polarityte-sometimes-roller-coasters-end-at-the-top

PolarityTE: Sometimes Roller Coasters End At The Top

PolarityTE Bull(ets)

PolarityTE (NASDAQ:PTE) is a two-year-old microcap biotech in the regenerative medicine field. Its platform shows incredible promise in its early commercial use. Its first product, already on the market, only needs to gain a small toehold in its addressable market of burn and wound patients to justify a doubling of the current price. If it becomes the new standard of care, the sky is the limit. Like all microcaps, the risks are great, but the rewards will be outsized.

The bull thesis, distilled:

  1. PolarityTE has developed a regenerative medical technology that is already showing outstanding results in the clinic.
  2. The company's competition for its first commercial product, SkinTE, is the current standard of care for severe burns and wounds: split-thickness skin grafts. There are many reasons why these grafts are terrible.
  3. It has a pipeline which it believes will launch many products for different organs and tissues.
  4. PTE is building a moat comprised of pending patents, trade secrets, compartmentalized internal knowledge, specialized knowledge of key leaders and customer satisfaction.
  5. Its products are designed to take advantage of FDA's Section 361 regulatory pathway, which takes one to two years to commercialization rather than ten or more.
  6. The company is not stepping on any toes in Big Pharma, for now.
  7. 2019 should be a big year for the company at medical conferences.
  8. Top leadership left lucrative careers at Johns Hopkins to start the company.
  9. The Directors and Clinical Advisory boards are composed of all-stars.

Regenerative Medicine

Regenerative medicine has gotten a lot of headlines because it sounds so sci-fi cool, but the promise is largely unfulfilled thus far. There is a lot of work on several fronts here, but PolarityTE is developing a platform "to induce cell and tissue polarity, creating uniquely functional tissue to mirror natural development in the human body." Does this sound like mumbo-jumbo to you? Join the club.

I'm not going to embarrass myself by trying to explain to you how this all works on the cellular level, pretty much all of which is trade secrets in any event. You can have a go at it on its website. Just a word of caution: the linked page starts with lots of pretty, clean 3D graphics, but if you keep scrolling you will get into photos of clinical results. The company's patients are severe burn and trauma victims, and the images are grizzly. It's some pretty impressive stuff, but the Before Pictures are not for those with weak stomachs.

Dammit Jim, I'm an analyst, not a doctor!

I start out very skeptical of claims like this. My training is in economics and politics, so on a certain level, all medicine is magic to me. Smart doctors who are leaders in their fields also start out skeptical, though from their expertise, not ignorance like me. They want to see clinical results with real benefits over the current standard of care before they move on from it. It happens, but it is a large shift that is a combination of technology, timing, execution, and a little luck never hurts. Never discount the power of inertia. Of great importance is getting these leaders - the department heads at key hospitals - to see a good reason to switch from the current standard of care.

Tyler M. Van Buren1 from Piper Jaffray interviewed one such surgeon about PolarityTE's first commercial product, SkinTE:

"We have spoken to multiple key opinion leaders in the field who have been able to use SkinTE on patients during its limited release. One physician, the Chief of Plastic Surgery at a leading academic medical institution in the northeastern United States, reported using the product in six patients, all who suffered difficult and severe wounds with tendon exposure. Much to his surprise and delight, SkinTE completely closed the wounds on 5/6 patients. The sixth patient was the most severe case, but still, SkinTE shrunk the wound by half and a much smaller traditional graft was added to achieve complete closure. Though initially being skeptical, this particular physician reported very positive experiences in some of the most difficult cases and as some patients even failed multiple grafts. Further, he stated that he "hates companies that promise a pot of gold, but in this case, it works."

It works. Have there ever been two sexier words?

SkinTE

SkinTE is the first product in a pretty aggressive pipeline using this technology that is intended to replace the current standard of care, split-thickness skin grafts. The surgeon receives a kit in retail-like packaging that contains everything needed to take a small, full-thickness sample of the patient's skin, and send it back to the PolarityTE lab. They process the sample and send back a syringe with a white pasty medium that contains the SkinTE treatment. Turnaround is 1-3 days, at the surgeon's choosing, and same-day if local to the lab. It is applied to the wound, and dressed normally.

Trade secrets fit neatly inside a chrome sphere. No black boxes required.

