Description

 Strategic Diagnostics is unusually cheap for a bio-tech at just 1.3 times book and an EV/Sales ratio of 0.73 which is remarkably low considering gross margins run 57% and are rising.  A quick look at historical financials reveals a company with weakly growing sales and marginal profitability that turned into losses in the last couple of years.  The flat sales growth, however, is the result of two patent-protected growing businesses (antibodies and food pathogens) offset by a sharply declining one (testing for genetically modified crops).   The agricultural testing business has declined to a small fraction of overall revenues, however, and therefore can't decline much longer.    Revenue growth will soon be in the financials and clearly evident to investors.  Furthermore, a recent management shakeup will very soon lead to profitability.  Activist bio-tech investors bought about 11% of the company around $4 in 2008, took control of the company by threat of proxy battle, and installed an entirely new management team.  The new strategy of cost-reduction coupled with greater emphasis on marketing of the anti-body business should result in a return to profitability most likely in the current quarter (4Q, 2009).   Profitability should rise nicely going forward as the two businesses grow and benefit from economies of scale.  Potentially very large upside exists as the companies anti-body business is increasingly focused on the emerging field of proteomics.  Higher margin revenues rising at higher growth rates are possible if and when the proteomics business accelerates.

History and Products

Strategic Diagnostics was put together by merger and acquisitions in the 1990's and early 2000's.  Their collection of diagnostic products includes their Micro-Tox product line that is used to rapidly test water for toxins.  China is a major user of this product but revenues in recent years have been flat and management is not emphasizing this product going forward.  Agricultural testing for the presence of genetically modified crops is another product line.  "Frankenfoods" was a major concern a few years ago particularly in the European Union which banned genetically modified crops from importation.  Diagnostic kits to detect the Roundup resistant gene and the STAR gene were a significant revenue producer in 2006.  Since then the market for genetic testing of crops has steadily fallen as the modified genes have become ubiquitous and have reluctantly been accepted.  The remaining two businesses are the company's future so I will describe them in more detail.

Food Pathogen Detection

The company manufactures diagnostic test kits to detect the presence of food pathogens such as salmonella, listeria, and E. Coli bacteria.  This is a large market (138 million tests each year for Salmonella and E. Coli) and the company has a relatively small but growing share.  Their product distinguishes itself from the competition by implementing a patented test kit called "Rapid-Check" that uses bacteriophage to get results faster and reduce false positives.  "Imposter" bacteria that are similar to salmonella, listeria, or E. Coli, but harmless, sometimes falsely set off diagnostic tests.  Strategic Diagnostic's Rapid-Check kits include bacteriophage, often called phage for short, that are viruses that kill bacteria very selectively.  Their products include phage that will kill the imposter bacteria but not harm the real salmonella or listeria.  Rapid-Check also includes phage that kill bacteria that may compete with the Salmonella bacteria that are being cultured.  The Salmonella can then grow more rapidly resulting in a definitive test result in less time.  The use of phage to eliminate competitors and imposters results in a test culture that gives accurate results in less time (12 hours rather than 24) with fewer false positives.  This product line has been steadily growing and is becoming a significant source of revenue as you'll see later when product line revenue is broken out.

Anti-bodies

For years Strategic Diagnostics has been a supplier of anti-bodies to pharmaceutical companies, cancer research centers, and universities.   The anti-bodies are manufactured using rabbits or mice and used in the research, human/animal diagnostics, and pharmaceutical industries.   This business has grown consistently and now constitutes more than half of Strategic Diagnostics revenue.   The business isn't proprietary but sports reasonably healthy gross margins that benefit from economies of scale.  In recent years the company has developed Genomic Anti-body Technology (GAT).  GAT allows Strategic Diagnostics to manufacture an anti-body to a protein without the actual protein antigen.  The only thing needed is the DNA sequence (in the form of a digital computer file) that produces the protein.  The Human Genome Project has mapped the entire human gene sequence which is capable of producing millions of different proteins.  The study of the proteins generated by genes is an emerging field known as "proteomics".  New drugs and diagnostic tests based on proteomics are being investigated by bio-tech and pharmaceutical companies.   GAT allows for "rapid development of diagnostic-grade clinical assays and research projects - from antibody candidate to critical high-quality reagent formulation. With GAT, the antibody is more likely to recognize the native conformation of target proteins, resulting in highly-reactive antibodies that enable research scientists to save time, money, and increase success rates".   Revenues from GAT are still small ($1.3 million in first 9 months of 2009) but growing rapidly.  Management is expending considerable resources on marketing GAT as will be discussed later.

