Foundation Medicine: Undervalued As It Rewrites The Script On Cancer Treatment

Dec.10.13 | About: Foundation Medicine, (FMI)

First Act

The story of Foundation Medicine's (NASDAQ:FMI) impact on the way cancer is treated has already begun to unfold in hospitals and research centers. However, the tale of its impact on the markets is still taking shape. Foundation Medicine offers diagnostic products that provide genomic information about each patient's individual cancer, enabling physicians to optimize treatments in clinical practice and enabling biopharmaceutical companies to develop targeted oncology therapies more effectively. The company believes that FoundationOne, their first clinical product, is the only commercially available comprehensive molecular information product designed for use in the routine care of patients with cancer.

In simple terms, the company tests cancer tissue to determine which genes may have been removed or altered, thereby causing the cell to become cancerous. They do this to inform the clinician and their patient what is causing the cancer. Once you know what is causing a cancer, you can select the best treatment to combat it. Likewise, the more information a biopharmaceutical company has about different cancer types, the more specialized and effective their drug designs can become.

The company's IPO was released at $18 on Sept. 25. Analyst coverage was optimistic at its IPO as JPMorgan set a price target of $38. Goldman Sachs stated that the product has hyper growth potential and estimated that the total market would be between $4B and $7B. They set their near-term price target at $33. Leerink Swann estimated that 1 million U.S. patients could use the FoundationOne product and set a price target of $39. The initial excitement about the company and some high-profile investors in Google (NASDAQ:GOOG) and Bill Gates led to an all-time high PPS of $41.50 before September's end.

Intermission

Since the beginning of October, the PPS has decreased fairly steadily, reaching a low of $20 in mid-November. Much of the share depreciation followed the Q3 earnings report, after which a three-day loss in value of approximately 30% occurred. The earnings report showed a net loss of $12.5M, while revenues increased 173% from $3M to $8.2M year over year.

A significant factor in the company's overall net loss was the lack of a coverage decision from Medicare and other insurance companies. Tests for patients covered by Medicare alone comprise 29% of all tests ordered. Approximately 40% of tests were billed to third-party insurers for which no payment was remitted due to insurers awaiting a decision from Medicare on which to base their own payments. Overall, 1,651 of the 2,577 clinical tests delivered were not reimbursed by quarter's end. Since the company does not report revenues until they are paid, the lack of a coverage decision contributed to unpaid revenues estimated between $5.4M and $6.1M for the quarter.

The lack of coverage decisions has been an ongoing issue in previous quarters, resulting in 3,042 uncompensated tests over the past nine months. The value of repayment would therefore be between $10M and $11.3M. These estimates are based on an average price paid per clinical test of $3,300 for Q3 and an average price paid per biopharmaceutical test of $3,700 from the Q10. It should be noted that some of the unpaid revenues may be from tests issued late in Q3 that are simply yet to be paid. Reporting such a large net loss in Q3 was, of course, unattractive to investors and the PPS fell abruptly as a result.

Second Act

The Q3 earnings and the market's decision to take a popcorn break present a great opportunity now for investors. The lack of a coverage decision from Medicare and other providers is a relatively short-term obstacle, one that FMI expects to resolve before the end of the year. The effect of not having a coverage decision on revenues was well known to analysts covering the company during the IPO and its impact was factored into the given price targets. Net cash on hand is $137.9M as of Sept. 30, ensuring that there will not be any near-term cash flow issues.

Once there is resolution, it will benefit the company in two ways. The first is from payment of future tests and the second is from repayment of previously issued tests. Third-party insurers often base their rates on the Medicare valuation for a service, so once the determination is issued, the remaining unresolved third-party payment rates should be hammered out fairly painlessly. Repayment of previously issued tests is not guaranteed, but would make sense given the circumstances. This could result in a short-term revenue boost of $10M to $11.3M, though likely not all at once.

In the meantime, the company continues to grow sales and revenues each quarter at an increasing rate as it expands its marketing expenditures. The current analyst revenue estimate for Q4 2013 is $8.1M, according to the Schwab fundamentals chart. This estimate seems likely to be surpassed by a significant margin given current trends. Extrapolating revenue trends using the average percent increase in tests delivered, and the average revenue/test delivered over the previous three quarters, the estimated Q4 revenue would be $13.9M with no coverage determination issued. Also extremely important to note is that not only have test deliveries increased, but also the turnaround time for a test was reduced from 21 days to 14 days during Q3 2013.

The table below shows 2013's trend in revenue and tests delivered as the company looks to nab the estimated 1 million applicable U.S. cases. Quarterly values for biopharmaceutical tests were estimated for Q2 and Q1 as they were only available at the six-month level. The table also shows revenue estimates assuming a coverage determination had already been issued at the low ($3,300) and high levels ($3,700) described earlier. An argument for lower Q4 estimated expenses can be made as one-time costs associated with the IPO buoyed the Q3 total, but will not be included in Q4.

Quarter

Tests Delivered

Revenue in Millions

Expenses in Millions

Low Revenues With Coverage

High Revenues With Coverage

Q4 Est.

5,204

13.9

25.8

17.2

19.3

Q3

3,542

8.2

20

11.7

13.1

Q2

2,342

5.9

16

7.7

8.7

Q1

1,642

5.2

12

5.4

6.1

Click to enlarge

Dramatic Twist

FMI has seen the significant sales growth shown above on the strength of only one product, FoundationOne, which is used in analyzing lung cancers. On Dec. 7 the company launched its second product, Foundation One Heme. The new product is targeted at hematologic malignancies, sarcomas and pediatric cancers and was developed in partnership with Memorial Sloan-Kettering Cancer Center. The release of Foundation One Heme occurred ahead of schedule as it was not expected to be commercialized until early 2014. The product launch is to be supported by the release of data from 10 studies, two of which have been released so far.

No estimates currently exist for the total patient pool or the adoption rate of the new product. However, the familiarity of clinicians and biopharmaceutical companies with FoundationOne should expedite Heme's use compared to its predecessor. By launching in early December, the company has given itself the chance to make clinicians and biopharmaceuticals aware of the new product in advance of Q1 2014, which should bolster sales to begin the year. If the company is able to achieve test deliveries for Heme that are similar to Q1 2013 for FoundationOne, revenues would be increased by an estimated $5.2M. Development of additional product lines is a high priority for FMI, as R&D expenditures accounted for $7M of the $20M in expenses during Q3.

The positive news regarding the introduction of a second product line is further bolstered by the recent announcement of Foundation One's use in a "Master Protocol trial," which is set to test 6,000 patients over the next five years. This represents approximately $4.4M in annual revenue based on average biopharmaceutical test prices in Q3. The results of the trial are expected to outline the methods to be followed for future individualized drug research. It also highlights the importance biopharmaceutical companies are placing on the future of individualized patient care.

Standing Ovation

There are many elements working in FMI's favor as 2013 winds down, including a rapidly increasing adoption rate, a largely untapped market, a monopolized product, introduction of a second product line, resolution of payments from insurers, and increased awareness of benefits to consumers who will subsequently demand testing in their evaluations. It is my belief that the combination of these elements is likely to push the company into profitability in Q1 or Q2 of 2014.

From a value standpoint, the company's current PPS is well below analyst targets that were set prior to introduction of the second product line. Not to mention the company valuation of $625M is well below the analyst estimated market cap of $4B to $7B. For these reasons, I believe that the company will see incredible growth in 2014 and beyond and that the current PPS of $22.22 is a very attractive entry point that should not be ignored by investors.

Disclosure: I am long FMI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.