|Shares Out. (in M):||36||P/E||0||0|
|Market Cap (in $M):||1,200||P/FCF||0||0|
|Net Debt (in $M):||-300||EBIT||0||0|
Foundation Medicine is an early stage biotechnology firm which performs genetic profiling of tumours. Genetic sequencing is an extremely exciting field, with a potential addressable market size of over ~$15b. Tumour sequencing is likely to be the most attractive segment of this market due to the fact that tumours mutate over time, resulting in both increased informational complexity and a need for repeat sequencing. The investment thesis is that the core competitive advantage in this field will be the possession, processing, and presentation of genomic data. If this is true, a first-mover advantage will be significant, and FMI is the clear leader at this very early stage. At a valuation of ~$1.2b, only a modest probability of success is needed for the likely return to be attractive.
FMI’s core product is a service offered to clinicians. A doctor will take a sample of a tumour from a patient and send it to a FMI lab. FMI will sequence the genetic code of the tumour and interpret this code for clinical relevance. A formatted report is then returned to the clinician, which includes data on drugs (including drugs in clinical trials) which may be effective given that tumour’s specific genetic profile. Test turnaround is ~ 2 weeks. FMI also allows clinicians to find and contact other clinicians who have submitted samples with similar genetic profiles to discuss treatment options.
The transaction economics are somewhat complicated. Physicians ordering the test submit a claim to the patient’s insurer for payment. Because genomic profiling is relatively new, most insurers do not have formalised procedures or billing codes for this service. As a result, insurers will often refuse to pay or require the clinician to provide burdensome documentation of the clinical neccesity, which discourages use. Currently only a single health insurer (Priority Health in Michigan) has made a positive coverage decision for FMI’s test. Medicare does not currently reimburse for FMI’s test at all, although one Medicare administrative contractor has issued guidelines recommending payment for FMI’s tests in lung cancer. FMI currently receives approximately $3,500 per test from insurers (this calculation excludes tests were FMI is not paid). In addition to typical SG&A costs, FMI incurs CoGS relating to its laboratory equipment. The genetic sequencing equipment is currently supplied exclusively by Illumina, which holds an effective monopoly on the sequencing equipment market. Gross margins were ~50% in the most recent quarter.
2. Market structure
Traditionally, cancer is diagnosed by site of origin (lung cancer, breast cancer, etc), and treatment guidelines outline appropriate therapy for each cancer type. Over the past two decades, cancer diagnosis has become increasingly more specific due to the rise of targeted therapies (see brief review http://www.aafp.org/afp/2008/0201/p311.html). For example, breast cancer is stratified by expression of two types of receptors (ER and HER2), and treatment differs significantly depending on the stratification. These cancer subtypes are currently largely determined by older tests such as immunohistochemistry or single-gene panels. As an example, the Quest lung cancer mutation panel tests for a handful of mutations in three genes (https://www.questdiagnostics.com/testcenter/testguide.action?dc=TS_LungCancerMutation_Panel). The issue with these tests is that each feature of the cancer must be tested for independently, and some amount of tissue is required for each test.
Comprehensive genetic testing is superior to these tests as it allows for a single, small sample to be sequenced and outputs essentially all mutations of relevance. FMI’s test sequences the entire coding region of ~300 genes known to be involved in cancer. Conversely, it is more expensive (thousands versus hundreds per test), and physicians are less familiar with the results. However, the cost of sequencing is declining rapidly, and genomic information is increasingly important and well-understood by clinicians. Initially, genetic sequencing will be reserved for cases where there are multiple mutations to test for (such as lung cancer), since this minimises the cost discrepancy. Eventually, I believe all tumours will be sequenced multiple times.
There is moderate quality evidence for the superiority of FMI's comprehensive testing relative to existing alternatives. One published analysis (Oncologist. 2014 Jun;19(6):616-22.) revealed that across 103 samples tested, 83% were identified to have an actionable mutation (shown below). Only 21% of these did end up receiving targeted therapy based on these results, highlighting that clinical practice has much further to go before it can fully utilise the data being generated, but the results are none the less highly promising. These figures are comparable to FMI-sponsored studies (Nat Biotechnol. 2013 Nov;31(11):1023-31). Another study, conducted at Memorial Sloan Kettering (MSK), found specifically that patients whose tumours tested negative using non-comprehensive genetic testing still benefitted from FMI's test (Clin Cancer Res. 2015 Jan 7. [Epub ahead of print]).
