₪ David Pescod's Late Edition November 19, 2007
AN INTERVIEW WITH SARA ELFORD
CANACCORD ANALYST,
(As of November 6, 2007)
D.P: We are here with Canaccord’s award winning analyst Sara Elford and Sara you’ve liked for the last year or so a company called TSO3, a Quebec-based company that has come up with a device that some people think every hospital is going to need down the road. What exactly is it?
S.E: If you look at each hospital and you go through surgery, there are various surgical instruments that are used in everyday hospital life. Those instruments are expensive, so consequently they are reused. There are some that are single-use instruments, but a vast majority of them are subsequently cleaned and sterilized so that they can be reused for the next surgery.
Historically there have been two types of technologies out there. One category is high temperature sterilization. Most stainless steel instruments can handle a very high level of heat. However, with the increase in minimally invasive surgeries, there's been an increase in use of polymers and heat sensitive materials in surgical instruments. This has brought about a need for low temperature sterilization technologies for these types of instruments.
... So there are two broad market categories; high temperature and low temperature sterilization. TSO3 is positioned in low temperature sterilization. Historically there have been two technologies that have tried to satisfy this market.
One is called Ethylene Oxide which is being phased out currently in many hospitals because it’s toxic and flammable. This gas leaves a residue on the instruments after sterilization, which means these instruments need to be aerated for a period of 24 to 36 hours. This means more instruments are required in inventory.
In order to displace Ethylene Oxide a company that everybody knows, Johnson & Johnson, came out with a new technology in the early 1990’s that relies on Hydrogen Peroxide. This technology came to the market with a very fast cycle time, but it was pretty expensive. Hospitals were willing to accept that incremental expense in order to achieve very fast sterilization and better safety.
So Hydrogen Peroxide would now represent over 50% roughly of the market. TSO3 looked at the market and thought if they could just satisfy this low temperature market with a technology that’s not only fast, but also safe and cost effective, it would have a winner.
TSO3’s is an ozone sterilization system that has FDA approval. It’s approved for sale in North America at this point in time. The sale cycle is long for many reasons. They're a pretty small Quebec-based company and they are trying to penetrate a conservative end market. Hospitals, and specifically their central sterilization departments, have not seen a lot of technologies come their way over the course of the last 50 years.
TSO3’s ozone sterilizer is the third low temperature technology they’ve seen over that period of time and they’re pretty small compared to their competition.
Slowly but surely they have established an installed base of ozone sterilizers and I think it’s 21 or 22 North American hospitals by this point in time that have bought a unit. I’ve spent a good part of my career trying to find companies that have emerging technologies that have the potential to displace incumbent ones and, if successful, very good growth and good stock momentum can occur.
As for TSO3, we’ve started to see the initial installed base build which is critical because it gives other hospitals comfort that in fact this technology is being used successfully by their peers, and you’ll start to see that momentum build. They indicated roughly a year ago that their sales cycle was about 18 months and we’re coming right into the end of that 18 month period in terms of their early effort, and consequently I think over the course of the balance of this quarter and going into the first quarter of 2008 we’re going to see a nice ramp up in revenue momentum. I also think when the market sees that, they should respond favorably to it.
I guess just to summarize; it’s a great technology, safe, substantially cheaper than what’s out there currently and starting to prove itself on a real life basis with early users. That ultimately becomes a showcase for future users. So I think the pipeline is robust and it’s now up to them to start to report on firm sales.
I’m a fan of the technology and I’m a fan of the business model. It’s one of those business models where you sell a system - I call it a razor blade business – and over the course of the life of that system, it generates a healthy annuity stream from the consumables and service.
Historically, if you look at all the very successful big companies out there whether it’s Johnson & Johnson or Gillette or whoever, you can certainly see that model is something that ultimately has produced great companies and the reason for that is it produces a great cash flow stream which is ultimately how we all value these stocks. TSO3’s day in the sun is coming over the course for the next several months.
D.P: You were saying that November 15th to January 1st, is a very important time for the company. Why is that?
