Monthly Digest: May 2023
A.I. investing / Third Stream watchlist / Naked shorts hysteria / M&A activity
Confluence features Monthly and Quarterly Digests, and the Annual Review & Outlook. In these issues, we explore investment trends in the emerging growth universe, highlight the performance of the 1,000+ companies tracked by Third Stream Research, and focus on our expanding watch list .
The Generative A.I. Investment Landscape
Venture capital investments in generative AI increased from $408 million in 2018 to $4.8 billion in 2021, and $4.5 billion in 2022, according to a report by PitchBook. The number and size of angel and seed deals has also grown, from 41 and $102.8 million in 2018, to 107 deals and $358.3 million invested in 2022.
Fascination with generative AI (GAI) has ignited a vigorous debate: as investors weigh the potential risks and rewards, a nuanced view reveals a mix of promising factors and heady challenges.
Generative AI's allure lies in its ability to reshape industries and redefine technological innovation. Breakthrough models like GPT-Neo and Stable Diffusion, capable of generating remarkably realistic text and images, have thrust the transformative power of generative AI into the spotlight.
The democratization of GAI technology has fueled a vibrant ecosystem of startups and smaller ventures. Initiatives such as EleutherAI (an open effort that developed GPT-Neo) have played a pivotal role in making sophisticated models accessible to a broader audience, eroding the dominance of established commercial labs such as DeepMind. Today, agile companies across many industries are working to leverage generative AI, which is fostering innovation and intensifying competition.
Naturally, dominant tech players (e.g. Alphabet, Microsoft) recognize the strategic significance and revenue potential of GAI. Through acquisition and strategic partnering, they aim to be the leaders in the generative AI domain. This not only affirms the commercial viability of generative AI but also creates potential exit opportunities for venture capitalists.
But cautious evaluation is warranted for VC investments in generative AI. Ethical concerns such as biases, privacy, and misuse must be carefully addressed. The evolving regulatory landscape introduces added uncertainties, while intense competition can be especially intimidating for emerging companies with limited resources.
Investors evaluating GAI companies must navigate this complex terrain. Scrutinizing critical factors such as team expertise, intellectual property strength, market positioning, and long-term viability is a required practice. By recognizing the potential of generative AI technology, its commercial applications, and the competitive landscape, investors can take on new opportunities while mitigating risks.
Yet, just as important, investors need to be alert to the potentially disruptive impact of GAI on vulnerable businesses.
For instance, Chegg, Inc. (CHGG; $1.2B) shares plummeted nearly 50% on May 2 after the online learning company's warning on the impact of ChatGPT freaked-out investors and analysts. While Chegg topped revenue and EPS estimates with its Q1 earnings report, management said that ChatGPT had a negative impact on CHGG’s new customer growth beginning in March with student interest spiking in the new AI tool. This sparked fears that ChatGPT may replace some of the company’s services for students.
This kind of scenario will be played out endlessly over the next two years.
Third Stream Research: Watchlist
PRPH, ORGS, CTSO, RCAT
Third Stream Research’s independent research coverage is presently focused on a single company: ProPhase Labs (PRPH). We initiated coverage in October 2022 and continue to issue quarterly updates. Our initial report and updates can be read here.
ProPhase Labs (PRPH; $157M) reported its Q1 2023 financial results last week, generating net revenue of $19.3 million as compared to $47.5 million for the same period one year ago. PRPH also produced a small profit.
As we’ve discussed, ProPhase is undergoing a fundamental transition into a radically different company, from a diagnostics lab that achieved strong revenue and earnings growth from COVID-19 testing to a fully diversified biopharma with an impressive portfolio of complementary businesses (genome sequencing, diagnostics, manufacturing, biotech products/compounds).
A complete research update will be issued next week for subscribers and all readers. Meanwhile, if you’re unfamiliar with PRPH check out Third Stream’s research.
Orgenesis, Inc. (ORGS; $30M), which we introduced last week in our Perspectives feature, announced that Metalmark Capital Partners, a leading private equity firm, will make an additional investment of $5 million into Orgenesis’ US-based point-of-care services subsidiary, Morgenesis LLC. This investment follows the previously announced investment of $30 million in November 2022. In addition, Metalmark has committed to investing up to an additional $15 million, subject to the achievement of certain milestones.
