Five months ago, I wrote two articles describing the market for Noninvasive Prenatal Diagnostics. These articles are a good starting point for anyone unfamiliar with Sequenom (SQNM) or their market position in molecular diagnostics:
Since then, there have been a number of announcements which led to a significant selloff. This article will recap those events and describe why I believe this selloff has provided an opportunity for high risk investors with a tolerance for volatility.
What follows is a recap of the significant announcements over the past few months, categorized as Intellectual Property Litigation, Operating Results from Q2-13 and Q3-13, or Segment and Product Update. Here are links to the announcements:
· Aug 19th Sequenom discloses 75 cost cutting plan
Intellectual Property Litigation
There were two significant court decisions in the ongoing legal battle over Sequenom's '540 patent. In August, the Federal Appeals Court ruled in favor of Sequenom, stating that the District Court had erred in its denial of Sequenom's motion for a preliminary injunction against Ariosa. They vacated and remanded the decision back to the District Court. In October, the District Court responded by granting Ariosa a summary judgment that the '540 patent was invalid. The reasoning was based upon the Supreme Court decision in the Myriad Genetics case. Sequenom has stated they will appeal this back to the Federal Appeals Court. My investment thesis on this patent is unchanged. I believe investors should not rely on this patent being upheld. Focus instead on which test is gaining market acceptance, as all the tests are actively being marketed and, to date, the market has ignored patents.
Investors should be aware that these legal issues are a significant drain on Sequenom's resources. The company spent approximately $11 million during 2012 on patent interference and litigation costs. During the first three quarters of 2013, this spending increased to approximately $15 million. The company is also paying royalties to Dr. Lo of approximately 6.5% on revenues recognized for MaterniT21.
Q2-13 Operating Results
The June 2013 results were by any measure a significant disappointment. Every operating metric was negative, including revenues, spending, balance sheet controls, cash burn and covered lives. Compounding the disappointment was the fact that these results were such a surprise, apparently even to management. Once the shock of the results had sunk in, it became clear that the root cause of the negative results was the lack of progress by CMS in establishing molecular diagnostic codes and reimbursement rates. This experience was shared and discussed by numerous other companies, indicating an industry wide issue leading to layoffs and cost cutting at many of these companies. In retrospect, it's clear that this was outside the control of management.
I am concerned that the management was so unprepared and apparently unaware that this issue would have such an impact. During presentations in both May and June, the company stated that they continued to be pleased with reimbursement levels. There was no indication that cash reimbursement was, in reality, trending down significantly. Also during the Q&A portion of the call, management seemed surprised by questions about why they didn't preannounce. The significant increase in inventory on hand, increasing the company's use of cash during the quarter, is another indicator that they were caught off guard by this impact. My belief is that these results, rather than the court rulings, were the driver of the significant selloff in the stock. It was stemmed somewhat by the Federal Court remand, only to continue with the District Court summary judgment.
Segment and Product Update
There were several positive announcements that may have been under-appreciated by investors. MaterniT21 Plus was improved and will now report additional findings for the presence of subchromosomal microdeletions and trisomies for T16 and T22. Sequenom has consistently expanded their test to meet the needs of high risk pregnancies. No other competitors have this breadth. In fact on a conference call last spring, Ken Song admitted that Harmony could only add more test capability by increasing their cost per test. The whole genome testing approach used by MaterniT21 (and Verifi) provides an ongoing incentive to add capability to the test that will further disadvantage competitors.
The New York State certification provides a market opportunity to gain share at the expense of competitors who are not yet certified. This opportunity could have long lasting impact as Sequenom gains mind share in this important market.
Both announcements in Genetic Analysis segment were important. The news that they filed the premarket 510(k) notification with FDA for their Impact Dx System represents completion of a company goal spanning the past 2 years. This is a requirement to expanding the (research use only) MassARRAY platform into commercial clinical labs. This has the impact of greatly expanding the total addressable market. They also announced they had retained Jefferies to review and advise them on strategic alternatives for this business segment. This was further explained as an attempt to find a much larger partner or buyer to invest in this emerging growth opportunity. Last year the Genetics Analysis segment contributed revenues of approximately $43 million and operating profits of $3 million. During the first nine months of 2013, these results were relatively flat as compared with 2012. Sequenom has made no reference to timing or any potential price range for this segment.
Q3-13 Operating Results The September 2013 results, released on November 7th, were the inverse of the Q2-13 results. Analyst expectations were low indicating a lack of visibility into reimbursement trends. The company delivered a strong quarter with beats across the board. Management was crisp and upbeat during their conference call, well-prepared to discuss numerous initiatives and new disclosures long awaited by investors. Some of the more important items were:
1) All major insurance payers are now reimbursing for MaterniT21 in the US, either under an agreement or as out-of-network payers.
2) Covered lives increased by 22% sequentially to 90 million. This represents lives under contract with Sequenom, as contrasted with some competitors who disclose covered lives when an insurer issues a policy statement covering prenatal diagnostic tests.
3) The company disclosed for the first time their estimate of collectible back billings ($46-51 million, net of allowances and write offs). They also provided additional context including the net change in Q3, reimbursements related to current quarter and current year. Combined, this was a major improvement allowing investors to estimate the average sales price of MaterniT21 for commercial payers in the U.S. I had previously estimated that this was $1,250 based upon some royalty information. My conviction level is much higher now within a range of $1,100 to $1,250.
