Expert Financial Analysis and Reporting

MelaFind

MELA Sciences (MELA) is in the early stage of rolling out MelaFind, an FDA approved handheld optical scanning device for assisting dermatologists in identifying skin lesions that may be melanoma. The device is placed over a skin lesion and uses imaging technology in which light of ten specific wavelengths is focused on the lesion and allows the three dimensional visualization of the lesion up to depths of 2.5 mm below the skin's surface. Computer algorithms are then used to analyze the potential that the lesion is malignant. It does this by relating the image results to 10,000 archived images of both benign and malignant lesions. Results are then available in less than one minute right in the doctor's office.

In a clinical trial of 1,300 patients presenting with over 1600 lesions, MelaFind detected 98% of melanomas, while missing fewer than 2% of these early cancers. A control group of dermatologists in another controlled study using conventional techniques misdiagnosed the presence of melanoma 28% of the time. MelaFind is intended to help the dermatologist confirm his diagnosis when he is equivocal and helps avoid unnecessary biopsies. It also holds the potential for detecting melanomas that have not been diagnosed.

My view is that this is a major new innovation for detecting melanoma early on before it has metastasized so that it can be successfully treated before it becomes life threatening. The Cleveland Clinic agrees with this as they have named MelaFind as one of the top ten medical innovations for 2013. If management executes in 2013 as I believe they can, I think that MELA Sciences can be a very interesting stock in 2013 and I will start building a position after this report has been disseminated. I think that it is inappropriate to have a position before I publish on a company.

MelaFind Launch Began in March 2012

MELA Sciences' stock has been the target of intense shorting over the last three years.

This started in 2010 when the FDA stated that the MelaFind PMA was not approvable even though it had received a favorable review by an FDA advisory committee. Subsequently, the FDA reversed its position and approval was gained in November of 2011. With the approval of MelaFind the naysayers switched their reason for shorting to the belief that the launch that began in March of 2012 is disappointing and signals limited commercial potential for MelaFind. The company counters that the shorts have a serious misunderstanding of the dynamics of the launch.

The company has a razor and razor blade sales model that starts with the installation of MelaFind in a physician's office at a cost to the physician of $10,000. Then each scan performed brings in $50 to MELA which is taken out of what physicians charge private pay customers, i.e. somewhere between $100 and $300 per scan. The company has carefully planned and executed the launch and in doing so has paid minute attention to getting physicians and patients to be aware of and understand MelaFind as opposed to a "willy nilly" effort trying to install devices everywhere. This planned, carefully controlled launch has been misinterpreted by many investors as being disappointing.

By January 2013, the number of signed user agreements that are preparatory to device installations in the US and Germany was about 100 with most having occurred in the last four months. The goal is to get to 275 by the end of March 2013. The company cites market research that it has conducted that suggests that the average dermatologist as they become skilled in its use might reasonably employ MelaFind once per hour. This suggests that an experienced dermatologist could use MelaFind eight times per day and assuming 50 weeks of practice each year; this could create 2000 uses per year which at a price of $50 per use translates into $100,000 of revenues per year for MELA Sciences.

The peak sales potential for each 100 device placements could be $10 million per year. Assuming the dermatologist charges $100+ per scan ($50 to MELA and $50+ for themselves) they could make $100,000+ per year for themselves from MelaFind. Aside from the obvious medical benefit of catching some hard to diagnose melanomas before they have metastasized and become life threatening and the cosmetic benefits of avoiding scars from unnecessary biopsies, there is a powerful economic incentive for dermatologists to use this product.

A way of looking at the addressable market in the US is to consider that there are 37 million visits to US dermatologists each year for medical reasons. Of these, market research conducted by the company and presented in investor conferences projects that 20% of these visits could result in the use of a MelaFind scan. This suggests a potential US addressable market of $370 million. Because MelaFind is a unique innovation in this space, investors can't judge its potential by looking at what other products have done.

Financial Position

The company had $13 million of cash at the end of 3Q, 2013 and may have burned $5 million in the fourth quarter. MELA contracted for an "at the market" equity line in June 2012 and they have been using this line to bolster cash. The total amount of money that can be drawn down under this agreement is $20 million and in the third quarter 10-Q it was disclosed that $3.4 million was drawn down in that quarter. This left about $16.4 million in the facility.

At a price of about $2.00 and based daily volume of 600,000 shares per day in 4Q, 2012, I estimate that the company could have used its ATM to raise as much as $3 million per month in 4Q, 2012 or roughly $10 million for the quarter. I am not saying that they did do this just that I believe they could have. The advantage of an ATM or an equity line is that they can be used quietly and effectively without the disruptions and price drops that so often come with the announcements and executions of public offerings. The company will not comment, but I would think that the cash balance at the end of 4Q, 2013 could be unchanged at $13 million and I think that the ATM can offset the cash burn over the next two quarters.

What Will Move the Stock in 2013 and 2014?

The critical issue for the stock performance this year and going forward is gauging the success of the launch. The company was focused through the March 2012 to October 2012 period on signing contracts, installing MelaFind devices and educating physicians on how to use the product. The small installed base in offices of physicians who were still in a learning mode did not initially warrant a concentrated sales effort. In 2013, a sales effort directed at increasing physician use and patient understanding has begun.

As the launch cycle matures, investors will focus on the number of MelaFind devices installed and the number of scans per installed device to judge the progress of the launch and to make future sales projections. Perhaps later this year or early next, I would anticipate that the company may release metrics that will allow this type of analysis.

At this point in time, there is no hard financial data to determine whether the bears or bulls are right. The call on the stock is whether you believe that the clinical and economic advantages of MelaFind will lead to a commercial success and whether you believe that this management can successfully manage the launch. I have followed this company for over four years and have watched Joe Gulfo, the CEO, over that period of time. He has my confidence and I also believe in MelaFind. Based on that, I am recommending that investors begin to take a position in the stock and if the unfolding launch provides evidence that I am right continue to add to their position. This is an investment approach that I often use with controversial situations like MELA Sciences.