NEO - NeoGenomics: Asset Growth Yet To Scale Gross Profitability Reiterate Hold

2023-08-09 05:26:49 ET

Summary

• NeoGenomics reported an 18% YoY increase in Q2 revenues, driven by stronger test unit economics in pricing and volumes.
• The company's revised FY'23 guidance and positive sentiment in its stock are potentially bullish factors.
• However, concerns about valuation and profitability off asset growth make the investment debate balanced in my view.
• Net-net, reiterate hold.

Investment updates

NeoGenomics, Inc. (NEO) came in with a decent set of Q2 numbers before the bell on Tuesday, with upsides observed throughout the top-bottom lines. Specifically, revenues were up ~18% YoY, driven by stronger test unit economics in pricing and volumes.

I had rhapsodized the importance of NEO creating economic value for its shareholders beyond the financial statements and accounting figures in my last publication. Chiefly, the company has been scaling up its asset base over the last 12—18 months, however, hasn't circled back the same level of investment in gross productivity. This, along with valuation factors and market-generated data are negatives in my view. These are balanced by positive points in 1) management's revised FY'23 guidance, 2) the unit economics in its clinical services arm, and 3) sentiment currently in its stock.

Alas, the investment debate remains balanced, and there's not enough margin in safety in the stock trading at ~3-4x forward sales to get me over the line at this point. Net-net, reiterate hold.

Figure 1.

Critical investment facts confirming thesis

There are three factors driving NEO's equity value that are discussed below. Each feed into its investment prospects moving forward in my opinion.

(1). Higher value tests fueling top-line growth

NEO pulled in $147 mm in consolidated revenue, up 18% YoY. It pulled this to adj. EBITDA of negative $2mm on a loss of $0.05/share at the bottom line. Each of these numbers was ahead of the Street's estimates.

The breakdown on its unit economics is fairly easy to comprehend:

• Clinical Services contributed $123mm, a 17% YoY growth, whereas clinical test volumes were up 8% compared to last year. Critically, volume growth came from the existing customer base and also new customers as well. Should this trend continue, it may lengthen the tail of income from same-customer growth.
• Each clinical test brought in an 8% higher revenue, settling at $417 revenue per test, the 9th quarter of sequential growth.
• This implies c.294,964 tests were performed during the period, up from 273,114 this time last year (417x294,964=~$123mm).
• The advanced diagnostics business pocketed $24mm in revenue, marking a 22% YoY gain. One thing I was pleased to notice was the company's decision to walk away from some of its smaller, and more or less unprofitable contracts in advanced diagnostics. Whilst this may hinder short-term growth in this arm, the key will be the profitable revenues going forward—a feat more likely with these consolidations in my view.

What's constructive to see is the combination of pricing and demand (volumes) fueling NEO's clinical segment's growth. It suggests it can retain a degree of pricing power without losing its customer base. Further, it illustrates the company is booking revenues on higher income tests that are paying off throughout the P&L. I believe this is critical to maintain for the company to catch a bid for H2 this year. A push to $420 in revenue per test, combined with another 8% growth in test volumes, gets you to $535.18mm in annualized sales revenue for its clinical services arm this year. This is a fairly tidy number in my opinion and corroborates management's revised guidance outlined later.

Figure 2.

(2). Profitability flat as assets scale higher

Moving down the P&L, quarterly gross profit came to $59.9 mm, up 36.3% against Q2 FY'23. Underscoring the upside was higher revenue, though it looked like there was a bit of dampening from increased payroll costs—not to be unexpected in this current climate. The gross margin came to 40.8% for the quarter. I've included all amortization charges related to acquiring the Inivata technology assets at this level. If you strip these out, you get another 400bps of adj. gross to 44%. Opex was up ~700bps to $90mm, and therefore was fairly well contained in my view.

One factor that's not aligning with my core investment tenets is the profitability NEO is producing off its asset growth. The financials listed in this report so far are indeed noted, especially the growth in unit economics outlined earlier, and upsides to gross profit. However, when scaling the firm's gross profit by its asset growth, the same level of profitability isn't observed.

