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Cytosorbents: Concentration Risk With Covid-19 Overexposure (NASDAQ:CTSO)

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Investment Summary

Cytosorbents Corporation (NASDAQ:CTSO) has had a bombastic year, on the back of high exposure to Covid-19 that has driven sales and shareholder value since the selloff in March. We believe the near-term upside remains for CTSO, via the demand for CytoSorb and its application in Covid-19, and the company has responded here by increasing manufacturing and distribution capacity. Currently, CytoSorb is being sold under emergency use authorisation (“EUA”), and there is probability that FDA approval will be on the horizon. Furthermore, recent advancements with military exposure via contractual tailwinds in the Haemo-Defend segment, signal potential sequential drivers to top-line volumes over the coming periods. Thus, there are drivers to the growth engine that should be reflected into revenue volumes, over the coming years.

However, we believe that the scope of CTSO’s near-term sales potential is contained to Covid-19 exposure, and that the recent developments and Covid-related tailwinds are already reflected into the valuation.

Data Source: Author’s Bloomberg Terminal

The level of further upside is controversial for CTSO. Plus, we believe that the market may have exhausted its viewpoint of CTSO for the time being, amidst Covid-19 vaccination advancements and CytoSorb’s sales restricted at the EUA level. Therefore, whilst the outlook for the company looks promising, considering valuations and potential drawdowns to 2020 performance, this balances the neutral view we hold. As such, we believe CTSO lacks conviction for immediate entry, and that further tailwinds are contained to the near-term.

The Portfolio Highlights CTSO’s Covid-19 Exposure & Concentration Risk

We must start the analysis by scrutinising what is realisable (in cash terms) for CTSO at the present moment. CTSO ramped manufacturing and distribution capacity to match demand for CytoSorb throughout Q2 and Q3, which drove sequential top-line growth to $10.5 million in absolute revenues, a ~70% YoY increase. Almost 100% was derived from the product portfolio, which is geared towards CytoSorb. Further capacity increases are likely for the remainder of FY2020, especially in view of the state of the pandemic in the US. Consequently, total revenue volumes YTD of CytoSorb have crossed $34 million, which shows a rebound from the Q2 trajectory. Due to the demand for manufacturing and distribution, margins were under pressure from Q3, and saw a ~300bps decrease YoY on the top and to operating leverage. Margin pressures were driven by underlying manufacturing costs, firstly by expanding production lines and also to labour capital. Margin pressures will likely remain in the near-term, as manufacturing capacity remains stretched at the helm of Covid-related demand, via the swath of new cases in the back end of FY2020. This is coupled with the lower-margin contributions via distributor focused turnover. Therefore, we see headwinds to operating leverage product margins for Q4, in the realms of ~175-300bps.

CytoSorb has approval in several geographical zones outside of the US, particularly in Latin America and the EU. All up there are 66 approval zones distributing CytoSorb, which does point to the demand-servicing nature of this product. The mechanism of action for CytoSorb, is to mitigate the effects from the hyper-release of inflammatory markers. The cartridges work under a blood purification hypothesis, that correlates with uncontrolled cytokine release in the body, resultant from hypercytokinemia (colloquially: cytokine storms). Cytokines are an essential part of the immune response in humans, however, they must remain under heavy homeostatic regulation, as a sudden hyper-cytokinetic response from foreign agent exposure, has high probability to cause multi-organ failure. So much is true with exposure to the SARS-2 Covid-19 viral target, which will cause hypercytokinemia within the systemic immune response. Notwithstanding the excess fluid that lung tissue accrues on the back of Covid-19’s viral symptomology compounded by cytokine storms. Therefore, CytoSorb has gained incredible traction this year, treating patients with this type of presentation and preventing mechanical ventilation.

Data Source: Cytosorbents Website

Over 100,000 CytoSorb cartridges have been distributed across the globe, which has saved countless lives. CTSO has therefore doubled down on the sales force, increasing the number of players to ~175 employees, and the main priority seems to be CytoSorb, CytoSorb, and yes, CytoSorb. To illustrate, management have guided $400 million in product sales over the coming periods at the upper bound (majorly comprised of CytoSorb), and have increased CAPEX allocation to the property, plant and equipment line, to expand manufacturing capacity by Q2 2021. Additionally, the company has key CytoSorb collaborations in the US with InvoSurg, Terumo Cardiovascular company and Surgical Partners in a commercial agreement in ~25 US states, albeit under EUA designation. This is coupled with the ongoing sales in registered countries. Therefore, the treatment is likely beyond its proof of concept stage, which could certainly attract a premium in the valuation.

