Guardant: Double-Digit Sales Projections Come At A Cost (NASDAQ:GH)

Investment summary

Following my last publication on Guardant Health, Inc. (NASDAQ:GH) The stock has drifted sideways and it looks like “hold“ was the right call.

In that report, I noted several factors that I believed would keep GH shares compressed. In particular, price-implied expectations suggested the market had a high required rate of return embedded into GH’s stock price. This meant the company had to produce stellar results to surprise investors. Sales growth was noted to be tremendously strong, and the revenue ramp had been linear since 2021. This was a positive.

Since then, there have been multiple updates to the investment debate, which I will delve into here today. I will also share the revisions I’ve made to my modelling on the company that incorporates these new developments.

Investors have clearly recognized the potential of GH’s sales growth, pricing the company at more than 5x sales as I write. This valuation reflects an exceptional growth forecast of 22–24% over the coming years.

Net-net, I continue to view GH favourably as a company and am inspired by its recent successes in the colorectal cancer testing domain. Unfortunately, this does not mean it is a successful investment at this point in time in my view, based on the core investment tenets I use. In that vein, I rate GH a hold on the grounds of fundamentals and valuation.

Recent developments

1. Shield blood test vote of approval

In late May, a panel assembled by the FDA majority voted that GH’s collateral cancer (“CC”) screening test, the Shield blood test, is safe and effective for patients. According to the World Health Organization (“WHO”), CC is the “third most common cancer worldwide accounting for approximately 10% of all [cases]”. It is also the second leading cause of oncology-related deaths in the world.

The WHO also mentions that CC is often diagnosed at an advanced stage, rendering treatment options to a select few. Consequently, there is a large need for a remedial and medical breakthrough in this domain, and this could be achieved through diagnostics in my view. It is critical to have an early diagnosis, thus, screening tests aimed at this point “upstream” from a CC diagnosis are a no-brainer in my view.

In that vein, this could potentially lead to a short-term thrust in sentiment to lift the company’s stock price. This is evidenced in the post-announcement drift, which has already seen investors add another $2–$3 per share in capitalization after the vote.

However, demand had arrived in the stock well before the announcement when it began to curl up from lows of ~$15–$16/share. The company’s Q1 numbers (discussed in further detail below) were the major catalyst leading into the Shield announcement. On the call, “Shield” was mentioned 29 times. And, most critically in my view, management’s updated guidance for 2024 (which I outline below) “doesn’t include any revenue contributions from screening, which are dependent on the timing of Shield FDA approval and medical reimbursements coverage.“

The move was interesting after FDA staffers commented earlier in the month on the Shield test’s potential risk of missing the detection of advanced adenoma (“AA”) in patients. For reference, AA is the primary precursor for CC.

However, the FDA supported the idea that the Shield test could improve screening rates and thus earlier detection of CC in adults aged 45 years plus.

Consequently, the Shield approval is a short-term catalyst that keeps me interested in this company and its stock. With shares rallying from the $16s to the $31s, as I write, it would be unwise to stay trigger-ready from the sidelines, for 1) improving fundamentals (i.e. operating earnings), and 2) valuations to cool off.

Figure 1.

Q1 2024 earnings insights

As far as growth is concerned, Q1 2024 was a good period for the company. GH did $168 million worth of business, up 31% on Q1 last year’s sales. Growth was underscored by a 20% increase in reported clinical tests to c.47,000 and a 37% spike in biopharmaceutical tests sold to ~8,500. It pulled this to gross profit of $103 million, a margin of 61% that decompressed 300 basis points year over year. This was driven by a better price mix in both operating divisions.

Management has revised its FY 2024 guidance following the quarter. It now projects 20%— 21% growth at the top line, calling for $685 million in revenues at the upper end of range, versus $670 million previously. It looks to clip 61%—63% gross margins on this, an increase of 100 basis points on the prior range. It expects to produce free cash outflow of around $285 million on this, an improvement from the $330 million forecast previously.

As I mentioned earlier, these forecasts don’t include any screening revenues, which have yet to be baked in following the Shield test’s vote of approval in May. Without clarity on the same, I do not want to speculate on this matter just yet, and would prefer to wait until Q2 earnings for more visibility.

Regarding the divisional breakdown of the Q1 top line-

• Precision oncology sales pulled to $156 million for the quarter, up from $113 million last year. This was underlined by 40% growth in biopharma test volume. Management said this was due to the strong pipeline it entered the year with and still expects additional volume growth in biopharma tests for the remainder of this year.

• Development services put up around $12.2 million of business, in line with management expectations. There were no obvious takeouts from this division during the quarter.

Management also noted that it has continued to increase the average sales price (“ASP”) of the Guardant360 liquid biopsy test for around 12 months now. It is now in the range of $2900-$2950 – above the forecasted range of $2050-$2900 outlined in prior calls. This is a potential tailwind to revenue moving forward, and the fact it is filling demand at these prices is good evidence of the market’s uptake of the product, in my view.

