for their third quarter ending September 30th and provided a business update. It was another solid quarter from both a financial and operational perspective. Relative to operational progress….a major highlight was approval by FDA of the proposed protocol modification to REFRESH II. FDA gave the green light in September and, per comments on the call, these small tweaks to eligibility criteria (related to age and weight) significantly improved patient enrollment rates. Since then, pace of enrollment has been about 2 patients per week and currently stands at 20. With more sites expected to activate, REFRESH II now finally appears to be moving along – that is a significant highlight in our opinion.

Meanwhile REMOVE, the Germany-based study funded by the German government and which is evaluating safety and efficacy of CytoSorb in patients with infective endocarditis undergoing valve replacement surgery, has 62 patients enrolled. As planned, an evaluation of the first 50 patients is now ongoing.

Relative to the financials, both the top and bottom lines were largely inline with our respective estimates. While product sales fell on a sequential basis for the first time in six quarters, they still managed to come in at the second-highest level in history and were up 48% yoy. Additionally, the ~3% qoq decline and similarly-sized miss to our number is explained by a less favorable fx tailwind in Q3 as compared to the prior quarter. Management also pointed to some seasonal softness in Europe during the summer months as potentially impacting sales. Importantly, CTSO is guiding for product sales in Q4 to be higher than that of Q3.

Relative to expenses and margins….product margin was a healthy 72%, although down about 200 basis points from Q2 and 250 bps lower than what we were anticipating. That should come back up, however, and likely surpass mid-70% with entire production moving to the new and more efficient manufacturing facility. We think the benefit to product margin will begin to show up in Q4 and should incrementally improve in 2019.

Operating expenses, at about 8% lower than our estimate and down almost 22% from Q2 (much of which is explained by lower stock comp), remain well under control. We continue to look for ever-improving operating leverage with product sales growth, incrementally widening gross margin and flattish opex. Q3 EPS was ($0.10), inline with our ($0.10) estimate.

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 (i.e. in Q4). CTSO has noted that they estimate this is achievable at a quarterly product revenue run-rate of approximately $5.5M. We continue to think this is achievable and model $5.5M of product sales, $6.2M of total revenue and $4.2M of gross income in Q4. While we have GAAP operating loss increasing from $2.7M in Q3 to $3.5M in Q4, almost all of our assumed sequential increase in operating expenses is related to non-cash stock compensation and clinical trial expenses.

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 51k human treatments vs. 31k one-year prior and 47k one-quarter prior), more reports of clinical successes and the awareness-related benefits of the ongoing REMOVE and REFRESH II clinical studies, enrollment in both of which is accelerating.

Much of the growth is coming from CTSO’s direct sales efforts. Direct sales in Germany accounts for more than 80% of CTSO’s total direct product sales and about 60% of all (i.e. direct and distribution) product sales. While Germany is the main direct-territory, CTSO also sells directly in Switzerland, Austria, Belgium and Luxembourg. Headcount of the direct sales team increased by 85% over the last 12 months and resulted in direct product sales growing 62% yoy through the first nine months of 2018. Direct sales accounted for 73% of product sales in the first nine months of 2018 as well as in the prior-year comparable period.

Noteworthy is that in Q3 ’18, direct sales accounted for only 66% of total product sales – down from an average of 76% through the first half of the year. The relatively low proportion of direct-to-total product sales likely explains much of the lower-than-expected product margin in the quarter (72% A vs 74.5% E). It also aligns with management’s comments regarding the seasonally softer summer (vacation) months in parts of Europe. Nonetheless, growth of direct sales and manufacturing efficiencies from higher production volumes have undoubtedly been major catalysts to product margin improvement, which widened 600 bps YTD 2018. And, with production now completely shifted to the new manufacturing facility, coupled with imminent implementation (i.e. January 1, 2019) of a dedicated procedural code in Switzerland, these catalysts could have even more substantial influence on margins and profitability.

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 possible 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/mid-2019), label expansion (including recently for OUS use in bilirubin and myoglobin removal) and potential new partnerships and government grants.

Q3 total revenue was $5.7M, up 50% yoy and flat sequentially. Product revenue was $5.1M (vs. $5.3M E), up 48% yoy and flat from Q2 ’18. Grant income remains robust and was $640k (vs $547k E) in Q3. 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 ~$4.7M available under their current roster, we model $653k to be billed in Q4 of this year and another $2.0M in 2019.

Relative to product sales, much of the recent growth has been attributed to improved reimbursement in Germany and expanding use and utility of CytoSorbents to address a growing list of critical care conditions. 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. Switzerland could soon provide another catalyst to product sales as a dedicated procedure code for cytokine reduction goes into effect at the start of 2019. While Switzerland is only about 10% of the size of Germany (in population), if CTSO’s direct-sales successes can be replicated there, we estimate incremental annual product revenue could be as much $1.2M.

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 recent 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 label expansion adds credence for use in these specific indications. Additionally, it can provide 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. CTSO’s most recent grant award, $3M related to further development of HemoDefend, came in August. This is an extension of previous grants and expected to fund a pivotal U.S. study for HemoDefend. As we explain below, we think HemoDefend may be a dark horse that is mostly being overlook by investors and the significance of continued development progress should not be underestimated.

Cash used in operating activities was $2.6M and $8.1M ($1.7M and $6.7M, ex-changes in working capital) in the three and nine months ending 9/30/18, compared to $2.2M and $6.1M ($1.4M and $4.5M, ex-changes in working capital) in the comparable prior-year periods. Cash balance was almost $25M at Q3 quarter-end. Subsequently, another $209k was raised from the sale of common shares via the ATM. Management expects current cash plus availability under the existing loan facilities and ATM access to fund operations into 2H 2020. We note that while CTSO has actively used the ATM, raising more than $14M in cash YTD through October, that given the reasonably healthy per-share selling prices, that total outstanding share count is up just 10% since the end of November 2017.

We are maintaining our $15/share price target on CTSO. See above for free access to our updated report which includes our operational update, financial model, valuation methodology and appendix.

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