Description

You’ve seen the bear case, now read the bull case…

With the stock market around all-time highs, it’s difficult to find companies with high quality businesses and rock solid balance sheets trading at cheap valuations. But I believe Mr. Market is giving us a gift in being able to buy Myriad Genetics (MYGN) at ~$23.

MYGN has the following characteristics (in my opinion):

• Sustainable competitive advantages (shorts disagree—more on this later)
• A bullet proof balance sheet with no debt and cash equal to ~30% of the market cap
• Trades at 5.8x LTM and 5.0x CY2014E EV/operating income
• Has historically grown at very high rates and should continue to grow revenue, operating income and EPS at 10%+, 15%+ and 20%+, respectively, over the next 5 years (shorts disagree)
• Growth will come from further penetration of existing markets that are just ~1/3 penetrated (end markets are growing at 11%+) and from entering large, new markets
• Is a non-capital intensive business; its investments to grow the company largely come through R&D at ~9% of revenue
• Free cash flow tends to be greater than net income partly explained by rather large stock-based compensation (18% of net income in FY2013)
• Over the past 5 years, OCF – capex has been 115% of net income while OCF – capex – stock-based comp has been 92% of net income
• Very shareholder friendly management that uses excess free cash  flow to opportunistically repurchase shares at good prices
• Over the past 3 years, management has returned 92% of free cash flow to shareholders, reducing shares outstanding by 20% by buying in stock at an average price of ~$22
• Is in the sweet spot of healthcare as it has a product/service that improves health outcomes and lowers costs for the health system

So the logical question is how can this opportunity exist given the valuation of the market? Due to some recent events, the future of its core business (75% of its revenue) has come into question (more on that later). To get a sense of the bear case, one can read VIC member, edward965’s short recommendation posted on 8/28/13. Bearish sell-side analysts include JP Morgan ($25 price target) and SunTrust Robinson Humphrey ($17 price target). Needless to say, I strongly disagree with their analysis and will attempt to show where and why I think the shorts are wrong.

As a result, over the past 4 months the number of shares short as a % of shares outstanding has increased by 28% and now stands at over 33% at 26.9M shares equal to ~14 days to cover. The % of shares outstanding short will likely be higher once it is announced how many shares were repurchased in the most recent quarter under the $153.4M remaining on its current authorization. Assuming the entire remaining authorization is executed, ~5.5M shares would have been repurchased, reducing shares outstanding by ~7% and therefore increasing short interest to ~36%. Also, given the bearish SunTrust report that came out on 10/10/13, which lead to the large volume (7.4M vs. avg. daily volume of 2.0M) that traded on Friday sending the stock down almost 8%, I would imagine more shorts have piled on top since 9/30.

This type of situation reminds me of GameStop (GME) back in early-mid 2012. GME was trading between $15-$25 and short interest ranged from 30%-50%. It had ~$5 in cash, no debt and was generating ~$2.50 in LTM EPS/FCF. The company’s plan was to repurchase shares with excess free cash flow. Increasing competition from technology was/is going to kill its business. If FCF didn’t implode the shorts would likely cover. So what happened? Revenue declined 7%, op. income declined 8.5%, shares outstanding have been reduced by 15% and EPS has increased by 10%. Over the next 1.5 years, GME has increased to $50 or a ~150% return. It went from trading at 3.3x LTM op. income to its current 9.8x. Meanwhile short interest has declined to 16%. It’s ironic that there are many less shorts at a valuation that is now 3x as expensive when the short interest was ~40%.

While MYGN’s short interest isn’t as high (per the 9/30/13 data), nor is the valuation as low as GME’s was at its bottom, MYGN has been (and should continue) growing at a much faster rate. If the shorts are wrong about MYGN’s earnings declining materially, a short squeeze could help improve the IRR on an investment in MYGN from current levels. At some point these 27M+ shares short will need to be covered.

Business Overview

Myriad Genetics is a leading operator of genetic testing of various cancers including breast and ovarian (via its BRACAnalysis and BART tests, which combine for 85% of sales) as well as colon (Colaris at 9% of sales). Its tests assess a person’s risk of developing disease, guide treatment decisions and assess risk of disease progression and recurrence. The company is expanding the number of cancers it will be able to test over the next few years with the recent introduction of a cancer panel, myRisk, which will incorporate BRACAnalysis and BART. In total this cancer panel will be able to further improve its industry leading accuracy and be able to analyze 16 more genes in 4 additional cancers at the same price it charges for the stand-alone BRACAnalysis test—which it will no longer offer in ~1.5 years. It also plans to launch cancer tests for prostate (Prolaris), melanoma (MelaPath), lung (myPlan Lung) as well as companion diagnostics (HRD). Importantly, these genetic tests greatly improve health outcomes while significantly reducing system-wide costs of expensive, reactive treatment.

Health System Return on Investment of BRACAnalysis Reimbursement

Insurance will only cover those who have already been diagnosed with breast/ovarian cancer or who have strong hereditary risk (i.e. 2 primary relatives such as mom and sister or 3 secondary relatives such as aunt and 2 first cousins):

• Spend $3,340 for test (+$700 for BART test) for a max investment of ~$4k
• If test is negative, do nothing
• If test is positive odds are close to 100% that patient will get at least breast or ovarian cancer and ~50% the patient will get both—then spend ~$15k in       preventative treatment
- In total an investment of ~$20k is made to save ~$250k in future treatment, which includes expensive biologic drugs, surgeries and/or chemotherapy

Since payers (insurance companies/Medicare) only reimburse for high-risk patients, the ROI is very high for the healthcare system. Since its tests are more accurate than the competition’s, the company claims its recently completed health economic model it has given payers shows that its more accurate tests save them an additional $2,615 per patient tested when factoring in downstream costs (i.e. a greater number of false negatives or variants of unknown significance, which results in higher levels of expensive, reactive treatment).

