Exact Sciences Q3 Earnings: Profitability Momentum Into 2023

Investment Thesis

Exact Sciences (NASDAQ:EXAS) is trading at $39 per share, up 20% since the company reported its third-quarter results last week after the Wisconsin-based gene testing lab beat EPS estimates by a wide margin, demonstrating operational flexibility that signals an ability to leverage its operations into profitability.

Historically, aggressive spending on commercialization and R&D plagued the nascent gene testing sector for the better half of the past decade, mirroring the industry’s unique structure, characterized by a narrow competitive moat, low switching costs, and barriers to entry, combined with the intense regulatory framework, and strict medical practice guidelines. Spending was necessary to:

1. Invest in clinical studies to convince Key Opinion Leaders “KOLs” to adjust medical practice guidelines.
2. Educate physicians about the gene tests’ utility.
3. Convince payers to reimburse market participants for the gene testing service.
4. Develop brand awareness among patients.

As capital costs rose this year, investors started to demand more precise paths to profitability. Against this background, EXAS’s third quarter results were a success, as correctly predicted in last month’s piece. This article reiterates our buy rating based on the company’s growing revenue, flexible operating structure, and solid regulatory foundation.

Revenue Trends and Q3 Results

In the past few years, EXAS made significant investments to expand its diagnostic menu into the burgeoning liquid biopsy space. After all, there are limits to the amount of diagnostic information one can extract from stool, especially when compared to blood. In 2019, EXAS acquired Genomic Health for $2.8 billion, the first step in expanding its footprint in the liquid biopsy space. It followed this acquisition with a second major deal, buying the assets of Thrive in October 2020 for $2.15 billion. To enhance its newly-acquired liquid biopsy R&D operations, the company licensed TARDIS in January 2021, a technology that enhances the detection of circulating tumor cells in cancer patients’ blood. One month later, in February 2021, the company bought Ashion Analytics to complement TARDIS. It also acquired smaller diagnostic labs throughout the years, including Viomics, Paradigm, Base Genomics, and most recently, Prevention Genetics and OmicEra.

Thus, EXAS is what we call an industry consolidator, and such businesses are understandably problematic given that, in some cases, inorganic expansion hides weakening core business, in this case, its colorectal cancer screening test, ColoGuard. However, EXAS’s acquired businesses this year were too small to distort the third quarter’s sales year-over-year comparison. For example, the average quarterly sales of newly acquired PreventionGenetics was $9 million (2021 estimates), compared to topline quarterly revenue of $360 million. Similarly, OmicEra’s sales forecast this year is $2 million, hardly impacting EXAS sales.

Having cleared inorganic revenue contributions out of the way, one can confidently assess EXAS Q3 results. During the quarter, Screening revenue (mainly consisting of ColoGuard sales) grew $80 million (29%), from $280 to $360 million in the three months that ended September 2022. The precision Oncology segment, mainly consisting of Oncotype sales, grew by $6 million (4%) from $145 to $151 million in Q3 2022. Excluding COVID testing headwinds which saw sales decline from $30 million to $10 million, the topline figure increased by 20%, from approximately $426 million to $512 million.

What is notable is that revenue growth came at a backdrop of operating expense declines, demonstrating the financial flexibility necessary to deliver on shareholder profitability expectations as the Fed continues raising capital costs. Operating loss declined $24 million (14%) from $162 to $138 million, despite rising revenue, breaking a historical upward trend as the company scaled up ancillary and supporting service, including customer service, sales, advertising, and in some instances, medical interpretation expenses.

Operating expenses in Q3 were flat when compared to Q2, despite continued strong growth across all of our key metrics […] We believe that our ability to control these expenses tightly while continuing our dramatic growth, illustrates the operating leverage. Rand Scott, Invitae Former CEO, Q3 2016 Earnings Call

There is still work to be done. In future periods, I expect accelerated operating cost reduction, at least as a percentage of revenue. The company has historically invested heavily in marketing and advertising, partnering with celebrities to encourage cancer screening. For example, the company partnered with Jamie Foxx through Stand Up For Cancer to educate people about the importance of colorectal cancer screening. The partnership included a $10 million grant to the Stand Up For Cancer organization. These expenses are easier to cut compared to other operating expense items.

How I might Be Wrong

There are limits to the amount of spending decrease the company can do. For example, given the recent regulatory wins in Japan, manifested in the Ministry of Health marketing clearance for Oncotype, increasing investment in the Asian nation would create meaningful value for shareholders. I don’t believe management would miss such an opportunity.

In recent months, the American Urological Association updated its prostate cancer treatment to incorporate genome analysis in treatment decisions, an event which most likely would require intensifying product awareness campaigns. In June 2022, PreventionGenetics received FDA approval for its companion diagnostic test, Oncotype, for IMCIVREE, a product marketed by Rhythm Pharmaceuticals. Starting next year, Medicare patients will receive free colonoscopies if initially diagnosed via gene diagnostic testing. All these events are reasons to expand marketing initiatives.

Risks to our cost-decline hypothesis also manifest in the fact that EXAS holds a significant amount of goodwill stemming from its aggressive buying in recent years. Goodwill constitutes about two-thirds of the company’s assets and is often reassessed in the fourth quarter, casting some shadow over the assessment carried out in this report. Nonetheless, any goodwill writedown impact is limited to non-cash income statement expense accounts.

Moreover, many of the company’s acquisitions are not particularly mature businesses. For example, TARDIS technology is not clinically verified, requiring significant investment to validate its clinical utility, according to the people behind the project.

Competition

EXAS flagship product, ColoGuard, is facing intense competition from peers developing liquid biopsy colorectal cancer screening tests. In February 2021, Guardant launched Guardant SHIELD and was planning to submit an FDA clearance before year-end, supported by a robust, 20,000-strong ECLIPSE clinical trial. Freenome is conducting the largest CRC liquid biopsy screening trial in US history, with 35,000 participants. The privately-held gene testing company recently raised $290 million from Roche (OTCQX:RHHBY), bringing the total funds raised above $1 billion. Nonetheless, I believe that the standard set by ColoGuard in terms of sensitivity and sensitivity is high, and these market entrants are competing on convenience, especially given the relatively low adherence ratio of stool-based screening tests. Thus, in the eyes of a physician, the first-line treatment course will likely prioritize ColoGuard but retain blood tests as a second-line diagnostic tool.

Summary

This might be a new era in the gene testing market as companies deliver on shareholders’ expectations for value creation – consistent growth accompanied by healthy margins. EXAS delivered exceptional quarterly last week, driven by robust growth and low operating expenses. Shares rose sharply since our last piece highlighting optimism over the company’s profitability plans. This positive performance will continue, underpinned by strong demand from institutional investors, increased awareness of gene tests’ diagnostic utility, and new product launches.

The most significant threat to this bullish thesis is increased operating expenses as EXAS continues fending off competition and preparing for regulatory clearance applications before year-end. Material and wage inflation are also factors to consider, along with physical shortages impacting prescription volumes.