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As a professional in the genomics community, I have been following Invitae (NYSE:NVTA) with great interest. However, I cannot understand why investors are so bullish on its long-term prospects when it continues to see such large losses. There are lots of ideas on how Invitae could become incredibly profitable in the future, but none of these seem validated for their particular circumstances. I wanted to write this article to question the mechanics of how Invitae will become profitable.

Invitae is democratizing germline genetic testing by making it affordable. With its low prices and execution at scale, it has grown revenues quickly. But it still keeps reporting more losses each year.

Source: Invitae 10-K data

This isn't unique to Invitae. Many of their competitors also make increasing losses, such as Fulgent Genetics and several private companies (private data). The exception is Myriad Genetics, which has diversified from the hereditary cancer testing market.

Myriad Genetics aside, Invitae's scale of revenues/losses are greater than many of its peers, as is its valuation. Investors consider its current losses as inevitable as Invitae invests extensively to maintain its growth trajectory. This is much like many other "tech" stocks; Invitae seems highly valued because fast growth in a nascent market might translate into market dominance, profitability and/or a high-valued acquisition. This figure shows how new tech markets develop over time with a winner-takes-all outcome, while the market becomes more highly valued. In the genomics industry, many of us suspect this could happen too for germline testing.

Source: PlayBigger

In addition, tech stocks often command higher multiples because their fixed costs are low, there is long-term value in the data that is being collected, and the marginal cost of adding new customers is low. Tech companies are given flexibility by their investors to sacrifice profitability at each transaction to prioritize growth as they plan to use the collected data as a revenue-generating asset.

There are reasons to be optimistic that this could happen for Invitae too. The germline testing market is indeed growing fast as reimbursements increase and expand, there is increasing awareness of genetic testing in the broader medical community, and Invitae has built a good brand and service globally.

However, as investors you may want to consider these risks.

Tech companies form monopolies because of some type of moat.

Companies like Genomic Health and Myriad Genetics also sell genomics tests, however their emphasis is on products that give them a competitive edge with discernible scientific differences. This could be through lab-developed-tests based on processes from discovery through to validation and reimbursement, and then applying a "blockbuster" financial model.

Invitae in comparison competes in the germline testing market, where there is limited differentiation between tests, creating a commodity market. These labs set up tests by assembling a pipeline using established methods that are shared across the community, free or otherwise. For example, these include mostly the same sequencing technology (Illumina), a bioinformatics pipeline often using similar tools (e.g., GATK), variant curation that uses publicly available databases to filter out irrelevant variants and identify suspect ones (e.g., ExAC, OMIM), and a scoring system for pathogenicity that is widely accepted (ACMG guidelines). The closest thing to a competitive advantage in this space is Myriad Genetics' database of BRCA variants, a large number of which are not shared publicly.

There is limited lasting advantage to be gained by Invitae in performing more testing than their competitors. Comparisons with Amazon's one-stop-shop model isn't appropriate. Amazon is a channel. Genetics is a small part of most physicians' day, so it is not likely to become a channel in the same way. If anything, the one-stop-shop needs to be a big pathology company (e.g., LabCorp or Quest), a channel that has integrated the genetic testing capabilities of Invitae.

Besides, in germline testing, loyalty is often attached to low prices. This has been shown by how easily Myriad Genetics' market has eroded once their customers were offered cheaper options.

Some labs may fine-tweak this better than others to improve efficiency. However, this does not manifest as a competitive advantage. Customers rarely do "bake-offs" to see which lab performs better for a range of difficult cases. Turnaround times are usually 2-6 weeks, with only limited demand to make this even quicker. At best, one could argue that it cuts down on costs and therefore prices, which has become Invitae's key differentiation.

Invitae's success is based on taking an established market and growing with it. Because of the lack of differentiation in this market since AMP vs. Myriad, market-leading low prices have helped grow Invitae's contracts with insurers and institutions. This is reflected in how Myriad Genetics' cancer revenues started to decrease after Invitae and others emerged with lower prices.

