Picks and Shovels for the Biotech Revolution – If You Like AFFX, Try LMNX

*** The following is a description of a small-cap, early-stage company.  I personally own shares and own shares for my clients, therefore my opinion is biased. Read and invest at your own risk. As always, you should do your own research before investing in anything.  This is not an offer to buy or sell securities. ***

In the last several weeks, Affymetrix (AFFX) has been highlighted numerous times by the IBD.  While I like AFFX and believe the stock is a good investment, Luminex (LMNX) offers investors a chance to buy an earlier stage company in the same industry.  I personally believe Luminex has a better strategy and has a greater opportunity than AFFX but I am not a biotech expert.  With that, here’s a brief write-up of why I like Luminex –

The Company

Luminex manufactures and sells molecular measurement and analysis systems used in biological testing for the life sciences industry. The Company’s xMAP technology allows its Luminex 100 System to perform up to 100 tests bioassays on a single drop of fluid by reading biological tests taking place on the surface of microscopic polystyrene beads called microspheres. 

To best get an understanding of the technology, look at the slide show (it takes a second to load, then use the >> buttons on the bottom of the page) on Luminex’s home page –

http://www.luminexcorp.com/01_xMAPTechnology/08_Tutorials/How_xmap_works

The Investment Thesis

Luminex has created an extremely attractive recurring-revenue business model based on its proprietary biological testing system.  While initial revenue growth has been driven by system sales, consumable microsphere sales will eventually begin to eclipse system sales.  This should create a sustainable and profitable recurring revenue stream.   

Despite its leading technology position, Luminex has only recently determined how best to market its products.  In its early stages, the company tried to build a direct sales force which was both expensive and time consuming.  Now, the company has opted to partner with leading diagnostics firms to sell its systems.  In this regard, Luminex has established 45 key strategic partnerships with leading research and clinical diagnostics manufacturers including TECHNE Corporation, Celera Genomics Group, Bayer Diagnostics and Abbott Laboratories.

In addition, Luminex recently hired a new CEO, the former head of Abbott Laboratories commercial diagnostics operations and CEO of Fisher Scientific.  The addition of a qualified and experienced CEO gives me some confidence that LMNX can manage its rapid growth. 

I believe the company now has the strategy and management leaders in place to finally begin to realize the true potential of the company’s proprietary technology.  The company can be thought of as a "picks and shovel" business for the biotech revolution – by owning LMNX you are not betting on a single positive outcome or FDA approval – instead you are betting on the continued growth of biomedical testing. 

The Numbers

Valuation
Market Cap : 346.69M
Enterprise Value : 317.46M
Trailing P/E : N/A
Forward P/E : 184.50
Price/Sales (ttm): 9.66
Price/Book (mrq): 7.78

Income Statement
Revenue (ttm): 35.90M
Revenue Per Share (ttm): 1.166
Qtrly Revenue Growth (yoy): 0.30%
Gross Profit (ttm): 9.83M
EBITDA (ttm): -3.56M

Balance Sheet
Total Cash (mrq): 29.24M
Total Cash Per Share (mrq): 0.934
Total Debt (mrq): 0

Cash Flow Statement
From Operations (ttm): -1.84M
Free Cashflow (ttm): -2.13M

Trading
Average Volume (10 day): 170,550
Shares Outstanding: 31.32M
Float: 28.41M
% Held by Insiders: 9.27%
% Held by Institutions: 38.10%
Shares Short (as of 10-Jun-05): 1.14M
Short Ratio (as of 10-Jun-05): 14.2

The Opportunity

The company has built a versatile system for testing, detecting and diagnosing everything from allergies to cancer to infectious diseases.  The versatility of the system is highlighted by the use of Luminex’s system to detect pathogens such as bacteria, viruses and toxins in subways and airports.  The company’s technology is currently being tested and used by Lawrence Livermore National Laboratory in its Autonomous Pathogen Detection System (APDS) – the following excerpt comes from the NY Times –

APDS is considerably more advanced than the biodetection system currently deployed in 30 cities under the federal BioWatch program. The earlier model uses filters that must be picked up and hand-carried to a lab for analysis. APDS, which requires servicing just once a week, continuously collects and analyzes air samples and sends a report back to a central monitoring station every 60 minutes. This reduces the time for detecting a bioagent release to an hour or less — time that could mean the difference between life or death for people in a contaminated area.

APDS, which is about the size of a refrigerator you’d see in a college dorm room, has been fieldtested in the New York subways, the Washington Metro, and at San Francisco and Albuquerque airports. The underlying technology has gone through a million tests without a single false-positive reading — a degree of reliability that is extremely valuable in real-world situations. As Howard Hall, a nuclear chemist whose office is developing radiation detectors, puts it: A detector "doesn’t do any good if a cop comes to the conclusion that every alarm is false."