The skin begins regenerating with all the functional units - hair, feeling, sweat and sebaceous glands all regenerating over time. The case studies on the company's website show the progress after 2-3 months, and it is pretty remarkable when you compare it to split-thickness grafts. If you look at the "Chronic Wound" case study (again, grizzly clinical photos at that link), you will see the clear difference. The patient suffered trauma to both legs two years previously. On one leg, the graft took, but the other had multiple failed grafts resulting in a chronic open wound. The side-by-side photos of the SkinTE leg versus both the chronic wound as well as the "successful" skin graft are night and day.

Which brings me to my next point, which is that…

The Current Standard of Care Sucks

The current standard of care is split-thickness skin grafts where large 2-layer "flaps" are transplanted from a donor site to the wound or burn. There are many problems here:

  • Some wounds are so large that they require multiple surgeries.
  • For large burns there may not be enough good skin to harvest for donor sites.
  • Infection is common.
  • So is rejection of the graft, necessitating additional surgeries. If multiple surgeries are unsuccessful, a large chronic wound can result.
  • If the graft takes, the skin can be very dry, tight and hide-like, causing chronic pain and joint problems.
  • Split-thickness is missing sweat glands, blood vessels, hair follicles and most of the sebaceous glands. Evolution put them there for reasons.
  • Surgery sometimes includes intense post-operative procedures like a hyperbaric chamber.
  • It is a painful, time-consuming and very, very expensive procedure that also looks terrible.
  • It is superior only to large chronic open wounds, amputation, or death by infection.

SkinTE has no real competitor other than this costly, painful, and often unsuccessful surgery. There are several synthetic or bioengineered alternatives on the market, but they are either failures like Dermagraft, only meant for small traumatic wounds like a bullet hole, or are temporary solutions to massive trauma of the derma and can't be considered competitors.

The Pipeline

PolarityTE has a pretty aggressive pipeline for bringing this same technology to other organs and tissues. Next up is OsteoTE for supplanting bone grafts, which is an even larger market than skin grafts. It is beginning its first limited commercial run now, but my opinion is that getting the SkinTE rollout right is far more important, and if the company announced a delay in OsteoTE to do that, I wouldn't blink, though I think other investors would not be as sanguine.

Anyway, here's the pipeline:

There's a lot there, but the first step is getting the SkinTE rollout correct.

The SkinTE Rollout

The SkinTE rollout has proceeded very slowly, which has frustrated investors. I hear from many corners, "If it's so revolutionary, why is revenue from SkinTE so small in the last 2 quarters?" This is a very good question, to which I do not have a definitive answer.

As I said, there is no boulder larger than the one biotechs have to push uphill. In addition to the hurdles in the Risks sections, doctors, especially in the US, are very conservative about trying new procedures that may open them up to malpractice suits. From a cynical point of view, it is very hard to sue over a procedure like split-thickness grafts, where failure, infection and other complications are not unusual. So doctors are going to need to see SkinTE work, work consistently and without adverse effects, and it will take the leaders in the field to push it over the hump.

On the other side of the ledger, these are top surgeons who are among the highest paid doctors. It must be frustrating to them to only be able to offer their patients something as awful as split-thickness grafts. I have to imagine they badly want something better.

Another issue, which I will address more fully below, is the time it takes to book revenue once they get into hospitals. Hospitals have all the bargaining leverage here, and they are used to dealing with the deep pockets of Big Pharma sales, so the first one is always free. And naturally they are going to try it out on the largest, most problematic wounds that have either failed grafts or are likely to fail. Since PolarityTE charges by the square centimeter, it is losing a ton of initial revenue to these freebies right now, but there's no way to avoid it.

In the last quarter of 2018, PolarityTE built up its sales force to 24 to expand into a regional sales push, many who came from Big Pharma at lower base salaries. They will never have the sales budget they had at their previous jobs. Doctors will not be getting free trips to Hawaii for conferences on the beach, nor large honoraria, nor lavishly expensive meals and gifts.

But the sales team has a product that works much better than the current standard of care, replacing costly surgery with a better, less expensive non-surgical alternative. Even so, this may not be enough. Technology, timing, execution, and a little luck never hurts. I'll talk about how that's going so far below under Financials.

Leadership

The core of PolarityTE's leadership are three surgeons who left their practices at Johns Hopkins to start the company. Just for reference, plastic surgeons are the highest paid doctors in America, averaging about a half million a year. The trade secrets that are the deepest moat they have are compartmentalized with these three doctors.

