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.

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.

Found this overview on sequestration impact:

How Sequestration Will Impact Existing Gov't Contracts

Law360, New York (July 10, 2012, 1:33 PM ET) -- Pursuant to the Budget Control Act of 2011, an automatic budget-cutting process known as sequestration is scheduled to occur in January 2013. While the political leaders seem to agree that this would be harmful on multiple fronts and should not be allowed to occur, no viable solution has yet been offered. In keeping with the maxim of hoping for the best but planning for the worst, this article provides a brief overview the impacts that sequestration will have on existing contracts and contract actions, and key facts that contractors need to know about their contracts to be prepared should sequestration occur.

The impacts that sequestration will have on existing contracts and contract actions relating to nonexempt programs turns on a few key factors, namely:

- the type of contract action in question;

- the fiscal year of the funds that have been used or will be used;

- whether any modifications are envisioned; and

- whether the contract is incrementally funded.

These are interrelated issues and will be addressed in the sections that follow.

Existing Fully Funded Contracts

The government is generally required to obligate the funding for the full costs of a contract at the time of contract award.[3] This is necessary to prevent violations of the Anti-Deficiency Act, 31 U.S.C. § 1341 et seq., as it ensures that the agency has sufficient funds to satisfy its obligations and does not incur liabilities in excess of its available funding. Because of this requirement, sequestration alone should have no direct impact on already awarded contracts for which the full funding has already been obligated and the contract is expected to stay within budget. In this scenario, the necessary funding from FY 2012 (or earlier) has already been obligated and the cuts to FY 2013 funding should have no impact.

Existing Incrementally Funded Contracts

An incrementally funded contract is one for which the agency has special authority to obligate only the current year's costs at the time of contract award, with the subsequent years' costs obligated annually thereafter. These special authorities may be standing authorities for a particular type of contract (e.g.,utilities contracts) or project-specific (e.g., expensive construction projects). Sequestration could significantly impact incrementally funded contracts. Most directly, the funding cuts for FY 2013 and beyond may leave an agency with insufficient funding for the phases of the contract occurring in those fiscal years. The risk of future-year funding lapses could also pose risks to the continued performance of already executed, already paid-for phases of incrementally funded contracts for nonseverable services (e.g., construction). Specifically, if the agency determines that it will be able to fund the future-year phases of an incrementally funded contract under its sequestration-level budgets, it may choose to terminate the contract for convenience now rather than continue performance on a contract that, either way, will be left incomplete.

Because of these risks, it is important for a contractor performing to know what priority the agency attaches to its incrementally funded contract. While an agency may not apply one appropriation to expenses properly directed to another,[9] agencies do have discretion to prioritize expenses within a particular appropriation and will be required to do so should sequestration occur. The higher the priority

that the agency attaches to the contract, the greater the chance that the next incrementally funded phase may survive sequestration.

Options Under Existing Contracts

Pursuant to 31 U.S.C. § 1502(a), time-limited funds may only be obligated for expenses incurred or contracts executed during the fund's period of availability. As a corollary to this statute, the bona fide needs rule provides that time-limited funds may only be obligated for goods or services that are necessary to satisfy a bona fide need arising during the funds' period of ability.[10] A contract option is considered a bona fide need of the fiscal year in which it is exercised, and thus must be financed with funds current for the fiscal year in which it is exercised. For contract options that are exercised before FY 2013, sequestration should have no direct impact on the execution and payment of that option. As discussed above, the necessary funding from FY 2012 (or earlier) will already have been obligated and the cuts to FY 2013 funding should not have a direct impact.

For contract options scheduled for exercise on or after Jan. 2, 2013 (the effective date for sequestration), sequestration will have a significant impact on the government's ability to exercise the option. Any such option would need to be financed with funds that are legally available for obligation in FY 2013, which may not be available because of the FY 2013 sequestration spending cuts. If a contractor were to continue performance in anticipation of an option that is ultimately not executed for this lack of funds, it would do so at its own risk and likely would not be compensated for this performance.

For contract options scheduled for exercise between the start of FY 2013 and Jan. 1, 2013, the impact of the pending sequester is unclear. This largely owes to the fact that the Office of Management and Budget has not yet made public its decisions of how to address executive branch spending during this period. OMB distributes funds to agencies through a process known as apportionment. This process

essentially tells the agency how much it has available to spend during a given time period, typically for the fiscal quarter. By limiting the agency's spending ability, the apportionment process prevents

agencies from depleting their funding early in the fiscal year and having to later seek deficiency or supplemental appropriations. While the FY 2013 appropriations acts have not yet been finalized, the funding levels set forth therein will certainly be higher than those that would be triggered under sequestration. The question is whether OMB's apportionment decisions for the first quarter of FY 2013 will be made with an eye toward the funding reductions that are scheduled to occur at the start of the second quarter of FY 2013. On one hand, OMB's past practice suggests that it will not consider the possibility of sequestration in making its first quarter FY 2013 apportionments.

