A rapidly rising short interest could spell trouble for a stock. In such instances, it's important to understand why shorts are piling into the equity in question.

Exact Sciences (NASDAQ:EXAS) has seen a flurry of short activity ever since the company's lead diagnostic test named Cologuard was recommended for approval by an Advisory Committee to the Food and Drug Administration last March as a diagnostic tool for colorectal cancer. Specifically, shorts are now in control of nearly 35% of share float and these numbers have only accelerated in recent weeks. So, let's take a closer look at why shorts are picking on this molecular diagnostic test-maker. 

EXAS Chart

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Is an FDA rejection in the cards?
One issue that is that is being floated by shorts is the possibility of a rejection, despite the 10 to 0 vote in favor of Cologuard's clinical profile. The concern raised by shorts is that Cologuard's late-stage trial had a fairly high number of withdrawals, suggesting that there is more than meets the eye with these data.

Specifically, Exact Sciences reported that 464 individuals withdrew their consent to participate in Cologuard's late-stage study. By the same token, it's important to remember that this trial enrolled a total of 12,776 patients, with 9,898 being included in the final analysis.

So while four hundred plus withdrawals may seem like cause for concern, we don't have much insight into why these patients withdrew in the first place and nearly 10,000 individuals did participate in the study. In short, the individuals that withdrew their consent represent a small fraction of the overall number of patients. 

Shorts are also betting on insurance problems down the road
Another oft-cited issue by shorts is that private insurers may refuse to pay for an "unnecessary" screening test. Because Cologuard isn't designed to replace a colonoscopy, many patients will end up having one regardless of their result with this fecal-based test. For instance, patients that test positive for a GI malignancy using Cologuard will undoubtedly have a confirmatory colonoscopy.

Patients in the high risk category for a GI malignancy will also have to undergo a routine colonoscopy every few years -- irrespective of their Cologuard results. So insurers could view this new diagnostic as simply adding an extra unnecessary step for the vast majority of patients.

On the flip side, I could see how a test like Cologuard could be used for more regular screenings in lower risk patients and as a way to increase compliance among high risk patients. At the end of the day, many patients simply refuse to have a regular colonoscopy; so Cologuard would offer these patients another alternative to an invasive colonoscopy. It's also important to remember that colorectal cancer screening tests are required under the Affordable Care Act, except by health plans that were in place prior to the act's passage.     

Foolish wrap-up
All told, I find the soaring short interest in Exact Sciences somewhat mystifying. A hard look at Cologuard's clinical profile, and the Advisory Committee's positive comments following the vote, make me pretty optimistic about an approval. While the FDA is known to surprise on occasion, I simply don't see any major red flags that would prevent approval.

On the coverage debate, I think shorts probably gain more traction with this argument. We won't know how Cologuard is used in the real world or covered by actual insurance companies until the product is in the marketplace. Some private insurers could balk at paying for a diagnostic that doesn't ultimately replace a colonoscopy. At the same time, there is a clear need for a test like Cologuard for patients that would do almost anything to avoid a colonoscopy.  

What's important to understand is that insurance coverage will play a pivotal role in Cologuard's peak commercial performance. Over the past few months, we have heard lofty peak sales projections topping $2 billion, which is probably a big reason why Exact Sciences presently sports a market cap of $1.26 billion. Shorts obviously believe these projections are unlikely to pan out if Cologuard makes it to the market and problems with private insurers may slow the test's market uptake.

Overall, I think these two issues are overblown. While I'm skeptical of the multibillion dollar peak-sales projections, I see how this test could fill a highly profitable niche within the industry and be a strong revenue generator for Exact Sciences moving forward. After all, it's not hard to point to a number of biotechs with highly profitable molecular diagnostic tests like Meridian Biosciences, Qiagen, and Thermo Fisher, just to name a few. Put simply, I think this midcap biotech should be on your watch list. 


George Budwell has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.