Denver Lough, CEO and head of R&D, is the founder and inventor of the whole thing. SkinTE is already working incredibly well in the clinic, and its pipeline shows great promise. As the head of R&D, he is irreplaceable. But as CEO, he is infected with a mild case of Elon Musk Disease. He tends to express himself in TED-speak that I believe undercuts the seriousness of what he's up to. For example, this leads his official bio:

"Dr. Denver Lough has always sought to investigate reality, pursue complex simplicity and develop a new paradigm in translational science."

Huh? I believe this sort of thing turns investors off. Dr. Lough should be focused entirely on the SkinTE rollout, interfacing with patients and his fellow doctors, and also leading development of the pipeline. He is irreplaceable in these capacities and that's where his leadership efforts will be the most valuable.

I think the announcement of David Seaburg in the newly created role of President of Corporate Development is an effort to get someone more finance-friendly in front of investors. He is a 25-year vet at Cowen and was already a board member.

Edward Swanson and Nikolai Sopko also are surgeons who left their practices at Hopkins to move across the country and join the PolarityTE team. Swanson is COO and Sopko is Chief Scientific Officer, and Lough is chief deputy in the lab.

Paul Mann is the CFO, and he is not a former surgeon from Hopkins. He has an engineering degree from Cambridge and brings a little British swag to meetings. His career has been mostly in finance - Soros, UBS (NYSE:UBS), Morgan Stanley (NYSE:MS), Deutsche Bank (NYSE:DB) and most recently Highbridge.

The Board of Directors

After a lot of turmoil, the company has solidified its board. Like the clinical board, it is composed of all-stars.

The Chair

Steve Gorlin is a biotech executive with 45 years and numerous startups under his belt. Probably the best known is Medicis Pharmaceutical which sold to Valeant/Bausch (BHC) for about $2.6 billion.

The Money Guys

Peter Cohen was on the Board of Directors at the NYSE, and was the CEO at Shearson Lehman Cowen. He is also a Trustee of Mount Sinai Medical Center. He has served on numerous boards, including The Fed Capital Markets Committee and American Express.

Rainer Erdtmann is a managing partner at Point Sur, the renowned biotech VC.

David Seaburg is a Managing Director and Head of Sales Trading at Cowen. As of this week, he is also President of Corporate Development.

The Professor

Jeff Dyer is the Horace Beesley Professor of Strategy at BYU, and Professor of Strategy at Wharton. Previously a Bain Boy.

The Biologist

Jon Mogford is the Vice Chancellor for Research at Texas A&M. His particular field is regenerative medicine.

The Lawyers

Willie Bogan was Associate General Counsel for medical supply giant McKesson (NYSE:MCK) until his retirement in 2015.

Minnie Baylor-Henry spent nearly a decade at the FDA before joining Johnson & Johnson (NYSE:JNJ) as Worldwide VP of Regulatory Affairs.

All together, insiders own about 42.5% of the company.

Risks: Be Afraid of All Microcap Biotechs

Photo: MamboZ

Fear is normally not a healthy instinct in the market, but for high risk/reward investments like biotechs, fear keeps you on your toes.

All new biotechs launching a single product or pipeline are very risky by nature. More than any other business, the regulatory, competitive, news-cycle and macro pressures are huge. How does a tiny company navigate the thicket of the FDA, insurance companies and medical-group administrators? They have four customers for every sale - doctor, patient, hospital administrators, and third-party payers. How do they satisfy all these parties, whose interests are not always aligned? How can their sales force compete with Big Pharma's? Can they survive a bad news cycle? How will they be able to navigate the unpredictable when they already have such a thin margin for error?

The boulder they are pushing uphill is massive.

Never overinvest in risky assets. The rewards from the winners are outsized, so protect your downside. Don't read this report, get too excited, and start dreaming of that house in Aspen you want. Downsize your dreams to a Winnebago; you can always drive it to Aspen.

If you worry that you are overweight biotech, you likely are.

If you are not a doctor or a biologist with specific experience, you will always be operating at an information disadvantage, which is never a good thing. Unless you have devoted your professional life to it, you will never be able to fully understand the medicine involved, and there will always be a level where you will need to trust the opinions of experts: doctors, healthcare executives and patients. Especially in the wake of the Theranos fraud, everyone is on high alert.

