• The U.S. Preventative Services Task Force’s Colorectal Cancer Screening Draft Recommendation issued yesterday is devastating for Exact Sciences’ only product, Cologuard.
• I think this is the beginning of the end for the company.
• My price target for the stock a year from now is $3, so I shorted more yesterday.

Also, attached are the slides I presented on it at the Robin Hood Investors Conference a year ago (also posted at: www.tilsonfunds.com/EXAS.pdf).

2) After the close today, Lumber Liquidators announced a settlement with the DOJ over its Lacey Act violations, and it turns out that the predictions I made two years ago were exactly right. Here’s the slide from when I first presented this short idea at the Robin Hood Investors Conference two years ago (on Nov. 22, 2013), when the stock was at $115.36 (I’ve posted the entire presentation, as well as subsequent ones at www.tilsonfunds.com/LL.pdf; in addition, I’ve posted the 18 articles I’ve published on LL since the 60 Minutes story aired on 3/1 at: www.tilsonfunds.com/LLTilsonarticles.pdf):

As I predicted, the company got off with little more than a slap on the wrist in terms of a fine, but we now know that it was, in fact, buying illegal wood, so coming under investigation, which pressured the company to buy legally, disrupted its supply chain and materially impacted margins, which was a significant contributor in the stock’s complete collapse.

A couple of quick thoughts:

1. a) As Lumber Liquidators admits in its press release, the settlement announced today has nothing to do with the much bigger poisoning-customers-with-formaldehyde issue:

The Company is continuing to cooperate with other agencies, including the Consumer Product Safety Commission, CARB, Securities and Exchange Commission and U.S. Attorney’s Office for the Eastern District of Virginia, with respect to additional ongoing inquiries and legal proceedings unrelated to today’s announced settlement.

1. b) On the first page of the 8-K the company just filed – but notably absent from the press release (gee, I wonder why?) – is this paragraph:

LLI also has agreed in the Plea Agreement to implement an environmental compliance plan (the “Compliance Plan”) for a

probation period of five years. If LLI fails to implement the Compliance Plan within three months of sentencing, it has

agreed to cease the importation of hardwood flooring until the DOJ determines that the Compliance Plan has been

satisfactorily implemented. During the first four years, LLI has agreed to engage an outside consulting firm to conduct

audits of compliance with the Compliance Plan and certain requirements of the Lacey Act.

In the rest of the 73-page document, there are enormously detailed compliance requirements.

This reinforces my point above: the real cost of this settlement isn’t the fines but the scrutiny and the costs associated with it. Whatever Lumber Liquidators has done to date to clean up its supply chain, it will have to do much more going forward under this agreement because both the DOJ and “an outside accounting and/or environmental consulting firm” will be crawling all over the company for the next 4-5 years.

In light of this, I think it’s highly unlikely that Lumber Liquidators will be able to rebound anytime soon to even the low end of its historical operating margin in the 4-9% range, as shown in this chart:

But overall it does look like Lumber Liquidators got off easy, which is why the stock is up 10% after hours. Maybe I’ll get lucky and the stock will bounce enough for me to short more…

3) My friend Chris DeMuth in an article he published yesterday showed the stock charts of the six short ideas I’ve posted on SeekingAlpha: WRLD, LRN, LL, IOC, DDD and UNIS. I had no idea they’d done so well: among these utter bags of crap, the best performer, LRN, is down 58% and the worst, LL, 84%, and the average decline is 70%. (It is a coincidence that my price target for EXAS, $3, happens to also be a 70% decline from its current price.)

4) A spot-on Heard on the Street yesterday on GE:

But even if Trian’s own expectation proves inflated, it is right that the market has underappreciated GE’s efforts. So the stock should do better.

GE’s industrial businesses, for example, have fairly strong defensive qualities. And about 83% of the company’s industrial operating income comes from recurring services, rather than equipment sales. While Trian bemoaned the previous “lost decade” for shareholders, and said the company’s profit margins could use some improvement, the fund made clear it believes in the business.

…Trian’s plan will require some patience. GE would likely need to finish its divestiture to consider additional balance-sheet leverage, according to Morgan Stanley. Even so, Trian’s leverage target of two times earnings before interest, taxes, depreciation and amortization doesn’t seem overly ambitious for a pure industrial company.

And, if nothing else, Trian’s involvement has caught Wall Street’s attention. The stock’s waiting game may be coming to an end.

5) Below are two in-depth articles by the WSJ and Bloomberg about how pretty much every drug company, not just Valeant and Turing, has been jacking up prices at a rapid clip for many years. Here’s an excerpt from the WSJ article:

A result of this pricing power is that across 30 top-selling drugs sold by pharmacies, U.S. revenue growth has far outpaced demand in the past five years, according to a Wall Street Journal analysis of corporate filings and industry data. Revenue growth averaged 61%, three times the increase in prescriptions.