S.E: That period of time from my perspective is important because historically the overall timing of sales, for whatever reason, has occurred late in the quarter.
There’s a budget cycle for capital equipment and I believe there’s also a “use it or lose it” factor. Anyone wanting to buy an ozone sterilizer, or any sterilizer in general, has to have it approved within their budget to go ahead with the requisition of it.
TSO3 is coming up to their calendar year end for a lot of these hospitals and in many cases that might mark the roll over period to a new budget, so I think if you look at their overall goal in terms of increasing sales momentum, and certainly they have indicated time and again that they expect to be active, technically it is likely that the back half of the quarter will see most of the quarter’s sales.
So, firstly, you could see the “use it or lose it” money spent as certain hospitals allocate their budget before the year closes and secondly, it fits in nicely with their sales cycle and the fact that they typically end up with late quarter sales.
D.P: Obviously if you’re looking at the risk on this, this is a company with only one product so that’s a concern? A one trick pony.
S.E: You’re absolutely right on that. That was something certainly I identify as a risk. Having seen 21 hospitals or 22 hospitals now having the unit installed and being happy with it means a significant amount of the risk has been removed in terms of is that one product going to be successful? That was a huge risk, going back three years. I think it is less of the risk today given that we have evidence of momentum with hospitals using it and seeing success in that the unit is performing as expected.
In my mind there's little technology risk left as the technology’s been working away in real life situations for quite some time now. So from that vantage point I think that’s been dealt with. The other area is not reflected in my model because I’ve seen no reason to go there until we get to that point, but hospitals are simply their first target market.
They see their ozone technology platform as being something that’s applicable to a broad range of markets like clinics, industrial applications, manufacturing applications, where they require sterilization.
There is an opportunity to produce bigger units or smaller units than what they currently produce that would broaden out their ozone market opportunities. So again, you have the technology proven and you do have the potential for new market applications in due course. I think it’s manageable. I would be concerned if we didn’t have any evidence of success.
D.P: You have a target of $5.50 on this story, so would that be a good gain should it all come together?
S.E: Same thing with Arise Technologies (APV), I value everything on the bases of the cash flow that I think it can produce and in TSO3’s case, because of that wonderful annuity stream that I talked about, if they are successful in building individual unit sales, this has the potential to be a great cash cow and cash cows have great values. They produce a high amount of free cash flow and the business model for this technology – for this company – can’t get any better in my view. They simply have to execute on that top line growth and the rest will follow.
...One of the things that I do to account for risk is I keep discount rates high. In other words, I discount that free cash flow back at a very aggressive rate, and in TSO3’s case, I’m using an 18% discount rate.
If they are ultimately successful in delivering on my forecast, and I get comfortable that the sale momentum is hitting what I want it to hit, like Arise, there’s upside to that target over time. Clearly, TSO3 is not in the hot solar space, where everybody has their eyes already glued. So they’ve got to establish that market themselves and attract that momentum and interest. That valuation is quite supportable based on the quality of the business model.
D.P: Is there a question we should be asking on this story?
S.E: I think you’ll get to the stage where it will all fall into place. A lot of people might say, “if it’s such a great story why is the market not responding?” I think there's a general view in the market that if this technology was as great as it is, then every hospital in the world would have one already. It just doesn’t work that way. You have people that are going to be skeptics and people who are going to want see more evidence, more data, a longer track record and all that stuff. So I think if we’re sitting here in the first quarter and we haven’t seen that pick up in sales momentum, then we need to start asking ourselves why.
So give them until the end of the quarter and into the first quarter and if we’re not seeing sales momentum, then it’s time to start asking very hard questions. Certainly I think the pipeline at this stage is full and the path is clear. There hasn’t been anyone else to come to the market with the technology and sell 21 units and then ultimately stop and fail.
This is the third technology in 50+ years and they’re making inroads, which means generally they’re going to continue, and once you have more and more hospitals using it, you’re going to see that momentum. So let’s just watch the momentum and see what happens and again I think investors will be well rewarded when that occurs.
D.P: Okay, thank you very much Sara!
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