So CTI Molecular Imaging, a Knoxville-based provider of PET (positron emission tomography) scan machinery, the scientific cutting edge, ought to be able to tell us about its future. But it can’t.

Here’s the problem: What’s “there” isn’t going to be “there” long. Just ahead, CTI is planning an act of commercial self-immolation, and the phoenix arising from the resulting ashes—well, its form resides somewhere out there in an as-yet-unknown science. CTI is in the process of transforming itself, just when its main product, the ECAT line of PET/CT scanners, moves from the laboratory into mainstream medical acceptance.

Here’s the deal. In the next few years, CTI expects to sell its manufacturing division—the right to make PET/CT scanners. Currently, CTI owns that business in a 50.1/49.9% split with Siemens, the German electrical giant that has a large worldwide presence in the medical device market. Siemens invested early in CTI’s commercialization of the PET scan and has always been a selling agent for the completed machines. Currently, CTI reports all of the division’s revenue as its own, but includes only its share of profits on the bottom line.

That will change. Once CTI has sold a specified cumulative number of machines, a put/call feature will be triggered, and negotiations could begin for Siemens to acquire the division that now accounts for 60% of company sales. The target number of machines for fiscal 2004 was 1,055—852 had been sold by year-end. CTI thinks it might reach the target, which rises by 74 per year, late in fiscal 2006.

To some investors, the Siemens put/call is the financial pot of gold, a base level of value that provides an underpinning to a weak stock price. Unfortunately, CTI investors have needed some kind of underpinning because the news out of CTI since its June 2002 initial public offering at $17/share has not been that great. Sales of imaging scanners fell 13% in 2004, and CTI’s share price slipped to $7.50 by October. Just when it seemed that everyone who needed a $1.6 million scanner already had one—and after a string of five out of six quarters with earnings below expectations—the company in Novem- ber posted a strong fourth quarter, said it expects to sell 175 scanners in 2005 versus 155 last year, and raised guidance for 2005. Its share price doubled to a recent $14.50.

The PET/CT scan market seems to have followed a predictable sales cycle: tentative early sales, as no one seems to know what to do with the machines, rapid run-up when the machines seem indispensable, then a flat-line or decline when the market is saturated. All this happened in a compressed five years.

Long available for research in universities, PET scanners entered the retail market when one indication—a particular form of lung cancer—was included in the Omnibus Health Reform Bill of 1998. That executive fiat—it didn’t come from the medical community—meant that Medicare would reimburse the health industry for the procedure. Once Medicare begins reimbursing, private payers pretty much have to follow suit. The rate per procedure was high—$2,500 a pop, which made it relatively easy for CTI to sell the machines. Even at relatively low usage—three or four daily iterations of the 15 minute procedure—investors would break even. Since 1998, many more cancer indications have been approved, though problematically, PET scans are being performed for only 20% of all indicated conditions in the United States, and lower elsewhere.

In 2005, a new indication for Alzheimer’s will go into effect. Like the first cancer approval, it covers only a small subset of the entire Alzheimer’s population, but Ronald Nutt, CEO and progenitor of CTI, thinks a similar broadening over time will occur in the Alzheimer’s field, even though the first procedure hasn’t been paid for.

That’s all good. At the moment, however, there are enough PET scanners to perform all the prescribed procedures.

As a science, PET is nothing short of amazing. Unlike most imaging methods, PET doesn’t create a direct image of what’s there. Instead, it captures a reaction to a radioactive substance. The patient ingests a radioactive fluid. Wherever the fluid encounters a biologic process, it sets off positrons, flying in opposite reactions. The computer picks these up and checks them against an algorithm—if they aren’t flying in opposite directions within a few nanoseconds of each other, they are discarded as noise. If they pass the test, the computer records them as evidence of biologic process—like a cancer, which may not yet have achieved the size of a tumor. So they provide a real advantage over other imaging techniques because they focus on biology, not bones and not soft tissue.

Unfortunately, with a PET scan it isn’t always easy to place the tumor exact location in the body. After all, PET scans don’t picture the bones that provide a visual gridwork like other types of medical images. That’s why PET scans have recently incorporated CT scans as well. The CT scans provide a computer-assisted, 3-D X-ray of the body, available in slices—the more traditional type of image that docs expect.

For a device-maker like CTI, the PET/CT machines are mixed blessings. On the one hand, they have significantly upped the price of machines. As a result, CTI has been able to offset falling sales numbers by focusing on increasing dollar volume. On the other hand, because machines are more expensive, they have become a harder sell, with entrepreneurs needing more scans per day to make them profitable.

