SourceBio International: Back with a Bang

SourceBio International: Back with a Bang

SourceBio International (SBI) has made a huge impact on its return to public markets. It reported a 139% rise in fiscal 2020 (FY20) reported revenues to £50.7mln from £21.2mln and underlying earnings (EBITDA) of £14mln, vs £3mln in FY19. Growth was driven largely on its rapid mobilisation of resources to create a new fourth division, infectious disease testing services.

We estimate that the current scale-up provides a peak capacity for up to £9mln revenues per month, prospects for sustained penetration in public and private testing markets, and to cater for evolving testing requirements. Equally, SBI is set to respond to the anticipated tsunami of neglected cases requiring diagnostics, research & development (R&D) support via its Stability Storage segment, and Genomics services, related to non-COVID care once a recovery begins, which should facilitate a turnaround in its other three core divisions.

After a five-year period as a private company, SBI is back with a laser focus on maximising value from its three core divisions: Healthcare Diagnostics, Genomics and Stability Storage. All provide services to the biopharma industry and healthcare providers, to meet the rising demand for outsourced services. The demand is being caused by a dearth of skilled clinicians to meet the specialist and complex requirements of diagnosis and treatment as well as the upsurge in personalised medicine. The provision of cellular pathology services (Healthcare Diagnostics) is a cornerstone (c 30%) of FY19 core revenues embedded in the NHS and private healthcare.

SBI is leveraging a rich seam of synergies in its customer base, being well embedded both in the NHS and among blue-chip biopharma. It is expanding capacity and opportunities to cross-sell and up-sell its services to form a more integrated offering to meet burgeoning demand from research groups among biopharma and healthcare providers.

At the same time, the group is now positioned to exploit merger & acquisition (M&A) opportunities, a key motive for its stock market listing, with a strengthened balance sheet, a growing cash pile and a disciplined approach to growing earnings. If the M&S activity does not materialise, the company is promising to pay a special dividend.

Equally, SBI can continue to leverage its strong niche in infectious disease diagnosis to continue to support the pandemic efforts, as well as for the future expansion of the new division by building a portfolio of testing services to account for evolving requirements and new technologies.

The investment case centres on the short and long-term growth opportunity; in other words, it is a proxy for market recovery and a hedge on infectious disease testing provision. In our view the c 40% rise in the share price since listing is justified by around £100mln of debt elimination alone, never mind the increasing visibility on the aggressive growth strategy and prospects. Taken in a sector context, the current value is also supported by peer group metrics, across the lab services and the contract services sector, which implies a current valuation of £230mln based on FY20 earnings.

We contend that the current discount to the market capitalisation compared to the peer group is because of the outlook for the prospects for infectious disease testing and lack of visibility on the timing of a recovery in non-COVID healthcare provision. With management targeting a rapid scale-up and an aggressive growth strategy to more than double the current market capitalisation, the strategy includes achieving scale by meeting the demand for recovery in elective and chronic disease care, and the longer-term delivery of infectious disease testing. As SBI executes its organic and acquisitive growth strategy and risk unwinds there is scope for a substantial re-rating on meeting broker earnings forecasts.

We look forward to news flow including the outcome of its Government National Microbiology Framework tender; new custom genomics projects to leverage investment in equipment and expanded facilities in global research & development (R&D) hotspots. We also anticipate the roll-out of digital pathology to build scale and margins and the potential to build up expertise in oncology via established capability, new alliances or acquisitions.

SourceBio International: expert Laboratory Services partner

SBI is a laboratory services and products company listed on London’s AIM and headquartered in Nottingham, UK. SBI comprises four divisions: Healthcare Diagnostics; Genomics; Stability Storage; and Infectious Disease Testing. It operates across six facilities in two continents and employs 235 staff.

The company listed on the LSE Main Market in 1999 as Medical Solutions, and was subsequently renamed Source Bioscience in 2008, and taken private by a consortium led by Harwood Private Equity and Continental Investment Partners, SA in 2016 to simplify the business and to reduce its cost base.

SBI relisted in November 2020, raising £35mln gross to help fund the scale-up of its COVID-19 infectious disease testing operations, to eliminate shareholder and bank loans and to maximise the company’s overall organic and acquisitive growth potential.

Strong customer networks represent an excellent springboard for growth

A multi-faceted growth strategy

SBI’s core divisions and strong customer networks represent an excellent springboard for growth. Its underlying track record in core services generated a compounded annualised growth rate (CAGR) in underlying earnings (EBITDA) of 47% and revenue of 9% from FY17-19. Management is focused on extracting maximum growth and value from high growth essential lab services against a backdrop of rising demand for outsourced services. The strategy includes:

• Focus on margin expansion via scale-up, including in cellular pathology and by executing higher value customised Genomics projects
• Geographic expansion, exploiting newly established facilities in global R&D hotspots including Dublin, Cambridge UK and San Diego
• Further diversification into high growth field of oncology notably in genomics and diagnostics
• Sustaining infectious disease testing in COVID through new commercial tie-ups and contracts, broader test menus
• Acquisitions or new alliances to complement existing expertise or address commercial opportunities

Focused on extracting maximum growth and value from essential lab services against a backdrop of rising demand for outsourced services

Core Revenues by Division

Source: Company info

The short term aims of the IPO and £35mln fund raise have been accomplished

SBI has executed its chief aims and has now transformed its capital structure and balance sheet:

• Eliminating roughly £100mln of debt, including £71mln of convertible notes plus bank loans. Net cash stood at £8.4mln the end of 2020
• Simplifying its capital structure
• Allocating working capital to rapidly scale-up infectious disease testing, a highly cash generative unit, with proceeds to be reinvested for growth and M&A
• The public listing provides the flexibility and status for accretive acquisitions to complement its expertise, broaden its offering in high growth markets

Prior to listing, SBI made a significant investment in facilities and equipment, locating itself for prime access to the highest concentration of leading biopharma, diagnostic and centres of clinical R&D at its Cambridge Centre of Excellence, its newly opened facility in Dublin and at its expanded and relocated San Diego facility.