Figure 3 shows the gross capital productivity NEO's generated each quarter on a rolling TTM basis. The trailing gross profit is taken and divided by the total assets, less cash and equivalents, each quarter. Cash is excluded as it is a non-operating asset in this instance, even though it has optionality. The analysis shows what capital charge has been added in the last 12 months, relative to the profits produced.

As shown, NEO has pared back its gross asset value, mainly through reductions in inventory and to a certain degree a pullback in tangible assets required to run the business. The corresponding profit gains on this have added another $0.02 in gross for every $1 in assets and could push to $0.03 by FY'23 yearend in my assumptions. However, these aren't the most attractive numbers in my view either. Especially when carrying the projections out to FY'24. I've got NEO at ~16% gross capital productivity by then, on asset growth to ~$1.6-$1.7Bn. Hence, ~$256mm in gross profit would be holding up ~$1.6Bn in assets.

This isn't a sustainable breadth in my opinion; thus NEO needs to step up in this domain. I'd be looking to annual gross of ~$400mm to get attracted here, otherwise ~25% gross return on assets (less cash). Until then, this isn't conducive to a buy rating on my calculus.

Figure 3. Note: Projections from Q3 FY'23—Q4 FY'24 are shown in rolling TTM format.

(3). Revised outlook great for sentiment

Management raised FY'23 guidance to $575mm, now calling for 13% at the top line, as shown in Figure 4. Note, only the upper bound of numbers are shown, alongside FY'22 actuals. It projects a $100mm loss on this, with an adj. pre-tax loss of $10mm.

Figure 4.

In my opinion this is great for sentiment in NEO's equity stock. We see sentiment positive for the company in two ways already.

One, is there's been 13 upward revisions to revenue and 12 to earnings from Wall Street analysts over the last 3 months. The trend is now biased to the upside, and consensus projects 10% growth this year, stretching another 10% into FY'25. That analysts are turning more constructive is potentially bullish, given that we have a representation of an entire subset of the market with these viewpoints.

Figure 5.

Two, options-generated data shows that investors are bullishly positioned via calls with demand stretching heavily out to strike depths of $20-$25 per share. This shows tangible capital at risk is projecting NEO to rally to this mark by the end of the month, where they can roll into new positions of the same strike if not there yet. There's no put matching on the other side of the ladder, with puts showing investors hedged to $15 at the time of writing.

Both of these factors indicate investor positioning may be bullish in NEO's equity stock.

(4). Technicals balance the case

The sentiment isn't shown in the price, however. On a trend basis, the stock has been pushing sideways into congestion. It broke below cloud support earlier this year, and, despite a test throughout July, the lagging line pieced to the downside in fairly quick succession. This tells me the trend is at least neutral at this point. We'd need a break above $17.20 to start thinking bullish territory again based on this chart.

Figure 6.

The weekly trend shows the stock trading into the cloud, further support of a neutral stance on these price studies.

Figure 7.

Finally, I've got wide breadth in price targets spun off by my point and figure studies below. These show objective price directives based on mathematical formulae and by removing the noise of time. That we have breadth from $15-$20 in these directives suggests a potential range between them, i.e., more congestion sideways.

Figure 8.

Valuation and conclusion

NEO is being sold at 4x forward sales and comes to us at ~2x book value. These are in-line with the sector, and there's no suggestion of a massive re-rating to either in my view. For one, the current price to the revised FY'23 sales outlook gets you to 3.4x forward as I write. This isn't necessarily a statistical move. At 4x the revised sales number, I get to $2.3Bn in market value, otherwise $18/share. This is a 17% margin of safety, and not enough to provide the kind of downside cover I'd expect if playing NEO in this fashion or positioning for the long-term. This supports a hold view.

These findings are supported objectively by the quant system, which has tracked NEO over the last 12 months and downgraded its rating on the company in April this year, as seen below.

Figure 9.

Alas, despite reasonable growth percentages throughout its top-line and gross margins, these aren't as attractive when considering the amount NEO's scaled up its assets in recent times. Based on my assumptions into FY'24, I believe these trends could very well continue, and therefore future growth in the company's operating assets may not yield the economic benefits I'd be after in buying NEO today. Net-net, reiterate hold.

For further details see: