Sphere Medical: CE Mark lowers investment risk

The receipt of the CE Mark represents a turning point for Sphere Medical, allowing the launch of the Proxima 4 device across the major European markets. Although we have factored in only a modest sales adoption curve in our model, the effective removal of regulatory risk means the impact on our valuation is material. Updating our three-phase DCF valuation sees the value rise by 38% from £21.8m (15.4p a share) to £30.2m (21.3p a share).

The granting of the CE Mark for the Proxima 4 device allows Sphere Medical to start its commercialisation across Europe. 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. The main clinical benefits are detailed in Exhibit 1.

Exhibit 1: Proxima’s five key clinical benefits

Source: Sphere Medical

The Proxima 3 version was launched in the UK in September 2014 and selected European markets in March 2015, targeting principally specialist centres in order to gain feedback to optimise the commercial product. Whilst Proxima 3 demonstrated consistent and accurate measurements of blood gases and electrolytes (to laboratory standards), a number of improvements were identified. The resultant Proxima 4 represents a major upgrade, with additional functionality (glucose and sodium analysis) and direct connectivity with hospital information systems (including Conworx and Clinisys), as well as simpler set-up. Further feature and design upgrades are expected, with lactate measurement and improved graphical displays planned for the next update (Proxima 4+).

Extensive pre-launch activities in Europe

Changing established clinical practise can be a major challenge so Proxima 3 was also used to educate opinion leaders in major centres. Over 30 hospital evaluations have been performed, with more than 150 patient connections. These pre-marketing activities have helped create a healthy pipeline of interest for Proxima 4, but converting awareness and interest into sales requires the support of compelling clinical and economic evidence. This has been done through two sizeable studies.

The first study, performed at Queen Elizabeth Hospital, Birmingham (UK) and published in Critical Care, 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.

The second study was performed at the University Hospital, Southampton and presented at the British Association of Critical Care Nurses annual conference (Sept 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.

Exhibit 2: The Proxima commercialisation strategy

Source: Sphere Medical

Such clear demonstrations of the accuracy and reliability of the results, coupled with the efficiency gains and cost savings achievable, have been a consistent theme among the specialist hospitals that have evaluated Proxima. Whilst these findings should help early adoption, the commercialisation strategy is based on increasing penetration through sequential development of Proxima by widening the panel of measurement parameters offered and broadening its applicability beyond the current patient groups. The continuing evolution through successive generations is seen as a major driver of greater uptake and usage by the existing target patient groups and by introducing its use to a wider care group audience.

For instance, Proxima 3 essentially targeted adult patients being treated for respiratory diseases and, at best, would see one or two units being placed per ten critical care beds. In contrast, 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.

Although Sphere Medical has a small direct sales presence (in the UK, Germany, Belgium and the Netherlands), the principal route to market is expected to be through partnerships with established distributors that have strong existing relationships with the relevant end user markets. Burke & Burke have been appointed as exclusive distributors for Italy and we expect the next stage will be discussions with other potential distributors for regions that are lacking a direct sales presence (notably France, Spain, and the Nordic areas). 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.

Proxima 4 CE Mark clears the path in Europe

We had expected the CE Mark to be granted earlier; however, such regulatory procedures are difficult to predict so it is worth examining the background. The CE Mark process involved separate reviews and approvals for each of the four system elements (flush, sensor, monitor and vials), as well as evaluating the whole system. So, the flush, which is designed to keep the lines patent, propagate the pressure wave form, and check the function of the sensor during use is a Class III infused medical device; the sensor, the disposable electronic device that performs the blood gas analysis, is a Class IIa medical device; the monitor, which converts and displays the signal from the sensor, is also a Class IIa medical device; and the vials, which contain the calibration and quality control solutions, are a Class I sterile medical device.

