Sphere Medical: sales traction is the key factor

Having launched the Proxima 4 device across several major European markets, the focus for the next 12 months is gaining meaningful sales traction. Whilst the rising number of clinical evaluations suggest this is progressing well, the lengthy sales cycle, coupled with further spend on product development, means cash out-flows are expected over the near term. Our forecasts show an overall funding requirement over the coming year of £7-8m. Our valuation, based on a three-phase DCF model, is unchanged at £30.2m (21.3p a share).

Sphere Medical has achieved a number of important milestones in the past 12 months. These include the receipt of the CE Mark for the Proxima 4 system in September 2016; the first sales in direct markets in Europe; the appointment of distributors in Italy, Spain, and now Austria; improving the connectivity with leading patient data systems; demonstrating the workflow benefits of using Proxima on critically ill, unstable patients; and completing the production facility in St Asaph, North Wales. Over the coming 12 months the emphasis is firmly on establishing a solid commercial platform and translating the healthy pipeline of clinical interest into meaningful sales traction.

The number of clinical evaluations continues to rise

Changing established clinical practise can be a major challenge, with numerous well-documented cases of products and technologies with proven clinical and economic benefits taking time to establish themselves. In part this reflects the complexity of purchase decisions within individual hospitals, with clinical evaluations being required to demonstrate the procedure’s merits and to understand how its use will impact existing clinical practises. The experience with previous generations of Proxima suggests the lead time from first meaningful contact to an order being placed lies between 9 and 12 months.

Following its launch in December 2016 over 40 hospitals have initiated the assessment process, with 30 having had the product demonstrated in their clinical setting. Of these 14 have conducted evaluations, with Proxima 4 being connected to real patients in a real setting, and six (across three countries) have progressed to placing their first orders. These figures compare to the 20 hospitals expressing an interest and 4 performing a clinical evaluation disclosed with the 2016 trading update in February 2017.

Proxima 4 is the latest generation of the Proxima micro-analyser platform and represents a major upgrade to the previous generations. As well as additional functionality (notably glucose analysis), direct connectivity with hospital information systems (including Conworx and Clinisys), and simpler and quicker set-up, a major advance with Proxima 4 has been its indicated use being broadened to adult patients undergoing major procedures (such as neuro and cardiac surgery) and in children heavier than 15Kg. Interestingly, the Royal Manchester Children’s Hospital has become the first to place an order for paediatric use. This underscores a key feature with Proxima in that it is an in-line “closed system[1]“, with all patient blood being returned, and such blood conservation is even more critical in paediatric applications.

New distributor in place for Austria

Sphere Medical has appointed Eumedics Medizintechnik GmbH as its distributor in Austria. This adds to Burke & Burke, who were appointed distributors for Italy in July 2016, and Proyectos Hospitalarios Internacional (Prhoinsa), who were appointed distributors for Spain in December 2016. Burke & Burke have completed training and have started their marketing campaign, with Prhoinsa due to start theirs imminently. 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 the end of 2017. 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.

Valuation

We last updated our model when the CE Mark effectively removed regulatory risk from our investment case. Our valuation remains unchanged 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 1.

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 protracted, 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 1: 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

Our forecast suggest the lengthy sales cycles, coupled with continuing development expenditure, results in cash out-flows for the coming years. At FY16 the cash out-flow from operating activities was £4.5m (from £5.1m in FY15), with cash and cash equivalents of £3.2m at December 2016, down from £10.0m the previous year-end. 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 a funding requirement of £7-8m during 2017, which is shown as short term debt for the purposes of our forecasts.

We have taken the opportunity to fine-tune our expectations for the near-term, notably on the revenue line. This reflects mainly the phasing of sales to distributors, including those expected to be appointed. The change is minor, with the FY17 revenue line dropping from £690,000 to £378,000 (see Exhibit 2).

Exhibit 2: Summary of changes to estimates

Source: Trinity Delta

Exhibit 3: 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.

[1] In a closed system all the blood samples are conserved and re-infused into the patient. In open systems these would be directed to waste, with the attendant issues of blood loss and contamination.