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Research Report Update

CUR.TO - DiagnoCure, Initiating Coverage at Outperform

03/20/2012

By Brian Marckx, CFA

We are initiating coverage of DiagnoCure Inc. (Toronto:CUR) with an Outperform rating and $2.25 per share price target.  Below are excerpts from our 20-page initiation report on the company.


BUSINESS

DiagnoCure Inc. (Toronto:CUR) is a Quebec, Canada-based developer of molecular diagnostic tests for the detection and quantification of various forms of cancer, including colorectal, prostate, lung and bladder.  The company was founded in 1994 and commercialized its first test, for bladder cancer, in Europe in 1998 and in 2000 the test received FDA approval.  In 2003 they brought an analyte specific reagent (:ASR) prostate cancer test to the U.S. market which used their proprietary PCA3 marker.  The company is looking to capitalize on the rapidly growing demand for more accurate and quantifiable cancer tests - which is being driven by molecular diagnostics, a segment experiencing 15%+ annual growth.       

The company's current focus is on prostate and colorectal cancer and includes its flagship PCA3 test (Gen-Probe's Progensa PCA3), for prostate cancer.  The test was approved in Europe in 2006 but had only been available in the U.S. in ASR format until receiving FDA approval in mid-February 2012.  FDA approval allows commercialization partner Gen-Probe to explicitly market Progensa PCA3 which could greatly expand its use.  The test, which uses the proprietary biomarker PCA3, could provide significantly greater clinical utility than the standard prostate cancer test (i.e. - PSA).  PSA is infamously unreliable and, coupled with a huge unmet demand for a better prostate cancer test, provides a potentially attractive opportunity for DiagnoCure.  The FDA approved indication (supported by clinical trial data) is to assess the risk of a future positive biopsy (i.e. - risk of diagnosing cancer in the future) following a prior negative biopsy - a worldwide market estimated at about $180MM (DiagnoCure receives royalties on sales).  We believe Progensa PCA3 may also have utility outside of its indicated use including potentially prior to an initial biopsy, which would greatly expand the market opportunity for the test.  

The company's colorectal cancer test, Previstage GCC, uses the marker Guanylyl Cyclase C (GUCY2C or more commonly, GCC) to stratify the risk of colon cancer recurrence by more accurately determining the stage of the disease, which is considered the best determinant of predicting cancer recurrence and survival.  As staging is used to determine the most appropriate course of treatment, mis-diagnosis can result in compromised patient care and outcomes.  DiagnoCure, which had been selling Previstage GCC through its own sales force until June 2011, expects uptake of the test to accelerate as a result of a recent out-licensing agreement and a regular flow of peer-reviewed publications supporting the utility of the test.  The target market are the ~70k patients in North America that have been diagnosed by traditional methods as having Stage I or II colorectal cancer but may actually have more advanced progression of the disease.  DiagnoCure estimates this market represents ~ $200MM in sales (of which DiagnoCure would receive royalties on).  

In the year 2003 DiagnoCure licensed development and commercialization rights to their PCA3 marker to Gen-Probe, which sells their current (and will sell their follow-on test) Progensa PCA3 tests.  In return DiagnoCure received an upfront payment and continues to receive sales royalties.  DiagnoCure had been selling their Previstage GCC test themselves but in mid-2011 they restructured operations, selling their CLIA-certified lab and granting worldwide rights to the Previstage test to Signal Genetics.  DiagnoCure received upfront cash and will receive ongoing sales royalties as well as some R&D funding.  The move was driven by DiagnoCure's desire to more rapidly expand growth of the GCC test via a partner with greater distribution reach, reduce operating expenses and to restock their cash balance, providing more opportunity to advance pipeline projects.  DiagnoCure had previously mothballed their lung cancer program but now with additional financial flexibility and funding afforded by the Signal Genetics deal, the company announced that it will resume the program which is expected to include the development of a multiplex PCR-based test.  

DiagnoCure's future now largely hinges on execution by their commercialization partners and their ability to capture as much of the target markets of each of these two cancer tests.  The recent Signal Genetics deal provides the company with much greater selling resources and reach.  While Previstage GCC has had only limited success to date, it's possible with Signal Genetics now onboard that sales could start to show more substantial growth in the U.S.  Similarly, Gen-Probe has not had much success in moving the needle on Progensa sales in Europe but FDA approval of the test offers a new opportunity to spark revenue growth.  U.S. regulatory approval now opens up the door to explicitly market the test with a potentially compelling message to a wide audience - including directly to the patient which could help uptake in the absence of widespread insurance reimbursement.  The rate of ramp in sales of the test may be determined by a number of things, many of which are out of the company's control including coverage decisions by private payers and the utility of the test in clinical practice.  Perhaps the most influential factor that may shape the near and intermediate term success of PCA3, however, will be the level of effort and resources that Gen-Probe dedicates to marketing and sales of the test.      


