NeoGenomics: ~27% Upside Potential Is Under-Reflected, Market Is Unfairly Discounting Shares (NASDAQ:NEO)
We are long NeoGenomics (NASDAQ:NEO) shares and hold a bullish long-term sentiment based on fundamental momentum, key differentiators within the portfolio mix and acquisition success over the previous periods for the company. NEO sits at the tip of the spear for our high-quality-growth-at-a-reasonable-price (“HQ-GARP”) list and offers a consolidated platform for comprehensive oncology diagnostics across a wide outlay, including pharmaceuticals, pathology and oncology itself. In fact, NEO has the widest cancer diagnostics test offering in the US, with a breadth of over 750 tests that penetrate into a number of panels, and backs this up with a growth vision to launch anywhere between 60 to 70 new test offerings per year.
Figure 1. Single-year price performance
Data Source: Author’s Bloomberg Terminal
Extending from the wide scope of test offerings, NEO has demonstrated an almost best in class acquisition history, targeting quality, high margin laboratory companies over the recent years. This includes the company’s collaboration and equity stake in Inivata back in May this year, particularly as the company aims to deliver ongoing value via expanding commercial reach in testing and diagnostics into minimal residual disease and liquid biopsy end-markets, thereby targeting cancer remission outcomes and improving treatment success. It is not unreasonable to foresee NEO continuing to target high margin, quality names into the future, including those that will complement the current portfolio setup and drive additional reach into adjacent oncology markets. As such, NEO will likely consolidate its oncology expertise into one house, and position itself as a market leader in oncology diagnostics, including adjacent segments such as companion diagnostics. We, therefore, are firm in the belief that NEO is a name of the future, and feel that much of the sell-side commentary has overlooked the upside potential in NEO’s acquisition strength and superior business model. Here, we cover all of the necessary moving parts in the investment debate, to assist investors in their own investment reasoning.
A High-Torque Flywheel For The Growth Engine To Date, and To Come
The first factor that the market is under-reflecting and creates strong conviction for entry is NEO’s accelerated growth sequence over the last decade. NEO has realised an above-market growth pattern of CAGR ~31% in revenue volumes and overall segment contribution over the past 10 years. Thus, NEO has likely captured additional market share over this time period, considering the outsized top-line returns relative to the wider market. Organic growth in the core business of clinical testing has matched overall annual growth rates over this period, and overall volumes in this segment have outsized at CAGR ~38% over the same time frame. Management are keen to remain prioritised towards the high growth portfolio segments of clinical services, pharmaceutical services, companion diagnostics and informatics. In fact, clinical and pharmaceutical services dovetail to form the bolus of NEO’s revenue drivers, accounting for 87% and 13% of contributions to the top, respectively. We believe this mix of revenue and gross profit contribution will remain as such into the coming years, as the structure has remained largely unchanged over the previous 5-year period, and the formula is working well.
Additionally, the company is well positioned to increase penetration and widen its TAM in companion diagnostics (“CD”), which continues to be a meaningful growth lever for the company over the recent periods. The CD market segment is estimated for an accelerated growth period over the coming years, having been sized at around $3 billion back in 2018. Projections anticipate this size to balloon by CAGR ~29% and reach around ~$10.5 billion by 2025. The high-growth forecast period is underscored largely by an increased breadth of scientific advancements made in key oncological arenas, that have incentivised the development of companion diagnostic tests, targeting various markers such as EGFR, PD-L1 and BRAF (amongst many others). The language on CD’s has been around for over 6 years now, with the FDA illustrating the demand for advancements in this segment back in 2014 and again in 2018. As CD’s have a predictive “power” in sorting and optimising candidates for various therapies, the FDA have continuously noted the upside in therapy approvals that coincide with companion diagnostic counterparts. Therefore, we firmly believe that NEO will continue to capture additional market share here, and expand volumes in line with the anticipated growth of the wider CD market.
Figure 2. CD Market forecasts 2018-2025
Data Source: Companion Diagnostics Market Forecast, 2018-2025
Back to testing services, NEO’s broad product offering reduces the concentration risk within the portfolio, permeating the necessary diversification benefits of consolidating many tests under the one roof. So much is true as the company offers the widest cancer testing portfolio in the US, with over 750 tests on the menu. We don’t feel the market is fully appreciating this fact, and believe that NEO deserves to trade higher with this included in the investment debate. Undoubtedly, NEO’s focus on CD offers unique synergies with the testing services segment, and acts as a meaningful compounder to this segment into the years to come. Given the strengths in clinical and pharmaceutical testing services the company exhibits at present, it is not unreasonable to foresee NEO obtaining a series of wins for CD and/or testing contracts in the years to come. This aligns with the evidence of Big-Pharma’s pivot into rare and complex disease segments that we’ve observed in recent times and this year in particular.