Despite the excitement following 1) the company’s Shield test approval with the FDA, 2) continued sales growth, and 3) revised FY 2024 guidance, in my view, they are not enough to change the fundamental economics of the company just yet. Not for my core investment tenets – we need more flesh to put on the skeleton.

Fundamental economics supporting hold rating

In the last GH publication, I illustrated the divergence in top-line growth to operating-line growth over the last two years. For the company, this isn’t necessarily a negative. Obviously, sales growth is the game’s aim for this name, given its efforts to establish its market footprint and introduce CC and liquid biopsy tests to the market. Higher revenues signal more tests/screens shipped out the door.

The fact pattern of how management is embarking on this route is quite interesting. What I want to see in a company focusing on rapidly growing sales is gross asset value that remains in check. In other words, assets shouldn’t be growing faster than revenues.

Secondly, I look for the amount of gross profit rotated back from the assets employed on the balance sheet. I have done this for GH in Figure 2. As observed, the company is rotating back around $0.21 in gross profitability for every $1 of assets employed in the company. All operating and non-operating assets are included here. As a positive the company is operating on fewer total assets today in than it was in 2021.

Figure 2.

This is important because the company has exquisitely high cash and marketable securities as a function of its total asset value. When you strip the capital tied up in marketable securities, the company is much “leaner“ from an asset intensity perspective.

For instance, in the March 2024 quarter, it booked total assets of $1.7 billion on the balance sheet against marketable securities of around $1 billion. Stripping the former out of the equation, this amounts to $676 million in assets on total liabilities of $1.6 billion (Figure 3). Given that the company is cash flow negative, it is perfectly reasonable to suspect it is holding this cash ratio so high as a liquidity buffer.

Still, I do not see management deploying to an advantage, or really deploying it at all in areas outside of 1) R&D and 2) marketable securities. This is illustrated in Figure 4. You can see from 2022 that when we entered the new interest rate cycle, management began diverting cash heavily to marketable securities on an incremental basis. At the same time, investment to R&D and capital expenditures has tracked lower.

Figure 3. Most asset value tied up in cash & marketable securities

Figure 4. Note the divergence in cash etc. to R&D, CapEx

For what it’s worth, of the inventory and receivables the company has got cash tied up in, it is turning over these values relatively quickly. Figure 5 illustrates the inventory and receivables turnover on a 12-month basis since 2021. As seen, the company turns over its inventories around 3–4 times every 12 months. It has been turning over receivables faster, from around 4x in 2022 to over 7x in the last 12 months.

Figure 5.

Updates to forward estimates

Consensus expects strong revenue growth from the company over the coming three years, averaging around 20% annually, against earnings growth of a similar amount. This would bring the company’s sales to $680 million this year and $811 million in 2025. If consensus turns out to be correct, this is a steep revenue ramp, as seen below.

Figure 6.

I have made the following revisions to my modelling after the company’s Q1 numbers (Figure 7). I align with consensus estimates of $680 million in sales by the end of this year. In my view, this could take an investment of $80 million—$160 million on capital turnover of 0.4x.

The problem is, if the consensus figures (and my own) are what is priced into GH’s current market value, then this leaves me little room to expect investors have priced the company incorrectly. In other words, my numbers don’t deviate from Wall Street, and therefore, I can’t say I hold a different posture from what is already priced in. I hold a neutral view.

Figure 7.

Valuation

The stock is still priced for exceptional growth and has high expectations embedded in it at the current multiple of 5x trailing sales of $564 million. If the company does hit the projected revenue growth rates outlined in this report (~21%), at the same 5x multiple—which is high in my opinion—the company is worth around $3.4 billion to us today, marginal upside of where it currently trades (5×680 = $3,400).

Moreover, if the multiple contracts to the sector median of 3.7x, even if the company hits the strong growth numbers projected, it would be worth just $2.5 billion to us under these assumptions. (3.7×680 = $2,516).

This shows the valuation is skewed to the downside. Even with tremendous growth rates, a contraction in the multiple would wipe the valuation on market by around 25% from a 26% decrease in multiple. Each of these factors supports a neutral rating in my opinion.

Conclusion

After examining the company’s recent developments and updated financials, my rating on GH remains a hold, neutralized by the high valuations it currently sells at. At 5x times sales, this is highly susceptible to multiple contraction, which could compress the company’s market value by potentially 25% if dropping to the sector multiple of 3.7x.

As such, despite impressive growth in unit volumes and dollar volumes, along with a high rate of growth projected going forward, my opinion is this is well captured in the current market value, leaving minuscule room for additional upside to the price-implied expectations. Reiterate hold.