September 3, 2021
Kromek: Well placed in the aftermath of Covid

Going back several months now when we first heard about the launch of Covid vaccines, many investors incorrectly assumed that, once the World is fully vaccinated, there will be no need for Covid testing. Wrong. More contagious & deadlier variants have continued to appear, together with the ever present prospect of perhaps totally  new infectious diseases that might even trigger another pandemic.

Equally, another danger which has receded in people’s minds in the throws of the Covid pandemic is the ever present threat posed by deliberate (re rogue states, organised crime &/or terrorism) &/or even accidental (say a lab) biological release of harmful pathogens into the environment. The US government recognises this, and hence wants to get ahead of the curve. My long term holding in pioneering radiation detection specialist Kromek is ideally placed to benefit in my opinion from the ongoing threat from both Covid and other new epidemics as well as terrorist type dangers.

In terms of the sector as a whole, I am actually very bullish on the healthcare sector: the long term defensive growth drivers of the healthcare sector (boosted by an aging population) are well understood.  But the reason I feel it’s an excellent time to consider investment in the sector is that it now has both recovery and long term growth drivers in its favour: counterintuitively, routine hospital activity (scans, operations etc, where Kromek has a significant presence) were amongst the worst hit activities due to Covid as all available resources were diverted to fighting the pandemic. There is now a huge backlog of orders for companies involved in providing routine healthcare products and services. I don’t think I ever remember a time when the healthcare sector had recovery prospects, not even in recessions!  The advantage is we don’t need to bet on a huge boom in the economy to see this recovery take place over the coming year. This recovery backdrop clearly therefore provides an added boost to Kromek’s growth prospects…

Pynk Community - Kromek Market Cap

Well Placed in the Aftermath of Covid

“What doesn’t kill you makes you stronger”. Radiation detection expert Kromek was hit by a ‘perfect storm’ in the Spring of last year, after the pandemic forced hospitals to postpone operations, borders to close and governments to impose national lockdowns, hitting the firm’s 3 core markets, namely Medical Imaging (SPECT, BMD), ‘Dirty Bomb’ Detection (D3S) & Airport Screening (baggage scanners). Investing in Kromek not only has enormous rebound potential, but owns some of the most exciting defence sector technology with growing civil market applications including in detecting the presence of pathogens like Covid19.

Pynk Community - Kromek Share Price Performance
Past performance is not indicative of future performance.
Source: Stockopedia

Kromek Company Description

Kromek is a radiation detection company operating globally in three high-value markets – Medical Imaging (eg BMD, SPECT), Nuclear Detection (D3S), Security Screening (Airport baggage/bottles), primarily using cadmium zinc telluride (CZT) crystals. Headquartered in Sedgefield (UK), Kromek has c.139 employees, of which approx. 116 are in R&D, with 3 further sites in California, Pittsburgh and Germany. The firm has filed/registered >280 patents.

Kromek Investment Case

It is difficult not to be excited by Kromek’s groundbreaking technology to sample air and identify the presence of any biological pathogen – including Covid-19 or any mutant version – that is being piloted in UK airports, hospitals and the retail sector in the coming months. It is based on Kromek’s work in developing a mobile bio-security system capable of detecting airborne pathogens for an agency of the US Department of Defence. The detector is incredibly accurate, giving a false alarm in just one in 800,000 tests.

Knowing a carrier is infected with a disease before they infect other individuals is key to halting the onset of an outbreak and will be critical in helping the world return to some form of normality even after the vaccine programme is rolled out. Other obvious non-military applications include use in sports arenas, theme parks, schools, offices and cruise ships. The fact that UK government agency Innovate UK is funding a £1.25m programme to customise Kromek’s biological threat detection solution is a strong validation of the technology. Commercial roll-out later this year is now a distinct reality together with a raft of other possible contract wins as the business ramps up.

