Major Milestone for Chembio (CEMI)

DPP HIV 1/2 Screen Approved in Brazil

Yesterday in an 8-K filing, Chembio Diagnostics, Inc. (CEMI) announced that it had been notified that Bio-Manguinhos (FIOCRUZ) had received approval from Brazil’s National Health Surveillance Agency to market Chembio’s DPP HIV 1/2 screening assay. The test will be used in the Brazilian public health market and is approved for used with oral fluid, blood and serum.

While delayed from management’s initial expectations, this approval actually comes slightly ahead of our updated forecast. The approval will trigger $400k in technology transfer fees to Chembio, payable by the end of the third quarter 2010.

This approval is a major milestone for Chembio. Per the terms of the technology transfer agreement, FIOCRUZ is required to purchase a minimum of $10 million worth of product from Chembio before rights to the assay are transferred to FIOCRUZ. FIOCRUZ will then pay Chembio a 4% royalty on sales of the product.

We stress, however, that this $10 million is only the minimum amount that FIOCRUZ is required to purchase. Under the “2004 Technology Transfer” agreement (relating to Chembio’s lateral flow HIV tests) FIOCRUZ was only obligated to purchase approximately $2 million worth of product before rights were transferred. At that point, the royalty phase commenced. Since inception of the 2004 agreement, FIOCRUZ has paid Chembio almost $8 million relating to the HIV lateral flow tests (product plus royalties).

In total, FIOCRUZ will be required to purchase approximately $12 million worth of product from Chembio relating to the four recent technology transfer agreements (covering the DPP HIV 1/2 screen, DPP multiplex HIV confirmation, DPP leishmania and DPP leptospirosis). We expect FIOCRUZ/Chembio to receive Brazilian regulatory approval for the DPP multiplex HIV confirmation test and the DPP leishmania test by the end of the third quarter of this year and the leptospirosis by year-end. This will trigger an additional $605k in technology transfer fees.

We expect product purchases from FIOCRUZ to average approximately $2.8 million over the next five years relating to these agreements, with about 80% of that total related to the DPP HIV 1/2 test that just received Brazilian regulatory approval. We estimate the 4% royalty phase (over the following 5 years) to generate approximately $110k in annual revenue for Chembio. Based on FIOCRUZ’s purchase history related to the HIV lateral flow tests, our sales estimates to FIOCRUZ for the DPP tests could ultimately prove to be conservative.

Bio-Rad Multiplex Product Development Phase Completed

Chembio also announced that Bio-Rad completed the development phase of the multiplex product that Bio-Rad is developing using the DPP technology. This allows Chembio to recognize the $340k as revenue in the second quarter. This had been previously paid by Bio-Rad and was carried as deferred revenue by Chembio.

Bio-Rad also exercised their option to manufacture the product. By exercising this option, Bio-Rad is obligated to make payments up to $275k to Chembio structured as: $125k due 30 days from option exercise date (i.e. – 7/25/2010), $75k due when Bio-Rad makes the test available for clinical evaluation and $75k due one year after the test is made available for clinical evaluation. The option exercise also dictates that Bio-Rad will pay Chembio 7% sales royalties.

Our current timeline is for the test to be made available for clinical evaluations late in the third quarter of this year. We also believe the test could receive CE Marking around the middle of 2011 and possibly FDA approval by the end of that same year.

Our expectations are that this yet-to-be disclosed multiplex product will be relatively small. We believe Chembio’s motivation for the agreement with Bio-Rad has more to do with validation of the DPP technology than it does with the moderate amount of income that Chembio is likely to receive from it. Therefore, the recent news that development has been completed and that progress is being made towards commercialization is likely worth more to Chembio than are these milestone payments (and eventually royalties) from Bio-Rad.

Valuation

We are maintaining our Outperform rating of Chembio Diagnostics with an Outperform rating. Based on the potential for the DPP product portfolio to significantly ramp long-term revenue, cash flow and earnings, we feel the company is grossly undervalued.

Average valuation for competitors in the rapid diagnostic testing space is 2.2x estimated 2011 revenue. Given that we estimate Chembio’s revenue growth rate will only begin to show significant acceleration beginning in late-2011 (following the DPP HIV and syphilis launch) and vastly outpace that of its competitors for the foreseeable future afterwards, we believe Chembio’s shares should trade at a significant premium. Our near-term price target of $0.90 is based on 3x our estimated 2011 revenue of $18.8 million.

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