Global Locations

Source: Company info

Core Health Diagnostics revenue stream is derived from providing outsourced cellular pathology services to the NHS, private hospitals and to the pharma sector

Healthcare Diagnostics

SBI provides comprehensive histopathology and clinical diagnostics services to a range of blue-chip pharma and diagnostic companies, healthcare providers and academia. The operating division generated around 37%, or £7.3mln of SBI’s core revenues in FY19, and is a key cornerstone for growth. SBI’s competitive strength comes from being deeply embedded in its client network including within the NHS as well as having access to a pool of highly qualified consultant pathologists. Pathology underpins SBI’s business, not only in terms of its reputation and sustained revenues but as a basis for cross-selling across its other divisions.

SBI’s core Health Diagnostics revenue stream is derived from providing outsourced cellular pathology services to the NHS, private hospitals and to the pharma sector, a highly specialised service that is vital in the care pathway for the management of disease. Cellular pathology involves the microscopic analysis of tissue samples obtained via biopsies to help diagnose, prevent and treat diseases, especially chronic disease. The annual value of pathology services to the NHS in the UK was an estimated £2bn in 2019.

Histopathologists are expert doctors, usually focusing on specific organs or tissues, to diagnose or study disease by examining samples of tissue, usually a small biopsy, detecting changes that explain what is causing a patient’s illness.

SBI grew its Cellular Pathology revenues at a 2017-19 CAGR of 34% (prior to the onset of the COVID-19 pandemic) and in FY19, Cellular Pathology accounted for about 90% of Healthcare Diagnostics revenues, with more than 35,000 samples per quarter received at the peak.

Consistent historical growth in Cellular Pathology revenue

Source: Company info.

Revenues from cellular pathology increased c 80% in the first quarter of 2020 (Q120) vs Q119, prior to the hit from COVID-19 from Q220 onwards, which is indicative of the extremely strong demand trend in place prior to the pandemic interruption.

SBI has established its strong position in this field via its relationships with a body of some 70 subcontracted remote working pathologists. This is the largest consultant pathologist network in the UK and a major advantage given the skill shortage in the field.

A 2017 census by the Royal College of Pathology found that only 3% of NHS healthcare providers that responded had sufficient histopathologists to cover demand. This factor, along with increasing pressure on healthcare providers, has been one of the drivers of outsourcing of pathology services. At the same time, delays are the cause of major bottlenecks in the prompt diagnosis and treatment of patients. In particular, the pressure is being created by the build-up in cancer cases and to meet the demands of more complex treatment including for personalised medicine. SBI currently specialises in gastrointestinal and dermatological pathology and so there is a clear potential to expand into the higher growth field of oncology (cancer treatment).

Barriers to entry and competitive advantages

As in all core areas, SBI has developed a trusted reputation. Its competitive advantages stem from the strength of its relationships and network of customers and suppliers that have taken years to develop, built on its reputation for high-quality service provision.

Part of the focus during the Take Private phase was to cultivate its commercial relationships as a partner rather than a service provider, which has enabled it to build multi-year service level agreements (SLAs), hence greater revenue visibility, primarily driven by demand from the NHS. The company meets the key criteria required of a pathology service partner:

• Accredited laboratories.
• Complies with regulatory requirements on the handling of human tissue.
• Access to a pool of consultants and a lack of new entrants into the profession.
• Speedy and accurate turnaround of samples.
• Trust, reliability and relationships.

Leveraging digital innovation to facilitate growth.

Historically, pathologists relied on the physical receipt of slides analysed individually under an optical microscope; however, the benefits of digital pathology technology, which is already well embedded in Canada and Europe in particular, are becoming more widespread, particularly in view of the shrinking workforce, combined with increasing pressure to improve healthcare outcomes at a lower cost.

The benefits are that samples can be scanned, enabling faster and wider data sharing across the diagnostic and care continuum, as opposed to transferring physical slides. This can also reduce the costs of transfer, and enables automation and speedier processing. In the UK, the growing recognition and adoption of digital pathology technology have prompted The Royal College of Pathologists to release guidance on its implementation. SBI is currently trialling and validating a Philips Digital Pathology System, in preparation for roll-out, initially to automate reporting on routine samples.

Organic growth opportunity for core specialities

Trends in the pathology field include the shift to value-based care as well as the ongoing growth of an ageing population. At the same time, laboratories look to manage costs and increase test volumes but are faced with the challenges of recruiting, training and retaining highly skilled staff.

Therefore, SBI has a significant competitive advantage by virtue of its network in private healthcare and in the NHS, and its access to consultants to continue to respond to this growing market. While COVID has diverted resources away from routine and elective care, causing a knock-on effect on SBI’s core revenues, which fell c 15% in the first half of 2020 (H120), equally there is a strong likelihood of a V-shaped recovery in demand once the pandemic starts to resolve in order to cope with the enormous backlog of cases. Once healthcare systems revert to routine care, SBI is in a strong position as a provider under its recently won contract under the Cancer Care framework, to step up the level of services provided in Healthcare Diagnostics.

