Genetics is a booming field for the next decade. One of the most obvious applications is genetic testing. In this field, I value the network approach used by Invitae (NVTA). The company intends to create a platform that brings together patients, clinicians, and payers, in a continuous service that can be accessed and updated anytime during the patient’s life.

I’ve been shifting my attention to the genomic revolution. The reason is simple, and I’ve explained it in depth elsewhere. In a nutshell, the valuations are sky-high for most stay-at-home stocks, but the genomic space has been underfollowed and undercovered due to its complexity. Here, I intend to break down the main components of a genomic play and convey it in a digestible form. One previous example of that is my CRISPR analysis.

(Photo Credit: Eelke)

Basically, I see the structure of the industry as an ecosystem composed of three main parts. The first is testing tools like the ones provided by Illumina (ILMN). I’ve written about this company and how it has allowed a dramatic drop in sequencing costs. However, I’ve been reviewing my assessment, and I now think the Pacific Biosciences (PACB) might be well-positioned to be successful in the space. Be as it may, that will be a discussion for another time. The second is the test and diagnostic services. Companies that buy the testing tools and develop services around them. The third is companies that develop therapies around gene-related diseases. That’s a simple formulation, but one that I believe provides a good enough framing.

Industry tailwinds

The costs are falling for the companies in the industry. The cost of sequencing a human genome has been falling faster than Moore’s law.

(Source: genome.gov)

That’s huge because the costs were prohibitive for products and services based on genetic information to become massified. Now that companies are targeting the $100 per genome mark, we might watch the proliferation of services and products in that space. Additionally, these cost decreases should allow more companies to pursue genetic-related services and products outside of healthcare. Sectors like agriculture, aquaculture, health insurance, materials, chemicals, energy, and electronics are likely to take advantage of lower sequencing costs to create new avenues for R&D.

For Invitae, there will be two order effects. The first is the growing demand for tests and services in healthcare. The applications for genetic data are growing at a fast pace, and companies providing the data will have huge demand. The second is the growing demand coming from other unexpected sectors.

How to differentiate?

In this field, companies are offering flexible laboratory-developed tests, and direct-to-consumer solutions, like the ones provided by Sema4, Myriad Genetics, 23andMe, or Genomic Health. Invitae is trying to establish an integrated network to be accessed by physicians during an individual’s life. Like all the networks, its value increases with each new user. In this case, the network is complex because it is an ecosystem composed of patients, doctors, and insurance companies (payers). That makes it likely to be a case where the winner takes most and helps explain why the company is looking to scale fast.

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However, developing and maintaining a network is not easy or cheap. For instance, the cost of accumulating data is high. Unlike social media that harvests inexpensive user data, Invitae harvests expensive user data. Yes, they have access to a huge pool of datasets, but they also have to sequence it, and that’s expensive. However, new technology in the industry can change that. The emergence of Pacific Biosciences’ HiFi sequencing technology might open a new avenue to a sustainable cost-reduction period in the industry. Invitae has already started to explore this route.

Additionally, Invitae needs to dilute the costs of laboratory infrastructure over a larger number of tests. To do so, the company will need to have a big gene library, and they’ll need to perform advanced research on the gene data. That will widen the test menu, which will help to attract more customers, and, in turn, drive costs lower, reinforcing the cycle.

The interpretation of results is another aspect to consider to reduce costs. You might get your DNA sequenced, but you would still need to understand which gene does what. These are very complex processes that require a lot of work. Currently, AI offers immense help in that process since it allows for the processing of enormous loads of data. That, I believe, is the secret sauce. Having more samples means having more data. With a powerful AI processing capacity, the company can expand its knowledge base and increase its testing menu. To provide some color, Invitae started with 200 genes in its first commercial offering, and it grew to more than 200,000 genes.

Next comes Invitae’s most used corporate strategy: focused acquisitions. The company has been acquiring companies that have the tech to build the testing network or buying companies that will allow them to drive down the costs. One example is rare disease diagnostics. Diagnosing rare diseases is like searching for a needle in a haystack. However, AI can lower the time and cost to do it. Diploid’s acquisition earlier in 2020 is a step in that direction. The company has an AI software called Moon that combines AI algorithms, a gene-disorder model, and a continuously growing genetic database to provide a diagnosis in minutes.

Other acquisitions include Genelex and YouScript, both providing pharmacogenetic information at point-of-care. That will help healthcare organizations to evaluate how an individual will react to a certain drug prescription based on their genetic information. More impactfully, by acquiring Archer DX, Invitae integrates germline testing, tumor profiling, and liquid biopsy capabilities in its platform.

