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.

Gen-Probe sale validates molecular future

Hologic, the "Woman's Health Company," announced today that they're betting the company on genomics.

Well, that's not exactly what HOLX announced, but practically speaking, when a $5B company with a mild amount of DX exposure decides to pay $3.75B to buy a nucleic acid testing firm (Gen-Probe), they're really betting the company on genomics.

I like the deal for both HOLX and GPRO - HOLX gets exposure to growing markets and technologies which nicely complement their core business. (Tthe combination of HOLX's focus on women's health and GPRO's HPV tests is a perfect fit.) GPRO - who's growth was slowing - gets a nice bump in valuation, and probably a good amount of independence.

It'll be interesting to see what becomes of the non-women's health applications of Gen-Probe. Will HOLX punt the cancer testing business to QGEN or Clarient (GE)? Since the deal is all-cash, HOLX might want to later de-lever by punting the cancer tests or other assets.

Two unfortunate side effects of the acquisition: Gen-Probe is/was the largest, most prominent molecular DX pure-play. With Gen-Probe losing its' independence, we're losing both a bellwether for MDX, and losing a buy-side specialist. Gen-Probe is/was in excellent position to commercialize interesting DX coming from smaller players, as is the case of their PCA3 product sourced from Diagnocure.

One other impression from the HOLX-GPRO deal: re-reading Roche's rationale for their pursuit of Illumina, it sure seems to me that Gen-Probe would have been a better fit for Roche instead of Illumina. I wonder if they'll try to top HOLX's offer. (Or maybe GE or Danaher will.)

Biotech needs more GE

My Dad sold industrial electrical supplies for GE, and from that exposure, I always thought that the drug discovery tools supply & services industry was similarly attractive to GE's for its' scale, business fit, customer base, and exposure to a growth market. (Many of GE's businesses can be described as supplying essential component technology to Fortune 500 business, be they jet engines, electrical transformers, or wind turbines.)

I had been saying that drug discovery was ripe for GE since 1998, when on the executive team at Upstate Biotechnology, at my suggestion, a GE acquisition was listed in our business plan as an exit scenario. In 2003, GE entered the drug discovery market by buying Amersham, and I felt vindicated, and hopeful that GE would continue investing in the drug discovery industry.

That generally hasn't happened, though things may be changing - GE today announced the acquisition of SeqWright, a Texas-based sequencing CRO.

(btw: a good overview of GE Healthcare businesses is available here.)

The press release for the SeqWright acquisition trumpets SeqWright's connection with GE's existing Clarient molecular diagnostics business. (Clarient having been acquired just a year and a half ago), but even together GE still only has its' toe in the molecular diagnostics water. (Especially since the always awesome World Map of High-Throughput Sequencers lists SeqWright as having only 3 machines - one each of 454, SOLiD, and HiSeq.)

The release also affirms that GE's business model in this space is SERVICE, not proprietary R&D/assay development. In other words, both GE and Roche have roughly similar M&A appetites in this space, but GE chose to buy modest capacity in SeqWright, while Roche wants to own an entire technology platform, if the Illumina deal were to close.

(Ironically(?), WSJ's coverage of the GE's acquisition of SeqWright says that Roche is a customer of SeqWright, which I'd bet wouldn't continue if Roche buys ILMN.)

The SeqWright deal reinforces GE's interest in the biotech industry (and more specifically, molecular medicine) not only as a validation statement, but for the fact that more big-league, results-oriented capital is being committed to biotech, as GE invested to generate tangible cash & EPS, whereas the majority of biotech investment is done to create speculative future value (and often only equity value, not cash-flow value.)

Let's face it: biotech needs more investors like GE, and more of their business mentality. GE's acquisition of SeqWright was, in effect, more capital voting for biotech businesses with customers and cash flow, as opposed to transformative technologies or "cool" tech platforms. VCs: why fund any technology company (i.e. company not developing leads) that you couldn't imagine selling to GE? As an example, consider a genetic engineering company like Amyris - sure, they can do proprietary biofuel R&D that might someday pay off, but isn't the highest NPV likely to come from selling the company's capabilities to generate cash flow?


One reason that GE hasn't been more active in the drug discovery industry is that there are not many acquisition targets available to provide scale. Only LIFE, QGEN, VWR, and ThermoFisher could add >$1B in annual revenue to GE, but in general, these companies have generally been valued at a price that would make difficult a non-dilutive acquisition for GE. Still, I can't ignore that LIFE CEO Greg Lucier is a GE-alum, and that QGEN would make a just about perfect complement to GE Healthcare's Life Sciences business.

I could also see GE getting involved in the pursuit of ILMN (it's the Amersham of 2012), but their lack of public involvement to date suggests to me that they either can't make the price work for them, or that GE invests in more predictable technology. (Why make a multi-billion dollar acquisition in Sanger sequencing if other tech platforms (like nanopore sequencing) might overtake Sanger tech?)

(btw: Roche upped their bid last week. ILMN didn't budge at all. I don't think this deal is getting done right now, but rather in 6-18 months time, after the ILMN board of directors experiences an unfavorable quarter.)

As for SeqWright, congrats to them and to any other CRO that manages to get liquid. Deal terms weren't announced, but if SeqWright was growing fast with the rest of the sequencing industry, and cash-flow positive, they probably got a decent price, though, on the flip side for GE, trading GE stock for an ongoing, competitive DNA sequencing lab is more EPS efficient and less risky than opening a lab using their own cash to buy equipment and hire staff, so there is a limit to what GE would pay. GE may have even made acquisition overtures to many sequencing CROs to see who would bite at the lowest price.

Let's hope that GE has a good experience with SeqWright, and further invests in the molecular medicine industry.

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.