As we have said, increased demand for pathology services is in large part due to rising cancer incidence with an ageing population, growing complexity of referrals, and the ability in the modern age to diagnose and treat early-stage cancer, so SBI is aiming to expand its oncology specialities to meet demand in one of the fastest-growing pathology work streams. So, broadly, labs are looking to digital solutions to help meet these challenges, and there are parallels with the radiology sector in which digital services (or teleradiology) have already been widely implemented to minimise the impact of a shrinking pool of highly qualified radiologists set against growth in demand. Medica Group (MGP) operates a successful outsourced teleradiology model in the UK and Ireland.

The implementation of digital pathology could have significant benefits for SBI including increasing throughput and efficiency and trimming the cost base by removing courier expenses. Furthermore, it opens up the opportunity to outsource work to a much wider pool of consultant pathologists based overseas. Other benefits include enhanced collaboration, improved teaching, cost savings, research facilitation, growth of speciality and enhanced patientcentred care. On the other side of the coin, the challenges include the full implementation, standardisation and validation of the digital pathology strategy as well as the need to control data privacy and storage and of course measurement of cost-efficacy.

These potential gains in efficiency and capacity have another implication for SBI, which looks to meet demand, all too clearly illustrated by the critical levels of stress placed on the NHS during the pandemic. So, while current customer Spire Healthcare (SPI) has its own network of around 20 pathology facilities in the UK, the increased demand being placed on the private sector to help absorb shortfall in public healthcare capacity is set to place more pressure on the sector's pathology services, sending demand for outsourced services skyrocketing. Potential efficiency gains and increased output via the implementation of digital pathology could provide the capacity to meet anticipated demand growth from the private sector and to achieve a higher share of the estimated £2bn a year UK pathology market.

SBI is making early inroads as a reference lab services provider in two specialist and high growth fields of genomics

Specialist genomics reference laboratory services

Within Healthcare Diagnostics, SBI is making early inroads as a reference lab services provider in two specialist and high-growth fields of genomics:

• Molecular diagnostics — screening samples using molecular techniques to detect and diagnose cancer and other types of disease.
• Personalised medicine — screening samples, drawing on genomics data derived through its Next Generation Sequencing services, using specialist analysis to support prognosis and ongoing care plan in partnership with clinical diagnostic companies. These typically include NGS panel tests that can screen for all the common genes for a particular cancer type.

Typically, a reference lab provides independent, high-volume, cost-efficient and specialist diagnostic services to complement the function of laboratories within biopharma or academic labs. This is a high-growth market, supported by explosive demand for cost-effective outcomes and value-based care.

The area is a key focus, for example, for big pharma whose interest lies in defining patient groups by genetic traits to help improve the efficacy and reduce the side effects of treatments, using molecular techniques. Single and multi-gene panels tend to be the first step in the genetic diagnosis of specific diseases.

The company has invested in the industry-leading NGS technology, the Illumina NovaSeq 6000 system:

• To facilitate higher value and higher margin NGS services
• To drive new revenue streams via contracting with clinical diagnostics companies to laboratory testing for developing new diagnostic tests
• To shore up its position as a preferred contract laboratory as new genomic tests are released to the UK market

Enormous scope to build market share

Group revenue from these services is currently only around 10% of Healthcare Diagnostics revenues, although it is higher margin than average for the group. There is enormous scope to build on its expertise in these areas, by leveraging its existing network of suppliers and customers, maximising the use of investment in gold standard NGS capital equipment, and from its strategically located laboratory facilities.

There are clear cross-selling and up-selling opportunities via its relationships in the cellular pathology market, using its reputation for high expertise to extend into the fastest-growing field of diagnostics, cancer care. The company currently works with leading research groups from pharma, healthcare providers and global diagnostics companies to provide additional testing services for patients diagnosed with cancer, enabling clinicians to provide a clear patient management programmes in quick turnaround times.

The validity and utility of NGS-based panel testing have been demonstrated for a wide range of conditions, from cancer to rare inherited diseases, pushing demand for sequencing for genetic tumour typing and diagnosis, and to support personalised medicine, develop companion diagnostics for certain cancers. For example, Roche (ROG) seeks to refine its ability to more precisely target, achieving greater efficacy and fewer side effects using its immunotherapies for lung cancer, via companion diagnostics and biomarker testing, given the increasingly competitive landscape. Another example is the entry of a raft of developers in the lung cancer field looking to develop therapies using the same molecular targets so the clinical outcomes of such therapies can have a bearing on huge investment and other strategic decisions. Cost efficacy and hence reimbursement is another key factor that dominates commercial success.

In diagnostics, the leading companies look to draw on the expertise and innovation of smaller players. Mega-league sequencing specialist Illumina (ILMN), which is in the process of reacquiring early cancer screening innovator Grail in a c US$8bn deal, has formed multiple cancer diagnostic partnerships; for example, its agreement with Myriad Genetics (MYGN) brings together clinically validated companion diagnostics and next-generation sequencing to advance comprehensive genomic profiling of tumour samples, and drive improved outcomes for oncology patients. OPKO Health (OPK) has developed a range of assays for common cancer biomarkers with its OnkoSight Advanced range for clear ‘therapeutic, diagnostic, or prognostic value’.

