SQI Diagnostics. Building bridges. Sufficient funds may have been secured. Conversion to revenue-based contract. Celiac test approval in Canada

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1 SQI Diagnostics Building bridges A C$4.2m equity issue may provide the bridge financing that our model indicates could be sufficient for SQI to achieve profitability by the end of This assumes C$1.5m revenues for FY14 increase to C$11.4m in FY15. To this end, the transition of the Global Pharma 1 contract from proof-of-concept into a revenue-generating agreement and Health Canada approval for SQI s celiac test are encouraging developments. We maintain our prior forecasts but adjusting for the capital raise, our valuation rises to C$76m (vs C$7m) although per-share reduces to C$1.35 (vs C$1.45). Year end Revenue (C$m) PBT* (C$m) EPS* (C$) DPS (C$) P/E (x) Yield (%) 09/ (6.2) (0.17) 0.0 N/A N/A 09/ (6.1) (0.15) 0.0 N/A N/A 09/14e 1.5 (4.9) (0.10) 0.0 N/A N/A 09/15e N/A Note: *PBT and EPS are normalised, excluding intangible amortisation, exceptional items and share-based payments. Revenues are risk-adjusted. Sufficient funds may have been secured SQI sold 8.4m units (1 share + 1 warrant) at C$0.50, raising gross proceeds of C$4.2m (C$3.7m net) in a public offering. Assuming significant revenues in FY14 and FY15, our model indicates this could be sufficient to take SQI through to profitability by end The warrants are valid for two years and have an exercise price of C$0.65. The number of shares outstanding is now 56.3m (vs 47.9m), and there are approximately 25.6m warrants and 2.3m share options outstanding. Conversion to revenue-based contract Generating substantial revenues from pharma customers for SQI s multiplexed assay technology is key to the investment case. SQI will now develop a 21-plex protein microarray to support Global Pharma 1 s clinical trials with its test drug, with SQI having previously conducted multiplex anti-drug antibody (ADA) assays to detect/measure immunogenic responses in pre-clinical testing. SQI will receive payments for services and for consumables used. Celiac test approval in Canada Health Canada has approved SQI s 4-plex assay (Ig_plex Celiac DGP Panel) for use in high-throughput clinical laboratories to aid the diagnosis of celiac disease. The panel operates on SQI s semi-automated sqid-x system and validation assays showed a high overall agreement with available predicate tests from AESKU, Bio- Rad and Inova. A 510(k)-based approval from the FDA is expected by H214. Our model assumes two Canadian labs and one US lab adopt SQI s assay by end Price Market cap Net cash (C$m) current estimate (post raise) C$4m equity raise 10 April 2014 C$0.50 C$28m C$1.1/US$ 4.6 Shares in issue 56.3m (post 8.4m new share issue) Free float 86% Code Primary exchange Secondary exchange Share price performance SQD TSX-V N/A % 1m 3m 12m Abs 4.2 (13.8) (45.1) Rel (local) 3.2 (18.6) (52.5) 52-week high/low C$1.03 C$0.41 Business description SQI Diagnostics is a Canadian diagnostics company. It develops and sells multiplexed research diagnostics to pharmaceutical companies to support clinical research, and in vitro diagnostic tests to centralised diagnostic laboratories for diagnosing autoimmune diseases, such as celiac, lupus and vasculitis. Next events Healthcare equipment & services Pharma customer deals 2014 FDA 510(k) approval of celiac test H214 Fiscal Q214 results May 2014 Valuation: Adjusted to C$76m or C$1.35 per share We maintain our prior forecasts but adjusting for the capital raise (8.4m new shares for C$3.7m), our valuation rises to C$76m (vs C$70m), although the per-share amount reduces to C$1.35 (vs C$1.45). The potential removal of SQI s financial overhang is positive, although this assumes our revenue estimates are met. SQI Diagnostics is a research client of Edison Investment Research Limited Analysts Christian Glennie +44 (0) Pooya Hemami Dr Mick Cooper +44 (0) healthcare@edisongroup.com Edison profile page

