Waldemarus
Investment Thesis
As a microcap early-stage biotech, OncoCyte (NASDAQ:OCX) combines high-risk/high-reward characteristics with extremely low liquidity and price discovery. The ticker is primarily a speculative trade option with implied volatility that is higher than many of its peers in the gene testing market. The company’s high-risk/high-reward profile is biased downwards due to recent regulatory disruptions that add further downward pressure on OCX shares in the short term, stripping the company from a crucial funding source necessary to commercialize its Laboratory Developed Tests “LDT.”
At this stage, I believe a bullish case in OCX mirrors bets on macroeconomic conditions rather than on a company-specific catalyst. As such, I would characterize the stock as a hedge in a diversified portfolio and not an investment on its own. Below is a brief discussion of some of the factors that could impact the stock in the near term and what impact they may have on the valuation of the shares.
Industry Trends
Understanding the regulatory and technological dynamics behind the gene testing market’s accelerated growth in recent years is critical to assess OCX’s challenges, opportunities, and market position. A crucial element of this landscape is the Affordable Care Act “ACA,” which carried a roadmap for regulatory changes that took effect long after it was passed in 2010 via a series of scheduled regulatory transformations as recent as 2020. The landmark federal statute is known for expanding insurance access for millions of people across the US, but what is less well-known is its impact on the gene testing industry.
I believe that ACA created an accommodative reimbursement platform for genetic screening by making coverage of preventive health services mandatory (prenatal testing is one such example). The Act fell short of explicitly tagging gene testing, which is understandable, given that when it was passed in 2010, the cost of Whole Genome Sequencing was $29,000, and the gene testing industry was yet to take off.
In subsequent years, gene sequencing advancements brought costs down significantly, making genetic testing more accessible and affordable than ever before. As a result, providers’ demand for clinical diagnostic testing services has increased exponentially in recent years. Today, OCX charges an estimated average of $1500 for its DetermaRx test and realizes a 30% gross margin, which is commercially-feasible pricing for all parties.
OCX’s competitive dynamics are also influenced by two landmark US Supreme Court rulings, lowering barriers to entry but limiting its ability to patent its discoveries. In 2013, the US Supreme court ruled that Myriad Genetics’ (MYGN) patents on the BRCA genes were invalid because they were not the result of novel inventions. This ruling lifted a significant legal barrier to entry into the genetic-testing space by enabling competitors to bypass Myriad Genetics by performing independent tests using the same technology platform. In 2012, another Supreme Court hearing, Mayo Collaborative Services v. Prometheus Laboratories, Inc, held that there is no valid patent for mathematical correlations linking the presence of biological markers with disease risk.
These regulatory developments allowed OCX to exist (by lowering barriers to entry) but also limited its ability to protect its discoveries and inventions, which utilize methods to detect DNA mutations and statistical correlations between biological biomarkers and cancers.
Commercial Challenges
Lung cancer, like many cancers, is more prevalent among the older population, rendering Medicare a key reimbursement partner, especially for OCX, whose pipeline is focused on the disease. The public insurer didn’t start coverage of lung cancer screening until 2015, and current standards of care guidelines recommend annual screening via low-dose computed tomography (LDCT.)
The company practically aims to change the standards of care for lung cancer diagnosis. This process is not easy and is even more challenging for microcap companies with limited financial resources, such as OCX.
In my view, the company bit more than it could chew by acquiring several companies in recent years and pursuing multiple indications simultaneously, a strategy adopted to reverse the previous CEO’s equally-flawed approach of focusing on a single product called DetermaVu (which failed to demonstrate efficacy in late-stage clinical studies), increasing product portfolio risk at the time.
Between these two extremes, the company has lost significant value to shareholders, as mirrored in per-share financial metrics, and today, it is restructuring its operations to stretch its cash balance over more years while simultaneously trying to commercialize new gene tests to replace current golden standards and fend off competition.