Attention has focused lately on new drugs with eye-popping prices and on a few whose price a new owner abruptly raised several-fold. But what many drug companies rely on for sales growth is a pattern of steady increases, year in and year out, on older medicines. Wholesale-price increases for the 30 drugs analyzed by the Journal averaged 76% over the five-year stretch from 2010 through 2014. That was more than eight times general inflation.

For 20 leading global drug companies last year, 80% of growth in net profits stemmed from price increases in the U.S., according to a May report by Credit Suisse.

And here’s one from the Bloomberg article:

A single, 5,000 percent price hike on an anti-parasitic drug made by Turing Pharmaceuticals garnered national media attention. But it’s just one of hundreds of smaller price increases drug companies make in the U.S. each year, a tactic the industry uses to generate more revenue from older medications.

Pfizer Inc., the nation’s biggest drugmaker, has raised prices on 133 of its brand-name products in the U.S. this year, according to research from UBS, more than three-quarters of which added up to hikes of 10 percent or more. It’s not alone. Rival Merck & Co. raised the price of 38 drugs, about a quarter of which resulted in increases of 10 percent or more. Pfizer sells more than 600 drugs globally while Merck has more than 200 worldwide, including almost 100 in the U.S.

Drugmakers have long said these increases aren’t felt by most consumers because intermediaries like insurers negotiate what is ultimately paid — meaning what they really charge for their drugs is far below the list price. Pfizer and its rivals say they can’t make those negotiated prices public for competitive reasons.

Like its competitors, Pfizer has been raising prices on older drugs in its portfolio for years. The increases in the U.S. have added $1.07 billion of quarterly revenue from mid-2012 to the middle of this year, helping limit the company’s total decline in quarterly revenue over that time period to $2 billion even as patents on blockbuster drugs expired, according to estimates from SSR, an investment research firm. In the case of Bristol-Myers Squibb Co., increasing the price of existing drugs in the U.S. brought in $435 million of revenue over the past three years, leaving the contraction of the company’s global sales at $280 million, SSR estimates show.

Well over a decade ago, I concluded that it was totally unsustainable for drug companies to charge massively higher prices in the U.S. vs. the rest of the developed world – it’s batsh*t crazy for us to allow ourselves to be the suckers at the poker table, subsidizing the industry’s global profits and allowing the rest of the world to be free riders. Thus, I have never invested in the sector, which has cost me a lot of money. It’s a good lesson that, when a market is totally dysfunctional, in which normal laws of supply & demand don’t apply, and the people/companies benefitting from the system are enormously politically powerful, then things that look unsustainable can persist for a long, long time (look at our chronically failing urban school systems for another good example).

I understand and appreciate the argument that the industry’s high profits support incredibly expensive R&D programs that develop many innovative drugs that improve the lives of millions (collectively, even billions) of people around the world. And we’re the richest country in the world, so why shouldn’t we subsidize the rest of the world – heck, that’s what we do with our military, right?

Both of these arguments make sense – but up to a certain point, not infinity.

Regarding the first argument, if I thought a meaningful amount of the pure profits resulting from endless price increases were being channeled into R&D, I might feel differently. Butaccording to the industry’s trade group, the Pharmaceutical Research and Manufacturers of America, total R&D as a percentage of total sales in 2013 was 17.9%. Even assuming that 17.9% of incremental revenues from price increases went to R&D, that still means that 82.1% doesn’t. Sure, some of this goes to incremental manufacturing and distribution costs, but the vast majority just drops straight to the bottom lines of these companies, increasing their already-fat margins and enriching shareholders and management.

To understand  how fat the margins are, here are the TTM after-tax net profit margins of the 10 largest pharma companies in the world, ranked by 2014 revenue:

1) Johnson & Johnson, 22.4%

2) Novartis, 37.8%

3) Roche, 17.8%

4) Pfizer, 18.5%

5) Sanofi, 13.3%

6) Merck, 24.5%

7) GlaxoSmithKline, 41.4%

8) AstraZeneca, 4.7% (historical net margin has been in the 20% range)

9) Bayer, 7.7% (pharma is only a small part of the business)

10) Gilead Sciences, 51.5%

Excluding the two outliers at the bottom and the one at the top (#8-10), the average profit margin is a mouth-watering 25.1%. That, folks, is where the vast majority of the endless price increases are ending up – and every single one of us is paying for it.

I’m actually somewhat sympathetic to the second argument, that it’s fair for the richest country in the world to subsidize the rest of the world, but I think things have gotten too far out of whack. Just Google “US drug prices compared to other countries” and read any study and you’ll see that we’re paying massively, not slightly, higher prices than any other country, even ones with similar levels of income/capita. I don’t think we can afford to let drug companies jack prices up at double digit rates every year with impunity.

