Legendary investor Benjamin Graham, a mentor of Warren Buffett, is thought to have originated the idea of "special situation" investments. In his classic book The Intelligent Investor, Graham discussed how there can be mispricing between assets and markets.
Fulgent Genetics (FLGT 0.39%) may have found itself in a very special situation where the market is mispricing the core assets of the company due to the cloud of uncertainty surrounding COVID-19 testing.
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In the right place at the right time
For years, Fulgent was a little-known biotech company laboring away in the genetic testing field. Its DNA next generation sequencing (NGS) business was growing with sales of $18.7 million in 2017, $21.3 million in 2018, and $32.5 million in 2019.
The year 2020 was a different story. The coronavirus pandemic stirred demand for a massive amount of testing. Fulgent jumped into the COVID testing fray, propelling 2020 revenue by almost 1,300% to $421 million. Fulgent's stock price followed suit, growing from $13 in early 2020 to more than $189 at its peak. As has been the case for many pandemic winners, the fall has been steep. Shares are now trading down 60% off their highs.
What do you do after winning the lottery?
As it turns out, Fulgent is a very capable operator, and was able to scale its business to deliver the testing with both high margins and high quality. As a result, a wave of cash has been flowing over the company.
As of the first quarter, Fulgent reported $697 million in cash on its balance sheet. Even though COVID testing volumes are winding down, estimates are Fulgent will close the year with more than $1 billion in cash -- quite the windfall for a year's worth of work.
Like most people who come into an unexpected fortune, Fulgent needs to think long and hard about how it's going to spend all that money.
One logical answer is for Fulgent to continue investing in its core NGS business. Even with potential clients distracted by COVID, Fulgent's NGS revenue in Q1 was up 115% year over year and 39% sequentially from the fourth quarter. This progress in the core NGS business will undoubtedly be helped by the visibility, relationships, and reputation Fulgent developed over the past year.
Another good area of investment may be international expansion. In 2017, Fulgent formed FF Gene Biotech, a joint venture in China. The venture's focus is to pursue cancer and rare disease genetic testing opportunities in China, which is projected to be a $4.5 billion opportunity by 2030. Fulgent recently announced it would invest an additional $19 million to obtain majority ownership of the joint venture. Other international opportunities will surely come its way.
Another opportunity is to go shopping. The genomics business is full of companies with good ideas and capabilities, but that need more cash to extend the runway until their innovations come to fruition. Fulgent may find itself in a position to buy other biotech companies to widen its product portfolio, acquire technology and talent, and grow its client base. Using M&A could be a way for Fulgent to both accelerate and de-risk its expansion efforts.
The path forward for COVID testing isn't all bad
Thanks to vaccines, COVID testing volume is falling off and creating a cloud of uncertainty around revenue and valuation. However, Fulgent's operational performance during the height of the pandemic led to contracts that will continue as the market shifts to "return" testing for schools and businesses. Additionally, Fulgent was able to use its NGS platform to identify virus variants in California and has secured long-term surveillance contracts with the Centers for Disease Control and Prevention (CDC) for this important work.
What could make this situation less than special?
It appears Fulgent is on a path to replace fleeting COVID testing revenue with long-term NGS revenue. However, the backfill is not likely to be perfectly timed, which could lead to a bumpy ride for investors. The market never likes to see declining revenue. Investors can often confuse uncertainty with risk, so it's likely that additional investors will choose to exit over the coming months, putting continued downward pressure on the stock price.
The riskiest alternative for Fulgent may be to buy another company. It would be easy to make a misstep in an effort to replace revenue. Also, Fulgent doesn't have a long history of making and integrating acquisitions, so anything more than a complementary "tuck-in" could be a real red flag.
For long-term buy-and-hold investors with a tolerance (or Ben Graham-like passion) for special situations, Fulgent may be a winning addition for your portfolio.