Reference lab services are needed to process samples and or to support the development of such assays. As such, this activity is driving demand for more outsourced services to specialist providers such as SBI. The landscape is broad although with demand anticipated to continue rising the company is well-placed to build on its expertise and leverage the cross-selling opportunities including with its more established Genomics division.

The company’s expertise in DNA sequencing is the foundation for up-selling towards more profitable, bigger projects

Genomics

SBI is equipped to provide gold-standard DNA sequencing services for pharmaceutical and biotechnology companies, academia, contract research organisations (CROs) and other research groups in the UK, Europe and North America. The Genomics division generated around £4.5mln of revenue in FY19, and the company’s expertise in sequencing is the foundation for up-selling towards more profitable, bigger projects and enables SBI to penetrate further into the field of personalised medicine and molecular diagnostics.

The Genomics business unit provides two complementary DNA sequencing methodologies, Sanger Sequencing and NGS. Sanger DNA sequencing is widely used for research purposes (for example, targeting smaller genomic regions in a larger number of samples), for sequencing of variable regions or for validating results from NGS studies. The methodology can be used to focus on inserts or mutations or to help identify a genetic variant responsible for a disease.

Genomic Sequencing has helped to facilitate a deeper understanding of biology and immunology and of the genetic coding of viruses. The applications are widereaching, spanning many fields including:

• Agriculture
• Antibody discovery and immunology
• Synthetic biology
• Cancer research
• Infectious Disease diagnostics

For example, a combination of NGS, Sanger and Oxford Nanopore sequencing methods was used by the team of scientists led by Dr Roujian Lu et al, in January 2019 and described in the article entitled ‘Genomic characterisation and epidemiology of novel 2019 coronavirus’, published in The Lancet, to define the genetic code of the samples from nine people presenting with a novel form of viral pneumonia, eight of whom had visited the Huanan seafood market in Wuhan.

Sequencing of viral material from bronchial samples helped confirm that the genetic code was a close match among all nine samples, and a match to the family of bat-derived beta coronaviruses, distinguishing it from SARS-COV. The analysis helped determine the origin of the virus, enabling the comparison of outcomes with existing databases of known viral genetic codes. This analysis was completed in a remarkably short space of time to identify the origin of the virus and supported the development of vaccines and diagnostic tests. The utility of genomic sequencing enabled UK scientists to quickly identify the new strains of the virus in late 2020.

Illumina NGS Workflow

Source: Illumina

The larger NGS projects tend to generate average gross margins up to 50% vs around 10% for smaller projects

Since Sanger sequencing is a generic service, at a set price, customers generally purchase credits or tokens in advance carried on SBI’s balance sheet as deferred income (of total accruals) of £1,742 at end June 2020, whereas NGS projects are typically larger and more specialised, and higher value than Sanger Sequencing projects. The larger NGS projects tend to generate average gross margins up to 50% vs about 10% for smaller NGS projects and are typically worth over £10,000 in revenue per project. SBI is looking to shift the mix away from the higher volume of lower value contracts it delivered in FY19.

Source: Company info.

There is a clear bridge and cross selling opportunity between the Genomics and Clinical Diagnostics segments

There is a clear bridge and cross-selling opportunity between the Genomics and Clinical Diagnostics segments given that genetic information is not just used to identify the sequences and characteristics but to detect the presence of disease and to specify its genetic origins. A central facet of the growth strategy is also to build on the synergies provided by its expertise in cellular pathology and genomics to target the burgeoning demand in oncology care.

SBI has access to all major Western markets including via its recently created Cambridge, UK Centre of Excellence

Maximising the organic growth potential

The upgrade to NGS provides the opportunity to branch out and to build on current expertise and drive higher revenue from bespoke projects. As we have said, the applications are diverse and the demand is buoyant owing to advances in technology, the development of targeted therapies coupled with the explosion of outsourcing services. As we will discuss later, SBI is also actively exploring accretive acquisitions in order to leverage its capabilities.

Industry analysts estimate that the Genomic Sequencing services market is set to more than double in value to over US$11bn by 2027 at a CAGR of c 11x%. The bulk of demand is being driven from companies in the US and with demand to shift from largely academic research into the pharma and diagnostics fields, and towards healthcare providers. SBI has access to all major Western markets including via its recently created Cambridge, UK Centre of Excellence. This is a key advantage given that many peers tend to process samples at headquarters based overseas. It has also expanded its presence in the US at its new facility in San Diego. The recent establishment of a Genomics base in Dublin also gives access to a huge concentration of diagnostics and biopharma companies and CROs, both locally and in Europe.

As stated, momentum in the field is driven by greater understanding of relationships between genomic traits and the likely treatment outcomes. In Oncology, the focus is on common cancers such as prostate, lung and bowel, affecting the global population. These are the diseases in which the greatest improvement in outcomes is expected and where there is scope for companies to recoup returns on investment in greater diagnostic precision.

The trends are the most visible among the Genomic diagnostic giants such as Illumina (ILMN) and Qiagen (QGEN) that are driving investment, forging partnerships with a multitude of smaller companies developing genomics assays.

The Biopharma industry is particularly looking to NGS methodologies for safety testing in the high growth field of biologics, such as monoclonal antibodies, advanced therapeutic medicinal products (ATMPs) and vaccines. It is also looking to outsource the service to reliable partners. Contract research provider Charles River (CRL) and its partner PathoQuest are expanding their NGS capabilities in North America specifically to respond to this demand by building a state-of-the-art genomic testing lab. SBI appears to be well-placed to tap into demand. Even capturing a small share of this large market, which is dominated by giant US-based reference labs servicing the pharma companies, healthcare providers and research groups, would present significant commercial potential from a relatively low revenue base.

