Cytek Biosciences: Why We Like CTKB (NASDAQ:CTKB)

The following segment was excerpted from this fund letter.

Cytek Biosciences (NASDAQ:CTKB)

One company we have done considerable work on, and built our position in is Cytek Biosciences (CTKB). A recent note from Morgan Stanley is very representative of the general approach towards small caps today. Specifically, Morgan has a price target about 40% above where CTKB’s shares ended the quarter, yet is equal weight rated (i.e., neither a buy nor a sell). One would think 40% upside was worthy of a buy in any environment, but not today! Morgan Stanley’s reasoning was as follows: given the nascent nature of CTKB’s business, particularly on the reagent front, and the sustained growth-to-value rotation as investors seek low-risk mature assets given an increasingly uncertain macro backdrop.” Cutting aside the jargon, the reasoning is effectively that this is a small, young, growing company and investors do not want that today.

Why we like Cytek:

CTKB is the leader in full spectrum flow cytometry (FSFC). In its simplest form, flow cytometry analyzes samples for the kinds of cells or particles present and studies cells to determine their characteristics like size and shape, surface markers, proteins, DNA, as well as the impact that potential treatments can have on cells. In other words, these are extremely versatile, widely deployed instruments used by core labs at universities, pharmaceutical and biotech companies, CROs, CDMOs, oncologists, immunologists, hematologists and more. Becton, Dickinson (BDX) explained the significance of flow cytometry on their Q1 2023 earnings call by remarking that: “When you think about who is getting Nobel Prizes in [cell therapy and immune-oncology]…, almost all of them were using flow cytometry and I’m convinced you’re going to see a whole new set of discoveries being uncovered with the new technologies that we’re rolling out right now.” BDX was speaking about their own instruments; however, CTKB is far ahead in FSFC both technologically and in selling instruments to practitioners.

The pivotal moment in CTKB’s history occurred in June of 2017, when CTKB debuted its Aurora flow cytometer, featuring full spectrum technology. Founders Wenbin Jiang and Ming Yan realized that technology from telecom could be applied to flow cytometry. Flow cytometry has been used for over half a century and historically has been dominated by Becton Dickinson, Beckman Coulter and Thermo Fisher (TMO) (Invitrogen). These technologies were built on vacuum tubes. Jiang and Yan built their flow cytometer on avalanche photodiodes, which are light detectors used for fiber optics. Avalanche photodiodes cost a fraction of vacuum tubes and are far more efficient and effective at detecting fluorescence. This enabled CTKB to come to market with a lower cost, higher quality instrument. At the core of CTKB is a mission to drive costs down for the industry. Since debuting the Aurora, CTKB added their Northern Lights platform optimized for Clinical (i.e., diagnostic) use cases, the Aurora Cell sorter, and a fledgling reagent business, each with a unique angle for lowering costs for users.

FSFC is the biggest change for the industry in over half a century. A department head of flow cytometry at a leading biotechnology company explained the evolution of flow cytometry in their workflow as follows:

Based on my experience, we’re doing about 40% full spectrum. I see that increasing. We’ve been acquiring more of these machines comparing to the conventional; the same thing applies across the board according to colleagues I’ve been talking to. Sometimes it’s a bit dependent on adoption, so some places if they’ve been really open to training people on the full spectrum, on the Aurora for instance, and having good training practices. With a full spectrum flow cytometer, because it’s looking at a wide range of emitted wavelengths, you end up with more details. When you are looking in a conventional flow cytometer, you’re looking only at the peak emitted wavelength, so a traditional flow cytometer may miss certain things.

This same practitioner said that three-fourths of their incremental flow cytometer purchases are CTKB’s instruments and he expects their market share to rise from high single/low double-digit industry-wide market share to over 50% in the next five years. Although these expectations might be aggressive (and we are far more modest in our modeled expectations), we have heard similar sentiments from other industry key opinion leaders. Customers and competitors alike respect CTKB’s field team for their expertise and partnership. This field team is a critical pillar behind the company’s growth strategy. A former employee in strategy at Thermo Fisher further validated CTKB’s customer-centric approach explaining that:

A core value proposition is their expertise in their key research areas. They will engage their customers and build out white papers on best practices and new innovations coming up. [This] gives a lot of visibility and thought leadership which differentiates themselves from other competitors. Broad spectrum of expertise across research areas gives them an edge as an entrant/provider….Based on my experience at Thermo, we do a lot of competitive intelligence, when interviewing different customers and they say Cytek has really good salesforce effectiveness.

Reagents are a critical pillar of CTKB’s growth, as these form a high margin, recurring revenue stream. When CTKB and their team speak about reagents, they actually talk about “applications” or “apps” because their efforts start with automating workflows and understanding their customer needs. The company’s strategy starts leverages their team of field application specialists in two critical ways:

1. The application specialists introduce customers and instrument users to the portfolio of reagents with samples and demonstrations to prove results. All the field application specialists are scientists themselves and this is different from competitors where the FAS and sales team are predominantly sales representatives with knowledge, but not expertise about the science.
2. The application specialists speak with their customers in order to understand their greatest needs and most frequently used combinations of reagents in order to build kits that simplify workflows in the lab. Whereas competitors like BD charge a premium for compiling separate reagents into kits, CTKB anticipates needs of their customers in order to pre-produce the kits and sell them at a discount to the price of each reagent purchased individually. Reagents in kits from CTKB cost about 1/3rd less than BD’s and this affords researchers the opportunity to do more experimentation on the same budget.

