Backed by legendary venture capital investor Dan Lufkin, Electro-Optical Sciences is a speculative play with enormous upside potential. With breakthrough technology for detecting early-stage melanoma, EOS is currently undergoing fast track review by the FDA. Demonstrating a 95% early detection rate, its new product MelaFind® has the potential to save thousands of lives annually because one American is dying from melanoma an hour. EOS has raised $73 million from the public markets so far, including a $15 million registered direct offering on July 16, 2009. Because in exchange for warrants   Kingsbridge Capital committed $45 million in an equity financing facility if it is needed , EOS should have more than enough cash flow  to get over the commercial goal line.
 
By Arnaldo Arroyo with Robert J. Flaherty
 
Recent Price:                     $7.23
Market Capitalization:     $145 million
52-Week Range:               $2.29 - 8.75
Shares Outstanding:          20.0 million
Float:                                    18.5 million
2008 EPS:                          ($1.08)
 
Balance Sheet as December 31, 2008
Total Assets:                      $17 million
Long-Term Debt:                 None
Shareholders Equity:        $15 million
Book Value Per Share:      $0.86
Monthly Burn Rate E:        $1.2 million
 

Buy Recommendation
 
Melanoma is currently responsible for approximately 80% of skin cancer deaths in the U.S. It also discriminates. The annual incidence of melanoma among Caucasian women in the U.S. aged 15 to 39 increased 50% between 1980 and 2004, according to a National Cancer Institute report in 2008. There are an estimated 120,000 new cases projected in 2009.
"Many of my investigators tell me that the incidence of melanoma in teenagers is approaching epidemic proportions," says Joseph V. Gulfo, M.D., president and CEO of Electro-Optical Sciences (Nasdaq: MELA).
The tragedy concerning the high percentage of deaths resulting from melanoma is that many of those deaths can be prevented if the disease is caught in the early stage. What's also unfortunate is that current out dated technology and primitive methods of analysis involve a good degree of subjectivity, or guesswork. This means that every time an early stage melanoma is missed -which takes place a significant percentage of the time--the patient could eventually die if the melanoma goes untreated and is allowed to metastasize, or grow.  
"You have one American dying of melanoma every hour," says Gulfo. "If melanoma is found early-or in its in situ stage on the epidermis-it is 100% curable. But if it invades up to one millimeter deep, it's only about 85% curable. Beyond one millimeter, or stage two, you can see the precipitous drop in survival."
But that may change. Irvington, N.Y.-based Electro-Optical Sciences has developed a breakthrough technology that has been clinically tested and proven to have a 95% accuracy rate in detecting early-stage melanoma. Its new product MelaFind® is an objective diagnostic screening test that emits 10 different wavelengths of light 2.5 millimeters below the skin's surface to capture images of suspicious pigmented skin lesions. The non-invasive, handheld device processes the images using algorithms based on a database that includes 9,000 skin lesions and 600 melanomas. MelaFind® provides the doctor with an immediate, objective result to aid in the decision of whether to perform a biopsy at the point of care. Today tissue is usually sent out to a laboratory and the patient must wait some days or even a week  until he or she knows the test results and whether he or she has cancer.
"I haven't seen 600 melanomas," says Gulfo. "A dermatology resident graduates his training having seen maybe a dozen early stage melanomas. So doctors see the need for this technology, and our market research suggests that they will embrace the technology."
MelaFind® has advantages for both the doctor and the patient. For the busy doctor, it will allow better customer service to their patients who face potential cancer diagnosis and are very anxious to find out the results. MelaFind® will also provide better patient flow. Due to the technology's high accuracy rate, the doctor will be able to see more patients rather than spending time performing unnecessary, time intensive biopsies. For the doctor, more patients also will mean more money.
In June, the company submitted a premarket approval (PMA) application to the FDA for MelaFind®. It's on a 180-day review cycle, so it is possible that by December the company will know whether MelaFind® has been approved or not.
In order to receive expedited review by the FDA, a company's technology has to meet one of five or six criteria. "The FDA felt MelaFind® qualified for three reasons," Gulfo explains. "One reason is that it's a breakthrough technology. The second reason is that it's intended for life threatening or debilitating disease. And the third reason is that there is a significant opportunity for decreasing patient morbidity, meaning the inconvenience of scars and pain from biopsy."
