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This will be a great year for life sciences tools and diagnostics companies, says Bryan Brokmeier of Maxim Group. And no, growth won't be driven by irrational exuberance, the senior analyst explains in this interview with The Life Sciences Report. Instead, the industry is bolstered by powerful tailwinds fanning new demand for molecular diagnostics, and by the clamoring of academia, pharmas and biotechs for specialized assay platforms. As Brokmeier lays out his sector growth theory, he also highlights a group of stocks with value drivers that could power a portfolio with biotechlike growth potential.

The Life Sciences Report: You wrote a note on Jan. 24, ahead of earnings, saying that you were bullish on life sciences tools and diagnostics, and that you expected 2014 to be a great year for both. Why are you bullish? What is driving these stocks?

Bryan Brokmeier: For the life sciences tools sector in 2014, we should see strength across all its end markets, particularly due to an improved academic funding environment and the strength of the global economy. But separate from those drivers, I expect pharma and biotech markets to improve as investors continue to fund more initial public offerings [IPOs] and secondary offerings, as well as because specialty pharma, generics and contract research organizations [CROs] show continued strength. All these entities require tools.

As for diagnostic stocks, these should perform well as the sector gains increased attention from investors focused on positive secular trends, the development of companion diagnostics, and because of recent U.S. Food and Drug Administration [FDA] clearances of various instruments and assays, including Affymetrix Inc.'s (NASDAQ:AFFX) CytoScan Dx Assay, for the postnatal detection of DNA copy number variants; Bruker Corp.'s (NASDAQ:BRKR) MALDI Biotyper, for identifying bacterial colonies; and Illumina Inc.'s (NASDAQ:ILMN) MiSeqDx, for DNA sequencing.

Also, life science tools and diagnostics companies have been investing in their own infrastructures and making acquisitions, and tools companies are partnering with diagnostic companies to further penetrate long-term opportunities in those markets.

TLSR: You have listed a bunch of interesting factors, but would you say that an improving global economy is the single biggest factor?

BB: The global economy positively impacts most of the end markets for tools companies to some extent but, most directly, it impacts the industrial and applied markets, which represent an estimated 36% of the industry. An improving global economy is an important tailwind, but there are many drivers of growth, many of them looking better in 2014 versus 2013. Gross domestic product [GDP] growth certainly helps, and I'm seeing that growth in GDP is projected to be about 1% higher in the G10 countries compared to 2013, including a strong improvement in the U.S. and Europe. Also, 2013 was negatively impacted by the difficult funding environment, and an improvement in funding is as important as the improving global economy. I'm talking more about life science tools companies in this case. The academic funding environment is significantly better now than it was last year.

TLSR: Improvement in academic funding sounds counterintuitive to me, because we're in an environment currently where some representatives in Congress are loath to support academic research. Could you tell me why you feel that academic funding from government will be improved?

BB: While there are many in Congress who would reduce government spending on everything, most of them understand that cuts to research and development [R&D] funding aren't the solution to improving the competitiveness of the U.S. economy. Governments across the globe are funding R&D; the U.S. lead in R&D is narrowing, and Congress knows that. While I don't expect Congress to do enough to stop the narrowing R&D lead, the overall trend should be positive. Looking at the 2014 budget, which was recently passed, the National Institutes of Health [NIH], the largest funder of biomedical research in the world, saw a 3.5% increase to about $30 billion [$30B] in 2014. That increase should be a very positive tailwind for tools companies.

TLSR: I think of life sciences tools companies' customers as being institutions, biotechs and pharmas. Are tools companies finding their way into clinicians' offices, clinics and facilities, where healthcare is provided directly to the patient? I'm asking because the tools markets-whether in academia, government, biotech or pharma-are large-dollar markets, but narrow.

BB: A number of tools companies are developing or acquiring diagnostic businesses of their own. Some, such as Illumina, which acquired Verinata Health Inc. in early 2013, are developing diagnostic tests that will be sold directly to physicians and hospitals. Illumina is also allowing diagnostic companies to act as conduits to penetrate healthcare markets by developing tests on Illumina's instruments.

Affymetrix is another example. It sells its CytoScan to diagnostic laboratories such as Laboratory Corporation of America Holdings (LH) and Quest Diagnostics (NYSE:DGX), but then it also has its Powered by Affymetrix Program, where diagnostic companies develop tests on its instruments for sale to healthcare markets. We saw one deal in Q4/13 that provided a significant one-time revenue item to Affymetrix because of a licensing agreement it signed with one of its Powered by Affymetrix members. I think we could see more deals like this for Affymetrix, and other companies in the space, in 2014.

