By Brian Marckx, CFA

Q4 Results

Interleukin Genetics (ILIU) reported financial results for the fourth quarter ending December 31, 2012 on March 28th. Revenue again came in relatively soft and below our number, yet net income / EPS actually came in better than our estimate as a result of ILIU's ever stringent cost control measures which have significantly trimmed operating expenses. Management noted on the call that revenue may have been impacted by Amway launching a new weight management program which includes ILIU's weight management test within a bundled weight loss product, thereby potentially negatively affecting sales of the weight management test through their partner stores.

Revenue

Q4 revenue of $339k was down 41% yoy, down 19% sequentially and about 51% less than our $689k estimate. As noted, the relative softness in revenue was attributed to Amway's new bundled weight loss product. As we've noted in the past, we view ILIU's pipeline, particularly their PST and osteoarthritis tests, as the major catalysts for long-term revenue growth of the company and, as such, the relative weakness in revenue from the current suite of products is less meaningful from a mid-to-long term investment perspective.

GM / Operating Expenses / EPS

GM was 15% versus our 49% estimate. The difference, also directly attributable to the softness in revenue and the fixed-cost portion of COGS. Relative to operating expenses, management continues to do a great job of wringing out costs with operating expenses coming in well below where we estimated them the last three straight quarters. In Q4 operating expenses were $1.1 million, down 15% sequentially and significantly lower than our $1.6 million estimate. Net loss and EPS were $1.2 million and ($0.03), ahead of our $1.4 million (loss) and ($0.04) estimates despite the lower than estimated revenue.

Cash

During Q4 ILIU was able to extend the maturity of the $14.3 million (fully-tapped) Pyxis credit facility from November 30, 2012 to March 31, 2014. And as a reminder, in June 2012 ILIU raised $3 million (gross, $2.7 million net) in financing from the sale of convertible preferred stock to Delta Dental.

Cash used in operations in Q4 and for the full-year 2012 were $1.3 million and $4.5 million. We ballpark estimated cash burn of about $1 million/quarter in 2013, which should decrease upon commercialization of the PST test (early 2014?). ILIU exited 2012 with $1.2 million in cash and equivalents. Management expects to raise additional operating capital (equity or debt) in the very near term.

Product Update

We think management remains intently focused not only near-term commercialization of their late-stage pipeline but also on reviving the recent lagging sales of their weight management test. While the main and most important focus right now is to get the PST test commercialized and supported by dental insurance reimbursement, the osteoarthritis test which could have enormous potential, particularly (at least initially) as a companion diagnostic in drug development clinical trials, could be next in-line as a revenue driver for ILIU.

> Weight Management Test: per the agreement signed last year with Amway Europe, the test will be available in certain parts of Europe beginning in 2013. ILIU will receive a royalty for each test sold. Relative to the Amway (U.S.) bundled weight loss product, while it's currently unknown how this may affect sales going forward, management made it clear on the call that they believe there is real potential opportunity to revive growth of the weight management test (and the other Inherent Health products) during 2013 and beyond.

> Osteoarthritis Test: the game plan continues to be to collaborate with a partner to bring the test to market. A paper with findings of the company's (in collaboration with Univ of North Carolina) 1,154-patient study validating the test as a predictor of progression of knee osteoarthritis was submitted for publication. Following publication ILIU will seek to partner. The test could have enormous potential value as a companion diagnostic in enrollment selection of clinical studies for the development of drugs to treat osteoarthritis, currently a huge unmet need.

> Periodontal Disease Test (PST): As a reminder, positive top-line clinical trial data of their PST test was released in early August 2012 (see our Investor Note below). ILIU just recently penned the initial agreement with Renaissance Health Service Corp (RHSC) relative to reimbursement of the test. The dental plans covering the PST test will reimburse for one cleaning per year as standard or two cleanings if the PST test determines the patient is at high risk of periodontal disease. A manuscript has been submitted for publication in a peer-reviewed journal - a prerequisite for RHSC's affiliates (Delta Dental) to begin marketing dental plans that cover the PST test is that the article must be accepted by May 31, 2013. While there's essentially no insight into if or when the article may be accepted or published, clearly the hope is that it will happen in the near-term. The next steps involve Delta Dental putting together the marketing material and selling the plans for plan periods beginning Jan 2014 to their customer bases (which initially covers 8 states). If all goes well, the Delta Dental plans incorporating the PST test will be finalized and plan participants will be notified by mid-to-late next year for those policies that renew in early 2014. ILIU noted that they are already preparing for the roll-out which included hiring a Chief Marketing Officer in January to spearhead the launch and increased processing throughput of their lab to handle the anticipated increase in demand.

Initial Agreement With Renaissance Health

Interleukin penned an initial agreement with Renaissance Health Service Corp (RHSC) relative to reimbursement of the company's PST test. The publicly released portions of the agreement, filed in an 8K on 3/1/13, outlines in somewhat general terms the nature of the guaranteed pricing provisions that ILIU will provide for processing of the tests, which are dependent on RHSC hitting certain milestones relative to rolling out appropriate dental plans covering the test.

In particular, ILIU will process the PST tests at a fixed price (not disclosed) for RHSC's affiliates and in the event that ILIU offers the test to other parties for a lower price, this lower price will also be applicable to processing of RHSC affiliates' tests for the 3-year term (through 2/25/2016) of the agreement. Milestones that RHSC must meet for this pricing arrangement to remain in place are that 1) their affiliates must develop and offer dental plans that reimburses for the PST test and which a "significant portion" of the affiliate's customers are eligible for and 2) prior to a specified date (not disclosed), RHSC's affiliates must have sold policies for these dental plans for the year beginning 1/1/2014.

ILIU notes in the filing that since timing of the launch of these dental plans is highly uncertain, that they do not expect any significant revenues from this agreement until at least Q1 2014 and potentially substantially later. This is largely in-line with our prior and current expectations and reflected in our assumptions in our financial model for ILIU. And while the agreement probably provides somewhat substantial wiggle-room as far as timing of the launch of the dental plans (notwithstanding the milestones), we view consummation of this agreement as clear positive as it marks the most tangible step towards tying the PST test to dental insurance reimbursement. Given that the PST test is what we expect to be a major catalyst to ILIU's long-term revenue growth (assuming reimbursed by insurance), this is a meaningful event.

OUTLOOK / RECOMMENDATION

We think it's likely that ILIU's suite of currently commercialized products will experience only flat to moderately positive sales growth, which is unchanged from our recent previous assumptions and that the major future growth driver of the company lies with its PST test (and potentially other pipeline tests including their osteoarthritis test).

We continue to model only modest revenue growth until after substantial commercialization of the reimbursable PST test (we model to start in 2014). We look for revenue and EPS of $2.1 million / ($0.10) and $9.0 million / ($0.03) in 2013 and 2014, respectively. We are maintaining our $1.30 price target and Outperform rating.

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