In February, EOS announced positive top-line results of its pivotal trial of MelaFind®. At seven centers across the U.S., MelaFind® was tested in 1,383 patients, making this the largest prospected study ever conducted in melanoma detection. The device detected 172 of 175 melanomas and "pre-melanomas," overall.
At present, MelaFind® does not have any FDA-approved direct competitors. There is currently no objective way of detecting melanoma. Current systems and methods of detecting the disease involve a great deal of subjectivity on the part of the doctor. For example, since 1985, dermatologists have relied on the ABCDE criteria for detecting melanoma (see our "Competition" section of this report). This form of analysis is completely subjective. About one quarter of dermatologists in the U.S. use a dermascope. This is a small microscope that magnifies and lights up skin lesions, revealing colors and below-the-surface features not visible to the naked eye. The doctor still has to subjectively determine whether it's melanoma or not.
 "A dermascope is very hard to use, and they can miss early-stage melanomas about 20% to 30% of the time," Gulfo claims.
Undoubtedly, cancer of the skin presents a large market opportunity. It is the most common of all cancers, with over 1.3 million projected cases annually. There are three significant forms of skin cancer: basal cell, accounting for approximately 75% of skin cancer cases; squamous cell, totaling approximately 20% of skin cancer cases; and melanoma, which accounts for an estimated 4% of skin cancer cases, but is responsible for approximately 80% of all deaths from skin cancer.
There is currently no cure for advanced-stage melanoma and treatment costs are estimated to run up to $170,000 per patient.
EOS plans to market MelaFind® as a point-of-care service. This strategy will generate recurring revenues based on the number of patients examined and will give physicians access to MelaFind® without having to make a major capital investment.
"There would be an initial placement fee in the neighborhood of about $5,000, or possibly higher," Gulfo says. Every time the doctor performs an examination using MelaFind®, he will have to purchase a media card from EOS. The media card stores the patient's data. No patient data is stored in the device itself. Therefore, MelaFind® is HIPAA compliant so patient privacy is safeguarded. Based on the company's market research, it is estimated that dermatologists who become converted to its merits will use MelaFind® at least once every hour.
Gulfo estimates that the absolute lowest price that the company would charge for a media card is $50. He believes a dermatologist could generate about $100,000 a year using MelaFind®. With approximately 10,000 dermatologists in the U.S., MelaFind® potentially represents a $1 billion in revenue opportunity.
EOS should not have any problem financing the commercial rollout of MelaFind®. In case it needs to tap into an extra source of capital, Kingsbridge Capital Ltd., a Dublin. Ireland-based private investment group has committed in exchange for warrants to provide, at EOS's sole discretion, up to $45 million in cash during the next three years, through the purchase of newly-issued shares of EOS common stock.
"It's a great insurance policy," says Gulfo. "If I were to call them and say, 'I want you to buy our shares,' they have to do it, and it's prescribed how it's done up to $45 million. But I don't have to use it. It's a kind of financial insurance policy."
The company plans to concentrate its marketing efforts in key regions of the U.S. The initial launch will be in the northeast. "It is the number one region in the country if you equally weigh incidence of melanoma, disposable income and number of dermatologists," he says.
EOS hopes to eventually broaden its marketing efforts to include primary care physicians, who are at the front line of early detection, but lack special training in identifying suspect lesions.
The American Cancer Society has been making people more aware of the growing incidence of melanoma. Because early detection is critical to survival, the ACS recommends that every American over the age of 40 undergo complete skin examinations on an annual basis. That is over 100 million. Younger women who frequent tanning salons also could save many of their lives by taking the examination.
"What you see in the summer time is the woman's magazines writing articles on skin cancer and melanoma. So for two to three months out of the year people think about it," says Gulfo. "We have an opportunity to create a 365-day-a-year awareness of melanoma and really impact the disease."
In June, EOS's shares were added to the Russell 2000 and Russell 3000 indexes. Since the Russell indices are reconstituted each June, EOS is sure to remain on the indexes for one year. The big advantage is that its stock will get more attention and more research coverage.
The minimum investing goal of each new Flaherty Special Situation is to achieve a gain of 50% to 100% within two years. In the past stocks backed by Dan Lufkin have performed even better. We hope MELA will too. It has the long term potential to exceed a billion in both revenues and stock market value. 