2 Global Pharma 1 goes commercial The transition of the Global Pharma 1 collaboration (with an unnamed major pharmaceutical company), from the research/validation phase into a revenue-generating agreement, is significant for SQI s commercial and business strategy. These contracts with pharmaceutical companies typically involve an initial validation phase, but once this hurdle is cleared, there is significant potential in SQI establishing an extensive and retained portfolio of business with the pharma company. When developing a new biological drug candidate, pharma/biotech companies need to be able to fully characterise the patient s immune response to the agent. Anti-drug antibodies (ADA) are a key immune response that can neutralise a biological therapeutic and are common when a biological drug is repeatedly given. For Global Pharma 1, SQI successfully developed a series of multiplex ADA assays to detect and measure immunogenic responses to Global Pharma 1 s drug during its pre-clinical development. The extended deal now means SQI will develop a 21-plex protein microarray, based on the prototype, for use in identifying specific immunogenic regions within a specific drug ( epitope mapping ) during Global Pharma 1 s human clinical trials. SQI will receive payments for services and the consumables used. Our forecast model assumes that SQI secures one new client (or converts one existing customer contract onto commercial terms) per quarter from Q114. The amount of work, and revenue received, from each customer will gradually increase, from C$200,000 in the first six months, to C$1.6m per year on a retained basis. Our assumption is that by Q415, SQI will have eight pharma customers, each generating different revenue levels depending on the maturity of those contracts. As a reminder, the status of SQI s existing pharma customer contracts are summarised in Exhibit 1. For confidentiality reasons, these customers often cannot be named, which is fairly typical of contracts in the diagnostics sector. Exhibit 1: Current status of pharma customer contracts Stage of development Product Candidate panel Proof-of-concept Assay development Automation Validation Ready to commercialise Cytokines 8 PLEX (RUO) Heparin Immunogenicity ( HIT ) Assay Global Pharma 1 Global Pharma 2 Isis Pharmaceuticals Global Pharma 3 Source: Company documents, Edison Investment Research IVD portfolio boost Health Canada approval for the Ig_plex Celiac DGP Panel allows SQI to market the diagnostic tool to clinical laboratories in Canada that typically perform high throughput screening tests for multiple autoimmune disorders, including celiac disease. The multiplexed assay provides semi-quantitative determination of the IgG and IgA immunoglobulin classes of DGP (deaminated gliadin peptide) and ttg (anti-tissue transglutaminase) antibodies in a single test, requiring only one human sample. Assessment of these gluten auto-antibodies is a key component of confirming a diagnosis of celiac disease. The panel uses the sqid-x system, a semiautomated diagnostic machine that can process hundreds of patient samples per hour. SQI s validation studies showed high overall agreement between its assay and commercially available predicate methods for detecting the four key analytes, as summarised in Exhibit 2. SQI Diagnostics 10 April

3 Exhibit 2: Ig_plex Celiac DGP Panel overall comparison to predicate tests ttg IgA ttg IgG DGP IgA DGP IgG Positive Agreement 100.0% 97.5% 98.5% 100.0% Negative Agreement 93.6% 88.0% 89.0% 93.6% Overall Agreement 96.9% 95.8% 96.2% 96.9% Source: SQI Diagnostics Indeed, in terms of sensitivity (correct identification of diseased patients) and specificity (correct identification of disease-free patients), Ig_plex was also comparable and often better than the predicate tests (Exhibit 3). Exhibit 3: Ig_plex Celiac DGP Panel sensitivity and specificity versus predicate tests Company Name Sensitivity Specificity ttg IgA ttg IgG DGP IgA DGP IgG ttg IgA ttg IgG DGP IgA DGP IgG AESKU 96.9% 95.2% 76.4% % 85.4%-99.4% 95.0% 95.0% 79.1%-99.1% 71.8%-97.3% Bio-Rad 94.9% 44.2% 87.2% 84.6% 98.8% 95.7% 96.9% 96.9% Inova Diagnostics 94.0% 50.0% 71.4% 89.2% 98.1% 98.4% 100.0% 97.3% SQI 97.9% 55.2% 84.8% 91.1% 99.6% 99.2% 98.9% 97.9% Source: SQI Diagnostics Celiac disease is a common autoimmune disorder triggered by the consumption of the protein gluten, which is found in foods containing wheat, barley or rye. Celiac disease causes an immune reaction in the small intestine, causing damage to the surface of the small intestine and an inability to absorb certain nutrients. The prevalence of celiac disease is estimated at 250,000 people in Canada and over two million people in the US, based on a prevalence rate of 0.71%. 1 Yet the diagnosis rate for celiac disease remains low, at just 15-30% of total estimated affected patients. SQI intends to file the Ig_plex Celiac DGP Panel in other countries, which we assume includes the US, which will use the 510(k) application route, again on the basis of equivalence to existing tests. The data reported by SQI in the validation studies suggest FDA approval should be secured, which we expect to occur by H214. Our forecast model assumes two Canadian labs and one US lab adopts SQI s celiac assay by end In 2015, we estimate that two additional Canadian labs and four new US labs start using SQI s test. In addition to its assay for celiac disease (and for RA, which is approved but not marketed), SQI is building a pipeline of other autoimmune assays, including a quantitative 12-plex panel for lupus, a quantitative 3-plex panel for vasculitis, and an 8-plex panel for Crohn s disease. The status of SQI s in-vitro diagnostics (IVD) portfolio is summarised in Exhibit 4. Exhibit 4: Current status of IVD pipeline Product Stage of development Candidate panel Proof-of-concept Assay development Automation Validation Approval/clearance IgX PLEX RA (qualitative) (1) IgX PLEX RA (quantitative) (2) IgX PLEX Celiac (qualitative) (1) IgX PLEX Celiac (quantitative) (2) Ig_PLEX Celiac DGP (quantitative) Ig_PLEX Vasculitis Ig_PLEX RA (quantitative) on hold Ig_PLEX Lupus on hold (3) Ig_PLEX IBD/Crohn s on hold Source: Company documents. Notes: (1) Approved/cleared in the US and Canada; (2) Approved/cleared in Canada and EU; (3) Restarting H214. On hold means no material expenditure at present, but test is viable for future development. 1 Rubio-Tapia A, et al The prevalence of celiac disease in the United States. Am J Gastroenterol Oct;107 (10): SQI Diagnostics 10 April