Registering a system that combines proprietary microchips, chemistry, software, hardware and novel manufacturing technologies, which all have to be certified and demonstrated to perform consistently to defined standards is complex and time-consuming. Proxima 3 received its CE Mark in June 2014 and Proxima 4, a major upgrade with additional functionalities including glucose measurements, was expected to receive its CE Mark around mid-2016. The delay against our expectations was due to additional questions by the regulator on one element and is not unusual in such devices with innovative technologies. The next generation device, Proxima 4+ (which, as mentioned earlier, brings additional parameters such as lactate), is still expected to be approved a year or so later.

Sphere Medical is also evaluating its options for other key markets. The strategy for approvals in the US, either through a 510(k)or PMA clearance, and Japan, the Pharmaceutical and Medical Devices Agency, are yet to be decided. The requirements for these registrations differ in subtle, but important, details and the processes require careful navigation. This may involve consideration of an eventual partner’s regulatory and marketing preferences. For example, a partner may prefer to register through the more complex PMA route, which usually involves at least one sizeable study involving hundreds of patients, rather than the simpler 510(k), which tends to be quicker and involves fewer patients (tens of patients) study, for reasons that would not be apparent without appreciating their market experience.

Commercial scale manufacture in place

A full scale production site has been established in St. Asaph, Wales, and is now fully approved and operational. Currently only certain elements of the production processes have been transferred. In the short term there is no requirement for significant capital expenditure, with this only likely to be required when volumes increase materially. 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.

The manufacturing strategy is to outsource or buy in appropriate elements of the production process, those that employ known or standard technology, while retaining the critical aspects, such as membrane deposition of the sensors, in house. This reduces technical risks, capital expenditure, development time, and complexity but still retains control of the core technologies and processes that differentiates the company. The products have been designed for flexible semi-automated manufacture, with relatively straightforward scale-up to fully automated assembly when volumes justify.

A sizeable market opportunity for Proxima

The market for blood gas and electrolyte measurement is large and growing. The demand is driven by increasing patient numbers in critical care and emergency departments, which reflects both the rising incidence of respiratory disorders, cancer, diabetes, and cardiovascular diseases as the population ages and the advances in medical practice that are altering treatment protocols.

New product development has seen a sizable shift from central laboratory analysis as more compact multiple component analysers, both bench-top and hand-held, allow the process to come closer to the patient. The consequent convenience and speed is encouraging greater use of these measurements as useful indicators of patient condition including respiratory and metabolic state. Aside from the standard monitoring, blood gas analysis is now the most frequent test performed on intensive care patients.

We detailed the various industry expert estimates for the market size in our Initiation report in February 2016. Each year around 340m blood gases and electrolyte tests are performed annually across the world, with the majority carried out on patients who have an existing arterial line in place (mainly in intensive care or in operating theatres). It is estimated that around 12m arterial lines are established each year and even if only 10% of these patients are likely to be suitable for Proxima then, at £200 per disposables, this equates to a market potential of around £200m.

In modelling our sales adoption for Promima 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 have also assumed 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.

Obviously much will depend on the quality of the distribution partners in the key European regions but the commercial strategy appears realistic, with clear acknowledgement that revenues will take time to reach their potential. This reflects the complexity of purchase decisions within individual hospitals as well as reflecting the need to understand how using Proxima properly will require changes to some clinical practises. Additionally, experience with other medical devices, no matter how compelling the clinical and economic arguments may be, suggests such initial caution is warranted.

Valuation and Financials

Updating our valuation for the granting of the CE Mark sees our valuation rise from £21.8m (15.4p a share) to £30.3m (21.3p a share) as the regulatory risk is effectively removed. 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 3.

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 finalise its commercialisation strategy; however, as visibility improves we envisage employing less cautious assumptions, leaving further room for upside.

Exhibit 3: 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.

We have made minor changes to our estimates as indicated in Exhibit 4 to take into account that it took longer than we expected for the CE Mark to be granted and the H116 results.

Exhibit 4: Summary of changes to estimates

Source: Trinity Delta

We remind that we estimate that Sphere Medical will likely have a funding requirement by early 2017 of c £10m, which is shown as short term debt for the purposes of our forecasts.

Exhibit 5: Summary of financials

Source: Sphere Medical, Trinity Delta  Note: Adjusted numbers exclude share-based payments and exceptionals.