So do I think things are going to change? Ah, that’s a different question. Most proposals that would rein in drug pricing would require Congressional action – and good luck getting anything through this Congress! But I do think we’re getting to the point where something meaningful might happen in the next few years, not decades, so this industry faces real tail risk (how much of a risk may depend on who the next President is and which party controls Congress after the election that is only 13 months away).

In the meantime, I do think that there’s so much public scrutiny right now that drug companies are going to be forced to significantly reduce the rate of price increases. I’d be shocked, for example, if the prices of the top 30 drugs rise 76% in the next five years, as they have in the last five.

6) An interesting article about Seth Klaman and his 1991 classic, Margin of Safety, which was very influential for me:

In October 1991, an unknown hedge fund manager published a book. A tight 249 pages, Seth Klarman’s Margin of Safety was by all contemporary standards a commercial flop. His publisher, he said, “didn’t do a very good job. Didn’t advertise it. Editors kept getting fired—I don’t think because of me—and by the third editor we finished the book, and then it sold about 5,000 copies and it died out. It was dead. It died.”

Except that it didn’t.

As the 25th anniversary of the hardcover’s publishing approaches, few investing books are more coveted than Klarman’s. Of the 5,000 original copies, Amazon lists only 13 for sale. The cheapest version of the once-$25 book, in “acceptable” condition with only “minimal highlighting/markings,” is a relative bargain at $1,396.77. “Very good” copies run nearer $2,000. “New” copies—whatever that means for a book out of print since the twilight of the Cold War—go for $2,899.95. My copy—advertised as “used, good, book & dust jacket are in good condition” and shipped to my offices in New York City—cost $1,601.99.

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Why Exact Sciences Is A Great Short At $10

Whitney Tilson

Oct. 7, 2015 9:46 AM ET

Disclosure: I am/we are short EXAS. (More…)

http://seekingalpha.com/article/3555646-why-exact-sciences-is-a-great-short-at-10

Summary

• The U.S. Preventative Services Task Force’s Colorectal Cancer Screening Draft Recommendation issued yesterday is devastating for Exact Sciences’ only product, Cologuard.
• I think this is the beginning of the end for the company.
• My price target for the stock a year from now is $3, so I shorted more yesterday.

The shares of one of my largest short positions (~3%), Exact Sciences, crashed by more than 46% yesterday to close at $9.98 after the U.S. Preventative Services Task Force’s Colorectal Cancer Screening Draft Recommendation listed Exact’s sole product, Cologuard, a poop-in-a-bucket screening test, as an “Alternative Test” rather than a recommended one, and said numerous damning things such as:

• The USPSTF found no studies that assessed the impact of screening with FIT-DNA [Cologuard] on cancer incidence, morbidity, quality of life, or mortality.
• Evidence on the optimal screening interval, if any, is lacking.
• A theoretical concern about FIT-DNA is whether its use might lead to more frequent and invasive followup testing in persons who are not at increased risk of colorectal cancer because of patient or clinician concerns about abnormal DNA results.
• There are no data that evaluate how to implement FIT-DNA into a longitudinal colorectal cancer screening program.
• …empiric evidence is lacking on appropriate followup of abnormal results, making it difficult to accurately bound the potential net benefit of this screening test.

I haven’t written about Exact Sciences prior to now because it isn’t a fraud/scam or doing nefarious things like so many of the stocks I’ve written about on Seeking Alpha (see Chris DeMuth’s summary of my calls on WRLD, LRN, LL, IOC, DDDand UNIS). Exact has a real product that addresses a very serious problem, the low screening rate for colorectal cancer, the second-leading U.S. cancer killer. Nevertheless, I felt (and still feel) that it’s a great short because the test has significant drawbacks that will severely limit its adoption and, in light of this, the valuation is absurd.

While I’ve never published an article about it before now, I did pitch this stock as my favorite short at the Robin Hood Investors Conference a year ago when it was at $24.22 (click here to see my slide presentation). In light of the 59% drop in the stock since then, it might appear to have been an easy short, but it was anything but. I first shorted it at $14.22 in April 2014 and watched it soar over the subsequent 15 months to a peak in late June of $32.85. This was extremely painful, but I was confident in my analysis and didn’t cover a single share – in fact, I added to the position on a number of occasions, most recently just a couple of weeks ago at $19.57 – so it’s nice to see my analysis (and stubbornness) pay off.

Why I Shorted More

Now I have a high-class problem: what to do when an investment works? While it can be dangerous adding to a short position that’s already fallen a lot, it can also be highly profitable if the stock continues to plunge, as my experience with Lumber Liquidators demonstrates.

The only rational way to think about this is to pretend like I never had a position and was looking at this stock for the first time today. In the case of Exact Sciences, I fail to see how a “single product” diagnostic company, whose test just got body slammed by a highly influential group, could be worth anything close to its current market cap of nearly $1 billion.