Pacific Biosciences of California Inc. (NASDAQ:PACB), on the other hand, is largely focused on the academic research and agriculture biomarkets. But through its partnership with Roche Holding AG (OTCQX:RHHBY), which it announced in September 2013, it will develop a diagnostic version of its single-molecule, real-time [SMRT] technology system. Roche, one of the largest diagnostic companies in the world, will have the exclusive rights to develop diagnostic tests that it will then market.

Companies are taking different approaches to penetrating the diagnostic market, whether they're doing it on their own or selling tools to the diagnostic companies that develop the tests. Over time I expect more integration, but I think that larger tools companies will always have their own diagnostic businesses, selling directly to the markets, as well as have partners that are more nimble and better able to identify opportunities in the market.

TLSR: You mentioned Pacific Biosciences and its deal with Roche. Currently you have a Buy on Pacific Biosciences, with a target of $9. Is this company in a position to begin receiving milestone payments for its SMRT technology partnership with Roche? I know that it got an upfront payment, but what about the milestones?

BB: Based on comments the company has made and conversations I've had, it's possible Pacific Biosciences could receive a milestone payment in 2014, but that is not currently in my model. I think it's more likely that the company will receive a milestone in 2015. That would be a significant catalyst for the company-not just receiving the payment, but also actually achieving a milestone. Many investors do not understand how quickly Pac Bio could achieve FDA approval for its instruments, and any steps in that direction will be a positive catalyst for the stock.

This is part of the reason that Pac Bio is our top pick for 2014. The company is much smaller and less flashy than its key competitor, Illumina, which is the industry darling. Management has done a great job of improving the performance of Pac Bio's instruments, expanding research applications and proving to the market that it can deliver. The CEO has been a consistent buyer of shares, which demonstrates his confidence in the company's opportunities as well.

TLSR: Pac Bio is up about 83% the past 12 weeks, and it's up 3.5x over the past 12 months. Are you anticipating that you could up your target price from $9?

BB: It could go higher. A number of catalysts are upcoming in 2014. Pac Bio presented at the Advances in Genome Biology & Technology [AGBT] meeting in mid-February, and the stock has had a really nice run since then. The company didn't have any huge, flashy announcements, but it certainly was positive that Pac Bio produced data for the first full assembly of the human genome using its SMRT sequencing technology. It was a big positive, and is getting a lot of attention from researchers. But the Street is still not giving Pac Bio enough credit for what it is accomplishing.

TLSR: After phenomenal appreciation, this stock has settled down some. Do you see this as a good buying opportunity?

BB: I think it is. As I've said, it's my top pick for 2014, after a really strong 2013, and these shares are still well below the IPO price, even after the strong share price appreciation. A lot of sellside analysts still aren't paying enough attention to it, and neither are many of the buyside firms. Once Pac Bio starts to get upgrades from other analysts, the buyside will pay more attention and start getting into the stock. This company is primed for takeout in 18-24 months. More investors will pay attention to that opportunity, on top of the improving fundamentals, as well as to when the company hits its milestones with Roche.

TLSR: Can you mention another name?

BB: I really like Sequenom Inc. (NASDAQ:SQNM). It's an out-of-favor name that has been severely impacted by molecular diagnostic reimbursement issues throughout 2013, and we believe its shares are severely undervalued. Not only should Sequenom continue to be the leader in the rapidly growing noninvasive prenatal test [NIPT] market, along with privately held Ariosa Diagnostics Inc., but we also expect the company to modestly diversify its revenues with penetration into the cystic fibrosis [CF] market with its Heredi-T Cystic Fibrosis Carrier Screen for couples planning a pregnancy, as well as the introduction of other new diagnostic tests. The catalysts include improving reimbursements, which is most important, the narrowing of its cash collection cycle and the sale of the company's bioscience business, which we anticipate will occur in H1/14 and which should provide Sequenom with enough cash to achieve profitability later this year.

TLSR: What is the growth driver here? Is it still the MaterniT21, which tests for fetal trisomy 21 [a third chromosome 21, which results in Down syndrome] in maternal blood? Or are other tests, such as the CF test or the SensiGene Fetal RHD Genotyping test, which screens for Rhesus D incompatibility, also drivers?

BB: The growth driver is still the MaterniT21. Sequenom keeps adding content to this test. It's not just trisomy 21; it also tests for trisomies 18, 13 and some rare chromosomal abnormalities such as trisomies 16 and 22-and other things as well.