4 Valuation We maintain our prior forecasts but adjusting for the capital raise (8.4m new shares for C$3.7m), our valuation rises to C$76m (vs C$70m), although the per-share amount reduces to C$1.35 (vs C$1.45). We value SQI based on a five-year ( ), risk-adjusted, sum-of-the-parts DCF valuation model. This includes a terminal value component (0.5% on 2018 free cash flow) and applies a standard 12.5% discount rate. The key components and assumptions with our model are summarised in Exhibit 5. Approximately two-thirds of value is attributed to the pharma customer business, which assumes consistent and timely execution of existing and new contracts. Exhibit 5: SQI valuation metrics and key assumptions Value driver rnpv rnpv per 2018 sales Key assumptions (C$m) share (C$) (C$m)* Custom pharma contracts (ADA assays) One new customer per quarter; eight customers by end-2015; 20 customers by end-2018; C$25k initial fee; gradual increase revenue per customer (C$200,000 in 1-6 months, to C$1.6m/year as retained basis); 65%-100% sliding scale of probability of success. SQiD equipment x SQiD-X (C$40,000), 2x SQiDlite (C$80,000) and 1x SQiDworks (C$200,000) machines sold in a 12- month period % sliding scale of probability of success. Custom pharma contracts (cytokine assays) plex, 10-plex and 10-plex (Quant) available in Q114, Q314 and Q115, respectively; sliding scale of adoption, after 2 years, 50% will purchase 8-plex, 25% for 10-plex and 20% for 10-plexQ; 70%-100% sliding scale of probability of success. IVD Two new labs/year in Canada; four new labs/year in US; all labs adopt all IVD assays when available: Celiac (Q214; 100% probability), vasculitis (Q314; 65%) and lupus (Q115; 50%). R&D (12.8) (0.23) % sliding scale risk-adjustment. Admin (7.7) (0.14) % sliding scale risk-adjustment. Cash Current estimate, post C$3.7m net raise from sale of 8.4m units (shares/warrants) Terminal value % annual growth on FY18 free cash flow, discounted at 12.5%, net of 30% tax. Valuation m shares outstanding (excludes dilution from warrants). Source: Edison Investment Research. Note: *2018 sales unadjusted. The price and value of each pharma contract may vary significantly, depending on assay complexity and the clinical stage of the subject product. Hence we adopt a base-case approach of one new customer per quarter, generating a sliding-scale of business, and retaining SQI s services for a number of years. Should the rate of new business not materialise as predicted, this would have a negative impact. Our per-share valuation does not include any potential dilution from 25.6m warrants (exercise price range: C$0.65 to C$5.00; expiry range: May 2014 to April 2016) in issue or 2.3m outstanding share options. Sensitivities SQI s technology has gained independent validation through multiple pharma customer contracts and the publication of certain studies (eg Algorithme and BMS). Technical risk therefore appears moderate as the majority of assay targets are clinically accepted, so there should be no problem about gaining regulatory approvals, physician acceptance and reimbursement. Conversely, at this stage, with modest revenues to date, there is reasonable commercial risk in SQI achieving the near-term sales targets we have modelled. The diagnostics field is highly competitive, with a number of large companies able to apply significant resources to promotion and commercialisation activities. The challenge for SQI will be in communicating and convincing customers of the improved accuracy and efficiency of its Ig_PLEX technology. We have assumed a consistent stream of new customers and a timely execution on these contracts, such that any significant delays in uptake could have a negative impact. SQI s pipeline of new customers and new assays looks promising, so delivery on these fronts, particularly over 2014 and 2015, could significantly improve valuations and sentiment. SQI Diagnostics 10 April