 

Business
 
Electro-Optical Sciences has spent about $75 million over an 11-year period in designing and developing MelaFind®. The non-invasive, hand-held imaging device emits multiple wavelengths of light to obtain thousands of characteristics of suspicious pigmented skin lesions up to 2.5 millimeters under the skin. The system uses sophisticated, proprietary algorithms to analyze these data against a proprietary database of melanomas and benign lesions. Based on the analysis, the system generates an objective, detailed report with information useful in the biopsy decision.  
 
Key components of the MelaFind® system include the following:
·     An illuminator that shines light of 10 different specific wavelengths, including near infra-red bands.
·     A lens system composed of nine elements that create images of the light reflected from the lesions.
·     A photon (light) sensor.
·     An image processor employing proprietary algorithms to extract many discrete characteristics or features from the images.
·     Proprietary MelaFind® database of pigmented skin lesions. The database includes in vivo MelaFind® images and corresponding histological results of over 9,000 biopsied lesions from approximately 7,000 patients. EOS believes this is the largest such database in the U.S. and a substantial barrier to competition.
·     MelaFind® lesion classifiers. The "brain" of the MelaFind system, these sophisticated mathematical algorithms distinguish melanoma from non-melanoma by comparing the lesion's features with the characteristics of the benign and malignant lesions stored in EOS's proprietary MelaFind® database.
·     Lesion classifier development and training is an iterative process involving: (1) selection of the lesion features that provide for optimal lesion discrimination; (2) optimization of the mathematical formulas to differentiate benign lesions from melanoma; and (3) expansion of the size and diversity of our proprietary lesion database. The performance of the lesion classifiers is directly related to the size of the database used in classifier training, as well as the degree to which the training database is representative of the lesions that will be evaluated by MelaFind® in commercial use.
 
As with many diagnostic systems, the diagnostic performance of MelaFind® is characterized using two measures: (1) sensitivity - the ability to detect disease when it is present; and (2) specificity - the ability to exclude disease when it is not present. Since sensitivity and specificity are typically trade-offs, meaning that as one parameter increases the other decreases, the MelaFind® lesion classifier is developed and trained with the intention that MelaFind® will detect all melanomas in the training data set with the highest possible specificity.
 
Management and Key Personnel
 
Joseph V. Gulfo, M.D., has served as president, CEO and a member of the board of directors since January 2004. From May 1999 to November 2004, he served as chairman, CEO and president of Antigen Express, Inc., a development-stage company developing immunodiagnostics and therapeutics for cancer.  It is now part of Generex Corp. (Nasdaq:GNBT.) Previously, he was COO and a director of Anthra Pharmaceuticals, Inc. and chairman of that company's UK subsidiary. Gulfo serves as a director of ProCertus BioPharm, Inc., a privately-held company. He received a B.S. in Biology from Seton Hall University, an M.D. from the University of Medicine and Dentistry of New Jersey and an M.B.A. in Finance from Seton Hall University. He was handpicked by Dan Lufkin.
 
Richard I. Steinhart has served as vice president of finance, CFO and treasurer since April 2006. Prior to joining EOS, he spent 14 years as managing director of Forest Street Capital/SAE Ventures, a boutique investment banking, venture capital and management consulting firm focused on healthcare and technology companies. Prior to Forest Street Capital, he was vice president and CFO of Emisphere Technologies, Inc. His career background also includes seven years at CW Group, Inc., a venture capital firm focused on medical technology and biopharmaceutical companies, where he was a general partner and CFO. Steinhart serves on the board of Manhattan Pharmaceuticals (MHAN.OB), a biopharmaceutical company and is chairman of its audit committee. He began his career at PricewaterhouseCoopers. He holds B.B.A. and M.B.A degrees from Pace University and is a certified public accountant.
 
