Not Your Father's Diagnostics: Ram Selvaraju on How Molecular Genomics Invigorate the Sector

Source: George S. Mack of The Life Sciences Report (12/5/13)
An old investment principle says the equity upside of diagnostics and tools companies can’t hold a candle to that of small biotech drug developers. Managing Director and Head of Equity Healthcare Research Raghuram “Ram” Selvaraju of Aegis Capital begs to differ. His research has uncovered small- and micro-cap companies developing sophisticated platforms in the molecular diagnostics space that are destined for significant revenue growth and profits. In his first of three interviews with The Life Sciences Report, Selvaraju lays out a handful of names with powerful technologies on the cusp of investor acceptance as huge growth plays.
The Life Sciences Report: Ram, I want to address the differences between new drug development in small companies and development of diagnostic technology in small companies. It’s clearly very difficult for a biotech company to get off the ground. Do you see advantages in investing in diagnostics versus micro-cap, early-stage drug development?
Raghuram Selvaraju: That is a very good question. There are advantages and disadvantages, as you will find when you compare any one sector to another. When we published our Healthcare Sector Update Preview earlier this year, we specifically drew investors’ attention to several factors, including the advent of the Patient Protection and Affordable Care Act, the additional data being parsed out of the human genome, the advent of next-generation sequencing becoming widely available, and more knowledge about mutations that are specifically associated with cancer, the prognosis of the disease and the likelihood of response to specific types of therapeutic regimens. With all of this together, you have the ingredients for a sea change in the molecular diagnostics space.
TLSR: So all these factors represent a material change in the diagnostics industry?
RS: Yes. In the past, diagnostics was considered a relatively humdrum subsegment of the healthcare sector. Most of the companies that played in it were primarily focused on selling high-volume, low-margin tests. That has changed relatively rapidly over the course of the past 10 years or so. Molecular diagnostics and high-content molecular diagnostic tests have become available—tests that actually guide therapy and provide value-added information regarding a patient’s prognosis, specifically in the oncology domain, but also for a wide array of other therapeutic areas.
What’s particularly interesting about this diagnostics world is that you can get a product approved through the U.S. Food and Drug Administration (FDA), but that is not the only way in which you can achieve commercial penetration. Many companies today sell a wide range of what are called laboratory-developed tests, which are regulated and certified under the Clinical Laboratory Improvement Amendments (CLIA) program. These in vitro tests are created and utilized by a single lab with a CLIA certificate for that specific test. Instead of being subject to direct FDA regulation, they are sold through CLIA-compliant facilities; the compliance with CLIA is what serves as the regulation for the test. These molecular diagnostics companies are, by definition, more risk-mitigated than biotech and pharmaceutical companies because they don’t have regulatory risk per se. The regulatory risk is in the facility, not in any specific test. As long as your facility passes muster, you can sell tests out of that facility.
In addition, molecular diagnostics companies are generating revenue from more sources than ever before. Today they derive revenue not just from sales to pathologists and hospitals, but also via collaborations with pharmaceutical companies in the development of so-called “theranostic” solutions. These approaches couple a molecular diagnostic test—a companion diagnostic if you will—with a corresponding targeted therapy that is aimed specifically at a subpopulation of patients within a particular disease area.
Because of these factors we think that, now more than ever, the molecular diagnostics space is particularly attractive to investors. It’s always been more risk-mitigated than the pharmaceutical/biotech space, simply by its nature, but margins are not as high as for a biotech or pharmaceutical product. Diagnostics represent a standard less-risk, less-reward kind of situation.
However, more reward is gradually coming into this space because molecular diagnostic tests are being priced higher, in part because they can be used to guide therapies. The diagnostics are of higher value than they were in the past. The focus has come to be on high-content, minimally or totally noninvasive tests, and that’s where we see the value accruing as we go forward.
TLSR: Ram, I want to continue for a moment with your thoughts around laboratory-developed tests and CLIA certification versus FDA approval. A company can, if it wishes, seek FDA clearance through a premarket approval (PMA) or 510(k) pathway for a test. However, when a company gets CLIA certification, without FDA clearance, isn’t it very difficult to go to the Centers for Medicare & Medicaid Services (CMS) and get reimbursement from Medicare and Medicaid?