Management believe that these developments will drive margins beyond 80%, but we hold the opposite side of the coin here, especially as operating leverage will remain under pressure from fit-outs and increase in manufacturing costs. Additionally, pricing will face competition from competitors, especially as a vaccine will likely be rolled out across next year. Whilst cases are on the rise again in key geographical zones, there is no doubt that they will settle once again, and the cadence of CytoSorb deliveries will diminish with this run-down. Most importantly, however, is that the company remains overly exposed to Covid-19 as the driver in engine growth. There is minimal product cushioning for CytoSorb underneath the pandemic, and management have modelled sequential growth primarily on the back of Covid-related demand. Long-term, investors will continue to scrutinise the margin pressures from manufacturing costs, that are related to servicing this demand. Additionally, once the pandemic diminishes, then we are yet to see a commercial strategy that mitigates the effects of this to date.

The above points clearly highlight CTSO’s portfolio exposure to Covid, and almost 100% of top-line volumes have resulted on the back of this. Thus, the concentration risk that surmounts from the portfolio must be factored into the valuation, and for investors. Compared to a company such as Avantor (AVTR), who’s portfolio has a maximum of 3% exposure to total sales from each portfolio segment, the effects of a slow-down in Covid-related demand will impact almost 100% of the portfolio, based on what treatments CytoSorb can convert into cash right now. The risk-adjustment that must be performed on CTSO’s valuation is therefore quite pronounced, which offsets the proof of concept premium attached to CytoSorb in the first place. Without adequate diversity in application for these cartridges, then the company is adding no real shareholder value, it is only the Covid exposure that is adding the value. Thus, we are heavily biased towards a neutral stance for CTSO shares at present, because we are fearful that the rotation out of biotech and healthcare stocks will impact expected returns significantly. We’ve already seen evidence of this since Pfizer’s (PFE) and now Moderna’s (MRNA) candidates (with 95% and 94.5% efficacy in targeting SARS-2, respectively) and the hype is beginning to fizzle down for all other related players. CTSO has committed large, one-off capital expenditures to fulfilling Covid-19 demand, and we question the longevity of this, alongside the diversification power within the product mix.

What Mitigates The Concentration Risk?

CTSO do have other pipeline developments that are worth noting, to help offset the above scrutiny. The first relates to CytoSorb’s additional applications, which are actually quite promising, and have the potential to provide a remedial breakthrough in cardiology.

Firstly, the Refresh 2-AKI trial has begun enrolments again, after CTSO paused the study to find a new contract research organisation. The randomized, blinded pivotal trial, is evaluating the use of 2 CytoSorb cartridges concurrently in the scope of cardiovascular surgery. The primary objective is specifically to reduce the incidence and/or severity of acute kidney pathology within ≤48 hours post-surgery. The single-cartridge dose regimen has been successfully used outside of the US in many cardiac surgeries, which gives good indication to potential outcomes of the Refresh trial. Additionally, it moves CTSO’s hypothesis for this product away from Covid, and addresses a wider market, that has the potential for deeper penetration over a far longer period. The 153 patient cohort will participate in ~25 different centres, and will recommence in Q1 2021.

The company also has several upcoming trials penned in for updates over the coming periods. The STAR Registry is investigating antithrombotic removal, whilst the 30 patient single-arm Tisorb trial, will investigate CytoSorb’s effectiveness in in Ticagrelor removal and that drug’s platelet aggregation effects, following emergency open-heart surgery. Then there are the 3 upcoming German trials; one for dual-shock reversal, the Hep-On-Fire acute on chronic liver failure trial, and another Ticagrelor removal study called CyTation. We can expect movement and readouts from these trials over he coming 12-24 months.

Then there is the Remove trial, which is evaluating CytoSorb’s use intra-operatively in valve replacement surgeries, to offset the risk for infective endocarditis. This certainly ties in well with the hypotheses around the Ticegrelor removal, and also links with the Refresh-2 trial, thereby giving CytoSorb additional exposure to the cardiology segment. Should success be garnered from these trials, then physician accounts may see an accelerated growth pattern and refill rates will reflect this as well.

We believe that the cardiology segment is the long-term catalyst for CTSO, although without robust clinical data so support the hypothesis and commercial potential, it is difficult to completely ignore the overwhelming reliance on Covid-19 for CytoSorb volumes. We believe there is greater penetration potential in cardiovascular applications for the cartridge, however, we must await for the data for insights into the commercialisation potential.