Biotechs require regular news-watching, as there can always be a relevant headline from a regulatory agency or from the clinic. Always check your confirmation bias daily; you may have been right yesterday, but wrong today. There is no substitute.

This past Monday, two analysts initiated coverage of PolarityTE, one with a $5 target, one with a $50 target. Then Oppenheimer came out overnight with a $30 price target. This gives you a sense of the range of possibilities. So biotechs are not for everyone, only those with a healthy appetite for risk, but also the good common sense not to take on too much.

Risks: Open For Business

I'll get to PolarityTE's answers to the questions I asked in the last section, but the biggest challenge for all new companies is keeping the doors open, something many noted economists have called "you know, super important."

Here is the real scary news in PolarityTE's recent 10-K filing:

The Company has experienced recurring losses and cash outflows from operating activities. For the year ended October 31, 2018, the Company's net loss and cash used in operating activities were $65.4 million and $28.5 million, respectively… Based upon the current status of our product development and commercialization plans, we believe that our existing cash and cash equivalents will be adequate to satisfy our capital needs for at least the next 12 months from the date of filing. We anticipate needing substantial additional financing to continue clinical deployment and commercialization of our lead product SkinTE, development of our other product candidates, and scaling the manufacturing capacity for our products and product candidates, and prepare for commercial readiness. We will continue to pursue fundraising opportunities when available, but such financing may not be available in the future on terms favorable to us, if at all. If adequate financing is not available, we may be required to delay, reduce the scope of, or eliminate one or more of our product development programs. We plan to meet our capital requirements primarily through issuances of equity securities, debt financing, revenue from product sales and future collaborations. Failure to generate revenue or raise additional capital would adversely affect our ability to achieve our intended business objectives.

So there it is: mo' money. The 12-month figure is based on the current burn rate, which should narrow over the course of the year, so the company likely has a little more cushion than that.

Unless it was 2009, the timing could not be worse. In my opinion, 2019 is likely to be a year where investors reduce their risk profiles. We are already seeing the BBB-AAA corporate bond spread rise, and I believe it will rise further, so debt markets will be expensive. PolarityTE did two new stock offerings in FY 2018, and I don't think another one in 2019 will be warmly received in the current environment.

So, that leaves private sources of capital - either equity or debt or a combination. Either way, I don't believe that it will be easy. Sources of capital that look firm now may be dry in 6-9 months, so it will be better to get this done sooner rather than later. It can shake out in one of two ways. If the company raises a small amount of capital or have to further dilute the shares, I don't believe the market will react well. But if it can get a large debt facility from a large institution, and the press release includes some very complementary words from said large institution, I think the market would view this very favorably. Personally, so long as it keeps the doors open and gives them more time to get SkinTE into hospitals, I don't really care, but I realize I am unusual in this respect.

In any event, besides the sales push on SkinTE, this is the key issue for 2019. I was very pleased by the addition of director and longtime Cowen vet, David Seaburg, to the team in the newly created role of President of Corporate Development. He will likely be leading the charge here.

Risks: The Regulatory Thicket

There is a lot of confusion which needs a bit of clearing up. SkinTE and OsteoTE are "registered" with the FDA, and that phrase smells funky to people, but they don't understand the specific regulatory framework under which these products operate. Human cells, tissues and cellular and tissue-based products (HCT/Ps) are governed by FDA regulations that provide a different pipeline than for traditional drug candidates.

SkinTE and OsteoTE are registered as HCT/Ps under Section 361 of the Public Health Service Act, FDA Title 21CFR1271.10.2 While still subject to strict oversight, the pathway allows self-designation and commercial use while clinical trials are still underway. So far there have been zero adverse effects from SkinTE and OsteoTE, so the FDA has used a light touch.

This can change in a heartbeat. Either the FDA or Congress can choose to change the Section 361 requirements. Even though PolarityTE specifically designs around current requirements, the FDA might decide it doesn't meet them and push it back to the Section 351 pipeline, which is less self-regulated and requires about 10 years to market, rather than the 1-2 years for Section 361 products. It is also subject to snap facility inspections, and failure could stop it cold, albeit temporarily.

