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Investment Thesis
As the hustle and bustle of the COVID-testing nears completion, Fulgent Genetics (NASDAQ:FLGT) finds itself with a good problem, what to do with all the cash it accumulated during the pandemic. After hitting the jackpot during the pandemic, the happy-go-lucky molecular diagnostic company now finds itself in a favorable position as it shops during a suppressed market with low valuation multiples.
The company’s valuations are attractive, with EV/Sales below 1x, even when excluding COVID sales. Beyond macroeconomic trends, this suppressed valuation mirrors management’s past mistakes and fears over excessive risk-taking manifested in the Fulgent Pharma acquisition. As the panic selling dissipates and markets return to normal, FLGT could surprise the market with its M&A activity or impress shareholders with organic revenue stability (and perhaps some growth) as demand for its clinical tests begins to normalize, not to mention the potential of an aggressive share repurchase program. In the meantime, investors might want to consider taking advantage of this window of opportunity to grab some cheap shares before it gets too crowded in the market.
Q3 Results and Macro Revenue Trends
At this point, nearly half of FLGT sales are non-core, COVID-related revenue, putting downward pressure on the top-line figure as we move forward in the coming quarters. Management expects Q4 revenue of $60 million, down 76% YoY, mirroring the rapid decline in COVID test sales in recent quarters. If the company’s estimates are true, next quarter could be the last leg of the COVID testing bonanza, with COVID PCR and Next Generation Sequencing “NGS” sales of a mere $8 million versus $52 million core diagnostic sales.
Core service revenue more than doubled in Q3, driven by new acquisitions, namely CSI Laboratories in August of last year, Inform Diagnostics last April, and its investments in Helio and Spacial Genomics, which, from my understanding, entail purchase agreements to perform molecular testing services and finally, its acquisition of majority shares of its Chinese Joint Venture, FF Gene Biotech.
FLGT hasn’t been particularly good at generating inorganic growth, at least in terms of absolute revenue numbers to incorporate a low revenue base in an expansive market. The growth strategy centers around international expansion, product menu diversification, building its NGS-as-a-Service sales and enhancing reimbursement pathways, including for new products, such as its liquid biopsy liver cancer test, Helio Liver. Revenue depends on both the level of reimbursement from insurance companies and the number of new patients it attracts through direct-to-consumer marketing and partnerships with healthcare providers and, in many cases, other gene testing labs outsourcing some of their work to the company.
As the COVID test subdues, we will also see pressure on margins, given the discrepancy of unit economics between PCR and molecular diagnostic tests. Molecular tests have higher prices but lower gross profit ratios.
Balance Sheet
FLGT’s home run with COVID in the past two years boosted its cash reserves while preserving balance sheet flexibility for future opportunities. The coronavirus crisis has dramatically changed the company’s financial profile. Despite its recent acquisitions, FLGT ended Q3 with $880 million in cash, cash equivalents, and marketable securities. This is enough cash to power the company’s growth initiatives, which center around international expansion, expanding its product menu, and building its sequencing as a service business. Its critical role during the COVID pandemic has developed its relationships with key healthcare providers in the US. These relationships provided growth opportunities in the future as patient volumes increased.
Going forward, the company expects to increase CAPEX spending as it expands its sequencing and technology capabilities, adds new employees, and expands its sales force to capitalize on the growth opportunities in the diagnostics market. Moreover, its acquisition of Fulgent Pharma, a clinical-stage biotech, will pressure margins.
Valuation
FLGT is undervalued. In the past three months, the stock price has dropped by more than 50% compared to competitors trading at much higher valuations. The company’s marketable securities now stand at 880 million, leaving an Enterprise Value of 120 million, below its 2022 core business revenue estimates, which stand at 178 million. Companies in the healthcare sector have a 4x EV-to-sales ratio on average. Even Neo genomics, FLGT’s closest peers, trades at 3x EV/Sales, despite the challenges mentioned here. FLGT, on the other hand, trades at less than 1X EV/Core Sales. Based on this valuation, I believe that the market is miscalculating the company’s actual value, and the stock should be trading at a higher multiple.
Part of FLGT’s discount stems from the acquisition of Fulgent Pharma, which is expected to put pressure on R&D expenses. Management also has a history of shareholder value destruction. For example, the CEO sold Cogent for 1 billion, below its IPO price. These negative factors are weighing on the company’s stock valuation.
Summary
The acquisition of Fulgent Pharma will negatively impact FLGT’s profitability in the short run, and the declining COVID revenue will also put pressure on revenue and earnings. However, even when incorporating these dynamics, one can’t ignore that FLGT is currently undervalued, with an EV/Core Sales of less than 1x. As a result, I believe that the depressed stock price represents an attractive entry point for long-term investors.
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