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Investment Thesis
Natera (NASDAQ:NTRA) is raising $400 million today (November 18, 2022) in a new equity offering. It already found buyers for its new 11.43 million shares priced at $35 per share, but one must note that it likely was a grinding process to find investors willing to pitch in. The company listed the help of eight investment banks for the effort, a large number considering the relatively small sum. The decision to raise capital throws a curve at current shareholders and underpins this article’s rating downgrade from buy to hold. At suppressed market levels, the dilutive effect of this equity raise is amplified. Below is an analysis of the company’s third-quarter results, an overview of its balance sheet, market position, and the reasoning behind the rating downgrade.
Competitive Moat
NTRA has a broad menu of gene tests spanning oncology, organ transplant, prenatal screening, and hereditary risk. Most of these services are built on a simple concept, the correlation between specific biological biomarkers, say, for example, a certain genomic sequence, and cancer risk.
You might remember from high school math that each multivariable regression equation contains one error variable. This also applies to what molecular diagnostic companies do. Tests are not 100% accurate, built on statistical correlation models derived from bio-data banks of genomic samples. At the center of these models are the laws of averages, and a patient’s condition is compared to a population medium, contradicting the essence of precision medicine; our bodies are different, requiring individualized treatment courses. At this stage, precision medicine is not entirely precise.
Another issue in any statistical model, including those used by gene testing companies, is that correlation doesn’t mean causation. Earlier this year, the WSJ journal published a story about Katy Mathes, who, together with her mother, sister, and four other relatives, decided to remove their ovaries after a gene test from Myriad (MYGN) indicated they were at a high risk of developing cancer, only for the company to later send a letter saying that the gene mutation underpinning the algorithm used in their diagnosis was later determined to be of “unknown significance” on ovarian cancer risk.
With this introduction, one needs to weigh their confidence in the company’s business model with a view of what precision medicine offers, with its narrow competitive moat taken into account. The lack of FDA oversight over the Laboratory Developed Test “LDT” market is particularly troubling here, as the analytical methodologies employed by these companies aren’t subject to the same rigorous review as more traditional diagnostic tests. We also see increased litigation proceedings as gene testing companies dismiss each other’s test results. In this press release, NTRA dismisses the accuracy of Guardant Health’s (GH) clinical study results. Similar disagreements are also noted between Key Opinion Leaders “KOL” and gene testing companies. For example, researchers at City of Hope (a member of NCCN) questioned the accuracy of Signatera, NTRA’s MRD platform. At times, some academics questioned the value of the cfDNA platform altogether.
There also comes the issue of a lack of meaningful patent protection. I believe gene diagnostic tests are a commodity, as explained in previous articles. Being the first in the market doesn’t create or translate to a competitive moat, at least as far as the technological edge is concerned. Natera was the fourth to enter the None-Invasive Prenatal Screening market, yet, it is now the leader in terms of volumes, thanks to an aggressive marketing and sales strategy than anything else, in my view. CareDx (CDNA) was the first to enter the transplant market. Yet, this didn’t prevent NTRA from expanding into that market last year, and CDNA’s assertions that NTRA infringed its patents were thrown by a judge, stating that these patents were not inventive. It is not surprising that NTRA sources some of its tests from Baylor Miraca Genetics Laboratory, which will conduct any test with a CPT code.
Given these limitations, one needs to judge a molecular diagnostic company on its ability to leverage operations into profitability rather than on whether it touts an innovative technology platform or growth figures. With this framework in mind, the following paragraphs assess NTRA’s Q3 result. But before that, a quick note on management is due.
Management
NTRA is notorious for its aggressive market approach. As a corporate citizen, it is not particularly a responsible one. Earlier this year, it was found guilty of false advertising and was ordered to pay $45 million to CDNA, nearly more than 10% of what it raised today. It also faces the same accusations from GH.
