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ILIU: PST Test Roll-Out Commencing

By Brian Marckx, CFA

Q3 2013:
  On Front End of PST Roll-Out

Interleukin (ILIU)reported financial results for the third quarter ending September 30, 2013 on November 14th.  Revenue was moderately lower than our estimate but operating income was significantly lower as ILIU ramped up spend on marketing activities related to the PST test.  We are maintaining our Outperform rating on shares of ILIU.  See below for access to our entire recent Investor Note on ILIU.

Q3 revenue of $419k was flat from Q3 2012, down 51% sequentially and about 17% less than our $505k estimate.  The majority of revenue continues to be generated from sales of the Weight Management test.  Since Amway began bundling the test as part of its promotional product bundle, sales of the test have been less regular q-to-q.  And while we think there's potential for future growth of the test, we view the PST and osteoarthritis tests as the major catalysts for long-term revenue growth of the company.

GM / Operating Expenses / EPS
GM was 13% versus our 40% estimate.  The significant contraction in GM is due to lower average price per test processed as a result of substantial amount (~43%) of sales of the Weight Management test made through the promotional bundle.  Operating expenses were $2.2 million, significantly higher than our $1.6 million estimate as a result of the aforementioned PST test marketing expenditures.  Net loss and EPS were $2.2 million and ($0.02), compared to our $1.4 million and ($0.01) estimates. 

Cash used in operations in Q3 was $1.8 million, excluding changes in working capital cash used in operations was about $2.1 million.  ILIU exited Q3 with $8.7 million in cash and equivalents, representing about 4 - 5 quarters worth of cash at the current burn rate, which should get them well into the initial roll-out of the PST.

As a reminder, in May Interleukin raised $12 million (gross) through the sale of 43.7 million shares of common stock.  This relieved the impending liquidity crunch and cleaned up the balance sheet and capital structure, eliminating all the preferred stock and debt.

Operational Update
The most noteworthy recent update is the initial roll-out of dental plans covering the PST test has now started.  ILIU expects this to be a measured launch, initially encompassing smaller employer groups on the front end, and then targeting a broader set of employers towards the back half of 2014 and into 2015.  Dentists with patients covered by these Right-Sized Dental policies in the initial roll-out will receive letters in November informing them that certain of their patients are covered by these plans.  These dentists will receive additional information about the policies and PST test and in early January will receive collection kits for collecting patient samples.  While we now do not expect significant revenue related to processing of the PST test during 2014, the fact that policies covering the test have been created and the roll-out is now underway are important milestones and indicative that meaningful progress has been made over the last few months.  We continue to expect a much more meaningful contribution from the PST test in 2015.

The other noteworthy update relates to certain changes to the agreement with RHSC which are outlined in an 8K filed by ILIU on November 7th.  As a reminder, in February 2013 ILIU and RHSC entered an agreement relative to reimbursement of the PST test.  Under that agreement, ILIU will process the PST tests at a fixed price (not disclosed) for RHSC's affiliates and in the event that ILIU offers the test to other parties for a lower price, this lower price will also be applicable to processing of RHSC affiliates' tests for the 3-year term (through 2/25/2013) of the agreement.  Milestones that RHSC must meet for this pricing arrangement to remain in place are that 1) their affiliates must develop and offer dental plans that reimburses for the PST test and which a "significant portion" of the affiliate's customers are eligible for and 2) prior to a specified date (not disclosed), RHSC's affiliates must have sold policies for these dental plans for the year beginning 1/1/2014.  Furthermore, ILIU agreed that for one year following the date that RHSC affiliates first offered these plans, ILIU would offer the test exclusively to RHSC affiliates and to no other parties.

The changes in the revised agreement (for RHSC affiliates to receive the preferred pricing) relate to 1) seemingly increasing the flexibility of timing (i.e.  - there is no longer a "specified timeframe") of when plans must be made available that cover a significant portion of RHSC affiliates' clients, 2) removal of "a specified date" related to when RHSC affiliates had to have sold policies for these reimbursed dental plans for the year beginning 1/1/2014 (instead RHSC affiliates are now obligated to "use best efforts to maximize the number of customers that offer" this dental plan), and 3) removal of the provision that ILIU would only offer the test exclusively to RHSC affiliates for one year following the date that RHSC affiliates first offered these plans.

