Illumina (NASDAQ:ILMN) truly revolutionized the approach to DNA sequencing. As a company, Illumina was able to shift from selling large bulky sequencing machines to rare specialized genomic laboratories, and started developing sleek and easy-to-operate sequencers that can be used in any hospital laboratory. Illumina sequencers now represent the standard in the field of genomics. While the revolution in DNA sequencing was going on, very few people paid attention to the Illumina stock. The stock lingered around $50, until it was re-discovered during the 2013 biotech boom. The price sky-rocketed up to $180 in early 2014. Even after the broad biotech sector correction, the stock is back at around $175, not far from its all-time highs. However, with the P/E at almost 120, Illumina offers limited opportunities for growth investors, in my opinion.
So what is the next growth play in genomics? While Illumina is in the center of attention for changing the world of DNA analysis, there has been a similar revolution going on in the world of RNA. Interestingly, also mostly unnoticed by the stock market. NanoString Technologies (NASDAQ:NSTG) represents an interesting play on molecular diagnostics. In comparison to Illumina, the NanoString platform analyzes RNA molecules, which are the result of DNA transcription. The system combines a target probe, which is mRNA-specific, and a reporter probe, which carries a molecular color-coded barcode. The unique barcoding process enables analysis of hundreds of targets in each reaction to obtain the expression profile of the cancer. The results are read by the nCounter Analysis System. Up to 800 target genes of interest can be analyzed in a single reaction. The key difference between DNA and RNA analysis is that not all genes that play the role in cancer are necessarily mutated and can be detected by sequencing. Also, the functional levels of RNA expression do not necessarily correlate with DNA mutation status. Therefore, RNA analysis provides the true functional profile of any given tumor and should be combined with the DNA sequencing. This is not the first time that RNA analysis was considered promising for clinical management. However, the NanoString platform has managed to overcome several hurdles in RNA analysis. The platform is relatively cheap, easy to use, and most importantly, performs great with formalin-fixed paraffin-embedded (FFPE) tissue, which represents the vast majority of all stored tumor tissue in clinical laboratories. This is a critical point, since many RNA-based analytical platforms for solid tumors have failed in the clinical world due to the fact that routine freezing of the tumor tissue is not practically possible in clinical practice.
From a research to a clinical laboratory market
NanoString first established its footprint in research and unleashed the ability to profile RNA from archival FFPE tissue. At that point, the company was one of the many research-focused developers with a limited market and limited growth opportunities. But the company followed a similar twist that brought Illumina from a manufacturer focused on specialized research laboratories into the clinical laboratory market, where growth opportunities are much bigger. The critical point for any company developing a novel laboratory test or platform is to realize that the clinical practice will not change even for the best test. Even the best new test has to be easy to implement into the routine laboratory workflow. And NanoString handled this task very well, and the number of nCounter systems installed in clinical laboratories is rapidly growing.
The Prosigna Breast Cancer panel is the flagship product for clinical laboratories, and represents a perfect example why RNA analysis will have to complement DNA analysis. The PAM50-based RNA analysis measures expression of 50 classifier genes and five control genes to identify the intrinsic subtypes known as Luminal A, Luminal B, HER2-enriched, and Basal-like. This analysis can predict the risk of breast cancer recurrence, and plays an important role in clinical management.
NanoString is aggressively pursuing further companion diagnostics, cleverly involving Big Pharma as well as independent researchers. In January 2013, Pfizer published a study showing the utility of the nCounter system for diagnosis of a lung cancer for which it has a specific therapy, and is now implemented as a clinical test (abstract here). In January 2014, the Lymphoma/Leukemia Molecular Profiling Project researchers published in the journal, Blood, the development and validation of a biomarker assay based on a 20-gene expression diffuse large B-cell lymphoma subtype classifier using NanoString's nCounter System (abstract here). They showed that the nCounter-based assay accurately and robustly assigned subtypes of diffuse large B-cell lymphoma from FFPE tissue samples with excellent site-to-site reproducibility and rapid turnaround time, making it feasible to implement in clinical laboratories and clinical trials, and to impact patient management. NanoString rapidly developed a partnership with Celgene (NASDAQ:CELG) to develop a biomarker test for lymphoma clinical trials. This may include up to $45 million in total payments based on achieved milestones, and NanoString can commercialize the test independently.
