This article reviews a biotechnology (healthcare) company that develops non-invasive genomics tests used to diagnose skin cancer. The product is considered superior to current test procedures, and revenues are growing rapidly. Further, the company has three additional products (still in development phase) with even larger total addressable market opportunities. Encouragingly, the company is working diligently to expand product usage by educating the medical community and by reaching out to more insurers to cover it. In this report, we analyze the business model, product advantages, market opportunity, competitive positioning, valuation, risks, and then conclude with our opinion on investing.

Overview: DermTech (DMTK)

DermTech is a biotechnology company working to redefine testing and identification of skin cancer at an early stage. The company is focused on development and commercialization of noninvasive skin sample collection diagnostic kits using adhesive tape biopsy methods. DermTech went public in 2019 as a result of reverse merger with Constellation Alpha Capital Corp., a special purpose acquisition company (“SPAC”) formed by Mr. Rajiv Sarman Shukla.

DermTech launched its first Pigmented Lesion Assay (PLA) product in 2016 for early detection of Melanoma which is the largest cause of skin cancer in the US. A PLA test involves a non-invasive procedure where an adhesive patch is placed on the suspicious mole or lesion on a patient’s skin and then it is peeled off. The collected samples are then sent to the company’s centralized lab in California for further study; and test reports are generated within three days of receipt of the sample.

With a negative predictive value (NPV) of greater than 99% (i.e., very low probability of missing melanoma), DermTech’s PLA tests are considered a significant improvement to current clinical procedures which involve a surgical biopsy and a doctor’s judgment (that can be sometimes subjective).

Furthermore, DermTech plans to launch its UV Damage DNA risk assessment product later this year and has 2 other non-melanoma skin cancer diagnostic products under development.

For a little more perspective on the business, DermTech is still in the early stages of growing penetration of its first commercial stage product and as such is currently incurring considerable losses. It primarily generates revenue by providing PLA test kits to clinicians and doctors, who then prescribe and conduct the tests on patients. These tests are later billed to Medicare or private medical insurance companies for payments on behalf of the patients.

DermTech had 1,430 unique ordering clinicians as of Q2 2021, which represents a YoY growth of 131%, whereas its billable sample volume increased by 267% YoY to 11,750 units. More recently, the company has also launched a teledermatology option including at-home sample collection for melanoma testing where patients can upload pictures of suspicious lesions and consult independent dermatologists for treatments.

DermTech also derives revenue from contracts entered into with pharmaceutical companies for supplying test kits to support their clinical trials and other research initiatives.

Revolutionizing current melanoma detection process

Currently, the typical melanoma test involves visual inspection by clinicians followed by a surgical diagnostic procedure for biopsy and histopathology or microscopic examination of cells changing over time which can be subjective and can lead to inaccurate results. Further, a patient has to undergo a biopsy multiple times for correct judgment which can be more costly.

DermTech is seeking to revolutionize the current process with its disruptive non-invasive genomics based technology which is more cost effective and delivers much more accurate results. In fact, DermTech’s PLA test has a negative predictive value of 99% (i.e., less than 1% probability of missed melanoma as compared to current process where probability of missed melanoma is 17%). It also has high probability of detecting actual positive cases of 91-95% as compared to current standard with a sensitivity of 65-84%.

Further, with a reduced number of biopsies and smaller excision size per melanoma, PLA tests are more budget friendly with an estimated cost of $760 as compared to traditional procedures which cost around $1,300, making it more attractive to payors and insurers.

Competitive Advantages

As far as competition is concerned, while there are several large pharmaceutical companies and early-stage startups such as Leo Pharma, Mindera Corp., Myriad Genetics, and Castle Biosciences that are developing minimally invasive genomics tests and gene expression assays, DermTech is the only company that has non-invasive genomics test commercially available in the market. Further, it has 6 US and 5 non-US patents already issued and several pending to protect itself from product replication in the future. Additionally, the company has already received FDA approval and is covered by Medicare which does not come easy.

Large Total Addressable Market

Dermatology is one of the largest medical markets in the US, and with 15 million surgeries conducted each year—skin cancer is among the most common cancers globally. In fact, as per The Skin Care Foundation, 20% of Americans will develop skin cancer by the age of 70, and more than 200,000 cases of melanoma will be diagnosed and 7,000 are likely to die with melanoma this year alone.

When detected early, the 5-year survival rate of melanoma is 99% and with the PLA test being highly effective in detecting early incidents, the potential benefits and market opportunity are significant.

DemTech PLA: With around 4 million biopsies for pigmented lesions being conducted in US each year, DermTech has a potential addressable market of $2.5B for PLA tests alone.

