FACTS: IsoTis released Q3 2006 results yesterday. Group revenues were USD
10.2 mn for the quarter while we expected USD 10.9 mn. Quarterly EBIT was
USD -3.1 mn while we expected USD -2.3 mn. Q3 net profit was USD -1.9 mn
while we expected USD -2.2 mn.

COMMENT: Group revenue growth for the quarter was 25% while we expected
33%. As a comparison, growth in the preceding four quarters was 45% and 24%
which means that IsoTis was able to maintain the growth trend on a high
level. With this solid quarterly performance IsoTis’ growth has been higher
than what competitors Wright Medical (5%) and Exactech (15%) reported for
their Q3, and what Osteotech (-2%) and Regeneration Technologies (-4%)
reported for their Q2 2006. IsoTis has therefore been able to gain market
share.
Product-wise IsoTis group sales were again supported by superior growth of
the Accell product family with 35% growth in the quarter and 41% growth for
the nine month period. Accell is growing due to good client acceptance,
investments into the sales force and shift of the
Geographically, North America, which represents some 65% of group revenues,
saw solid growth of 19% in Q3 (expected 19%) which compares to 22% and 14%
in the preceding two quarters. The international franchise, accounting for
some 20% of group revenues, saw sales growing a strong 40% (expected 40%)
after 39% and 46% in the previous two quarters. The OEM business,
accounting for some 15% of group revenues, saw sales growing 30% (expected
120%) after 294% and 106% in the previous two quarters. IsoTis signed an
OEM agreement with Alphatec Spine during Q3 2006 and could book first sales
from that contract already. On the other hand, one other OEM partner
ordered less than we anticipated during the quarter. IsoTis reiterated the
fact that they have minimum supply agreements with their OEM partners but
that overall quarterly OEM sales follow a volatile pattern as the minimum
supply agreements are valid for a 12-month period.
On the profitability side, Q3 2006 gross margin was a good 64.4% (expected
63%), which marks an improvement over the 63.1% and 62.2% reported in the
preceding two quarters. Drivers of gross margin improvement are increased
sales volumes, positive mix effects (more Accell), lower purchasing prices
and increased manufacturing efficiency.
The quarterly EBIT margin reached -30.1% (expected -21%), which compares to
-20% and -26% over the last two quarters. G&A was 29.2% of sales, higher
than our anticipated 26.5%, based on higher legal compliance costs (Sarban
Oxley). M&S was 45.8%, higher than our estimated 39.0%, based on higher
sales reps commissions, additional hiring of sales reps, participation in
trade shows and an expansion of the marketing department. R&D was 19.4%,
higher than our expected 18.5%, based on ongoing investments into Accell
product family developments. IsoTis management stated that R&D expenses
will continue to rise slightly in the future. The net loss difference (USD
-1.9 mn reported vs USD -2.2 mn expected) is smaller than the EBIT
difference as a result of the foreign exchange gain of USD 0.9 mn, which is
based on intercompany loans, and which is not cash effective. At September
30, 2006, IsoTis had a net cash position of USD 15.7 mn. In the first nine
months the cash drain was some USD 1.9 mn per quarter from operating
activities. At the current cash burning rate IsoTis will reach a net debt
position within eight quarters.
As for the outlook, management reiterates its guidance of FY 2006 revenue
growth of 25% to 30% (we carry 30% in our estimates). Management also
reiterated that they will continue to intensify product and business
development in order to introduce new products.
Valuation wise, IsoTis trades at 1.9x and 1.5x, respectively, 2007 and 2008
EV/Sales multiples, which place it at a discount of 30%-40% to the average
of Swiss and international medtech players. IsoTis’ P/E and EV/EBITDA
multiples are not relevant for the time being as the company is still in
the red.

CONCLUSION: Solid Q3 2006 performance of IsoTis. Top-line growth slightly
below of expectations, operational profitability slightly below and bottom
line slightly above forecast. If not for the foreign currency gain, net
profit would also be somewhat below expectations. IsoTis’ cash drain from
operations of USD 1.9 mn per quarter will lead to a net debt position in
two years. Currently, IsoTis still enjoys a net cash position of some USD
15.7 mn. A major positive of the results is the fact that IsoTis is
becoming more and more predictable. We will not materially change our
estimates.

Christoph Gubler, CFA
MedTech Analyst
Equity Brokerage
Lombard Odier Darier Hentsch & Cie.
Sihlstrasse 20
8021 Zürich