Tina Cheng-Avery serves as vice president, commercialization. She joined Electro-Optical Sciences in February 2008. Before joining the company, Cheng-Avery served as vice president of marketing at Pierre Fabre Dermo-Cosmetique USA/Genesis Pharmaceutical, where she managed the Avone and Glytone dermo-cosmetic skincare lines distributed through dermatologist and plastic surgeon offices. Previously, she was global marketing director for skin care at Elizabeth Arden, where she managed a $300 million skin care portfolio. During this period, she led a collaboration between Elizabeth Arden and Allergan Pharmaceuticals in order to launch Prevage Anti-Aging Treatment. Other previous stints include vice president of marketing for Wella Personal Care of North America, group product director at Johnson & Johnson's Neutrogena Corporation and associate brand manager for Aveeno at S.C. Johnson & Family, Inc. Cheng-Avery holds a M.B.A. from the Kellogg School of Management at Northwestern University and a B.B.A. from the University of Michigan.
 
Chris Butler is vice president - operations. Butler began serving as vice president of technical support in June 2006. He brings more than 20 years of experience in the medical device industry in areas of product support and operations management engineering. Before joining EOS, Butler served as manager for global service and support at Bayer HealthCare. In addition, he managed the launch of Bayer HealthCare's first diagnostic integrated modular platform, a blood analyzer that for the first time combines chemistry and immunoassay capabilities in a single unit. He also developed and implemented comprehensive product support plans including the establishment of product development requirements, launch and support strategies, customer and service documentation and training, service cost predictions and reliability management.

Finances
 
To date, Electro-Optical Sciences has not generated any revenue from MelaFind®. Since going public in 2005, the company has financed its operations primarily through the sale of stock. In July 2008, the company netted $11.1 million through a registered direct offering of 2 million common shares at $5.68 a share to undisclosed accredited investors. In 2007 and 2006, EOS initiated private placements raising $11.5 million and $13.2 million, respectively.
In May 2009, it recently entered into a committed equity financing facility with Kingsbridge Capital Limited, a private investment group, in which Kingsbridge has committed to provide, at EOS's sole discretion, up to $45 million in cash during the next three years through the purchase of newly-issued EOS common stock.
On July 16 EOS raised gross proceeds of $15 million by selling 2.4 million shares of common stock at $6.25 per share to institutional investors. The money that was raised was not part of Kingsbridge Capital's committed equity financing facility. This means EOS can still tap into the untouched financing facility at its own discretion. The CEO looks upon the $45 million equity line of credit as an insurance policy that when used appropriately provides protection to investors, particularly in these uncertain and turbulent times.
 
History
 
Electro-Optical Sciences was founded in 1989. At that time, the company provided research services, mostly to U.S. government agencies, on classified projects. All of EOS's historical revenues have come from activities and products that have been discontinued, including its DIFOTI product, a non-invasive imaging device for the detection of dental cavities. In April 2005, EOS decided to discontinue all operations associated with DIFOTI in order to focus its resources on the development and commercialization of MelaFind®. 
 
Our sister Flaherty Financial News Newsletter of July 29, 2009 has a little item on "Dan Lufkin does well by doing good with MELA." It explains that after Dan lost an old friend to Melanoma whom he felt had been misdiagnosed and then diagnosed late, Dan decided to back a budding venture which had the potential for early detection of this killer. For youngsters among our readers, Dan is one of the best and most successful venture capitalist investors and managers of new enterprises who has ever graduated from the Harvard Business School.  The entire piece on Dan Lufkin and MELA is archived at www.flahertyfinancialnews.com .  
 
