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Resonance Health Limited not worth the risk (ASX:RHT)

Claude Walker — Tue, 03 Jun 2014 11:42:04 +0000

In its most recent quarterly report, Resonance Health Limited (ASX: RHT) reported positive operating cashflow of $94,000 and $829,000 in the bank.

The company has successfully raised $500,000 at 5c per share, and currently has an open capital raising for up to $4.6 million more, which was supposed to be for the commercialisation of Hepafat Scan and R&D on the fibrosis scan. The company has a cashflow positive business line, the Ferriscan.

My thesis was that the funds raised would accelerate the Hepafat scan revenues, and that the company would be able to utilise the Ferriscan network to commercialise Hepafat scan much faster than they had commercialised Ferriscan. Either way, I expected operating leverage would make the company sustainable and cashflow positive in the short term.

In this context, the company has seen fit to announce a heads of agreement to buy another company, VueKlar Cardiovascular Limited.

One of the directors of Resonance Health Limited is Jason Loveridge. He is also a director of VueKlar Cardiovascular Limited.

I found what I believe to be Vueklar's Annual Report from Jan 2013. You can see that the company had over 200,000 pounds cash and intangible assets valued "at cost" of about 223,000 pounds. Based on today's exchange rate, that's about $400,000 (Australian).

This $400,000 was spent on acquiring and maintaining patent rights as well as cardiovascular product development expenditure. Oh, and by January 2013 the Scottish Government had given the company grants of 185,000 pounds - over 80% of the cost of the patents and technology development. At any rate, that was over a year ago. Assuming it didn't get more grants from the Scottish government, the company presumably has a fair bit less cash than the 200,000 pounds it had in January 2013 - especially given that it has 5 people in its "management team". I doubt they are working for free.

VueKlar Cardiovascular Limited has 3 major shareholders: the Scottish Government fund that seeded it and the MD and the Medical Director. These 3 parties own 78% of the company.

Just 8 months ago, Jason Loveridge joined the board. Bloomberg states that Loveridge was also a director of Arthro Kinetics Plc from 2006. In fact, he was also CEO. Let us quote from the announcement that company made on 25 November 2008.

"Since the Company's flotation on AIM, the share price of the Ordinary Shares has fallen substantially. Despite significant improvements in the strategic direction of the business, its strengthened management and financial performance in the last 18 months, the long term trend in the share price on AIM has been one of steady decline. The loss of shareholder value has been considerable, to the extent that the Company has a current market capitalisation of approximately £1.5m, below what it currently holds in cash."

The company was delisted. Is that the success you're dreaming of?

Oh wait, there's more. Believe it or not, Arthro Kinetics was selling a revolutionary new implantable technology! It must have looked like a winner... it was even featured in a newspaper in 2007:

"Dr Jason Loveridge, chief executive of Arthro Kinetics, which makes the system, said: "Our CaReS technology offers a genuine regeneration solution to patients and with over 1,000 patients already implanted in Europe we look forward to equally positive outcomes in the UK."

Resonance Health shareholders can only hope that VueKlar is better than Arthro Kinetics, which judging by its website is today languishing in obscurity.

In light of all this I spoke to Liza Dunne, the CEO of Resonance Health today, for a about 35 minutes. I was extremely irate because I do not believe that this acquisition is in the interests of shareholders, and I feel like this is reckless change of direction. I'm not going to quote her, but I will tell you my impressions.

Ms Dunne was adamant that the heads of agreement was in the interests of shareholders, and objected when I suggested that the parties suggesting this transaction were not putting their money where their mouth is. While understandable, her defensiveness was unjustified, especially as she did admit that there was a conflict of interest, Loveridge being on both boards. When the last Resonance Health annual report was published, it showed that Loveridge was not a shareholder.

Every transaction will have a winner and a loser. Given that this little start-up is presumably low on cash and miles from commercialisation, I would have thought it is worth very little - certainly not worth the risk of pumping in millions of dollars that could otherwise go to existing Resonance Health shareholders' profits. On a purely logical level, if VueKlar is so promising, why is it unable to raise capital (or sell for cash) in the UK? After all, London has one of the most sophisticated capital markets in the world.