PCA3 Commercialization Strategy…

The test has been available in the use in ASR format in about 13 laboratories in the U.S. (including Quest, Lab Corp of America, and Bostwick) and fully commercialized in over 40 labs in Europe.  It is just beginning roll-out in Canada.  FDA approval now opens up the door to explicitly market the test with a potentially compelling message to a wide audience - including directly to the patient which could help uptake in the absence of widespread insurance reimbursement.  The rate of ramp in sales of the test may be determined by a number of things, many of which are out of the company's control including coverage decisions by private payers and the utility of the test in clinical practice - which are both closely related.  Despite FDA approval and coverage under existing CPT codes, more robust reimbursement for the test may be a progressive process related to evidence from clinical practice that it can actually improve patient care and/or reduce unnecessary procedures and the related costs - which may take some time.  One positive factor is that healthcare reform measures have put greater focus on more rapid adoption and reimbursement of tests that can save money and improve patient care - which could potentially bode well for even more favorable reimbursement of Progensa PCA3.  FDA approval will also hopefully facilitate more widespread reimbursement throughout Europe (which is a country-by-country decision), lack of which has hampered sales of the test (the test launched in Europe in late 2006).  Perhaps the most influential factor that may shape the near and intermediate term success of PCA3, however, will be the level of effort and resources that Gen-Probe dedicates to marketing and sales of the test.  A dedicated marketing effort will be key to maximize potential sales of the test.           

Gen-Probe currently sells the test in North America and Europe and is expected to eventually be run on Gen-Probe's fully-automated PANTHER system, a next-generation instrument complementing their older TIGRIS system.  PANTHER was CE Marked in late 2010 and received Health Canada approval in August 2011 - it is already available in Europe and Canada.  Gen-Probe filed for 510(k) approval of PANTHER in May 2011 - approval is expected to come in the first half of 2012.    

The recently approved FDA indication for Progensa PCA3 is "for use in conjunction with other patient information to aid in the decision for repeat biopsy in men 50 years or older who have had one or more previous negative prostate biopsies and for whom a repeat biopsy would be recommended by a urologist based on standard of care".  It is contra-indicated for men with atypical small acinar proliferation (:ASAP).  As a negative Progensa PCA3 result is associated with a lower chance of a positive biopsy, the expected value-added by using the test is to reduce the number of unnecessary repeat biopsies.  

There are approximately 1 million prostate biopsies done every year in the U.S. and a similar number done in Europe.  Worldwide, about 3 million prostate biopsies are done every year.  As roughly 70% of prostate biopsies are negative for cancer, based on the indicated use of the test, this means the maximum combined U.S. and European markets are roughly 1.5 million people.  While we note that not all patients with initial negative biopsies will be recommended for a repeat biopsy and ASAP is present in about 5% of biopsies - both of which mean that the indicated target markets may be slightly smaller than 1.5 million, for our financial model-building and forecasting purposes we think 1.5 million is a fair gauge of the indicated target market (U.S. and Europe combined).     

Based on $100/test, this represent a total indicated U.S./European (i.e. - where the test is currently available) market size of approximately $150 million.  Per terms of the development and commercialization agreement with Gen-Probe, DiagnoCure will receive royalties equal to 8% of worldwide sales of the PCA3 test up to the first (cumulative) $62.5MM in sales and 16% royalties beyond $62.5MM (cumulative).  Approximately $27MM in sales have been generated to date (i.e. - ~ 1/2 to the $62.5MM mark when royalties of 16% kick in).  

Based on an assumed $150 million total market (not including off-label use), this represents potential peak royalties to DiagnoCure of $24 million - more realistic peak penetration of the total market is probably closer to 50% (reached several years after launch) however, equal to peak royalties to DiagnoCure of $12 million.  However, if also used outside of the FDA-approved indication (i.e. - off-label), especially prior to a first biopsy, this could potentially  expand the market for the test to many times the size of the indicated market.  DiagnoCure believes the expanded market opportunity for the test is represented by the 9 million people worldwide that are screened with a PSA test and show elevated PSA (>2.5ng/ml).  Progensa PCA3 could potentially be used to with these individuals to help determine whether an initial biopsy should be done.  Based on a $100/test, this represents an expanded annual market size of approximately $900 million.  This market is relatively large and potentially offers significant upside to our model depending on success of Progensa PCA in penetrating this market segment as we currently model only very modest sales of the test related to use prior to first biopsy - we will update our model accordingly.    

Our model assumes the $62.5 million in cumulative sales watermark (moving the royalty rate to 16%) is attained around mid-to-late fiscal 2013.     

Q4 2011 and 2011 full-year (ending 10/31/2011) royalty revenue from Gen-Probe were $125k and $605k, approximately flat and up 8% compared to the year earlier periods, respectively.  $605k in royalties translates to about $7.6 million in PCA3 revenues to Gen-Probe - which (assuming a total market of $150MM) equals just over 5% of the target market.  Approximately 65% of Gen-Probe's PCA3 revenue currently comes from Europe - although with FDA approval, a greater percentage may now shift towards the U.S.