On this point, the company remains insulated from major competition by leveraging their exposure as an oncology pure play. The focus seems to be consolidating the entire scope of oncology service offerings under the one roof, expanding their operations away from just a laboratory player. Consequently, whilst the company remains entirely exposed to oncology, they are remaining insulated and differentiated by diversifying within the single-segment, thereby dampening the concentration risk, as mentioned – penetrating wide instead of just deep. To illustrate, current offerings within the product mix include cancer cytogenics, FISH testing for haematologic tumours, over 150 molecular oncology tests, surgical pathology consultations and bone marrow consultations, plus over 30 next generational sequencing test applications. This separates NEO away from peers, and establishes the company’s very clear footprint as more than just a laboratory company, but rather as a specialist oncology market-leader, by our view.
Given their position as an oncology pure play as mentioned, the company is more than well positioned to deliver consistent and reliable cash generation over the coming years. Adding more torque into the growth engine is the traction exhibited in the pharmaceuticals services (“PS”) segment, which synergises well to complement the overall oncology diagnostics route. NEO has continued to deliver a robust growth pattern in their PS operations, which have held up well against competition and to Covid-related headwinds this year, posting ~25% in contributions to the top from this segment YTD. Total sales are ~13% exposed to PS revenues based on Q3 results. Compounding this narrative is a heavy backlog that has grown ~57% YoY and almost 30 new diagnostics via CD’s ready for pipeline conversion. Much of the growth story here is underlined by clinical validation, assay development and diagnostic testing advancements, in keeping with the core business model. NEO tucks their organic operations in with service offerings to larger pharmaceutical players, and recognised ~$17 million in revenues from this type of service in the 3rd quarter, a 38% YoY growth pattern.
Figure 3. NEO Revenue Volumes & Enterprise Value, 2016A-2020A
Data Source: Author’s Bloomberg Terminal
Sequentially, we are aligned with management’s view of sales expansion here, and believe ~15-17% recognisable expansion in revenue volumes is certainly not unreasonable for Q4 2020. We see additional evidence of NEO’s commitment to better patient outcomes and improve efficiencies in clinical testing results via their informatics focus, where they are undoubtedly aiming to optimise patient enrolments to squeeze the most juice out of each and every clinical trial. Add in the fact that management aim to launch up to 70 new tests each year, then we see pipeline tailwinds that investors must realise weigh heavily into the investment debate. Therefore, the company has greater tangible control over profit and cash flow outcomes as key end-markets begin to expand, and we feel that there will be an accelerated growth pattern in the uptake of NEO’s testing accounts that aligns with their expansion in test offerings and the wider market growth, over the coming 5 years.
Acquisition Success- Increases margin potential with very little OPEX tied in
We would also point investors to NEO’s success in acquisition targeting, and the various transactions that have generated upside to the company’s operating leverage and relief of margin pressures over the recent years. This is certainly a differentiating factor that may be under-appreciated by the market at this point in time, especially as the company has managed to acquire and successfully integrate several names at an absolute dime. Such names include Human Longevity, where NEO acquired the oncology assets at only 2.5x total revenues (~62% below the average industry target), in addition to names like Genoptix and Clarient who were acquired at similar valuations. Success in this strategy of acquiring high quality names at significant discounts (relative to market acquisition multiples) have permeated into overall liquidity preservation and dampening of operating expenditures across the portfolio.
Another very key differentiator in strategy is the splitting of focus away from R&D spend and pipeline conversion alone. Instead, NEO frees up capital away from high variable expenditures linked to clinical trial development, in order to obtain already established test labels, viewing acquisitions as an effective medium to widen the breadth of test offerings. This presents a myriad of benefits that drive profits with very little OPEX tied into the mix, thereby widening ROIC and capital allocation potential. As such, cash flow from operations has widened over time in tandem with operating leverage, especially as the company has a large fixed cost base to work around, whilst lowering variable input costs through acquisition activity. Consequently, the company leverages further cost reductions via economies of scale, to lower the incremental unit costs of individual testing products. Management remain focused on reducing the average cost per test into the coming years. We see evidence of the same in the construction of the new facility located at Fort Myers, where the priority remains on automation over additional headcount. As a result of these measures, NEO has managed to trim costs per test by ~40% over the last 10 or so years, which will only be bolstered by the efforts mentioned above.