Luminate: Additionally, the company is planning to launch its next product “Luminate” by early next year which is an at-home test to quantify UV damage to the skin. Luminate has a much larger addressable market targeting 82 million US adults aged 35-54 years. Roughly 1/3rd of this group is prone to actinic sun damage. Investors must note that, since Luminate is a Lab Developed Test (LDT), it does not need to go through FDA approval or other clearances and because DermTech is planning to market it to consumers directly, it will be easier to commercialize.

CTCL and Carcinome: And with two additional products in the development phase, DermTech estimates its total addressable market at $10 billion.

Early revenue stage company, but poised to grow as commercialization deepens and products under pipeline are launched

DermTech reported total revenue of $3.1M in Q2 2021 (see earlier revenue chart) which represents a YoY growth rate of 269%, whereas sequentially the company’s top-line was up by 24%. Assay revenue, which contributes 90% of the DermTech’s business, increased 349% to $2.9M as compared to last year. The strong growth was primarily driven by growing sample volume resulting from more unique customers as well as an improved average selling price of test kits due to a better customer mix. Billable sample volume increased almost 3x from 3,200 in Q2 last year to 11,750 in the recent quarter as more sales representatives were onboarded by the company to market its products.

The average selling price increased from $201 in Q2 last year to $248 in the recent quarter as its contracts with large payors including Blue Shield of California, Blue Cross Blue Shield of Texas and Blue Cross Blue Shield of Illinois came into force. Moreover, Medicare, from where DermTech generates higher ASP increased in overall proportion from 16% last year to 19% in the recent quarter. Going forward, as the company onboards larger payors, its ASP is bound to increase.

“We increased our number of unique ordering clinicians in Q2 by approximately 230 clinicians or 19% sequentially to achieve a total number of unique ordering clinicians of 1,430. We believe increasing sample volumes and ASP through additional payer access, success with appeals, and increasing our Medicare proportion will provide long-term - a long-term compounding effect on future revenue growth.” – John Dobak, CEO in Q2 2020 earnings call.

Profitability still elusive, however enough liquidity cushion to absorb the current cash burn rate over the medium-term

DermTech’s business operations involve high fixed costs related to management of its California based laboratory, required testing equipment, and management personnel, and as such, profitability can be achieved only through economies of scale. In Q2 2021, the company reported a gross margin of 16% which was a significant improvement from -71% reported in the same quarter last year primarily driven by strong top-line growth.

As the company’s capacity utilization increases going forward, its profit margins will improve. Having said that, operating losses increased from -$9M in Q2 2020 to -$17M in Q2 this year, which is more than 5 times its total revenue. Sales and marketing expenditure more than doubled to $8M as DermTech expanded its sales team and also invested to create awareness about its product amongst clinicians.

Additionally, R&D expenses increased 316% YoY to $3.6M as the company hired a new Chief Scientific Officer and Chief Medical Officer, while also continuing to invest in the development of its products which are currently in the pipeline. Its total cash burn rate (FCF) for the first 6 months of 2021 stood at $24M. We believe, the company’s cash position of $269M along with the ability to raise additional capital will provide enough cushion to support DermTech’s investment in the business over the next 2 to 3 years.

Well-placed to grow into its premium valuations

Biotechnology companies often trade at valuations that are a function of long-term (5-10 years) earnings power potential of under-development drugs rather than the already announced or existing earnings stream. DermTech’s stock has remained highly volatile in the last 3 quarters. Its stock price hit an all-time high of almost $80 when the company announced its agreement with Blue Cross Blue Shield of Texas for Skin Cancer Assays. However, since then the stock has corrected.

DermTech currently trades at an EV to Sales ratio of 72.6x. Although company’s current valuation is at a premium based on the near term earnings power, we believe with one product (Melanoma test kit) already undergoing commercialization and another product (Luminate UV damage test kit) with a much larger TAM set to be launched early next year, the company is well placed to grow into its premium valuation.

Risks

Delay in technology development: Three of DermTech’s products with a much larger addressable market are still in the development phase. Any delay in launching its pipeline products may significantly impact the company’s long-term prospects.

Failure to commercialize its product: It will require substantial time and effort for DermTech to educate the medical industry about the advantages of its product offerings given that the company’s products are novel. Further, a lot of effort will be required to attract more regional and national payors to include its products in their policy coverage. Having said that, we like the progress the company has made on this front so far.

Conclusion

Revolutionizing the skin cancer industry, DermTech has introduced a disruptive product that is far superior and patient friendly than currently followed practices (that involve multiple biopsies and provide inconsistent results). While still in the initial phases of growing penetration of its first commercial stage product, the company enjoys immensely large market potential and is already well on its path to capture a major share of its targeted addressable market in the coming years. Having said that, by their very nature, biotech companies are volatile and therefore investors need to take a longer-term view and also be ready to stomach wild swings in the stock in the near to medium term.

We don’t yet own shares of DermTech, but we are keeping it high on our watchlist.

Healthcare Stock: Tremendous Upside Potential