The good news on this front is the recent addition of Minnie Baylor-Henry to the Board of Directors. Baylor-Henry is an attorney who spent eight years at the FDA as Director of the Division of Drug Marketing, Advertising and Communications (now the Office of Prescription Drug Promotion) before 10 years at Deloitte and Johnson & Johnson, where she finished up as J&J Worldwide VP of Regulatory Affairs for Medical Devices & Diagnostics. She currently runs her own regulatory consulting firm.

Just a hunch, but she may be of some assistance here.

Risks: VACuumed Up

Another big hurdle is getting approved by medical groups for use in their hospitals and clinics. This is a long drawn-out process, the procedures of which vary from institution to institution. There is no one way in, but all new products must get past the dreaded value action committees (VACs).

Like every committee in history, successful navigation for third parties depends as much on understanding its internal politics as having something of value to offer. Some committees only meet quarterly. The approval process takes up to six months and then of course, the first one's free. Because it takes months for SkinTE to do its thing, it can take up to a year to get from VAC to actual revenue. It is the Great Black Hole of Bureaucratic Uncertainty Number One (GBHBU1).

PolarityTE's approach has been to build up an all-star Clinical Advisory Board early on. Click on that link and Google these people - they are all key leaders in reconstructive surgery, associated with major hospitals, universities, and medical organizations that have burn and trauma units.

The long-term strategy paid off again recently with VAC approval by University Hospitals Cleveland Medical Center, which is a giant healthcare organization centered around Case-Western University. It encompasses 18 hospitals, 40 clinics, and 200 doctors' offices spread out over 15 Ohio counties.

I would imagine that key to navigating it through the VAC was Dr. Anand Kumar, Chief of Pediatric Plastic Surgery, University Hospitals Rainbow Babies & Children's Hospital, and a member of the PolarityTE Clinical Advisory Board. His ready-made quote for the press release:

SkinTE has made an immense impact on our pediatric patients at UH by minimizing donor skin site pain, discomfort and unsightly scarring. Patients and their parents have noticed that the regenerated skin is soft, pliable and non-adherent to the underlying wound. SkinTE is a complete paradigm shift from adherent split graft treatment of the last century.

So, while navigating these committees is never going to be easy, it's nice to have a champion on the inside who already has seen the clinical results up close over a period of time, and is already comfortable with it. So far the company has gotten approval from every VAC it's gone to. 100% is a good number.

Risks: GBHBU2

Insurance companies. It seems like everyone has a frustrating story of being denied coverage for a newer, less expensive treatment in favor of tried-and-maybe-not-so-true methods. I recently had one of these befuddling calls myself, where my insurance company eschewed the thousands of dollars I was trying to save them in provider reimbursements. Not out of stupidity or greed, but out of risk-aversion. They are the Great Black Hole of Bureaucratic Uncertainty Number Two.

Insurance companies exist to pool and manage risk, so they are naturally averse to it. Changes move slowly and deliberately, and not until they've done a proper cost/benefit actuarial analysis. This can take years of clinical use.

There is not much PolarityTE can do here except keep pushing, but cost versus graft surgery is certainly in its favor.

Risks: Big-Footed?

Here's a bit of unambiguous good news. The company's competition is the current standard of care, split-thickness grafts, an expensive and frequently unsuccessful surgical procedure. There is no big pharmaceutical company which is threatened by this except on the very margins, so there is no reason for Big Parma to Big Foot it. Yet.

Risks: Satisfying The Customer(s)

My number one metric for all companies is customer satisfaction. It is the best moat of all, not just because it's so effective, but also because it is 100% in the company's control. It is no accident that Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) have the highest customer satisfaction. People love both companies, which keeps them buoyed when other things that are out of their control are going badly.

For a new company with their first product, it is even more important to get as close to 100% customer satisfaction as possible. You only get one chance to make a first impression. In the medical world, this adds an additional layer to the problem, because there are multiple customers on every sale: doctors, patients, hospital administrators and hopefully third-party payers. That's a lot of people to keep happy, just for one sale, and their interests are not always aligned.

The slight evidence we have so far is very positive on this front. From Tyler Van Buren's report:

We were able to speak with leading KOLs [Key Opinion Leaders] in the field - many who are chiefs of plastic surgery/reconstruction departments at top-tier medical institutions. One physician specializes in craniofacial surgery and facial trauma/reconstruction and focuses on a pediatric population. This physician used SkinTE in five patients, all of which were successful after a single application of the product. This physician reported that the regenerated skin looked "better, more flush, and supple" than a STSG, stating that it "feels like natural skin" with "some pigmentation."

