Unhealthy Prognosis for Venture-Backed Diagnostics

Tim Gallagher shared with you: Some brilliant caution on molecular diagnostics from Bruce Booth. Turns out, MDx development is just about as risky and capital intensive as therapeutic development, with arguably less upside and liquidity.   Unhealthy Prognosis for Venture-Backed Diagnostics forbes.com

Dako acquired by Agilent

Deals are getting done in the tools & content space, and valuations are jumping as shown by the Agilent-Dako tie up this week at 6X trailing revenues!!!* (and also the Gen-Probe acquisition by Hologic, at roughly the same valuation multiple.)

For perspective, the just re-done AFFX-eBioscience deal was at a ~4X multiple. So how is Dako 50% more valuable on the basis of revenue multiples? (Or ~7X more valuable on a gross valuation basis.)

-a bias towards higher value products in the sales mix. Per this article, reagents are only ~15% of Dako sales, while 85% is attributed to the anatomic pathology market. (Slippery, as much of the purchases for the path market are reagents in value added packaging (kits, etc)). The lesson here for life science tools companies: climb the value curve - even if just a step or two - and put a new label on your company. You're not a reagents company - you're a clinical diagnostics or molecular diagnostics company, even if none of your products have 510K approvals from the FDA.

-clinical lock-in. Once a clinician or pathologist learns to rely on a pathology product, momentum and familiarity are more important to follow-on sales than price.

-IP. Dako's assays and components are proprietary whenever possible, and quite likely patented in a minority of cases. (With trade secrets being more important than formal IP protection in most cases in this field.)

Note: the acquisition ISN'T driven by cutting edge technology. Much of Dako's products are related to immunohistochemistry (IHC) - a very standard, widely used assay technology. I suppose you could start an argument over whether or not Dako is a molecular diagnostics company - their pathology products help target molecular medicines on a by-patient basis, but these diagnostic assays are not particularly 21st century, relying on protein detection.

Also driving this deal: as noted in this story, Agilent's $4B cash hoard - half of which they are using to do this deal - is largely offshore. Agilent's choice was either to repatriate the profits and pay a huuuuuge tax to the US government (newsflash: the US has the highest corporate tax rate in the world), or re-invest the proceeds in overseas assets, like Dako. It sure would have been nice if that capital could have been re-invested in US life science companies.

The quick reaction from financial analysts is that Agilent paid full-price for Dako, but the deal will be immediately accretive to earnings, and, since Agilent used off-shore funny money to fund the deal, probably could have and would have paid more. (Plus, sizable companies in the clinical diagnostics space for acquisition are becoming scarce.)

I'd say this is a good buy by Agilent, and hope that no one mistakes the huge celebratory party Dako's Danish and Swedish owners are throwing (surely with copious amounts of aquavit, Tuborg, and Absolut), as anything other than just the way the Scandinavians roll. (Speaking from personal experience. Hei skål!)


* note that the Agilent press release refers to 2010 revenues for Dako at $340M. I bumped up Dako's sales by 10% to reflect 2011 revenues.

MDx pure-plays: exception, not the rule

After writing about Gen-Probe's acquisition the other day I wondered how many stand-alone molecular diagnostics (MDx) companies were left. Here's the entire list of independent MDx companies that have reached critical mass (>$1B valuation):

1. Myriad Genetics

(You could make a strong case for Qiagen or Cepheid as well, but the majority of their businesses are still reagent supply, and hardware, respectively. Genomic Health (GHDX) just misses as their valuation is ~$125M short for now, but there is every reason to believe that GHDX will graduate to "critical mass" with time.)

There's a lot of MDx business addressed by subsidiaries of large companies (Roche Diagnostics, Abbott, or Clarient, for example), micro-cap MDx companies (Response Genetics or Diagnocure for example), or general clinical testing companies (Quest Diagnostics, LabCorp, etc.) so the lack of pure-plays isn't reflective of market interest. Instead, it reflects how in molecular diagnostics, good distribution and good capitalization are more important than good science and IP.

I think it is also reflective of the fact that success in the diagnostics field can not be driven by one or a small handful of diagnostic products or technologies, but instead by a broad catalog of assays, markets, and technologies. (The exception is Genomic Health, with a single product - OncoType DX - generating 100% of its' ~$200M in annual revenue.) This is really unfortunate for the dozens of single-product micro-cap diagnostics companies (Trovagen, Diagnocure, Response Genetics, etc.) Their two choices are either: hyper-specialize to dominate a market niche and hope to be acquired by a bigger player, or wait around to be steamrolled by a much bigger company with better distribution when the big company decides to enter the same space. 

Unfortunately, most small MDx companies overvalue their technology and their niche market, and overestimate how high the barriers to entry are in their market. These small MDx companies don't realize that they're often just re-selling time on their lab equipment, rather than building a defensible, sustainable business. Case in point: MolecularMD.

How can you tell if an MDx company is special or is just renting time on their equipment: look at the gross margins. Myriad Genetics has an 87% gross margin. Response Genetics: 48% gross margin.

It is also likely that the message the markets are making is that successful diagnostic companies need not be tech-centric, meaning that differences between genomic and protein technologies are an artificial, meaningless distinction. No clinicians will really care if a diagnosis is generated using PCR or protein arrays, and payers care only about efficacy and cost.

With the MDx opportunity widely dispersed among small and large diagnostics companies and clinical labs, there is a BIG opportunity for some well-capitalized venture to collect the niche assays dispersed among smallish MDx companies (buying at a price driven by a small multiple of net cash flow), and building a broad, specialized sales & distribution network with better operating margins collectively than apart. This is also the sort of space ideal for a VC fund that believes in MDx but wants to make a larger, lower-risk investment in the field.