RS: There have been a lot of changes to CMS. Companies can’t practice code stacking in a systematic manner anymore. In the past, you could assign a specific code to a particular procedure—polymerase chain reaction (PCR), for example—and every time your diagnostic method utilized that procedure, you could “stack” the code for that procedure to come up with a price for your test. If you had to perform 100 PCR reactions for a given test, and the price per PCR procedure was, say, $10 according to CMS, your price per test would then be $1,000 and CMS could not argue with the pricing.
Nowadays, companies have to achieve what’s called value-based pricing, which is primarily driven by acceptance of the test in the medical community and the generation of peer review data that would lead Medicare, Medicaid, Novitas Solutions Inc. or CMS to proactively provide reimbursement. It must meet their guidance of what is clinically meaningful and medically impactful.
Peer review data generation is easier than going the PMA route because, to get a PMA, a company probably would have to do a large, randomized, prospectively defined trial to determine the prognostic value of a particular diagnostic test. A trial generating data for a PMA could take years, depending on the indication. But a company could generate peer review data in a matter of six to nine months, and then take another six to 12 months, say, to get it reviewed and published in a peer-review journal of some significant impact. These days reimbursement can be obtained based simply on the peer review process. Many companies have managed to get reimbursement for CLIA-certified tests this way.
TLSR: How large can reimbursement get for some of these more sophisticated molecular diagnostics and prognostics?
RS: Think about Genomic Health Inc. (GHDX:NASDAQ), with its Oncotype DX test, which is currently reimbursed at around $4,000 per test. Think about Foundation Medicine Inc. (FMI:NASDAQ), a company with a recent initial public offering (IPO), which has a test that is routinely reimbursed at $5,800. Even think about a company that we at Aegis Capital recently IPOed, Cancer Genetics Inc. (CGIX:NASDAQ), which has tests that are routinely being reimbursed at anywhere from $1,300–1,800. Rosetta Genomics Ltd. (ROSG:NASDAQ), another company that we cover, managed to get reimbursement approved through Medicare’s Novitas Solutions Inc. administrator at around $3,600/test; this test is aimed at determining the origin or primary site of a cancer, called cancers of unknown primary. There are a number of companies that have not gone through the PMA or 510(k) route that have successfully managed to obtain reimbursement for tests.
TLSR: I want to switch topics and address something that concerns the molecular diagnostics industry as a whole. On Oct. 30, the U.S. District Court of the Northern District of California granted Ariosa Diagnostics Inc. (private) a motion for summary judgment and denied Sequenom Inc.’s (SQNM:NASDAQ) motion for summary judgment. That was with regard to Sequenom’s 540 patent, of which it is the exclusive licensee. Your thoughts?
RS: To give some background, the ruling you’re referring to was rendered by Judge Susan Illston, against Sequenom and in favor of the plaintiff, Ariosa Diagnostics. The 540 patent covers Sequenom’s main marketed product, the MaterniT21 test, which is aimed at prenatally diagnosing chromosomal abnormalities in a noninvasive fashion by using a maternal blood sample as opposed to amniocentesis, which has risks for both mother and fetus. Basically, the judge said that the presence of fetal cytogenetic material in maternal blood is a naturally occurring phenomenon and, therefore, cannot be patented. Accordingly, she ruled that Sequenom’s 540 patent is invalid and cannot be upheld because it covers the packaging of natural phenomenon.
Now, obviously, that is not our position. We believe that such patents include a heck of a lot more than just claiming a natural phenomenon. What the 540 patent contains is, in our view, a system for diagnosing chromosomal abnormalities noninvasively. It’s not enough to simply say that you know fetal genetic material is present in maternal blood. You have to find a reliable way of detecting its presence, of amplifying it to a significant enough extent that you can distinguish it from the maternal DNA and then, finally, you have to figure out how to interpret the cytogenetic material that is present to make a diagnosis of some import—for example, whether a particular fetus is carrying Down syndrome.
