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Natera: The Bear Case

|Includes: Natera (NTRA)

Natera (NASDAQ:NTRA) remains an attractive short opportunity despite price declines of 19% year to date and 52% since their July 2015 IPO. The short thesis is driven by deteriorating fundamentals which appear poised to worsen during 2016. Longer term, industry trends will become headwinds to the company strategy of competing with large clinical labs through an expensive direct field sales organization.

Natera's primary product is Panorama. This noninvasive prenatal screen represents 73% of their 2015 revenues. The remaining 27% comes from complimentary reproductive health products including carrier screens, miscarriage analysis, paternal testing and pre-implantation genetic testing. The majority of this article will focus on NIPT given its' relative share of current revenues and future growth prospects.

Annual Unit Cost and Test Volume

Natera does not separately disclose cost of revenues for their various products. The following table was generated from company disclosures in their S-1, 10Qs and 10k.

  2013 2014 2015
Cost of revenues (000) $37,275 $78,396 $112,845
Commercial accessions 85,000 215,000 310,000
Unit cost (1) $439 $365 $364
       
Tests recognized 58,000 138,000 138,000
% tests accessioned in CY 97% 93% 84%
CY tests recognized 56,360 128,340 115,920
% accessions in CY (2) 66% 60% 37%
       
Unrecognized accessions in CY 28,740 86,660 194,080
% tests 34% 40% 63%
       
Unrecognized test pool beg year NA 28,740 105,740
Addl recognized from PYs 1,740 9,660 22,080
% unrecognized pool (3) NA 34% 21%

The following annual trends are worth emphasizing:

  1. The volume ramp in 2014 led to unit cost savings of 17%. This trend did not continue in 2015. Natera indicated the unit cost of their microdeletion panel was the reason and a primary R&D focus for 2016.
  2. The percentage of commercial accessions that were recognized (reimbursed) has dropped dramatically over the past 3 years from 66% in 2013 to only 37% in 2015.
  3. The percentage of prior unrecognized accessions that were reimbursed in 2014 was 34%. This percentage dropped to 21% in 2015

International Markets

The US market has seen the most robust adoption of NIPT over the past few years. International markets are now following suit as indicated by tests reported by BGI, Berry Diagnostics and Roche among others. The following table of geographic revenues was generated from reports filed by the company with the SEC. This trend indicates Natera has lost significant market share internationally which represents roughly 75% of the total available market.

Revenues in millions Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15
Other Americas $1.0 $1.2 $1.3 $1.4 $1.3 $1.2 $1.1 $0.9
YY         34% 3% -13% -37%
Europe, Middle East, India, Africa $2.5 $3.2 $3.6 $3.8 $3.9 $4.1 $3.8 $3.7
YY         58% 28% 5% -5%
ROW $0.6 $1.1 $1.6 $1.5 $1.3 $1.3 $1.3 $1.5
YY         111% 17% -21% 2%
Total intl $4.1 $5.5 $6.5 $6.7 $6.6 $6.6 $6.2 $6.1
YY         61% 21% -5% -10%

Panorama Data

As can be seen in the following table, the number of commercially reimbursed tests has not grown despite company claims to the contrary. The primary revenue growth driver has been price increases related to the attach rate of the Panorama microdeletion panel.

Revenue in millions Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15
Revenue $19.6 $27.8 $33.8 $34.9 $34.8 $35.5 $34.1 $35.2
YY         78% 28% 1% 1%
Accessions 38,000 47,000 49,000 51,000 56,000 58,000 67,000 73,000
YY         47% 23% 37% 43%
Rev per accession $516 $591 $690 $684 $621 $612 $509 $482
YY         20% 3% -26% -30%
                 
Recognized tests 27,000 35,000 33,000 26,000 29,000 28,000 31,000 30,000
YY         7% -20% -6% 15%
Rev per recognized test $726 $794 $1,024 $1342 $1,200 $1,268 $1,100 $1,173
YY         65% 60% 7% -13%
                 
change in unrecognized tests 11,000 12,000 16,000 25,000 27,000 30,000 36,000 43,000

Source: All data found in or computed from SEC filings.

Supplemental Data

As indicated in the following table, there was a significant reduction in the amount of accrual based revenues in the most recent quarter. This combined with a trade receivables balance that is > 10x the billings for the entire fourth quarter could be a warning sign of uncollectibility.

  Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15
US direct rev 64% 76% 80% 75% 73% 77%
US lab partner rev (1) 22% 10% 6% 10% 13% 10%
Accrual revenue (2,3) 28% 19% 18% 20% 23% 1%
Cash basis revenue (2) 72% 81% 82% 80% 77% 99%
             
Medicaid provider states     31 33 36 37
Lab partner network     70 70 70 70

Note 1) Trend reflects the loss of US lab partners to competition in 2014.

Note 2) Calculated based upon 1) Natera 10k disclosure that 85% of 2015 revenues was cash basis, and 2) Q3 2015 10Q disclosure that 80% of year to date revenues were cash basis.

Note 3) Based upon Natera disclosures accrual recognized revenues in Q4 2015 were approximately $500k. This compares very unfavorably with trade receivables at December 31, 2015 of $6.8 million (before the 14% doubtful account reserve).

Reasons Fundamentals Are Poised To Deteriorate Further

The previous tables show some disconcerting trends. However there are several reasons why future deterioration is highly likely.