And another surgeon:

This physician was also impressed with the seamless collection and delivery process, reporting a turnaround time average of two days. When asked to rank the product on a clinical utility scale from 1-10 in comparison to substitutes, this KOL gave SkinTE a 7-8 vs. a 3-4 rating for substitutes available on the market. This physician stated that SkinTE offers the ability to avoid the operating room, and believes that the uptake will primarily come from burn patients calling it the "holy grail for burns." When asked to identify the greatest road-blocks in terms of physician uptake, this KOL guided that surgeons will need to see more data from the company and have one of their own back it in order to begin the waterfall effect. If this were to occur, both physicians agree that SkinTE has standard of care potential for burn and trauma wound patients.

And patients?

We have spoken with SkinTE-treated patients who are ecstatic with the results. One patient expressed regaining sensation, hair, and pigmentation in severely wounded skin.

So, being a geek for customer satisfaction, these quotes warm my cockles. I would imagine that keeping surgical rooms available for other patients also makes hospital administrators happy.

Risks: FRAUD!

(No, not fraud.)

If you Google PolarityTE, it will not take you long to come across the farcical claims of fraud made by Andrew Left at Citron Research. I covered this nonsense extensively, but the Reader's Digest version goes something like this.

In 2015 and 2016 Denver Lough was casting around for investors for the technology he was developing at Johns Hopkins, and he fell in with a very, very bad crowd.

Barry Honig and John Stetson were a part group of investors who are shady as hell, and are now under various SEC charges. All you need to know about them is another one of their companies was called "Riot Blockchain". Have you ever heard a name more guaranteed to be a pump-and-dump scam? They may as well have called it "Buzzword Buzzword." I'm just going to stipulate that they are The Worst, and Lough should have known better.

It took a while, but the company has extricated itself from this early unforced error. None of this original group are on the board or in any executive position, after they were finally able to get rid of Stetson a few months ago. Some are still shareholders, but they hold zero influence beyond that.

I encourage you to read Left's reports, such as they are. If you can get past the 1990s-style text formatting, I think you will find his arguments thin and unsupported by facts. Or any familiarity with the FDA and SEC, which a quick Google search would have helped him with.

The Stock

I've been continuously long PTE since the spring. Here's that roller coaster:

ChartData by YCharts

I was a genius there for about five minutes. The stock had a lot of buzz in the spring, and it spiked up to over $41 intraday on heavy volume on June 21. Then, Citron released its report groundlessly alleging fraud on June 25, and you can see the result. Notice that short interest doubled in the seven weeks leading up to the Citron report, which I imagine is Left shorting on his own recommendation before releasing the report.

With insiders holding 42.5% of the shares, currently almost 60% of publicly traded shares are held short, at a range of sell prices. So it is super tightly-held right now, market depth is a puddle, and daily volatility is crazy. Since I've owned it, the 14-day Average True Range has not dipped below 5% of share price, and it is regularly in the double digits. Just this year has seen four days where daily True Range was over 15% of the previous day's close. But nothing will match the excitement of last September 25th, when its True Range was over 40% of the previous day's close.

So not only has the stock been very volatile over time, but intraday as well, even minute to minute. I've begun to ignore the price, and spend more time looking at the bid/ask spreads, market depth and block trades, for signs that liquidity is growing. This year I'm seeing what I think is a pretty orderly retreat by the shorts without panic. This is pushing the stock price up, but not as much as a short stampede would. It's still unclear what the picture is, and until the short positions are covered, and liquidity returns, the stock will continue to bounce around. The last few days have seen spikes of high volume and tighter spreads, though they are still large.

Financials

I'm tempted to just say, "microcap biotech" here and move on. What we'll be looking at is typical of a biotech having just entered commercialization - revenues grow slowly, while operating expenses skyrocket.

ChartPTE Revenue (Quarterly) data by YCharts

Yeah, I know. Microcap biotech, what can I say?

So let's dig a little deeper. Earlier in the year, PolarityTE bought out one of its primary vendors, IBEX, a contract lab in Utah. The lab mostly does PolarityTE's work, both before and after the sale, but it does have a bit of excess capacity, and as one of the only vendors in the region, PolarityTE is able to get a little extra revenue from a contract service business. Hopefully, we can see a little growth there in 2019 to help stem the tide of cash burn, and it's made an important hire in that respect.