Because all these aspects are embedded in the claims of the Sequenom patent under dispute, we believe the judge made a heavy-handed, draconian interpretation of the Supreme Court ruling rendered earlier this year in Association for Molecular Pathology v. Myriad Genetics Inc., where the High Court ruled that gene patents are not valid and not enforceable because they cover genes, which occur in nature.
TLSR: My understanding is that this could be overturned. When will this case resolve?
RS: Sequenom has indicated that it will appeal this ruling. We will not have a decision for at least the next six to eight months, but we do not anticipate that the judge’s ruling will be upheld in its current form. It may be modified or it may be rejected in its entirety by the appellate court. If it’s rejected, we think that would be a very good thing for the molecular diagnostics space, not because we think that people should be allowed to patent naturally occurring phenomena, but because we believe that there needs to be some incentive for innovation to occur in the molecular diagnostics space.
Even if the Ariosa Diagnostics v. Sequenom ruling is ultimately upheld in some way, I can tell you that many companies in the molecular diagnostics space are either going to be unaffected entirely or minimally affected, because these innovators tend to continue to innovate. They generate founder intellectual property (IP) wherever they are operating.
TLSR: Let’s talk about companies. Choose one.
RS: The idea of founder IP leads me to a very good example of an innovative company, TrovaGene Inc. (TROV:NASDAQ), which I cover with a Buy rating and a price target of $10.
TrovaGene has founder IP in the detection of transrenal nucleic acids, which are shed naturally into the urine. That is certainly a naturally occurring phenomenon, but TrovaGene’s IP is not just about the presence of transrenal nucleic acids. It’s about the detection of such nucleic acids. It’s about theamplification of such nucleic acids.
Without the specific knowledge and techniques that TrovaGene possesses, simply knowing that genetic material is present in urine doesn’t help you at all. You cannot make a meaningful diagnosis about any disease with just that knowledge in hand. You need to be able to detect and amplify the genetic sequences in the urine. From our perspective, the additional IP that TrovaGene possesses is more important than the founder IP concerning the picking up of transrenal nucleic acids per se.
Even if TrovaGene were to face competition in the transrenal nucleic acid detection market, we believe the company is far enough ahead of any competitors that it would maintain a meaningful lead for a significant period of time.
TLSR: Ram, TrovaGene’s platform is indeed noninvasive. You don’t even need a needle stick to draw blood. But is the entire platform, whether it’s melanoma-focused or lung cancer-focused, about detection through the urine medium?
RS: Yes. It’s all through the urine medium. In our view, that differentiates TrovaGene as a company and puts it in a different domain than molecular diagnostics firms that have to use blood or biopsy tissues in their tests. This is probably the most noninvasive test available because it uses urine as the analyte. Urine is voided naturally several times a day. You can collect as large a volume as you need over time. It is most likely the best analyte through which to do real-time monitoring, and to allow sample concentrations so there is enough genetic material to make a meaningful diagnosis. That’s the fundamental strength of TrovaGene’s IP.
TLSR: Another company?
RS: We cover a company called Venaxis Inc. (APPY:NASDAQ), which is gearing up to report data late this year or early next year on a test for appendicitis called AppyScore. The AppyScore test, in our view, is not as accurate as some of the other molecular diagnostics offerings, but it has very substantial negative predictor value. In other words, the AppyScore test is designed to make sure that doctors know if a patient does not have appendicitis, and this should, therefore, avoid unnecessary expense, unnecessary travail and unnecessary and painful procedures for the patient.
We feel the AppyScore test has potentially significant value. The trial is aimed at securing FDA 510(k) clearance for the test. The product should be launched in H1/14. We believe this could, by itself, make Venaxis a profitable company. We have a $3.50 price target on the company.
TLSR: You have written that the AppyScore test for appendicitis is a risk-mitigated asset because the evidence of its negative predictive value is so clear. How much of that is built into the current stock price? Could that be baked in such that the stock doesn’t have a lot of upside premium when the AppyScore test is cleared by FDA?
