QSI - Quantum-Si: Market Overreaction May Provide An Excellent Entry Point

2023-08-09 22:27:53 ET

Summary

• Quantum-SI released its Q2 2023 earnings report, which showed lower-than-expected revenue and reduced forward guidance.
• The company shelved its carbon product and identified problems with its AI software.
• Despite the market's negative reaction, the company has strong potential in the protein sequencing market and has a solid financial position.

Quantum-Si Inc. ( QSI ) released its Q2 2023 earnings report on Monday, August 7 ^th , and the market did not take it well.

Q2 revenue fell well below expectations at $200K v $400K, and forward guidance was reduced. A key product was shelved, and problems with the AI software were itemized. As a result, the share price dropped precipitously (down 30% on the day), and continued to fall on Tuesday.

I will explain why I believe the market is overreacting to the update and why I am looking for a turning point to buy QSI.

In the FY2022 report , QSI itemized three key objectives for 2023

Our first priority is to commercialize Platinum, Carbon and the 2M chip.

The Carbon product is no longer a priority; management implied it has been shelved for now. Efforts to sell the Platinum (which uses the 2M chip) are increasing with a new sales team and improved sales management.

Our second priority is to lead with innovation.

QSI remains the market leader in this area, first to market, and currently the only protein sequencing tool available. A recent peer-reviewed in Nature was the first published by any company trying to commercialize protein sequencing.

Our third priority is to preserve financial strength.

The flawless balance sheet, reduced expenses during Q2, and the focus on commercialization impressively maintain the balance sheet and preserve the cash runway.

QSI has a first-mover advantage in a huge market with an unmet need for a reliable, low-cost protein sequencing machine. The QSI product made its first sales in Q1 2023, and if QSI can work to resolve issues and feedback, it could quickly scale into an enormously profitable business.

The importance of Proteins

Proteins are a folded string of amino acids and represent most of the molecules in our body (after water). Proteins are responsible for almost every biological function in our body; unlike the genome, the proteome is in constant flux. Proteins function as antibodies, hormones, and enzymes. The complete set of proteins is known as the proteome.

The information in cells begins with DNA encoding, leading to around 20,000 genes known as the genome. More than 90% of the genome is transcribed into RNA, producing more than 100,000 transcriptions that combine to make more than 1 million proteins. The majority of variation within living cells is in the proteome.

In recent years the genome has been sequenced and decoded, giving a greater understanding of the genes and the information they carry. Genomics has allowed genetic variation investigation and led to new drugs and medical advances. So far, the same is not true for proteomics; sequencing proteins has proven technically challenging and expensive.

The proteome is essential in cancer research and has been used to detect the presence of different types of cancer. Biomarkers (a measurable indicator of a medical state) have been found using mass spectrometry. Mass Spectrometry is currently the standard method to study the proteome. In May 2014, a draft map of the human protein was published in Nature that was derived using mass spectrometry.

The complex nature of the proteome has held back research that requires the sensitivity of analysis available with DNA sequencing techniques. A cell can have more than 10,000 proteins and Mass spectrometry requires high protein levels to detect it. Aberrant proteins can exist in tiny quantities that are undetectable by mass spectrometry. A single molecule-based sequencing method can potentially revolutionize protein science and medicine.

QSI's mission is precisely that, and the goal is often repeated in earnings calls

to bring next-generation sequencing to every lab, everywhere

There is currently no high throughput technology (an automated tech) to analyze single proteins. QSI is developing a desktop unit that will explore a protein, work out the sequence of amino acids it contains, and use AI to output relevant information to the research science community.

The Total Addressable Market

Markets and Markets published a research paper in May 2023 estimating the size of the Proteomics market to be $32.4 billion in 2022 and with a 14.6% CAGR $72.9 billion by 2028. The paper focuses on the use of mass spectrometry-based imaging to develop an understanding of the proteome, and it quotes the high cost of instruments and technologies as being the main brake on the growth of the market itself, leading to limited adoption in areas that would lead to novel drug development, vaccines, and diagnostic tools.

QSI's product, with a price tag of $70,000, is significantly less than the $1 million currently required for Mass Spectrometry

Quantum Sci Approach

The long-term goal of QSI is to develop a machine that can sequence all proteins and identify errors in the sequencing code.

QSI has developed a desktop machine based around a silicon chip of their design. The M2 chip is the main component of the device and contains much of its IP.

Simplifying the process, it goes like this

1. The sample is loaded into the device.
2. Proteins are split into peptides (short strings of amino acids).
3. The peptides fall into millions of reaction chambers on the M2 silicon chip.
4. A mixture of chemical recognizers is added to the reaction chambers, binding to certain Amino Acid strings.
5. Lasers are fired at the luminescent recognizers, and light measurements are taken.
6. The software uses light measurements to determine the nature of the protein.