The company is also adding more payers to its list of contracted managed-care companies, which is increasing the number of covered patients and thus improving its reimbursement. Most of its revenues are still on a cash basis and not on an accrual basis. I expect that to improve during 2014 and into 2015. Another major growth driver for Sequenom is the penetration of international markets, which still represent a very small percentage of its total revenues but represents a huge opportunity for the company.

TLSR: You mentioned the other big player in the NIPT market, Ariosa, as well as Verinata and Natera [private], which are carving out market share. I know you like Sequenom very much, but how much pressure do you expect from competitors? What will be their effect?

BB: They are putting pressure on Sequenom, but it's a huge market opportunity, and I think there's room in the market for more than one player. Sequenom has a very strong sales force, and so does LabCorp, which is partnered with Ariosa. So does PerkinElmer Inc. (NYSE:PKI). But I don't feel that Natera and Verinata have gotten as much traction in the marketplace as Ariosa and Sequenom have. They are starting to catch up, but Sequenom and Ariosa still have very strong leads over those other companies.

Over the long term, as I said, international markets are going to offer significant opportunities to all these companies. As the costs of sequencing come down and as throughput improves, it may make more sense to bring this kind of testing into the average maternal-fetal risk market, which represents a huge opportunity. Instead of about 700,000 [700K] annual high-risk births, you're now talking about 4M annual average- and high-risk births in the U.S. As the market grows, so does the opportunity, which will be huge if Sequenom's test is recommended for average-risk pregnancies.

TLSR: Your target price on Sequenom is $6, which implies a double from current levels. This stock is down about 45% from 12 months ago, and it's been weak all year. From your perspective, is this a good buying opportunity?

BB: It's a great buying opportunity for a stock that has a lot of upside. Given the competitive environment and all the lawsuits among the players in the space, there is certainly risk, but there is huge upside to the company.

TLSR: Another company you might mention?

BB: Fluidigm (NASDAQ:FLDM) has very strong intellectual property. It also has a first-mover advantage in the nascent field of single cell analysis. We're increasingly confident that the company is poised to grow organic revenue of about 20% for the next couple of years, given recently announced investments and the single-cell targeted sequencing workflow that was released in late 2013. Fluidigm plans additional single cell protocols in 2014 and early 2015.

In addition to the opportunity in single cell sequencing, we expect the company to introduce a new instrument in the next six months, which would further support its growth trajectory. Moreover, the recently announced acquisition of DVS Sciences further strengthens the company's leadership position in single cell analysis. The acquisition also creates synergies, including potential development of a microfluidic cell culture instrument ahead of DVS' CyTOF 2.

TLSR: Another company?

BB: While Pac Bio, my top pick for 2014, is going to perform extremely well, Bruker is my top pick over the next 18-24 months. Bruker is a solid company with huge, unprecedented, margin-expansion opportunities over the next few years, particularly with an improving outlook in academic research, which is Bruker's strongest market. There is huge upside from the consolidation of facilities, outsourcing of certain products and manufacturing, as well as from working capital improvements. We saw huge improvements in 2013, particularly around the company's inventory management, and there is opportunity in 2014 to drive further working capital improvements, which will improve Bruker's cash flow position.

TLSR: Could you mention another company?

BB: Affymetrix is another strong name that has pulled back recently. The company came out with strong revenue growth guidance for 2014, but it is going to be spending more money than what a lot of investors were expecting.

In 2013, members of the company's management team waived bonuses for themselves, and that helped the company free up its cash position as it further paid down debt and improved the balance sheet. But management is going to take bonuses in 2014. Because of the strong run-up in the stock over the last year, stock option grants are going to be at a much higher level than in 2013. The company also sees great growth opportunities ahead due to R&D investment over the last year, and with the introduction of a number of new products. The company sees a lot of opportunity to further penetrate international markets if it invests the money, and so it will be investing more money in its sales and marketing efforts in China and the Middle East, which I think will pay off over the next couple of years and over the long run. The spending makes sense.

In the end, what really matters in this industry is the revenue line. Yes, Affymetrix is spending the money, but it will pay off for investors in the long run.

TLSR: Bryan, the gene expression business is not a growth driver anymore. Where is Affymetrix's growth coming from?

BB: The reason the stock pulled back over 2009, 2010 and 2011 is because the company's gene expression business has been declining. Affymetrix was the market leader in this area, but that business is a much smaller piece of the company's revenue now. Gene expression currently accounts for only 30% of the company's total revenues, and half of that is from newer, growing product lines, such as the Human Transcriptome Array, which is not something investors properly recognize. Investors are expecting that 30% of Affymetrix's business will decline 10-15%, but really only half of that gene expression business is going to decline at that level. As the company delivers on growth in 2014, I think it will be well positioned as a potential takeout target later this year.

