Sunday, November 27, 2016

A Christmas Stocking Stuffer for You & Your Children… EXAS!

Since Exact Sciences has recently rebounded off of a $14.11 low this past week which appears to have closed a gap in the chart from July, it seems like a good time to go deeper on some fundamental metrics for the makers of Cologuard that give us confidence in major price appreciation for investors over the coming years.

As posted last month, EXAS took a fairly big dive after reporting Q3 numbers.  Although management tightened up their revenue guidance for the full year from $90 - $100 million to $93 - $95 million, I do not feel that this was the catalyst for the decline, let alone a 15% plunge from the previous close of $19.60

In fact, management had guided to the mid-point of the revenue guidance range back in Q2.  Moreover, EXAS had beaten just about every metric during their Q3; including reporting gross margins of 57% and a better recognized selling price of $412 for the quarter, up from $392 in Q2.  For the quarter, EXAS also reported that another 9,000 physicians had signed up to order Cologuard, well ahead of the previous quarter’s pace of 6,000.   In Q3, 68,000 Cologuard tests were completed - - - and this may have been where disappointment came in, given that a “whisper” number of 72,000 had been making its way around the Street.  Management continued to reaffirm full year guidance of 240,000.  Thus, Q4 test guidance is 78,000.

It's apparent to us that the entire medical diagnostics sector has been under selling pressure since early October when Illumina (ILMN) missed Q3 and guided lower for Q4.  Moreover, the first stock sale in 2 years by three of the biggest insiders in EXAS management (CEO, COO, and CSO) also created further uncertainty for EXAS investors.  All told, the stock sales that occurred shortly after the Election added up to 1.4 million shares at prices between $17.36 and $17.68   While it is difficult to say whether or not the Alternative Minimum Tax (AMT) was a consideration when it came to selling stock from the exercise of option grants (that were not due to expire until 2019) - - - it is interesting to note that CEO Kevin Conroy still retains 82% of his total equity position after his reported transaction.

As I look to what has historically been a challenging Q4 for the company given the Holiday Season, it’s perhaps a good time to offer some perspective regarding just how large the addressable market is for Cologuard, and why I want to be a buyer of any weakness as I see significant price gains ahead for investors in this cutting edge diagnostics company.

First off, it’s important to note that EXAS and its management team has been able to achieve every regulatory milestone that it has been faced with ever since CEO Kevin Conroy came aboard to turn the company around in 2009.   

Creating an automated molecular lab, FDA approval, Medicare (CMS) National Coverage Determination (NCD) at a hefty reimbursement price of $509, to colon cancer guideline inclusion from the U.S. Preventative Services Task Force, and finally inclusion in HEDIS quality point system.  The current management team has done an awful lot of heavy lifting when it comes to getting Cologuard ready for commercial launch.  In doing so, the company has generated a tremendous amount of intellectual property (IP) which serves as a massive “moat” guarding its kingdom in the non-invasive colon cancer screening market. Given the fact that the U.S. Preventative Services Task Force (USPSTF) has only met once since 2007 to update colon cancer screening guidelines, it’s quite evident that EXAS has a fairly long runway before another non-invasive screening test could possibly compete with Cologuard.

From here on out, there are no more binary regulatory events related to Cologuard.  From here on out, EXAS is simply a straight sales execution growth story that is tapping into the massive under-screened baby boomer demographics of the U.S. population.

There have been numerous articles on EXAS written up over the years that have appeared on the likes of Motley Fool, Seeking Alpha, The Street.Com, and other blogs that have been extremely cautious on the Company, I do not share such tepid expectations.  In fact, if you look closely at the authors of these articles, they appear to be young guys who incorrectly and confusingly apply the financial metrics for a “value” stock with those of a “growth” stock like EXAS.  As a result, the analysis by these folks is flawed from the start.  No professional investor would ever confuse the kind of cash-flow metrics that one would apply to a mature value stock like Chevron, with that of EXAS.  But for some reason, a majority of these young small hedgefund guys who have written about EXAS do just that.  My analysis will steer clear of this flawed methodology and highlight the tremendous growth curve that I see lining up for this innovative medical diagnostics company.

The power of Baby Boomer demographics in the United States and lack of current screening compliance (and competition) should offer a very clear idea as to why I am so bullish on EXAS.  But first, let’s provide some basic background info on colon cancer in the U.S.

Colon cancer (CRC) is the #2 cancer killer for people over the age of 50.  It kills 50,000 people annually.  Approximately 5%, or 1 in 20, Americans will be diagnosed with CRC in their lifetime. 137,000 people a year are diagnosed with colon cancer. The median age at colon cancer diagnosis is 69 in men and 73 in women.  It costs Medicare (the health care plan for people 65 years and older in the U.S.) $15 Billion annually.

Colon cancer is not a death sentence if detected early.  It is a fairly slow moving cancer that does not metastasize until Stage IV.  If caught in Stage I, a patient has a 5 year relative survival rate of 92%.  But if not detected until Stage III-B, that 5 year survival rate slips to 69%.  Stage III-C is 53%.  And Stage IV is only 11%.