Summing up, the company is developing a network approach instead of a direct-to-consumer used by many competitors. The company has focused on driving costs lower by using the most cost-effective technology available. The adoption of PacBio’s HiFi technology seems like a step in that direction.

Driving the costs lower has allowed the company to be aggressive in pricing, and it has helped in growing the test volume. Finally, the various acquisitions have brought software, AI skills, and new testing capabilities to the platform, which will help to widen the offerings.

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How to improve the financials?

(Source: Invitae)

The company’s revenues have been growing at an impressive pace. Revenues expanded by 47% in 2019, and it reflects the aggressive approach to generate volume growth. The company is on an evident scaling-up period, and the gross margins are also accompanying the trend. The gross margin has improved from being negative in 2015 to a stable 45% in 2018 and 2019. However, scaling-up also means higher R&D and SG&A expenses.

(Source: Author’s computations based on SEC filings)

I see the scaling-up as an opportunity. Firstly, it is likely that the company will miss on earnings, and that might throw the stock down temporarily. Secondly, the company is scaling because it knows that there is a market for its product.

The improvement in the bottom line is dependent on two main fronts. First, reaching out to new markets, which will result in revenue growth and the dilution of SG&A expenses. Second, the improvement in the gross margin, i.e., becoming more efficient.

On the COGS front, the company’s double approach, i.e., exploring alternatives to Illumina’s technology and stimulating economies of scale, has allowed a decrease in the cost per sample from $264 in 2018 to $245 in 2019. The development (or acquisition) of AI capabilities will also help reduce labor costs, and medical interpretation of the results will bring further declines.

In my opinion, the biggest quest to improve the bottom line is on the payers’ side of the network. Physicians will hardly prescribe an expensive test to a patient if they can’t get a reimbursement. Reimbursement is dependent on several factors, and it is up to the payer to determine if a test is appropriate. Additionally, payers also define who they contract in case they need a test. Therefore, getting coverage and a contract from payers becomes essential to grow the business. Invitae currently has contracts with payers amassing a total of 295 million lives. That’s reflected in the 60% growth in billable tests in 2019.

Wrap-up

Some studies suggest that the global market for pediatric rare disease diagnostics will be worth more than $27 billion in 2024. That’s a very tangible market to target, and one where clinicians, third-party payers, and parents are very much aligned in the awareness that there must be a better way than years of trial-and-error before clinicians reach a final diagnostic.

That might very well be the breakthrough for Invitae, but there are lots of other avenues to take, other being non-invasive natal screening. Nevertheless, a tremendous increase in revenue will be necessary to make the company profitable. Two main factors might help the company in its pursuit. First, the next generation of sequencing technology, like PacBio’s HiFi, will likely help to sustain the drop in costs that the industry has been experiencing. Second, reduced costs will be a driver for new demand for genetic tests. More tests mean more data for Invitae to apply its AI and add more genetic content to its test menu. That will be another driver for demand.

I like to end the pieces on genetic companies with a word of caution. These are very risky enterprises, do not doubt it. In this case, I could write a piece only focused on the risks.

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First, there might be one or more competitors that might have better technology or market offering. Genomics is a very dynamic field, and with costs dropping, the barriers to new entrants also drop. That’s the recipe for innovation and competition. One thing that worries me is a new entrant completely disrupting the network model followed by Invitae. Nevertheless, the threat might also come from an established big pharmaceutical player, heavy on resources.

Second, the ability to gather support from third-party payers is crucial to keep the company growing and expanding its edge. Also, the ability to convince physicians to prescribe the tests and the competence to navigate the payers’ requirements to get the reimbursements.

Given the serial-acquirer profile that Invitae has developed, integrating all the acquisitions seamlessly becomes essential. If they fail to accomplish it, that will result in costly write-offs and investor scares, which might push the company out of the capital markets.

Finally, currently, the balance sheet is solid. However, the company might need cash to finance an acquisition (or to cover the cash burn), meaning that there is a good chance of a significant issuance of stock in the coming years.

That said, there are more than enough unmet needs in the marketplace for the company to build a $2 to $3 billion sustainable revenue stream during the next couple of years. If the current decrease in costs holds, the company will likely turn profitable. If that scenario materializes, the current market capitalization could easily double.

Disclosure: I am/we are long PACB, NVTA, CRSP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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