DARPA Contract Extension

On June 14, 2021 the company said that it had received a $6m follow-on order from DARPA (US defence agency), covering Phase II of its development of a biological threat detector which - via rapid DNA sequencing – will continually monitor, sense, analyse and identify such airborne bugs. The pathogen detection system is an extension of DARPA’s broader SIGMA+ threat detection and analytics initiative which uses a common network infrastructure and mobile sensing capability to identify chemical, biological and nuclear mass destruction threats. DARPA have invested $13m to date in Kromek’s technology. Revenue recognition for the second phase just awarded will be milestone based but revenues should in effect be recognised on a reasonably straight line basis as non-recoverable engineering work.

In addition to the ever-present danger of bio-terrorism, the outbreak of the pandemic has exposed the world to the severity of biological threats and their potential impact on public health and the global economy and has demonstrated the need to rapidly evolve bio-security systems and associated technologies. This contract will allow us to continue our work in developing a mobile wide-area biosurveillance system capable of detecting airborne pathogens in real-time. We look forward to reporting on our progress as we deliver on our milestones. Arnab Basu, Kromek CEO

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100s of Possible Applications for the Technology

Although Kromek has moved to the next phase with the US govt with their bio threat detection technology, it has excitingly has managed to hold on to all IP for follow on international development and civil applications. The civil market potential together with sales potential to other international defence agencies is enormous.

Elsewhere, these mobile static devices (see below) are currently successfully being piloted at UK airports and other public venues.

Pynk Community - Kromek Use Cases
Source: Kromek

The technology can be used to immediately flag the presence of someone with a contagious disease and allow effective mitigation of the risk of transmission. By placing samplers in high footfall areas, such as airports and hospitals, or where people are in close proximity for long periods, threats can be identified without having to individually test people. Knowing a carrier is infected with a disease before they infect further individuals is key to halting the onset of an outbreak and before it causes major global disruption. Non-military applications include use in shopping centres, sports arenas, theme parks, schools, hospitals, offices, airplanes, and cruise ships.

Recent Results Demonstrated Business Recovery & Exciting Growth Prospects

We are starting to see a return to some normality in business patterns. Our largest medical OEM customer has begun shipping their next-generation scanner, which, as they continue to ramp up installations in the second half of the year, will enable the fulfilment of the long-term contract we have with them.

Looking ahead, the positive momentum seen in the last two months of the first half has continued into the second half of the year with increasing detector shipments. The renewed level of activity within our customer base is underpinned by the commercial traction Kromek has demonstrated in recent years in winning multiple, high-value contracts and we are excited about our new opportunities in the bio-security market. As a result, we expect to see significant growth in second half revenue compared with H1 2020/21. Arnab Basu, Kromek CEO, commenting on the first half results.

The momentum in the business has continued to the full year. At their full year results presentation recently, Kromek announced a range of contract wins worth over £0.75m. Management also revealed that the current order book covers 75 percent of analysts’ revenue estimates for the 2021/22 financial year which point towards turnover rising from £10.4m to £15m.

It’s important to note the huge impact on profitability from this expected increase in turnover given the relatively high fixed cost base/high operational gearing Kromek enjoys.   So the business is forecast to move from last year’s Covid-19 impacted cash loss of £1.7m to a small adjusted cash profit (according to estimates by house broker Cenkos and Equity development). In fact, Cenkos estimates that every £1m of additional revenue could generate £0.5m of incremental cash profit for the company.

Further Wins Very Likely and Not Factored into the Price

It’s important to note that there is every possibility that current forecasts are upgraded in the months ahead. Estimates do not currently factor in any further wins from Kromek’s biosecurity pathogen detectors which sample air and identify the presence of any biological pathogen including Covid-19. In the past month, DAPRA awarded Kromek a follow-on US$6m (£4.2m) contract to deliver an automated and fully mobile airborne pathogen detection system, and the company has been awarded a £349,000 contract from the UK Ministry of Defence. Chief executive Arnab Basu (pictured) says his company is in “serious discussions with multiple governments” and notes that “its unique set of IP isn’t reflected in the current valuation.” I feel a raft of positive news flow set to be announced on multiple fronts in the coming months may very well lead to a marked rerating of the shares.