Separately, Orgenesis released its financial results for the first quarter of 2023, reporting revenues of $7.04 million, slightly down from $7.21 million in the same period last year. The 2% decrease can be attributed to a $4.7 million increase in point-of-care (POC) cell processing due to newly signed cell processing contracts and a $1.4 million increase in cell process development and hospital services revenue. However, these gains were offset by a decline of $6.3 million in POC development services.
Management attributed this progression to Orgenesis’ revenue model, where, following the completion of POCare development services performance obligations, ORGS entered into cell processing agreements with certain customers. Ownership of any intellectual property created now rests with these third-party customers. Orgenesis has successfully fulfilled its performance obligations under all POCare development services contracts from previous years.
In addition to its POCare Services platform, Orgenesis is advancing its therapeutic pipeline. The company is leveraging government grants and funding from regional partners while actively seeking licensing and marketing partnerships for its more advanced product candidates. Management believes that strategic partnerships would enable the company to further utilize its POCare platform, especially as some of its assets have reached a mature stage of development.
CytoSorbents Corp. (CTSO; $152M) released its Q1 2023 financial results, reporting revenue figures that align closely with expectations. In the first quarter, revenues rose by 8.7% to $9.4 million, compared to $8.7 million in the same period last year. Product sales remained relatively flat at $7.9 million, largely due to the adverse impact of currency exchange rates.
CTSO specializes in blood purification for the treatment of life-threatening conditions in intensive care units and cardiac surgery. Its flagship product, CytoSorb®, is approved in the European Union and is distributed in 75 countries worldwide. Cumulatively, more than 203,000 CytoSorb devices have been utilized as of March 31, 2023.
In terms of financial performance, product gross margin declined to 68% from around 80% in the previous year, primarily due to manufacturing inefficiencies associated with the relocation of manufacturing operations to a new facility and startup activities at the new site. However, the company anticipates a return to product gross margins in the 75%-80% range for the remaining quarters of 2023.
The net loss for the quarter improved to ($7.3) million compared to ($9.0) million in Q1 2022. Operating cash flow showed a use of cash amounting to approximately ($3.1) million, an improvement from an operating cash use of ($8.1) million in the same period last year. This improvement in the cash burn rate was partially attributable to the effects of positive working capital items.
CTSO maintains a strong balance sheet, with unrestricted cash and cash equivalents totaling $19.0 million, alongside restricted cash of $1.7 million as of March 31, 2023. Long-term debt stood at $5.0 million, with an available credit facility of $10 million. Furthermore, the company has access to $24.3 million under its ATM equity facility. It is worth noting that CTSO also possesses net operating loss carryforwards of $27.2 million, which serve as a tax shield for the future.
CTSO reported the progress of its pivotal STAR-T randomized controlled trial. The trial enrolled 80 patients on schedule in mid-April 2023, following the first milestone of 40 patients enrolled in November 2022. This triggered a pre-specified Data and Safety Monitoring Board review, which is expected to conclude in the coming months. The trial continues to enroll patients efficiently and is currently in its final stage, with completion anticipated in the summer.
Red Cat Holdings (RCAT; $51M) secured a purchase order to supply 200 long-range, high-speed FPV (first-person view) drones to Ukrainian drone pilots involved in the conflict with Russia. The delivery of these FPV drones is scheduled for June.
Red Cat specializes in integrating robotic hardware and software to offer crucial situational awareness and actionable intelligence to warfighters and battlefield commanders. The drones that will be provided have the highest power-to-weight ratio in the drone industry, enhancing maneuverability, especially when coupled with the FPV functionality. These FPV drones are capable of operating in GPS-denied and GPS-jammed battlefield conditions.
Recently launched, the Teal 2 drone is equipped with Teledyne FLIR's Hadron 640R sensor. This sensor provides end-users with high-resolution thermal imaging in a small (Group 1) form factor, specifically optimized for nighttime operations. Red Cat's technology partners for the Teal 2 include Athena AI, Reveal Technology, and Tomahawk Robotics.
Given that a significant portion of drone activity occurs at night, management believes the Teal 2’s nighttime drone capabilities is at the forefront of the industry. The company reports it has sufficient U.S. manufacturing capacity to enable it to swiftly fulfill orders ranging up to several thousands of units.