Recent Events Leading to New Competition

On 6/13/13, the Supreme Court of the United States ruled that five of Myriad’s claims covering isolated DNA were not patent eligible, but did uphold its four patent claims on complementary DNA (cDNA). The technical definition of cDNA is that it is single-stranded DNA synthesized in a laboratory using messenger RNA as a template and the enzyme reverse transcriptase. Since this DNA is synthesized in a lab (i.e. it is not naturally occurring in the human body), it is therefore patent eligible. Myriad claims its BRACAnalysis test contains several cDNA and method of use patents, which encompass the probes and primers used in this test. As a result of this ruling, various would be competitors have since entered the BRCA testing market with the view that they would not be infringing on any of Myriad’s enforceable patents. Myriad disagrees and is trying to get a preliminary injunction, which is unlikely to happen. After the preliminary injunction trial concludes later this month, Myriad will likely sue Ambry, Gene by Gene and any other competitors for infringing on their upheld patents. It could take another 1-2 years before this gets resolved. All of my scenarios assume competition is here to stay and will be increasing over time.

BRCA competitors currently include Ambry Genetics (main competitor to MYGN in colon cancer) and Gene by Gene. Future potential competitors would include LH, DGX and hospital labs from major Universities and cancer research centers, DNA Traits, Ethigen, GeneDx (subsidiary of BRLI) and Pathway Genomics.

Competitive Advantages

Myriad has some key competitive advantages and only one disadvantage, its higher price. These advantages result in a better quality test coupled with better customer service. So the ultimate question comes down to whether or not these advantages are sustainable such that Myriad can continue to justify the premium for its genetic tests. Since Myriad has been the only company conducting BRCA testing for the past 18 years, here are the following advantages it has:

1) Having tested over 1M people for breast/ovarian cancer, it has a vastly superior genetic mutations database compared to the next best alternative in the public domain, which is what current and would be competitors are using to classify BRCA gene mutations.

When someone gets tested for BRCA 1/2, there are 4 answers one will get from the test. It can be that one does not have a genetic mutation, one has a benign mutation, one has a deleterious mutation or one has a variant of unknown significance (VUS). The more comprehensive the database, the greater the likelihood one will get a definitive answer regarding the classification of that genetic mutation. Thus if one uses the public databases vs. Myriad’s database, the patient is more likely to get an answer that there is a variant, but the significance is unknown vs. knowing whether it is benign or deleterious. In conducting my channel checks in speaking to various University and cancer research center labs, they felt their VUS rate for BRCA testing was 10%-15% vs. Myriad’s 2.1%. That means on average, about 1 out of 10 patients using one of these new competing labs will get an inconclusive answer when she has a variant whereas Myriad would be able to classify that mutation correctly more often. The more inconclusive tests there are the more incorrect clinical decisions are made, which lowers healthcare outcomes and increases downstream costs to the system.

Myriad had contributed to the public database from 1996 to 2004. Through 2004, Myriad had cumulatively conducted ~150k BRCA tests. From 2004 to 2010, Myriad had cumulatively conducted 600k tests or an incremental 450k from 2004 to 2010. By the end of 2010, Myriad’s BRCA mutations database stood at ~14,000. Over the last 3 years, it has conducted another ~400k BRACAnalysis tests resulting in another ~1,000 unique mutations to bring its database to ~15,000. When analyzing the two public databases (ClinVar and BIC), there are 5,804 unique mutations combined as of mid-September. Based on the disclosure by BIC, 64% of its unique mutations come from the data Myriad reported through 2004.

Another key thing to note is that public databases contain mostly just the deleterious mutations. The BIC database’s % of mutations classified as benign/likely benign was just 3.37% while ClinVar’s was even lower at 0.77%. This is not representative of the classification of a normal population sample where the majority of mutations are classified as benign. The reason why this is so important is that if the public databases do not have a robust classification of both benign and deleterious mutations, then there will be a higher VUS rate from competing labs.

There are only three ways to grow these public databases. One is to have physicians get a patient’s permission (to avoid breaking HIPAA) in order to send in her old test results to ClinVar and/or BIC. Go directly to the patient to have her send in her old test results. Third, a new BRCA testing entrant such as Ambry’s lab is used and upon receiving the results, the physician gets the patient’s permission to submit her test results to the public databases.

Effectively, it would take at least 3 years (450k patients needed to be tested / LTM market volume of 150k tests) in order for the public databases to catch up to Myriad’s database. From the court documents filed on 9/6/13 by Ambry’s lawyer it states, “Even after Myriad’s patents expire, it will be many more years before the information in the public databases is comparable to what is in Myriad’s database.” One of the main reasons why it will be difficult to get enough new patient testing volume to bolster the public databases to a similar parity level to that of Myriad’s is because it will be difficult for sales people to convince physicians to use a new lab that will have a higher VUS rate. While Ambry is leading with price as its main competitive differentiator in that its BRCA test costs $2,200 vs. Myriad’s at $3,340, physicians or patients capture practically none of the savings. Thus without an economic incentive, it’s difficult to see why many physicians would take the risk of switching to a less accurate lab. This risk is by no means small as it puts a patient’s health at risk and at the same time exposes the physician to incremental financial liability and reputational damage. If new competitors cannot take significant market share from Myriad, then it will take a very long time for the public databases to catch up to Myriad’s level, let alone ever. In my channel checks, I spoke with various OBGYNs and oncologists who use Ambry for colon cancer testing. They all said that it was not worth the risk to switch from Myriad to Ambry for BRCA testing.