Not only does Kromek have a robust product offering in key areas of border control and terrorism threat detection – its dirty bomb detectors are now used in 26 countries, and post-Brexit, Kromek is only one of two UK companies offering this type of radiation technology. The company should therefore be a clear beneficiary of the UK Government’s recently announced £329m five-year nuclear detection budget, given that the UK Government is “localising supply chains” post-Brexit. Interestingly, the CEO revealed that Kromek has £20m worth of revenue in active procurement in the nuclear sector that “could be delivered this year”, highlighting the marked increase in activity being seen across major international markets.

In healthcare scanning, Kromek is scaling up its US$58m seven-year contract with an Original Equipment Manufacturing (OEM) customer that is installing the company’s cutting edge CZT detectors in medical imaging scanners in multiple countries. The contract supports a third of analysts’ full-year revenue estimates. More awards should be forthcoming given that an increasing number of OEMs are deploying ‘best in class’ CZT detectors in scanners to more accurately diagnose and treat patients with cancer, Parkinson’s Disease, cardiovascular illnesses and osteoporosis.

In security screening, Kromek has received its first commercial order, and subsequent follow up orders, from an OEM customer whose next-generation scanner, based on Kromek technologies, achieved the highest level of European liquid explosive detection certification for cabin baggage. In addition, the company has received orders for CZT modules to be designed into an advanced baggage screening system of a new US-based customer.

Importantly, Kromek has the funding to support delivery of further contract wins following the £13m equity raise at 15p a share in February 2021. Closing net cash of £7.4m is effectively £8.8m as post financial year-end the US Government has written off US$1m Covid-19 Paycheck loan and a further US$0.8m loan is expected to be forgiven, too.

Product Applications for a Post Covid World of Vigilance

In the civil space, and funded by a £1.25m Innovate UK grant, Kromek’s Covid-19 pathogen detectors are being piloted successfully in UK airports, hospitals and the retail sector ahead of commercial roll-out this year. A false alarm rate of only one in 800,000 tests means that detection levels are comparable with gold standard PCR tests. According to Paul Hill at Equity Development, the annual global market for the biological threat detection devices at £500m and believes that Kromek could win a 20 per cent share on a 25 per cent profit margin.

Chief executive Arnab Basu revealed during the results call that Kromek is undertaking field trials with the pre-production prototype collecting airborne samples from urban and rural locations, and has field tests in London with two UK government agencies. Kromek also plans for delivery of units for pilot deployment in the US in the first half of 2021. Any success in any of these trials will be strongly supportive of much higher share price levels.

Kromek Equity Placing: ramping up Covid-19 pathogen detectors

Kromek has announced in February 2021 a placing and open offer to raise £13m at 15p a share. Up to 25 per cent of the proceeds will be used to commercialise Kromek’s biosecurity pathogen detectors which sample air and identify the presence of any biological pathogen including Covid-19. They will be piloted in UK airports, hospitals and the retail sector in the coming months ahead of commercial roll-out. In addition, up to 20 per cent of the funds will be used to expand sales and marketing efforts for Kromek’s nuclear detection and medical imaging activities with the balance used to deleverage its balance sheet. It is clear that the open offer significantly accelerates the commercial ramp up in a business that is showing great recovery and growth potential. The shares have more than doubled in price since I purchased them and the pull-back on news of the placing is in my opinion a repeat buying opportunity.

Ground-breaking Technology Moving into Civilian Markets

Pynk Community - Kromek Biothreat Detector Timeline

The technology uses state-of-the-art RNA/DNA sequencing to continuously monitor & collect airborne microbes (eg Covid19), which are condensed into single droplets of water. These samples are then genetically coded, with results available in <60 minutes. Not only detailing exactly what families of viruses & bacteria are present, but also which specific strain or mutation.

This really is ground-breaking stuff that could potentially revolutionise how mankind deals with any deadly pathogen. Especially in high footfall locations such as airports, hospitals, city/shopping centres, sports arenas, theme parks, government buildings, schools, offices, airplanes, cruise-ships and so forth.

To be clear, Kromek’s smaller civilian version is not yet commercially available. But should be over the next year or so after being trialled by DARPA. With substantial long-term market drivers and significantly expanded production capacity in place, Kromek is well positioned to deliver on demand from around the world for next-generation radiation detection technologies.

