Md Babul Hosen
Investment Thesis
NeoGenomics (NASDAQ:NEO) shares jumped more than 35% in the past two weeks, as the molecular diagnostic company showed signs of stability in Q3 following a tumultuous six months caused by a badly-executed succession plan ultimately failing to fill the gap left by the retirement of ex-CEO and company veteran, Doug VanOort. Under the current management, the company is now focused on optimizing its portfolio and reigniting growth in order to restore investor confidence.
We will set clear priorities of which opportunities to pursue and, importantly, not to pursue. Chris Smith, CEO, Q3 2022
With new management in place, I believe NEO could be an attractive investment going forward. Unlike many of its peers in the liquid biopsy space, NEO has a tried-and-test core clinical diagnostic segment with a positive cash flow to support its growth ventures. Our hold rating mirrors NEO’s strong position in the cytogenetics space, relationship with pathologists, a renewed focus on near-term profitability, and finally, low valuation, weighed against execution risk and potential impact of one-time restructuring costs in Q4. A rating upgrade is conditional to increased earnings visibility, cost-containment initiatives, and clearer strategic direction.
Third-Quarter Results
Despite operational headwinds exacerbated by a botched leadership transition plan, NEO sales demonstrated stability during the third quarter. The better-than-expected results ended three-quarters of sales declines, thanks to NEO’s Chair, Lynn Tetrault, and her emergency command team, who took over the CEO’s office responsibilities, guiding NEO through challenging times following the sudden departure of former CEO Mark Mallon. Q3 results are primarily attributed to “Operation Catalyst,” the “no-regrets” stabilization program implemented by the company chair and her emergency team, which aimed at ensuring smooth operations without committing to strategic changes before the new CEO took office. Investors attempting to size up the new CEO must wait until fourth-quarter results to draw solid conclusions about strategy and company direction, given that he was only appointed at the end of Q3, on August 15, 2022. I expect more leadership changes in the coming months. Nonetheless, this piece will discuss some of the hints thrown during the quarter by the newly-appointed CEO’s first earnings call.
Now that we have cleared this out of the way, we can commence commenting on Q3 results and provide some forecasts for the coming few quarters. The three main highlights of the quarter are 1) Core segment stability: Clinical Services sales increased by 3.8%, highlighting exemplar execution as the company continues to navigate challenging reimbursement headwinds and industry-wide shift to multi-panel assays enabled by Next Generation Sequencing advancements and cannibalizing existing smaller panel tests. 2) Pharma services segment grew by 18%, but I would be careful reading too much into this, as the top line was heavily impacted by project timing and pharma customers’ clinical trial progress. Nonetheless, it shows that damage from leadership disruptions hasn’t impacted its pipeline and relationship with pharma companies. 3) EPS beat estimates by a wide margin. This is a tricky one to assess. First, part of this is attributed to the “no-regrets,” non-committal Operation Catalyst, which avoided strategic initiatives that would otherwise increase R&D spending as NEO advances its Liquid Biopsy segment. However, one should also give credit to the fact that the clinical segment’s gross margins increased, despite volumes dropping, mirroring successful pricing strategy as NGS large panel assays volumes increase. Overall, I don’t believe that the EPS beat, which stood at 35% (-$0.14 actual vs. -$0.20 estimate), is repeatable.
What to Expect From the New CEO
NEO isn’t exactly a tech powerhouse, and I am not surprised that the CMS rejected its RADAR colorectal cancer “CRC” liquid biopsy test last month. Not only because CRC has one of the highest bars in the molecular diagnostic tests, mainly stemming from adequate alternative screening tests, including FIT tests and intense competition from industry peers, including recently introduced Guardant Shied by Guardant Health (GH) which received Medicare reimbursement last August, and Signatera, marketed by Natera (NTRA), but also because NEO has always been focused on generic testing products, with well-established clinical validity. It only recently started dabbling with R&D initiatives after it figured Liquid Biopsy is (or at least was) a hot commodity that could help attract higher valuation to its shares.
Seeking FDA approval for a laboratory test is new for us, and we’re working hard to understand and meet the requirements of the FDA. Q2 2018
In terms of the FDA-approved assay, our team is working very hard on this. We’re – this is a voluntary submission on our part. We’ve said all along that there are a number of reasons that we’re doing this. We want to make sure that we have FDA-compliant processes in a world in which companion diagnostics may be more important. We think that Pharma will appreciate the quality of processes that we have that are FDA-compliant. But this is a lot of hard work. This is a novel test that we’re submitting to the FDA. And frankly, we’re learning a lot through the process. I think in the last call, I said that fall or the fourth quarter would be a target for us. We’re still targeting the fourth quarter. But we’re learning a lot. And the FDA has been fabulous. We’ve been working closely with them. They’ve been very encouraging. But there’s a lot of learnings here, and that’s still our target, but we want to make sure that people understand that this is new territory for us. Q1 2019
Chris Smith has a background in the blood testing market, unlike the previous CEO. I expect him to double down on Inivata (acquired last year) Liquid Biopsy projects. Thus investors should see an increase in spending and a decrease in EPS. What is most worrying is what I believe the CEO’s skepticism over what was previously described as market opportunities and “work-in-progress” projects underpinning its goodwill and intangible assets. This was evident in his sarcastic comments made to NEO staff and communicated during the earnings call.
I joke with a team here you trip over opportunity here, and I think part of us is with prioritization. I think we try to be too many things too, too many people, and I think our ability to focus on the chosen few and execute is going to have a remarkable impact on the business. Chris Smith, CEO, Q3 Earnings Call
The CEO also alluded that we might see potential one-time charges, which, from my understanding, could be in the form of asset write-offs as the company optimizes its portfolio. I believe that the company is posed to deliver disappointing fourth-quarter results.
We expect to encourage certain one-time charges as we make investments to drive improvements in both growth and profitability longer term. Q3 2022
Summary
NEO delivered solid revenue during the third quarter, demonstrating signs of stability after a steak of negative sales growth. Nonetheless, one should note that the results during the quarter mirror the efforts of the previous interim CEO and Chair and her emergency leadership council, who took over the responsibilities of the CEO’s office after the abrupt departure of the former CEO.
It is still too early to assess the new CEO’s performance, and next quarter, we might be able to establish a more concrete assessment of NEO’s new direction. Nonetheless, I expect higher losses as the company optimizes its portfolio and advances its liquid biopsy molecular testing menu.
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