2) Myriad has superior customer service in dealing with VUS. First, if a patient has a VUS, Myriad will test his/her family members for free to see if that can allow it to classify the mutation as benign or deleterious. After that, if the variant’s significance is still unknown, over time as the VUS become classified as benign or deleterious, Myriad will proactively contact physicians to let them know of the reclassification for their patients. This information is critical in driving optimal clinical decisions. In conducting my channel checks, several physicians who use Ambry for colon cancer testing told me that it rarely, if ever notifies them of VUS being reclassified.

3) Myriad has faster turn-around times than competing labs. Myriad’s turn-around time is at or less than 2 weeks. In speaking with the Director of Diagnostic Development at Ambry, I was told that Ambry’s turn-around time is 3-4 weeks. Speed is very important to 15%-20% of the BRCA testing market where patients being tested are pre-surgical. Ambry didn’t think it had a realistic shot at this part of the market. In fact, ~2/3 of the market today comes from the oncology side where women have already been diagnosed with breast cancer. It will be more difficult to convince this part of the market to accept an inferior level of speed/service.

4) Myriad has a superior sales force in terms of number of people employed, but also in terms of their training and therefore ability to teach physicians how to effectively read test reports and recommend the best course of action for patients. From the channel checks that I’ve done, physicians maintain that the customer support from Myriad is “incredible” and is typically better than Ambry’s on the colon cancer side. Because Myriad is the 800 pound gorilla, it can afford to spend more to have a larger sales force, which makes it that much more difficult for new entrants to penetrate the BRCA market. Most likely, Ambry will have the most success targeting oncologists who currently use it for colon cancer and Myriad for BRCA testing.

The fact that Myriad has 70%+ share in the colon cancer genetic test market, has never had a patent advantage to compete over the past 13 years and continues to grow this business at 20% rates should speak to the aforementioned competitive advantages. Also, the fact that Ambry only has 12% of the colon cancer market with stagnant share should also speak to the opportunity set against Myriad in the BRCA test market. In fact, in speaking with Ambry’s Director of Diagnostic Development, his view was that at a minimum, over the long-term Myriad would retain at least half of the BRCA market and that material share erosion, if at all, would happen over a long period of time since a sales force is needed to convince physicians to switch labs. Also, it’s worth noting that before they launched their BRCA test, he thought Ambry’s VUS rate would be ~10%, which is in-line with some of the major University labs I spoke with who said their VUS rates would be between 10%-15%.

Short Arguments & Rebuttal to Short Arguments

1. Short: From VIC member, edward965: “Ambry Genetics began  offering the same tests at 1/3 less cost per test… I’m told it’s as good as the competition.”

Rebuttal: He is correct about Ambry’s lower price. In terms of “as good as the competition”, it appears that opinion is coming from Ambry. Unfortunately, there is no independent, third party that exists to evaluate the relative accuracy of one company’s genetic test vs. another’s. On Ambry’s website it states that, “The BRCA1/2 VUS rate (combined) for our first 1000 reported cases was just under 5% and has consistently declined to a current level of 4.4%.” Based on this statement, one might draw a similar conclusion.

However, this statement is very misleading. First, if you look at what Myriad’s VUS rate was back in 2004 (up to the point where it had contributed to the public database), its VUS rate was ~12%. But keep in mind that its database included both deleterious AND benign mutations that the public databases do NOT have. Myriad didn’t reach a 4%-5% VUS rate until 2008/2009 and had cumulatively tested ~500k patients at that point or an incremental ~350k from 2004. Thus it is practically impossible for Ambry to have this VUS rate.

Second, Ambry’s stated VUS rate is on a sample size of a few thousand samples as opposed to 1+ million from Myriad.

Third, Ambry’s few thousand samples are likely a much “clearer” pool of mutations to classify than what Myriad gets. The reason being is that the few thousand samples Ambry is basing its VUS rate on are likely reflex samples from Myriad that were already classified as no mutations detected for BRCA and then sent to Ambry for a full cancer panel. In the PI court case, on 8/30/13 Myriad’s Director of Variant Classification Program stated regarding Ambry’s supposed VUS rate:

“This [VUS] number is likely not representative of the same testing population being tested by Myriad, resulting in the number being lower for Ambry than it would be if they were testing the same types of patients being tested by Myriad (i.e., all comers). Early adopters of Ambry’s panel tests (which likely represent a large portion of the samples used to calculate Ambry’s BRCA 1/2 VUS rate) are likely reflex tests from Myriad BRCA 1/2 ‘No Mutation Detected’ samples. In fact, physicians have volunteered to us that this is precisely the case based on conversations between these physicians and Ambry’s laboratory director. These physicians have told us that Ambry actually asks for the patient’s Myriad test report. Thus, this patient population being tested by Ambry is likely enriched for patients who match the reference sequence and do not carry variants in BRCA 1/2 . This is akin to saying I can guess with great accuracy the weight of people walking by when the majority of them have their precise weight stamped on their forehead. So likely Ambry’s VUS rate would be several percentage points higher if they were testing the same population being tested by Myriad.

Finally, Ambry’s sequencing coverage of the BRCA 1 ad BRCA2 genes is slightly less than Myriad’s coverage. Ambry does not sequence as deep into the highly variable intronic regions, thus decreasing its ability to detect both VUS and deleterious mutations. Again, if I intentionally avoid guessing the weight of some percentage of those people walking by, especially those who are the hardest to guess, than my reported ‘accuracy’ will be higher.

Myriad regularly received inquiries from health care providers about how we would classify a variant that was classified a particular way by Ambry. For example, since 2010 we have received 44 different requests to help interpret an Ambry test for Lynch syndrome (hereditary colorectal cancer), where Myriad and Ambry are direct competitors. Since June 2013, Myriad has received nine information requests from health care providers who have used Ambry as their primary testing laboratory and received a BRCA 1/2  classification of ‘VUS’. In five of those nine cases, Myriad had a clinically meaningful classification where Ambry did not.”

