Novacyt Shares Plunge 40% as Government Contract in Doubt

Novacyt Profit Warning: Shares in diagnosic test specialist Novacyt SA (LON:NCYT) fell 40% as a intra-day profit warning was released revealing that its contract with the UK Government to provide Covid-19 testing has fallen into dispute. On a day where the news was dominated by the death of the Duke of Edinburgh, it could be interpreted that this mid-day release could have been buried by that news. But this was not to be. The selling continued all day and there was no signs of a recovery by the end of the day:

novacyt profit warning

Novacyt are a fascinating company. Specialising in clinincal diagnostics, prior to last year they were akin to many early stage pharamaceutical companies, being loss making and indebted. But at the start of 2020, they released a diagnostic test for Covid-19 which quickly gained international approval and business has exploded for them.

Their share price has also seen a rise which is more akin to crpytocurrencies rather than equities. From lows to 15p, the share managed to exceed that of 1200p, although even before the profit warning it has given some of this back. Today’s price is still well above the price it was last summer, and puts the market cap of the company at roughly £300m.

What did the Novacyt profit warning say?

The trading statement was put out at 12.30pm; usually a bad sign. We get straight into it:

On 29 September 2020, Novacyt announced a second supply contract with the DHSC for exsig® COVID-19 Direct kits and other products. In the full year trading update announced on 29 January 2021, Novacyt explained it was in active discussions with the DHSC regarding an extension of the supply contract. Unfortunately, an extension has not been agreed, although the Company supplied PROmate™ in Q1 2021 in accordance with DHSC demand. Regrettably, the parties are now in dispute regarding the contract, which may have a material impact on Q4 2020 revenues. However, the Company has taken legal advice and believes it has strong grounds to assert its contractual rights.

This is an extremely material contract. According to a note on Research Tree, this contract had two parts: the first one commencing in September 2020 for the supply of Covid-19 testing equipment and support for 6 months. The second part was an extension for a further 10 weeks, generating another £100m of revenue. Helpfully the RNS gives us clarity on how material it is:

Novacyt delivered revenue for Q1 2021 of €83.0 million (£72.6 million). Approximately 50% of Q1 revenue was driven by sales to the DHSC, predominately PROmate™.

Subsequently, the warning is delivered:

Given the ever-changing nature of the COVID-19 pandemic and diagnostic testing demands, the Company continues to have limited visibility over future sales. Whilst the Directors are confident new contract wins will continue as Novacyt expands international sales and into private sector testing, they believe revenue and profit for 2021 may be lower than current market expectations due to the absence of the DHSC contract extension.

The research note is referred to for these expectations: 2020 was expected to show revenues of 311.6m EUR, and operating profit of 209.3M EUR.

Ominously, the warning also goes on to hint that lost sales may not come back:

Novacyt expects PROmate™ to continue to be rolled out in hospitals, private sector settings and international markets for the foreseeable future, although the Company believes that Q1 PROmate™ sales may be sufficient to support the NHS current roll out plans for the remainder of 2021.

Presumably with the UK government making tests available for all it seems that they are sourcing tests from elsewhere. Anecdotal evidence suggests this; someone I know recently received a test in the post, which was made in China. Clearly, Novacyt don’t have a monopoly on this.

Novacyt: The Business

Novacyt’s last published accounts only covered the period to 31 December 2019. Bizarrely enough, these accounts are almost of little use. Thanks to the large scale-up in Covid-testing, the business today is much different from the one depicted in the accounts last year.

The 2020 full year update was released on 29 January 2021 and demonstrates just what had happened. Revenue increased from 13.1M EUR to over 311.6M EUR – an increase in excess of 20x. That revenue was also converted to profits, with EBITDA at 210M EUR, and also cash – the net cash balances sit at over 100M EUR, up from just 1.8m. The second half of the year showed a vast acceleration from the first half of the year.

The chief cause of this was the increase in business of the polymerase chain reaction test (PCR) by its Primerdesign segment. As we can see from the first half, revenue from this product increased in every geographical area. The main increase was in Europe:

That trend continued into the second half, with the signed UK government contract being worth in the region of £250m – although a portion of this is now in doubt.

Rather sensibly, the company has ploughed some money back into its business, further developing its Covid-testing ability and expanding to cover avian flu. They also have developed a lateral flow test for Covid-19 – this purports to be cheaper and easier and results given instantly and not having to be checked in a lab. They have also developed mobile laboratories which would further increase the ability to test.

The research reports (available on Research Tree) indicate that Covid-19 appears to be a one-off boost for Novacyt’s business. It sees revenues and profits tailing off over the years – although not entirely disappearing. Revenue in 2025 is projected to be 155m EUR, of which 29.9m is derived from the Covid test (as opposed to 174.6M EUR last year). However, thanks to investments in to other products, the business is still predicted to be profitable to the tune of 70m EUR before tax and have a cash pile of some 500m EUR – at least that was before today’s announcement.

Is the Novacyt profit warning a buying opportunity? 

This is a very interesting warning and more of a special situation given that the revenues here are artificially high; paid out by governments in a time of emergency. For value investors, there will be a lot of interest here. The market cap of 300M was underpinned by 100M EUR in cash as of 31 December last year, and it seems likely that this amount is even higher given that the Covid-19 tests in general have been highly profitable. So even assuming that the revenues from the UK do not come back at all, this would leave the business on a cheap multiple once it is cash adjusted.

There are quite a few unknowns to be had. It seems likely to me that the dispute with the UK government with regard to the contract is money-related. The profitability of the contract is extremely high, with gross margins in excess of 80%. This may not have been evident at the time of signing the contract, but in light of the results the optics look very bad, considering that ultimately it is the taxpayer that is footing the bill to deliver massive profits to private shareholders. Whilst the accounting will be more complex, this does not also sit will with the pledges from the larger pharma companies that they are not profiting from delivering vaccines.

Optics may also be poor for the company should they decide to enforce these rights. An £100m deal is likely to be worth £60-70m EBITDA and £30-40m in cash. They certainly have the firepower for a legal battle with their cash reserves but this would expose the profitability of the contracts for all to see. As we can say, the cure for high prices, is high prices themselves, and it could be that cheaper suppliers become available. The UK government already seem to be heading down this path. However, this could easily be a bluff.

However government contracts are not the only game in town. It seems quite clear that the market for diagnostics will still be large at least for the next years. Gaining competive advantage in this area seems difficult however. One metric would be reliability and accuracy. But with Covid becoming more and more well-known every day it seems that even inside a year that lateral flow tests from different companies will be as reliable as each others.

Novacyt differs from many companies that warn on profits in that there is no danger to the business. It is still extremely cash rich. It is intruigingly priced currently, although there are many unknowns. No position now, although at £1 lower I think the risk/reward looks favourable. 3/5.

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