CTI is quick to jump on the higher price as a reason to explain the slowdown in sales—the sales cycle takes longer, they say. CTI also has recently folded its sales force into Siemens’ competing effort. When the two were consolidated, Siemens and CTI discovered they were both counting on the same sales, so when added together, they came up short. Bear Stearns analyst Rick Wise credits the CTI-Siemens sales re-alignment with scanners’ recent pricing stability, a 200 basis point increase in operating margins, and an expected five cents a share cut in 2005 operating expenses.

To improve sales, CTI needs a better market: doctors must prescribe more procedures. Mark Rhoads, a former CTI division president who’s now an industry consultant, says docs don’t fully understand the new procedure, partly because the pure PET scans need a radiological specialist to read them. He also cites the high cost of scans, which can be a hindrance for older patients with poor prognoses.

Nutt largely agrees with the analysis but sees lower costs as a natural progression: high initial rates are necessary to get machines in the marketplace, then the market can tolerate lower fees once the usage rates begin to climb. Still, the low 20% penetration of existing scans is a problem, and cost cannot be ignored as a factor. High reimbursement rates got the machines out there, available for consumers, but those same rates now keep some dollar-conscious docs from ordering the tests.

All of this talk, of course, is about the machines, which will remain the focus of CTI for the next few years. But possibly only that long. After that, the whole machine problem belongs to Siemens, and the question becomes: What’s left for CTI?

At the moment, CTI’s other major division is radiological. It supplies the radioactive substances clients ingest just before the scans. The solution, called FDG, has a half-life of two hours, so a centrifuge used to manufacture it must be located close to the scanning site—FedExing the stuff isn’t an option. CTI has established relationships around the country to do this. To be sure, this is big business, though CTI’s margins are higher in the detector material it sells that allow scanners to find biomarkers. In November, Medicare cut its reimbursement to hospitals that purchase FDG to $220 per-dose from $324. To be an exciting business, new applications for PET and FDG—such as recently added cervical cancer and Alzheimer’s—must be found.

For CEO Nutt, the future of CTI lies in the new medicine that knowledge of the human genome will begin. Having mapped the human genome, the future of medicine, he believes, is molecular. For example, the gene for breast cancer is well-known, and, unfortunately, if your DNA shows you have it, that means you are susceptible to the disease. At some point, we may be able to alter the gene, but we are also concerned, in the meantime, whether or not the gene is expressed—whether the DNA is creating the proteins that will create breast cancer. To track that, medicine must develop a biomarker, something that will interact with the specific gene and then register on the PET scanner. The market for this is large, though the science isn’t there yet. At the moment, CTI is working with the major pharma companies to develop it.

In much the same way, CTI has bought a number of small companies that take the knowledge conferred by a PET scan and apply it in specific fields. Miranda develops software to aid drug development, and Concord Micro is used to apply PET scans to small animals, again to further drug development. Molecular Tech Inc. is a research arm in the aforementioned biomarker arena that probes the pathways of disease.

This is the future for CTI: developing both new biomarkers that will make thePET/CT scan the basic tool of genomic medicine and new machines that will help interpret and use the PET/CT scans for a better understanding of illness—in the lab and in the hospital. In other words, CTI’s future remains with PET scans, but in the area around the machines rather than the machines themselves.

It’s an interesting scenario. It might work, and work huge. But it’s off in the future and unproven. In the meantime, CTI investors face recently improved earnings and a growing scanner pipeline. And the probable sale of this core business for an unknown price.

Business Essentials

Company: CTI Molecular Imaging

Symbol: CTMI (NASDAQ)

Operations:
Makes PET and PET/CT scanning machines, biomarkers and detector materials used to detect and treat cancer, cardiac disease and neurological disorders. Owns 50.1% of main PET machine unit.

Headquarters: Knoxville

Top Management:
Chairman • Terry Douglas
CEO • Ronald Nutt
CFO • David Gill

Largest Shareholders: (2004 proxy statement)
Terry Douglas - 7.3 million shares, or 16.3%
Capital Group Cos - 4.7 million shares, or 9.6%
Ronald Nutt - 3.5 million, or 7.8%

Revenue:
2004 • $401.7 million
2003 • $362.3 million
2002 • $258.4 million

Net Income (loss):
2004 • $18.6 million, or 40 cents a share
2003 • $20.6 million, or 44 cents a share
2002 • ($3.4 million), or (25 cents) a share

Price/Earnings Ratio: 35

Market Capitalization:$645 million (on Jan. 3, 2005)

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