Rebuttal: The only way an insurance company would grant Ambry, LH, DGX or any other lab this right over Myriad is if there is 100% certainty that a lab’s accuracy is equal to that of Myriad’s. In speaking with several different executives in charge of reimbursement rate contracts at the large insurers, they told me that given how politically sensitive breast cancer is, they would be very reluctant to force physicians to use a particular lab without being able to definitively prove another lab is equal in efficacy. The reasons they said they would move very cautiously are: increased liability from false negatives, false positives and unnecessary unknown variants that could be known if using the best lab, bad press from such situations, additional costs from having to reflex to a more accurate lab and an overall relatively small level of savings given that using a cheaper lab would only save 1/3 of the cost, but could potentially result in higher downstream costs.

It’s important to put this whole thing into perspective of the entire healthcare system. The entire BRCA/BART testing market is currently ~$600M. If all tests were switched to Ambry, the savings to the entire healthcare system would be ~$200M—and that assumes there are no reflex tests sent to Myriad and zero additional downstream costs generated. The U.S. spends $3 trillion annually on healthcare with costs spiraling out of control. Every little bit of savings helps. But the reality is using a significantly less accurate genetic test results in worse health outcomes and won’t result in any savings—and likely higher overall costs.  

3. Short: From edward965: “As quoting from a previous VIC pitch, ‘proprietary unpublished data on 4,000 unique BRACA mutations took over 10 years to build’, but that isn’t playing out. In fact, since most tests outside the US are done by others, I just don’t see that.”

Rebuttal: There are a few reasons why most tests outside the US are done by others. First, the market is much smaller. The annual volume in Europe is a quarter the size of the US. As a result, Myriad historically didn’t focus on the OUS market given the US market was/is very underpenetrated, has been continually growing double digits and presented a much easier growth path. Myriad needed to build a central lab in Europe in order to have similar turn-around times as it does in the US and recently set one up in Munich where it is currently losing ~$10 million pre-tax annually. Second, because it didn’t have a physical presence in Europe to compete, it didn’t bother to deal with lawsuits it would take to enforce its patents. Third, most of the testing volume in Europe comes from specialist cancer hospitals that perform their own, relatively inaccurate tests on campus. For Myriad to be successful in taking share in Europe, it needs to come in with an approach of educating physicians on their superior accuracy/service offering to get them to want to give their samples to Myriad instead of to their hospital’s lab. Myriad realizes it’s going to be a long and slow process to make real progress in OUS markets.

Just because other labs have performed the test in OUS markets does not mean they are on equal footing with Myriad. Many labs can perform the test in the US and abroad. It’s a question of what lab can perform it with the best value proposition, which includes both quality (accuracy, turn-around time and customer service) and price.

4. Short: The SunTrust analyst believes the future market growth is less than what the company believes it will be. He says, “It seems important to…remind investors that this is a once in a lifetime test. Every year, Myriad must find all new patients.”

Rebuttal: He is correct that this is a once in a lifetime test. So let’s take a step back and put everything into perspective. Myriad has performed ~1M BRCA tests over the past 18 years. In the LTM, Myriad performed ~140k BRACAnalysis tests and the annual run-rate is ~150k. There are ~230k breast cancer cases diagnosed in the U.S. each year. Another way to look at this is the total female population in the U.S. is ~185M. The lifetime incidence rate is 12.3%. So that means the maximum potential pool of women to be tested in the U.S. for breast cancer is ~23M. There is a 1.4% lifetime incidence rate for ovarian cancer, which results in 2.6M women. However, there is a decent overlap of women who are diagnosed with breast cancer that are also diagnosed with ovarian cancer in their lifetime. Assume the number of female births coming into the population pool is offset by an equal number of deaths leaving the pool. So for simplicity purposes use a max population pool of 23M. Myriad puts the U.S. target market at 11M women. This means that less than 10% of the women in the U.S. have been tested that can/should be.

The company believes the annual BRCA testing market is 1/3 penetrated meaning the potential annual market size is ~420k BRCA tests. If the annual BRCA test market were to get there overnight, it would take over 50 years to test the max pool of untested eligible women or 24 years based on Myriad’s target market of 10 million remaining untested women. At a minimum, it seems reasonable to think that the number of annual BRCA tests should be at parity with the annual number of breast cancer cases diagnosed in the US. It would take a 10% CAGR for 6 years for the test market to reach parity with the annual number of breast cancer diagnoses. I use 10% annual growth in my base case. Bottom line, the BRCA test market is likely to continue to grow at healthy rates for many more years to come.

Rebuttal: It is important to understand MYGN’s cost structure to get a sense of what this type of impact would do to its profitability. While cutting price by 1/3 is certainly a horrible (and unlikely) scenario, profits would not go to nearly zero. One must realize MYGN has certain variable costs. It has 18% of revenue going to sales commissions and ~9% of revenue is spent on R&D. Using FY2013/LTM numbers, one can look at this hypothetical impact and see what profitability would be reduced to.

While cutting R&D is never ideal, it would look to keep its R&D spend at a ~9% of revenue level as it has publicly said time and again. This level of R&D would still allow the company to innovate and come up with new genetic tests as it has done with smaller levels of R&D spend. Also, it could easily shut down its Munich lab if it doesn’t gain any traction in Europe over the next 1-2 years.