We would also mention the contract agreements with the Army Medical Research Acquisition (“AMRA”) and US Department of Defence (“DOD”) which were awarded to CTSO for their HaemoDefend segment. The application here, is to remove anti-A and anti-B antibodies in the blood and plasma transfusion process, for the delivery of blood in trauma-type situations. One can clearly see the alignment with the US Military in this sense, especially in urgent situations where blood testing is not applicable, such as in the battlefield. The AMRA and DOD contracts were valued at $1.1 million and ~$4.5 million, respectively, which differentiates the portfolio away from CytoSorb, and creates a potentially long-tailed asset value for the HaemoDefend segment. Should the company deliver successfully on these contracts and produce exactly what these 2 agencies are after, then the incremental asset value of HaemoDefend will continue to expand over years to come, with greater certainty, considering the alignment with Government contract manufacturing.

Therefore, whilst we scrutinise the CytoSorb segment’s exposure and reliance on Covid-19 in the near-term, there is hope on the horizon for the company. In this vein, these are the potential inflection points that could deliver shareholder value, should the company successfully make the necessary conversions from the pipeline. Although there is high asset potential (including the contact manufacturing component) and potential diversity effects in the points outlined above, there are still several contingencies, plus pipeline and execution risks that impact our valuation.

Outlook – Operating Leverage Under Pressure

We see sequential revenue growth of ~30% over the coming 5 year period, and are conservative in projections in the base case (shown below) considering the diminishing effects of Covid-19 to product margins. We believe that EBITDA-level margins and operating leverage will face significant pressures over the coming years, especially on the back of manufacturing costs related to CytoSorb capacity. We view free cash growth over the same period, and healthy margins there. However, in our downside scenario, we’ve priced in greater than expected R&D expenditures that will hamper FCF margins and absolute growth. This will be reflected on EBIT and EBITDA level lines, in our view, especially considering the straight-line expenditure that CTSO will incorporate on the PP&E lines on the balance sheet over the coming periods. Thus, whilst we do see top-line leverage over the coming periods, we are more conservative vs consensus on the same, whilst remaining reserved on operating income. We’ve modelled the slow-down in Covid-19, and only ~60% probability of CytoSorb’s cardiology conversion to revenue projections. Thus, FCF conversion in our model is impacted by this, also.

Data Source: CTSO SEC FIlings; Author’s Calculations

The company left Q3 with cash and equivalents of just over $80 million, a significant quarter/quarter increase that was led by a ~$58 million equity facility from Cowen & SVB Leerink. That decision was most likely to support liquidity and ensure adequate liquidity protection in view of the manufacturing and distribution capacity demand in the upcoming periods. The capital structure remains equity focused and the debt ratio is ~16%, which has come down after the company amended terms under debt servicing, on the back of the equity raise. Debt therefore has remained stable, although the debt ratio has corrected. Investors should realise that the equity structure is what has driven the debt measures to remould, not necessarily the overall debt figure. We see evidence of the equity focus with equity to assets of ~77%, whilst debt as a function of equity is only 20%. Total debt to capital is ~17%, whilst interest is not well covered at -6% coverage from EBITDA level earnings. Profitability in EBITDA pressures are the major conflicts in our modelling, which may impact the capital structure over time. Additionally, we view drains and pulls on liquidity via manufacturing and distribution costs, related to CytoSorb over the coming periods, therefore will be eager to see the cash balance in Q4. Further financing may be dilutive in nature, considering the current capital makeup, in our view. Therefore, we encourage investors to consider these points in their credit analysis of the company.

Data Source: CTSO SEC Filings; Author’s Calculations

Valuation

Lack of profitability makes valuation to comps more difficult at this stage, in our view. Viewing multiples YoY, we see the majority of multiples correcting from Q2 2019. Shares are trading at ~5x book value, and ~9x top-line earnings. On an EV level, shares are trading at ~8x Q3 sales, which we believe will begin to come down by Q1 2021.

Data Source: Author’s Calculations

Modelling the DCF of free cash conversion over the coming 5 years, we see a fair value of $5.50, ~36% downside on today’s trading. We’ve modelled CytoSorb sales over the coming periods into this particular valuation, including the ~60% probability for early uptake in the cardiology application. Here, we use a discount rate of CTSO’s WACC at 9.7% with a terminal growth rate of 3%, which is not unreasonable. As customary, we build many valuation models with several inputs, which can be seen below on the sensitivity matrix, using the base case as an example. Within the matrix, investors can observe the upper and outer limits of our valuation inputs via the box within the matrix, and taking the arithmetic mean of the values there, we see a fair value of $4.75, well over 40% downside on today’s trading of $8.71.

