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Why Investors Are Paying a Premium for EXACT Sciences Corporation

EXACT Sciences Corporation (NASDAQ: EXAS) operates in an industry famous for cutthroat competition that strangles profitability. In this context, the stock's 300% run-up to a nosebleed-inducing valuation this year seems ludicrous.

To see why investors are willing to pay an immense premium for a diagnostics stock, let's begin with the enormous potential for its Cologuard brand.

Room to run

Over the past several quarters, Exact Sciences has thrilled investors by surpassing its own lofty sales growth targets. During the three months ended September, the company completed 136% more Cologuard tests than in the same period last year.

Image source: Getty Images.

The blowout quarter led management to raise the number of tests it expects to perform in 2017 a few percentage points higher, but at about 570,000, the company hasn't even scratched the surface of the enormous potential market for non-invasive colorectal cancer (CRC) screening. American Cancer Society guidelines suggest around 80 million Americans should get checked out regularly, but only about 30.4 million have been following those guidelines.

Most blame patients' abhorrence of colonoscopies for the low rate of compliance. Depositing your "sample" into a Cologuard kit isn't pleasant, but the painless process can be completed in the privacy of your bathroom and won't force you to miss a day of work.

At about $500 per test, Cologuard could generate more than $5.5 billion in sales each year if just 40% of the eligible U.S. population begins using it at recommended three-year intervals. Even though Exact Sciences just reported a blowout quarter, at an annualized run rate of just $290 million, the company's top line still has a lot of room to grow.

Getting there

While the company's top line at the moment is a tiny sliver of its perceived potential, there are reasons to believe it can continue rising at a steep trajectory in the quarters ahead. This June, the National Comprehensive Cancer Network added Cologuard to its list of recommended CRC screenings. This helped raise the overall number of healthcare providers that have started ordering the kits for their patients 11% to 91,000 during the three months ended this September.

The Cologuard self-administered colorectal cancer screening kit. Image source: Exact Sciences Corporation.

I've never bet against Exact Sciences, but I was skeptical about whether or not private insurers would be willing to cough up more than $500 for a new type of cancer screen every three years. Even though Cologuard presents a terrific value proposition for end payers over the long term, the average American tends to switch insurers before they have a chance to reap the benefits. This is why I found it extremely encouraging that Aetna voluntarily lowered the recommended age for regular screenings from 50 to 45 years old for African Americans due to an above average CRC incidence rate in this population.

Now that major U.S. insurers have come around, the percentage of adults over 50 years old with coverage that includes regular Cologuard screenings has risen to an impressive 86% from around 72% near the beginning of the year.  

A hefty premium indeed

We can't use the standard price-to-earnings ratio to measure the premium investors are willing to pay right now because Exact Sciences still hasn't turned a profit corner. As a multiple of sales, though, the stock trades at a nosebleed valuation compared to industry peers such as Qiagen and Myriad Genetics. Both are both profit-generating pioneers of genetic cancer testing, but they trade at single-digit multiples of trailing sales.

EXAS PS Ratio (TTM) data by YCharts.

Enthusiasm for Exact Sciences' recent performance is understandable, but the stock trades at such a high premium that a minor hiccup could lead to heavy losses. Unfortunately, there are some spicy meatballs on the company's plate that could cause a major case of indigestion. 

Exact Sciences doesn't have to share the algorithm it uses to combine 10 CRC associated biomarkers into a single result, but it can't stop a competitor from employing a similar technique. Without another fecal DNA test in clinical trials, Exact probably has more to fear from the rise of blood-based cancer screening procedures.

The FDA approved one of these "liquid biopsies" for CRC screening last year. Aetna considers the Epi proColon screen experimental due to insufficient evidence, but there's just no telling how much longer Cologuard will lead the non-invasive CRC screening market. Without another product to generate sales, investors might want to avoid the stock while it carries such a steep premium.

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Cory Renauer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.