Keep in mind that the US BRCA and colon cancer genetic testing market continue to grow at very strong rates. In the first 9 months of FY2013, Myriad’s revenue grew 21% before growing 31% last quarter largely due to the Angelina Jolie bump. So if one is considering where MYGN’s profits would be in 2 years with its markets growing at a minimum 10% CAGR, even with this kind of pricing reduction, the hit relative to its LTM profitability would be much less than what edward965 believes and on a per share basis, with continued strong share repurchases (as it has done the past few years), EPS would be flattish. Here’s the math:

BRACAnalysis Revenue: $460.3M (+14% YoY)

BART Revenue: $59.1M (+355% YoY)

Colaris Revenue: $51.9M (+10% YoY)

Other Revenue: $41.8M (+24% YoY)

Total Revenue: $613.2M (+24% YoY)

GP: $533.6M

SG&A: $251.8M (including $26.6M of stock-based comp)

R&D: $53.7M (8.8% of revenue)

EBIT: $228.0M

Net operating income: $136.8M (no interest income, 40% tax rate)

Op. EPS: $1.69

S/O Diluted (8/1/13): 81.1M—using treasury method

Cash & investments per share: $6.55

FY2015E (downside scenario, per edward365’s pricing assumptions for BRACAnalysis)

BRACAnalysis Revenue: $336.9M (assumes 7.5% market growth for 2 years, 5% share loss with pricing down by 1/3)

BART Revenue: $83.6M (assume gets to ~42% penetrated of a $200M annual market or a 75% attachment rate to BRCA test volume vs. 61.3% in FY2013 and 69.2% in Q4’13)

Colaris Revenue: $47.1M (assume 10% volume growth for 2 years, constant market share and pricing down -25% vs. FY2013)

Other Revenue: $55.3M (assume 15% growth for 2 years; Prolaris doesn’t gain traction in the marketplace)

Total Revenue: $522.9M

GP: $434.0M (gross margin down 400 bps to 83.0%)

SG&A: $225.6M (including $26.6M of stock-based comp; closure of Munich lab that saves $10M in SG&A; plus lower commission costs given rate is 18% of revenue)

R&D: $47.1M (9.0% of revenue)

EBIT: $161.4M

Net op. income: $126.7M (no interest income, 40% tax rate)

Op. EPS: $1.36

S/O Diluted (8/1/15): 71.1M (assume $250M of FCF is used to repurchase 10M shares at $25 per share; no further option dilution as options issued are under water)

Cash & investments per share: $7.85 (cash & investments at $558.1M; cash increase due to working capital benefit at 30% of revenue as revenue declines)

Using a 12x P/E on op. EPS plus net cash gets one to a total value of ~$24 equal to zero downside. The reason why a 12x P/E is very reasonable on this low case is that from this point forward having re-based its revenue/earnings with lower pricing, MYGN would be able to grow. In 2 years its core markets will remain less than 50% penetrated plus its newer tests like Prolaris (prostate cancer) should begin to make an impact to the P&L.

FY2015E Armageddon Scenario (BRCA pricing gets cut by 50% making the market unattractive for competitors as pricing of ~$1,600 would be well below Ambry’s $2,200 price and physicians would have little incentive to switch labs)

BRACAnalysis Revenue: $241.0M (assumes 5.0% market growth for 2 years, 5% share loss with pricing down by 50%)

BART Revenue: $74.5M (assume gets to ~37% penetrated of a $200M annual market or a 70% attachment rate to BRCA test volume)

Colaris Revenue: $40.1M (assume 5% volume growth for 2 years, constant market share and pricing down -30% vs. FY2013)

Other Revenue: $50.6M (assume 10% growth for 2 years; Prolaris doesn’t gain traction in the marketplace)

Total Revenue: $406.2M (-33.8% vs. FY2013)

GP: $321.7M (gross margin down 780 bps to 79.2%)

SG&A: $204.6M (including $26.6M of stock-based comp; closure of Munich lab that saves $10M in SG&A; plus lower commission costs given rate of 18% of revenue)

R&D: $36.6M (9.0% of revenue)

EBIT: $80.6M

Net op. income: $48.4M (no interest income, 40% tax rate)

Op. EPS: $0.68

S/O Diluted (8/1/15): 70.6M (assume $210M of FCF is used to repurchase 10.5M shares at $20 per share; no further option dilution as options issued are under water)

Cash & investments per share: $8.40 (cash & investments at $593.2M; cash increase due to working capital benefit at 30% of revenue as revenue declines)

Assuming no future growth (to be conservative), apply a 10x P/E on op. EPS plus net cash gets one to a total value of ~$15 equal to -33% downside.

FY2015E Base Case Estimates/Value

BRACAnalysis Revenue: $501.2M (assumes 10.0% market growth for 2 years, 10% share loss with pricing flat)

BART Revenue: $93.4M (assume gets to ~47% penetrated of a $200M annual market or an 80% attachment rate to BRCA test volume)

Colaris Revenue: $56.9M (assume 15% volume growth for 2 years, market share gains of 2.5% and pricing down -20% vs. FY2013)

Other Revenue: $60.2M (assume 20% growth for 2 years; getting benefit from Prolaris and companion diagnostics)

Total Revenue: $711.8M (translates into 7.7% growth per year for 2 years, which is lower than management’s 5-year CAGR goal of 10%-15%) 

GP: $621.6M (gross margin +30 bps to 87.3%)

SG&A: $273.8M (including $26.6M of stock-based comp; Munich lab remains open)

R&D: $62.3M (8.8% of revenue)

EBIT: $285.4M

Net op. income: $171.2M (no interest income, 40% tax rate)

Op. EPS: $2.35

S/O Diluted (8/1/15): 72.9M (assume $275M of $325M in FCF is used to repurchase 9.2M shares at $30 per share; assume 1M shares of option dilution as options issued are ~15% in the money)

Cash & investments per share: $7.57 (cash & investments at $551.1M; cash increase because of $50M of FCF not used for share repurchase partially offset by working capital increase at 30% of revenue as revenue increases)

Using a 15x P/E on op. EPS plus net cash gets one to a total value of ~$43 equal to 88% upside over 1-2 years. The reason why a 15x P/E is very reasonable on this base case is that its business model sustainability will be proven out and its core markets will remain less than 50% penetrated plus its newer tests like Prolaris (prostate cancer) should begin to make an impact to the P&L.

