Invite Stock: Split Business Model Offers Tactical Opportunity

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Investment thesis

Illumina’s (NASDAQ:ILMN) technological advances in gene sequencing have helped grow the genetic testing market by improving testing accuracy while dramatically reducing the cost of disseminating genome analysis data. However, it was the efforts of Invitee (NYSE: NVTA) which eventually led to the revolution of the sector. By lowering prices from competitors and establishing reimbursement pathways with payers, NVTA has democratized the market and paved the way for wider access to precision diagnostics and preventative screening.

Price as a mechanism to increase market size and meet unmet demand is certainly a tool. – Sean George, Q4 2017 Earnings Conference Call

Despite its lackluster finances, the company’s paladin role has given it an air of legitimacy within the investment community. Many saw him as an industry pioneer leveraging his volume-based strategy and big data to grasp the link between genes and health.

As we reduce costs, we expect to see an increase in content. As we add more content, we expect to see an increase in volume. And as volume increases, we’re starting to see an impact on discussions and payor revenue. We believe these four dominoes will become an engine of growth as we grow our business and drive us towards future profitability. Call on third quarter 2015 results

In my opinion, investors (and management) seem to have abandoned the company’s strategy after spending many years chasing profitability, which for a long time seemed to be around the corner. Gross margins have not increased with volumes, and despite its investment in clinical trials to establish germline mutation screening pathways, the lack of a competitive moat has hampered its ability to achieve an adequate return on investment. For example, the company studied germline mutations in prostate cancer using data from his biobank, but I think that’s fair encouraged its competitors to do the same. The Supreme Court of the United States decision against Myriad (MYGN) limiting the patentability of DNA mutations allowed NTVA to enter the market but also reduced the ability to obtain a return on investment on its clinical trials, such as the one mentioned above. In other words, I believe that the assumption that genetic testing is a commodity, which underlies the company’s business model, also underlies its lack of profitability. This sentiment was captured by the co-founder of NTVA:

Our view is that prices will come down in this space as they do in any generic industry where there is competition – Randy Scott Q1 2016 Earnings Call

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NVTA Gross Profit Margin (Quarterly) given by Y-Charts

We cannot rely on the reshuffling of the leaders in progress in the company. Key leadership positions have already been assigned to insiders, namely the roles of CEO and Chairman, and I believe they are unlikely to disrupt the status quo, at least as much as an outsider would do. In the press release announcing the leadership transition, the company describes the new CEO (former COO) as “a growth-oriented business leader”, which I believe could lead to the same non-profit growth that led to the erosion of shareholder wealth in the first place.

As for what will happen to NVTA shares, I believe the company will reduce cash burn and beat EPS guidance in Q3 after fire a third of its workforce. Thus, there could be a tactical opportunity to capitalize on some volatility. But in the long term, I think his position in the market has yet to be tested after spending half of the last decade building a position in the market with artificially low prices.

Margins

Early on, management laid out its plan of attack, which was to relentlessly focus on driving down the price of genetic testing to create volume-based profitability. To achieve this goal, the company cut unnecessary expenses wherever possible and invested in costly IT initiatives to streamline operations and increase productivity.

The reason we then focus on volume outside of its obvious measure of business success is that our business model is built on an assumption of scale. Randy Scott, Q1 2016

Every one of our sales reps would tell you that when they go into a sale, their mission is to provide more affordable, high-quality genetic testing to patients and doctors. Randy Scott, Q4 2015 Earnings Conference Call

However, this cost-cutting approach came at the expense of profitability. The turnaround to plan crowned a long list of broken promises and missed profitability deadlines, including that of 2016″inflection point,”2018″positive cash flow, and the goal of “50% gross margin” over the years.

I think management is part of the problem comparing NVTA’s business model to Amazon’s (AMZN) and asking investors for patience based on this premise.

So, as we’ve said many times, it’s an Amazon-like business model for genetics. And I think we’re seeing a lot of positive signs internally, we call it beating the rock. Randy Scott, Q4 2015 Earnings Conference Call

While it would be remiss not to show patience for an AMZN-like opportunity, I think certain factors cloud the comparison. First, the genetic testing industry is not as scalable as online retail for regulatory reasons. For example, the Clinical Laboratory Improvement Act “CLIA” framework requires NTVA will provide a technician to interpret complex test data for patients, which will increase variable costs and decrease scalability. Moreover, the healthcare sector is fragmented and inefficient, which prevents one company from dominating the market.

Evaluation

NVTA’s main rival, Myriad (MYGN), has been more conservative in pricing its products, earning more per test sold, as shown in the chart below. This certainly cost it market share, but left it in a stronger financial position, as evidenced by its superior balance sheet indicators.

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Gross Profit Margin MYGN given by Y-Charts

In pursuit of its volume-based business model, NTVA amassed $1.6 billion in debt, acquiring Ciitizen, Genosity, One Codex and ArcherDX, to name a few. MYGN, on the other hand, has no long-term debt and, in my opinion, has been more careful in its acquisitions.

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MYGN Total long-term debt (quarterly) given by Y-Charts

When the debt differentials between the two clinical diagnostic companies are taken into account, MYGN appears to be undervalued relative to NVTA. One way to incorporate debt into the valuation comparison is to use EV/Sales multiples. Looking at the two rival companies, we see that NVTA is trading at 3.4x, while MYGN is trading at 2.4x EV/Sales.

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NVTA EV to revenue (forward) given by Y-Charts

How can I be wrong

Our holding rating on NVTA reflects our view that the ticker will underperform its peers in the coming quarters due to increased competition in the genetic testing market, sudden go out of IVF activity and continued pressure to reduce cash burn. However, it is worth noting the ticker’s increasing volatility over the past few months, reflecting the company’s high risk/reward opportunity. These dynamics threaten our assumption of control.

Additionally, even though NVTA has underperformed its peers, it is possible that it will outperform the broader index. The genetic testing market is expanding, providing a dovish trend that casts uncertainty on our holding rating. For example, society stands to benefit from the rapid introduction of gene therapies fueled by recent technological advances in molecular biology. For example, Spark Therapeutics sponsors a Partnership with NTVA offering the free genetic testing needed to determine eligibility for its ACL drug, Luxturna.

Summary

In summary, although NTVA stock is trading at a discount to its peers on some metrics, taking into account leverage and lack of profitability, the company appears to be trading at a premium valuation. Management appears to have lost sight of its top priority, boosting sales by lowering prices while trying to make up for the lack of profitable sales growth with costly acquisitions of smaller rivals.

As part of his to plan at round things around, management To cut almost a third of the Workforce. I believe that should be good for the PESand cash flows in the third trimester, giving investors a chance at take advantage of recent volatility in the short term.

In my opinion, investors seeking a defensive position in the healthcare sector or exposure to the genomics industry would be better off trading with market leaders with established market dominance, such as Laboratory Corporation of America (NYSE :HL) and Quest Diagnostics (NYSE:DGX) or NVTA providers such as ILMN, Qiagen (NYSE:QGEN) and Roche (OTCMKTS:RHBY.)

About Chris McCarter

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