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Summary

  • FDA has approved new enteric test that should increase sales in the coming quarters.
  • Year over year sales of consumables are up 108%.
  • FDA is expected to approve enteric viral test in coming quarters.

Nanosphere (NASDAQ:NSPH) develops molecular diagnostic tests and markets its products under the Verigene system brand. Over the last three years, Nanosphere's revenue has increased by a factor of four. This company has positioned itself to leverage the growing molecular diagnostic industry.

It recently received FDA clearance for an enteric test that should act as a huge growth catalyst, but the market has punished it severely instead. We believe that despite the recent short-term problems, it has substantial upside potential in coming years.

Business Model

Nanosphere develops targeted molecular diagnostic tests. Molecular diagnostic tests analyze each individual patient's biological marker in the genome and proteome in order to find out how their cells express their genes as proteins. These tests apply molecular biology to medical testing. This type of individualized tests can help doctors with detection of diseases at a very early stage that leads to optimal patient treatment. Also, early detection of the diseases translates into savings in treatment costs that help improve the overall health care economies.

Nanosphere generates the bulk of its revenues from selling Verigene microbial cartridges. The Verigene system consists of a microfluidics processor, a touchscreen reader and disposable test cartridges. These cartridges use proprietary nanoparticle chemistry to offer simple-to-use, highly accurate multiplex molecular diagnostics that rapidly detect infectious pathogens and drug resistance markers. The FDA has so far approved testing of Influenza (A/B), RSV (A/B), H1N1, Flu A - H3, Flu A - H1, Staphylococcus spp, Listeria spp, and Clostridum difficile by using Nanosphere's Verigene system.

Usually it takes up to 72 hours to identify a disease by using traditional microbiological tests. However, Nanosphere's Verigene system can reduce the waiting time to only ten hours. The reduction in the diagnostic phase means an average 6.2-day reduction in length of stay for the patient in the hospital. It also reduces the mortality in intensive care from 47.8% to 9.5%.

Besides the obvious clinical benefits, Nanosphere's tests can save $21,387 on average per patient. There are a handful of companies that currently have molecular diagnostic test products in the market. For example, GenMark Diagnostics' (NASDAQ:GNMK) XT-8 system and Cepheid's (NASDAQ:CPHD) GeneXpert system. However, Nanosphere's tests have certain clear advantages over other FDA approved systems.

  • Verigene tests are completely automated that reduces possible human error
  • It only takes up to 10 hours to get the results
  • It allows for multiple tests to be run at the same time on the same sample, on a single platform
  • Nanosphere claims that its technology is at least 100 times more sensitive than current diagnostic technologies, which provides a significant advantage because it can detect proteins at lower concentrations equating to earlier detection of disease

Although Nanosphere's products have technical superiority, its competitors have greater financial, technical, and other resources available to them. Hence, part of Nanosphere's success will depend on its ability to establish competitive marketing, sales, and distribution channels. The costs of molecular diagnostic test are a bit higher compared to microbiological tests.

Nevertheless, when patient care, long stay period, and other costs are considered, it is more economical for the health care industry to use the molecular diagnostic test. According to Dr. Frederick Kiechle, molecular diagnostic tests are rapidly becoming popular and the profit margins of these companies are increasing. Nanosphere has positioned itself to take advantage of this growing trend towards the molecular diagnostic tests, which will like become the norm in the coming years.

Background

Dr. Robert Letsinger and Dr. Chad Mirkin founded Nanosphere, Inc in 1999. The company headquarter is located in Northbrook, Illinois. Initially, the founders used their own technology developed at Northwestern University to launch the business. In 2007, Nanosphere, Inc went public and it was listed on the NASDAQ. The IPO raised approximately $88 million, after deducting underwriting discounts and commissions. The bulk of the proceeds, around $48 million, went to finance ongoing research in connection with the development of additional genomic and protein tests. As of 2014, Nanosphere has remained committed to continued scientific discovery and innovation with more than 175 patents to its name.

Growth Catalyst

According to Nanosphere's Chief Financial Officer and VP of Finance & Administration, Roger Moody, the biggest catalyst driving their business right now is sepsis. It is an illness where the human body severely responds to bacteria or other germs. It is one of the major unmet medical needs in the United States health care system. Currently, treatment of sepsis requires $15.4 billion in annual spending in the country.

The simple solution to treating sepsis involves an early detection. Nanosphere's Verigene system based testing is positioned to resolve this problem by offering more accurate and faster detection of the disease at an early stage. On June 25, Nanosphere got clearance from the FDA for its Verigene Enteric Pathogens Nucleic Acid Test. This is an exciting and significant development for the company, as it will enable Nanosphere to continue building its product portfolio in the microbiology infectious disease market, which will directly contribute to further growth of the company.

