EKF Diagnostics: Far From Anaemic

EKF Diagnostics is a publicly listed healthcare company founded in 1990 in Barleban, Germany, which is currently headquartered in Cardiff, Wales, UK. It is a global manufacturer of point-of-care (POCT) devices and tests for diagnostic use in Haematology, Diabetes and Women’s Health. EKF also owns a 100% controlled subsidiary holding, Stanbio Laboratory, a business segment EKF calls the Central Laboratory, which produces and sells enzymes and other components for clinical use. EKF had a stellar year in 2020, as they managed to adapt their expertise and manufacturing capabilities to provide contract manufacturing to the Covid-19 testing effort, primarily through their product named ‘PrimeStore MTM’, a viral transport medium that carries and transports pathogenic samples. The viral medium effectively kills any pathogen — in this case, the Covid-19 virus — but keeps its DNA or genetic makeup intact so scientists can test and identify whether an infection is present. This product line had revenues of £26m in 2020 and helped offset a 14% decline in the ‘core’ business, lifting group revenue by 45%. As you would expect, these results have lifted EKF’s shares dramatically since the start of the pandemic (the shares are up 270% since the March 2020 low). So, is EKF a business worth holding onto for the long term? And should investors who aren’t EKF shareholders look to add this business to their portfolio’s?

Firstly, let's take a look at EKF’s business segments. EKF sells analysis machines and tests in three specific markets:

Haematology, with machines under the brand names Hemo Control, DiaSpect, UltraCrit and Hematastat, which measure various cell counts in patients' blood. Each test on a machine is a disposable unit, and EKF receives a high volume each year from its installed base of Haematology analysis machines. In 2019, EKF sold more than 28 million tests for the DiaSpect Tm range. Tests are used in field clinics, GP surgeries, blood banks and maternity wards and are used to make blood donation and anaemia diagnosis easier.

Diabetes, with machines under the brand names BioSen, Quo-Lab and Quo-Test that measure HbA1c levels (Glycated Haemoglobin) and glucose and/or lactate levels. HbA1c is the accepted long term barometer of patient wellbeing and their compliance with the treatment regimes — HbA1c measurement is closely followed by GPs and other health care professionals to monitor the progress of a diabetes condition.

Women’s Health, a much smaller market for EKF. The Women's Health product range focuses on specialist diagnostics used to address conditions and complications associated with pregnancy and childbirth.

EKF also has a peripheral business unit named Central Laboratory and Life Sciences, which houses the Stanbio subsidiary, responsible for selling clinical reagents and enzymes. Clinical reagents are the substances that are used in test kits, which are then utilised in analyses machines, similar to those that EKF sells in Diabetes and Haematology markets. The central lab sells these clinical reagents for use in ‘open channel’ systems, which, in layman's terms, is for sale to third party diagnostics providers. This business unit means that EKF is a vertically integrated diagnostics supplier with revenue sources coming from upstream (central lab products) and downstream (machines and tests for end customers).

This Central Laboratory and Life Sciences segment is where the impressive revenue gains in 2020 were delivered, as this segment houses the PrimeStore MTM products, which boosted revenues 405% for the segment to £30.9m from £6.1m the year before. PrimeStore has proved quite the hit with Covid-19 testing facilities — some operational wins from the year-end report were as follows:

  • Supply contracts won with Public Health England, private labs and universities in the UK;

  • A large contract with a distributor to supply the Government of Ireland;

  • Exports to European mainland following business wins in Germany and with a multinational partner;

  • Manufacturing lines established in Cardiff, Barleben and Leipzig.

Whilst this boom in revenues off the back of Covid-19 related PrimeStore sales has delivered success for EKF, it is worth noting that in a typical year the Central Laboratory segment will be the slowest growth in EKF's business. Also worth noting is that the rest of EKF's business also declined in 2020, as patients with Diabetes or Haematological complications are at higher risk to Covid-19 and thus an increased number of patients in these categories stayed away from health facilities during the year. Results in 2020 showed the decline in the two largest ‘core’ segments of Diabetes and Haematology at -7.5% and -20% respectively.

So looking past the great year of 2020, what opportunities does EKF have at its disposal?

Firstly, and probably most importantly, we have to discuss the PrimeStore MTM product line and the benefit of the pandemic to EKF's bottom line. EKF has literally spun up a revenue source worth roughly a third of group revenues in a relatively short period of time. Covid testing is likely to continue for a period of time to come. However, the duration and intensity of testing is still a major question. We can probably expect the other business units to bounce back to similar levels of growth seen in previous years, but arguably five years from now, Covid testing will be either far-reduced or a thing of the past (he says, touching wood!). If this is the case, then EKF either has to re-purpose its PrimeStore sales to other viruses or hope it can continue to market to the coronavirus test market, for whatever variant or strain is grappling the world at that time. For me, both options are not desirable, as any pivot to other viruses will likely see a high sales mix from third world countries that historically have seen higher levels of viral outbreak (like Zika, Ebola and Malaria), which will result in much lower gross margins than selling to the British Government. Similarly, it is likely that developed economies get vaccinated first, so any resurgence of Covid-19 in the coming years is likely to be seen in areas with less vaccine density, which is also likely to result in lower profitability.