Figure 4. Widening revenue/OPEX mix- The market is unfairly discounting the above-market growth and upside from cost reductions in cash flow valuations
Data Source: Author’s Bloomberg Terminal
It is not unreasonable to foresee NEO continuing the acquisition trend over the coming years, continuing to put the strong balance sheet to effective use. This aligns with the company’s growth vision of consolidating their position as a market leader in precision oncology, and serves to widen the already established footprint. We believe that the company will continue their focus in adjacent testing markets, such as liquid biopsies and minimal residual disease, to continue the above-market growth pattern exhibited over the last 10 years. We believe that NEO has continued to steal market share from competitors via this above-market growth sequence (the market has growth by CAGR ~6% over this period, for reference) and continuing to extend reach will feed into this continuum. To illustrate, the company entered into an ownership stake for Inivata in May this year, to establish themselves as an early market entrant into what seems to be highly lucrative markets in liquid biopsy and minimal residual disease. Inivata is also a pure play, albeit in liquid biopsy, and NEO has put the balance sheet to effective use, to lever Inivata into the portfolio and gain exposure to the ~$15 billion liquid biopsy and minimal residual disease market segment. Given the company’s track record of successfully integrating tuck-ins over the years, we feel as much will occur with Inivata, and will serve NEO by recognising profits with little OPEX tied in, as previously discussed. Given that interest is covered ~7x, leverage is contained to ~9x and debt as been well managed, further acquisitions are on the horizon by our view. Total debt to total capital is only ~25%, and the capital structure remains equity focused with total equity to assets of ~69%. Thus, equity holders are likely to see the upside via this strategy, especially as liabilities remain well covered and make up only ~22% of total assets.
We view a period of high-growth in revenue volumes, gross level earnings and free cash flow over the coming 5-year period. Here, we view margin expansion of ~900 bps at the gross level, with significant widening of EBITDA and operating level margins in this horizon also. Moreover, we see free cash conversion at ~3% by 2025, and believe this fits the thesis that acquisition activity and product development to market will remain the focus and priority use of cash over this time frame. Given the significant expansion to enterprise value over the last 4 years, from ~$790 million to $5.9 billion most recently (on a $5.9 billion market cap), it is not unreasonable to anticipate financial performance to translate into upward share movement over this time period.
Figure 5. Forecast and key financials summary- CAGR ~48% at the EBITDA level is being overlooked by the sell-side and market alike.
Data Source: NEO SEC Filings; Author’s Calculations
What About The Investment Case, Though – Can One Secure An Oncology Pure Play, With The Language Amongst Asset Managers of Sector Rotation and A Correction in Equities?
Firstly, the market’s view of NEO has been one of under-appreciation, by our view. Shares have seen ~85% upside YTD, in a year that has really catapulted the investment case for NEO, based on the fundamental and technical momentum. For those holding NEO in market or beta neutral portfolios (as we are), the name is a robust holding with only ~18% causal relationship to the wider market, and a correlation coefficient of only ~48%. NEO remains unexposed to the overall market, thereby partially immunising against the market risk, and therefore enables investors to consider positive factor loadings to more powerful common equity factors, like momentum or value, for example. This is a strategy that we employ as an objective of achieving neutrality, separating the alpha and tilting exposure to momentum and other equity factors (size, value etc.) where relevant. This is certainly critical information investors must consider in the debate, especially those holding or intending to hold NEO in portfolios.
Figure 6. NEO vs SMID indexes- notice the disconnect to the upside from November illustrating the outperformance.
Data Source: Author’s Bloomberg Terminal
Excluding the systematic exposures, the second point of discussion here is one of idiosynchronatic risk. Much of the debate here is amplified by pipeline risks, execution risks, competition, reimbursement challenges and regulatory headwinds. There are other factors for consideration too, like the map to net profitability, margin stressors and the balance sheet. We are of the firm belief that NEO remains immunised here also, especially given the track record in acquisitions as risk controls to the balance sheet, pipeline risks and execution risks, in particular. Tangibly, the remaining risk profile is meaningfully dampened by NEO’s TAM growth forecasting, the above-market growth sequence exhibited over recent times, in addition to the company’s growth vision of up to 70 new tests for each forthcoming year. Add in NEO’s market-leading position as an additional risk control, and the points such as competition and regulatory headwinds are significantly levelled also.
