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Investment Thesis
Since downgrading CareDx (NASDAQ:CDNA) to Hold from Buy last month, shares have declined more than 20%. Our previous article cited lower revenue visibility after the molecular testing company posted a core revenue decline during the third quarter that ended in September 2022. However, given the strong financial position, unique multi-modality organ transplant rejection testing platform, and modest operating losses allowing CDNA to pivot to profitability quickly, I don’t see a more downside trajectory. Last week the company announced a $50 million Share Repurchase program, which, in addition to low valuation (EV/Sales around 2x, compared to the industry average of 4x) and short-term management profitability goals, this article upgrades CDNA’s rating from Hold to Buy.
Market Position, Recent Updates, and Strategy
In the past decade, molecular diagnostic companies have emerged as some of the most promising and exciting new healthcare companies, aiming to change how patients are diagnosed and treated. While these companies are in an exciting growth sector, many need help financing their growth and generating sufficient cash flow to fund their operations. The current market condition highlighted these challenges, forcing many companies to reassess their business strategies to establish clearer paths to profitability. None of the dozen molecular diagnostic companies I cover is profitable. The reason behind this is the nature of the industry, requiring significant spending on clinical validity studies to influence Key Opinion Leaders to change current standards of care. Physicians are creatures of habit, and one can imagine the effort needed to convince an oncologist to change how they treat a cancer patient.
One question that comes to mind is whether growth is sustainable after the behemoth spend sales and marketing is completed. The answer to this question will become apparent in the coming quarters as most molecular diagnostic testing companies wind down operating expense spending and prepare for the next phase of the industry’s life cycle.
While there is uncertainty about the success of this transition, a number of companies have higher chances than others of pivoting their businesses into profitability. CareDx is one the leaders in this category, with a strong balance sheet and manageable operating losses and cash burn, standing at a mere $16 million and $7 million in Q3. Most of the losses stem from its clinical validation trials as it continues its efforts to gain Medicare coverage for its Lung cfDNA test, and the dual modality AlloMap Kidney test, in addition to sales and marketing spent to increase adoption of its tests in the 250 transplant centers across the US.
Last quarter’s results were disappointing, with reimbursement falling below expectations, leading to a 2.5% revenue decline in CDNA’s core testing service segment. This decline was buried under non-core digital and patient record service offerings it inherited from the TTP, MedActionPlan, and TransChart acquisitions in the past few quarters.
Testing volumes increased 15% YoY to 46500 tests. However, as mentioned above, reimbursement headwinds led to a decline in core testing service, and this isn’t very reassuring for a growing company. The confusion was apparent during the Q3 earnings call, as analysts tried to wrap their heads around Average Unit Price “AUP” trying to understand the reason behind this decline. One can’t ignore new market entrants, namely Natera (NTRA), which introduced its Prospera Kidney test last year, at least in terms of the impact on volumes. One should also expect intensifying competition as NTRA continues investing in clinical validity initiatives to build up its CMS dossier for Prospera Heart (CDNA’s bread and butter) and Prospera Lung. Regarding competition, one should give credit to CDNA, which offers the only multi-modality testing service (cfDNA and gene expression tests.)
Concerning market position, CDNA is the leading post-care organ transplant company. However, its aspirations to become a digital health platform that could be utilized by patient communities outside the organ transplantation realm may be limited by technological advancements in the organ transplant business. For example, TransMedics (TMDX) has recently developed an FDA-approved organ transplant device that revolutionizes the sector. While it is set to improve organ transplant rates, benefiting CDNA, it is naturally closer to transplant hubs than CDNA.
Financial Position, Valuation and Rating Upgrade Rationale
Last week, CDNA announced a $50 million share repurchase program, signaling management’s confidence in its financial position, supported by $360 million in current assets, weighed against $70 million in current liabilities. The repurchase program is expected to reduce outstanding shares by 8%, based on the current share price of $12.3. This, combined with management’s near-term profitability goals (cash flow positive in the first half of 2023) and the 20% share price decline in the past few weeks, pushes us to revise our rating from Hold to Buy.
CDNA’s blue sky target price of $24 per share represents a 100% upside from the current share price but is conditional to a convergence of CDNA’s price multiples with the industry average. For example, if CDNA EV/Sales and Price/Sales rise to the health sector’s median levels, we could see CDNA shares double.
While Q3 results cast some uncertainty regarding future returns (as discussed in the previous article), the company is well-positioned to capture opportunities in a growing and increasingly fragmented marketplace. This, in addition to the share buyback program, near-term profitability goals, and the ticker’s abrupt correction, drives us to revise CDNA’s rating from Hold to Buy.
Summary
CDNA shareholders are still trying to wrap their heads around the company’s mediocre third-quarter performance, which saw core revenue decline by 2.5% YoY. Volumes increased 15% YoY but were negatively impacted by a lower reimbursement rate for the company’s existing product suite, and management cited an unfavorable payor mix. In my view, this would have explained a flat revenue but not a revenue decline. The low growth, at least in terms of volumes, was partially caused by CDNA losing market share due to increased competition. However, this article revises CDNA’s rating from Hold to Buy based on three factors: First, the newly implemented share repurchase program will reduce the company’s outstanding shares by 8% if prices remain stable. Second, the ticker’s 20% price decline leaves the company trading at 1.3x EV/Sales and 2x FWD Price/Sales ratio, well below industry averages. Third, the company has a strong balance sheet and is on track to meet its near-term profitability goals, which includes achieving free cash flow breakeven in H1-23.
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