Short FLGT

Fulgent Genetics (NASDAQ: FLGT) is arguably the most compelling short idea I have found in 2022: unsustainable economics, an actionable catalyst already in place, and fraud as the fat cherry on top. We believe both of its operating segments are worthless as the setting normalizes over the next two years. Given the General Collateral borrow rate, only HSD Short Interest, and ADV of ~$17mm, this trade is actionable in size.

FLGT was formed in 2011 as Fulgent Therapeutics -> launched a genetic testing services business in 2013 -> discontinued the pharma business in 2016 -> IPO’d in 2016 at which point it had a Market Cap/EV of $157mm/$207mm and did $18mm in CY16 sales.

Its share price was flat through CY19, and then COVID became a reality in early 2020. FLGT launched a new segment in March 2020 to provide RT-PCR tests primarily within California using its existing lab facilities. LA County and San Bernardino are FLGT’s two largest clients, which makes sense as FLGT is based in suburban LA. FLGT provided 4.4mm and 10.0mm billable tests in 2020 and 2021 vs. the cumulative 0.1mm billable tests provided from inception through 2019. Revenue has thus gone from $32.5mm in 2019 -> $422mm in 2020 -> $1bn in 2021.

Quarterly data has shown that the sequential step up in COVID testing through 2021 has sharply rolled over. This is in line with the tone shift by governments as they have virtually accepted COVID to be inevitable. Rapid Antigen tests are far more effective in scaling testing throughout a county/state/country and will be used in lieu of RT-PCR tests, which are more costly and less scalable given the lab-oriented testing process. Honestly, we think COVID testing is becoming more of a formality, evidenced by various countries removing the COVID testing requirements to travel (local economies / small businesses need the support from tourism dollars).

More importantly, FLGT landed the most outrageous contract terms through 2021, where it charged $100 per RT-PCR test that costs $24 to produce (76% GM). Meanwhile, other providers currently charge between $10-30 per test with the same/superior cost structure. An official survey on LA County COVID-19 Testing Services from November 2021 is publicly available online. ShieldT3 charges between $15-$30, SummerBio charges between $10-25, UCLA charges $20 per RT-PCR test. This is ultimately a HSD% GM business where the product is a pure commodity with no difference in testing accuracy across providers.

How did FLGT land such unreal contract terms? For starters, we can look at LA County, which comprised 26% of Sales in 2021. A publicly disclosed government letter from November 2021 indicated that FLGT had won a no bid contract with LA County (meaning FLGT bypassed the standard process of bidding and thus got away with charging $100/test). Sound fishy? Furthermore, 2020 and 2021 represented peak COVID: there simply was not enough capacity across available labs to process all the demand for COVID tests. Players like FLGT took advantage of the demand inelasticity to gouge on profits while offering larger lab capacities.

FLGT breaks out its revenue between Insurance, Institutional and Patient ($556mm, $436mm, $1.1mm contribution to FY21 sales). $310mm of that Insurance revenue came from the HRSA COVID-19 Uninsured Program. In other words, the government was footing the bill for uninsured people to get COVID tests – this effectively enabled a price gouging bonanza at the expense of Uncle Sam.

However, the most recent 10Q filing disclosed that the HRSA program stopped accepting claims on March 22, 2022! It’s also worth noting that COVID Testing data from LA County indicates that over 50% of capacity (that capacity being just a fraction of capacity ordered in 2021) has gone unused in recent months! What happens when demand for COVID tests normalizes at a marginal fraction of 2021 volumes, the government no longer blindly foots the bill, and other players provide this commoditized test at close to marginal cost? What happens to FLGT’s bottom line when this gargantuan revenue stream compresses in GM% and shrinks in underlying unit volume?

FLGT’s legacy business did $102mm in LTM Sales through Q1FY22 vs. $954mm in aggregate – roughly just 10%. This segment is focused on providing DNA “Next Generation Sequencing” and “Sequencing as a Service”, as per their filings. This just means testing certain genes for inherited conditions / diseases namely via screening panels and deletion/duplication analysis.

This is where the second leg of fun begins. FLGT’s management has ties to China and FLGT officially has a joint venture with Fujian Fujun Gene Biotech Co., Ltd., or FF Gene Biotech. Their intent is to “bring FLGT’s NGS Capabilities to the Chinese genetic testing market.” In November 2021, the FBI publicly stated their concern over “Fulgent’s strong ties with BGI, WuXi, and Huawei Technology” – all of which are under the control of the Peoples’ Republic of China. The FBI also referenced a NY Times article from October 2021 that warned that “Chinese companies are collecting genetic data from around the world, part of an effort by the Chinese government and companies to develop the world’s largest bio-database.” FLGT basically has a footnote in all its products, where customers agree to share their test data with interested parties! At the same time, this legacy segment competes against industry giants such as Quest Diagnostics, Lab Corp of America, Abbott Labs, and Perkins Elmer, to name a few. In 2021, R&D increased by $12mm ($8.8mm in personnel/SBC, the rest in COVID supply expenses). How exactly does a subscale player with virtually no R&D budget expect to offer any incremental value proposition vs. these real companies with billion-dollar plus R&D budgets? I am still looking for the answer to this one.