Nanosphere is currently targeting 4,000 hospital-based laboratories in the United States alone and more around the world. It signed an agreement with HealthTrust on June 23 to provide multi-target molecular diagnostic tests for the nearly 1,400 acute care facilities that are part of the HealthTrust membership. This contract will enable HealthTrust to offer its members access to buy Nanosphere's portfolio of Verigene multiplex molecular diagnostic infectious disease tests, including those designed to rapidly and accurately detect infections of the bloodstream, respiratory tract and gastrointestinal tract. By bringing additional 1,400 care facilities under its umbrella in the country, Nanosphere should be able to sharply increase its sales in coming quarters.

Financials

Since 2011, Nanosphere has generated consistent (albeit seasonal) quarterly growth. Compared to less than $0.75 million of revenue in the last quarter of 2010, its revenues reached $2.67 million in the second quarter of 2014, representing a 380.6% increase in the span of only 36 months. As Dr. Frederick Kiechle mentioned, the profitability of this sector will increase as it scales over time. The increased sales delivered even better quarterly gross margin for Nanosphere. Compared to a near breakeven margin at the end of the first quarter of 2011, Nanosphere's quarterly gross profit increased by 436.4% at the end of the second quarter of 2014.

However, in the first and second quarter of 2014, Nanosphere's revenues have gone down to $3.28 million and $2.67 million, in that order. On the other hand, gross profit went down to $1.26 million and $1.0 million. "Our instrument sales fell well short of expectations due to timing of hospital capital budgets and a continued lengthy customer implementation process," the CEO of Nanosphere, Michael McGarrity, explained. In the midst of the decreasing sales, Nanosphere has already lowered its guidance for the third quarter of 2014.

Although the quarterly revenue decreased, the Q2'14's $2.67 million revenue still represented a 44% year-over-year growth for Nanosphere. If we dig further, the majority of the Q2'14 revenue came from consumable sales, which was $2.2 million or 82.40% of the total revenue, representing a year-over-year growth of 108%.

The molecular diagnostic test market is maturing as hospitals are embracing the molecular diagnostic test over microbiological tests. Hence, we expect the revenue of Nanosphere to continually grow amid strong secular growth momentum created by the organic demand. In addition, the economies of scale imply that its gross margin will continue to surplus its revenue growth rate.

Despite the consistent year-over-year revenue growth, Nanosphere is still not profitable and continues to lose money. During the last two quarters, Nanosphere's cash from operating activities deteriorated from to -$10.12 million.

As of Q2'14, Nanosphere has generated around $1 million gross profit of its $2.67 million revenue. Current estimates suggest that its revenue will reach $6.95 million by the second quarter of 2015. At this rate of revenue growth and associated improving margins, it will take less than two years for Nanosphere to become a net cash flow positive company.

Nanosphere currently has $35.45 million in current assets, where $21.8 million of it is in cash and equivalents. At the current rate of $10.05 million losses per quarter (as of Q2'14), the company will stay solvent for another two quarters without requiring additional financing.

Risk Factors

Nanosphere faces competition in the protein detection market from companies that provide mass spectrometry systems, including Applera Corporation, Cepheid, Ciphergen Biosystems, Inc. and PerkinElmer, Inc. However, they are extremely costly, require significant time and effort by sophisticated staff and cannot detect many complex, disease-causing proteins.

Regardless, these different products have more resourceful companies behind them who have more established marketing, sales and distribution services compared to Nanosphere. The competitions from alternative diagnostic tests are one of Nanosphere's biggest challenges.

Furthermore, it will take at least eight more quarters for Nanosphere to become cash flow positive and it only has enough cash reserves to last for only two more quarters. This poses a significant risk to investors at the current stage. As soon as Nanosphere has to raise funds in a year, its market valuation will sink in proportion to the additional financing.

Conclusion

MicroCap Intelligence uses a proprietary quantitative model and strict investment criteria to identify small and micro cap companies that have a high potential for price appreciation with less potential for loss. As a microcap turnaround, Nanosphere meets the MicroCap Intelligence investment criteria on both growth prospects and profitability.

Nanosphere meets most of the MicroCap Intelligence investment criteria as it has over three years of consistent revenue and associated gross profit growth. In addition, Nanosphere has positioned itself in an expanding market.

Disclosure: The author is long NSPH. 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: MicroCap Intelligence is a team of analysts that focus on small and microcap stocks. This article was written by Asif Imtiaz and Wilton Risenhoover, two of our analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Source: Nanosphere: An Unappreciated Growth Story