RS: We don’t think so. We believe that investors are not giving Venaxis credit for its test. At about $1.90/share, with a $40 million ($40M) market cap, we think the current market value does not reflect the potential of this test. We could see the potential value being significantly above where our price target is today if the test is approved and on the market in the U.S. If this test were to generate $15M/year in revenue, and a 10x multiple is thrown on top of that, you’re looking at a $150M enterprise value.
TLSR: Let’s go to another one, please.
RS: Cancer Genetics, which I mentioned earlier, is a recent IPO. The company is developing some very interesting high-content molecular diagnostics solutions, focusing on both solid tumors as well as hematological malignancies, the latter of which is its principal focus at the moment.
We think that Cancer Genetics is an attractive investment at this juncture primarily because it has a diversified revenue model. It derives revenue from sales to pathologists, hospitals, academic institutions and pharmaceutical companies engaged in using its tests in conjunction with clinical development of investigational drugs.
TLSR: Cancer Genetics has a current market cap of about $131M, trading at about $14/share. Your target price is $25, which is an implied double from here. How do you arrive at that valuation?
RS: Cancer Genetics has a relatively well-publicized relationship with Gilead Sciences Inc. (GILD:NASDAQ) for development of a Gilead drug called idelalisib, which is currently under review at the FDA. If the therapy were to be approved, we believe that for every $100M worth of idelalisib sales, $12–15M worth of diagnostic revenue could directly accrue to Cancer Genetics. And Cancer Genetics has a revenue base projected for the full year 2013 of only about $6–7M. That’s a significant potential future value driver for this company.
I would also point out that Foundation Medicine is a competitor to Cancer Genetics, though it doesn’t have the same kind of product and, in fact, only has a single test on the market, whereas Cancer Genetics has five. If we look at the valuation discrepancy between Cancer Genetics, at $131M, and Foundation Medicine, at about $717M, it is very significant.
From our perspective, Cancer Genetics is, on the basis of relative risk-reward, a much more attractive investment opportunity than Foundation Medicine. Cancer Genetics has more tests on the market, a leaner organizational structure, a more diversified revenue base and the potential to generate significant revenue from sales of its test to Gilead, which has a proven, targeted therapeutic agent that could receive approval by the middle of next year. We’re not bearish on Foundation Medicine’s prospects. We simply feel that the valuation discrepancy between Cancer Genetics and Foundation Medicine is unwarranted.
TLSR: Do you follow LabStyle Innovations Corp. (DRIO:OTCBB)? Are you familiar with the company?
RS: I don’t have a rating or coverage on LabStyle Innovations currently, but we have an interest in the company because it’s developing a very interesting approach to diagnostics at the level of data capture, at the point at which the diagnostic test is administered.
What the company has come up with is a very clever paradigm for blood glucose monitoring, to gauge the effectiveness of insulin therapy in diabetics. The test is administered via a handheld device called the Dario, and results can be directly read on a smart phone (like the iPhone) or similar device. The data gathered are presented pictorially and are very easily understandable. This device could, generally speaking, be much easier for diabetics to use on a daily or hourly basis, and could achieve much broader usage as patients become much more compliant.
TLSR: How are the data stored and managed?
RS: As the glucometer and smart phone capture these data, they are stored in a cloud form. You can access the data very easily. You can use it for all kinds of real-world applications, including in clinical trials, where you’re assessing the responsiveness of particular patients to specific types of drug therapy. LabStyle is an interesting story to watch and a company investors should be aware of going forward.
TLSR: You follow Navidea Biopharmaceuticals Inc. (NAVB:NYSE). In mid-March of this year its radiopharmaceutical product Lymphoseek (technetium Tc 99m tilmanocept) was approved for lymphatic mapping of diseased lymph vessels in breast cancer and melanoma. What are your thoughts about the company and its shares today?
RS: Navidea’s shares have been beaten down dramatically recently because the company has serially disappointed on the earnings front. Navidea is trading at about $220M in valuation. It recently raised a substantial amount of money. We have had a Hold rating on this company for a substantial period of time, but we have a $2/share price target. The fact that the stock is currently trading at about $1.65/share may indicate that, at this juncture, it’s time to stop being so bearish.