For instance, in the April 2011 budget showdown, OMB did not issue its guidance on the threatened "Government shutdown" until the day before the shutdown was to occur.[15] The presumed rationale for this late issuance was it could be construed as an admission that the political parties could not reach a deal, which could in turn be perceived as a political defeat.

This same rationale would seem to apply here, as OMB likely will not follow an apportionment approach suggesting that sequestration is a fait accompli when three months and a lame-duck session of Congress

remain in which to strike a deal. But on the other hand, OMB cannot simply turn a blind eye to the cuts that may be on the horizon - especially given the political parties' inability to reach a deal even for

matters that they agree on, never mind a matter with such far-reaching budgetary and debt consequences as sequestration. Against this background, what steps may a contractor take to safeguard its interests with regard to contract options that are scheduled for exercise in FY 2013?

First, as discussed above, the contractor should attempt to learn from the agency what priority the agency attaches to these options. If the option is a high priority, then there is a greater chance that the option will be exercised even if sequestration occurs. And if the option is not a high priority, at least the contractor will have that knowledge and can begin positioning itself now for the possibility that the option may not be exercised.

Second, to the maximum extent possible, the contractor should push to have the option exercised in FY 2012 or the first quarter of FY 2013, as funding will still be available for these options at presequestration levels. Note, however, that this solution may not be available for a significant swath of contracts; because of the bona fide needs rule, an agency generally cannot exercise an option in FY 2012 (or the first quarter of FY 2013) if the need for that good or service will not mature until FY 2013 (or FY 2014). But to the extent that such early or moved-up exercise of options is permitted by law, it may be one means by which contractors can avoid - or at least postpone - the impacts of sequestration.

IDIQs and Task and Delivery Orders

The impact of sequestration on indefinite delivery, indefinite quantity ("IDIQ") contracts is governed by elements discussed in each of the above sections.

First, the guaranteed minimum under an IDIQ must be obligated at the time of contract award. Thus, for already awarded IDIQs, the funding from FY 2012 (or earlier) has already been obligated for the guaranteed minimum and the cuts to FY 2013 funding should have no impact on the agency's ability to pay the guaranteed minimum.

Second, the task or delivery orders under an IDIQ are subject to the same general rules discussed above or options; that is, the obligations occur as the orders are placed and are chargeable to the fiscal year in which the orders are placed. Sequestration should thus have no impact on the issuance and payment of task or delivery orders that are made before the end of FY 2012, and should have little to no impact on orders made before the effective date of sequestration in January 2013. This same rationale applies with regard to orders placed under similar forms of task or delivery order contracts, such as multiple award task order contracts.

Modifications to Existing Contracts

For contract modifications that result in price adjustments, the impact of sequestration turns on whether the modification is beyond or within the scope of the original contract and the timing of the modification.

"If the modification exceeds the scope of the original contract, for example, by increasing the quantity of items to be delivered, the modification amounts to a new obligation and is chargeable to funds current at the time the modification is made." In addition to likely requiring a sole-source justification for such a modification, any out-of-scope modifications occurring in FY 2013 would need to be financed with funds that are legally available for obligation in FY 2013. But because of the FY 2013 sequestration spending cuts, agencies simply may not have the funds available to finance such a modification.

If the modification is within the scope of the original contract, the increased cost is deemed to "relate back" to the original contract obligation and must be paid from the same year of funds as were

obligated for the original contract.[21] For instance, when a construction contract is modified solely to reflect the additional costs of differing site conditions, and not to change the project itself, it is generally viewed as an in-scope modification that should be financed with the same year of funds as were originally obligated for the contract. Because in-scope modifications are financed with prior-year funds, whereas sequestration only effects future-year (i.e. FY 2013 and beyond) funds, sequestration should have little impact on an agency's ability to execute and fund in-scope modifications to existing contracts.

Conclusions and Recommendations

As demonstrated above, there is no one-size-fits-all answer for whether and how a contractor may prepare itself for the potential impacts of sequestration. Each contract and contract action is unique, and contractors will need to examine their individual contracts and pending contract actions to determine whether and how they may be impacted by sequestration. In performing this evaluation, a contractor should seek to learn the following:

- whether the program to which its contracts relate has been deemed exempt from sequestration;

- the funding source and funding years for its current and anticipated contracts, options, and task or delivery orders;

- whether its contract are fully or incrementally funded;

- what priority the purchasing agency attaches to the contractor's current and anticipated contracts, options and task or delivery orders; and

- know what modifications are planned for existing contracts. With these facts in hand, a contractor may be able to predict its contracting future and avoid - or at least postpone - the strains that may be posed by sequestration.