SCIE: Near-Term Product Launch. Initiating At Outperform (SCIE)

SCIE: Near-Term Product Launch. Initiating At Outperform

Brian Marckx, CFA

We have initiated coverage of SpectraScience, Inc (SCIE) with an Outperform rating and $0.40 per share price target. See below for access to our full 16-page report on SpectraScience which includes a background on the company and their flagship product, WavSTAT4, an analysis of their near-term target markets, and our financial model and valuation methodology.

BUSINESS
SpectraScience, Inc has incorporated their proprietary and patent-protected technology into their WavSTAT Optical Biopsy System which can instantly determine if tissue is normal, pre-cancerous or cancerous, without the need for a physical biopsy. The WavSTAT Optical Biopsy System is classified as a Class III medical device and received FDA approval through the PMA (i.e. – most stringent) regulatory process for use during endoscopic screening in the year 2000. It has since been enhanced and the current version, called WavSTAT4, already has CE Marking and can be marketed in the European Union for diagnosis of all types of cancer. The system is expected to make its debut in Europe this coming week (October 22 – 26) at the 19th annual United European Gastroenterology Week in Stockholm, Sweden. WavSTAT4 could receive FDA approval (via a supplement to the original PMA application) and launch in the U.S. in 2014.

For colon cancer, SpectraScience's initial target market, WavSTAT is used and is compatible with flexible endoscopes, which are used during routine colonoscopy procedures. With over 3 million colonoscopies performed every year in the U.S. and another 4+ million in Europe, the procedure is one of the most common methods for colon cancer screening.

Until recently SpectraScience had also been pursuing the further commercialization of a cervical cancer diagnostic instrument, which was acquired (along with 34 patents and 28 additional patent applications) through the November 2007 purchase of Luma Imaging Corporation. Luma had developed and received FDA approval for an optical, non-invasive diagnostic imaging system called LUMA Cervical Imaging System (Class III device) that was proven to be more effective than traditional colposcopy diagnosis in the detection of cervical cancer precursors. However, in order to fully commercialize the LUMA system, it required further development, including additional and potentially costly and time-consuming clinical studies. As a result, SpectraScience recently shifted their focus and resources towards WavSTAT, which management believes holds the most opportunity (especially from a return on investment standpoint). The company subsequently began winding down their LUMA business and in 2010 wrote off the remaining fair value of the LUMA inventory. This freed up more operational and financial resources which have now been fully dedicated to the commercialization of WavSTAT. SpectraScience retained the intellectual property of LUMA for use in the development of future generations of the WavSTAT System.

OUTLOOK
Our Outlook is based on a number of assumptions and estimates which were gleaned through discussions with management and our own research. Our Outlook also assumes that SpectraScience hits a number of significant milestones over the near-to-mid term and that the economics of WavSTAT4 and SpectraScience's business model work not only for SpectraScience, but also for distributors, hospitals, physicians, third-party payers, and potentially patients as well. Failure to hit some of these milestones (which we allude to below) or a break in the chain of the economics of their business model, could significantly alter SpectraScience's future.

SpectraScience's roll-out of WavSTAT4 is expected to kick off with introduction of the system at the 19th United European Gastroenterology Week in Stockholm, Sweden, taking place during the fourth week of October 2011. General timelines put the system on the European market and generating revenue (albeit modestly initially) from the colon cancer application in late Q4 2011. Esophageal cancer diagnosis could follow beginning in the second half of 2012. Beyond 2012, additional applications could come online including bladder and lung cancer. If all goes well SpectraScience will enter the U.S. market with WavSTAT sometime in 2014. The U.S. roll-out is expected to follow a similar pattern, initially targeting colon, then esophageal and then potentially following with bladder and lung.