Given that Resonance Health Limited can scarcely afford to commercialise VueKlar based on its own cashflows, it will likely need to raise capital to develop the business. The UK company gains access to Australian capital markets, and existing Australian shareholders are diluted, and our right to the future cashflows of Ferriscan diminished to the extent that we stand little chance of actually seeing any of that money. Looks to me like this is a potential exit strategy for VueKlar shareholders and an opportunity for VueKlar to access our cashflow.

I do think Dunne genuinely believes it is a good move. However, I'd like to know if Loveridge was present at the Board meetings that discussed this potential takeover. I'd also like to know if Loveridge has any track record generating returns for shareholders of listed companies, because if he does, I can't find it. If I was still a shareholder, I'd asked to see the minutes of any board meeting discussing the potential acquisition.

Unfortunately Dunne seems to think the risk/reward profile for the acquisition is favourable. She seemed to think it is an opportunity to diversify away from the growing scan revenue streams. The word diworsify is invented to describe this kind of strategy.

Dunne was unwilling or unable to give even a ballpark estimation of how much it would cost to take the stents that VueKlar are developing to market. She did agree that it is more expensive to get approval for internal medical devices than it is to get approval for the scans.

The worst bit was that she seemed to think that the addition of this miles-from-commercialisation speculative venture would improve the prospects of Resonance Health. It's breathtaking to think that a loss-making venture with little more than a set of patents and an idea in development would improve a business that was on the verge of profitable and could replicate its service at virtually no cost.

Ms Dunne was quite enthusiastic about the patents. Incidentally, patents are not that useful if you don't have enough money to enforce them. They are also not that useful if you don't have an approved product that they protect. Also, patents expire. They do not generate cash on their own.

Your guess is as good as mine regarding how much it would cost to commercialise the VueKlar stents, but it would be a lot. They don't let you just put things in people's veins without some serious testing. It would seem likely that Resonance Health would have to spend a considerable amount - millions, if not tens of millions. After all, this is a device that is has to be safe to be inside someone's artery. Getting this selling is a long and expensive road, with plenty of risks along the way.

If the capital raising for $5 million was intended to cover the costs of funding VueKlar, then that should have been disclosed from the outset. It looks to me like the broker expected the market to love this announcement, seduced by the unrealistic pie-in-the-sky potential of the VueKlar technology (that no-one in the UK even wants). Timed, as it was, just days before the end of the capital raising, it was obviously intended to have punters reaching for the cheque book. And it might have worked. Indeed, a couple more positive announcements and some positive cashflow could send the share price flying - but this is one for the traders, not the long term investors, in my opinion.

The big mystery in all of this is Director Simon Panton. He owns about 18% of the company going into the capital raising, and is up for over $800,000 in the capital raising, if he wants to take up his full entitlement. It is a gutsy investor that plunges $800,000 into a capital raising after the company has traded - largely - at a discount to the capital raising price, and has just announced plans to further dilute shareholders with the acquisition of a company that is making a loss, no proven product and is literally years away from earning a dollar.

This saga reminds me of another listed company, CO2 Group Limited (ASX:COZ), now called the Commodities Group (ASX:COZ). C02 Group made a successful bid to acquire a start up with a highly capital intensive project in August 2012 (incidentally, there were plenty of ties between the acquirer and the acquired company). You can see what the share price has done since then.

Oh, and "the Commodities Group" is currently raising up to $10 million in a 4 for 9 entitlement offer to fund their plans.

It is now plain for all to see that the priority is not to become cashflow positive. There will always be plenty of money for endless capital raising to fund technology that may or may not prove viable, let alone profitable. Some companies just continually raise capital forever. Mining tenements and biotechnology are traditional pursuits of such vehicles. However, I have zero interest in joining that endless capital raising merry go 'round.

If the priority was to return funds to shareholders, then the company would invest in selling its existing services. Instead it is considering an investment in a company that will require many millions more before it has a commercial product. That is not a game plan that generates wealth for shareholders (except those who sell at the right moment).

I remember a presentation by a world-renowned successful short seller. He said that Western Australia was literally the wild west of speculative companies, and that the way to spot potential short targets was to spot the people who were involved in past destruction of shareholder wealth. I am paraphrasing, but that was the message.

The Author does not own shares in Resonance Health. Nothing on this website is advice, ever. It is a blog of my investing, triumphs, and, in this case, mistakes.