The CEO’s fiery spirit was mirrored in his decision to receive his salary in stocks, as shares plummeted in response to a short-seller report highlighting management’s aggressive billing approach. I’m not sure what the point was, given that management was selling shares almost every month since the decision, limiting the perceived benefits of the decision on aligning his interest with shareholders, but that’s beside the point.
I have to say that I wasn’t expecting the company to raise capital at this stage, given the state of the market, with the stock trading at multi-year lows, amplifying the dilutive effect. All other molecular diagnostic companies are on a budget, trying to pivot into profitability to avoid shareholder dilution for the sake of shareholders. However, if one asked me which, out of the 18 or so gene testing companies currently on my watch list, is most likely to make such a move, I would have said NTRA for the reasons stated above. From the earnings call, investors should expect a ramp-up in cash burn and operating losses, deviating NTRA from its peers currently implementing cash reduction plans to decrease reliance on suppressed equity markets.
Third-Quarter Results
NTRA reported strong results in Q3, with revenue growing 33%, fueled by an increase in volumes and a rise in average selling prices partially offset by a challenging reimbursement environment, mainly from commercial payors. These results mirror the company’s progress on the commercialization front, including its partnership with the National Cancer Institute “NCI,” in which NTRA will provide MRD testing for NCI’s 2000-strong clinical study. The company also became a UnitedHealth (UNH) Preferred Laboratory Network provider last July. On the regulatory front, the company scored a win from the CMS, extending Medicare coverage for its MRD test for bladder cancer in July 2022. The company also cited the CMS’s pricing decision for Signatera IO in November 2021, which stood at $7300 per test, as a factor for the company’s exemplary performance. On the R&D front, the company presented various clinical studies supporting the validity of its test menu and announced that it has recently filed a premarket approval for its NIPT test after it posted encouraging results from its 20000-strong SMART clinical study. In summary, Q3 has been a productive and active quarter, with the company aggressively pursuing and achieving growth.
One element overshadowed the company’s progress, pushing the stock to a four-month low, despite earnings and revenue beat and FY2022 higher guidance update. As mentioned in the previous articles, the molecular diagnostic test has undergone a paradigm shift from “growth at all costs” to “the quest for profitability.” The pressure from suppressed stock prices is forcing many biotechs to rationalize their investments and concentrate on pursuing profitability. NTRA made it clear that it is going in the opposite direction, warning investors of margin pressures as it ramps up sales for products with narrow reimbursement pathways (to establish a strong market position, according to management) and doubling down on clinical studies and commercial activities, guiding for a higher cash burn in 2023. A few days later, the company announced it was raising $400 million in new equity offerings.
One can’t rule out that management is preparing to settle with Ravgen. Ravgen accused about half a dozen gene testing companies of using its propriety tech in the NIPTs market. NTRA is one of these companies awaiting trial. Last month, Ravgen won a $273 million court order against Labcorp (LH). Last week, Quest (DGX) settled with Ravgen. Soon it will be NTRA’s turn, and given its leading position in the NIPTs market, it’s likely to be the biggest payer for Ravgen. Thus, I believe management might be raising capital, at least partly to protect its balance sheet once the verdict comes in – if, indeed, the judge rules in favor of Ravgen. As of September 2022, the liquid asset balance stood at $750 million, against the $400 million annual cash burn run rate, excluding the expected ramp-up in spending.
Summary
NTRA reported strong third-quarter results, posting double-digit revenue growth thanks to robust demand for its diagnostic tests, regulatory wins, and continued commercialization initiatives. Management revised the company’s full-year outlook upward, citing strong demand for its MRD molecular diagnostic test in the US.
Shares declined to a multi-year high despite the fact that EPS and revenue beat as uncertainty looms over the extent of cash burn and subsequent dilution. The company expects higher cash burn as it focuses on growth projects which drive multiple opportunities; however, the short-term uncertainty has the potential to cause investors to reassess the investment case, as I did, downgrading the rating from Buy to Hold.
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