OUR KEY ASSUMPTIONS

• Additional Capital: SpectraScience will need to raise additional capital in the near-term. We assume they are able to raise sufficient capital in order to fund the pre-launch and launch of WavSTAT4
• Distribution: both E.U. and U.S. sales / marketing is handled by third party distributor(s). Initial agreements in place within the next few weeks to facilitate E.U. launch. Expect SpectraScience will look to bring on a major distribution partner over time which can handle worldwide (Europe and U.S.) sales
• Revenue Model: sell WavSTAT system to distributors at cost. Distributors place system at no charge to customer. Distributors purchase disposable forceps from SpectraScience and resell at higher price
• E.U. Launch: commences in Q4 2011 for colon indication. Esophageal in 2012, followed by bladder and lung indications in later years
• U.S. Launch: regulatory approvals via supplement to original PMA. Launch commences in 2014 for colon indication. Esophageal follows shortly afterwards. Bladder and lung indications are marketed in later years
• Reimbursement: currently unclear what degree of insurance reimbursement WavSTAT may enjoy in various parts of Europe. The onus to market the system where reimbursement may be most favorable will likely fall with international distributors. Reimbursement in the U.S. will likely be, at best, very spotty, at least initially. Expect SpectraScience to target managed care organizations where cost benefits of WavSTAT can be leveraged

Along with the assumptions above, our revenue model is based on our best-guesses relative to the rate of WavSTAT unit placements, selling prices of the forceps, and utilization (i.e. – forceps unit sales).

Unit Placements
As we assume a late Q4 launch of WavSTAT (in Europe), we model immaterial revenue through the end of the current year. We estimate approximately 30 WavSTAT systems placed through the first six months of 2012 but expect the system placement rate to begin to significantly pick up in the second half of that year, facilitated by the commencement of marketing for esophageal cancer (along with the initial colon indication). Our model assumes just over 100 systems are in use in Europe by the end of 2012. Our model assumes consistent growth in the placement rate throughout 2013, driven fairly equally between the colon and esophageal applications. We also think SpectraScience could be marketing for a bladder cancer indication in Europe by the tail-end of 2013 and model over 400 systems in place by the end of that year. U.S. launch could come in 2014, initially for colon and followed by esophageal in that same year. SpectraScience may also look to continue to expand into additional applications in Europe. Our model assumes SpectraScience tops just over 1,000 total units in service by year-end 2014.

Forceps
Until WavSTAT is on the market, the realizable price-point for the forceps will be unknown. Based on discussions with management, current expectations are that the colon forceps will be offered at a lower price-point compared to those for other indications (i.e. – esophageal, bladder, lung, etc). Colon clearly represents the low-hanging fruit and, being the initial target market, means SpectraScience / distributors may have an interest in sacrificing some margin in order to grab market share, maximize the unit placement rate and help spark utilization. The size of the colon cancer market also makes it one of the most attractive and, therefore, means even relatively low margins (~ 50% initially) can be highly profitable with even moderate utilization. Our model currently incorporates an assumption that SpectraScience sells the colon forceps (to distributors) in the $100 – $200 range (per unit) and ~ 2x to 3x that amount for the other applications.

Utilization
Our assumed utilization rate is arguably conservative at approximately 4 patients per device per week. We also note that we assume no increase in the rate of utilization as additional indications come online or with commercialization in the U.S. Using this assumed utilization rate, along with our estimated ~ 300 average number of units in service throughout 2013, equates to approximately 60k procedures with WavSTAT during that year. That is less than 1% of the more than 6MM combined colonoscopy and upper endoscopy (i.e. – esophageal cancer diagnostic) procedures performed in Europe each year.

REVENUE
Using the assumptions and estimates above, we think SpectraScience could generate $3.6 million in revenue in 2012, including $1.4 million from forceps. As the installed base grows and additional indications come online (the related forceps which we expect to carry higher price-points), revenue growth should significantly accelerate – which is reflected in our estimated revenue figures beyond 2012. We model revenue of $15.4 million in 2013, including forceps sales of $8.9 million, and $40.5 million in 2014, including forceps sales of $27.7 million.

GROSS MARGIN
Gross margin will be a function of realizable selling prices of the forceps (including an appropriate margin for distributors) and the related cost to manufacture them. The colon forceps will likely carry the thinnest margins compared to those for other applications. This is due to the expected lower selling price combined with the colon forceps requiring more optical fiber due to the longer tube used for colonoscopies compared to other procedures such as esophageal screening. Over time, we expect gross margin to widen significantly due to a combination of factors; an ever greater proportion of overall revenue will come from forceps sales (as opposed to WavSTAT system sales which we model to have a 0% margin), forceps margins from follow-on indications should carry a higher margin than those for colon, and higher production volumes should offer some economies of scale. SpectraScience may also have the opportunity to raise prices down the road. We model forceps margin of approximately 45% in 2012, growing to ~ 63% in 2013 and ~ 73% in 2014.

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