And not only can Luminex’s system detect airborne pathogens, it has been used to detect and diagnose cancer.  Recent research highlighted in the Nature journal indicate that body chemicals called micro-RNAs can be used to diagnose certain cancers and choose the most effective treatment.

The key to the system is its low cost, open architecture.  This strategy allows partners to develop their own tests and applications which, in turn, should rapidly increase the number of systems in place and exponentially increase the number of tests being run.  And the relatively low cost of the system allows partners of every size to test the system for their own unique applications. 

For instance, Tm Bioscience recently introduced the first DNA-based blood test to help detect cystic fibrosis.   The test directly analyzes human DNA to find 39 mutations in and 4 variants of the CFTR gene that are considered indicative of cystic fibrosis. It will be used to help diagnose cystic fibrosis in children and to identify adults who are carriers of the gene variations.  Although LMNX did not develop the specific CFTR test, it generates royalty revenue for each kit sold by Tm Bioscience. 

The business model is highly scalable.  Rather than maintain its direct sales force, the company has built a royalty-based revenue model which is driven by the company’s partners.  Twenty-two of LMNX’s partners had sold consumable products based on its technology and paid royalties.  But the true growth and profitability lies in the company’s consumable microspheres.  LMNX consumables are proprietary to its installed based of instruments and should provide the company with a steady base of recurring, high-margin revenues.  As the number of systems and applications expands, the use of consumables should grow exponentially. 

While the valuation is certainly far from cheap, the stock is still flying under the radar.  The company has had between one and two analysts cover the stock sporadically since 2001.  Institutional ownership of the shares remains below 50% and the market cap has yet to reach a level where most institutions can take a large position.  This gives the opportunity to buy before the company is widely understood and known. 

The last quarter showed that the business can work.  While its been a long time coming and the business is still small, the company’s last quarter gave a glimpse of what the business could become.  While overall revenue growth was non-existent, the breakdown of the revenues and margins were revealing.  Luminex’s royalty revenue increased to $1.2 million, from $605,000 in the prior year’s quarter, representing over $19 million in royalty bearing sales by LMNX’s partners.  The 19 partners for whom LMNX recognized $605,000 in royalties for Q1 2004 represented approximately $1.1 million of the Q1 2005 total, an increase of approximately 75% over their prior year payments.  As additional partners commercialize and expand their menu offerings, royalty revenues should continue to grow at a rapid pace. 

In addition, high margin consumable sales, comprised of microspheres and sheath fluid, increased to $3.5 million during the first quarter of 2005 from $2.5 million for the first quarter of 2004.

The higher level of royalty and consumable revenue highlights the company’s scalable business model.  The higher level of royalty and consumable revenues increased the company’s gross margin to 53% from 42% in the prior year’s quarter. 

Charts courtesy Luminex

The Risks

This company is obviously very early stage and thus the operations and stock are subject to high volatility.  This is not the type of story you should invest in if you have trouble stomaching volatile moves.  In the past year, the stock has fallen from $12 to $7 and risen back to $11, even though the company has executed according to plan. 

Management does not give financial guidance.  I think this is the right thing to do since its operations are still subject to extreme fluctuations and are reliant on third party partners.  However, it adds to aforementioned volatility.

The company’s financial performance is subject to how well its partners execute their business plans.  Since the company has no direct sales force and relies on royalties for revenues, it is essentially not in control of its own fate. Three of the company’s partners reported royalties totaling approximately $640,000, or 53%, of the total royalties for the last quarter, indicating the company is very reliant on a few number of partners.  However, the royalty based business model is also one of the advantages since it provides the company with low cost revenues and a highly scalable business model.   

While the company has cash on the balance sheet, doesn’t need much capital and has a relatively low cash burn rate, Luminex may need financing in the future.  Typically, small cap companies that need financing find their stocks come under pressure. 

The Chart

Not many analysts like tedious sideways charts, but I love long bases.  I try to hold stocks for at least two years and aim for 100% returns during that timespan.  The only way I have found to achieve that type of return without constantly trading is to buy stocks that are breaking out of long bases.  Not IBD-type six or seven week bases but long bases that take a year or more to form.  That way, when the stock breaks out, you know it is in solid hands and won’t simply be flipped back in your face if it goes up 10%.  That said, I like LMNX’s chart but it is hitting resistance.

    

Additional Research

www.luminexcorp.com

http://www.nature.com/news/2005/050606/full/050606-9.html

http://www.fortune.com/fortune/technology/articles/0,15114,474287,00.html