3. Competition & sources of competitive advantage
There are four key competitive forces I believe relevant to this market:
Firstly, the breadth of genomic data possessed will be an important differentiator. FMI has sequenced 43,000 clinical cases cumulatively to date and plans to sequence 45,000 in F2015 (cf. 24,000 in 2014). While these numbers are small, competition is mostly non-existent at present. Currently, the closest analogue to FMI’s test is MSK-IMPACT, a test developed by MSK. MSK-IMPACT is processing roughly 600 samples monthly, approximately one-fifth of FMI’s volume. MSK is a non-profit; the lack of notable commercial competition highlights the challenges of operating in this segment (reimbursement) but also the large lead that FMI has over competition. While competition will undoubtedly arrive (many firms have announced various plans and development pathways), the conclusion to draw is simply that FMI will have a significant data advantage when this competition does begin to gain market penetration.
The importance of this data is difficult to overstate. See natey1015’s write-up of Myriad to understand the benefit in interpreting mutations that arises from having the largest genetic database. Note that for Myriad, the advantage referred to mutations in only two genes (BRCA1 & BRCA2), while FMI will have a lead in the 300+ genes it sequences, including many extremely rare mutations. Like Myriad, there is a risk of public backlash, and open databases of clinical variants do exist, although these are impaired by poor standardisation and quality checking. The ability to contact other clinicians and discuss rare mutations will also lead to network effects.
Secondly, clinician familiarity and habituation are important. Unlike simple serological tests, genetic testing is complex and many community physicians have only a basic understanding of the relevant principles. As a result, it will be important to standardise reporting and provide clinicians with an easily usable interface. While anyone can design such an interface, FMI’s head-start and prominent technology credentials (Google is an investor and has a board seat; FMI tests are covered for Google employees) will be an advantage.
Thirdly, distribution and payment contracts are important, and in these areas FMI is at a disadvantage to larger players such as LabCorp and Quest Diagnostics. Both these firms have discussed moving into genomics, although the opportunity remains somewhat small relative to their overall businesses. This issue was also partly addressed by the recent collaboration agreement that FMI signed with Roche (which now owns 57% of the business). Roche will provide marketing support in the US and take over commercialisation ex-US.
Finally, the sequencing technology will potentially be an important determinant of market power. As mentioned, currently FMI uses Illumina equipment to perform all its sequencing. Illumina has a dominant market position, commanding ~80% of the market for comprehensive sequencing equipment. The main competitor currently is Thermo-Fisher, who have an inferior product and appear to be limiting investment in the space. Conversely, the rapid growth of the market has attracted competition, and BGI (a Chinese firm) recently announced a new competing product. While Illumina could therefore squeeze out profits from this market if it retains a monopoly position, I believe this is unlikely. Most importantly, the cost of sequencing continues to decline rapidly, and as a result, the proportion of value accruing to the equipment portion (relative to the service and information processing portion) of the product continues to decrease. Since competition in this space is mostly on the level of cost-effectiveness, even inferior competition will be sufficient to prevent Illumina from capturing too large a portion of the value. As proof of feasability, MD Anderson (a prestigious cancer center similar to MSK) have also developed their own panel using Thermo-Fisher's technology.
The key existing competition is therefore from academic centres (MSK, MD Anderson) who are not seeking to compete nationally. These highly specialised academic centres comprise 20% of all cancer care in the US. Future competition will arise from existing lab service providers (LabCorp & Quest). These already have products that utilise the same sequencing technology, although they have a much more limited range of genes tested (LabCorp's IntelliGEN panel tests 50 genes), and lack expertise at the complex informational capabilities required for more comprehensive tests. Other firms involved in genetic testing (Illumina, Thermo-Fisher, Myriad, Genomic Health, many others) have all announced some degree of intention to offer tumour sequencing services, although again their commitment and initial traction in this segment remain to be seen. FMI's first-mover advantage and (in my view) superior strategy suggest it has a strong possibility of developing a competitive advantage in this market.
4. Valuation & conclusion
US cancer incidence and prevalence is 1.7m annually and 15m, respectively. Mortality is ~0.6m. The US addressable market size is therefore likely between 1m (assuming only severe/metastatic cases are sequenced) and 15m (assuming all cases are sequenced yearly) tests annually. Assuming price per test declines to $1,000 by the time such penetration is achieved, market size will be between $1b and $15b. Assuming this takes 10 years, a 10% required return, and a 5x revenue valuation, FMI’s current stock price implies a required market-share of between 4% and 58%.
Clearly, this is a high-risk investment, and the range of potential outcomes is large. The above figures should be sufficient to demonstrate that if FMI develops a competitive advantage as I expect, the payoff will be large. For comparison, consensus estimates of 2019 revenues average $600m (range $400m to $750m). There are many moving parts not discussed here (FMI's business servicing pharmaceutical firms; the important differences in clinical utility across cancer types; the impact of immuno-oncology; size of the international opportunity) but the fundamental bet being made is that FMI's first-mover advantage will translate to a lasting competitive benefit. If it does, investment at the current valuation is very likely to be rewarding.
Growth in clinical adoption.
Reimbursement decisions by payors/Medicare.