Leading supplier of outsourced stability storage products and services for many blue-chip and top 20 global pharmaceutical companies

Stability Storage

SBI is a leading supplier of outsourced stability storage products and services for many blue-chip and top 20 global pharmaceutical companies as well as contract manufacturers and analytical laboratories. It has cGMP/HPRA/FDA (regulatory bodies) accredited sites in the UK, Ireland and the USA. It also invested for growth by relocating to expanded facilities in San Diego to service the vibrant community of life sciences companies and laboratories situated in the locality, and also with expanded capacity at the Tramore facility in Ireland.

Stability studies are an essential part of drug development, throughout all development phases with strict timelines for analytical testing. Stability studies prove how the quality of an active pharmaceutical ingredient (API) changes over time in line with environmental conditions. Stability studies also help to determine the re-test date of the API, shelf-life of the drug product and recommended storage conditions. Many of these regulatory requirements are set out in Good Manufacturing Practices (GMP) guidelines.

SBI is one of a relatively few companies offering specialised services and equipment to enable drug and medical devices companies, and CROs to meet stability testing requirements. The growth in outsourcing the function hinges on the underlying buoyancy of drug R&D and also on the fact that stability storage functions are both capital and management intensive functions. The expansion is also due to an increased demand for disaster recovery storage, contingency storage programmes and ‘storage-only’ projects where a GMP outsourcing partner is critical to mitigating risks associated with the lifecycle of pharmaceutical products.

Stability Storage Revenues

Source: Company Info.

Stability Storage Services present attractive high gross margins of c 80%, for SBI with over 76% of FY19 revenues derived via recurring revenue streams generated from multi-year service level agreements (SLAs).

The Stability Storage division comprises three strands:

• Stability Storage Services
• Equipment
• Service and Validation

The company complies with the globally accepted quality standards set out by the International Council for Harmonisation of Technical Requirements for Pharmaceuticals for Human Use (ICH), which sets and oversees consistent quality standards within the field of Stability Storage and are GMP certified ISO 9001:2015 facilities. ICH pharmaceutical stability guidelines provide guidance on the amount and the type of drug substance and drug product stability data needed to support a marketing application.

Vaccine stability storage for COVID vaccines

SBI also operates vaccine stability storage for COVID vaccines, covering a vital element in the development and supply of these products.

Vaccine Storage Temperatures

Source: FT

Equipment Manufacture

SBI manufactures temperature and humidity controlled equipment for stability studies for sale and/or lease to customers on-site.

Bespoke Equipment

Walk-in room

Controlled Environmental Storage

Source: Company info

This includes cabinets for low volume storage, reach-in rooms and walk-in rooms for high volume storage, offering standard volume capacity between400 litres and 43,200 litres.

SBI also provides service and validation to established clients including:

• Regular and periodic servicing and testing of installed storage equipment at customer premises to ensure adherence to relevant regulatory standards
• 24-hour call-out service for clients to rectify any issues with performance and to keep the equipment running at optimum levels of performance
• Analytical Testing service established in 2020, periodic withdrawal and testing of customers’ product samples

SBI has benefited from the expansion of outsourcing by biopharma companies to trusted suppliers’ services

Targeting increased share of buoyant outsourced Stability Storage market

SBI has built a strong reputation in over 30 years of provision of stability storage services, offering enormous opportunity to continue to benefit from the growth in demand in underlying markets. With accredited facilities adjacent to some of the most active centres of development, and with most of the fixed costs already invested, including the site and storage units, it is able to respond at a low relative incremental cost. It is focused on benefiting from the recovery in non-COVID related demand, as well as on supplying suitable facilities essential for COVID vaccine testing and stability storage.

With these trends in mind, SBI is also investing to upgrade its technology via mobile applications to allow remote control and monitoring, including by upgrading existing installations. Cost control and standardisation have also been and continue to be key focal points.

Another lever for growth includes expanding its own capacity to service clients on-site although this is likely through partnering rather than by establishing a costly field force of service engineers. We assume that such a relationship might include allying with companies operating in cold chain logistical support. Other natural partners in our view could be specialists in cell and gene therapy, logistics and supply chain in adjacent areas, food and drink or other GMP controlled, accredited services such as in the chemicals industry.

Stability Storage services is a segment of the broader US$11mln analytical services market forecast to increase by 11% a year this decade. The dominant players include Charles River (CRL), Intertek (ITRK) and analytical lab specialist Eurofins (ERF). These giants are able to provide a continuum of services including analytical services, preclinical work including toxicology. There are a number of companies offering specialist equipment or lab-based stability services, many of which are private companies such as Broughton Labs in UK and Q1 Scientific in Waterford, Ireland. The equipment landscape is dominated by the likes of Thermo Fisher (TMO: market cap US$190bn) and Cytiva, formerly GE Healthcare.

In the services market, SBI has benefited from the increased propensity of biopharma companies to outsource services to trusted suppliers to allow the biopharma companies to focus capital and resources on R&D. The sustained growth in R&D investment (particularly in biologics) with an increasing focus on regulation, safety and quality are among the key drivers. The global pharmaceutical analytical testing outsourcing market size was valued at US $6.5bn in 2020 and is expected to grow at a CAGR of 8.3% this decade, tracking the rise in investment in innovation or new product development.