It’s very important to understand OncoCyte’s strategy to diversify and de-risk our product portfolio. Q2 2020 earnings call
OCX has one clinically-available product, DetermaRx, and another test available for Research Only Use, “ROU,” DetermaIO. DetermaRx’s commercial launch commenced in 2020 and aimed at diagnosing patients who are at high risk of lung cancer recurrence. The test competes with Natera’s (NTRA) Signatera for Lung Cancer, available for ROU since 2017 and for clinical use since 2021. Guardant Health (GH) announced the introduction of its test in August this year, directly competing with OCX and NTRA. I believe more gene testing companies will enter the market, not because of the financial reward (Market size stands at $140 million) as much as low barriers to entry for established gene testing companies who easily can leverage their existing liquid biopsy platforms into new tests.
OCX is still a long way to realizing DetermaRx’s revenue potential and will need to invest more in clinical trials to influence Key Opinion Leaders “KOL” (US medical and professional associations) to adjust their standard of care guidelines. Although Medicare covers DetermaRx, OCX finds itself compelled to invest in additional clinical trials to enhance product market acceptance. This is why, despite the fact that the product is commercially-available to physicians with favorable Medicare insurance coverage, the company is recruiting for a clinical trial study it started earlier this year.
Regulatory Change On The Horizon
OCX built its strategy on the assumption that it will continue to operate with a limited need for FDA premarket review and approval. In fact, the vast majority of gene diagnostic tests on the market today are not FDA-approved, exploiting a 1988 CLIA waiver on LDTs. However, the FDA may expand its oversight in the near future because of its concern about the increasing use of LDT products with minimal clinical data supporting their safety and efficacy and the potential for misleading results to lead to incorrect treatment decisions or even dangerous medical complications. In recent months, multiple investigational reports highlighted dramatic incidents of flawed use and interpretation of gene LDTs, creating negative publicity over the unregulated genetic testing products and raising serious questions about the safety and accuracy of these products, renewing the FDA’s determination to regulate the market as discussed in more detail here.
[…]focusing on what we believe to be the biggest unmet needs with the lowest technological hurdles and potential shortest time to market. OCX 2015 Annual Report.
None of our LDTs are anticipated to be listed with the FDA – OCX 2018 Annual Report.
In 2008, the FDA asked Exact Sciences (EXAS) to cease all commercial activity related to its colorectal cancer screening test until it got regulatory approval, resulting in catastrophic ramifications for the company. Like OCX, EXAS was a microcap at the time, with one product on the market. EXAS had to fund its R&D through new equity offers for six years before it was approved by the FDA, significantly reducing the value of its shares. At $0.7 per share, I’m unsure whether OCX can do the same.
Financial Position
OCX ended Q2 with cash and cash equivalents of $45 million. On an adjusted basis, its cash burn rate stands at approximately $3.5 million per month. Its current pipeline consists of four key projects; continue commercializing DetermaRx, advancing DetermaIO from ROU to clinical use, and commercial launch of DetermaTx and VitaGraft. Cash burn will likely ramp up as the company advances the development and commercialization activities across its product portfolio.
I don’t believe that investors can lean on DetermaRx revenue anytime soon. The test is still in the early phases of commercialization, and while it enjoys a favorable reimbursement decision from the CMS, its modest revenue mirrors poor market acceptance from healthcare providers. The likelihood of sustained revenue growth from this product remains highly uncertain as the company faces growing competition from other small biotechs developing competing products. For this reason, I believe that equity raising will remain an essential source of financing for the company in the foreseeable future.
Summary
The gene testing market is expected to grow rapidly over the long term due to the rising awareness about genetics’ role in disease prevention and treatment. However, oncology diagnostic is a challenging sector for industry players to navigate in light of the recent increase in regulations and scrutiny targeting the emerging field of LDTs, and the high commercialization and marketing expenses necessary to influence KOLs and standard of care guidelines.
The potential for negative regulatory intervention puts OCX’s strategy into serious question. Given what we know about the company today and what it’s likely to do in the near term, I believe the current share price doesn’t adequately reflect this risk. Based on my analysis, I rate the risk level for investment in OCX stock as high.
Be the first to comment