CTKB IPO’d in the summer of 2021 amidst euphoric valuations in technology and life science-related securities. The vast majority of the shares sold in the IPO were by the company itself. This $200m raise helped to build a strong cash position that today represents over 1/4th of the company’s market cap. Since late 2021, shares have been under pressure as market sentiment has shifted and investors have fled growthier securities for more stable ones. Unlike other high-flying IPOs of the 2021 vintage, CTKB has been and will continue to be profitable on an EBITDA and adjusted EPS, as well as on a GAAP basis for the FY 2022.

The flow cytometry market did approximately $5 billion in annual sales in 2022 and is expected to grow at a CAGR of approximately 7.5% over the next decade. Instruments account for 30-35% of those sales, reagents and consumables are about 30%, services approximately 15%, with software and accessories the residual. Academic and research account for approximately 2/3rds of industry needs, with diagnostic the rest. Traditional flow cytometry is approximately 60-70% of sales to date, though the pendulum will flip towards full spectrum by 2030- 35 and become the dominant share. FSFC is more cost effective, is improving faster and the innovations in AI and software will compound those advantages to tip towards full spectrum. CTKB has dominant market share in full spectrum flow and should continue to maintain their market share with superior technology and the lowest cost offering. Competition comes from BD’s FACSymphony line, Sony’s line of spectral analyzers and Thermo’s Bigfoot. As of today, this adoption of full spectrum is Western-centric, with AIPAC the laggard.

We build a 30-year DCF on CTKB with $0 terminal value and triangulate with nearer-term EBITDA multiples. Our numbers in our estimation are exceedingly conservative. We apply a 9.4% growth CAGR over the 30-years, in an industry with 7.5% annual growth. Our five-year sales CAGR is 21.3% and ten-year CAGR is 16.7%. EBITDA margins rise from an 8.3% in 2022 to 28.1% and 36.3% respectively in 2028 and 2033. The EBITDA margin growth is attributable to three primary forces:

1. Reagents evolving from a high single-digit percentage of sales in 2022 to approximately one-third of sales in five years and nearly half of sales in ten years. Gross margins on reagents are 75% throughout our model, though we think there is upside above 80%. This compares to 70% on the instruments themselves.
2. Services gross margin rising from 14.6% in 2022 to 60% in ten years, driven by a more mature installed base, with a far smaller percentage of the installed base subject to warranty and replacement obligations by Cytek, as well as leverage on the service team’s heavy fixed cost structure (when the installed base was entirely new, the service margin was actually negative). Even if you believe the service margin would never rise above the 30% target management provided in their 2022 investor day, the impact on the price target would not even be $1/share. For additional context, service gross margins have already improved to over 40% as of Q1 2023.
3. Leverage on corporate OPEX from 62.7% of sales in 2022 to 44.2% in five years and 37.7% of sales in ten years. Importantly, the primary lever in OPEX stems from G&A as a percent of revenue more than halving, while R&D and S&M continue to grow at double-digit rates in gross terms, albeit at a slower pace than top-line affording modest leverage.

Summing this all up and adding in $296 million of net cash post-Luminex asset acquisition, our base case price target is approximately $18.25 per share. In this DCF, we fully expense all stock-based compensation. These numbers triangulate to 38x 2024 adj EBITDA, on revenue growth of 24.6% and 10.7x 2028 adj EBITDA on revenue growth of 17.7%.

We also run an IRR analysis with an exit multiple of 25x adj EBITDA in each year. High quality assets in the space trade with EBITDA multiples ranging from 20x up to 40x. The lower end tend to grow in the high single/low double digits. In our base case, we expect Cytek to grow at a double-digit pace for the next decade, supported by flow cytometry’s strong growth and full spectrum gaining an increasingly greater share each year. Should Cytek trade for 25x 2028’s $322m in base case EBITDA, today’s price would return a 24% IRR over that time frame. There are numerous potential acquirers who could pull forward this return at even higher multiples. Potential acquirers include Thermo Fisher, Danaher (DHR), Perkin Elmer, Beckton Dickinson, Beckman Coulter, Waters, Agilent (A) and Mettler-Toledo (MTD) to name a few.

We think our numbers are generally conservative. One important sanity check is looking at Cytek revenues relative to industry scale in five and 10 years time. In five years, flow cytometry revenues in aggregate will be approximately $7.7b. We are assuming $610m in revenue for Cytek, or 7.9% share of industry revenue. In 10 years, industry revenue will be approximately $11b and we are using $1.1b for Cytek, which approximates to 9.8% revenue share. Our numbers are driven by the company’s installed base growing from 1,607 at the end of 2022 to 6,600 in five years and 11,600 in ten years (excluding the acquisition we discuss above). For perspective, the industry-wide installed base is upwards of 50,000 units.

The foremost risks we face for Cytek from here are the following:

• In the near-term, the company is exposed to funding cycles in academia and across the pharmaceutical and biotech industries. They have grown strongly through these pressures, though the situation could worsen.
• The path to clinical approval in the U.S. could lengthen or even fall-through. Though we think this is unlikely, we are assuming clinical adoption in our model.
• The company could spend considerable R&D dollars and building the Amnis imager into the Cytek equipment lineup without commercial uptake following through. Importantly, we are not yet assuming a contribution from this asset, but it could suppress margins if the path is more challenging than hoped.
• Competition could intensify with existing players like Sony (SONY), BD or BC achieving breakthroughs that lead to cost parity with Cytek. We believe Cytek’s customer support is a critical source of advantage; however, some large customers prefer working with one single vendor and the broad portfolios of these other players could hurt Cytek’s market share.
• Reagent adoption is a critical driver of our expectations and the company could fail to gain share given most researchers are reluctant to change their suppliers.