Although undergoing colonoscopy once every 10 years has been the “Gold Standard“ of care for decades, such an invasive test does carry surgical risk among other negative consequences, and is not an ideal general population screening test.  Studies have also indicated that a screening interval of 10 years may not be ideal.  At the end of the day, a colonoscopy is only as good as the gastro-intestinal physician who is performing it.  The average scope time is roughly 13 minutes. Should the bowel not be cleansed properly, identifying polyps (especially flat-serrated polyps in the proximal colon) can be difficult.  The cleansing process that is required the night before a colonoscopy is not looked forward to by patients.  Moreover, studies have shown that the sodium phosphate that is used in the cleansing process has been directly linked to causing liver damage.

The American Cancer Society and U.S. Preventative Services Task Force recommends colon cancer screening start at age 50.  Unfortunately, people have shied away from undergoing such an invasive procedure as colonoscopy.  As a result, it is not often complied with and is the single biggest reason why the U.S. loses 50,000 people a year to CRC.

Colon cancer has claimed the lives of Farrah Fawcett, Jack Lemmon, Milton Berle, Joel Siegel, Sam Simon (creator of The Simpsons), and former Oakland Raider “Hall of Fame” quarterback Kenny Stabler- - - just to name a few celebrities.  

In the past decade, the incidence rate for younger people has also been increasing.  Colon cancer is no longer merely thought of as a disease that only impacts older people.  For example, Katie Couric’s husband Jay Monahan died at age 42 from colon cancer. Monahan’s cancer went undetected until Stage IV.  Closer to the home of Exact Sciences in Madison, Wisconsin . . . Dylan Cappel a graduate of the University of Wisconsin and a graduate assistant coach for the men’s varsity rowing team, died at age 23 while training for a berth on the 2004 USA Olympic Rowing Team.  He wasn’t diagnosed with colon cancer until Stage IV.

At present, data shows that 40% of the U.S. screening population has not undergone any kind of screening whatsoever for CRC.  50% have undergone colonoscopy and 10% have undergone a Fecal Immunochemical Test (FIT) that must be taken annually.  Given that CRC is the #2 killer of Americans over the age of 50, one can clearly make the case that our current screening methodologies have failed.  Current tests are simply not user-friendly, and thus not easily complied with in order to be effective.

All of the above factors, provides a terrific landscape for a new “game-changing” high performance non-invasive test like Cologuard- - - a test that can be taken in the privacy of one’s home, once every 3 years, does not require any kind of bowel cleansing or suspension of medication, is far cheaper than colonoscopy (by 60%) - - - and commands sensitivity and specificity performance on par with colonoscopy.

So just how big is the market place for Cologuard in the United States?
For starters, the Medicare addressable market (those 65 and over) in the United States is 55.5 million.  This is 46% of the market.  And Medicare pays $509 for anyone in that age group to take Cologuard once every 3 years. 

When one considers that the Baby Boom generation celebrated their 65th birthday on January 1, 2011 - one realizes that on that day, today, and for every day for the next 19 years, 10,000 baby boomers will turn 65.  That means the Medicare addressable market place for Cologuard increases by 3.6 million every year till 2030.  By 2030, more than 20% of the U.S. population is projected to be age 65 and older, compared to just 13% in 2010 and 9.8% in 1970.

The other 54% of the CRC screening market (ages 50 – 64) comes to 64.5 million and is growing just as rapidly given the aforementioned Boomer demographics.  In fact, the biggest single age group in the U.S. is 53.  The 50 – 64 age group is steadily becoming covered via commercial insurance.Given the June guideline inclusion decision by the U.S. Preventative Services Task Force, 80% of this age group will be commercially insured by January of 2018 to use Cologuard.

Adding up the 50 – 64 age group with the Medicare population gets us to 120 million people in the addressable U.S. market.  Management at Exact Sciences has indicated that a 30% penetration of the market is highly realistic.  In fact, it is interesting to note that CEO Kevin Conroy has stated on several occasions that “half of Cologuard sales are coming from those who have previously undergone colonoscopy.”  As physicians and patients become more aware of Cologuard, it would appear that Cologuard certainly has a most realistic opportunity to become the new standard of care for colon cancer screening.

A 30% market penetration expectation would mean that 36 million people could potentially be using Cologuard once every 3 years.  That means 12 million tests annually. 

If we were to assume a blended average price of $550 (retail: $649 and Medicare: $509) annual sales for Cologuard would be $6.6 Billion.  A market-cap of $33 Billion is generated when using a very conservative price/sales multiple of 5x.  Assuming no additional capital raises are needed and the current outstanding common share count of 106 million shares, a price per share of $311 is generated. 

Should Cologuard only achieve 10% market penetration of the addressable screening population of 120 million people, a share price of roughly $104 is generated.

