Things have gone well for Exact Sciences (NASDAQ:EXAS) since I last wrote about this up-and-coming diagnostics company in July of 2014. With a favorable CMS coverage decision in hand and a commercial launch underway, the shares have appreciated more than 40% and outdone the $20 base-case fair value I laid out at the time.
Since commercialization has begun, Exact Sciences has followed a path that should be familiar to the more grizzled veterans of med-tech stocks - namely, adoption hasn't ramped up quite as quickly as the Street hoped and it is costing more money to build and support the sales effort. As is, the shares look pretty much fairly valued to me today.
Seeing the Cologuard designated a Class A or Class B test by the USPSTF would be a significant help in securing commercial insurance coverage, but a cost effectiveness study due later this year could pose a threat to future pricing, as does competitive blood-based tests on the way. I'd certainly be happy to reconsider the shares on a pullback, but it would take some combination of a lower price, faster adoption, more assurance on pricing, better visibility into European sales, and/or more color on the pipeline to get me more bullish right now.
Fueling The First Stages Of The Launch
By typical med-tech standards, I think the launch of Exact Sciences' Cologuard test has gone relatively well. The company had 140 direct sales reps at the end of the first quarter and management is accelerating its hiring plans - looking to have 200 reps on board by mid-year instead of earlier guidance of 200 reps at the end of this year.
With so many new hires, sales force productivity is predictably quite low right now, but it doesn't seem out of line with what companies like Cytyc (long since acquired by Hologic (HOLX)) produced during their launch windows. Utilization from existing customers seemed to be close to three tests per account per quarter and a significant number of orders came from accounts with no direct sales contact.
Exact Sciences has also made some incremental progress on expanding its marketing base. The company's partnership with Ironwood (IRWD) more than doubles the effective sales force and gives the company a window into accounts that its own sales force were not going to target during this initial phase. Exact Sciences has to share a chunk of the revenue generated this way (I don't believe management has disclosed this, but something in the neighborhood of 20% would be typical), but it's a relatively low-cost way to build recognition during this early phase of the launch.
Will The USPSTF And Cost Effectiveness Studies Support The Story?
Two events should occur in 2015 that could have significant bearing on Exact Sciences' launch and eventual addressable market. The first is a determination from the United States Preventive Services Task Force (USPSTF) regarding the net benefit of the Cologuard test.
If the USPSTF determines that there is a moderate certainty of high net benefit, a high certainty of moderate net benefit, or a high certainty of high net benefit (Grades B, B, or A, respectively), U.S. commercial insurance companies like UnitedHealth (UNH) and Anthem (ANTM) will be required to cover the test. As around 50% to 55% of the target market in the U.S. is covered by such plans, that's not a trivial consideration for the company, particularly as convincing commercial insurers to sign on has thus far been a challenge for the company.
Later this year there should also be the publication of a cost effectiveness study. As are most things concerning Exact Sciences, the ramifications of a cost effectiveness study are controversial. Some have tried to draw straight lines between the sensitivity/specificity of colonoscopies and FIT tests to estimate the potential "fair" price for Cologuard (meaningfully lower than the currently reimbursed amount of $493). While I wouldn't rule out that risk, I would note that the very clean safety profile of the Cologuard and the high compliance rates for the test (above 70% so far) could result in a conclusion above where a straightforward correlation study would lead.
Competition Will Be Coming
No test sells itself and no test stays exclusive for long - something I had to re-learn the hard way with LipoSciences and its cholesterol test. While the company's DEEP-C test established solid sensitivity and specificity, it is not at the level of colonoscopy, particularly with respect to precancerous lesions (though the effective sensitivity improves when you consider the frequency of use of the Cologuard test relative to colonoscopy).
Furthermore, there are tests heading toward market that could challenge the Cologuard. Epigenomics (OTCQX:EPGNY) recently reported successful results from its ADMIT study of its Epi proColon study; a study designed to establish superior compliance to FIT testing. While the study was targeting an 8% improvement, Epigenomics delivered better than 11%. Epigenomics should be able to get approval this year for U.S. marketing, and while the sensitivity and specificity are below the levels of Cologuard, the appeal of a cheaper (perhaps below $150/test) blood-based test could be significant.
In addition, there is VolitionRx (VNRX) and its blood-based NuQ test. More sensitive than the Epi proColon (but slightly less specific), the NuQ has shown better sensitivity for smaller pre-cancerous adenomas than Cologuard. Better still from a marketing perspective, it can be run on a standard ELISA platform and will likely be pretty cost-effective as a result.
Estimating The Value
I won't pretend that a negative result from the cost effectiveness study, and a meaningful haircut to pricing in its wake, wouldn't be a significant blow to valuation and that's one of the biggest risk factors I see. That said, I don't feel like my underlying assumptions are all that aggressive. Adjusting for compliance (at a 65% rate) and low single-digit market growth, I'm looking for Exact Sciences to get 5% share in 2018 and exceed 10% share in 2022. Provided that pricing doesn't erode substantially, that supports over $1 billion in revenue at the end of 2022, with further potential upside from Europe (where pricing could be a real battle for the company).
I believe that Exact Sciences can get the gross margin past 60% in 2017 and quite possibly north of 70% in five years. Even with significant sustained R&D expense (to develop better versions of this test, as well as tests for Barrett's esophagus and/or pancreatic cancer) and an ongoing sales ramp, I believe a 20% operating margin can be reached in 2019 with upside into the 30%'s and possibly higher. As far as big modeling unknowns go, I would note that the company's stock option expense runs pretty high and the company will almost certainly need more working capital in the future, as well as additional fixed infrastructure once the 1M/yr test capacity is close to full utilization.
The Bottom Line
Discounting these cash flows back, as well as factoring in the equity raise and options, I come up with a fair value in the same neighborhood as before, but a little higher - about $20.50. As the company will burn most (if not all) of its cash, I'm excluding cash on hand from the valuation. I'm also excluding European revenue and any pipeline products, though management may give more insight here during its upcoming Analyst Day.
As things sit today, I don't think Exact Sciences is unreasonably valued by the market. This has long been a controversial name and I suspect it always will be - bears said the company would never get reimbursement close to $500, now they're saying a cost effectiveness study will gut that, and even if they're wrong about that, they'll point to competition/utilization, or some other reason to dislike the stock. For my part, I'm not inclined to chase the shares today - I like the test and I like the company, but I think the price already discounts close to $1.6 billion in revenue in 2024 with a FCF margin well in the 20%'s.
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