Competition
 
At present, MelaFind® does not have any direct FDA-approved competitors. Current systems and methods of detection rely on physician experience and expertise in recognizing patterns that are associated with melanoma and non-melanoma in order to render an interpretation and diagnosis. Among the number of systems and methods used to assess pigmented skin lesions are naked eye examination, whole body mole mapping systems,  digital dermoscopes, spectrophotometric intercutaneous analysis (analysis of skin structures through measurement of how they absorb light of different wavelengths), confocal microscopy and spectrophotometric, or color, analysis.
Still, the current primary method for detecting melanoma relies mostly on a doctor's ability to recognize whether a pigmented skin lesion is suspicious for melanoma and therefore requires a biopsy. To form a diagnosis, the doctor does a visual examination using the ABCDE criteria: Asymmetry, Border irregularity, Color variation, Diameter greater than 6 millimeters and Evolving-change in ABCD.
Whole body mole mapping consists of periodic photography of patients, typically those at high risk for developing melanoma. The pictures are reviewed clinically. This service is provided at some diagnostic imaging centers and dermatology offices. DigitalDerm, Inc. offers a computerized system for acquisition, storage, and review of the pictures.
Dermoscopes allow for non-invasive visualization of colors and microstructures of the epidermis, the dermal-epidermal junction, and the papillary dermis not visible to the naked eye. They are used by approximately 25% of dermatologists in the U.S. and are associated with a long learning curve. Leading manufacturers of dermoscopes are Welch Allyn, Inc., Heine Optotechnik and 3Gen, LLC.
Digital dermoscopes allow for dermoscopic images to be visualized on a computer screen at larger magnification. These images also may be stored and compared to images taken previously. Although some digital dermoscopes provide information regarding the probability that a lesion may be melanoma compared to a database of lesions, no system other than MelaFind® is under PMA development for objective interpretation.
Manufacturers of digital dermoscopes include Derma Medical Systems, Inc., ZN, High Medical Systems S.P.A., Vision Technologies AG, Polartechnics, Ltd., Biomips Engineering and Sci Base AB.
Spectrophotometric intercutaneous analysis is a technique of visualizing collagen, blood and pigment. UK-based Astron Clinica manufactures a device using this technique.
Confocal microscopy is an experimental approach for non-invasive visualization of skin structures at the cellular level. The device utilizing this technique is in development by Lucid. Other imaging modalities include molecular imaging in which tagged antibodies search for cancer cell antigens. Molecular-based approaches are being investigated. Dermtech, for example, is exploring messenger RNA analysis of surface cells.
A spectrophotometer, a device for measuring the absorption of different wavelengths of light, is offered by Medical High Technologies S.p.A. In contrast to MelaFind®, the product does not perform automatic quality control of images and has an external light source. EOS believes that the reported sensitivity of 80.4% would not gain market approval. EOS's management is not aware of efforts directed to obtain PMA approval of the product.
All of the following technologies are in the very early stages of development. Balter Medical, for instance, is using optical transfer diagnosis to identify melanomas. The technology measures how much light is absorbed in healthy versus diseased tissue to determine whether cancer is present. Raytheon Corporation, partnered with Arizona Cancer Center, is using satellite-based remote imaging technology in detecting skin changes that could indicate the presence of cancer. Vanderbilt University has introduced technology called Confocal Raman Micro-Spectroscopy, which uses a reflective laser to produce a molecular fingerprint of the underlying tissue to indicate the presence or absence of disease.
 
RISKS
 
Recently, EOS shares short have jumped  over 60% to 1.8 million and shorts may cause management trouble. Secret short sellers often do. With the back stop of Kingsbridge Capital's committed $45 million line of equity financing facility, Electro-Optical Sciences should not have any problem crossing the commercial goal line. However, even with the expedited review by the FDA, there is still no guarantee that MelaFind® will be approved by the federal agency. Also, dermatologists must be convinced that adopting the technology will help and not hurt or replace them. It will also mean many who see patients in a number of various rooms must change their old work habits and must move the portable MelaFind® system from examining room to examining room. Change, we can't escape it, but few of us like it, including our favorite dermatologists. 
 
CONTACT INFORMATION:
Electro-Optical Sciences Inc.
www.eosciences.com
3 West Main Street, Suite 201
Irvington, NY 10533
Phone: (914) 591-3783
Fax: (914) 591-3785
 
IR Contact:
David Carey
Lazar Partners, Ltd.
Phone: (212) 867-1768
E-mail: dcarey@lazarpartners.com
 
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