Description

Genoptix (GXDX) is a specialized lab company focusing on delivering cancer diagnostic services in the US. The company has an innovative business model, and

that has driven an impressive growth trajectory with revenues increasing from essentially nothing in 2004 to almost $200mm in the LTM period. With revenue

growth rates averaging over 150% from 2006-2009, the stock has historically traded at a decent multiple, but with growth slowing this year, due to a number

of factors discussed in more detail below, we have seen a migration away from the stock as growth investors sell out of what can no longer be considered a

"growth stock". That has left us the opportunity to buy a solid business trading today 3.4x LTM EBITDA, or 7.5x LTM ex-cash EPS. This valuation is in part due

 to 45% of the company's market cap being held in cash ($139mm as of 9/30), with no debt on the balance sheet. This cash presents both an opportunity

and in a way, a threat to the company, but holding that to the side for a moment, the stock is simply too cheap at current levels.

Why has GXDX gone from nearly $40/share in May to $17 today? In early May, the company missed Q1 EPS and revenue projections, ending a record of

earnings beats as a public company. Management missed their own target of $50mm of revenues and actually generated $47mm (21% growth), blaming

 weather-related issues. At that time the company reaffirmed both top-line guidance of $235-240mm and EPS guidance of $1.80-1.85 (with $30mm in

capex). The stock closed down 23% that day as a number of analysts cut their targets and recommendations, and investors doubted management's

excuses.

A month later, ahead of a presentation at a sell-side conference, management cut their guidance to $210mm in revenues (14% YoY growth) and $1.20 in

EPS. They cited the following (weather clearly was not the only problem):

"However, physician practices are under intense economic pressure, which when combined with increased competitive presence in the market, is

GXDX closed down 25% that day, to $17.19.

Finally, in late September, within another conference presentation, the company disclosed a Q3 forecast of volumes and revenues down 5-10%

sequentially. They also cited a 2H 2010 EPS impact of ($0.10) for their laboratory capacity expansion and ($0.09) for their sales and marketing

expansion. These were below expectations, so while they did not address the full year guidance at that point, the implication was that we would

likely see another reduction. Predictably, the stock was down 11% that day to $14.65, with another couple of analysts cutting their recommendations.

That leaves us, for what it's worth, with 1 "buy" and 10 "holds".

Since then, GXDX has recovered somewhat, particularly as their Q3 revenues were only down 3% sequentially (up 3% YoY excluding changes

in accounting estimates in each period). The business appears to have stabilized after absorbing the multiple challenges presented by price

competition (from both the larger labs and smaller, local labs), payer pushback, and the economic environment potentially driving patients to

delay tests. Importantly, the company has reported that ordering customers (doctors) have grown this year to over 1,350 (after a period

where that figure remained flat), and most critically, the company's average price per test has remained at ~$3,100, in line with prior quarters and

the company's expectations going forward. This is especially notable because earlier in 2010, GXDX signed a contract with Aetna as a major

commercial payer (a strong endorsement of the service GXDX provides), and has not seen any price pressure as a result. The company anticipates

 signing another contract with a major commercial player before the end of the year. For what it's worth, our checks suggest while competition has

 increased, volumes and prices are in fact stable currently.

As Medicare rates have set the floor for GXDX ASPs, any changes there must be monitored. This appears to actually be a tailwind for the company

in 2011. Based on recently released CMS Medicare Physician Fee Schedule Final Rule, and assuming the physician fee schedule fix remains in place

 as is (a move that Congress is likely to make during this lame duck session), management has guided to an incremental increase of up to 5% of

total revenues in 2011 (more detailed guidance to come early next year).

What might GXDX do with their cash hoard? The company has spoken repeatedly about growing their solid tumor offering and expanding beyond

their current blood / bone marrow focus. They may also invest in other IP-related products, e.g. licensing agreements, which would allow them to

 leverage their sales force and lab facilities. The expansion of these assets (the sales force grew to 90 reps this year vs 65 a year prior) have actually

 hindered margins and cash generation in 2010 as management ramped up for expected volume growth which was not achieved; we would expect

 the company going forward to grow into this fixed cost base, supporting margins.

Company Description (per 10K)

"We are a specialized laboratory service provider focused on delivering personalized and comprehensive diagnostic services to community-based

hematologists and oncologists, or hem/oncs. Our highly trained group of hematopathologists, or hempaths, utilizes sophisticated diagnostic technologies

 to provide a differentiated, specialized and integrated assessment of a patient's condition, aiding hem/oncs in making vital decisions concerning the

 treatment of malignancies of the blood and bone marrow, and other forms of cancer. Our key service offerings, COMPASSSM and CHART®, are designed

 to meet the specific needs of community-based hem/oncs. Our COMPASS service offering includes the determination by our hempaths of the appropriate

 diagnostic tests to be conducted and the performance of these tests. We then evaluate, synthesize and summarize the results into an easy to read

comprehensive report, and our hempaths are available to interpret these results jointly with the hem/onc, giving them the benefit of our expertise and

analytical experience. Our CHART service offering combines multiple COMPASS assessments and analyses of disease progression after intervening

 clinical action, providing the hem/onc with a valuable diagnostic tool to track both a patient's disease and response to the hem/onc's prescribed

 treatment regimen over time."

Is M&A a Likely Outcome?

Recent deals in the space, while not all necessarily comparable, suggest that cancer diagnostics is a consolidating industry. In particular, LH purchasing

 Genzyme Genetics, GE purchasing CLRT, and MCK purchasing US Oncology Holdings all point to large healthcare players bolstering their offerings in

cancer diagnosis and cancer care. The valuations have typically been quite large in these deals, and while avoiding reading across to GXDX, it would

 seem safe to say that any transaction, were it to occur, would have to be at a substantially higher valuation than today's trading level. Furthermore,

 arguably the two best fits - LH and DGX - have the capability and desire to do deals. And in this respect, GXDX's cash balance - and resulting valuation

 - represents a threat to its independence.

Per the 10/20 DGX earnings call (CEO Mohapatra):

"We generate strong cash flow. We have committed  to deploying  our cash to drive growth. Our preference is to invest in acquisitions primarily in

genetics, esoteric testing and cancer diagnostics including anatomic pathology. We are active in evaluating important sale acquisitions that make

economic and strategic sense."

 "Well, we have a very active program on M&A and we constantly evaluate what is available. But we are primarily focused on the M&A which is going

 to help us our genetic, esoteric and we'll always take fold-in libraries and all laboratories or the hospitals, so I think it boils down to what makes

economic sense and what makes strategic sense. And we're very encouraged about what is available now in cancer diagnostics and in the genetic field."

Catalyst