EKF doesn’t just rely on PrimeStore growth however, it has an installed base of machines that have delivered growing unit and test sales over the years, and interestingly, EKF has spun off a business in 2018 called Renalytix AI, now listed on the AIM market as well as the Nasdaq in the US. Renalytix AI is a life science company in the field of Kidney disease, which is currently working with the Mount Sinai Health System, an integrated health system in New York. EKF still owns around 3% of Renalytix stock and has a Preferred Partnership Agreement with Mount Sinai Innovation Partners. EKF recently signed a non-binding contract with MSIP to look at licensing new technology in the field of inflammatory bowel disease.

Both this partnership and the ability to pivot towards the opportunity of providing products to aid the testing efforts in the Covid-19 pandemic show that EKF is more than just a diagnostic company. To me, this shows that management are capable of sourcing opportunities and being agile to the needs of the marketplace.

However, there are a few risks to EKF’s execution going forward:

Firstly, I want to question EKF’s use of the word ‘installed base’ in their financial reports. In fairness, EKF does relate their machines on many accounts to the Razorblade/Razor model (the model which Gillette pioneered — they sell you a razor for a reasonable margin and then sell you the blades, which is where all the profit is generated), which I expect is a similar principle to diagnostic machines. However, for me, an installed base represents a significant sunk cost borne by the end-user (for instance, an elevator or a jet engine or in the medical sense, a Davinci robotic surgery system). All these products require a very capital intensive outlay, which the end-user would never wish to replace, and thus, subsequent servicing and parts revenues can be garnered from the installed base in years to come. Looking at a European wholesaler, you can find EKF’s Diaspect monitor for roughly £400 — not exactly a high replacement cost if competitors start to sell a superior or cheaper unit cost product. The reason I mention this is because EKF noted in their 2020 results presentation that the Diabetes analysis machine market has begun to see many competitive entrants off the back of the popularity of GP testing for Hb1Ac levels.

As I have discussed in the earlier ‘opportunities’ segment, it may be likely that the strong trajectory of growth of PrimeStore products is challenging to continue post-pandemic, and underlying growth rates for the wider business have not been exactly stellar in recent years.

Looking into EKF’s financials from 2015-2020, we are able to paint an interesting picture of progress. Growth in 2015 and 2016 is a little volatile due to the sale of a business unit in 2015 and thus the restatement of revenues to reflect the loss of that segment. Generally, growth has been in the mid-single-digit range, seen in the years 2017-19. Growth of 45% in 2020 shows you the impact of Covid-19 compared with prior year performance. Gross margins (revenue minus cost of goods) have actually grown in 2020 to 57%, showing that the additional revenue from PrimeStore products is accretive to gross margins, thus the revenue is not from a discounted source (hence my rationale behind reduction in profits from lower margin developing countries, as EKF mainly supplies Europe & the US with PrimeStore currently). EKF has emerged into operating profitability in recent years, and its operating margin is volatile but has held in the low double digits for the last four years. In a good year, ROCE also can deliver good results around the 15-18% mark. However, volatility here has been evident with two years of low returns on capital in 2017 and 2019. Looking further to the balance sheet, EKF is in a very strong financial position, with low total liabilities and a very comfortable debt to equity ratio of 0.29 (this measures the level of debt, to the total equity of shareholders. Typically a ratio of <1 is seen as manageable).

In summary of the financials, I think EKF is yet to show investors that it is a company with ‘superior’ operating metrics. Profitability in operating margin terms has been quite volatile, and revenue growth prior to the pandemic has been rather pedestrian. Having said that, the balance sheet is very strong, and should EKF be able to keep up recent performance, it could very much turn itself into a superior company.

I do expect 2021 to be a record year for EKF, as even more Covid-19 testing kits are rolled out and bounce back is seen in core product lines, with patients more comfortable to return to the healthcare system. This record could see EKF earning 3p per share, which would place EKF on roughly 28 times 2021 earnings. However, 2022 could see a significant decline in PrimeStore business if Covid testing unwinds, and this makes medium-term earnings estimates very difficult to calculate. This uncertainty on EKF's future earnings potential would leave me to consider any investment for EKF as a purchase of the 'core' operations and view the PrimeStore sales as a potential bonus. The core business will likely deliver 1.5p to 2p of earnings per share in 2022, which would put EKF on a valuation of around 40-50x 2022 estimates, plus the potential for PrimeStore sales. To me, EKF's core business is not growing fast enough to justify this premium price, and therefore, the onus relies on the PrimeStore product line delivering growth in the future. With so many uncertainties surrounding the future of PrimeStore testing, I personally will not be initiating a position in EKF Diagnostics at today's price.

The Twenties Trader does not own shares in EKF Diagnostics.

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