SKHHY - Veracyte: The FDA Is Stepping In

Summary

• The FDA is working with congress to extend its regulatory arm over the gene testing market.
• Veracyte's products are marketed as LDTs and are not approved by the FDA.
• Regulatory risk weighs against Veracyte's relatively low cash burn and robust balance sheet, underpinning the hold rating, as discussed in more detail below.

Investment Thesis

The genetic clinical diagnosis market is experiencing rapid change as companies shift away from "growth at all cost" strategies in response to the rising cost of capital. Some examples of this doctrine shift include Invitae's ( NVTA ) decision to cut a third of its workforce in July, Veracyte's ( VCYT ) discontinuation of its Colon diagnosis segment, and Exact Sciences ( EXAS ) management's renewed commitment to what they term "Profitable Growth" during a Q2 earnings call last August.

We're emphasizing profitable growth going forward. We want to make sure that we built here sustainable and generating kind of consistent growth in cash flow . Jeff Elliott, EXAS CFO, Q2 Earnings Call

Regulatory disruptions are also on the horizon after a flurry of negative publicity around the accuracy and flawed use of gene testing renewed the FDA's commitment to regulate the Laboratory Developed Test "LDT" market. From experience, a soft landing (e.g., compliance grace period) is not guaranteed.

VCYT's new management finds itself in a challenging position, having to balance growth with profitability against a backdrop of increased competition, looming regulatory change, and more intense scrutiny from investors as the era of free money comes to an end.

Revenue Trends

The unique industry structure in which VCYT operates molds the company's day-to-day operations, strategy, and prospects. At the center of this structure is the patient, who, as a healthcare consumer, might have wondered why, since early detection of cancer dramatically increases survival rates, isn't every person routinely screened?

To answer this question, we find ourselves at the intersection of gene testing service and gene sequencing equipment provided by the likes of Illumina ( ILMN ), Thermo Fisher ( TMO ), Agilent Technologies ( A ), Bio-Rad Laboratories ( BIO ), Qiagen ( QGEN ) and Pacific Biosciences ( PACB ). Ten years ago, sequencing a human genome cost $30,000. Thus, commercial adoption for routine screening was unfeasible. Today, the same test cost less than $400, and prices continue to decline; last month, ILMN unveiled NovaSeq X, which the company says will bring the cost down to $200. Economic feasibility has been a critical driver for the industry's growth in the past few years, as shown in the graph below.

In the past few years, Medicare and many private insurance companies started covering routine screening, but for now, coverage is limited to higher-risk individuals, mainly adults aged 50 or higher. As NGS prices decrease, the insurance coverage will expand to a broader population base, potentially bringing new growth opportunities as screeners become more widely adopted. This premise constitutes a critical element in the bullish thesis, often touted by the industry's CEOs, and attracting growth-focused investment funds, such as Ark Invest and SoftBank ( OTCPK:SFTBY ), to the sector.

Given the focus on high-risk patients, Medicare plays a critical role in the industry. VCYT, for example, derives 30% of its revenue from the Center for Medicare and Medicaid Services "CMS," and that is even at the lower end of the industry range, and I believe it excludes Medicare Advantage enrollees participating in the public program through private insurance companies. For this reason, the commercialization process starts by establishing clinical validity studies complied in a dossier to the CMS for each test. The studies are not FDA-validated, exploiting a 1988 CLIA waiver (which is threatened by new regulatory changes -more about this in the next section.)

After a CPT is obtained, attention is shifted to Key Opinion Leaders "KOL" consisting of the US Medical Associations and Standard Setting bodies, a critical element to encourage healthcare providers to utilize the test.

The majority of these clinical evaluation studies are not FDA-approved, and in many cases, the clinical trials are conducted with questionable standards, leading to significant data irregularities, if not outright fraud (e.g., Theranos). This has been noted by multiple KOL organizations and researchers, questioning the efficiency and accuracy of VCYT testing products and data throughout the years, highlighting the risk that the FDA might not accept the company's clinical validation data at face value and require a formal approval process.

