Richard Drury
Investment Thesis
In the previous article, we looked at OncoCyte’ (NASDAQ:OCX) platform and compared its potential against structural risks, manifested in a weak balance sheet, intensifying competition, and low earnings visibility, and concluded that risks outweigh rewards, assigning its ticker a Sell rating. Since that piece was published last month, OCX shares have declined by more than 50%. This article will revisit the molecular testing microcap, discuss how the company’s operating strategy may alleviate some of these concerns, and outline the steps it may take to attract investors and raise capital. Moreover, we discuss the third-quarter financial results and summarize key financial highlights.
Balance Sheet
OCX currently has $34 million in cash, cash equivalents, accounts receivables, and marketable securities, including a small number of shares in Lineage (LCTX) and AgeX (AGE). These liquid assets are weighed against the $11 million cash burn in the latest quarter, which partially incorporates management’s August cost reduction plan, entailing a 12% decrease in employee headcount. Nonetheless, OCX has always been frugal and less aggressive in its operations than its peers, limiting the scope of its cost-reduction efforts.
More importantly, it left OCX in an unfavorable market position. As mentioned in the previous articles, the nature and structure of the molecular diagnostic market require significant spending on awareness campaigns, clinical validity studies, and relationship-building with Key Opinion Leaders to add molecular testing to the standard of care practice guidelines, not to mention billing and collection teams to grapple with commercial insurance companies to reimburse genome diagnostic tests. Given these market dynamics, almost all of OCX’s peers are unprofitable. What marks out OCX is the lack of the necessary revenue base to pivot into profitability now that cost of capital increased and equity funding dried out. In other words, OCX doesn’t have that leverage available to its peers and is left racing against time to scale its sales. Interestingly, despite DetermaRx being on the market for more than two years with Medicare coverage and no “direct competitors,” OCX is still out of the network of commercial payors and absent from NCCN guidelines.
Management has already tapped several funding sources, which, albeit not exactly non-dilutive, temporarily reduce OCX’s reliance on equity financings in the short run until the company is back on its feet, and equity financing becomes more accommodative. These sources include two separate preferred equity and warrants transactions from long-term strategic investors, including $10 million convertible 6% cumulative dividend preferred stock in September 2022 from Broadwood Capital LP (its largest shareholder) and $32 million in warrants from a group of investors represented by BTIG LLC in April 2022. I am not sure how deep-pocketed these strategic investors are, but most likely, they are not thrilled to see their investment decline by more than 50% in less than one month. At some point, these investors will decide to cut their losses.
Based on OCX’s cash burn rate, the company has only a few quarters left of runway to support its operations and meet its financial obligations ($13 million in current liabilities as of September 2022). It may be forced to raise additional capital to support its ongoing operations through its ATM program, which I believe has a balance of $43 million left before it is forced to shut its doors for good. If the company exhausts its ATM program, the number of outstanding shares will increase by 85% to about 218 million, up from 118 million based on the current share price of $0.43. This $43 million would add about one year of the cash runway.
The only way out for management (beyond a general improvement in macroeconomic and market conditions) is to find commercial partners for all its portfolio (not just the kitted business), to share costs and profits. This will be hard, given that in these market conditions, everyone (except for Natera (NTRA)) is looking to cut costs after the Fed raised (and continues to raise) the cost of capital.
OCX portfolio and Q3 Results
Last week, OCX reported third-quarter results that failed to meet Wall Street expectations by a wide margin. Sales were $1 million, flat on a year-to-year basis, compared to an estimated $1.5 million, missing consensus by about 34%.
The company’s only clinical product is DetermaRx, an early-stage lung cancer molecular test that helps physicians determine whether chemotherapy is necessary after surgical Lobectomy (the standard of care practice for Stage 1 and 2A lung cancer patients). DetermaRx is the primary source of revenue, representing roughly two-thirds of sales in the nine months that ended September 2022 and 93% for Q3 revenue. DetermaRx sales nearly doubled last quarter, reaching $950,000. However, the increase comes from a low revenue base in an expansive market, estimated at $140 million. Moreover, the $4 million annual revenue run rate from DetermaRx doesn’t provide meaningful operating leverage for the company to generate sustainable profits any time soon. The company sells the product for about $3700 – $3500 (according to Missouri State and Test Catalog), in line with other multi-panel molecular diagnostic tests. Nonetheless, molecular diagnostics has high fixed costs, putting pressure on margins, which came negative this quarter. In future periods, the impact of intangible asset amortization related to recent acquisitions will kick in, adding significant non-cash expenses and putting more pressure on GAAP margins.
Most disappointing during the quarter was the decline in Pharma services revenue, consisting primarily of DetermaIO sales, which is currently marketed as a Research Only Use “ROU” product. In previous quarters, management expressed confidence that the segment will have less volatility, despite lumpiness derived from its dependence on clients’ clinical trials.
We expect an increasing predictable level of pharma services revenue ahead. – Mitch Levine, March 10, 2022
A Note On Rating Upgrade
As I reviewed the financial position of OCX in detail, I concluded that it exhibits many of the characteristics of a stressed balance sheet. This underpinned the junk status assigned in the previous article. However, at a $50 million market cap and no debt (aside from the hybrid $10 million preferred stock bearing a cumulative dividend of $600,000 annually), the company is debt free. Its liabilities are mostly contingent on milestones, which, by definition, enhances its valuation once met. Excluding these contingent liabilities, which sum to $60 million as of Sept 2022, total liabilities stand at $15 million, compared to a tangible asset base of $51 million (most of which is cash), leaving an adjusted tangible book value of $35 million versus a $50 million market cap.
Moreover, fundamentally, OCX’s products and platform are not inferior to its peers. The company simply doesn’t have enough capital to continue investing in product development and marketing to enhance its growth prospects. Its troubles are largely due to macroeconomic disruptions inherent in a high-interest rate regime suppressing its main source of funding; equity. I expect investors will show more confidence as risk appetite returns to the market. Given OCX’s current valuation, I see it as a potential investment target for growth-oriented investors, especially if and when market conditions improve.
Between its current distressed balance sheet, low valuation, and potential for stock market recovery, I believe that a Sell rating is no longer warranted. However, it should be noted that in no way does the rating upgrade mirror improving meaningful operational improvements beyond progress made to gain CMS coverage for its products, which already factor in its growth prospects discussed above.
Summary
Although OCX made some mistakes in the past, the company’s reliance on equity funding was, until recently, a common practice in the gene testing industry, a model shaped by the unique industry structure that necessitates spending on marketing campaigns to change the standard of care practice to incorporate gene testing. Even with this, while almost all gene testing companies are unprofitable, they offer a more attractive investment opportunity than OCX, given the lack of a solid revenue base to leverage operations into profitability.
The company is racing against time to ramp up revenue generation before cash runs out. In the third quarter, cash burn totaled $11.4 million, mostly related to selling and marketing expenses as the company continued its efforts to raise awareness and gain adoption for its molecular tests.
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