Cord Blood Banking Blues

Our investment in cord blood banking company, Cryo-Cell (CCEL.ob), now close to a year old, continues to dissappoint us. When a company's share price underperforms our expectations for more than a year, we think it is prudent to try to understand what the market may be telling us about the long-term prospects of a company and the proper valuation for its shares. Our perspective is that the market is very efficient over longer time periods (3 years+), so if an invesment is not showing profits after over a year (we could lengthen this reassesment time, but once a year is probably about right), it is time to reevaluate the position and question our investment assumptions.

So what could be bugging the market about Cryo-Cell (CCEL.ob)? By all accounts the company operates in an attractive growth industry, cord blood banking, and has strong prospects for growth. In addition, the company has a solid balance sheet, a recurring revenue model, is cash flow positive and has little need for capital expenditures in the years to come. What is wrong with the picture?

How Attractive Really is the Cord Blood Banking Business?
In looking for some answers, the obvious first place to look is at the industry as a whole. Perhaps, the cord blood banking business is not as good as it seems.

On that note, in the company's recent 10K we found this relevant quote: "Despite the potential benefits of U-Cord® stem cell preservation, the number of parents of newborns participating in stem cell preservation is still relatively small compared to the number of births (four million per annum) in the United States. Some reasons for this low level of market penetration are the misperception of the high cost of stem cell storage and a general lack of awareness of the benefits of stem cell preservation programs. However, evolving medical technology could significantly increase the utilization of the U-Cord® blood for transplantation and/or other types of treatments."  We would add to the above, that many doctors are still completely skeptical as to the true medical benefits of stem cell preservation.

The bottom-line appears to be that the adoption rate of stem cell preservation has been slow and as such companies in the industry have not been growing as quickly as one would expect given the huge potential market for their products. In addition, the whole business of stem cell preservation is becoming somewhat commodotized, and it is difficult to understand how the various companies will differentiate themselves in order to sustain prices well above costs.

Can one still remain bullish on Cryo-Cell (CCEL.ob) considering seemingly negative current industry conditions? We think the answer is yes. As regards to slow market penetration of stem cell preservation, we think that this will change dramatically in the coming 5 to 10 years. Despite the skepticism of the medical profession, increased marketing on the part of stem cell preservation companies, and continued favorable news regarding stem cell based treatments will convince more and more parents to bank their child's cord blood in the coming decade. In addition, with the passage by the Senate last year of HR 2520, which authorizes $79 million in federal funding for the collection and storage of umbilical cord blood for stem cell research and the treatment of diseases, cord blood banking companies now have a powerful ally in their marketing assault. We would note that Cryo-Cell's largest competitor and closest comp, Viacord (VIAC) is forecasting 20% revenue growth in 2006, implying that industry dynamics remain quite strong.

Of course, the key question really is if cord blood banking will really prove beneficial for people in the longer-term, but we think the obvious reply is: Does it really matter? The US Consumer pays for so many clearly unproven and most likely ineffective health treatments, that it seems inevitable that cord blood banking, which in reality does have alot of real evidence in its favor, will over time be added to the list of required health care expenditures. If everyone you know is banking their child's cord blood, can you as a parent deny your child the potential benefits, to save only $125 per year? We think not.

The commodization of the cord blood banking industry, is probably a more serious issue facing companies in the industry, including Cryo-Cell. However, this is simply a marketing issue and a good marketing team should be able to devise a strategy so as to differentiate a particular company and retain premium pricing. Cryo-Cell, in particular, seems to be taking the lead in this area. For instance, this year the company is adding a new Plureon Stem Cell preservation program, to complement the U-Cord service. This new Plureon program will clearly differentiate the company and allow for some pricing power long term. It is also instructive to read Cryo-Cell's cord blood comparison chart to see the various marketing lingo available to the company to support premium pricing in the years ahead. The chart can be found by clicking here. Interestingly, Cryo-Cell's prices are still lower than competitors, which implies that the company is not generating as much revenue as it could.

The bottom-line is that the cord blood banking industry is attractive longer-term and there are clearly ample opportunities for Cryo-Cell to compete effectively and grow revenues and profits significantly over the coming years.  If industry conditions do not provide us with a reason to  consider selling the stock, what else can be wrong here?

Cryo-Cell's Dirty Laundry: Revenue Sharing Agreements
Without delving into Cryo-Cell's storied and corrupt history, since that is already in the past, current investors still need to be aware that past management and the current CEO retain one ludicrous and unethical relic: Revenue Sharing Agreements.

From the company's 10-K: "The Company has entered into Revenue Sharing Agreements (“RSAs”) with various parties whereby these parties contracted with the Company for a percentage of future storage revenues the Company generates from clients in specific geographical areas. The parties typically pay the Company a non-refundable up-front fee for the rights to these future payments."