4) Tests provided to government payers dropped from 26% in Q2-13 to 21% in Q3-13. The company will continue to restrict test availability to those payers where reimbursement has been problematic. Government payer mix continued to decline to 17% in the month of September. However, management expressed some optimism that progress was being seen with some state Medicaid agencies in response to this test access restriction. This potentially good news was not included in their estimate of back revenues to be collected and could result in incremental cash flows and unit testing as states resolve payment issues.
5) Sequenom took a one time charge of $6 million for expenses relating to a reduction in staff, subleased facility space and RetnaGene intangible assets. RetnaGene has been particularly hard hit by these coding issues given the customer demographic for age related macular degeneration. These cost efficiencies will lead to a decrease in annualized spending of $13m starting in the December 2013 quarter.
6) International revenues for diagnostics continues to grow, representing 11% of segment revenues in the quarter.
Is the bottom now in the rear view mirror?
I believe the odds are now heavily tilted toward long investors in Sequenom. To summarize why, let me draw an analogy to a golden cross technical indicator. This buy indicator comes about when the 50 day moving average for a stock crosses over the 200 day moving average. For purposes of this analogy, consider the number of body blows this stock had to absorb over the past 250 or so days:
1) Illumina changed from a partner to a competitor when it bought Verinata.
2) The district court ruled against Sequenom's motion for a summary judgment twice and when vacated and remanded back, issued a summary judgment for Ariosa.
3) Disclosed an inadequate outside billing service, which required a several month transition to in-house billing to improve controls and visibility.
4) CMS coding transition which led to reduced revenues and cash flows.
5) Investors questioned the investment in lab capacity and infrastructure as too expensive once reimbursement delays began to erode their available capital
All of these catalysts have helped drive the stock to ever lower levels. Stock trended weaker leading to the inevitable conclusion that the company would need a dilution capital raise in order to survive.
The short term indicator in the golden cross is the 50 day moving average. In that context we can see the short term catalysts that have created optimism:
1) Hired Jefferies to monetize the Genetic Analysis business segment. This business segment could be valued by the right partner at between $100 and $300 million. Note the current market cap of Sequenom is approximately $315 million.
2) Sequenom has gotten serious about expense management. This will bring profitability more quickly. It also minimizes the need for a capital raise, should the monetization of the Genetic Analysis segment be delayed or not occur.
3) The company has provided an estimate of unreimbursed billings which has multiple ramifications. Now there is increased visibility over pricing which should improve sequentially with each new data point. Also, the ability to estimate this number moves the company a step closer to accrual basis.
4) Gross margins are improving with the reduction of government payer tests which have not been reimbursed historically.
5) This reduced availability of tests is having the preferred impact of improving dialog with Medicaid agencies. This could lead to improved cash flows and increased unit growth in the future.
6) Two major customers were disclosed in the 10Q representing a significant increase in reimbursements. These payers were likely out of network payers which may be a prelude to one or more new national payer agreements in the next few months.
7) Despite the significant improvement in Q3 revenues, the company disclosed that the unreimbursed receivable estimate grew by $8 million during the quarter. That increase combined with the growth in international was quite strong in light of the restricted government testing achieved.
The short term trend is far more compelling with the news cycle swinging from a bearish to bullish sentiment. The first stage has already occurred, with a rally of 60% during the past two weeks. That leads to the more important issue: Is the short term rally coming to an end, or is this the first stage of a longer term uptrend? My answer for that relies on the following perspectives:
- The stock high was just shy of $5.00 during the past 120 days, before it sold off due to the poor reimbursement results in Q2-13. The catalyst behind the selloff was two-fold: How long will the reimbursement climate for molecular diagnostics be a head wind for the company? Will this last long enough that Sequenom will be forced into a dilutive capital raise? Very valid concerns which caused analysts to reduce their price targets to a consensus of $5.00.
- Results for Q3-13 should have alleviated most of this concern and uncertainty. Collections beat expectations by almost 10%. Cost cutting was achieved across the board. Actions were initiated which will result in reduced spending in 2014 of approximately $13 million. The company decided to focus their investment spending on NIPT and hired Jefferies to help find a strategic buyer for their MassARRAY bioscience segment at a time when this opportunity is ripe. Already we have seen numerous comments from analysts relating to improved disclosures, cash flows and reimbursements, as justification for raising forecasts. I expect them to begin raising price targets as this rally continues, adding further momentum to this rally.
- Valuation comparables for this company are hard to determine. There are three competitors: Ariosa, Illumina and Natera. Ariosa and Natera are both private. Illumina is not particularly helpful, considering how immaterial Verifi is to their results. The calculation I use is enterprise value as a multiple of 2014 revenues. At the time I wrote this article, SQNM was closed at $2.67 for an enterprise value of $375 million. Consensus C14 revenue expectations are $235 million, which yields a multiple of 1.6 times. This is well below the range for small to mid sized biotechnology companies. My targeted multiple is three given the amount of uncertainty that still exists. That results in a short term price target of $5.50 for a move of approximately 100%. Once the company is able to convert to accrual revenue recognition, another catalyst will exit as both the C14 revenues and enterprise multiple should move in a favorable direction. This could happen as soon as March, 2014.
Please do your own analysis before making any investments in this company. This is a high risk investment that is a favorite of the short community. This combination results in a lot of volatility, making it ill-suited for most investors.