CEO Jeff Thompson said during RCAT’s earnings call on March 7 that he “expects the next six months to be the most exciting six months in company history with material sales, partnerships and new products.” This order for 200 drones is a positive start.
January’s naked-shorts hysteria— where are those stocks now?
In January 2023, a group of primarily micro and nanocap companies went public with their gripes over naked short sellers, claiming their stocks were being artificially depressed by illegal trading activity. Battles of this sort go back to the 1980s, after the boom in new issues of small tech and biopharma companies was ignited early in the decade. This time, the alleged victims are putting up a united front.
The band of brothers included Verb Technology Co. (VERB; $6.3M), a provider of interactive video-based sales apps with operations, education company Genius Group Ltd. (GNS; $26.4M), e-scooter and e-bike maker Micromobility.com, Inc. (formerly Helbiz) (MCOM; $4.9M) and Creatd Inc. (VOCL; $6.2M), which aims to unlock creativity for creators, brands and consumers. They sought measures to ensure “greater integrity in the capital markets.”
In a February press release, Blink Charging Co. (BLNK; $455M) a manufacturer, owner and operator of EV charging equipment and services, disclosed the following:
“In its review of unusual trading patterns, the Company believes that certain individuals and/or companies may have engaged in manipulative and/or suspected illegal trading practices that may have artificially depressed its share price….The Company suspects that its actual short position may be greater than the 30+% reported to FINRA and the public….The Company feels strongly that this predatory behavior in our capital markets must be thoroughly investigated and stopped. Utilizing the services of ShareIntel and their ability to proactively track equity flows and identify suspicious, aberrant and/or unusual trading activity, is the first step in our commitment to protecting our shareholders’ investment in our Company by doing all we can to uncover and combat suspected illegal naked short selling. The Company plans to take any and all legal actions in this endeavor.”
Ryvyl (RVYL; $31M), a blockchain and stablecoin tech company, biotechs BriaCell Therapeutics (BCTX; $111M) and SciSparc Ltd. (SPRC; $4M), and AgriFORCE (AGRI; $9M) are among the other accusers.
Each of these aggrieved firms are alleging that naked short selling has caused damages to their stock prices and harm to shareholders. This is the work of the SEC and possibly others to investigate. Based solely on observation for many years, we believe that managements very rarely garner for themselves or their shareholders any net positives when they go public with claims about naked shorts undermining their stocks.
We produced this stock chart on the nine companies just mentioned. The timeframe covers from January 23, 2023—when the group first issued various press releases on their gripes with the antagonists, and initiatives to fight back—to May 12. Eight of the nine stocks suffered losses, ranging from -15.5% (RVYL) to -87.4% (VOCL). Only BCTX eked out a fraction of a point gain. The benchmark Russell Microcap Index was down 10% over the same period.
Naked and unafraid
Approaching claims of naked short selling with a healthy dose of skepticism is crucial, irrespective of the size of the company making the allegations. Naked short selling involves selling shares that 1) you don’t own, and 2) do not actually exist, in the hope of covering at a lower price to earn a profit.
Companies with market capitalizations under $100 million are particularly susceptible to manipulation by short sellers, since their stocks may have liquidity issues, making them more vulnerable to any significant sell orders.
But proving illegal naked short selling—which federal regulators banned in 2008 in the wake of the financial crisis—is a difficult task, in part because loopholes exist. It's also common for companies to blame short sellers for their financial woes, even if short selling isn't the primary cause. Some firms may complain about conspiracies of naked short sellers as a diversion from poor financial performance or other underlying fundamental maladies.
Naked short selling has been a contentious issue in finance, with some critics arguing that the practice contributes to market volatility and poses a threat to financial stability. However, recent academic research suggests that the impact of naked short selling may be overstated.
Declines resulting from naked short selling tend to be temporary and often reverse themselves within weeks. Moreover, no single firm has gone bankrupt solely due to short sellers, as short sellers typically target firms with poor business fundamentals.
While the debate over naked short selling is likely to continue, it’s important for investors to focus on underlying business fundamentals and consider the evidence before making investment decisions. Ultimately, the impact of naked short selling may be less significant than previously believed.
Mergers & Acquisitions
Assertio's expansion continues with Spectrum acquisition and ROLVEDON's success in the market
Assertio Holdings (ASRT; $407M) is acquiring Spectrum Pharmaceuticals (SPPI; $256M) in an all-stock and contingent value rights (CVR) deal.