So basically, as Cryo-Cell's revenue grows the company will continue to pay higher and higher fees to RSA partners, limiting the cash-flow available to shareholders. For instance in the last year, revenues at Cryo-Cell grew by 18% and interest expense (how the company artfully refers to its RSA payments), grew by 15%. The RSA expense also removed almost $0.04 per share from earnings. The company's effective interest rate on its RSA "debt" is a mind-boggling 23%!

For our perspective, the RSA issue at Cryo-Cell is very troublesome and remains the one true negative surrounding the company. Why would an investor want to invest in a company whose "interest" rate and expenses will keep increasing year over year, eliminating profits that would otherwise flow to sharehoders?

The unwillingness of the current CEO, Mercedes Walton, to renegotiate these agreements (which are quite easy to restructure), appears to prove that either she is incompetent as a CEO and/or she is involved in some way with the third-parties who are receiving payments from Cryo-Cell for the RSA agreements.  On our end, we have faxed and emailed Ms. Mercedes Walton several times to kindly ask for an explanation of these agreements and her unwillingness to renegotiate them. Not surprisingly, we have never received a decent response from Ms. Mercedes Walton, indicating quite clearly that despite the talk, she is clearly not at all interested in shareholder value. We urge all investors in Cryo-Cell to fax and email Ms. Mercedes Walton and demand that these agreements be renegotiated. The fax number is listed on Cryo-Cell's website or you can call the company at:  800-786-7235

Cryo-Cell's Low Valuation Could Attract Activists

Given the issue with the RSA agreements, and a CEO hell bent on keeping Cryo-Cell's stock price down, it is reasonable to ask why we don't just sell our shares and move on.  The reason is simply because Cryo-Cell's valuation is extremely attractive at current levels and we hold out some hope that dissident and activist shareholders will soon be sucessful in removing the current CEO and takeing the proper actions to increase shareholder value.

The current CEO controls a mere 3.4% of the outstanding shares, while some Florida investors controls over 5%. These investors continue to buy shares on the open market and have already let the CEO know of their dissastification with her management of the company. We think it is only a matter of time before other shareholders wake up and demand the removal of the current CEO.

With a more shareholder-friendly CEO in charge, we think the company's value would increase dramatically. By our estimation, the company currently throws off at least $4 million a year in free cash-flow (nearly $5 million when you remove the RSA's), a number which could increase dramatically over the coming years as cord blood banking goes mainstream and the company is operated more efficiently. In addition, the company has nearly $9 million in cash or $0.70 per share.

At its current price of $3.34, Cryo-Cell is valued at about $30 million (12.2 million shares outstanding*stock price minus cash). This implies a multiple of about 6X Free-Cash Flow or an over 15% free cash-flow yield. Even if you add in some potential dilution from a settlement with RSA holders, we still think the company's Free Cash-Flow Yield is about 13% . We think it is extremely difficult to find growth companies providing this type of free cash-flow yield.

The bottom-line is that we are reluctant to sell our shares of Cryo-Cell at current bargain prices, despite what we believe is an anti-shareholder CEO. Our hope is that in the coming year, as Cryo-Cell begins to show some decent revenue and earnings momentum, more shareholders will become interested in the story, and with a broader shareholder base (including funds) it may become easier to replace management and position the company correctly to reward shareholders in the coming years as cord blood banking goes mainstream. As well, we think Cryo-Cell would make a good acquisition target for ViaCell (VIAC), the largest cord blood banking company in the world. ViaCell's (VIAC) is roughly four times the size of Cryo-Cell, and it would make sense for the company to begin to acquire smaller competitors in order to speed up growth, justify its valuation of over 3X enterprise to sales, and make decent use of its $60 million in cash.

Comments

[One Guy]

Excellent writeup, thanks. I've been thinking more about CCEL as they released earnings this morning, the market has punished them for announcing that they're investing heavily in building market share -- not sure if this will be a buying opportunity or not.

[Cord blood resources]

Good point. There are however a few other things many people should be aware of. Most know that cord blood banks collect, process, test and store the donated umbilical cord blood for the public use, taking into account the great number of people who are diagnosed with life-threatening diseases each year. Therefore, cord blood banks look after expectant mothers, informing them about the importance of their umbilical cord blood and the possibility of helping some people who suffer from terrible diseases. Nevertheless, the information and sensitizing of the population is not fully achieved as in the case of simple blood donation. Cord blood stem cell transplants are considered in order to replace blood marrow transplants. The possibility of finding the match for the patients in need increases, as in 2001 the Institute of Medicine of the National Academies stated that roughly 20,000 American lives were saved through transplants of stem cells. I’ve covered some other aspects related to this topic on my website, Cordbloodhub.com - please let me know if you find them useful.

Regards,

Michael Rad