Veracyte Q3 Earnings: Good Execution; Sustainable Rally

Investment Thesis

In past articles, I talked about a paradigm shift in the gene testing industry from a “growth at all cost” to a “profitable growth” market approach pushed primarily by rising capital costs as the era of free money comes to an end. Gene diagnosis is a new field, and market participants adopted an aggressive commercialization strategy that incorporated significant spending on clinical validity studies and product awareness campaigns. This aimed at influencing Key Opinion Leaders “KOL” to change the standard of care practice guidelines and payors into expanding insurance coverage to their products to achieve rapid growth.

This historical pattern has been adopted broadly by market participants (as mirrored in anemic profitability figures across the board) but to varying degrees. For example, smaller market participants, such as Veracyte (NASDAQ:VCYT) and CareDx (CDNA), have lower cash burns compared to peers such as Natera (NTRA) and Invitae (NVTA), allowing them to more easily pivot to profitability in response to the new market dynamics.

I imagined this paradigm shift as a combination of increased profitability at the expense of slower revenue. While I noted VCYT’s low cash burn in the previous article, I wasn’t expecting the magnitude of its turnaround.

Veracyte is not as deep in the red in terms of cash burn compared to its peers, making it easier to leverage operations to profitability.

I see VCYT in a favorable position to pivot into profitability, given its stronger balance sheet and better cost structure relative to its competitors – The FDA is Stepping In, October 2022

Yesterday the company released results for the third quarter, showing significant revenue growth and cash flow improvements driven by solid demand for its diagnostic products. Here are a few highlights from the company’s earnings release.

• Revenue grew 25% year-over-year to $75 million
• Gross margin improved to 66% compared to 64% a year ago.
• Operating loss down 30% despite rising revenue
• Positive operating cash flow of $7 million, compared to a $1.4 million cash burn a year ago

These numbers are a model example of profitable growth, raising the bar for the entire sector. Other companies should take note of VCYT’s success, as the industry now focuses on improving margins and returns to generate sustainable profits for investors.

Spectacular Q3 results

VCYT reported solid quarterly numbers, with revenue reaching $75 million, up 25% from the previous quarter. Core diagnostic testing, which represents 85% of total sales, grew by 27%, driven by higher testing volumes, namely Afirma Thyroid and Decipher Prostate tests. VCYT displayed fantastic financial discipline, with operating loss down by a third, despite rising revenue. Operating cash flows were $7 million, compared to a $1.4 million cash burn in the same period of last year.

As mentioned in previous articles, higher capital costs made profitability the top priority for shareholders. This quarter, VCYT significantly reduced operating expenses as a percentage of revenue while continuing to grow the business at an impressive pace. This is a notable deviation from past trends where revenue growth outpaced profitability resulting in an unsustainable business model. Gene testing companies, such as VCYT, have traditionally spent significant amounts of capital on marketing, product awareness campaigns, and validity studies, all aiming at changing the standard of care practice guidelines to achieve growth. This quarter the company managed to do both, a positive surprise from the less-known gene testing company.

How did VCYT achieve such positive results? This is primarily due to the continued focus on operational efficiency, low-cost platforms to drive international growth, and increased collaboration between the company’s various business units to deliver better value to its customers. For example, the company continues to leverage its NanoString (NSTG) nCounter Analysis System (where VCYT has an exclusive global license outside the US) to leverage Europe’s renewed interest in gene diagnostic testing, an area where I believe the continent lags the US by a few years. For example, while UnitedHealth (UNH), the US largest health insurer, started covering prenatal screening for medium-risk pregnancies in 2020, it wasn’t until last month that the UK’s national health system adopted a similar program. In November 2021, Sweden expanded coverage for the Prosigna Breast cancer test, following the UK and Germany. This unique exposure to the international market is a significant tailwind in the coming years. Another driver of growth was the August 2021 acquisition of HalioDx, a provider of non-invasive imaging technologies for diagnostics and monitoring patients undergoing treatment for cancers, namely its flagship product Decipher Prostate. This added some inorganic growth, but management’s success in enhancing the performance of acquired assets has been equally important in driving results. For example, the European Society for Medical Oncology adopted Halio’s Immunoscore Colon Cancer Test in practice guidance for Pan-Asian-adapted versions of its clinical practice guidelines in November 2021, after the acquisition. Decipher Prostate is now the second most popular test in the company’s portfolio after Afirma prostate cancer. Overall, I believe international exposure now stands between 15% and 20%

One must recognize the buildup in literature around VCYT’s products in the past year, accelerating the adoption of its tests in the standard of care practice guidelines. For example, in September 2021, National Comprehensive Cancer Network (NCCN) incorporated Decipher Prostate in its guidelines. Envisia Genomic Classifier for IPF was highlighted in updated practice guidelines published in the American Journal of Respiratory and Critical Care Medicine (AJRCCM). These developments contributed to this quarter’s exemplary performance.

Regulatory Risk Re-assessment

In a previous article, we highlighted regulatory risks related to the FDA’s initiatives to regulate the LDT market. However, the evolving political landscape forces me to revise my assessment in view of the possibility that the 2014-2016 regulatory and political pattern for LDT oversight may repeat this year.

In 2014, the FDA provided guidance to regulate the LDT market, supported by the Obama administration in the same fashion it announced earlier this year. However, in 2015, republicans won Congress and emphasized less regulation and more business-friendly healthcare policies in their platform, as mirrored in the July 2015 21 Century Cares Act, aimed at speeding up the drug approval process. In 2016, the Trump administration shelved the proposal indefinitely.

Earlier last month, Congress decided to temporarily hold the VALID act that would have given the FDA new powers to regulate LDTs, perhaps until the mid-term election results come out. In light of the current political landscape, I see less political risk for the gene testing market, as republicans seem to be having a lead in the polls going into the election period.

Summary

Now that the era of free money is over, investors demand profitability instead of inflated revenues and low operating profits. Yesterday, VCYT exceeded investors’ expectations, coupling solid revenue growth with improved profitability. Revenue grew a solid 25% while operating losses declined 30%.

The company’s product menu succeeded in securing significant market shares, namely Afirma Thyroid and Decipher Prostate, without digging itself deep into the red in terms of cash flow, contrary to its competitors. I am encouraged by the economics of scale and the fact that this company is generating strong cash flow with room to grow, given the fast demand for genetic testing in Europe and the US. Given recent developments, this article updates the VCYT rating from hold to buy.