As you mentioned, Lymphoseek is approved in the U.S., and the company is partnered with Cardinal Health Inc. (CAH:NYSE). It’s used in sentinel lymph node mapping, which is an important diagnostic approach for the detection of head-and-neck cancer, breast cancer and various other types of solid tumors, where physicians are looking for the telltale signs of cancer in the lymph nodes. The company has a pipeline of product candidates coming up behind, including an Alzheimer’s diagnostic, NAV4694 (fluorine-18 labeled radioisotope), as well as a potential Parkinson’s diagnostic, NAV5001 (an iodine-123 radiolabeled imaging agent).
The diagnostic tools in the company’s pipeline could be of significantly greater commercial value than Lymphoseek itself. As of right now, we don’t think the market is valuing the Lymphoseek opportunity appropriately, merely because sales initially have not been tracking. At this juncture, this is a risk-mitigated opportunity. Even though we have a Hold rating, we think that our current price target does demonstrate potential upside.
TLSR: Ram, the Alzheimer’s disease diagnostic product, NAV4694, is a PET scan radiotracer. Eli Lilly and Co. (LLY:NYSE) has a product for the same indication, Amyvid (florbetapir F 18 injection), which it got with its acquisition of Avid Radiopharmaceuticals Inc. for $800M. GE Healthcare (GE:NYSE) has a product that was approved by the FDA in October called Vizamyl (flutemetamol F 18 injection). CMS has told these companies, I believe, that it does not want to reimburse these radiotracers because it doesn’t have definitive evidence that they will help patients. Where does that leave NAV4694?
RS: Alzheimer’s is such a large market that even if we have minimal reimbursement for such a modality, a company like Navidea should be able to generate meaningful sales on the product eventually, as long as its clinical data are good. But the company has to go through the clinical development process first. At this juncture, quite frankly, nobody is giving the company any credit whatsoever for the Alzheimer’s diagnostic. It’s a free call option at this point.
TLSR: One final question. All these stocks have been weak. Does this indicate to you that this is an opportune time to pick a basket of these names?
RS: We believe so, and I obviously like the companies we’ve discussed. If you looked at cyclical trading patterns in the healthcare sector, October and the first half of November have traditionally been weak. The fact that the sector had performed so well in 2013, and the fact that seasonal weakness is generally confined to the months of October and November, would have generally indicated that the sector was due for a pullback around this time.
But we feel the worst is over, and the sector should get back to its winning ways. One of the bright spots going forward should be the molecular diagnostics sector, because there is such significant need. These high-content, high-accuracy molecular diagnostic tests bring with them the potential to guide therapy, and the potential for noninvasive real-time monitoring.
TLSR: It’s been fun, Ram. Thank you. I’ll be speaking with you again in a couple of weeks for part two of the three-part series we are doing with you. We’ll pick up on a new topic then.
RS: Thank you so much. I appreciate it.
Raghuram “Ram” Selvaraju’s professional career started at the Geneva-based biotech firm Serono in 2000, where he discovered the first novel protein candidate developed entirely within the company. He subsequently became the youngest recipient of the company’s Inventorship Award for Exceptional Innovation and Creativity. Selvaraju started in the securities industry with Rodman & Renshaw as a biotechnology equity research analyst. He was the top-ranked (#1) biotech analyst in The Wall Street Journal’s “Best on the Street” survey (2006) and went on to become head of healthcare equity research at Hapoalim Securities, the New York-based broker/dealer subsidiary of Bank Hapoalim B. M., Israel’s largest financial services group. While at Hapoalim, Selvaraju was regularly featured in The Wall Street Journal, Barron’s, BioWorld Today, and Reuters/AP. He was also a regular guest on the Bloomberg TV program “Taking Stock,” appeared with Bloomberg TV’s on-air correspondents Betty Liu and Gigi Stone and was a guest on CNBC’s “Street Signs with Herb Greenberg.” He is currently an analyst with Aegis Capital Corp.
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