FY2015E High Case Estimates/Value

BRACAnalysis Revenue: $524.3M (assumes 12.5% market growth for 2 years, 10% share loss with pricing flat)

BART Revenue: $103.8M (assume gets to ~52% penetrated of a $200M annual market or an 85% attachment rate to BRCA test volume)

Colaris Revenue: $68.1M (assume 20% volume growth for 2 years, market share gains of 5.0% and pricing down -15% vs. FY2013)

Other Revenue: $65.3M (assume 25% growth for 2 years; getting benefit from Prolaris and companion diagnostics)

Total Revenue: $761.5M (translates into 11.4% growth per year for 2 years, which is towards the low end of management’s 5-year CAGR goal of 10%-15%) 

GP: $666.4M (gross margin +50 bps to 87.5%)

SG&A: $284.9M (including $26.6M of stock-based comp; Munich lab remains open)

R&D: $64.7M (8.5% of revenue)

EBIT: $316.7M

Net op. income: $190.0M (no interest income, 40% tax rate)

Op. EPS: $2.55

S/O Diluted (8/1/15): 74.5M (assume $300M of $350M in FCF is used to repurchase 8.6M shares at $30 per share; assume 2M shares of option dilution as options issued are ~30% in the money)

Cash & investments per share: $7.21 (cash & investments at $536.6M; cash increase because of $50M of FCF not used for share repurchase mostly offset by working capital increase at 30% of revenue as revenue increases)

Using a 20x P/E on op. EPS plus net cash gets one to a total value of ~$51 equal to 156% upside over 1-2 years. The reason why a 20x P/E is very possible on this high case is that its business model sustainability will be proven out, its core markets will remain less than 50% penetrated, its newer tests like Prolaris (prostate cancer) are growing faster than expected, its new companion diagnostics (HRD test) launch in 2015 and other tests such as myPlan Lung receive reimbursement approval.

Prolaris: Prolaris, launched in 2011, is a prognostic test for prostate cancer. This 46-gene molecular diagnostic assay assesses the likelihood a patient will have a slow growing, indolent form of prostate cancer that can be safely monitored with active surveillance vs. a more aggressive form of the cancer that warrants aggressive treatment such as radiation therapy or a radical prostatectomy. This test would help physicians’ ability to predict disease outcomes and therefore optimize treatment/health outcomes.

The reason a test such as this is needed is because the existing PSA screening results in overtreatment of prostate cancer. Most men diagnosed with prostate cancer have a slow-growing indolent form of the disease, but over 85% of diagnosed men are treated with aggressive therapy. This not only results in unnecessary costs to the healthcare system, but it also exposes patients to unnecessary risks such as impotence and incontinence.

To give a sense of the market opportunity, the lifetime incidence rate in the U.S. is 15.3%, which means that there’s a maximum population pool of ~24M. In the U.S. each year there are ~240k men diagnosed with prostate cancer and ~30k deaths from the disease. Currently, there are 2.6M men alive who have a history of cancer of the prostate. Worldwide there are over 900k prostate cancer cases diagnosed annually.

The list price of Prolaris is $3,400. Assuming a 15% discount off list price and using 240k tests per year (at parity with the annual # of prostate cancer diagnoses) would put the U.S. market at $700M. The contribution margin on this revenue would be ~60% (87% gross margin – 18% sales commission – 9% G&A overhead) or a ~$420M profit pool. If MYGN could realize 10% of this opportunity by FY2016, this would add $42M to op. profit equal to ~20% of LTM op. income. It’s not much of a stretch to believe Myriad could be doing ~24k annual Prolaris tests a few years from now if it receives reimbursement from CMS within the next 6-9 months. From FY2016 onward, this would provide another material growth driver to earnings.

Currently, Prolaris is not covered by commercial insurance or CMS. Myriad has conducted 9 studies on 3,000 patients supporting the efficacy of the test. Myriad expects to receive reimbursement approval from CMS by mid-2014. Since ~2/3 of prostate cancer diagnoses are in men 65+ years of age, CMS reimbursement is key. Once CMS approves reimbursement, commercial insurers would likely follow suit soon thereafter.

In doing channel checks, it appears to be a two horse race for this market between MYGN’s Prolaris and Genomic Health’s (GHDX) Oncotype DX prostate cancer test. The channel checks believe Prolaris is more accurate than Oncotype DX. Also, Myriad is 1-2 years ahead of GHDX and should most likely get reimbursement first. A first mover advantage would certainly be helpful.

Assuming the test is accurate, there is a very high ROI to the health system. The number of prostatectomy procedures performed annually in the U.S. are 138k at ~$20k per procedure. Given 85% are unnecessary procedures, this results in an unnecessary cost to our health system to the tune of ~$2.4 billion annually. Testing all 138k men each year at a cost of ~$2,900 would cost the system $400M for a net savings of ~$2.0 billion annually. This is an ROI of ~500%.

Skeptics say urologists are financially motivated to perform surgery, but in order to realize the market potential, Myriad’s sales force will have to show physicians they can actually make more money over time from active surveillance compared to performing surgery on their patients.

Humologous Recombination Deficiency (HRD): Myriad plans to launch the first part of its next generation of companion diagnostics, HRD, in 2015. HRD offers a tailored treatment strategy to each individual since it can determine based on the DNA that is already compromised, which tumor cells can be pushed over the edge by the right drug. HRD is relevant to breast, ovarian and lung cancer.

