Decision Diagnostics: Meaningfully Derisked And Substantially Undervalued
Jun. 7, 2016 6:13 PM ET| About: Decision Diagnostics Corp. (DECN), Includes: JNJ
Logical Assessment Logical Assessment?Follow(320 followers)
Long/short equity, biotech, healthcare, small-cap
Send Message|Logical Assessment
Summary
Diabetes represents a massive market opportunity, particularly within diabetic test strips.
Although once closely guarded by large pharma with patent litigation, Medicare policy changes have eroded large pharma's pricing power over diabetic test strips.
Johnson & Johnson has been embroiled in a legal battle with Decision Diagnostics over the past five years.
Surprisingly, J&J has failed to secure a single legal victory against Decision, and DECN stands to benefit massively from its countersuits.
Although Decision Diagnostics has experienced a significant reduction in risk over the past three years, its share price has failed to reflect this, highlighting a favorable risk/reward profile.
A Well-Guarded Diabetic Oligopoly
Diabetes is a modern day pandemic fueled by the increasing growth of obesity throughout developed countries. With the global market for diabetes therapeutics and diagnostics expected to reach a staggering $157 billion by 2017 and growing 25% annually, smaller sub-markets such as glucose monitoring and diabetes management have grown accordingly ($10 billion in the U.S. for 2015). Companies such as J&J (NYSE:JNJ), Roche (OTCQX:RHHBY), Abbott (NYSE:ABT) and Bayer (OTCPK:BAYRY) have dominated this sub-industry for years, taking a lion's share of the revenues and immense profits year over year. Despite shifts in government and third-party reimbursement negatively impacting the margins of blood glucose strips, their market dominance has continued in no small part due to their teams pressing litigation of their patents. Where in essence, a near insurmountable barrier to entry existed with companies such as J&J suing small players attempting to enter this lucrative business into oblivion.
One such case involves the market leader, Johnson & Johnson, and a tiny company, Decision Diagnostics and its subsidiary PharmaTech Solutions, setting the scene for what many have called a David and Goliath story. Covered extensively by a Seeking Alpha contributor in 2013, I've been sitting on the fence while quietly eyeing the battle between Decision Diagnostics and Johnson & Johnson play out over the last three years.
Although the story remains the same, Decision Diagnostics has had a meaningful string of victories over this time frame. However, these victories have failed to be reflected in the share price, which leads me to the conclusion that DECN is significantly undervalued despite being meaningfully derisked. David has slain Goliath, but still stands in his shadow.
Decisive Legal Victories Against Johnson & Johnson
The following is a brief history of the five-year legal war waged by both companies. Although paradoxically extensive and cursory, it represents my good faith effort to include the salient points one would discover during a thorough due diligence process.
In 2011, Johnson & Johnson filed a suit against Decision Diagnostics on the basis of patent infringement violations and included within the suit was an injunction against sales of Decision Diagnostics' Genstrip (its proprietary blood glucose monitoring strip). This was a near coup de grace to the company, embroiling Decision Diagnostics in an expensive legal battle while negating its ability to generate profits to pay for said costs.
At the end of 2013, Decision Diagnostics fortunately won two battles that provided it forward momentum in its war against J&J. Stated within this opinion, and succinctly summarized by a fellow contributor:
"The U.S. Federal Court of Appeals ruled that Shasta Technologies, the original concept holder for Genstrip who had assigned all product rights to Decision Diagnostics and their Pharma Tech subsidiary, was within their rights to sell their glucose testing strips, and that any decision allowing LifeScan, a Johnson & Johnson subsidiary, to block sales would be unfairly eliminating competition (which was J&J's original plan). Furthermore, the ruling went on to say that the strips did not embody the claimed invention and were unpatentable."
Later that year, the United States Court of Appeals issued its mandate, finalizing its November 4, 2013, ruling. With these keystone victories in place, Decision Diagnostics regained the ability to generate profits, and put the first chink in the patent suit of armor, protecting Johnson & Johnson's multi-billion cash cow.
In 2014, DECN pivoted from defense to offense with multiple countersuits against Johnson & Johnson focused on anti-trust and false advertising violations, as well as damages inflicted upon the company from J&J's patent litigation. These countersuits were funded via a terms agreement with a major litigation prosecution fund, probably as a result of Decision's victories in 2013. The unpatentability of Johnson & Johnson's glucose testing strip was sustained in August 2014 by the USPTO in a final ruling, further driving the nail in the coffin regarding J&J's ability to protect its highly profitable diabetes monitoring assets, and minimized DECN's risk to further patent litigation.