Recognizers

The development of the recognizers is a key part of the IP; they are short-lived fluorescent molecules that bind to particular sequences of amino acids and single molecules, the silicon chip measures the fluorescence in several ways and the information leads to a thorough understanding of which protein is present.

The development of the receptors and the software's ability to determine what is present based on the fluorescence is crucial; when the Nature article was published (October 2022), it said

Recognizers for new amino acids or PTMs can be evolved from current recognizers or identified in screens of other scaffolds, such as other types of NAA- or PTM-binding proteins or aptamers. Extension to detection of all 20 natural amino acids and multiple PTMs is feasible for de novo sequencing; however, partial sequences are sufficient for most proteomics applications, which rely on mapping to predefined sets of candidate proteins

(Source: The Nature article white paper)

The white paper is the only peer-reviewed article published by any company investigating this technology (QSI earnings call FY 2022).

Q4 2022 earnings call expanded on the current state of the recognizers

accelerated our product development efforts and successfully demonstrated the ability to recognize 15 out of the 20 amino acids. This represents a path to more than 70% coverage of the Human Proteome identification of up to 90% of proteins,

(QSI: Earnings call Q4 2022 Transcript , 2023-3-6)

Currently, QSI can detect 75% of amino acids and the software can use that recognition to identify 90% of the human proteome. It represents a significant advance on what is available in the market.

The M2 Sequencing chip

The semiconductor is the heart of the technology and is produced in a standard fab. The chip, designed to analyze millions of chambers in parallel, one molecule at a time, controls the laser and the sensors that detect emitted photons. It is impossible to amplify proteins, so the chip's single-molecule sensitivity is crucial.

In November 2021, QSI acquired Majelac Technologies LLC (1022 FY 10K), a semiconductor packaging company in Pennsylvania. The chip is a consumable in this device and will be a part of future consumable sales along with the recognizers.

They are the first company (I could find) that has successfully enabled NGPS (next-generation protein sequencing), allowing for the identification of proteins that will unlock new research areas in some of the most important medical fields, including cancer and immunology.

The people

These small disruptive tech companies all have a compelling story, a great idea that will serve a large market. In my view, the story is not enough to invest, the science is one thing, but the ability to commercialize that idea is quite another. In my trading plan, commercial revenue is a crucial differentiator. Once a company has actual sales, I consider its technology validated, giving it a significantly higher chance of success.

In QSI's case, commercial validation arrived in Q1 2023 with a small number of sales of its Platinum device (3 units, I estimate). These units were all placed with academic research institutions representing the most significant part of the QSI sales funnel. The small number of units and the nature of the purchasers has me classifying them as early adopters rather than commercial customers; they are testing the technology to see what it can offer rather than using it in commercial operations.

The ability of the management team to fully utilize these early adopters and their findings regarding the product will be a crucial element in the success of this company. In the Q2 earnings call, we heard about some initial feedback from the early adopters, which were not all positive. The software did not deliver the insights the researchers sought, and the wide variety of sample types, preparation techniques, and sample concentrations caused issues.

Can the management negotiate these issues and use the feedback positively to develop QSI and its products?

Firstly who are they?

CEO Jeff Hawkins

Before joining QSI, Jeff was CEO of Truvian Sciences. Truvian has developed a desktop blood testing device shown in July to be comparable with laboratory blood testing services. Jeff led Truvian during the development of the device, leaving just before the product went to final testing and an FDA application, as the article says the testing was successful. (He also notably said that Theranos was science fiction, not science ).

President Patrick Schneider

Patrick was with MilliporeSigma for more than eight years before joining QSI. MilliporeSigma is a life science company that Merck & Co (MRK) owns. Patrick was responsible for business strategy, partnerships, and M&A activity.

These two guys together give me enormous confidence that QSI has the people with the right blend of qualities to manage QSI through this early adopter phase and move it toward commercial success over the next 12-18 months.

Poor results reduced guidance.

The Products

QSI is developing a protein discovery platform; before Q2, they had said it would consist of three elements (Carbon, Platinum, and Software).

The rationale for Carbon was convincing,

Carbon is an automated sample preparation device due for release in 2023. I thought Carbon would be an essential device increasing the potential customer pool for QSI. Sample prep is manual, complicated, and requires highly trained staff with specific skills and knowledge. People with these skills are in high demand and carry high salaries. During the Q2 earnings call, the CEO explained that the early adopters had experienced problems integrating Platinum into their workflow and that a change was needed in the R&D strategies of QSI; he said QSI ....

had gaps in terms of addressing the full scope and complexity of the proteomics workflow.