Introduction to Resonance Health Limited (ASX:RHT)

Claude Walker — Fri, 16 May 2014 02:56:12 +0000

Resonance Health Limited (ASX: RHT)

Hidden Report: Is Resonance Health worth the risk? (ASX:RHT)

Claude Walker — Wed, 30 Apr 2014 02:08:22 +0000

Answer: No. The buy thesis is broken by announcement dated 3/6/2014. Update to come.

Update 3/6/2014: The original research has been coloured an annoying green colour because I no longer stand by it. I am keeping it here because I don't want to whitewash it. However, I don't encourage people read.

When I wrote the below research Resonance Health was trading in basically the same range it is currently trading, 4.7c -5c. However, since then a lot has happened and I written this update on Resonance Health Limited ASX:RHT.

An interesting new addition to my watch list operates within the nexus of medicine and technology. Its name is Resonance Health Limited (ASX: RHT). Resonance health owns software that analyses data obtained through magnetic resonance imaging (MRI) of a patient's liver to determine an accurate measurement of liver iron concentration. No new equipment is required at the diagnostic site, although the MRI clinic does need to send the scan to Resonance for analysis. After 2 business days, Resonance Health sends the analytical report of the patients liver iron concentration back to the MRI centre, and the doctors take it from there.

The big reason that I think Ferriscan will continue to be used more often is because in some instances it replaces an actual liver biopsy. The advantage is not so much improved accuracy as it is lower cost and less pain for the patient. That means, that patients and insurers would generally support the process. Furthermore, I suspect (purely intuitively) that medical professionals are more likely to take up a new technology when they know that it will reduce patient trauma. Indeed, I believe patient welfare is either the most common or second most common motivation for people to become doctors.

Ferriscan definitely faces competition, but it was pleasing to see it was named in this academic article. The most recent half yearly report stated that “The volume of image analysis services provided by the Company in the 6 month period was 35% higher than in the corresponding half-year, resulting in an increase in sales revenues to $1,048,869 for the half-year.” However, it's worth noting that a mention in an article doesn't mean much, and there are definitely other ways to diagnose liver iron content. It's simply not clear that Ferriscan is the best. Nonetheless, the sales in the USA indicate that doctors can be convinced to use it.

The company has a two other products in the pipeline. One for diagnosing fatty liver disease and one for liver fibrosis. The most important (and next to be commercialised) is HepaFat scan, a diagnostic tool for – yep you guessed it – diagnosing and monitoring fatty liver. This is not completely novel by any means. To quote an academic article abstract published in 2009: “Several magnetic resonance (MR) imaging-based techniques--including chemical shift imaging, frequency-selective imaging, and MR spectroscopy--are currently in clinical use for the detection and quantification of fat-water admixtures, with each technique having important advantages, disadvantages, and limitations.” HepaFat scan has FDA 501(k) marketing approval on the basis that it is substantially equivalent to existing products. The hypothesis is that HepaFat scan will replace some biopsies (with the support of insurers and patients). However, as a doctor friend of mine pointed out, a biopsy is a sample and an MRI is a photo - you will generally be able to get more information from the sample (which surgeons can take from various parts of the liver).

The company “is currently investigating a number of commercialisation paths” for the HepaFat-Scan, though it was pleasing to read that it is “is now available to specialist clinicians and pharmaceutical companies developing therapies to address fatty liver disease using the same service delivery model as FerriScan.” That’s exactly what you want to read because it implies that the ROI on Hepa-Fat Scan will be better than FerriScan as the company can leverage existing systems and networks to roll-out the product.

Resonance Health Future Cashflow Valuation

The thesis for investing in Resonance Health assumes that the company isn’t far from becoming cashflow positive, and that the current capital raising will be the last. The company is currently raising capital at 5c per share to fund the commercialisation of HepaFat-Scan and the Liver Fibrosis test. I get a buy price of about 5c, assuming the capital raising is largely successful.

