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.

Oncology-related stocks with profits and no R&D risk? Yes, please!

I can't give much of a recommendation on their choices, but SeekingAlpha puts forward a list of stocks related to oncology that are also profitable.
Take a read here.
Their choices are Quest (DGX), Genprobe (GPRO), and Genoptix (being acquired by Novartis.) I'd also nominate Genomic Health (GXDX), Myriad Genetics (MYGN), and Qiagen (QGEN).

Each of these companies are squarely in the diagnostics space, so they offer the stability of selling a product, rather than the ups and down of product development (as in drug discovery/development ventures), while, in many cases, having the same IP moat as the drug disc/dev companies, as the diagnostic technology or target IP is often patented, or the 510K FDA approval rserves as a barrier to entry for competitors.

It is generally perceived that diagnostics offer less upside than drug disc/dev companies, but if you consider how aggressively young biotech companies partner away risk (and upside), you wonder if the diagnostics companies offer the same upside, with much less risk.

Consider 3 companies:

Exelixis (EXEL), a biotech founded in 1994. Market cap: $1.2B
Myriad Genetics, a molecular diagnostics company founded in 1991. Market cap: $1.7B
Genomic Health, a molecular diagnostics company founded in 2000. Market cap: $725M.

There's a huge amount of selection & survivor bias in this analysis, but if you assume that each company was seeded with $20M in equity at founding, you would see the following CAGR in valuation:

Exelixis: 27%
Myriad: 25%
Genomic Health: 38%

This is not to say that these companies have generated internal rates of return (IRR) at these levels, as each company had a different financing strategy. Very light analysis indicates that Exelixis was much less capital efficient than either Myriad or Genomic Health

Exelixis:$1.11B in paid in capital 
Myriad: $580M paid in capital
Genomic Health: $255M in paid in capital

Without knowing the exact dates and amounts raised by each of these companies, a precise rate of return can't be calculated, but simple observation (compare today's market caps to the amounts previously invested) suggests that not only were the diagnostics companies much lower in inherent risk, they are also higher in investment returns.

So, before buying into a drug discovery/development stock, consider following SeekingAlpha's advice, and look at profitable and growing oncology stocks like those listed above.