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For many endeavors, there is a trade off which is neatly summarized with the saying “Good, Fast, Cheap: Pick two.” The idea is that a job can be done quickly and well, but it will be expensive. Or it can be done quickly and cheaply, but the results won’t be very good. You get the idea. The only circumstance in which these constraints can be broken is through the use of a transformational technology. The advantage of such a technology that enables good, fast and cheap, is that it can be priced similarly to other good, fast solutions (i.e., expensively). In other words, it enables very high profit margins without hurting competitiveness.

Alternately, good, fast and cheap can be used to rapidly build market share against good, fast, expensive competitors. I have recently come across a medical diagnostics company with such a transformational technology, Nanosphere (NSPH). As an added bonus, a modest regulatory setback Tuesday has led to a major sell off in the stock, pricing it very cheaply and setting it up for extraordinary long-term gains.

First, I’ll quickly describe the technology. Nanosphere has the ability to attach diagnostic molecules to gold nanospheres, which allows extremely sensitive fluorescent detection of both protein and nucleic acid (DNA, RNA) targets. This technology has been built into their Verigene SP system. This system is set up to enable Nanosphere diagnostics to be run by an unskilled technician, with no sample preparation (that’s the SP in Verigene SP), with all tests performed on a single instrument. Each test has its own cartridge, and once the patient sample is placed in the cartridge, the cartridge is plugged into the Verigene instrument, and after automated processing, the test results are reported. The system is inexpensive and simple enough to be deployed in small hospitals or clinics that currently don’t have molecular diagnostics capabilities (NSPH estimates there are 40,000 such locations). At the same time, it is sensitive enough to enable tests that even large national diagnostic labs don’t have access to.

Now let’s look at how far along in development the Verigene system is. There are currently four tests approved for use in the U.S. and/or Europe: hypercoagulation (U.S.), warfarin metabolism (U.S., Europe), respiratory viruses (U.S., Europe), and Plavix metabolism (Europe). There are currently 50 Verigene systems in regular use in the U.S., and Nanosphere just began selling Verigene in Europe in Q1, 2011. As for the growth rate, although the system has been approved in the U.S. for several years, 12 of the 50 systems in use were delivered in Q1, 2011, so obviously growth is ramping up quickly. Europe should also grow quickly from its base of zero.

It is important to note that Nanosphere should soon benefit from a “critical mass” effect with its system. When the Verigene system had only one or two assays of interest to a customer, the fixed costs of the system and a technician were only be justifiable for customers with large numbers of patients. As more tests become available, the return on the Verigene investment goes up and it becomes more cost effective for more and more customers (the customers operating leverage increases). As more customers purchase the system and its tests, Nanosphere’s operating leverage should also increase. This [operating leverage]-squared effect should drive Nanosphere rapidly into profitability once the critical mass is reached.

Management is estimating that they will reach profitability break-even at 400 customers using 4 assays each. That seems achievable within 2-3 years, given current growth rates and their expectation of having 8 total tests approved by the end of 2012. The question then becomes, does the company have the funds to operate until they achieve profitability? That answer is most likely, “yes”. The company has ~$60 million in cash after a recent stock offering, and their current burn rate is $30 million per year. Given that the cash burn should drop as sales pick up, it’s likely that they will reach break-even with their current cash. If another round of fund-raising is necessary, it should be only modestly dilutive since the amounts will be small and the company should be trading much higher with profits just around the corner.

Another striking comparison: given the $60 million cash, no debt and a $64 million market cap (at $1.51/share), the market is currently valuing NSPH’s transformative technology and FDA approved products at $4 million. That looks outrageously cheap to me.

Before I wrap up, I want to look at a couple of the more interesting assays Nanosphere has in development. First I’ll consider the Plavix metabolism assay, which is approved in Europe but received a “not approvable” letter from the FDA today. Plavix is an antiplatelet agent used to inhibit blood clots in coronary artery disease, peripheral vascular disease, and cerebrovascular disease. Plavix is a prodrug, meaning that the drug itself is not active. Rather it is metabolized by the CYP2C19 enzyme, transforming it into the active substance.

The problem is that a significant percentage of the population has genetic variations of the CYP2C19 enzyme that make it largely incapable of metabolizing Plavix into its active form. These patients have a 1.5- to 3.5-fold higher chance of dying or suffering complications because the drug doesn’t work for them. Because of this problem, the FDA has given Plavix a “black box” warning, suggesting that patients be tested (if possible) before Plavix use to ensure that it will be effective.

Given that many uses of Plavix are urgent, a rapid, widely available test such as Nanosphere’s should be extremely valuable. This is particularly true since Plavix is an expensive drug ($6.6 billion in sales in 2009) that will become generic by the end of this year. There are competitive molecules such as prasugrel (Efient) that don’t require genetic testing, but they will remain patented (and therefore, expensive) for many years. Nanosphere’s Plavix test should offer an excellent value proposition since it will enable the use of a cheap generic (Plavix) in most cases, while preventing its use in cases where Plavix will put the patient at risk. Based on this value, and the fact that Nanosphere’s test is already approved in Europe, I consider it very likely that the test will be approved in the U.S. early next year, providing significant revenues to NSPH.

The next test I’ll discuss is their Troponin assay. Troponin is a protein expressed in the heart that is normally virtually non-existent in the bloodstream, but blood Troponin levels become elevated after heart attacks. Measuring blood Troponin levels is a very effective way of determining if patients with ambiguous symptoms such as chest pain are actually having a heart attack. Traditional Troponin assays were not very sensitive, and couldn’t detect elevated Troponin levels until 8-24 hours after a heart attack. Nanosphere’s assay is much more sensitive, and can detect elevated Troponin levels in 86% of heart attacks immediately upon arrival in the emergency room and 100% of heart attacks within 2 hours.

The speed of this assay, and the ease with which it could be deployed in every hospital and medical clinic, suggest that it should also be extremely valuable. Other, similarly sensitive assays are available, but if a hospital has to send samples to a testing center for analysis, valuable time will be lost. Nanosphere’s assay is expected to be approved in 2012.

Nanosphere’s pipeline is deep, and I can’t possibly discuss all the assays in research and development, but the opportunities do seem to be extensive. It’s very difficult for me to try to predict revenues and profits for Nanosphere several years into the future. The best I can do is compare them to other molecular diagnostics companies that are farther along in their development. One example would be Quidel (QDEL). They use fairly standard technology and have a fairly undifferentiated set of assays, but they’re profitable, with a market cap of ~$500 million. Cepheid (CPHD) has a more impressive technology base, though Nanosphere still has advantages. Cepheid isn’t profitable, but has a market cap of ~$2 billion. Myriad Genetics (MYGN), on the other hand, is an example of what you can do with a single high-value assay (MYGN does have other assays, but the vast majority of their revenues comes from a single test). Myriad is extremely profitable, but possible patent issues have held their market cap down at ~$2 billion. I’ll assume that Nanosphere is likely to reach at least the profitability and market cap of the smallest of these, Quidel. If Nanosphere reaches that market cap of $500 million, it will represent a gain of roughly 680% from current levels.

For those of you who have read my recent article on building a high-return, modest-risk biotech portfolio, Nanosphere represents the sixth stock in that portfolio. I think it has a ~70% chance of success, and obviously the 600% return exceeds my requirements for the portfolio.

And here’s a company presentation for anyone interested in a quick extra look at Nanosphere.

Source: Nanosphere's Extraordinary Growth Potential in Medical Diagnostics