Source: Myriad Genetics 10-K data

An average COGS of $252/per sample compared with ASPs of $440 is too simplistic a calculation because some of their tests have multiple prices, and with the introduction of NIPT and whole exome sequencing, the cost basis for some for their tests varies. Some of their prices have been broken out in a previous Seeking Alpha article, which demonstrate how Invitae is selling below their cost for some of their tests and rely heavily on Medicare (and investors for that matter) to subsidize their price sensitive customers.

The most obvious example of selling below cost is their private-pay NIPT solution that is outsourced to Illumina at a cheaper price than what Illumina charges. I'm aware the typical prices for NIPT are higher, and Invitae also implied this in their earnings call explaining that their average COGS (currently $252) had actually increased in part due to NIPT.

Through my experience working for instrument vendors and also the labs, through several off-the-record conversations with many of their competitors globally, the gossip is that Invitae is boldly selling below cost when it needs to. I've heard that one of their competitors have considered making an official complaint about this in the country they operate in. And when I asked one of Invitae's sales reps about this strategy at a conference, she smiled nervously and crossed her fingers.

You may also want to consider this: Invitae currently makes >93% of their revenue from US markets, which for now is great for them because outside of the US they tend to sell their tests at $250. However, about half of the global market for genetic testing is outside of the US (depending on the report you read), so if they need to continue expanding, their ASPs could drop further.

At the same time, how much R&D and sales & marketing costs can they strip away? Because of its valuation Invitae also needs to maintain its growth trajectory, cutting down on these areas creates risks to their long term growth. Contracts will give them some immunity to competition, but for how long if other competitors start to provide even lower prices?

Invitae has done an admirable job to grow as they have over the last few years. But how much more funds do they need to raise to keep this up? At what rate must they continue growing at to maintain your optimism, and for how much longer, before they demonstrate how they can convert their market dominance into sustainable profits?

I don't know the answer to that. But in echoing a recent tongue-in-cheek article from The New York Times, I do know that there has never been a better time for a patient without insurance coverage to get a genetic test.

The genomics market has grown at phenomenal rates regardless of which marker you want to use. 30% per year could be inferred from Illumina's data, which is much higher than pathology in general, which for example is in the single digits for Quest and LabCorp.

There is no doubt that some areas of testing will grow fast. But only a handful of Invitae's tests have actually progressed through to routine use. A market for a pathology test is created by meeting milestones, more or less in this order: analytical validity, clinical validity, clinical utility, professional guidelines, and finally reimbursement. In different geographic regions, different germline tests have been taken through this journey. As controversial as Myriad Genetics have been, we can thank them for helping to developing the acceptance of testing for hereditary breast and ovarian cancer.

Although Invitae is trying to help generate evidence to influence professional guidelines, it is not feasible to try moving the market towards reimbursement and regular usage for all their tests. Therefore their growth challenges aren't competition with other labs, but are (a) tests that aren't reimbursed and/or (b) physicians not ordering the test when they should.

To understand (a), we can use Myriad Genetics as a comparison. Myriad Genetics identifies clinical areas of interest and develops a specific test following the process described above, validating it extensively. This will help provide evidence to influence professional guidelines and eventually get some reimbursement approvals for their unique test. This model has its own risks - it relies on trials and is very slow - but to some extent, these market factors remain within their control.

On the other hand, "by leaning on well-scrubbed, publicly available data from studies of gene variants and rare disorders, Invitae doesn't need to run lots of expensive clinical trials on its own." This suggests Invitae relies on the various markets to mature on their own, without having to contribute extensively. Whether a test for say, dilated cardiomyopathy, is considered essential and not just investigational to justify reimbursement, is not in Invitae's area of influence.

To understand (b), one the biggest problem we have in germline diagnostics is tests not being ordered when they should be. Outside of the well-known areas like cancer, when a physician comes across appropriate patients they might not remember, or even want to use the test.