HRD test is the most accurate way of determining double-stranded DNA deficiency at the tumor level. MYGN intends to launch the platinum indication for HRD in calendar year 2015 and the PARP-inhibitor in calendar year 2017. The testing opportunity is ~0.5 million patients in the U.S. annually and depending on the test price, the market size could be $1 billion to $2 billion. However, this won’t be able to make a real impact to earnings over the next few years. But this does represent a real growth leg for the back half of the decade.

myPlan Lung: Lung cancer is the most common cancer worldwide, accounting for 1.3 million deaths annually. The lifetime incidence rate for lung cancer in the U.S. is 6.9% or ~22M of the population. In the U.S. ~226k new lung cancer cases are diagnosed annually. Currently, there are 374k Americans living with lung cancer. The  lung cancer five-year survival rate is just 16.3%, lower than many other leading cancer sites such as colon, breast and prostate. Over half of people with lung cancer die within one year of being diagnosed. However, the five-year survival rate dramatically increases to 52.6% for cases detected when the disease is still localized within the lungs. But just 15% of lung cancer cases are diagnosed at an early stage.

This underscores the importance of a test such myPlan Lung, which the first data published in Clinical Cancer Research last month shows that it’s a significant predictor of lung cancer death in patients with early-stage, resectable lung adenocarcinoma and may be a valuable tool for selecting which early-stage patients should be considered for additional post-surgical chemotherapy. Assuming the number of annual tests could be in-line with the number of annual lung cancer cases diagnosed, this would put the U.S. target market at ~$700M while the OUS market is theoretically much larger given almost 5x the size in annual lung cancer diagnoses. That being said, this test won’t be able to make a meaningful impact to earnings within the next few years.

MelaPath: 14% of all skin biopsies are classified as indeterminate. This affects over 275,000 patients annually. The physician really can’t look at the cells under a      microscope to determine whether or not the patient has a malignancy. Uncertain biopsies are a major cause of malpractice lawsuits. MelaPath will be able to assist the physician in determining whether or not the skin biopsy represents a benign nevi or a malignant melanoma, really improving the diagnoses and saving lives. The Company believes this is an $800M global market split evenly between the U.S. and OUS.

International Expansion: Currently, Myriad is losing ~$10M a year in overhead at its lab in Munich trying to gain a foothold for expansion into Europe. The BRCA market in Europe is currently ~1/4 the size of the US market, but pricing is higher. The potential market opportunity in terms of the number of annual breast cancer cases diagnosed is actually larger than the US, but it will take a long time for the company to make in-roads into various European countries.

None of the shorts or bearish sell side reports mention the strategic value Myriad could be worth to a potential acquirer like a large cap pharmaceutical company in the biologic cancer space such as Roche or one of the big lab companies like LH or DGX. This is another layer of downside protection should an Armageddon type scenario ensue.

LH has proven to be an acquirer in the specialty testing space over the past number of years, spending ~$3 billion since 2005 on acquisitions including several different labs conducting various esoteric tests. Per its 10-K: “Part of the Company's strategy involves deploying capital in investments that enhance the Company's business, which includes pursuing strategic acquisitions to strengthen the Company's scientific capabilities, grow esoteric testing capabilities and increase presence in key geographic areas.

DGX has proven to be an acquirer in this space as well. Since 2007 it has spent over $3 billion on acquisitions of labs conducting various esoteric tests. The multiples of these purchases are all at least 2.5x revenue compared to MYGN trading at 2.1x LTM revenue.

The major lab companies like LH and DGX have proven time and again that their ability to grow organically in the specialty test market is sub-par. Neither company spends much in R&D. If you look at the colon cancer market that has been around for 13 years, neither company has been able to gain significant share.

Myriad’s mutations database is very helpful in trying to come up with companion diagnostics to understand which cancer drugs work well for certain people. This database has and continues to give Myriad an advantage in its R&D efforts to launch new cancer tests and allows for superior R&D productivity. As a result, this information could be quite valuable to pharmaceutical companies trying to come up with drugs for various types of cancer. It’s worth taking note just how many pharma companies are working with Myriad. The list includes AstraZeneca, Sanofi, DaVita, BioMarin and TEVA’s Cephalon as well as others.  Also, it plans to launch its new companion diagnostics test (HRD) in the next few years, which is where the future of launching cancer drugs is going since payers (governments/insurance companies) are increasingly only willing to pay for expensive biologic drugs that have high success rates of materially improving survival rates.

By the way, have you seen the prices big pharma is willing to pay for some of these companies in this space? Roche has a division that makes up over 20% of its business dedicated to diagnostics. Roche was willing to pay 20x EBITDA for ILMN in the past year, which has similar growth as Myriad. MYGN trades at 5.6x LTM EBITDA. ILMN would have cost Roche $6.7 billion. Roche bought Ventana (pharma and diagnostics) in 2008 for $3.4 billion or 12x LTM revenue. Today MYGN’s enterprise is just $1.3 billion and trades at 2.1x LTM revenue. 

Management Incentives

A large portion of management’s compensation is in the form of options. For the top executives, ~2/3 of their compensation is from options awards and they receive very reasonable cash compensation (~$700k to ~$2M depending on the executive) given how well they’ve grown the business thus far. Management appears to share the wealth with their employees and keep their interest aligned as ~63% of the stock based compensation went to other employees outside of the top ranks.

These top executives have been increasing their exposure to MYGN over time as they have exercised less than what they have been receiving over the past few years. As you can see below, every $1 move in the stock is worth at least $1M pre-tax to them. They are very financially motivated to drive the share price higher by growing EPS through operating income growth and meaningful share repurchases at attractive prices.

The CEO owns 85k shares, has ~3.2M options struck at an avg. price of ~$19 with an avg. of ~6 years remaining.

The COO owns 48k shares and has ~1.3M in options struck at an avg. price of ~$21.50 with an avg. of ~7 years remaining.

The CSO owns 18k shares and ~1.0M in options struck at an avg. price of ~$19 with an avg. of ~6 years remaining.