Managing and servicing the development of biologics like monoclonal antibodies, or cell and gene therapies (which are expected to account for c 25% of new drugs entering development in the next decade) requires specialist cold chain and storage and testing, while smaller batches of treatments for personalised medicines including autologous cell therapies are all major drivers of increased demand. The proliferation in the number of virtual biotech start-ups is also a leading indicator of demand growth in outsourced expertise.

The division benefits from cross-selling opportunities alongside Genomics to biopharma customers for R&D new drug candidates to offer services and equipment.

SBI achieved the highest level of accreditation (UKAS 15189) to meet government standards

Infectious Disease Testing

The company moved swiftly to mobilise and redeploy its laboratory services capacity for COVID-19 testing by May 2020, having achieved the highest level of accreditation - UKAS 15189 - to meet government standards in April, already having staff qualified in molecular and clinical diagnostics. Its strategy provides a hedge against the fall in activity in non-COVID related healthcare diagnostic services, more than offsetting the slowdown in demand for its core services.

Since initiating in May, SBI has scaled up daily testing capacity, volumes and revenues, to provide gold standard test processing. It has won a significant volume of business by means of its acceptance onto the high volume DHSC/NHS framework agreement and its subsequent renewal, processing 400,000 tests under the contract by end December 2020, with around 70,000 tests processed in December alone to provide surge capacity.

The company provides test processing and sample analysis for a range of tests with PCR being the gold standard and the starting point of its service provision. A central facet of the growth strategy includes building a portfolio of infectious disease offerings to facilitate growth so that it is not dependent solely on PCR testing for growth. As a starting point, testing services covered include:

• OptiGene RT-LAMP is a rigorously evaluated, highly sensitive test that offers rapid turnaround including for asymptomatic patients

Gold standard RT-qPCR testing services to the NHS, private healthcare providers and commercial customers - the ‘backbone’ of the testing provision

LamPORE, a high-accuracy molecular test for corporate and consumer customers. Endorsed by NHS studies as equivalent to the gold standard RTPCR, including for asymptomatic test subjects, with saliva testing

The company provides a testing, processing, logistics service enabling a results turnaround (crucially) within a 24-hour period. This is via the public contracts as well as provision of a home testing service. More recently the service has been diversifying into the high street test market. It also provides private services to corporate clients, for example, employee testing and is able to supply the test-to-release government compliant service, enabling release from self-isolation on a return flight as well as Fit-to-fly certification at £99 per test.

Competitive advantages

Since initiating, the company has expanded its laboratory space following a fit-out in July 2020, scaling up its capacity to respond to demand for its COVID-19 testing services. SBI’s strong foothold and relationships with the NHS enabled it to win the contract and rapidly gain traction in the infectious disease testing market.

These factors enabled SBI to rapidly build a highly cash-generative revenue stream that was the main contributor to unaudited £50mln of revenues for FY20, EBITDA of £14mln and a margin of 28%. FY revenue was more than double FY19 revenue of £19.8mln and EBITDA nearly five times FY19 EBITDA of £3mln, more than offsetting the slowdown in underlying core services demand.

SBI’s strong foothold and relationships with the NHS enabled it to win the contract and rapidly gain traction in the infectious disease testing market

Source: Company info.

Commercial expansion

Going forward, the provision of diagnostic testing for COVID-19 falls under Public Health England’s (PHE) National Microbiology Framework tender worth up to a total £22bn initially into 2023, on a rolling 3-month contract basis. SBI has submitted a tender to participate under the contract, which is divided into four lots or categories, for the provision of Clinical Laboratory Diagnostic Testing Services.

Confirmation of the outcome is due to be announced in February. The contract is a non-specific award for diagnostic services and if awarded to SBI, could be retained to provide services that might include testing vaccine efficacy, immunity or other broader opportunities. SBI expects to increase daily testing capacity above the original target of 10,500 to support its bid. Apart from this, new commercial partnerships include:

• Oxford Nanopore strategic commercial partnership announced in December — corporate and consumer customers — complementary to the PCR test — rapid turnaround — 99.1% sensitivity and 99.6% specificity. Adds significant testing capacity to process more than 9,000 samples in 24 hours per unit — results reported via LIMs. UKAS accredited labs. In fixed laboratory or mobile community testing, the service is expected to broaden access to rapid, high-quality testing to enable people to return to work, to visit friends and relatives safely, and will potentially assist with international travel
• Spire contract renewed

In January, a supply agreement with a leading UK high street retail and pharmacy group to provide laboratory-based testing services to support the roll-out of COVID-19 testing across UK stores. Initially, a 12-month agreement to support in-store PCR Testing services. If the pilot phase is successful, this could be a much wider opportunity in the future

Significant scale and capacity present a sustained commercial opportunity

SBI achieved target capacity to process 10,500+ tests per day in December up from its starting volume of around 6,000 tests back in May.

Processing is carried out at its Nottingham-based laboratory. In FY20 the public sector took the dominant share in the public/private split of volumes/revenues. At £40-45 per test paid by the largest customers, this implies monthly peak revenue prospects of up to £9mln and at gross margins of over 40%. New commercial initiatives, expansion into the private sector and extended test capacity all provide prospects for the absorption of this capacity.

Experts have reiterated that population-wide repeat testing will be the only viable route to increased socialisation in the coming months

Growth prospects

There are around 80 companies in the private sector offering COVID testing, in addition to Government networks such as the Lighthouse Labs. SBI is among some 30 private and public labs (as at December 2020) with the required level of accreditation to provide Test-to-Release and point of care testing, and to be included on the list of Government providers. UKAS 15189 will become mandatory by summer 2021, potentially refining the list of providers and the company appears well-placed to win the PHE contract.