The amended agreement allows ILIU to immediately shop the test to additional dental plans but we also feel it provides additional time and flexibility to RHSC in terms of selling the plans.  However, as we indicated when the initial plan was announced, that agreement already afforded somewhat substantial wiggle-room as far as timing of the launch of the dental plans (notwithstanding the milestones). So we would not characterize the softening provided to RHSC in the amended agreement as overly material.  On the Q3 call management also made an interesting point, that being that under the initial agreement which gave RHSC exclusivity during the first year, dental practices that had some patients covered by these policies could not request a PST for other patients not covered by these policies even if the patient were to pay out of pocket.  With the amended agreement, which provides for much broader availability to patients and insurers, this is now possible.

Product Update
We think management remains intently focused not only near-term commercialization of their late-stage pipeline but also on reviving the recent lagging sales of their weight management test.  While the main and most important focus right now is to get the PST test commercialized and supported by dental insurance reimbursement, the osteoarthritis test which could have enormous potential, particularly (at least initially) as a companion diagnostic in drug development clinical trials, could be next in-line as a revenue driver for ILIU.

> Weight Management Test:  per the agreement signed last year with Amway Europe, the test became available in certain parts of Europe.  ILIU receives a royalty for each test sold.  Relative to the Amway (U.S.) bundled weight loss product, while it's currently unknown how this may affect sales over the long term, management remains focused on reviving growth of the weight management test (and the other Inherent Health products).

> Osteoarthritis Test:  the game plan continues to be to collaborate with a partner to bring the test to market.  A paper with findings of the company's (in collaboration with Univ of North Carolina) 1,154-patient study validating the test as a predictor of progression of knee osteoarthritis was submitted for publication.  Following publication ILIU will seek to partner.  The test could have enormous potential value as a companion diagnostic in enrollment selection of clinical studies for the development of drugs to treat osteoarthritis, currently a huge unmet need.

> Periodontal Disease Test (PST):  As a reminder, positive top-line clinical trial data of their PST test was released in early August 2012.  In February 2013 ILIU penned the initial agreement with Renaissance Health Service Corp (RHSC) relative to reimbursement of the test (this agreement was slightly modified in November).  The dental plans covering the PST test, which are called "Right-Sized Dental" will reimburse for one cleaning per year as standard or two cleanings if the PST test determines the patient is at high risk of periodontal disease. With the UofM PST study published in the Journal of Dental Research in June 2013, that prerequisite has been met and RHSC's affiliates (Delta Dental) will market dental plans that cover the PST test to their customers.  The next steps involve Delta Dental putting together the marketing material and selling the plans for plan periods beginning Jan 2014 to their customer bases (which initially covers 8 states).  If all goes well, the Delta Dental plans incorporating the PST test will be finalized and plan participants will be notified this year for those policies that renew in early 2014.  ILIU noted on the Q3 call that this is now happening.  The expectation is that the early roll-out will encompass smaller employer groups but then progress to larger employers going into late 2014 and 2015.  Case studies garnered from the initial launch will be used to help promote these plans and the PST to larger groups.

ILIU noted that they are already preparing for the roll-out which included increasing processing throughput of their lab to handle the anticipated increase in demand.  ILIU is also actively engaging dental practices in order to facilitate education about the test and making sure they have test kits available in the early phase of the launch of these plans.  Dentists with patients covered by Right-Sized policies in the initial roll-out will receive letters in November informing them that certain of their patients are covered by these plans.  These dentists will receive additional information about the policies and PST test and in early January will receive collection kits for collecting patient samples.

Management recently noted that since the study publication that they have already received positive feedback from key opinion leaders on the PST test.  Interleukin is also focused on building awareness about the PST test which should complement's RHSC's marketing efforts and facilitate the chances for a strong launch.  The company recently hired a Chief Marketing Officer to spearhead the introduction and launch of PST and to generate early awareness.  Interleukin is already making headway with awareness building in an effort to introduce the PST test to dental professionals across the country.  In early August the company published a guest editorial in the Journal of the American Dental Association, which reaches over 200k dentists, titled Personalized Medicine Enters Dentistry: What Might This Mean For Clinical Practice.  The company also will continue to be very active in attending and presenting at key dental industry conferences and events to help their awareness building efforts.  This includes the annual meetings of the American Academy of Periodontology, the American College of Prosthodontists, American Dental Association workshops and a presentation at the National Institutes of Health which is expected to have several hundred dentists in attendance.

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