[Editor's note: The author has made some changes to this article since original publication. Apologies for any confusion this may have caused.]
Brief Background. Sequenom (SQNM) is a diagnostics company that has commercialized non-invasive diagnostics tests, branded as Heredi-T™ CF, MaterniT21™ PLUS, Heredi-T™, SensiGene® and RetnaGene™. It sells the hardware platform (MassARRAY) and consumables to run those tests, as well as performing those tests as a service in its own laboratories. Instrumentation and customer purchase consumables, together referred to as Products, and diagnostics services, referred to as Services, comprise SQNM's primary revenue streams. SQNM has established itself as the leader in the non-invasive pre-natal testing (NIPT) market, primarily through its detection of trisomy for chromosomes 21, 18 and 13. The company has not yet reached profitability, however.
Q1 2013 Performance Review. SQNM made some nice progress in Q1 2013:
- Tests performed grew from 33,000 to 44,500 on a quarter-over-quarter (Q/Q) basis;
- Payment collection for tests performed gained enough traction to yield an increase in the average revenue per test (ARPT) by 2.2% Q/Q;
- Gross revenues increased by ~38%.
- Operating costs decreased by 2%.
Unfortunately, the Q1 earnings report also had items that were of slight concern:
- Products revenue declined ~25%;
- cost of revenues increased ~15%;
The cost of revenues increase is understandable because of the rapid growth in test volume. The total cost increases were sufficient to drive the earnings-per-share (EPS) loss to -$0.26 on expectations of -$0.22. The stock did experience a ~15% pop after earnings, primarily as a result of the growth in tests accessed.
Estimating Q2 2013 Performance. To estimate revenue and earnings numbers for Q2 2013, growth and decline rates of the following factors need to be modeled:
(1) change in number of tests performed;
(2) change in ATP per test;
(3) decline in Products revenue;
(4) increase in cost of revenues;
(5) increase in operational expenses.
Number of Tests Performed. In my previous article, I made the assumption that test volume would grow 15% quarter-over-quarter (Q/Q). This was meant to be a conservative estimate to the actual 34.5% test growth experienced from Q4 2012 to Q1 2013. Given that SQNM is pushing hard to sign on with insurers, thereby expanding lives covered, a 25% test volume growth from Q1 2013 to Q2 2013 seems reasonably aggressive. In Q2 2013, a 25% increase in tests would result in 55,625 tests accessed.
Due to the trend towards next-generation sequencing for everything diagnostics related, I believe SQNM faces an uphill battle to sell its instrument and consumables to outside laboratories. Revenues from product sales came out to a ~25% decline in sales of products in Q1 2013. I believe this theme will continue throughout the year, even though management has offered explanations for the quarterly decline, and make the assumption in my earnings model that product sales will decline 10% Q/Q.
Average Revenue Per Test. The ARPT in Q1 2013 was $653, a number that reflects the payment collection ability for tests performed up to a year ago. During their earnings call, SQNM management mentioned that it is able to recognize revenue for ~30% of tests it performs in a given quarter and the remaining is recognized in subsequent quarters. Since it is focused on capturing market share as quickly as possible, SQNM is discounting its MaterniT21 test and given the mix of price points for its other tests, we will likely see ARPT grow incrementally rather than exponentially. After all, it makes sense to discount your best seller in exchange for gaining market share quickly.
There are competitors that pose risks and downward pressure to SQNM's pricing power. Some competitors have products on the market; some are in the process of ramping up a commercial launch, while others are future entrants in the NIPT market. Ariosa Diagnostics is a current competitor, while Natera is aggressively pushing its recent launch through acquiring distributors and NIPD Genetics will enter the market in the future. Through its acquisition of Verinata Health, Illumina (ILMN) could become another competitor probably as early as 2014. Because of the trade-offs between capturing market share and competition, I kept the Q/Q growth in ARPT at a reasonable 2.5%. ARPT grew at 2.3% from Q4 2012 to Q1 2013.
Expenses. Calculating earnings, or in this case losses, requires making some estimates on expenses. I assumed a 10% Q/Q growth rate for cost of revenues and a 1% decline for Q/Q operating costs. In Q1, the increase in cost of revenues was 15% and a pleasantly surprising decrease of 2% in operating costs from Q4 2012. While the costs for performing tests should continue to come down as scale and workflow efficiencies take hold, it seems that capturing an ever larger market share in an increasingly competitive market will continue to pressure expenses upward.
Earnings. We can estimate gross revenues by multiplying the Q2 estimated number of tests by the Q2 ATP estimate. From that we subtract all expenses, divide by the number of common shares and arrive at a loss of ($0.20) per share in Q2 2013. Extrapolating to Q3 2013, I get ($0.14). For Q4 2013: ($0.05). Thus, it seems that SQNM will not hit profitability until 2014. The caveat to these EPS estimates is continued use of cash-based accounting. SQNM has mentioned that it would switch to accrual sometime in 2014, in which case the revenue numbers would experience a nice bump and could lead SQNM to be profitable in the same quarter the switch is made. The table below summarizes the numbers.
# of Tests
M = millions;
Stock Price. Based on a 4X multiple of 2013's revenue and 116.5M common shares available at the end of Q4 2013, I get a stock price of $7.13. SQNM has not seen these levels in years, but strong revenue growth and containment of expenses should drive the stock price higher. The number of shares short has declined from 37.7M at the end of April to 34.33M at the end of May, equivalent to 30% of shares sold short. One solidly positive surprise could send these short sellers scrambling to cover and would deliver a sizable pop to SQNM's stock price.
Note on 8-K Filing. The most recent 8-K filing from Sequenom was interesting for its ratification of two equity issuance plans, the 2006 Equity Incentive Plan and the 1999 Employee Stock Purchase Plan. Under these plans, SQNM may issue 4M and 2.3M common shares for each plan respectively. Given the current outstanding share count of 115.2M shares, there are a couple of ways to interpret this eventual ~5.5% share dilution that SQNM is planning through the incentive plans.
One effect of an increased share count will be to make the earnings-per-share loss smaller than it would be without the added shares. As SQNM grows its way to profitability, it will take increasingly smaller EPS losses due to the compounding of revenue growth and share count increase. Unfortunately, once it hits profitability, the bigger share count will result in a smaller EPS profit. The reverse is true for profitable companies in decline. Share buy backs yield increases in EPS for profitable companies, but once those companies slide to a loss, there are fewer shares to divide the loss into and EPS becomes a big negative number quickly.
A second interpretation is that SQNM management wants to reward its directors and employees with low-priced shares now, implying that management believes the share price will be much higher than where it currently is. Timescales by management tend to be measured in quarters and years, implying a higher share price in late 2013 - early 2014. This timeframe parallels my stock price projection of $7.13 in the next nine months.
My bet is that management is so confident of its testing volume growth that any bottom line fiddling due to share dilution will be negligible. Assuming that this read of SQNM management's perspective is correct, I feel more confident in choosing the more aggressive growth estimates modeled above.