Exact Sciences Traveling A Familiar, Tough Road

| About: EXACT Sciences (EXAS)
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The relatively successful Cologuard ramp in 2015 was overshadowed by a disappointing initial USPSTF determination in October and a test volume shortfall in the fourth quarter.

Exact Sciences has coverage for more than half of its target market, but the company is spending more than previously expected to support the launch and pricing risks remain.

Exact Sciences shares seem undervalued if the company can achieve low-to-mid teens share of its target market and 20%-plus operating margins, but further funding will likely be needed.

As I've written in reference to med-tech in the past, sometimes FDA approval is the relatively easy part of the process. Almost every company can talk up the prospects for an experimental drug, device, or diagnostic test (with sell-side analysts dutifully parroting them), but products don't sell themselves and navigating the correct path through patient/doctor education, pricing, reimbursement, and so on is trickier than many investors realize or expect.

When last I wrote about Exact Sciences (NASDAQ:EXAS) I mentioned the risk that the company could get an adverse ruling from the United States Preventive Services Task Force (USPSTF), and that happened. While the initial ruling wasn't a clear-cut "don't use" for the company's Cologuard test, it wasn't the unambiguous positive decision that investors were hoping for and that would have spurred widespread commercial reimbursement in 2016.

Absent a final ruling from the USPSTF, Exact Sciences is in a tough spot. A negative USPSTF determination doesn't prevent private insurers from covering Cologuard, but it gives them an excuse not to and/or to push hard for pricing concessions. While I've remodeled for a slower uptake of the test, a lower ASP, and higher spending, I still arrive at a fair value that suggests meaningful undervaluation. If the company can deliver the expected volumes this year investors may reconsider the name, but if the uncertainty about reimbursement starts impacting that ramp, all bets will be off.

The Ramp Has Started...

Quarter-by-quarter isn't an especially good way to judge a company, but it makes more sense in the context of a company like Exact Sciences that is just getting started and has to convince the market that there is as much commercial opportunity for the Cologuard test as hoped. The company saw test volume grow from around 11,000 tests in the first quarter, to 21,000, to 34,000, and to 38,000 for the fourth quarter.

While the first three quarters of 2015 were above management's guidance, the fourth quarter reversed that trend. Management nevertheless maintained its outlook for 240,000 tests in 2016, 130% better than 2015. I'd also note that the company has been adding around 6,000 physicians to its prescribing list each quarter, with about three-quarters of those doctors re-ordering the Cologuard.

Patient compliance has been mentioned before as a key risk factor and a significant aspect of future reimbursement. While I have been modeling for 65% compliance rates, compliance has been running in the low 70%'s (71% in Q1, 73% in Q2 and Q3, and 71% in Q4). That compliance is coming at a price; management doesn't break out all of these spending items (nor would I expect them to), but Exact's spending has been higher than I expected and some part of that could be tied to the elevated level of interaction the company pursues to keep compliance rates up.

Spending Is Running High

I've often commented that initial med-tech commercial launches always cost more than the Street expects. I had thought that I'd adjusted accordingly, but Exact is outspending those projections. On the sales and marketing side, I believe this is a "takes money to make money" situation and I think Exact Sciences is smart to use the money it raised back in 2015 to help fund the sales and marketing efforts it takes to build and support the commercialization process.

And it is not as though these efforts have been wasted - while some private insurers like UnitedHealth (NYSE:UNH) don't reimburse for the test today, the company has added multiple Anthem (NYSE:ANTM) states and already has more than half of its target market covered with reimbursement. Given that I don't expect Exact Sciences to reach 20% penetration of its addressable market within my 15-year forecast period, I would argue this at least modestly de-risks the projections a bit.

Spending On R&D Apparently More Controversial

The market was definitely rattled by the initial USPSTF release in October and some analysts took down their 2016 test volume guidance by nearly half. Moreover, the market appetite for risk within the med-tech sector has vanished. Those have definitely been the driving factors in sentiment around Exact Sciences, but it seems as though there has also been discontent over the company's relatively robust spending plans in R&D.

R&D spending rose about 17% in 2015 and management's June Analyst Day laid out a more ambitious pipeline than I believe some investors expected. It wasn't news that Exact is working on a test for pancreatic cancer or Barrett's esophagus (which management thinks could be worth $550 million and $500 million, respectively), but the addition of the lung cancer test in cooperation with MD Anderson seemed to prompt some concerns that the company was diverting focus and diluting resources at a time when the Cologuard ramp needs to be the priority.

Exact Sciences has since ended the partnership with MD Anderson and decided to take a shot at the USPSTF in doing so. Exact basically claimed that the primary reason they ended the partnership was because the company couldn't accept the prospect of spending $50 million to $100 million on a study that could have enrolled as many as 15,000 people (versus the 12,700-person Deep-C study for Cologuard) only to have the task force turn up its nose and claim insufficient data as a reason not to endorse the test.