DCF Model, CTSO WACC of 9.7%, 3% terminal growth, Base Case:

Data Source: Author’s Calculation’s

Observe the range in DCF outcomes when manipulating the hurdle rate to reflect the added pipeline risks associated with CytoSorb, and/or opportunity cost over other lower-risk instruments. One could also include the AMRA and DOD contracts within their own calculations also.

CTSO Sensitivity Matrix:

Data Source: Author’s Calculation’s

If we were to theorise CytoSorbs asset value, then we would refrain from adding a premium to our base case revenue projections into 2025. NPV inputs are the same as above, using CTSO’s WACC of 9.7%. Doing so gives a value of $12.19 per share for the CytoSorb segment, which is decent upside on today’s trading. Then, we’d value the 2-year AMRA and DOD contracts using the same methodology, which gives ~$0.60/share. Thus, a sum of the parts framework, we’d see a valuation of ~$12.80, which reflects the cardiology potential of CytoSorb. In the upside case, one could apply a 1.5x premium to CytoSorbs projections, which would bring the valuation higher. In the blue-sky case, we’d include cash per share of ~$2, however, offsetting this is the source of the cash (equity raise vs operations) this quarter.

Therefore, we’ve got the problem of vastly different ranges in valuation depending on the preferred methodology, when using the same relative inputs. Thus, we’ll take the mean and median of the outcomes to give more certainty. Let’s use the WACC-related inputs to do so. The median and mean score of $12.80 and $5.50 is $9.15. If we use the $4.75 figure, it’s $8.78. Thus, we believe these calculations support our thesis, that the majority of the upside from CytoSorb and other segments is already priced into the valuation. We are happy to explore a wider range of values, but this case certainly represents the fact that shares are trading at or close to their fair value at today’s trading.

Further Considerations

Shares have demonstrated quite volatile price dispersion YTD that has reverted back towards mean returns over this period. At the current period, we see some upward pressure from the long term trend, that is balanced by downward pressure from the high back in May. Since September, shares have traded sideways, snaking around the mean return, and bouncing in between resistance and support. Shares are being squeezed from both ends, and the downward pressure has offset the longer-term recovery that has occurred from the selloff in March. As investors can see on the chart below, the bottleneck that is eventuating will likely contain prices within the current trajectory, which supports out neutral view. The struggle between the bulls and bears is imminent, and the macroeconomic crosscurrents that are resulting from the rotation out of biotech and healthcare stocks is apparent in CTSO’s case, by our estimate. Thus, the below chart supports our neutral view.

Data Source: Author’s Bloomberg Terminal

Further evidence of the above can be seen on the chart below, as our regression testing has shown low factor exposure to momentum, since around September. Shares remain in healthy RSI ranges, but no autocorrelation exists there by our analysis. With momentum slowing, and snaking down towards pre-pandemic levels, its hard to justify a conviction for immediate entry at this point.

Data Source: Author’s Bloomberg Terminal

In Short

CTSO has given investors ~126% upside YTD, which was excellent for holders back before the selloff. Since, we’ve seen shares struggle, and there is pressure on the charts from both ends of the spectrum, meaning price dispersion is likely to remain contained for now. Looking beyond here, the portfolio remains heavily exposed to Covid-19 related outcomes, that is reflected in risk-adjusted valuations, especially with the concentration risk in the current product revenue. We firmly believe that the exposure to Covid-19 cannot continue to drive sequential growth that CTSO has seen this year, especially as cases will diminish at some point, and more so with the arrival of vaccine candidates. Furthermore, management’s decision to expand manufacturing and production lines will stretch operating margins ,and likely place further pressure on the top once Covid-related demand diminishes. With these high capital expenditures, delivering high ROIC and on capital deployment will be crucial, and the return must reach above 10%, based on the cost of capital. Whilst cash increased markedly quarter/quarter, the equity offering of ~$58 million was the large driver of this, nonetheless, the balance sheet has been fortified for the upcoming quarters. Offsetting the portfolio concentration risk is CytoSorb’s application in cardiology, which has a greater potential to make a meaningful penetration over an extended period, in our view. Whilst the asset value is expanded for CytoSorb here, there still exists pipeline risks and the risk that commercialisation will not manifest as intended. Especially as the majority of the work is still in trial phases, right now.

Based on these figures, and a fair analysis into the potential valuation, we’d see a fair value of ~$8.80-$9.15, which reflects our thesis that the majority of the upcoming value is already priced into the valuation. We believe that the company has to demonstrate a greater conviction for immediate entry, however this is a story that we certainly look forward to scrutinising over the coming periods, especially if Covid-related demand is here to stay for some time. We look forward to providing additional coverage.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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