Valuation Upside

Excellent Rebound Potential in the Core Business & Further Contract Wins Likely

There are several drivers that give us greater certainty that earnings will be higher this year.As I have stated on my previous posts, I believe the temporary impact of Covid on healthcare stocks is a great buying opportunity, Kromek has enormous rebound potential as hospitals get back to their routine business. Bigger picture, it’s important to remember that most of the delayed hospital ‘elective procedures’ have not been cancelled, they are simply deferred for a later date. At some point these patient backlogs will need to be eliminated, requiring new imaging equipment that Kromek’s patented CZT technology should be able to support.

Growth in 2022E:  Market continues to forecast £5m of incremental revenue growth in FY22E to £15m. It is in my opinion very likely that we see at least a further 15-20% uplift in Group revenues as new orders are won and business normality returns.

IP owned: Kromek retains all the associated intellectual property (IP) and rights to commercialise SIGMA outside the US. Phase 2 extends the detection capability into viral as well as biological threats and will see extended field trials before full roll-out. The commercial roll-out could clearly generate an addressable market materially in excess of the developments awards seen to date.

DARPA: The 28 month milestone based contract will account for a material amount of forecast incremental revenue growth in 2022E. This means a total $13m development value to date received from DARPA but clearly the commercial value of the system once rolled out is very likely to be materially in excess of the development value awarded to date.

The orderbook at hand basically covers the majority of this year’s forecast and even more important for the valuation is the fact that the use of the company’s pathogen detectors is now expected to be expanded for use in the non-military sector in response to the outbreak of Covid-19. This transforms the prospects and the size of the addressable market. After Covid, the priority in being vigilant against any new outbreaks will surely be very high.

It is important to note that Kromek’s detectors are proving popular in Europe, too, with the European Commission and Irish Civil Defence also using them. Given the heightened terrorism risk across the world, the 26 countries currently deploying the technology is likely to grow. Finally, with the new equity funding has strengthened the balance sheet and fast tracks commercialisation prospects, and the removal of this funding worry may well also go some way towards supporting a higher valuation.

By FY22, improved operational gearing should materially drive profits higher, as a larger chunk of incremental revenues drops straight to the bottom line.

Finally Kromek is very much an outlier in terms of the peer group - average rating but with far higher than expected expected sales growth rate:

Pynk Community - Kromek Growth Rate
Source: Equity Development
Past performance is not indicative of future performance.

Key Risks

In my view, KMK is an exciting technology business where the high risk is somewhat mitigated by the current recovery taking place in the core business.

I see key risks as:

  • Covid19 related effects may endure longer than expected, impacting their key image scanning markets
  • The adoption of new break-through science can take longer, and cost more
  • Orders tend to be lumpy in nature, and therefore by their nature difficult to forecast
  • The company is executing on many fronts, and management resource may become too stretched.
  • Scaling up production and aftermarket support to satisfy substantially higher volumes could cause teething problems.
  • Protection of intellectual property, especially from patent challenges.
  • Competitive pressures – yet given Kromek’s leading position in CZT, then this looks a less immediate threat.
  • Customer concentration, and regulatory changes which may impact the introduction of CZT based products.
  • The firm has been until recently loss making. In the event more funding is required, then it is not certain that future capital would be available at commercial rates

Conclusion

Relatively High risk / High Return Investment but there is the Dual Investment Case of Recovery Alongside New applications of Their Technology

Kromek’s shares have continued to drift in recent months on a lack of newsflow and on the back of the recent share placing. I don’t think the market has factored in the size of the rebound in the core business nor the size of the potential commercial opportunity of Kromek’s new technology in a world forever changed by Covid to taking risks of pathogens extremely seriously. I feel there is every likelihood we get more positive news on the business in the next few months. The value of the company’s IP is not reflected in the price nor is the sheer profit growth opportunity given that the business is now firing on all cylinders and the shares - on < 4x EV/EBITDA for a business with truly groundbreaking technology and a large addressable market - are an extremely attractive prospect.

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Written by
Pouneh Bligaard
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