Waiting For Clarity Is A Tough Wait

I'm sympathetic to the frustration at Exact Sciences that would lead the CEO to calling out the USPSTF (sympathetic to and agreeing with are not the same things, however). The USPSTF's decision has since proven controversial, with multiple parties (including the American Cancer Society) openly urging them to reconsider. What's worse, it would seem that the USPSTF evaluated the test in a way contrary to how it's supposed to be used.

The USPSTF is not wrong that the test is inferior to colonoscopy, but then that was never the point. A colonoscopy is the gold standard in terms of accuracy, but it is more expensive and considerably more invasive - people may not like handling their own waste, but they generally like a scope in their rectum/colon even less, and the preparation for a colonoscopy isn't especially pleasant either. I won't rehash the pro-Cologuard arguments further than this; I've written a lot about that in the past (as have others on Seeking Alpha) and I suspect the sides are pretty much locked in among investors as to whether it's a worthwhile test or not.

As I said earlier, the ambiguity from the USPSTF doesn't help, but it clearly hasn't prevented Anthem from agreeing to cover the test in some areas. Moreover, the exceptional level of comments has led the USPSTF to delay publication of its final determination until late in 2016, and that may point to at least a prospect of a rare reversal.

Not securing the USPSTF's support is almost certain to slow the ramp of the test, make the pricing negotiations with private insurers more strained, and force a higher level of sales and marketing spending to maximize the yield on the available market - if the number of covered lives doesn't expand from here, Exact Sciences will have to significantly increase its penetration rate versus prior estimates to achieve the same usage (the company would need 22% penetration instead of 13% to meet my 2024 test volume number if they don't get further positive coverage decisions).

Pricing, too, is going to remain a battle. Various parties have pushed the CMS to lower its reimbursement for Cologuard, and the general trend in Medicare reimbursement overall is that it doesn't get better with time. While Exact is going to be pushed hard by companies like UnitedHealth to concede on pricing, that could open a dangerous Pandora's box for the company.

Recalculating The Value

My expectations for Exact Sciences were lower than the Street's to start with, so the impact of all of 2015's bad news to my valuation isn't quite as dramatic. The net effect on the revenue side is that I'm expecting a lower ASP going forward unless the USPSTF reverses itself and I'm shifting the penetration rates by a year (the former 2016's rate becomes the new 2017, etc.). I've also adjusted my spending assumptions to reflect the higher actual spending of 2015 and what I project the company may have to do to restore/maintain momentum.

I'm looking for about $89 million in 2016 (which is bang in line with the average expectation), a little over $490 million in 2020, and $1.25 billion in 2025. I'm looking for gross margins to go from the 40%'s to the 60%'s and ultimately the low 70%'s. I still believe that operating margins can exceed 30%, but it'll take a while to get there and positive cash flow may not arrive until 2019 or 2020 (versus my prior expectation of 2018). Longer term, I think Exact Sciences can achieve FCF margins in the 20%'s. While I'm including the R&D spending for tests for pancreatic cancer and Barrett's esophagus, I'm not including any revenue from these tests until there's compelling evidence of efficacy.

Discounted back, that works out to a fair value just under $14 at today's share count, but I think further fundraising could be required. That wouldn't be needed for at least a year though, and that offers the possibility that the share price recovers and/or the company sees a solid enough ramp to secure other types of funding (like debt) at better terms. Raising all of the capital gap I forecast at today's share price would drop the fair value to about $9.50. Raising it at half of today's price would still support a fair value of close to $7.50.

Clearly, I could be wrong about the adoption rate, pricing, and/or spending. Likewise, competition could knock down the Cologuard, as Illumina's (NASDAQ:ILMN) GRAIL could at least conceivably find the way to create a simple blood-based test, and companies like PacBio (NASDAQ:PACB)/Roche (OTCQX:RHHBY) could likewise offer their own alternatives, to say nothing of companies pursuing different oncology testing technologies.

The Bottom Line

Exact Sciences can't afford any near-term shortfalls with testing volume, as investor confidence is already badly shaken. I continue to believe that the Cologuard offers enough efficacy and value for the money to work, but it takes more than that to successfully commercialize a new diagnostic product and there is a real risk that Exact Sciences never manages to convince the gatekeepers that the Cologuard is meaningfully different and better than fecal immunochemical and fecal occult blood tests. Those risks seem more than reflected in the share price, though, so this is a name that aggressive investors may want to consider during this period of weakness and uncertainty.

Disclosure: I am/we are long RHHBY.

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.