TLSR: You follow diaDexus Inc. (OTCQB:DDXS). Did you want to comment on that?

BB: This is another stock that's been oversold recently. DiaDexus has been putting up very strong growth over many years. But investors were looking at the company as a play on GlaxoSmithKline's (NYSE:GSK) darapladib drug opportunity. Darapladib was intended to reduce lipoprotein-associated phospholipase A2 [Lp-PLA2], which is what diaDexus is testing for in GSK's large, phase 3 STABILITY trial. GSK has been using diaDexus' PLAC Test to test for levels of Lp-PLA2. The data on darapladib came out on November 12 of last year, and it wasn't positive. The trial missed its primary endpoint, and so diaDexus' stock pulled back significantly. It has come back a little, but not enough.

However, not even looking at the other growth opportunities that diaDexus has ahead of it, darapladib isn't dead quite yet. The GSK CEO has recently commented that he and his team have seen more information than the Street on the STABILITY trial, and the drug may still work in a subset of patients. On top of that, a second phase 3 clinical trial is expected to be completed in March, which could further support the commercialization of darapladib and the opportunity for the PLAC test to be used as a companion diagnostic. On top of the darapladib possibilities, diaDexus continues to grow its base business at a solid, double-digit rate and it has very strong profit margins. It is also working on improving its product pipeline, about which we may start to hear some more information during 2014.

TLSR: Bryan, are you saying that even if GSK or someone else does not develop an efficacious Lp-PLA2inhibitor, diaDexus is still a growth play?

BB: Yes. A couple of research publications have been put out that call high Lp-PLA2 levels a risk factor for cardiovascular disease, and that is upping the importance of a diagnostic test that can measure Lp-PLA2. More doctors are adding this to their lipid panels.

TLSR: Are there other names you could mention? Any larger-cap companies?

BB: LabCorp and Quest are larger companies. These clinical laboratories have been beaten up because of molecular diagnostic reimbursement code problems-the same kind of thing that has impacted Sequenom, the overall reimbursement pressures seen throughout the clinical diagnostic industry. We expect those reimbursement issues to continue to be a problem in 2014. However, we expect volumes to start improving as more patients come into insurance enrollments via the Patient Protection and Affordable Care Act, and also due to longer-term secular trends that are driving growth.

TLSR: Are mergers and acquisitions [M&A] an important factor for both these companies-LabCorp and Quest?

BB: M&A is an important factor. LabCorp has a long history of making accretive acquisitions. Quest recently made a nice acquisition of Solstas Lab Partners, which will help drive revenue growth and margin expansion in 2014 and 2015. It also creates the opportunity for further M&A in the space in 2014. Quest has a new management team that has been delivering on the promises to cut costs and improve the company's overall organizational structure, with the goal of positioning Quest for improved growth over the next few years. While these companies continue to face a number of headwinds, they also have long-term secular trends working in their favor. These stocks have been oversold to their current levels. For investors who have a long-term investment horizon, now is the time to start looking at these stocks.

TLSR: Best wishes, and thank you.

BB: Thanks.

This interview was conducted by George S. Mack of The Life Sciences Report and can be read in its entirety here.

Bryan Brokmeier, senior life science tools and diagnostics analyst, covers medical device, healthcare service and life science companies as a vice president of equity research at Maxim Group. Brokmeier has been with Maxim Group since 2009, when he joined as an associate analyst covering medical device, healthcare IT and service companies. Previously, he worked as an associate analyst at Credit Suisse and as a senior portfolio accountant at Brown Brothers Harriman. Brokmeier has been quoted in numerous financial publications, such as The Wall Street Journal, Barron's, Investor's Business Dailyand Bloomberg News. He holds a master's degree in business administration [finance and accounting] from Indiana University's Kelley School of Business, and a bachelor's degree in finance and applied economics from Ithaca College. He is a CFA charterholder, and a member of the New York Society of Securities Analysts, the CFA Society of Chicago and the CFA Institute.

DISCLOSURE:
1) George S. Mack conducted this interview for The Life Sciences Report and provides services to The Life Sciences Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Life Sciences Report: None. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Bryan Brokmeier: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None My company has a financial relationship with the following companies mentioned in this interview: Sequenom Inc., Fluidigm Corp. and diaDexus Inc. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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Source: Bryan Brokmeier Remains Bullish On Life Sciences Tools And Diagnostics Companies