Just for fun, let’s not even include the 50 – 64 age group.  Instead, let’s just simply take the current Medicare (CMS) population of those that are 65 and older and make a projection.  We will also be ultra-conservative and assume that there is no growth whatsoever in that addressable age group.  No Baby Boomer demographics whatsoever.  The 65 and older Medicare population will remain fixed at 55.5 million.

A 30% penetration of 55.5 million would produce 16.6 million tests over a 3-year period, or roughly 5.5 million tests annually.  At $509 per test, we are talking about $2.8 Billion in sales.  Again, using a fairly conservative 5x price/sales multiple, we arrive at a market cap of $14 Billion and a price per share of $132.

As one can see, it’s difficult to generate any kind of price per share projection under triple digits, when using just a 10% penetration of the addressable market, let alone a 30% penetration of the Medicare population. Even a mere 10% penetration of the Medicare market generates a price per share of $33.

It is also interesting to note that Exact Sciences is aligned with the esteemed Mayo Clinic when it comes to R&D.  The Mayo team of Dr. David Ahlquist in Rochester, Minnesota has been working for the past six years on a pipeline of new ways to identify cancer via liquid biopsy (a blood based screening test).

As many are well aware, back in January of 2016 Illumina (ILMN) announced that they were undertaking a project called GRAIL - - - a project whose goal is to develop a pan-cancer screening test by directly measuring circulating nucleic acids in blood.  While this project has attracted $100 million in funding from various high-profile investors such as Jeff Bezos, Bill and Melinda Gates, and Sutter Hill Ventures, it is uncertain what regulatory path such a test would take, let alone how specific the tests are for identifying individual cancers from a blood sample.  There are big risks and uncertainties.

GRAIL will attempt to catch tiny and rare fragments of tumor DNA and use its gene-sequencing prowess to determine the tumor’s location.  It’s the equivalent of finding a certain needle in a haystack full of fakes.  Considering the stakes of a false positive or negative, accuracy is going to obviously be a huge concern.  As Max Nisen of Bloomberg notes, “Getting from finding DNA scraps to a definitive and accurate diagnosis is going to be a long, tough road.”  Given all of the above, GRAIL’s self-set goal to hit the market in 2019 seems extremely aggressive.

So what does this have to do with EXAS?

In an investor conference this past summer, Exact Science CEO Kevin Conroy was quoted as saying, “We believe that we have solved the issue of false-positives in liquid biopsy.”

When I first heard Conroy’s words . . . my ears nearly melted-down!  In fact, I actually replayed the webcast several times in order to make sure that I heard him correctly.  His statement was incredulous to me; and it appears to back up the idea that EXAS and their partnership with the Mayo Clinic is actually 6 years ahead of ILMN chasing the Holy GRAIL.

For example, CEO Conroy has mentioned that their team at the Mayo Clinic has been developing a liquid biopsy test for lung cancer.  The typical standard of care for a patient who is found to have had a nodule appear during a chest X-ray is to undergo a $3,000 surgery.  During this procedure, a small piece of lung tissue is plucked from one’s lung and sent out to a lab for biopsy.  This procedure unfortunately creates a ton of emotional stress for the patient; worrying about what the implications are for this nodule even though 95% of the time they are benign. On top of that, the threat of the lung collapsing from biopsy procedure is not minor, cited at 15% in the linked article.

Suffice to say, EXAS will be releasing data on lung and pancreatic cancer detection sometime during the first half of next year at a major medical conference.  Some speculate early June, when the annual American Society of Clinical Oncology (ASCO) conference kicks off in Chicago.

In any event, Kevin Conroy is on record as saying that their team at Mayo has been working on the top 10 cancers.  It will be interesting to learn more in the coming year about whether or not these tests will be strictly monitoring or diagnostic in nature, or whether there is a liquid biopsy type opportunity for a mass population screening test for lung cancer.

One thing is certain.  The intellectual property developed by EXAS lead research scientist, Graham Lidgard and his team has made all of this possible.  In 2014, I toured the EXAS lab in Madison, Wisconsin and it was impressive.  Their molecular platform which was developed to detect colon cancer via Cologuard, now appears to be the basis to detect and monitor other cancers as well.  This is no longer a one-trick pony.  Therefore the intellectual property that EXAS commands is quite valuable. So valuable that EXAS has been approached to license their molecular platform by other diagnostics company’s.  So impressive, that it just might have beaten Illumina to the Holy GRAIL!

All that being said - EXAS's pipeline is valued at ZERO right now, the stock literally did not move at all when Kevin stated the above quote on liquid biopsy false-positive issue, or even when he later reiterated it and expounded to indicate they thought over 90% sensitivity and specificity numbers were achievable.

For all of the reasons above, I am most bullish on EXAS over the next several years and will remain an active buyer on any kind of weakness.  It is without a doubt, my favorite growth stock on the board

 Disclosure: I am long EXAS!  Do Your Own Due Diligence!