Investment Case

So what's the investment case here?  I'm not a bio-tech expert so I can't predict that GAT technology is going to help cure cancer or that Rapid-Check is going to take half the pathogen testing market in the food industry.  The current valuation, however, is so low that all that is needed to make for a winning investment is a continuation of long-established growth in these two businesses.  While overall SDIX revenues are flat, their core patent-protected businesses have been growing.   Digging through annual reports for the individual product revenues results in the following historical numbers

                                           2009                 2008                  2007                2006              2005

1)Anti-body                         15,067*           13,821              14,281               11,104            10,725                  

2)Food Pathogens                  5600*              5500                 4600                 3700               3300

3)Ag genetic testing               2267*              2900                 3100                  5400    

4)Water quality                      4933*              5210                 5099                  5203              5139 

Overall revenue                   27,953*            27,659              27,207               25,522           24,845

Operating Profit                   (2097)*            (7566)              1403                    580                  673

     *2009 data obtained by multiplying 9 month result by 4/3 (no seasonality in this business)

The anti-body business and food pathogen business have grown consistently since 2005.  Furthermore, the 2009 operating loss of $2097 will disappear in 2010.  This can be seen from the most recent quarterly financials.

2009 Third Quarter ended Sept 30, 2009

Revenue:                                    $7196

Manufacturing cost :                    $3083

Research and development:          $752

SG&A                                          $3720

Operating Profit:                         ($281)

The operating loss was reduced to $281 thousand from $578 in the first quarter and $714 in the 2^nd quarter.  The company's efforts to cut costs are partially responsible for the substantially improved operating loss.  In fact, the manufacturing costs are inflated in the 3Q financials above due to a one-time charge of $203 thousand for severance, relocation, and lease cancellation costs related to the Oct. 30, 2009 closing of their Dallas Texas anti-body manufacturing facility.  The one-time charge will not appear on successive financial reports except possibly for a small amount in Q4 2009.  Further, there should be substantial cost savings from the consolidation of the Dallas anti-body manufacturing operations into their Windham Maine facility.  If the closure had happened the prior year, an operating profit likely would have been reported in this quarter (3Q 2009).  It therefore appears likely that the company will be profitable going forward (barring an unexpected) revenue drop and should report a profit in 2010.  Importantly, as the anti-body business grows, there likely will be improved gross margin.  With a 29% increase in anti-body revenue in the 3Q 2009 compared to 2008, overall gross margin improved to 57% from 48%.  Management explains in the 10Q as follows:

" Gross profits (defined as total revenues less manufacturing costs) for the third quarter of 2009 were $4.1 million compared to $3.3 million for the same period in 2008. Gross margins were 57% and 48% for the third quarters of 2009 and 2008, respectively. The increase in margins was primarily attributable to increased production volumes in the life sciences business which created a lower per unit cost of sale."

 I'll take a stab at 2010 and 2011 earnings assuming for 2010 that revenues remain the same as 3Q 2009 for all four quarters.  I'll back out the $203 thousand special charge and assume additional cost savings of $500 thousand (for the whole year) from the closure of the Dallas facility.  For 2011, I'll assume revenues rise by 10% with an increase in gross margin from 62% to 64% from economies of scale and greater percentage of higher margin GAT revenue.  SG&A will increase by 8% assuming some increased efficiency from the larger revenue base.  These assumptions seem reasonably conservative as anti-body revenue was up 29% in the most recent quarter and made up more than 50% of total revenue.

                                          2010                     2011

Revenue                             $28784                $31,662

Manufacturing                     11,020                   11,493

R&D                                    3,008                     3,008

SG&A                                  14,568                  15,733

Operating Profit                       188                    1428

Operating profit/share          $0.01                     $0.07

If we continued with 10% growth we'd see about $0.13 in 2012 and continued earnings growth that would more than justify the current valuation of $1.30.   The new management concedes that near-term growth will be slow because of weak economic conditions but appears bent on more rapid growth eventually especially in the GAT anti-body business.  Here's some history.