Because of the insufficient evidence and the limited follow-up, we do not recommend either in favor of or against the use of gene expression classifiers - AME, ACE, AACE 2016 Study

High surgical rate in Afirma GEC benign nodules reveals an FNP-ISG of 7.3% in our community endocrine surgical patient population; this value exceeds the 5.7% reported in the multicenter 2012 Afirma GEC validation study - AACE 2017 Study

Below is another quote pointing at the same issue from the American Thyroid Association, questioning VCYT's clinical trial data.

The use of the Afirma™ GEC at Mayo Clinic showed a lower than expected rate of benign results and a lower than expected rate of cancer at surgery in nodules that were noted to be suspicious on GEC [...] This study also raises questions as to the effectiveness of the GEC in preventing surgery for benign nodules, especially given the high cost of the test - American Thyroid Association 2018 Study

The National Comprehensive Cancer Network maintains Fine Needle Aspiration "FNB" cytopathology test as the standard of care for Thyroid cancer screening but states that Gene testing could be used as a confirmatory tool. Despite the endorsement from some KOLs (mostly due to inefficiencies in golden standards of care in the case of Afirma), medical societies are still asking for more data on VCYTs products, including Afirma, which has been on the market for nearly a decade. The company continues to invest in this endeavor, as mirrored in last week's Afirma study presentation to the ATA. If the FDA were to regulate the market today, these validity gaps would exacerbate the regulatory risk, in my view.

Competition

Two Supreme court rulings in 2012 and 2013 significantly reduced the technological moat of gene diagnostic labs. The quality of diagnostic gene tests depends mainly on correlations between biological markers and the disease in question. A gene testing company can use biobanks to look for correlations and run a patient's sample against this algorithm. Is this patentable? Not anymore, thanks to the rulings above. This significantly lowers barriers to entry, making gene testing a commodity.

Some industry leaders tout the value of their biobanks that allow them to study such correlations. However, building a biobank is relatively easy. A few months ago, Eli Lilly ( LLY ) started multiple programs in collaboration with NeoGenomics ( NEO ) to provide free gene profiling of cancer patients. My guess is it is building its biobank.

These intense competitive dynamics are mirrored in Afirma's many competitors, such as ThyGeNEXT® and ThyraMIR®, developed by Interpace Biosciences ( OTCQX:IDXG ) and ThyroSeq, a division of Australian Sonic Healthcare ( OTCPK:SKHCF ), which sells its products in the US, Invitae , and Ambry Genetics, among many others.

Balance Sheet and Regulatory Disruptions

On a positive note, Veracyte is not as deep in the red in terms of cash burn compared to its peers, making it easier to leverage operations to profitability. Its products are profitable at a gross margin level. Currently standing at 150 employees, the sales team forms a significant part of operating expenses, giving the company some leeway if and when it chooses to leverage operations into profitability.

However, if the FDA decides to regulate the market, the impact on VCYT could be catastrophic. The FDA doesn't require a PMA or 510-k from gene testing companies. However, it retains the right to do so (as VCYT states in its annual report), but most gene tests on the market today enjoy CLIA-waiver, including VCYT's products. In a rare incident in 2008, the FDA abruptly asked Exact Sciences ( EXAS ) to halt all sales operations until it gained regulatory clearance. It took EXAS six years to finish its clinical studies and acquire authorization, costing the company a significant amount of cash, funded mainly through dilutive equity offerings. Thus, a soft landing when and if the FDA extends oversight over the market is not guaranteed, contrary to the views of VCYT's former CEO (who departed last year). VCYT ended Q2 with $180 million in cash, cash equivalents, and receivables, weighed against a $2 million cash burn during the TTM.

Summary

VCYT's products are not FDA-approved. More importantly, some researchers questioned the accuracy of the company's lead products. This impacts commercialization efforts, but more importantly, it exposes the company to regulatory risk as the FDA prepares to extend its oversight over the gene testing industry.

On a macroeconomic level, rising capital costs push many gene testing companies to revise their growth strategy. I see VCYT in a favorable position to pivot into profitability, given its stronger balance sheet and better cost structure relative to its competitors. On a TTM basis, the company is trading near operating cash flow breakeven. Nonetheless, as mentioned above, regulatory risk could significantly change these dynamics, as the company is likely to channel more cash to obtain PMAs and 510-ks for its tests, especially in light of the negative reviews of some studies.

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