Marty Chilberg's  Instablog

United Health is the largest coverage provider in the US. Today they joined the ranks of Wellpoint, Aetna, Anthem, Humana and Empire, changing their policy for non-invasive prenatal tests (NIPT) to medically necessary for high risk pregnancies. The market leader in this space is MaterniT21 Plus (SQNM).

This policy statement change is an important step for all companies offering NIPT. The primary competition to MaterniT21 Plus is Harmony (Ariosa Diagnostics) and Verifi (Verinata acquired by ILMN). These companies are all in various stages of negotiating to get paid for their tests. They are in high demand by pregnant women classified as high risk. A quick overview of the process required when new tests are launched follows. Note these are personal opinions based upon various company statements and not validated.

1) Launch test: out-of-network (OON). Fight with insurers over billings with numerous appeals and months of delay before resolution. Could result in complete denial, which results in no reimbursement. Time frame could take up to 9 months with payments relative to list from 0-100% Average reimbursement level is likely quite low with revenue recognition lagging cost of test by several quarters.

2) Test gains traction: Need to show significant activity in market to gain the attention of the medical community and coverage providers. Having large numbers of billings with resultant appeals, starts building a history. Process is still very time consuming and administratively intense. Payment fluctuations are still wide but with history comes some compression of range. Estimate of resolution of billing is still likely in the 6 month range.

3) ACOG/CTAF: The opinions that these tests were medically necessary was a significant step last fall. This determined the target market as high risk, and is required for many coverage providers to adopt policy changes. Payment fight is somewhat easier as repetition and validation of need have an influence. However, still out of network and not yet determined by coverage provider as medically necessary. Billing reimbursement process continues to be arduous and lengthy. Estimated reimbursement timeframe is 4-6 months.

4) Insurance provider adopts policy statement as medically necessary. Big improvement. Complete denials for reimbursement should be eliminated. The test should now be In Network but with no contract, the billings continue to be disputed. Reimbursement timeline likely reduces to 3-5 months with some earlier receipts and final appeal resolution still administratively intense. Should see acceleration of cash receipts and revenues.

5) Company signs a coverage contract with insurance provider. Test is In-Network with billing amount and payment terms now set. Contracts likely have confidentiality clauses which means rates can't be disclosed to market. Larger providers could require "most favored nations" clauses stating if other contracts get signed for lesser amounts, they will get a price adjustment. Now the receivables are real with cash flow projections more predictable. Could still have delay to accrual based revenue recognition however given accounting rules.

6) Once there is a contract and some reimbursement history, the company is able to properly document that 1) an agreement exists, 2) price is fixed and 3) reimbursement is reasonably assured. At that time revenue will be recorded upon billing rather than cash receipt. It's unclear how many billing and payment cycles a company will need to be able to convert. SQNM management has implied it would be a 1-2 quarters after each contract sign is signed.

7) If there is a contingency clause for most favored pricing, the company would still need to reserve revenue for price concessions. Only after all significant coverage providers have signed can investors start becoming comfortable with estimates of average selling price and gross margin of the test.

As of January, Sequenom had approximately 15% in category 5-6 and perhaps 5% in category 6. The level in category 6 was small enough that conversion would have been immaterial to overall results for C12. However, they now could have over 60% of their billings in category 4 which is substantial progress over prior quarters. Looking forward to hearing about coverage negotiations in call next week as well as any discussion of timing for conversion to accrual. Unless they are unable to achieve the reimbursement levels desired, we should see some substantial percentage of their billings convert to accrual within the next 3 quarters.

Disclosure: I am long SQNM.

2013 is looking like a pivotal year for the NIPT market. Sequenom appears to be the market leader with a run rate of 120,000 as of the end of last year. However, this lead is much slimmer than earlier due to increased competition. Genomic sequencing is targeted to be a massive market looking forward and the prenatal space is on the leading edge. The main players in this space are as follows:

Sequenom - MaterniT21 Plus

• List $2,700. Reimbursement rate unknown
• MPSS has higher cost as it looks at more cfDNA fragments
• Run Rate 120k all high risk and US
• Covered lives 56m US at 1/13. Target 120m by end of 2013
• COGS approximately $500

Ariosa Diagnostics - Harmony

• List $795. Reimbursement rate unknown
• Domestic sales/marketing partner LabCorp
• Targeted sequencing is cheaper as it analyzes fewer fragments
• Run Rate 100k Dec-12. Virtually all high risk and US.
• COGS much lower per company.