The CEO said that Carbon may not be the best long-term solution, and QSI were now working on aligning their Platinum device with commercially available liquid handling platforms and sample prep chemistry that may be an equal or better fit for customers.

Carbon was put on hold in the Q2 2023 earnings release, which resulted in reduced guidance. I assumed each sale would likely be one Carbon and one Platinum in the early days.

Platinum:

The flagship product is designed to allow single molecule detection and next-generation protein sequencing traditionally performed on mass spectrometry devices costing as much as $1,000,000. The Platinum retails for $70,000, and the protein sequencing unit received its first sales in Q1 2023.

I estimate that QSI sold three devices in Q1 and two in Q2. Revenue came in below expectation because we were told QSI had two orders for Europe that had not been shipped due to import/export paperwork and would be shipped in Q2. It is possible that no sales were made in Q2 if the revenue booked was the two delayed devices from Q1.

Quantum-Si Cloud:

Software is a key tool that uses the information gathered from Platinum to identify proteins and post-translational modifications that impact its location and function within a cell.

Early adopters have found the software to perform below their expectations, with the CEO commenting.

Early customer feedback identified a set of software features that were important for customers to efficiently analyze and interpret their experimental data.

Management discussed in the Q2 earnings call how they have re-distributed R&D towards improving the software. An update was published in July that management said has been positively received and is a better fit with what the users need.

The purpose of the QSI concept is to deliver the information researchers need to understand the proteins in the sample they are looking at. One element of that is the Platinum device capturing the data from the sample; the other is the software interpreting this data into a form usable by the researcher.

Ongoing R&D will be required to improve this and so far; the information from management is positive. They are responding quickly to customer requests, changing the focus of R&D, and delivering the changes required. Maintaining good relations with the early adopters will be a crucial element of QSI fulfilling its goal of having a platinum device in every lab globally.

The Financials

QSI has a near-flawless balance sheet with zero debt and a cash runway well into 2026. With sales already beginning and a marketing ramp up planned, things look very promising.

A key part of my trading plan is to build a three-statement model of a company and use it to track its progress and, when I have enough data, produce a fair value calculation. In Q1 2023, QSI reported its first sales, and although it declined to give any proper guidance, the earnings call contained many of their thoughts.

Below are some key line items from the model written before the Q2 results. I had forecast revenue of $ 0.6 million in Q2, some 50% higher than the street forecast, with a gross margin of 48%, and all other costs flat Q on Q for the year. (green text actual data, blue text author forecast, black text calculation)

This initial forecast was based on information gleaned from the Q1 earnings call. The revenue forecast included the deferred revenue of $0.2 to Europe and new deals in line with Q1 (so $0.2+$0.4). Q2 was a big miss, and guidance for the remainder of the year was reduced. The Carbon device has effectively been shelved and will not provide the Q4 bump expected.

The screenshot below shows the updated model with the Q2 data replacing the projected. My forecast revenue for FY 2023 has fallen from $2.8 million to $0.99 million. Margins dropped from 48% to 38%.

I will update the model each quarter, and the forecasts will become more accurate as I do. Future articles will contain the updates.

Conclusion

Shares fell over 30% following the Q2 results and continue to fall. Revenue missed by 50% margins came in well below expectations. Carbon was removed from sale, and problems with software were identified.

It sounds terrible, but if, as management suggests, Carbon was unlikely to sell due to the customer's workflow, then there was little point in bringing it to market or spending any further money to develop it.

The early adopters highlighted Software issues, and quickly redeploying staff resolved these issues.

The changes led to a significant drop in R&D expenditure, down $2.4 million from Q1 2023, and a smaller drop in SG&A despite increasing marketing efforts, which speaks to solid cash preservation strategies.

The management has the experience to navigate this early revenue / early adopter phase and their actions in moving quickly to refocus the R&D in light of customer feedback, delivering a software update in July, and stopping development of the carbon product in favor of integrating the Platinum device with current workflows will aid the future sales of Platinum which was always going to be the make or break product.

The market is huge, QSI has the first product available at a lower cost and all evidence suggests it works well and is accurate. It is not yet the final version but QSI are moving quickly to give researchers the output they want and need.

I did have two positions in QSI, one from just after the Q1 report at $1.58 and the other last week at $3.10 when I was expecting an earnings beat. The two positions closed for a small aggregate loss when the share price gapped lower at the market open Monday, August 7th.

I will buy again when I think the current drop is complete and update in the comments when I do.

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