The acquisition features Spectrum’s ROLVEDON, an innovative long-acting G-CSF product that entered the market in October 2022 and quickly established itself as a potential winner. G-CSF (granulocyte-colony stimulating factor) is a type of protein called a growth factor. It increases the number of some types of white blood cells in the blood.
Dan Peisert, CEO of Assertio, is confident about retaining the majority of Spectrum's commercial team and add operating costs of ~$60 million annually. The remaining cost synergies are expected to accelerate and enhance the profit opportunities for the combined company and generate double-digit accretion to adjusted EPS and increased operating cash flow in 2024.
This move takes advantage of Assertio's digital non-personal platform, offering complementary dual channels to support clinical messaging, reimbursement education, and enhance ROLVEDON's awareness. By leveraging these integrated resources, Assertio aims to expedite the product's launch and maximize its impact in the market.
Under the agreement, Spectrum stockholders get 0.1783 shares of Assertio common stock for each share of SPPI. This implies an upfront value of $1.14 per Spectrum share (~$248M) based on Assertio's stock price on April 24, and an initial 65% premium to SPPI closing price on such date.
In addition, Spectrum stockholders get one CVR per Spectrum share entitling them to receive up to an additional $0.20 per share in total (~$43M), payable in cash or stock at Assertio's decision, for $1.34 (~$291M), a total potential premium of 94%. Each CVR represents the right to receive a certain amount upon ROLVEDON net sales.
After the merger, Assertio stockholders will own ~65% of the combined company while the remaining ~35% will be owned by Spectrum stockholders.
Jounce Therapeutics acquired by Concentra Biosciences, jilting Redx Pharma
Jounce Therapeutics (JNCE; $102M) turned its back on Redx Pharma's proposed merger in favor of Concentra Biosciences' surprise offer. Concentra sent a letter to Jounce's board of directors on March 14, offering to acquire all of Jounce's shares for $1.80 each. After negotiations, Jounce announced that it had accepted Concentra's slightly increased offer of $1.85 per share, representing a significant 75% premium to Jounce's March 14 share price.
The tender offer was set to begin on April 7 and include a contingent value right (CVR) for Jounce's shareholders, entitling them to 80% of the proceeds from licensing or selling off any of Jounce's legacy programs, mirroring a similar provision in the planned deal with UK-based Redx.
The acquisition, which closed earlier this month, was subject to Jounce having at least $110 million in cash and equivalents. In comparison, Jounce was expected to contribute at least $130 million to its planned combination with Redx.
Jounce's board unanimously approved the merger agreement with Concentra. Consequently, they withdrew their recommendation for shareholders to accept the Redx offer.
In response to Jounce's decision, Redx expressed disappointment but remains confident in its future. The company said that it will explore all available options in line with its strategy, despite the offer for Redx not having formally lapsed under the U.K. Takeover Code.
However, while this news brings good fortune to Jounce's shareholders, it spells trouble for the company's employees. As part of the merger, 84% of Jounce's workforce will be laid off, an increase from the 57% layoffs expected in the Redx combination. The remaining employees will focus on finalizing the sale and overseeing Jounce's ongoing clinical programs, including vopratelimab, JTX-8064, and pimivalimab.
Jounce has faced challenges due to clinical setbacks in recent years, prompting the company to seek business development opportunities for its two lead clinical programs, as it believes it lacks the resources to demonstrate their value, according to Fierce Biotech.
Concentra Biosciences is a relatively unknown entity, with limited information available on its website. However, SEC filings reveal that its parent company, Tang Capital, which is described as a life sciences-focused investment firm on LinkedIn, already owned approximately 10% of Jounce.
See you next week, and thank you for your support.
Josh
Connect with me on Twitter and LinkedIn.
Thanks for reading Confluence! Subscribe for free to receive weekly issues.
Disclaimer
The content provided in this newsletter is intended to be used for informational purposes only. It is important to do your own analysis before making any investment based on your own personal circumstances. You should take independent financial advice from a professional in connection with, or independently research and verify, any information that you find on our website and wish to rely upon, whether for the purpose of making an investment decision or otherwise. Joshua Levine and Third Stream Research were not compensated by any company, directly or indirectly, mentioned in Confluence, and we do not own shares in any companies mentioned.