Invitae themselves are aware of this risk, stating that "clinicians in other areas of medicine may not adopt genetic testing for hereditary disease as readily as it has been adopted in hereditary cancer."

Not using a genetic test may not be detrimental for patients. Often, a genetic test is seen as supplementary to the diagnosis. A patient with dilated cardiomyopathy for example, can be diagnosed and managed without germline testing. Yes, a test would help, especially to identify which of their family members are at risk. But quite often, a cardiologist can make the diagnosis without genetics. It is not essential in most cases that they see. This isn't to say that cardiologists aren't ordering these tests, but it may take a while before the majority of cardiologists start to do the same. Genetic testing instead will be taken up where it dictates treatment such as for hereditary breast and ovarian cancer. But unfortunately, many germline tests are not paired to treatment outcomes.

There's a lot more cancer testing to be done, but Invitae's growth can't just be through cancer. Quoting Invitae again: "A lack of or delay in clinical acceptance of broad-based panels such as our tests would negatively impact sales and market acceptance of our tests and limit our revenue growth and potential profitability." For that to happen for other diseases, the rate of reimbursement and broad changes in physician practice may be the limiting step.

There are other ways to grow Invitae's markets, and the direct-to-consumer (DTC) market is being considered. However, expectations need to be managed. The DTC market has grown, but most of it is for ancestry uses. Color Genetics started out focusing on reaching women and offering BRCA testing at low prices, but has had to expand its markets from the DTC market to other ones, suggesting limits to their initial market. Sema4 have articulated their difficulties in this market too. Invitae may be able to learn from these companies and get a better shot, but it won't be without increasing competition from ancestry companies themselves expanding into healthcare services.

Tech companies have relatively low fixed costs. Frankly, they don't have to sequence each user's DNA and there is supplier competition.

I don't mean to state the obvious, but unlike traditional tech companies, Invitae and others in this industry have high costs to collect, sequence, and analyze each new "user." Health datasets are arguably more valuable than social media ones, but it costs a lot more.

Sequencing costs aren't coming down as quickly as it did previously. Over 2007-2015, the cost of sequencing plummeted, but this has since tailed off.

Source: National Human Genome Research Institute

Illumina in recent years does not feel the same competitive heat they did a decade ago. Although they still have competitors in their research markets, none are close to breaking in on their grip on the clinical market. This has been demonstrated many times but most recently with Qiagen ending their own sequencer's developments and instead partnering with Illumina. As a monopoly, Illumina gets to choose when to develop lower-cost sequencing, and have previously shared that they first need to investigate the elasticity of the clinical market. In the meantime, they can continue to be the arms suppliers for all parties in this price war.

There are other costs that can't be whittled away much further, such as library prep, collection costs, and staff time. As a result, there is a floor that probably isn't too far away.

If data is expensive to generate, what is this data that Invitae is getting?

It is not yet clear how much of the data Invitae has can be reused. Patients can opt out of having their data re-used, and in Europe patients have to opt in.

Consent for further use of data is taken more seriously in the medical community than in the DTC market. Physicians I've met don't sign their patients up for data exchanges, they simply want a test that is performed for the one question they are trying to answer at that point in time. This is important to understand. Even in a values-outcome healthcare system that we are moving into, pathology is still a question-then-answer model between a physician and the lab, not this multi-use and multi-direction relationship between several physicians, the lab, and their patients. This may limit the allowance provided to Invitae to re-use the data, even when de-identified.

Invitae uses a large sequencing panel to generate data for the patient being tested. This may have changed recently with more and more labs running all tests on whole exomes so that the data is uniform, but reading between the lines into Invitae's marketing materials and their COGS suggest that this isn't routine yet. This means that the data they are collecting is both lacking (by sequencing panels only and not the whole exome or more) and likely inconsistent, reducing the power of the dataset they are amassing. Genomics England in comparison sequences the entire genome for all their patients.

