Sphere Medical: gaining sales traction is now key

During 2016 it was the CE Mark grant that represented a turning point for Sphere Medical, as this allowed the launch of the Proxima 4 device across several major European markets. The focus for 2017 will be translating the healthy pipeline of clinical interest into meaningful sales traction. However, the lengthy sales cycle, coupled with further spend on product development, means cash out-flows are still expected until FY18. Our valuation, based on a three-phase DCF model remains unchanged at £30.2m (21.3p a share).

The 2016 results are a useful reminder of the progress that Sphere Medical has made over the past 12 months. Whilst the granting of the CE Mark for the Proxima 4 device in September 2016 was a major highlight, a number of other milestones have also been achieved during the period. These include: improved connectivity with the leading patient data systems; increased the number of clinical evaluations by hospitals; shown the workflow benefits of using Proxima on critically ill, unstable patients; the appointment of distributors in Italy and Spain; posted the first sales in several direct markets in Europe; and established the production facility in St Asaph, North Wales.

Looking ahead to 2017, the major focus will be to establish a solid commercial platform and to gain sales traction. We expect further distribution agreements to be struck, as well as a greater focus on the areas serviced by the direct sales team. On the product front, the statement suggests that Proxima 4+ remains on track, although the expected launch date is unlikely to be announced so as to not hinder uptake of the current version. It is worth noting that our forecast suggest the lengthy sales cycles, coupled with planned development expenditure, results in cash out-flows for the coming years. We remind that we estimate that Sphere Medical will likely have an overall funding requirement during 2017 of £7-8m (ex the Silicon Valley Bank loan of £3m).

Improved connectivity and easier setup for Proxima 4

Proxima 4 is the latest generation of a proprietary micro-analyser technology platform that accurately and rapidly measures a variety of different blood parameters (including pH, pCO2, pO2, electrolytes and glucose) at the point of care (POC) in near-real time. Proxima 4 represents a major upgrade to the previous generations, with additional functionality (notably glucose analysis) and direct connectivity with hospital information systems (including Conworx and Clinisys), as well as simpler and quicker set-up.

The added features of Proxima 4 (notably the glucose analysis) means its use can be broadened to adult patients undergoing major procedures (such as neuro and cardiac surgery) and in children heavier than 15Kg. Management expects this to result in opportunities for 4 to 5 Proxima 4 systems to be placed per 10 critical care beds. The addition of lactate monitoring and suitability for all paediatric use planned for Proxima 4+ would take it into sepsis, trauma and renal patients as well as general complex surgery and could raise penetration to 5 to 6 units per 10 ITU beds. Exhibit 1 details the commercialisation strategy.

Exhibit 1: The Proxima commercialisation strategy

Source: Sphere Medical

The number of clinical evaluations is rising

Changing established clinical practise can be a major challenge so Proxima 3 was not only used to fine-tune the commercial version but also to educate opinion leaders in major centres. Over the past two years more than 30 hospital evaluations have been performed, with more than 150 patient connections. These pre-marketing activities have helped create a healthy pipeline of interest and since the Proxima 4 has become available four hospitals have used the system on patients, including with children heavier than 15Kg, and a further 20 have requested evaluations. This interest is expected to increase as the year progresses, but converting awareness and interest into sales requires the support of compelling clinical and economic evidence.

Two studies demonstrate clinical relevance

Over the past year a study was performed at the University Hospital, Southampton and presented at the British Association of Critical Care Nurses annual conference (September 16). This examined the work flow impacts of using Proxima in a highly optimised and well-equipped cardiac intensive care unit. A total of 20 patients, 10 on Proxima and 10 using near-patient bench-top blood gas analysers, had an average of 10 measurements each over a 24 hour period. The results showed a statistically significant reduction in the time taken to deliver results (>20%) and delay in start of testing (>50%). Additionally, it showed a reduced time away from the bedside of 3:07 minutes per test. Interestingly, around a fifth of the samples were delayed because, for a variety of reasons, the bench-top analyser was not immediately available.

This builds on the earlier study, performed at Queen Elizabeth Hospital, Birmingham (UK) and published in Critical Care, that evaluated the Proxima 3 miniature in-line blood gas analyser as part of a method comparison clinical study in the intensive care setting. Over 300 assessments – including the usual pH, pCO₂, pO₂, haematocrit and electrolytes – were made in 20 patients comparing Proxima and the reference Roche Cobas b221 bench top analyser. These results showed excellent correlation at both the collective and individual sample level, with the authors stating there was unequivocal agreement. Additionally, the staff found the system easy to use in practice, with clear benefits apparent within a short time.