The CFO owns 47k shares and has ~1.3M in options struck at an avg. price of ~$18.50 with an avg. of ~6 years remaining.

How the Bearish Sell-Side Analysts Arrive at Their Price Targets

The JP Morgan analyst does a DCF using a -10% perpetual growth rate and a 10% discount rate. He thinks over the next four years, BRACAnalysis pricing will decline -20% and that Myriad will lose 20% market share. He forecasts MYGN will have $13.89 in cash per share by FYE 2017 and will do $1.77 of EPS in FY2017 (diluted shares outstanding decline modestly to 79.9M). Backing out the cash, his $25 price target implies a 6.6x P/E.

The SunTrust analyst bases his $17 target primarily off of his Base Case CY2015E EPS using a CY2014 P/E multiple from comps of 13.5x. Applying 13.5x to a Base Case of $1.17 CY2015E EPS equals $16. He has a Low Case and High Case for CY2015 as well. He probability weights the Low Case price target of $11 (using $0.22 of EPS) at 25%, the Base Case of $16 (using $1.17 of EPS) at 60% and the High Case of $34 (using $2.31 of EPS) at 15%. Adding up the probability weights of the 3 cases gets to his $17 price target.

There are some key things worth noting. While he doesn’t cite which comps he uses, there isn’t one company in the same industry that has the kind of cash rich balance sheet Myriad possesses. In fact several companies have net debt. Given MYGN’s net cash position is equal to ~30% of the market cap at $6.55 per share is not inconsequential. Also, it’s not as if management has not shown the willingness to repurchase shares at opportunistic prices over the past few years. So if one wanted to use his Base Case target price of $16 and add the $6.50 of cash, the adjusted price target would be $22.50—effectively where the stock currently trades.

Lastly, in looking at his model, there appear to be some key errors. First, his cash/share for FYE 2013 is $4.47. He includes short-term marketable investment securities, but leaves out long-term marketable investment securities, which is equal to ~$2 per share or almost 10% of the market cap.

Second, his cash flow statement, ending cash balance and shares outstanding estimates for FY2014 and FY2015 do not make any sense. While he includes share-based compensation expense, net for FY2010-FY2013, he has it at zero in the cash flow statement for FY2014 and FY2015. This reduces free cash flow by ~$53M over those 2 years. Of the $251.9M in FCF generated in his model over those 2 years, he assumes $220M is used for share repurchases and $31.9M increases its cash balance.

However, when looking at his income statement model, the shares outstanding have barely budged and are down by just 1.6M over that 2-year period. This makes no sense. Using an average share repurchase price of $27.50 would result in 8.0M shares repurchased using $220M. It seems he is double penalizing the company for option dilution. He is not giving MYGN the benefit in its cash flow from operations by adding back stock-based compensation nor is he using a realistic average share price for repurchase and/or amount of option dilution to get to an accurate share count reduction based on the $220M he assumes for share repurchases. At the same time, his FYE 2015 cash balance does not include long-term marketable investment securities, which is another ~$2 in value or ~10% of the market cap.

Risks

The biggest risk by far is if insurance companies view genetic tests as interchangeable. This could result in either significant reimbursement pricing cuts and/or volume being steered away to lower cost/preferred labs like LH/DGX. Were this to happen, the aforementioned Downside or Armageddon scenarios would apply. However, I believe this is unlikely given the sustainable competitive advantages Myriad possesses coupled with changing dynamics of the genetic testing market as Myriad’s next generation sequencing test, myRisk, replaces its BRACAnalysis test. Comparing one company’s test vs. another company’s test will become increasingly difficult since it will be apples (new technology with greater accuracy testing for cancers/genes) vs. oranges (old technology). Also, it is worth noting that Myriad’s myRisk cancer panel will not only be more accurate and encompassing than competitor’s cancer panels such as Ambry’s CancerNext, but it will also be ~$1,000 or ~20% less expensive.

Cigna’s current requirements for genetic test reimbursement mandate that a patient meet with a genetic counselor to get their approval prior to ordering the test. Because of the shortage of genetic counselors in the U.S., this would place a bottleneck in the system and slow down genetic testing growth. In all of my channel checks with physicians who order BRCA tests, since the family history requirement is so high to get reimbursed, there are many more instances where a patient with the requisite family history is denied reimbursement vs. one who doesn’t have the necessary family history, but gets reimbursed. As a result, there does not appear to be unnecessary tests that are reimbursed by insurance. As of now, no other insurance companies have followed suit. But if others were to, this would impact growth of the genetic test market.

Summary

To get to my Base or High Case, one must believe that competition is unable to bridge the gap in service quality and/or test accuracy relative to Myriad in BRCA—and that the insurance companies cannot prove that competitors’ tests are equal in efficacy. As a result, insurance companies will continue to allow physicians to choose which labs they use for genetic tests. The only thing insurance companies will get involved in is pricing and possibly finding other ways to stem the growth of these tests by implementing programs like the one Cigna recently put in place.

If the current practice of allowing physicians to choose which labs they want to use for these tests remains in place, then Myriad is in a great position. There is no economic incentive to the physician or patient from using a cheaper test. Come 1/1/14, most people will not have a co-payment thanks to the ACA. So if there were any doubt that a competitor's test is less accurate, why would physicians switch? Maybe some dislike Myriad because it had a monopoly on this test, didn't share genetic information, etc. and would do so out of spite. For that reason there will probably be some physicians (predominantly in academic centers that make up ~30% of testing volume) who will switch labs. But most will not and thus Myriad’s business should continue to grow at a healthy double digit CAGR for years to come.

This report is neither a recommendation to purchase or sell any securities mentioned. The author and/or his/her employer may or may not have a position in any security discussed in this report. Further, the author and/or employer may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be correct as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information.

Catalyst