In addition, it is not clear how much clinical data Invitae is getting with each sample, which is crucial to bring meaning to the genomic data. Although physicians are encouraged to provide as much information as possible when a test is requested, my experience is that most of the time you just get a few relevant snippets of information. It would be specific to the clinical indication relevant to the test ordered, not across a whole range of medical information. For example, a patient may get tested for the breast cancer genes, so Invitae may collect information on their breast cancer diagnosis, personal, and family history. But would they get information on other medical conditions deemed irrelevant at the time? Would they get updated information after the test is performed and there is no more interaction with the lab? I doubt it, because Invitae's customers are in the business of diagnostics, not research.

The research arena is designed to generate genomic data paired with a rich treasure trove of clinical data that is also longitudinal. This is what "population genomics" is about, and the high water mark is the UK biobank where an extensive number of participants are documented extensively. Illumina is tracking about 50 other programs and many of these are undertaken by healthcare systems themselves because of the extent of data required and the research context.

Invitae and other labs are also getting into this business to support these projects. These include Color Genomics and Helix - both of whom had to expand upon their earlier business models to both grow revenue and collect more data. But I haven't seen evidence to suggest that Invitae has taken any sustainable leads here.

Finally, if data is their play, I cannot fathom why they got into the NIPT market given the genomic and clinical data they would get from each patient will be limited.

If Invitae sells lower-than-cost tests even when they operate on their scale, and without a moat they cannot just flip on a switch and raise their prices once they take a monopoly, they have to use this data for some future revenue stream. What are their options?

Sales of datasets to pharma:

Pharma companies benefit from these datasets to help them identify potential drug targets (e.g., what variants are correlated with a symptom that could be targeted) or to identify patients (e.g., which diagnosed patients with a relevant mutation they could trial a new drug on). One early example of this first model is Amgen purchasing deCode back in 2012 for its database, although I have been told that this has not led to much return on investment.

Invitae's datasets may not be fully consented for their research use, and may have patchy genomic and clinical information. 23andMe in comparison has built a product for this business model, collecting extensive non-genomic information from their patients. Although their genomic dataset is sparser, it is generally consistent.

From an R&D perspective, if pharma had to choose which was more important, they may prefer better clinical information linked to sparse genomic information over deep genomic information linked to sparse clinical information. This is because the clinical information helps them identify disease/symptoms/patients, while 23andMe's genomic information might provide sufficient "tags" that they can drill down on later. The genomic dataset from 23andme, although sparse, has the advantage of being genome-wide and the tool they use is designed for this purpose. I am not sure whether 23andme generates useful clinical information - I imagine it is hard through a DTC setting - but perhaps it is more harmonized between samples because they are in direct contact with their customers. Overall, this tells me that while Invitae could try selling to pharma companies, it remains to be seen what advantage they have and whether pharma will continue making these investments.

The alternative for pharma is to generate this data themselves, as Regeneron are doing.

Sales to pharma to help them generate data:

If pharma decides to generate their own dataset, they might outsource the collection, data generation and data analysis. This is what several of Invitae's competitors do too, including Fulgent Genetics (NASDAQ:FLGT) and Centogene (OTC:CNTG).

I've noticed in comments across SeekingAlpha articles that these two services to pharma are often confused. This second example has little to do with Invitae's dataset, but more to do with treating pharma as an institutional customer and providing "sequencing-as-a-service." This is a hotly contested market as non-clinical labs also compete in this space - these are the labs that hold the vast majority of Illumina's sequencers. If you thought germline testing was a race to the bottom, this market is probably already at the bottom and will bring down a lab's ASPs even further. This is not the market you growth investors are looking for.

Selling re-usable pathology tests to doctors:

I said that pathology is a transaction business model at present, rather than this multi-sided, multi-use model. The truth though, is that many doctors would love to see this new precision medicine future where pathology does not follow a use-and-dispose model.

This fits with Invitae's "Genome management" future, where the data is potentially re-usable but Invitae has not described in much detail how this will all work. This future will no doubt come in some shape or form, but the size of this change is monumental.