NEW MANAGEMENT

Steve Becker, manager of Greenway Capital, an investment partnership based in Dallas Texas partnered with Richard Van den Broeck, manager of HSMR Advisors LLC, to wrest control of Strategic Diagnostics.  Greenway Capital filed a 13D disclosing a 10% ownership in March 2008.  Mr. Becker forced board of director membership for himself and Mr. Van den Broeck by threat of a proxy battle.  Strategic Diagnostics relented and expanded the board to include the pair.  Mr. Van den Broeck is a Harvard CFA investing in biotechnology stocks since 2004 using HSMR Advisors as the investment vehicle.  Prior to that he was at Cooper Hill Partners from 2000 to 2004, and prior to 2000 he was the bio-tech analyst at Merrill Lynch .  Steve Becker runs Greenway Capital that invests in small stocks with a concentration in healthcare and technology stocks.  Shortly after they joined the board, SDI's CEO resigned (in June 2008) beginning a total revamp of the management team.  Francis DiNuzzo who had just joined the company as Chief Commercial Officer became the CEO.  In October, 2008 Deborah Barbara joined as VP of business development.  Monette Greenway was hired as VP of Marketing and Sales in February 2009 along with Robert Laffer as Sales Manager Life Sciences.  Finally, Kevin Bratton joined as CFO in June 2009 after acting as CFO in selling Cytogen Corporation to DUSA Pharmaceuticals.  All of these new people are veterans of the life science industries.  There is unquestionably a new emphasis on marketing and sales to the life sciences industries and the entire management team was selected with that purpose in mind.  All these changes happened just in time for the economic melt-down and the resulting dearth of funding for bio-tech companies.  As bio-tech investment returns, demand for Strategic Diagnostics anti-body products and GAT technology in particular should accelerate.

R&D ACTIVITIES

Research and development spending continues at a rate of $3 million a year.   Another valuation metric is that the Enterprise Value / R&D ratio is a little under seven.  One never knows how R&D spending is being used but some is hinted at in the following comment about the recently granted patent on phage technology

Dr. James Stave, SDI Vice President of Research & Development, added, "This patent application is an example of the creative work that we're doing at SDI. We continue to explore and develop technology solutions that address real issues and result in better decision-making tools for our customers. We are particularly excited about this technology because we believe that it should be generally applicable to all microbiology tests that employ an enrichment step, even those in markets outside of food and water pathogen testing, such as pharmaceutical research and medical diagnostics."

Another hint is revealed in the comments of the CEO regarding efforts to provide higher value services to the life sciences industries.

Fran DiNuzzo commented, "Having worked closely with Matt over the past few months, I look forward to leading the company through this transition. I plan on continuing to move our antibody business further up the value chain from contract manufacturing to proprietary and collaborative biomarker development. With two proprietary technologies generating revenues today and R&D efforts underway to increase our revenue and growth potential, I am very excited at the opportunities that SDI has before it."

TAX-LOSS SELLING?

It's interesting to note that the stock traded above $2 in August and again in October.  The 3^rd quarter earnings release on Oct. 29^th had only positive news with the highest revenue and lowest operating loss of 2009.  SDIX trades at a fraction of the $4-$6 trading range of a few years ago and institutional interest has evaporated as the market cap has dropped from $100 million to $25 million.  I suspect some year-end dumping might be responsible for the recent weakness. 

INSIDER BUYING & STOCK BUYBACK

Finally, I'll note that the company instituted a stock buyback in Oct 2008 and bought back 400K shares at an average cost of $1.34.  Steve Becker added a few shares in August around $1.60 and several members of management picked up some shares in the $1 to $1.18 range last March.

Risks:  While SDIX trades at value prices, it is a bio-tech stock with a mediocre-at-best history.  A new management team is in place with a new marketing strategy, but it's not at all clear this strategy will be successful.  While antibodies have been used in diagnostics and drug development for years, new technology could  displace GAT at any time eliminating the company's growth vehicle.  While I like this investment and own it, I wouldn't recommend it to my grandmother.

Catalyst

Revenue growth becomes evident with a return to profitability