With daily test capacity of 600,000+ in the UK and growing, the onset of the third wave of more infectious strains and planned comprehensive vaccine roll out to high priority groups by end February, experts have reiterated that population-wide repeat testing will be the only viable route to increased socialisation in the coming months. The PHE tender indicates that the funding horizon for COVID stretches into 2023.

As we have already discussed, SBI is well embedded in the NHS as well as in the UK private health sector and so the renewal of contracts, including the DHSC contract news due in February, is a major growth contributor. We also estimate that there would be further growth into the private sector in the workforce, leisure and travel segments in particular to absorb capacity. The testing opportunity for COVID looks set then to extend well beyond 2021.

As the landscape alters, needs are also set to change notably in asymptomatic testing programmes across the NHS, private healthcare as well as many commercial sectors. Other trends include:

• Testing for vaccine efficacy and duration of the immune response
• Adaptation of tests to cope with new strains of the virus
• Rapid tests
• Further inroads into the high street as services scale up
• Regular population scale epidemiological surveys, R rate testing

Beyond the pandemic

There are clear opportunities for sustained growth by building on SourceBio’s established expertise in infectious disease testing, for extended testing capacity in influenza and other viruses particularly since awareness of the need for greater preparedness has been profoundly altered.

The planned rapid completion of the UK vaccination programme could, if rolled out to a sufficient proportion of the population, help to reduce the incidence to controllable levels; however, we will still need to respond to future waves of infectious disease, potentially be ready for the onset of influenza in the peak season as well as for any possible recurrence of a SARS COV-2 virus. As a result, the continuing study of infectious disease, vaccine adaptation to new strains and perhaps an unleashing of new technologies accelerated by the pandemic offer many opportunities for SBI to benefit from its raised profile.

M&A prospectsExtending services, raising expertise in high growth areas

We have already discussed the priorities and opportunities for organic growth and SBI’s competitive advantages. The company is actively evaluating a range of acquisitions via organic means, M&A and geographic expansion focusing on:

• Expanding cellular pathology market access to private healthcare in London, via lab acquisition
• Growing market share in the US in cellular pathology and healthcare diagnostics
• Building on oncology expertise through acquisition

Infectious disease rapid sequencing services

The first priority is to access its cash pile from COVID testing revenue, while its public status affords the opportunity to issue shares or raise funds to facilitate M&A. SBI emphasises that in-depth due diligence is being exercised to explore markets, geographies, competitive fit, growth, cash generation, and management. It seeks to acquire businesses with a track record of growth and cash generation and those that will provide rapid enhancement to earnings per share.

The many trends driving healthcare M&A more broadly reflect those that are also driving growth in the outsourcing of services and for SBI, in particular, these include increasing its market share and patient access, achieving a higher level of services across the continuum in niche, high growth areas. The macro trends include increasing cost consciousness among global pharma, which is driving outsourcing.

Sector trends

Judging by consolidation trends in the sector in 2019/20 the appetite for investment appears to be relatively buoyant although there have been few deal metrics disclosed that we could identify. The most visible and prolific acquirers appear to have been the industry giants such as Lab Corp (LH) and Quest Diagnostics (DGX) looking to shore up geographic networks in the US in particular, both in oncology specialities and pathology. On the molecular diagnostics front, some notable deals have been Exact Science’s (EXAS) acquisition of Genomic Health’s genomic oncology diagnostics platform for US$2.8bn in cash and shares. In 2020, genetic testing expert Invitae Corp (NVTA) acquiring the in vitro diagnostic assets of Archer Dx. So, buoyant activity among the customer base can fuel knock on demand for SourceBio’s services.

Revenue growth across core continuing services from FY17-19 at a CAGR of 9%, equivalent to an absolute rise of 19%

Financials

SBI generated revenue growth across core continuing services from FY17-19 at a CAGR of 9%, equivalent to an absolute rise of 19%. Gross margin stood at an average 43% FY17-19 (including discontinued operations) at an EBITDA CAGR of 47%. The breakdown of core revenues per division and P&L progression is illustrated below.

Historical P&L

Source: Company Accounts

In the period the company almost doubled the EBITDA margin from 7.9% to 14.3%

In the period the company almost doubled the EBITDA margin from 7.9% to 14.3%, It cut operating costs and pre-exceptional items from 39% of continuing revenues in FY18, to 35% in FY19, conducting a programme of rationalisation and cost savings across the core business, despite upgrading its sales force in FY17, thus accomplishing many of the aims of the Take Private strategy.

The onset of the pandemic interrupted core revenues in the first half of 2020, although this has been more than offset by the influx of new infectious disease testing revenues from May 2020. SBI achieved a 50% increase in infectious disease testing capacity by December: unaudited FY20 reported revenues more than doubled to £50.7mln from £21.2mln on EBITDA of £14mln, c 5x FY19 EBITDA, on a margin of 28%.

SBI executed on its IPO aims of capital reduction and extinguishing debt

We note that FY17-19 SBI's capital expenditure totalled around £1.6mln plus it invested £1.1mln in the first half of 2020 (H120) to cover its facility expansion and capital equipment purchases. At the end of June 2020, (pre-IPO) net debt stood at £103.7mln, with cash of £1.5mln, borrowings of £4.4mln, lease liabilities of £3.9mln and other loans of £96.9mln including loan notes of £71.1mln, which were converted into equity on 13 October 2020. It has executed on its initial aims having raised £35mln gross issuing 21,604,938 new shares at 162p in parallel with listing. Shares in issue stood at 74,183,038 following the capital consolidation and reduction and the loan note conversion.