Source: Invitae Q2 2019 slides

It is beyond the scope of this article to describe on how a healthcare system might go through such a large, large, change. It requires changes in the way reimbursement works, the way EHRs work, and the way physicians are trained. It will likely need large numbers of trials and other data to validate this new approach, and cross-functional cooperation and funding on an enormous scale. There are studies being completed but who can say how long this future will take to be prepared? While this is the dream for medicine and a key reason I work in genomics, the system is not in place yet and there are no consensus road maps on how we reach this "genome management" future.

This is similar to the ideal future of all of us using fully driver-less cars one day. The technology for cars seems to be getting there, but this is not the only critical development required. There are factors like infrastructure, incentives, habits, etc, that also need change but aren't easy to. Illumina recognizes this too, and this may have played a factor as to why it hasn't prioritized dropping their prices.

By being the central testing lab for a range of genomic tests, Invitae will no doubt be a valuable company when this future arrives. But they need to be careful to avoid being a "Moses company." Moses featured in the Bible's Old Testament with a vision to bring his people to a new Promised Land. Although the vision was accomplished, he died before it came to pass, and instead his successor was the person who brought the people over. Invitae's vision is inspirational, but will they bring us to this Promised Land, or will they instead be laying the groundwork for other labs to do so?

I think that while monetizing data might be a useful trick to keep up its sleeve, without a validated monetization model that will work for their particular set of opportunities and challenges, Invitae might need a more mainstream business model to reach profitability to fall back upon.

Could it continue to grow as a pathology company? Invitae doesn't seem to want to compare itself to the Quests and LabCorps of the pathology industry. But if it wants to reach even more patients, what is the path forward - especially with its financial situation?

It may need to consider selling itself to one of these big pathology organizations. Genomics is an isolated pathology discipline and won't become mainstream until it is integrated with other pathology activities. For example, many pathology tests are ordered in groups by physicians and there is convenience of using the same vendor. These can be linked together so that physicians can "reflex" from one result to the next appropriate test to order. Genetic testing must be included in this pattern in order for it to become mainstream.

For this value to be realized, Invitae could be valuable to a large pathology company, because physicians are more likely to want the "Amazon of pathology," not the "Amazon of genetics." LabCorp and Quest Diagnostics (NYSE:DGX) have already purchased other germline testing labs for this purpose. It is not clear whether this has led to any synergies yet.

Invitae continues to grow its testing volumes quickly, and as a result so has its valuation. But at some point it needs to deliver profitability, either to make money off each transaction, and/or find a new business model. Invitae has grown fast primarily because of its low prices and ability to execute testing at scale. It needs to maintain its low prices because it is otherwise difficult to create a differentiator in this market.

If Invitae waits for reagent costs to go down, it has limited bargaining power, and the floor is near. If Invitae cuts into its fixed costs it runs the risk of slowing down its growth, which is risky given how it is valued. Invitae also needs the market to continue growing, much of which is not under its control.

If Invitae wants to find a new business model to capitalize on its stockpile of data, it needs to articulate this vision more specifically and validate it with the wider healthcare community. If Invitae wants to partner with a large pathology organization, it may need to validate how genetics is integrated with other areas of healthcare.

As we have found with WeWork and other recent news stories, we need to be careful not to value non-tech companies as tech companies. Even though Invitae will benefit from tech - such as its culture and ability to raise funds, it is still hampered by restrictions found in a traditional and slow moving pathology industry, regardless of whether genomics is a little quicker.

Invitae needs to validate how it really intends to make money. I write this humbly acknowledging that I am not in a position to take these questions to Invitae's senior management themselves. And I don't take pleasure in knocking Invitae. I work in their industry, have gained from their contribution, and am excited by their growth and success. However, if you are an investor who believes that Invitae's valuation will continue to rise because it is dominating a fast-growing market and collecting interesting data, make sure you ask hard questions about how this can be materialized into profits.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Invitae Needs To Validate How It Really Intends To Make Money - Seeking Alpha

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