But the big news is the slow growth of revenue in the SkinTE rollout thus far. I've discussed it above, but let's look at the numbers.

Total H2 SkinTE revenues were only $673,000, $429,000 in Q4. But it's very hard to get a true sense of how many paying patients that was exactly.

Unlike many companies in its sector, SkinTE has a very simple and predictable payment formula: $1,000 flat plus $60 per square centimeter. The average wound size treated in 2018 was about 500 square centimeters, which is $31,000 per patient. So at this calculation, there have been only 22 paying patients thus far.

But if you look at the clinical photos on its website, you will see that there is a wide range here, from chronic diabetic ulcers just a few square centimeters (~$1,200) to severe burns covering thousands of square centimeters (~$120,000), so patient mix is key. The $673,000 in revenues could be 560 paying diabetic ulcer patients, or six paying burn patients, or anything in between.

Likely the freebies the hospitals requested were for their most challenging and expensive cases, so that's a lot of revenue lost to promotional costs in the early rollout.

The company finished the year with 56 active accounts3 and 336 in-process accounts.4 So it has nice momentum headed into 2019 with its customers, but they need to start getting more revenue to stem the tide of cash burn.

Valuation

I'm going to start off by saying I find this sort of analysis to be suspect, especially with microcaps. People want to see it, so here it is, but any freshman finance major will tell you that the target price output to any sort of cash flow analysis is highly dependent on assumptions, which usually turn out to be very wrong.

I've made a Google Sheet of the calculations, and you can enter in your own assumptions and figure out how to back-engineer any result you want, from zero to kajillion. It's a Make Your Own Adventure, so have fun with the Google Sheet, kids; but remember, safety first.

That being said, here we go. I'll do Tall, Grande and Venti scenarios. Piper Jaffray's Van Buren modeled a fairly conservative pace of uptake, at 3% of addressable market by the end of 2024, with a 15% annual risk-plus-inflation discount to future earnings. We both model only SkinTE revenue. My scenarios differ in that:

  • I will assume faster uptake than Van Buren, but a much higher risk premium, which I think makes more sense for SkinTE.
  • Even though it has no current interest expense, I am using a levered accounting, so you can add in new 2019 debt in the Google Sheet and see the effect on target price. Unless you punch in a usurious rate, it will not make much of a difference.
  • He does a 10-year model; I only do 5.
  • He models linear growth; I model exponential growth using a five-year CAGR.

Van Buren's model came up with a $30 target price, though he notes, "this number could be ultra-conservative given that only assumes ~3% penetration in the three severe acute, chronic, and burn wound indications." I think it is way too conservative.

Assumptions for all scenarios (you can modify these in the Google Sheet)

  • Operating expense growth: 15%/year.
  • Capital expenditure growth: 15%/year.
  • D&A growth: 15%/year.
  • Net working cap growth: 15%/year..
  • Terminal growth rate: 12.5%/year
  • EBITDA multiple: 10x.
  • Risk discount to future earnings: 20%/year.
  • Inflation rate: 2%/year.
  • Patient population growth rates: acute wounds - 0.5%; chronic wounds - 1%; burns - 0.25%.
  • Addressable markets in 2019 (number of patients): acute wounds - 150,000/year; chronic wounds - 1,000,00/year; burns - 40,000/year.
  • Average wound size (sq. cm): acute wounds - 450; chronic wounds - 3; burns - 1,700.
  • 2019 market penetration: 0.2% for all three markets.
  • Uptake will be faster in chronic wounds and burns.
  • I did not include the 2019 capital raise in the equation, since we don't know what it's going to be, but you can add that into the Google Sheet.

Scenarios

The big assumptions with respect to revenue will revolve around uptake in the three indications: acute wounds, chronic wounds and burns. I believe uptake will be fastest in chronic wounds, where the cost is actually reasonable enough for many patients to afford out-of-pocket. At an average wound size of 3 square centimeters, the cost of SkinTE treatment is only $1,180.

Also, severe burns are the most problematic of these indications. They cover large areas, there may not be enough donor site for grafts, and failure is common. So I think burn doctors may be more willing to take the risk of jumping over to a new, less-tested product.