Vernita - Verifi

• List price $1,200. Reimbursement rate unknown
• MPSS similar to MaterniT21 Plus
• Domestic sales/marketing partner Perkinselmer
• Purchased by Illumina recently
• Run rate unknown. Believed to be distant third

Natera - Panorama

• List price $1,495
• Limited release. Expected widely available end of Mar-13
• Domestic sales/marketing partner Quest Diagnostics
• Looks at Single Nucleotide Polymorphisms SNP with informatics
• Run rate premature. Limited clinical trials/none blind

Cellscape - Clarity

• Test not on market. Said to be signing sites for clinical trial
• Positioning test as a microarray diagnostic test rather than a screen from fetal cells that are pregnancy specific
• No information on launch target or pricing yet

Disclosure: I am long SQNM.

TCS reported revenues of $132.7 million and $487.4m, for the quarter and year ended December 31, 2012, respectively. The revenues included approximately $3 million for sale and licensing of patents, without which, they met street consensus for the quarter. Government revenues came in at $82.6 million or 62% of total. However, order flow during the quarter was soft resulting in a decline in government funded backlog of $31 million, to $93 million. With the backdrop of sequestration, the pending fiscal cliff and political issues, this represented a solid performance.

Commercial revenues totaled $50.1 million for the quarter, up about 4% from both prior year and prior quarter. However, this included the patent transactions which accounted for more than the total growth. During the conference call, the company commented that E911 growth offset declines from telecom provider navigation revenues.

Reported adjusted earnings were $0.20 per share, over 2x consensus expectations of $0.09. The patent transactions represented about $0.04 per share. Also contributing to the out-performance, was a sequential improvement in gross margin of 400 basis points and lower than anticipated operating expense.

The company provided their first look at 2013, guiding revenue expectations to a range of $450-$475 million. TCS guided earnings per share to a range of $0.25-$0.31 per share. TCS does not provide quarterly guidance. This guidance was below consensus street expectations, which served to mute the reaction to the December beat. This softening of expectations for 2013 was consistent with that seen by many companies in the defense sector.

Additional highlights worth noting

· The WWSS contract vehicle has been extended to march 2014. This vehicle has approximately $2 billion remaining. TCS has won over 40% of all task orders awarded under this contract vehicle.

· TCS was named as one of 8 awardees of the DISA 5-year, $ 2.6 billion CS2 contract.

· TCS was named as one of 20 awardees of the Army 5-year $10 billion GTACS contract.

· TCS was renewed under the GSA services contract. Historically this has provided approximately $50 million over a 5-year duration.

· TCS announced that the Blackberry 10 handset will include TCS navigation, maps, LBS and software components. This was structure with both recurring and non-recurring revenue components.

· The IP monetization that occurred in the December quarter is expected to continue and become a recurring revenue stream. Another opportunity has already been negotiated and is in due diligence.

Homeland Security Eagle II contract vehicle is now not expected to be announced until spring of 2013.

· The company early-retired $10 million of their convertible notes that become due in 2014. They announced they are evaluating option to retire the remainder, stating conditions were favorable and any impact on common shares should be modest.

· Goodwill and other intangible assets decreased sequentially.

Summary

There was much to like about the latest quarter and the outlook for the future. However, until sequestration and defense spending picture is clearer, TCS will likely not be fully rewarded for it. I view this as a trading stock rather than a long term hold. Volume is too low. The debt overhang is still too high. Reliance on the government sector is too significant. And, the outlook for the 1H of 2013 is soft per a recent conference presentation by the CFO. Once the order flow begins under the above-mentioned contract vehicles, this could rally hard given the current low valuation.

Disclosure: I am long TSYS.