	Year	Growth Rate	Cashflow	DCF Value	FCF Improvement
0	2014		-$200,000	-$200,000
1	2015	Maiden free cashflow	$150,000	$135,000	$350,000
2	2016	300.00%	$600,000	$486,000	$450,000
3	2017	80.00%	$1,080,000	$787,320	$480,000
4	2018	45.00%	$1,566,000	$1,027,453	$486,000
5	2019	30.00%	$2,035,800	$1,202,120	$469,800
6	2020	16.00%	$2,361,528	$1,255,013	$325,728
7	2021	14.00%	$2,692,142	$1,287,643	$330,614
8	2022	12.00%	$3,015,199	$1,297,944	$323,057
9	2023	10.00%	$3,316,719	$1,284,965	$301,520
		Total DCF Value	Discount Residual Value (10x cf)	Total DCF Value
		$21,413,106	$12,849,648	$8,563,457
		Indicative SP	Shares on Issue (Diluted)
		$0.046	463,000,000
		Cash Per share
		0.010799136
		Indicative SP w/ cash
		$0.057

This estimate of future free cashflow is my best guess of an achievable long term path. It indicates that the company is worth buying from about 4.6c to 5.7c, depending on how much value you accord to the cash, that they hypothetically would have, if the current capital raising is fully subscribed. Of course, if the capital raising (priced at 5c per share) is not fully subscribed, then it would make only a small difference to this valuation, because it would reduce the number of shares on issue.

The company has just released the latest Appendix 4C, - the Quarterly Cashflow statement for the quarter to 31 March 2014. The sales volume for the quarter was up 6% on the preceding quarter, and the operating cashflow was positive, at $91,000. To my mind, that makes the estimate above (for maiden free cashflow of $150,000 in FY 2015) look quite achievable - perhaps even too conservative. Because the guesswork is quite difficult, I've included the amount that cashflow would have to increase each year. Put simply, if you don't think Resonance Health can grow cashflow at well above $400,000 per year, then you definitely disagree with my analysis - and that is quite reasonable. As the charts below clearly show, sales revenue is not currently growing at the required rate. Having said that, in the quarter to March 2014, the company reports receipts from customers of $649,000. This means that it is reasonable likely that the company will record the best ever half in terms of receipts, in the second half of 2014.

A guessing game

I had a look at the history of revenue, expenses, receipts and payments as preparation for my guesses about future free cashflow. Either way, it’s quite difficult to predict that Resonance Health will earn over $3.3 million in free cash flow in FY 2023. While I do think that it is reasonably achievable, I'm not convinced that it is particularly likely.

Resonance Health Cashflow graph

Resonance Health Profit Graph

The company is extremely coy about where its revenue comes from: clinical trials and normal patients are not treated as different segments. However, the company did inform us that clinical trials revenue was up 91% and normal patients revenue was up 47%. By my calculations that means that back in HY 2013 (the pcp) revenue was about 60% patients, 40% trials, but that in HY 2014 it was more like a 53%/47% split. NB: this was corrected as there was previously an error in the "total revenue" for H1 2014.

	H12013	H12014	Increase Factor
Patients	376825.3182	553933.2177	1.47
Trials	259128.682	494935.7826	1.91
Total	635954.0002	1048869

Clinical trial margins are obviously better, but extremely lumpy. However, it’s not unreasonable to expect that the company will be able to secure some clinical trial revenue for Hepa-Fat Scan too. Certainly, that is the impression that the company seeks to convey in their recent capital raising presentation that stated: “246 trials currently registered on clinicaltrials.gov for non-alcoholic fatty liver disease.”

Risks

First of all, the current capital raising might fail. That would make the projected growth extremely difficult to achieve. Further, the analysis above assumes HepaFat-Scan can be commercialised. This is yet to be proven.

Summing up

This is one of the most speculative companies I’ve ever written about, the only more speculative one being Vmoto (ASX: VMT). Resonance Health has never given money back to shareholders, and it hasn’t even turned a profit based on its core business. I do own shares in Resonance Health, but I don’t consider myself capable of valuing such a company – I'm out on a limb here.

There’s more to be written about Resonance, especially on the subject of management, but suffice it to say right now that I’m willing to trust management for now. The largest shareholder is Executive Director Simon Panton, who doesn’t have much of an Internet footprint, from what I could find, but who has “successfully” run a business, according to the Resonance Health 2013 Annual Report. If anyone has views about the management team, please be in touch, I’m underwhelmed with the amount of info I could find. Total directors remuneration for FY 2013 was $367,000, which is not unreasonable.

I am certainly not sure that Resonance Health is undervalued. However I do think on the balance of probabilities the company is worth more than 5c per share.

The Author owns shares in Resonance Health. Please note that a share entitlement offer is currently open at 5c per share, the author is entitled to shares under the other and currently intends to take them up. Nothing on this website is advice, ever. The purpose of this blog is to keep track of my decisions and invite feedback

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