Under the Radar: Cellestis

PORTFOLIO POINT: Cellestis is an exciting biotechnology company with an exciting innovation, no debt and excellent earnings. It’s no miracle cure for investors, but worth an examination.

As the Australian market rallies on the back of international enthusiasm for our strong economy it is becoming harder to find well priced stocks. And when you consider the inherent uncertainties of US monetary policy, global currency markets, commodity prices and the property sector, it is especially difficult to find sectors or investor themes that exhibit qualities of long-term defensiveness, value and growth, let alone all three at once.

The healthcare industry is becoming the exception: the sector has been left behind by the equities rally since March 2009. As the Australian dollar goes from strength to strength, this disparity is becoming all the more apparent.

Not only are major health stocks such as CSL Limited (CSL), ResMed Inc (RMD) and Cochlear Limited (COH) being hurt by the spread between overseas US dollar revenues and local Australian dollar reporting, but the sector in general is being left behind by cyclical or “risk” stocks that are riding the momentum of investor exuberance.

All well and good, you might think; healthcare has a reputation for being the market’s dowdy maiden aunt – stolid and sometimes useful, but never terribly exciting. But that’s a myth that’s easily shattered when you consider the underlying financial performance of many of the industry’s best-known brands.

While stocks such as Primary Health Care Limited (PRY), Sonic Healthcare Limited (SHL) or Sigma Pharmaceuticals Limited (SIP) have been big disappointments on both the sharemarket and the income statement, the likes of CSL, ResMed and Cochlear have been most unfairly treated.

CSL, for instance, doubled its earnings per share after tax and before items from 95.17¢ in the year to June 2007 to 185.19¢ in the year to June 2010, yet the share price barely moved, from $29.33 to $32.58.

It’s a similar story at ResMed and Cochlear, with earnings increasing well beyond the share price and price/earnings multiples falling significantly from previous levels. Yet one of the most impressive disparities – if we can call it that – is with little-known Cellestis Limited (CST), whose earnings per share went from –2.38¢ in 2006-07 to 8.13¢ in 2009-10, but whose share price actually fell $3.26 to $2.75 at the end of the financial year.

As the following chart shows, it just gets better – or worse, depending on your point of view. Cellestis is now trading at $2.39, having hit a low of $2.32 in September. And this is notwithstanding a 3.5¢ fully franked final dividend during that time; a dividend that was 75% bigger than the previous year’s final dividend and more than double the interim to December 2009.

Looking at the chart it’s hard to believe that Cellestis, a developer and marketer of immune disease diagnostic products, is producing such good results and is in such good financial shape. This is a company with zero debt and which had $6.79 million in net operating cash flow in the 2010 financial year on tangible assets of $35 million; in other words, a very strong return.

Cellestis has the hallmarks of company with strong management and good cost control, with annualised return on equity coming in at 35.79% in the same year. Earnings per share growth in 2009-10 was, meanwhile, 12.97%, after a massive 315.80% the year before, when sales of the QuantiFERON TB Gold assay (its core diagnostic product) came into their own.

The company’s key intellectual property is the QuantiFERON system, an interferon-gamma release assay (IGRA) in the jargon, which is applicable in many auto-immune diseases, such as HIV and cancers, but is mainly used in testing for tuberculosis (which left untreated has a mortality rate of 50%).

In 2008, a US medical journal found the QuantiFERON system six times more accurate in predicting TB development among exposed populations than the traditional tuberculin skin test, or Mantoux test, which was developed in France in 1907 and has been used ever since.

This is a significant development in the field but like with many biotech projects it takes a long time to get end users, and the market, excited.

Tuberculosis, like scarlet fever and the whooping cough, is often considered a 19th century disease, but still affects 11 million people each year, according to the World Health Organisation. These statistics include 9.4 million new incidences each year and, tragically, 1.3 million deaths.

Further, the average untreated person with tuberculosis infects between 10 and 15 people and one-third of the world's population currently hosts TB bacilli, the disease-causing mycobacteria. A lot of these incidences are in the Third World, where the UN Millennium Development Goals have targeted the disease's reversal by 2015, but TB is also a First World disease and that is where Cellestis is presently focused.

Beyond the complications of working in the Third World, Cellestis has found that the US, Europe and Japan, in that order, alone constitute a large enough market to provide significant potential. During 2009-10, the US provided 44% of revenue, Europe, the Middle East and Africa (EMEA) 34%, and Japan and the rest of the world, including Australia, made up the rest. Growth during the last year was 49% in the US – Cellestis’s core market – while growth was 31% in the EMEA region and 8% elsewhere.

It’s in the potential, however, where things get really interesting. Although Cellestis has only modest upside, of about 8% to our $2.58 valuation, our modelling takes into account only price to earnings and estimated cash flows, not the blue-sky potential.

The chart below contains Cellestis’s estimates that it has penetrated just 4% of its potential market, which ignores regions such as India and sub-Saharan Africa, where tuberculosis testing is useless due to the ubiquity of the disease. Based on the second chart, even if growth rates that Cellestis has been achieving in the US recently are anything to go by, the company will still not have fully met its potential for years to come. And that, by the way, is assuming that TB remains the only major disease for which QuantiFERON technology is mainly used.

As acceptance of Cellestis’s products becomes more widespread in the medical fraternity, investors can expect the revenues to follow. In news that should please investors, the US Centers for Disease Control released guidelines in June that specifically recommended a type of test of which Cellestis is the leader, as should the dissemination of a recent study in Chest, the journal of the American College of Chest Physicians, that confirmed QuantiFERON as the most accurate TB infection test.

As with many small caps in the space, swings in sentiment can have a material effect on the shareprice. The company has seen its share price surge above $4.70 on speculation about tests, earnings and agreements, only to fall again despite the fundamental picture remaining the same.

Investors need to keep in mind that Cellestis, like all the small cap stocks we profile in this column, is especially prone to market gyrations, rumour mongering, day trading and illiquidity. The advantage for small investors, however, is that these stocks can also deliver superior returns as long as the investor is patient, focused on the fundamentals and disciplined.

Obviously, too, the strong Australian dollar is crimping take-home profits significantly, but if the currency situation changes, the benefits to Cellestis compared with the rest of the market are clear.

QuantiFERON is an exciting Australian innovation that deserves wider recognition. Having said that, Cellestis is no miracle stock. If investors can ascertain the upside while keeping their feet on the ground, stocks like Cellestis have the potential to deliver great outperformance.

Michael Feller is an equities analyst at Lincoln Indicators. Lincoln develops Stock Doctor, Australia’s premier fundamental analysis research service. The author or the Lincoln Australian Share Fund may have interests in any of the companies mentioned.