FLGT has also done a series of tuck-in acquisitions, which makes the legacy segment’s topline growth even less impressive. What’s more atrocious is that FLGT has a knack for acquiring companies that are just as questionable as they are. For instance, FLGT acquired Cytometry Labs in August 2021. Cytometry was the target of a cyberattack in February 2022, which resulted in an “unauthorized party obtaining certain documents containing patient information…like name, date of birth, address, medical record number, health insurance information, and case number, which is a unique identifier used in lieu of your name to identify a testing sample.” FLGT also acquired Inform Diagnostics in April 2022. Inform Diagnostics (fka Pathology Laboratory) paid $63.5mm in 2019 for “improper financial relationships where they provided referring physicians subsidies for electronic health records systems and free or discounted technology consulting services.” In July 2022, Inform Diagnostics settled with the US Department of Justice for $16mm after admitting that “between 2013 and 2018, it routinely and automatically conducted additional tests on biopsy specimens prior to a pathologist’s review and without an individualized determination regarding whether additional tests were medically necessary.” FLGT’s minority investments do not fare any better: Their equity stake in BostonMolecules was fully written off within a year after initial investment in 2020. I see these tuck-ins as indicators of management’s horrendous capital allocation.

That’s not to mention the eyebrow-raising “investments” management has authorized following its COVID windfall: a $5.4mm private jet in August 2020, $200K of office furniture/supplies from JEM Enterprises (which very conveniently is run by the CEO’s wife), a $5mm cash payout for the CEO on top of his options, to name a few.

The final piece of evidence? In March 2022, FLGT filed an 8K disclosing a new clawback policy that permits them to “seek recoupment of incentive compensation…in the event that an Executive engaged in serious misconduct, or failed to supervise a subordinate employee who engaged in serious misconduct which the Executive knew…was occurring, and such misconduct resulted in a material violation of law or a written Company policy that caused significant financial or reputational harm to the Company.” Why would this policy be implemented out of the blue? One can only try to piece the picture together, though I believe government authorities are closing in on FLGT and management knows it.

Valuation:

FLGT conducted 10.0mm tests at an average price of $100 in 2021, 2.1mm of those tests relating to the non-COVID business. We think that ~8mm tests represented peak COVID and current contract terms do not represent the rates going forward.

Extrapolating from LA County Survey data, we think 2mm tests in a “normalized, post-COVID” year is generous for FLGT. Our checks indicated that FLGT was bidding for renewing contracts at slightly over $50/test earlier this year. We think $30 is more realistic considering the rapid normalization of demand and what other competitors are already bidding at. This would imply a 20% GM (vs. 76% historically), which we view as generous; there is more room for margins to fall even at those levels.

The COVID segment would then yield $60mm in topline (vs. the ~$900mm it provided in 2021) and $12mm in GP (vs. the implied $600mm GP provided from 7.9mm tests * $76/unit). FLGT had $100mm in FY21 OpEx: we think the fixed costs associated with the COVID segment exceed $12mm and that this segment will subsequently not generate any real FCF. This segment is worthless.

The legacy segment is a subscale operator propped up through a hodgepodge of sketchy M&A. I am unsure what real value proposition they offer. The gargantuan risk I cannot get over in this segment are the blatant red flags mentioned prior. Barring any dramatic acceleration in organic topline, this segment operates at roughly breakeven.

The one thing management arguably did right (in their own self-interest) was raise a ton of cash via equity offerings at peak COVID levels. They have roughly $1bn in net cash on their B/S. We think both segments are worthless and that the residual value for shareholders is in the net cash. That said, we would apply a discount to that cash balance considering the enormous risk of federal scrutiny/fines and poor capital allocation policies. Management has sold shares in the public market at every opportunity, and we do not think they have any goal besides fattening their own pockets. We think they are willingly doing so at the expense of unknowing customers and shareholders.

We thus think FLGT’s equity is worth around $750mm, or roughly $25 per share. That yields close to 60% in downside from today’s levels. Taking the net cash at face value yields roughly $33 per share, or close to 50% in downside. When this company is inevitably exposed by a source with more authority than myself, I believe FLGT will head to the gutter. I think this judgement day will arrive sooner than later based on the findings above.