5 Financials We estimate SQI ended fiscal Q214 (31 March 2014) with C$0.9m in cash. This follows a C$1.4m (net) private placement in January 2014, through the sale of 2.965m units (one share + one warrant) at $0.50. These warrants have the same exercise price (C$0.65) as the new public offering just completed. Adding the C$3.7m (net) now raised from the sale of 8.4m units (one share + one warrant) indicates an estimated current cash balance of C$4.7m. SQI plans to allocate ~C$1m to finance sales and marketing initiatives, ~C$1m to R&D activities to build an assay menu (key to long-term IVD growth) and diagnostic platforms, ~C$0.5m for the expansion of manufacturing operations, and the remainder to working capital/general corporate purposes. We model risk-adjusted revenues in FY14 and FY15 at C$1.5m and C$11.4m, respectively. This is primarily driven by the pharma customer business, assuming timely execution of existing and prospective contracts. Revenues in FY13 were C$3,000 (vs C$12,000 in FY12). SQI recorded just C$2,000 in revenues in fiscal Q114, so we expect a significant increase for the remainder of the year, particularly in H214. Should these sales be achieved, and if operating expenses do not deviate significantly from our estimates, our model indicates that SQI could achieve profitability by the end of 2015, and without the need for further finance. The company s stated base-case cash burn guidance is C$346,000 per month, and it states that existing cash is sufficient to fund its operations for at least 12 months. Our financial model is summarised in Exhibit 6. SQI Diagnostics 10 April

6 Exhibit 6: Financial summary C$'000s e 2015e 2016e Year end 30 September IFRS IFRS IFRS IFRS IFRS PROFIT & LOSS Revenue ,517 11,448 23,328 Cost of Sales 0 0 (530) (4,007) (8,165) Gross Profit ,441 15,163 Research and development (3,890) (3,858) (3,965) (4,083) (4,206) Corporate and general (2,131) (1,928) (1,654) (1,737) (1,824) Sales and marketing (288) (449) (577) (657) (690) EBITDA (6,734) (6,695) (5,357) 679 8,196 Operating Profit (before GW and except.) (6,198) (6,129) (4,865) 1,097 8,584 Intangible Amortisation (99) (103) (119) (133) (141) Exceptionals/Other Operating Profit (6,297) (6,232) (4,984) 964 8,444 Net Interest Other (25) Profit Before Tax (norm) (6,187) (6,104) (4,852) 1,114 8,620 Profit Before Tax (FRS 3) (6,311) (6,207) (4,971) 981 8,479 Tax Deferred tax Profit After Tax (norm) (6,187) (6,104) (4,852) 1,114 8,620 Profit After Tax (FRS 3) (6,311) (6,207) (4,971) 981 8,479 Average Number of Shares Outstanding (m) EPS - normalised ($) (0.17) (0.15) (0.10) EPS - FRS 3 ($) (0.17) (0.15) (0.10) Dividend per share ($) BALANCE SHEET Fixed Assets 3,322 3,082 2,858 2,705 2,583 Intangible Assets ,092 Tangible Assets 2,637 2,307 1,972 1,714 1,490 Other Current Assets 4,208 1,724 2,766 4,601 13,653 Stocks Debtors Cash 3,818 1,415 1,689 3,569 12,631 Other Current Liabilities (1,018) (454) (724) (724) (724) Creditors (1,018) (454) (724) (724) (724) Short term borrowings Long Term Liabilities Long term borrowings Other long term liabilities Net Assets 6,512 4,352 4,900 6,582 15,512 CASH FLOW Operating Cash Flow (6,692) (5,522) (4,425) 2,276 9,469 Net Interest Tax Capex (432) (429) (387) (397) (407) Acquisitions/disposals Financing 10,091 3,548 5, Dividends Other Net Cash Flow 2,967 (2,403) 274 1,879 9,063 Opening net debt/(cash) (851) (3,818) (1,415) (1,689) (3,569) HP finance leases initiated Exchange rate movements Other Closing net debt/(cash) (3,818) (1,415) (1,689) (3,569) (12,631) Source: SQI accounts, Edison Investment Research. Note: revenues are risk-adjusted. Our model does not include any potential dilution from 25.6m warrants (exercise price range C$0.65 to C$5.00) in issue or 2.3m outstanding share options. SQI Diagnostics 10 April

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