You can see all the math in the Google Sheet, but here's how it shakes out:

Tall

Grande

Venti

Acute wounds

3%

3%

5%

Chronic wounds

5%

9%

15%

Burns

4%

6%

10%

Which computes to:

Tall

Grande

Venti

Revenue ($M)

$357

$491

$818

EBITDA ($M)

$187

$321

$648

Target Price

$25

$45

$95

Just for fun, what if SkinTE is able to become the standard of care in five years? I'll model that at 80% market share for all segments, and upping CapEx and OpEx growth to 60%.

Venti with 4 Espresso Shots

Revenue ($M)

$7,824

EBITDA ($M)

$6,642

Target Price

$950

Um, yah. Anyway, like I said, I'm not a fan of this sort of analysis, but there it is.

Conclusions: Buy, Mortimer!

So long as you have the stomach for risk and volatility, I strongly recommend a buy on PolarityTE. There are tremendous risks involved, but the rewards will be stunning if SkinTE can become the new standard of treatment, which it definitely has the potential to become - technology, timing, execution, and a little luck never hurts.

The rewards will be outsized if this thing flies, so there's no reason to overposition yourself. What that means to you is a function of your own risk tolerance. For me, that means that I've kept it at about 4% of my active portfolio, even as I brought my overall long positioning down to 30% over the autumn, where I still am.

2019 is the pivotal year for PolarityTE. The crucial issues are how the company is going to raise more capital at the same time it is rolling out its first product and building out its sales force. These are not unrelated. If the rollout goes well, funding will be easier to get. In any event, it would be better to secure it sooner rather than later.

Wall Street is beginning to take notice, and four analysts have initiated coverage in the past month, three just this week. All but one have a price target of $30 or more. This is great momentum, and additional coverage will only add to that.

Another tailwind in 2019 will be presentations at medical conferences by surgeons who have used SkinTE. As noted, one of the keys to successful rollout is to get the leaders in the field, who represent the top burn and trauma centers in the country, on board with the shift. They can help convince other surgeons of the advantages here, much better than even the best sales team.

Watch the news every day, as the tide can turn quickly, and keep your confirmation bias in check. This is no substitute.

Photo: Andrew Borgen

I haven't been on a roller coaster in years. The last time, our car got stuck up at the top of one of the rises, and we had to wait an hour while management got a cherry-picker to get us down, four at a time. Some of the riders didn't like it up there, but I did. The weather was beautiful, we had a great view, and I was up there with a good friend who had enough candy to pass out to everyone. We were the last ones to get off the ride, and frankly I didn't want to leave.

Sometimes roller coasters end at the top.

Thanks for reading. Comments? Questions? Insults? Have at it.

Endnotes

1 Tyler M. Van Buren has a background in biology, with an MS from UC-San Diego. He not only writes a great research thesis, but I also can't help but notice that he sports the names of two different 19th Century US Presidents. I desperately hope the "M" stands for Madison or Monroe.

2 Here's the text of that title:

An HCT/P is regulated solely under section 361 of the PHS Act and the regulations in this part if it meets all of the following criteria:

(1) The HCT/P is minimally manipulated;

(2) The HCT/P is intended for homologous use only, as reflected by the labeling, advertising, or other indications of the manufacturer's objective intent;

(3) The manufacture of the HCT/P does not involve the combination of the cells or tissues with another article, except for water, crystalloids, or a sterilizing, preserving, or storage agent, provided that the addition of water, crystalloids, or the sterilizing, preserving, or storage agent does not raise new clinical safety concerns with respect to the HCT/P; and

(4) Either:

(I) The HCT/P does not have a systemic effect and is not dependent upon the metabolic activity of living cells for its primary function; or

(II) The HCT/P has a systemic effect or is dependent upon the metabolic activity of living cells for its primary function, and:

(a ) Is for autologous use;

(b ) Is for allogeneic use in a first-degree or second-degree blood relative; or

(c ) Is for reproductive use.

So SkinTE is unambiguously good to go with (2), (3) and (4). The definition of "minimally manipulated" could change, and that's where the risk lies.

3 The company defines an active account as "one where the product has been used already whether it's through a trial evaluation or a paid product."

4 The company defines an in-process account as "hospitals or clinics that have initiated the VAC review process, initiated trial evaluation agreements or purchase agreements that have not used the product yet."

Disclosure: I am/we are long PTE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.