Competition and business model
OncotypeDx from Genomic Health (NASDAQ:GHDX) also performs RNA-based assays for breast, prostate and colon cancer. I will not go into details of which RNA analysis is more sensitive or more accurate. The NanoString platform seems to provide better prognostic value than the older OncotypeDx assay (abstract here).
What I would like to focus is a difference in their business models. Getting the breast cancer analysis from OncotypeDx is simple. The pathology department in the hospital sends them the patient's tissue. OncotypeDx performs the analysis and issues the report. Clear and simple; however, the hospital does not make any money from it, OncotypeDx does. In contrary, NanoString does not perform the clinical test, but sells nCounter system, kits and reagents. There are several advantages to the NanoString business model, in my opinion.
NanoString makes money from selling the nCounter systems, as well as laboratory consumables, while the clinical or research laboratories run the test and report it. The beauty of this system for the laboratories and hospitals in comparison with sending the tissue to OncotypeDx is that the hospital can bill for it. This gives hospitals a very strong incentive to implement the testing platform. Selling the nCounter equipment to clinical laboratories puts the hospital laboratory behind the wheel, enabling them to charge for the tests, which were previously sent out. Using this strategy, NanoString will de-centralize the RNA diagnostics market, similarly to how Illumina decentralized DNA analysis. Every cancer center or laboratory that is sending breast cancer cases to OncotypeDx will do the math and realize they can make the money from testing their patients themselves and not giving the profit to OncotypeDx. NanoString will make money from selling nCounter machines, selling testing kits and selling the reagents. Once the laboratory purchases the nCounter, it will have to keep purchasing consumables from NanoString. The fact that Prosigna test is FDA-approved makes it incredibly easy to implement in any clinical laboratory. If NanoString is able to reach the critical mass and sell the nCounter system to a sufficient number of clinical laboratories, it will establish itself as a leader of the expression profiling in clinical diagnostics. There is a clear parallel with Illumina, which was able to establish itself as the leader in the DNA sequencing, putting the clinical laboratories in charge, selling them sequencers, chips and reagents.
Prosigna has already been adopted by some of the largest private laboratories, such as ARUP, Quest Diagnostics and LabCorp, as well as several academic hospitals and cancer centers, such as UC Davis and UAB Cancer Center.
The fruits of this strategy are already remarkable. The Q1 2014 total revenue was $8.8 million, which represents 54% growth in comparison with Q1 2013. The Q1 2014 instrument revenue was $3.4 million, which is 110% up, and laboratory consumables revenue was $4.8 million, which is 29% higher than in Q1 2013. Gross margin is over 50%, and 2014 outlook is $45-50 million. This growth is particularly impressive when we realize that total annual revenue was $11.7 million in 2010, just three years ago. And with only ~200 nCounter systems installed so far, the company is really just scratching the surface. The company had $85.8 million of cash as of March 31, 2014, i.e. ~$4.7 per share, which is remarkable for a stock trading currently for $13.5 and provides a pretty safe cushion.
The stock is mostly flying under the radar. Diagnostic biotech companies usually do not get the same amount of hype as drug developers. One of the reasons is that most of the investors have a really hard time understanding the laboratory science, molecular barcoding technology and advantages for diagnostics and laboratory workflow. However, rapidly growing NanoString represents an interesting growth opportunity in molecular diagnostics, with revolutionary yet solid science, rapidly growing market share and revenue and undervalued stock.
This article is not meant as a recommendation; only to inspire thought and discussion. You should do your own research and consult with professionals before investing in stocks. Biotech stocks are associated with high risk, including a total loss of the principal.
Disclosure: The author is long NSTG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author is currently involved in academic research using NSTG platform.