We would also point investors to the fact that testing remains the critical regimen (not just a critical, the critical) that governs all major therapies, notwithstanding its absolute quintessential role to stem oncology treatment guidance. So NEO’s location at the testing and diagnostic stage of intervention, directly impacts the downstream of eventual therapy in a big way. This includes the shifting treatment paradigm of prevention over cure in the current narrative, whilst integrating technology and cloud-based testing platforms into the process. If NEO continues along the accuracy and breadth of offerings route, there is no question that they will remain at the forefront of any shift in paradigm to the view of disease.
Moreover, in relation to peers, NEO’s profitability is far ahead of the herd, again bolstering the investment case. We would also point investors to the fact that NEO’s speed of innovation must be factored into the investment picture also. Over the last decade or so, the concept of an “economic moat”, which we prefer to call the operating or company bastion, has been balanced by the concept of speed of innovation. One simply cannot deny the fact, that the most successful names in a myriad of industries have been underscored by the concepts of the bastion and speed of innovation. NEO remains at the tip of the spear here, especially given the growth vision of up to 70 new tests a year, heavy acquisition targeting and widening penetration vs just going deep, which each add fuel to the cadence of innovation. When competitors are fulfilling pipeline progression, NEO already has advanced onto the next panel of testing, or developed the next complementary mix to clinical diagnostics, for instance. We would strongly urge investors to consider this fact in all investment debates aside from NEO, as speed of innovation has become one of, if not, the most powerful indicator to company outperformance over the last decade. Now, as NEO drives sales volumes via the existing product suite, this will only expand, as the speed of innovation snowballs and continues to gain traction with more optimisation and integration of automation/technology. Ultimately, this serves investors via free cash conversion, value creation through share growth and longevity in both. Each of the factors listed in this section further illustrates the disconnect in underlying value and current price distribution, and we call for NEO shares to converge to the upside based on the underexploited opportunity that has been overlooked by many analysts.
In consequence to the above, we feel that NEO is parallel with our definition of HQ-GARP, which expands beyond the traditional explanation of GARP by adding in the two themes of the company bastion and speed of innovation. Both themes add additional layers of insulation to the portfolio, and therefore translate into NEO’s valuation, which certainly commands a premium, by our best estimation. As such, shares are trading at a significant premium to peers on a multiples basis, which is certainly warranted. Trading at ~13x EV/sales, and ~9x book value both represent significant value creation for shareholders, albeit at quite reasonable absolute (versus relative) figures. The market has overwhelming expectations of shares at 183x P/E, and shares also trade high at 77x Q3 EBITDA. We would point investors to the fact shares are trading at ~33x gross profit on an EV and market cap level (TTM figures). We have begun to prefer using gross profits in our valuation analyses, as gross profits are cleaner (versus EBITDA) and have greater forecasting power based on previous trajectory. Therefore, shares command a premium, and are attractive on a valuation front, thus supporting the thesis of the bastion and speed to innovation.
Figure 7. Comparables Multiples Analysis
Data Source: Author’s Calculations
We assign a 2.5x premium to our 33x EV/Gross profit multiple, which gives us a forward multiple of 41.24x in this segment. The premium reflects the above-market growth sequence over the last 10 years and aligns NEO to other high-growth names in the overall market. Therefore, assigning this forward figure to our 2021 gross profit estimates of ~$185 million (base case), we see a price target of $64, highlighting the disconnect in valuation to current market pricing. Assigning the same premium to 2022 gross profit projections, and discounting back to today at 11.77%, we see a fair value of $67. This hurdle rate signifies the opportunity cost of holding a 10-year treasury and the S&P 500 expected return over the same horizon. Both scenarios show 20%-26% upside on today’s trading (subject to change with publication times) and meet the hurdle and then some, representing a meaningful return over the opportunity cost of holding securities with lower risk baked into the potential outcomes. Again, the majority of price target ranges lie within the $55-$60 range, and do not accurately reflect the value of the future cash flows that NEO may meaningfully generate over the next 5-10 years. We believe at least $5 of fair value has been unaccounted for in the current bullish commentary, and feel that investors are at a disadvantage if/when relying on these analyses alone.