The indefensibility of J&J's blood glucose testing assets is evidenced by Johnson & Johnson's multiple attempts for mediation and settlement in 2014 and 2015. Decision Diagnostics, perhaps smelling the blood in the water, rejected every single settlement offer from the company. As a result of DECN's rejections, J&J mounted last ditch efforts attempting to protect its $3 billion LifeScan business. These efforts began March 2015, where LifeScan/J&J filed its final appeal in the United States Court of Appeals for the Federal Circuit in order to overturn the decision made by the USPTO regarding the unpatentability of the claims in LifeScan/J&J's '105 patent. The solicitor general of the U.S., Donald Verrilli, Jr., promptly slapped this down when he filed a notice of an intention to intervene in the U.S. Court of Appeals for the Federal Court.
Perhaps coming to the quiet realization that its LifeScan patent protection was about to crumble altogether, Johnson & Johnson took some measures in May 2015 to cushion the blow. J&J offered a partial surrender to DECN, which included the dismissal of lawsuits regarding other patents and monetary damages alleged by Johnson & Johnson. As expected, the Federal Court affirmed the final ruling of the USPTO court, finally killing LifeScan/J&J's ability to bring the suit against Decision Diagnostics and its subsidiary on the front of patent infringement altogether. This final ruling not only brought nearly five years of patent litigation to a head, but also set the stage for Decision Diagnostics to wage a one-sided war against its former oppressor.
In a textbook example of just desserts, following the ruling on J&J's '105 patent, Decision Diagnostics filed a lawsuit against LifeScan/J&J for alleged infringement against two separate patents, 6,153,069 and 6,413,411, seeking compensation and damages in the amount of $400-700 million. Although a fairly logical progression given the indefensibility of J&J's patent protection, this attack begs the question: How will Decision Diagnostics finance its continued legal battle?
Well, in May, the company issued an update revealing that the district court judge ordered J&J and PharmaTech (Decision Diagnostics) to participate in mandatory mediation to resolve all patent and trademark infringement litigation filed by J&J against PharmaTech - some of this litigation dating back almost five years. The mediation concluded with the dismissal of all litigation by J&J against Decision and its subsidiary - the full surrender. Moreover, J&J also agreed to pay a cash sum to Decision Diagnostics in consideration for PharmaTech's agreement to vacate all claims made in its anti-trust litigation (note that this does not include DECN's patent infringement suit).
Although the court has made the cash settlement amount confidential (not uncommon in J&J settlements, especially when it loses), Decision Diagnostics indicated it believes it has been justly compensated through the settlement. Interestingly, Decision Diagnostics elected to directly transfer the entire cash settlement award into a newly created litigation-financing fund. In essence, by finally obtaining a much-needed war chest, Decision Diagnostics has announced its intention to go "berserk" on Johnson & Johnson.
Meaningful Advances In The Core Business
Given the headways Decision Diagnostics has made in regards to its litigation front, it's easy to lose sight of the fact that the company is a business centered on the production and sales of its blood sugar testing strips. Although I believe the current primary thesis for meaningful share price growth lies in the legal side for DECN, the following is a list of advancements on the company's largely overshadowed core business.
Although previously unable to sell its Genstrip products due to an injunction included within J&J suit, this injunction was lifted near the end of 2013, thus enabling Decision Diagnostics to begin generating profits again. Despite this, the company faced many difficulties stemming from the ongoing legal battle with J&J, not the least of which was the 30-page certified letter campaign, threatening letter sent to Decision's clients, but more importantly to the customers of DECN. Decision estimated in court filings that over 25% of the independent pharmacies in the U.S. received these letters. Then, concerns grew in the investment community regarding the company's ability to finance the sales and growth of Genstrip sales. This arose naturally as a result of the costly nature of fighting a legal battle, especially against a healthcare titan such as J&J. The shortage of capital often resulted in severe inventory shortage of the Genstrip product, owing to the timing of the various settlements with Johnson & Johnson and capital raises.
As the legal landscape progressed steadily towards Decision's favor, so too have the conditions surrounding the company's ability to conduct business. Benefiting from increasingly optimistic outlooks on the legal outcomes and the strength of the Genstrip products, Decision Diagnostics has been able to consistently secure financing at relatively favorable terms, along with key business developments in regards to manufacturing and sales channel growth.
In 2015, Decision Diagnostics completed an investment in special manufacturing equipment in Korea, thus securing a reliable source for the maintenance of inventory levels, especially as sales continue to ramp up. With this key manufacturer in place, the company's most recent quarterly filing reveals production capacity at 500,000 packages per month. This translates to comfortable scaling up to $5-10 million in revenue per month at maximum capacity.
At the start of the following year, the company was able to retire a significant portion of its old outstanding convertible note debt, and by securing a key investment by Alpha Capital Anstalt in the form of less dilutive, 18-month 15% Original Issue Discount instruments. Finally, attesting to the viability of the company's Genstrip products, Decision Diagnostics announced the execution of an agreement with Retail Monster, LLC, a retail and marketing specialist firm centered in the U.S. Retail Monster boasts a proven track record of growing and developing brands, representing brands such as Disney, DreamWorks, Nickelodeon, and Levi's to name a few, where Retail Monster's retail customer revenue equates to over $30 billion in sales over the last decade. This represents a road map for presumably substantial growth over the next few years as Retail Monster will broker contracts with major retailers around the U.S. and Canada for a percentage of the profits. Disclosure of the company's ad spend report seems to support the company's continued sales growth with televised commercials running on major networks such as AMC, CNN, Oxygen, and VH1.