Distributors in place in Italy and Spain

Sphere Medical appointed Burke & Burke as exclusive distributors for Italy in July 2016, with launch stocks of the Proxima 4 system delivered in late December. The exclusive distributor for Spain, Proyectos Hospitalarios Internacional (Prhoinsa), was appointed in December 2016 and remains on track to launch in Q217. Additional regional partners are expected to be confirmed during the year, with a target of having a sales presence that addresses 60% of the European Union by end-17. The key priority is the securing of a network of local partners that are committed and capable of maximising the commercial potential of Proxima 4.

Commercial scale manufacture in place

A full scale production site has been established in St. Asaph, Wales, and is fully approved and operational. In the near term there is no requirement for material capital expenditure, with this only likely to be required when volumes increase significantly. Once fully commissioned, it is expected the site should have sufficient capacity to manufacture all of Proxima’s forecast needs for the near- and medium-term. The pilot manufacturing line operating in a dedicated clean room at the Harston site remains available, offering the capacity to build sensor array assemblies and disposables if required.

Valuation

We last updated our model when the CE Mark effectively removed regulatory risk from our investment case. Our valuation remains unchanged on these results at £30.2m (equivalent to 21.3p a share). We value Sphere Medical using a three-phase DCF model, assuming a discount rate of 10%, terminal growth of 2% and a long-term tax rate of 20% (not reflecting the potential benefits of the Patent Box incentives). We also ascribe an 80% probability of success to the Proxima cash flows (previously 60%, which included regulatory risk) to take into account the commercialisation risk until additional distributors are appointed. The breakdown of our valuation is shown in Exhibit 2 overleaf.

In modelling our sales adoption for Proxima 4 (and Proxima 4+ from 2018), we have taken note that the sales cycles for such products tends to be around 9 to 12 months, as equipment that can change clinical practice usually has longer assessment periods, which means meaningful revenue is not expected to flow through until 2018. We estimate the sensor, calibration solutions and flushes are priced at £200 and the monitor and stand are effectively leased out for a nominal sum. Such pricing suggests that if a patient is expected to need around 8-10 blood gas measurements per day then the Proxima systems should become cost-effective and effectively defines the target population.

We have adopted conservative assumptions throughout in our modelling; for instance, the valuation includes only the sales for use in the critical care settings, with no value assigned to its possible use in other settings, neither does it consider the inherent value of the technology platform. We feel this is currently appropriate as Sphere Medical has yet to demonstrate successful execution of its commercialisation strategy; however, as visibility improves we envisage employing less cautious assumptions.

Exhibit 2: DCF valuation of Sphere Medical

Source: Trinity Delta

Notably, we also ascribe no value to potential cash flows from other markets such as the US and Japan (or even RoW markets that recognise CE Marking) at present until such times as the company confirms its strategy for these key regions. Clearly as progress is achieved, we would expect to revisit the model and anticipate the valuation would reflect this.

Financials

The loss after tax for FY16 was £4.5m (£5.5m in FY15), with a loss per share of 3.2p (4.8p in FY15). Revenues for the year remained small, but doubled from £15,000 to £30,000. Despite the preparations for Proxima 4’s commercialisation, operating expenses before amortisation were kept below budget at £5.1m (£8.1m in FY15). Selling and marketing costs rose to £1.3m (from £1.0m), with production overheads up to £1.4m (from £1.3m). Administrative expenses reduced to £1.7m (from £2.2m). Reflecting the rising visibility, product development costs of £0.7m (£1.7m in FY15) were expensed and, following accounting practice, £2.1m (£0.9m in FY15) was capitalised. Net finance income of £72,000 (£91,000 in FY15) represented income on the cash deposits. The R&D tax credit was £0.6m, the same as in FY15.

The cash out-flow from operating activities was £4.5m (from £5.1m in FY15). Cash and cash equivalents were £3.2m at December 2016, down from £10.0m the previous year-end.

Exhibit 3: FY16 results variance compared to forecasts

Source: Trinity Delta, Note: All figures for Estimates and Actuals in £’000s, except for Adj. EPS in pence

Our forecasts for FY16 are shown in Exhibit 5, and the changes are detailed in Exhibit 4.

In January 2017 a £3.0m loan facility from Silicon Valley Bank was established, being repayable by 2020. An initial £1.5m was drawn down at the time, with a further £1.5m conditionally available until March 2018. We remind that we estimate that Sphere Medical will likely have an additional funding requirement of £7-8m during 2017, which is shown as short term debt for the purposes of our forecasts.

Exhibit 4: Summary of changes to estimates

Source: Trinity Delta

Exhibit 5: Summary of financials

Source: Sphere Medical, Trinity Delta  Note: Adjusted numbers exclude share-based payments and exceptionals; the short-term debt is illustrative of the company’s funding requirements.