Thus, we firmly believe that the market is under-reflecting NEO’s potential as a market leader, and may be unfairly discounting NEO shares, whilst also discounting the acquisition power and expertise in oncology. We feel that shares are worth north of $60-$64 even in the downside case, and given the fundamental and technical momentum exhibited this year, we feel that there is high probability of NEO shares converging to the upside in the coming periods.
On the charts, shares have exhibited a remarkable performance YTD, climbing northwards since the selloff in March. Since November, shares have made the break away from the mean return level, recently breaking the upper resistance ceiling, as observed on the chart below. Investors can witness the mean reversion activity YTD via the red line in the regression channel, and see that pricing distribution has held support/resistance at the defined levels within these bounds, as exhibited. Given the recent breakout, along with the speed and direction of the near-term upside, we firmly believe that the market is confirming our thesis that shares will converge to the upside towards our price target over the coming periods.
Figure 8. Pricing distribution YTD
Data Source: Author’s Bloomberg Terminal
Given the combination of relatively mild market correlation and positive factor loading to momentum and on balance volume this year, recent upticks in both validate the strength and direction of share movement in the coming periods. Shares have recently breached the RSI 70 level and into overbought territory, although given the causal relationships to the momentum factor, pricing distribution has remained northward. Nonetheless, investors should keep a close eye for a pullback towards the mean return level, as has occurred repeatedly this year, as indication for immediate entry and allocation. Tracing in at or slightly below the mean return pricing point seems to be in the $45-$50 ranges, based on tangible evidence from the chart above. On balance, volume is exquisitely strong at present, and the momentum level supports the bullish picture, therefore any retracement towards the mean will be balanced by continued convergence to the upside, in our view. Autocorrelation of OBV and momentum over the course of this year, confirms the causal relationships between the 2 and pricing distribution across the testing period. Thus, those holding NEO in more market neutral portfolio strategies will benefit from positive factor loading towards these equity factors on this evidence, so it seems. Based on this, we would encourage investors to focus on reversion activity over the coming periods for entry.
Figure 9. Positive factor loading to momentum/OBV drives upside
Data Source: Author’s Calculations
NEO has high potential to convert on fundamental momentum that has garnered speed over the previous 5-10 years into the coming periods. The market is under-appreciative of many factors raised throughout this analysis, and is unfairly discounting NEO shares away from their fair value of $64-$67, by our view. The company has the potential to become a market-leader in oncology diagnostics and overall oncology services, by our view, and is well positioned to capitalise on widening addressable markets over the next 5 years at least. Given the growth vision, that seems to consolidate a plethora of oncology services and diagnostics under the one roof, NEO should remain on track to maintain the cadence of acquisitions and tuck-ins to expand the product offerings within the portfolio, whilst keeping a lid on operating expenses and R&D spend.
There are several risks that must be factored into the investment debate, and although we feel NEO mitigates the majority of these via the business model and market’s view of shares, they still remain present and deserve to be recognised. Firstly, there are pipeline risks that must be considered, including the goal to launch up to 70 new tests per year moving forward. That’s seven-zero. It’s a phenomenal feat, and requires utmost diligence and dedication to converting this number to market. Additionally, there runs the risk that future acquisitions may not integrate successfully, and that the company may actually have to pay a premium to close transactions for high quality names. Moreover, there are execution risks that the company may lose some of its market positioning as an oncology leader, and that the plan to consolidate as a full house of oncology services may fail to be as successful as planned.
Moreover, shares are trading at a premium, which is certainly warranted, but investors should consider the potential sector rotation language that is triangulating amongst asset managers at this point in time, especially with record high valuations, plus an unforgiving forward and yield curve that feeds into that scenario. Thus, equities in total may be seeing a correction towards more realistic valuations. Offsetting these last 2 risks are NEO’s low correlation to the market movement and our definition of NEO as a quality company, which may therefore quantify the name as a value play, especially considering the disconnect in pricing to our valuation of $64-$67. Additionally, should downside risks come to fruition, say in the downside scenario, we believe shares are still worth ~$60-$64, meaning there is a marginal effect on valuation given exposure to the downside.
In any respect, we feel that NEO is one for the future, and that shares have high probability of converging to the upside based on the points raised throughout this analysis. It is quite unfortunate that most of the neutral and/or bullish commentary have overlooked most of the upside drivers, and failed to factor in underlying growth levers like acquisition strength and the superior business model. We look forward to continuing the story on NEO into the near future, and investors can expect additional coverage over the coming periods.