The Floodgates Have Opened
Across the board, things are looking up for the microcap company. Through a string of hard-earned victories, the gates to the highly profitable diabetic blood testing market have opened for Decision Diagnostics. The market for diabetic test strips has changed radically over the past four years, driven by the advent of the Medicare competitive bidding implementation, reducing the pricing power of the "Big 4" pharma companies regarding their test strip products. In effect, the power of the incumbent players in the market has eroded, creating a vacuum where the Genstrip line of products can potentially thrive. J&J used to generate nearly $3 billion in yearly sales on its life scan products; its revenues have declined 12% year over year since 2012 despite the continued growth of the diabetes market.
The lower price point of Decision Diagnostics' test strip products should easily allow for an eventual 5% market penetration worldwide, relative to J&J's current market. This would translate to ramping revenue growth up to $120 million, highlighting the opportunity present in the company's core business. As mentioned earlier, inventory shortage was a salient concern for Decision Diagnostics until recently this year. The company estimates that lack of inventory to service sales orders lowered Q1 2016 sales by at $250,000. According to this statement, it would not be surprising to see sales north of $2 million for the year of 2016.
Considering The Risks
The company has been substantially derisked over the past three years. For the most part, there is zero patent litigation risk remaining with J&J. Rulings obtained over the past year have rendered Johnson & Johnson unable to pursue any further legal action against Decision Diagnostics. Moreover, the cash settlement received by the latter has gone straight into a war chest to finance future legal costs incurred in the process of suing J&J for patent infringement. Keep in mind that Johnson & Johnson had to post a $12.7 million bond during the legal proceedings; this coupled with the fact that Decision Diagnostics repeatedly turned down settlement offers from J&J before being mandated to attend mediation strongly implies the settlement amount is well in excess of $12.7 million. With this cash secure within Decision Diagnostics' legal fund, the outcome of its suit against J&J can be seen as a free call worth potentially hundreds of millions of dollars with zero financing risk.
The company itself is fairly liquid with an average dollar volume of $200,000 being maintained over the last three months. The company has been able to finance itself through debt financing; preliminary sales data appears positive enough where the company may reach profitability by the end of the year. In doing so, Decision Diagnostics would no longer be reliant on outside sources of capital in order to run its business. Cash generated beyond the breakeven point could go towards retiring all of the company's currently existing obligations.
From my due diligence, the only salient risk with DECN might be dilution risk. Although, the company will most likely not require any further capital injections, the nature of its protracted battle with J&J has required a revolving door of debt financing in order to stay afloat. Although, the terms of these deals were not toxic, examination of the combination of common and preferred stock issued through this period reveals there are 90 million shares outstanding on a fully diluted basis. This could potentially depress the share price by 30% without consideration for any progress or shortcomings experienced by the company over the following year.
Closing Thoughts And Milestones
When I first took a glance at Decision Diagnostics three years ago, I considered it an interesting speculative play, not too dissimilar to Vringo (VRNG). Any loss in the courtrooms spelled certain doom for the company, and it was not a risk I was willing to accept, even as a gambling man. Remarkably, for a company that was running on fumes fighting the Goliath that is Johnson & Johnson, Decision Diagnostics has continued to decisively prevail over the giant for the past three years. Johnson & Johnson can't even sue the company anymore!
Despite the progress Decision Diagnostics has made, the share price is actually lower than it was when I first looked at the company over three years ago. It's shocking, especially in consideration of the profoundly lowered risk profile. The company is sitting on a war chest of funds for its continued patent litigation, has a reliable supplier and source of capital, and has enough cash to last in a year where sales can be expected to grow to the critical breakeven point. News flow supporting or providing updates on any one of these key points should easily count as a catalyst supporting an inflection in the share price.
In a strange way, the story between J&J and Decision Diagnostics is truly mind-boggling. If Johnson & Johnson took any other course of action other than the one it chose, it would not be in this predicament. The giant could have just ignored Decision altogether; perhaps, it could've focused resources on advertising or promotion to deny DECN a foothold in the market, or it could've just acquired the tiny company altogether and moved forward. Instead, it committed to a series of monumentally stupid decisions that has endangered the very foundation of its life scan golden goose. As an investor, I relish the irony of the situation, especially when the share price is too good to pass up.
Disclosure: I am/we are long DECN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
bout this article:Collapse
With comments
Emailed to: 205,678 people who get SA Tech Stock Report daily and 495,826 people who get Investing Ideas daily.
AI