Subsequently, SBI extinguished its remaining loans of about £26mln by end December 2020 (likely helping to relieve future finance costs which were £9.1mln in FY19, and £5mln in H120) and so net cash at end FY20 stood at £8.4mln, largely derived from the scale-up of infectious disease testing volumes. From the position of improved balance sheet strength, SBI will reinvest the cash generated to help enact its M&A and or partnering initiatives and to fund its organic growth across the core divisions as well as for working capital purposes.

Future prospects

Clearly, it is impossible to call the ‘end’ of the pandemic and recovery in non-COVID related healthcare. SBI operates in high growth segments and is hedged by the contribution from infectious disease testing, and is ready to participate, leveraging its expanded capacity once a recovery does take place. The management has stated its intention of delivering a rapid scale-up via organic means and M&A. With many of the fixed costs already behind, the focus is on accretive acquisitions.

Organic growth initiatives include the further scaling up of its high margin business and recurring revenues. In Stability Storage services this will be achieved by leveraging its expanded facilities, while the company will also seek to provide more bespoke NGS projects in Genomics and Healthcare Diagnostics, scaling up cellular pathology services via digital pathology and further penetration into private healthcare. SBI can also leverage its accredited status and networks to win ongoing business in infectious disease testing.

Valuation

SBI’s share price has risen over 40% since it floated as visibility on its high growth potential, its capital structure and debt position have all improved. In our view, the current valuation is more than underpinned by its FY20 revenue and margins judging by the metrics of a group of peers.

We illustrate a cross-section of a group of companies in the sector. We include labs, many of which are giants, although which have high-cost structures and significant debt.

Many events can support the organic and acquisitive growth strategy

The average revenue and EBITDA multiples for the group selected illustrate that typical trailing enterprise value (EV) multiples are around 4 x revenue and 19 x EBITDA. This implies a current valuation of SBI of £230mln or £267mln based on its FY20 EBITDA or £189mln based on revenues.

This is not a definitive method since forecast data availability are limited and there are few smaller quoted peers; however, it provides a good benchmark. In our view, SBI’s current value is more than supported by its historic track record. Also, if we take into account that since floating at a valuation of around £75mln SBI has reduced net debt by c £100mln, this by itself justifies much of the recent uplift in value in our view.

Peer group multiples

Valuations

Source: FactSet/ Morningstar/data at 22 Jan 21

SBI’s capacity, service provision can contribute to growth targets alongside an eventual recovery in ‘normal’ healthcare provision

Future upside

As we know, SBI has aggressive plans for growth and to leverage its strong position. It has in fact openly stated that it intends to achieve a market capitalisation north of £400mln in the short term. So, taking our benchmark group, this would imply annual top-line organic or acquisitive growth of say 18% pa over a five-year period, or 16% pa EBITDA, which may seem modest bearing in mind its three-year track record of c 9% per annum and the prospects for recovery and/or sustained infectious disease testing as well as accretive growth.

We work back from the current market capitalisation using the peer group metrics, which implies a FY21 forecast EBITDA of around £10mln on revenue of £54mln, completely disconnected from FY21 broker estimates of £57.5mln EBITDA and £157mln revenues (source: S&P Global Market Intelligence). We contend that the current discount to market capitalisation compared to the peer group is because of the lack of visibility on the sustainability of revenue in infectious disease testing as well as the eventual timing of a recovery in non-COVID healthcare.

On the other hand, there are many potential events on the horizon and growth initiatives right across the business. As risk unwinds, and particularly as the organic and acquisitive growth strategy unfolds (which can expand SBI’s service capacity to contribute to its targets), the eventual recovery in ‘normal’ healthcare provision should drive core growth.

Infectious Disease Testing

• PHE contract tender outcome in February
• Partner with new test providers and form additional commercial customer-facing contracts
• Broaden the test menu for COVID and non-COVID testing for long term growth

Healthcare Diagnostics

• Roll out digital pathology in full, to build scale and margins once elective surgeries resume
• Extend specialisation in oncology - the highest growth field of cellular pathology
• Leverage Genomics sequencing, and diagnostics capability in full

Genomics

• Build higher value, custom NGS projects to leverage investment in equipment and expanded/new facilities in global R&D hotspots

Stability Storage

• Implement further technology upgrades
• Leverage capacity uplift in high margin (80%+) Stability Storage services
• Acquisitions and alliances
• Partner with a complementary business to build a field force of engineers to fulfil Stability Storage needs alongside capacity growth
• Lab acquisition or commercial contracts to access cellular pathology market in London

Sensitivities

There are many factors that drive demand and trends, and we highlight some of the most relevant areas that we have identified for SBI:

• Timing of market recovery and renewal of the government COVID testing contract
• Commercial execution across the group
• Effective technology upgrades, and a successful and cost-effective transition
• Recoup return on investment on equipment and facilities
• Pricing and reimbursement trends
• M&A execution
• Data privacy management
• Regulatory changes and the ability to move in line with requirements

Conclusions

Without doubt, the pandemic has been the single largest wake-up call for investors in healthcare in our lifetime, and we reiterate SBI’s opportunity to leverage its raised public profile, networks and expertise to rise to meet demand with the vision of becoming an expanded, broader and more specialised pharma services company over the medium-term horizon.