Nanosphere: The Next Cepheid?

| About: Nanosphere, Inc. (NSPH)

Despite last week's hit, Cepheid (NASDAQ:CPHD) has been a stock market darling over the past 4 years, as it has taken advantage of a huge opportunity in the MRSA screening market. MRSA is a "staph" germ that does not get better with the first-line antibiotics that usually cure staph infections. When this occurs, the germ is "resistant" to the antibiotic. MRSA infections can also occur in healthy people who have not recently been in the hospital. Most of these MRSA infections are on the skin or less commonly lung infections.

Cepheid's GeneXpert machines, which are testing machines installed at hospitals and reference labs, can run tests for Flu, RSV, MRSA, C Difficile, and Group B strep. With their machines you run one test at a time. Each time a test is run Cepheid makes anywhere from $15 to $45 per test. The machines cost in the thousands of dollars and are either financed or purchased outright. It's a tremendous razor/razor blades business model.

For years Cepheid has tried to do a MRSA test for blood culture; however, they have not been able to succeed. In 2007 they partnered with bioMerieux to develop a product that could test blood samples and identify a variety of infections within a shorter time period so that a patient could be administered targeted antibiotics for the specific infection he/she has while still at the hospital. However, in 2010 this partnership was dissolved (go to p4) because the Cepheid technology failed to deliver the required product and to this day Cepheid still hasn't been able to capitalize on this opportunity.

Recently an article in the NY Times about a young boy that contracted an infection that was not properly identified and ultimately resulted in his untimely death shed light on this problem. It is likely that a blood stream assay would likely have caught this young boy's condition and allowed him to be treated quickly in time to help him survive.

Enter Nanosphere (NASDAQ:NSPH). Nanosphere's Verigene testing machine (much like the GeneXpert machine from Cepheid) can do multiplexing, with some limitations, and provide results in 2 to 3 hours, as opposed to the 2 to 3 days that it takes for typical blood cultures and other tests. Multiplexing is the detection of multiple pathogens within one test. A lab technician can perform the Nanosphere test with minimal test prep and the Verigene system produces an easily readable result within a short period of time. Since the test is easy to read, there is no need for a skilled cytologist or pathologist to read the results.

On June 27th Nanosphere received FDA clearance for its gram positive blood stream infection test from the FDA. This test will be utilized in hospital level labs to identify blood infections and any resistance markers in 2 to 3 hours, versus the traditional blood culture lab test which takes 2 to 3 days.

This is the first approval by the FDA of a sample to result, multiplexed test. The increased speed of diagnosis of the test will allow doctors to focus antibiotic treatment faster. The faster the antibiotics can be focused (from broad spectrum treatments to pathogen specific treatment) the quicker the recover time and the less the side effects to the patients, and the lower the cost to the hospitals. Most of these blood borne pathogens are acquired while patients are already hospitalized for other illness or surgeries.

Nanosphere currently has clearance for Respiratory Virus [RV], Blood Stream Infection [BSI] - Gram Positive, Hypercoag, and Warfarin Metabolism. They are targeting Troponin, Plavix, BSI - Gram Negative, C Difficile, and Enteric Panel. The Enteric Panel is the holy grail: being able to identify all enteric organisms with one test would be game set match for Nanosphere. Nanosphere projects $390,000 annually on average from test revenues for all of the tests they are targeting. Of those tests they have clearance, they anticipate generating $190,000 in test revenues annually from each machine placed.

NSPH employs the same razor/razor-blade business model as Cepheid. They currently have 166 customer placements of their machine and are projecting 380 placements by q2 2013. They expect to be cash flow positive with the placement of 400 machines and with FDA clearance of about half of the tests they are targeting (or about $200k annually in test revenues). They have already just about reached their target for FDA clearance on tests needed to generate $200k in annual test revenues. Now it is a matter of increasing machine placements at hospitals and labs.

In q2 2012 they had 25 customer placements and are averaging roughly 3 times as many placements per quarter now than they were last year. The Gram Positive Blood Test FDA clearance is thought to be a game changer and should result in an inflection point in machine placements.

They believe with 400 installed machines generating $200,000 annually in test revenues, they will be able to generate $75 Million in revenues and $40 Million in gross profits (assumes a 54% margin - test revenues have much higher gross margins), which is what they expect annual operating expenses and R&D will be.

Nanosphere is potentially a game changing molecular diagnostics company, saving hospitals time, money and lives. At a valuation of $150 Million after a recent secondary offering, with $50 Million in cash in the bank, and no debt, Nanosphere looks to have a lot of upside and could potentially become the next Cepheid. While it may not get to the same valuation, it appears that the current valuation significantly underestimates Nanosphere's potential.

Disclosure: I am long NSPH.