Sequenom Q1 2015: Trying To Make Sense Out Of Confusion

Sequenom (SQNM) announced revenues of $37.8m and diluted earnings per share of $0.11 after hours on May 6, 2015. This blog will attmept to make some sense out of the report because frankly the company did not do a very good job explaining it. As I outlined here I was very hopeful management would take the time to lay out a road map of what changed in their reporting to allow investors to better understand the new business model. Unfortunately that didn't happen. They did however provide some clues or hints that are useful. I'll try to dig through what they did say to try to outline how the changes impacted the results for the March 2015 quarter.

IP Pool Detail

We know that Sequenom signed a transformative licensing agreement with Illumina on December 2, 2014. That agreement had the effect of pooling all NIPT intellectual property "IP" of the companies. This pool is administered by Illumina who is responsible for:

• Sales and marketing activities to sign new licensees.
• Working with licensees to validate the tests to enable processing of samples at their labs.
• Defending the IP in world wide, excluding existing disputes with Ariosa/Roche or Natera.
• Administering the relationship including support, billing and collection activities.

Disclosures related to the IP Pool administration:

• Licensees existing at the signing date continue to be administered by the party who signed the agreement.
• Sequenom licensees are on the accrual basis while Illumina is administering their licensees on the cash basis.
• Illumina and Sequenom share the IP Pool with Sequenom getting a minority share.

More on these in the revenue section.

As of December 2014 there approximately 21 licensees with another 3 signed during the March quarter. At December 2014 the breakdown was:

1. 2 were Sequenom and Illumina themselves.
2. Sequenom brought 6 into the pool: Life Codexx, Lab Cerba, SRL, GeneTech, Quest and Mayo.
3. Illumina brought the remaining 13, including LabCorp.

Not all of these licensees are up and running. All the Sequenom international licensees were active in the fourth calendar quarter. Domestically, Quest announced that their licensed test was available at the end of April 2015. On their earnings conference call, Illumina announced that they have several licensees that are not yet validated and temporarily sending samples to the Verinata lab for processing.

What caused revenue to miss street estimates?

The international revenue was under 10% this quarter and therefore not specifically dislosed. This is informative with respect to the revenue shortfall. In the December 2014 quarter, international contributed 15.4% of revenues up from 12.5% in the first calendar quarter. The December 2014 quarter calculates to approximately $5.7m. This growing international adoption may very well have continued during the March 2015 quarter, yet total international revenues fell to under $3.5 million. This sequential drop makes up much of the revenue short fall. Referring back to the disclosures it makes sense, though it's unclear why the company didn't lay this out for investors. There were two components of the international drop.

1. Both the licensees in Japan (GeneTech and SRL) were sending samples back to the US for processing when the December quarter began. Therefore the average unit price was consistent with that arrangement or much higher than licensing revenue per unit. When they validated their test and began processing samples locally, the average unit price dropped as it does for any licensee. Likely by at around 60% as shipping and cost of goods sold was eliminated from Sequenom's cost structure.
2. All royalties from international licensees are no longer being reported as revenues by Sequenom. The company has never disclosed this amount but I've estimated it at around $1.4 in Q4 2014.

The accessions disclosed for NIPT and Other LTD were both pretty solid, especially considering any drop from licensees like those in Japan that began processing tests themselves. There does appear to be a small drop in the MaterniT21 average sales price (2-3%). The likely drivers:

• Seasonality: Deductibles are reset at the start of every year. That reset has an impact on the amount the company bills and collects from payers. All copay or deductibles paid by individuals are recognized on a cash basis.
• The company mentioned that 90% of March tests and 76% of the tests for the quarter were billed under the new CPT code and reimbursement level. While this was not mentioned as a headwind, I suspect there was a little price compression from this shift.

Test gross margin percentage drop to 46%

Most of this drop was also driven by the transition to the IP Pool. Assuming the estimates for international licensing from Sequenom partners was estimated correctly in the last section:

• Q4-2014 had approximately $1.4m in license payments which had no cost of revenues. This remains in the test revenue calculation since the company chose not to separate prior periods for investors.
• Q1-2015 international licensing from Sequenom partners was likely $1.6m to $2m with both Japan partners contributing for the entire quarter. If I understood the accounting described by the company, this total was recorded in cost of sales as an amount to be paid into the pool. Sequenom recorded their portion of the revenue as an offset. While the company won't provide their split of the pool, we know it is less than half. I used 30% for Sequenom portion, based upon the negotiating leverage of Illumina and the costs they are incurring.
• There was a $1m catch-up royalty cost from converting from cash to accrual basis due to the IP Pool.
• The remainder of the margin comprehension was likely due to the drop in average sales price in the quarter.

Revenue guidance

After considering the above description, the company guidance is not particularly surprising. The components to consider include:

• Expect Q2 2015 revenues to drop by $3 million sequentially. That is very likely directly attributed to Quest converting to a licensee at the end of April. Sequenom loses the direct test revenues. They also have to record the revenues Quest owes to the IP Pool as a cost of revenue, net of their portion With so many of Illumina's licensees sending samples to them awaiting validation, it will likely take another quarter for this IP Pool sharing to starting tilting more in Sequenom's favor.
• Expect the IP Pool revenue to come in around the mid-point of the $6m to $14m guidance. This is consistent with the revised accounting, netting the portion earned by Sequenom against their contributed amount to the pool.
• Expect the 2015 revenue to come in toward the low end of the $150m to $170m range. Same reasons.

Final thoughts

1. The sequential increase in sales and marketing spend of $1.7m should not have been a complete surprise to the street. Launching two new tests will clearly have a cost, though I'm surprised the company didn't highlight that on the last call.
2. The $21M recognition of the deferral related to the clinical data has no ongoing impact. While a positive, it is nonrecurring and largely irrelevant to ongoing operations.
3. Product release targets for non-invasive karyotype NIPT and Research Use Only liquid biopsy both remain on track for 2H 2015.
4. The $1.3m in IP Pool revenues looks to be the amount Illumina reported. That likely is mostly from LabCorp in the month of December 2014.

The bottom line is that the impact of this transition wasn't telegraphed very well. The short term impacts now show up and appear to signal negative operating trends which isn't accurate. Despite this minor set back, the fundamentals all remain intact. Illumina will push to achieve a land grab in the sequencing market prompted by the pending low risk market opportunity and cancer diagnostics. Sequenom will absorb this 1-2 quarter earnings compression into a longer term upside as the overall market grows.