  1. Average Sales Price "ASP" is likely to decline materially in 2016.
  2. Insurance providers will increasingly direct testing to competition who have more established in-network coverage.
  3. Competitors with multiple NIPT options or with lower unit costs will drive average risk pricing well below profitable levels for Natera leading to some challenging choices.
  4. Natera's focus on US NIPT has put them at a disadvantage internationally where the lions share of the growth opportunity resides.
  5. Clinical labs in the US have achieved significant market share gains of late. This trend seems likely to continue which is a macro headwind for Natera.

2016 ASP decline The company has indicated at various times over the past several months that pricing will be adversely impacted by their transition to In Network. The extent of this impact has not been quantified, likely because it depends upon the pace of additional coverage agreements and price concessions required.

  • "The direct in-network transition began with the signing of Aetna and Cigna on December 31, 2015. in-network reimbursement will be lower and will adversely impact CY16. " Source: Natera Q4 2015 conference call.
  • "Guidance does reflect a substantial reduction in microdeletion reimbursement in 2016." Source: Natera Q4 2015 conference call.

Insurance Providers Are Decision Makers Despite claiming to have a coverage network of 160 million lives, Natera is at a significant disadvantage to US competitors. The vast majority of this coverage network is that of their lab partners which is relevant for only 10% of company revenues. Insurance providers increasingly will be the primary decision maker on test selection, sending market share to the test provider in-network with negotiated prices.

  • "We and our laboratory partners have in-network contracts with insurance providers that account for over 140 million covered lives in the United States." Source: Natera S-1
  • Temple University MFM: "It is all determined by the insurance company. The insurance company will contract and get the best rate and tell us if we use LabCorp, Quest or another lab" Source: MDxI 2014 Market Research Survey
  • Robert Wood Medical School Genetic Counselor: "If I had to put who decides the test in order, it is the insurance company, the provider and then the patient." Source: MDxI 2014 Market Research Survey

Lower Cost NIPT Options As price negotiations progress for average risk, competitors with lower cost structures such as Illumina (NASDAQ:ILMN) or LabCorp (NYSE:LH) have more pricing power. Sequenom (NASDAQ:SQNM), with three separate NIPTs, allows the opportunity to price each test relative to the risk profile and unit cost.

  • The LabCorp coverage network and positioning of InformaSeq between high and average risk NIPT will likely lead to volume increases and cost efficiencies that will challenge Natera.
  • A majority of the cost of NIPT is reagents which are supplied by Illumina. Illumina has disclosed an 80% margin on their consummable revenues.
  • The only announced coverage agreements for average risk have been made by Sequenom in California, Connecticut, New Hampshire and Maine. Source: Sequenom press release.

Resumed International Growth May Be Challenging Most major international markets have been very active over the past year establishing licensing relationships or distributor arrangements with other NIPT providers. The largest markets include:

  • China: BGI and Berry Genomics have the lions share of the current China market which is growing rapidly. Source: GenomeWeb interviews with BGI and Berry Genomics CEOs.
  • France: Biomnis, Laboratoire Cerba, Labco and Synlab have a significant share of the current French market through their licensed NIPTs.
  • Germany/Switzerland: Major NIPT competitors include Labco, Synlab, Roche, Sonic Labs and Life Codexx. Panorama is available through Unilabs and as a license by Gentica.
  • UK: The UK market is very fragmented and competitive with all major players involved. Numerous licensed products will likely take share as local processing occur

Clinical labs are important to gain market share Labs will use their large coverage networks, national lab footprint and efficiencies to leverage their licensed NIPT to gain share. Medicaid provider regulations work to their advantage as well.

  • We have expanded our U.S. direct sales force to increase our direct sales, but a significant element of our commercial strategy remains to establish and leverage relationships with our laboratory partners to sell Panorama and our other products both in the United States and internationally. Source: Natera S-1
  • Approximately 40% of all births in the United States are to state Medicaid program recipients. Under Medicaid regulations, in order for us to be reimbursed by a state's Medicaid program, we must be recognized as a Medicaid provider by the state in which the Medicaid recipient receiving the services resides. As of December 31, 2015, we are recognized by 37 states as a Medicaid provider. We may not be able to be recognized as a provider by many more Medicaid programs, because some states require that a provider maintain a laboratory in that state in order to be recognized. Source: Natera 2015 10k
  • We face the risk of our laboratory partners terminating their relationship with us and completely suspending the sale of our products. Both Quest Diagnostics Incorporated, or Quest, and Progenity, Inc., or Progenity, who were our two largest laboratory partners in 2013, terminated their agreements with us in 2014. Each began promoting the NIPT of a different one of our competitors, and Quest currently promotes its own NIPT. As Quest and Progenity have done, other laboratory partners may decide to exercise their termination rights under our contracts, or any laboratory partner that is not bound by obligations of exclusivity or non-competition to us or our products could decide to sell a competing product. Source: Natera 10k

Summary

Natera has been successful generating (largely unreimbursed) test volume by focusing on average risk in the US over the past two years. Their attach rate for microdeletions and carrier screening has generated sufficient revenue growth to generate investor interest. The next year appears to be a transition period for the company but the question investors must ask is: A transition to what?

If the end game is worth it, investors may be willing to wait through the transition absorbing the cash burn of $80 to $90 million, declining ASPs and eroding unit market share because the total market potential is so large. The bear argument though is more compelling. They will go through this transition to find that their reliance on a direct sales strategy to compete with the US clincial lab duopoly of LabCorp and Quest in the US and other dominant chains internationally is not viable long term. The bear case seems hard to refute.

Disclosure: I am/we are short NTRA.

Additional disclosure: Long ILMN, SQNM