I expect that the USPSTF report, which could hardly have been more damning, will cause what little demand there is for the test to plunge (what physician is going to prescribe an “Alternative Test” when far cheaper, established “Recommended Screening Tests” are available?) and many good salespeople to flee (one friend, who knows many Exact salespeople, tells me that the sales force is in a state of chaos, hardly surprising since most of their options are now underwater). As a result, I think the company is likely to miss analysts’ revenue estimates by a country mile. Specifically, Cannacord and Wedbush, in their latest reports, predict 2016 revenues of $112 million and $113 million, respectively, which I think is laughable.

In Q2, Exact’s revenues were $8.1 million, which analysts expect rose to $12.6 million in the just-ended Q3. I have no view on whether Exact will meet this number when it reports earnings at the end of this month, but I have a strong opinion that the company has almost no chance of meeting analysts’ consensus going forward revenue estimates of $18.2 million in Q4 and $139.8 million next year. In fact, I think Q3 may well prove to be the peak and that the company’s revenues will be well less than half what analysts are currently forecasting.

Enormous Cash Burn

If I’m right about a massive revenue miss, this, by itself, will crush the stock – but in addition, I think it will be difficult for Exact to reduce the enormous cost structure it’s built up in anticipation of Cologuard’s launch. As this chart shows, the company has been burning an average of $37 million over each of the last three quarters:

Quarterly Free Cash Flow Over the Past Three Years

Note: Free cash flow is defined as cash from operations minus capital expenditure.

Source: S&P Capital IQ

Assuming Exact burned a similar amount in Q3, then it has roughly $350 million in net cash remaining (nearly $4/share, thanks to a very well-timed secondary offering in July at $25.50), which gives the company some breathing room. But investors who think this cash provides much downside protection for the stock are mistaken, in my opinion, because it will be needed to cover the company’s large ongoing losses and thus will never be returned to investors.

Further adding to Exact’s potential problems are two agreements with the state of Wisconsin and the city of Madison. Earlier this year, the company struck a deal with the Wisconsin Economic Development Corporation in which Exact will receive $9 million in tax credits, but only “by investing $26,264,000 in capital expenditures in Wisconsin and creating 758 new full-time positions – with an average wage of $24.47 per hour – in the state by December 31, 2020.” Additionally, Exact is on the verge of signing an agreement with the city of Madison whereby the company would receive a $12 million grant to build its new headquarters in a downtown development. In exchange, however, Mayor Paul Soglin notes that “Exact Sciences will provide financial guarantees to bring at least 400 jobs to the headquarters facility and repay the city if those jobs are not created or if the jobs are relocated from the facility in the future.” These agreements will make it very expensive for Exact to downsize, should that be necessary.

Thank You, Analysts

As Exact reports the dismal sales and enormous losses I expect over the next year and the stock continues to collapse, I think analysts will eventually throw in the towel, just as they did with Lumber Liquidators. For now, though, they’re in denial: of the three reports I read Monday, by the analysts at Jefferies, Canaccord and Wedbush, not one downgraded the stock and they generally said positive things such as:

• We’d be buyers below our price target of $18;
• Initial reaction appears overdone… we continue to view Cologuard as a potentially game-changing test; and
• We expect volatility, but reiterate our BUY rating.

Tuesday morning, the Canaccord analysts issued a new report in which they took down their numbers, but reiterated their BUY recommendation and wrote: “With EXAS’ stock down ~45% following the news, but with EXAS owning a great test across a large sales force with strong commercialization intact, and Medicare unaffected (~60% of payors), we think the risk/reward is to the upside today.”

I am grateful to these analysts for propping up the stock enough for me to add to my short position above $11 Tuesday. (Hat tip to the two analysts who’ve consistently been spot-on: Dr. Cathy Reese at Empire Asset Management and Bryan Brokmeier at Maxim Group.)

My Price Target is $3

I think Exact’s stock will trade down over the next year to a slight premium to cash (which I estimate will be about $2.35/share a year from now), which would put the stock around $3, a very nice return on my short from current levels.

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3 Of Seeking Alpha’s Best, Part II

Oct. 6, 2015 7:00 PM ET  |  13 comments  |  Includes: ALJJ, CSTE, IOC, LL, LRN, UNIS, WRLD

Chris DeMuth Jr.

Value, event-driven, arbitrage, hedge fund manager

Disclosure: I am/we are long ALJJ. (More…)

Summary

As a hedge fund manager, who do I think is worth following on SA?

3 (more) writers I take seriously and think you should too.

This is the second in a continuing series.

In Part I, I looked at three of Seeking Alpha’s best contributors. In this sequel, I offer three more worth following.

• Whitney Tilson
• Ben Axler
• Andrew Walker