Castle Biosciences, Inc. — Q3 2019 Form 10-Q
Reporting period: Three and nine months ended September 30, 2019. The company is a commercial-stage dermatological cancer diagnostics business; its principal products are DecisionDx-Melanoma and DecisionDx-UM. The quarter includes the July 29, 2019 IPO and conversion of its preferred stock and convertible notes into common shares.
Financial performance and liquidity
| Metric | Q3 2019 | Q3 2018 | Nine months 2019 | Nine months 2018 |
|---|---|---|---|---|
| Revenue | $14.8 million | $3.7 million | $34.2 million | $11.3 million |
| Gross margin | $13.1 million; 88.4% | $2.4 million; 63.6% | $28.9 million; 84.5% | $7.4 million; 65.4% |
| Operating income (loss) | $4.4 million | $(2.9) million | $4.7 million | $(8.6) million |
| Net income (loss) | $5.8 million | $(3.5) million | $3.2 million | $(10.2) million |
| Net income (loss) attributable to common stockholders | $5.5 million | $(4.5) million | $0.9 million | $(13.0) million |
| Operating cash flow | Not presented quarterly | Not presented quarterly | $2.5 million | $(9.1) million |
- Revenue increased 298% year over year in Q3 and 202% for the first nine months. Test report volume rose 29.5% in Q3 and 24.0% year to date. Management attributed growth mainly to DecisionDx-Melanoma, higher test volume and reimbursement, including Medicare coverage and the test’s new ADLT status.
- Q3 basic and diluted earnings per share were $0.43 and $0.05, respectively. Nine-month basic earnings per share were $0.17, while diluted loss per share was $0.67; the filing attributes the difference to dilution/conversion accounting. Preferred dividends and accretion reduced income attributable to common stockholders.
- Nine-month results included a $5.2 million noncash gain on extinguishment of debt, partly offset by $2.9 million of other expense, including fair-value losses on notes, warrants and an embedded derivative. The notes and warrant liabilities converted or were reclassified in connection with the IPO.
- Cash and cash equivalents were $94.5 million at September 30, 2019, versus $4.5 million at December 31, 2018. Financing cash flow was $88.1 million, principally reflecting $65.9 million of net IPO proceeds and convertible-note proceeds. Investing cash outflow was $0.6 million.
- Debt principal was $26.7 million; carrying value was $24.9 million after discounts and issuance costs, including $3.3 million current and $21.6 million long-term. The term loan is secured by substantially all assets except intellectual property, bears 8.55% interest at quarter end, and principal payments begin June 2020.
- Current assets were $109.9 million and current liabilities $9.2 million. Accumulated deficit was $54.3 million.
Material changes and management outlook
- The July IPO raised $73.6 million gross and approximately $65.9 million net. Preferred shares and convertible notes converted into common stock; shares outstanding were 17.1 million at September 30. The company reported that it had not used IPO proceeds through quarter end.
- Revenue growth and operating leverage drove improved margins. SG&A rose 81.8% in Q3 and 62.4% year to date, reflecting sales-force expansion, administrative headcount, professional fees, insurance, events and travel. The sales organization grew from 14 to 23 territories, with another expansion planned beginning December 2019. R&D also increased.
- In June, lenders amended the revenue covenant from a trailing six-month to trailing three-month test and replaced the $5.0 million revolver with an increased term loan. The company said it was compliant and management expected compliance with the amended covenant for at least the next 12 months. The lenders set future covenant thresholds, and failure could trigger accelerated repayment.
- Management said cash on hand and expected product collections should fund operations for the foreseeable future; elsewhere the filing states the company believes resources are sufficient for at least 24 months. No specific revenue or earnings guidance is provided. Management expects significant spending on commercialization, clinical studies, product development and public-company costs, and anticipated launches of two late-stage candidates in the second half of 2020.
- The company’s prior-year audit reports included going-concern explanatory language tied to covenant concerns. The filing says the covenant amendment improved management’s outlook, but continued compliance and the ability to sustain growth remain important.
Risks, contingencies and unusual items
- Revenue depends heavily on a small number of government and commercial payors. For the first nine months, Medicare accounted for 47% of revenue and Medicare Advantage plans 28%. Coverage, reimbursement rates, denials, audits and collection timing may materially affect results.
- Revenue includes estimates of variable consideration. Prior-period estimate changes increased Q3 revenue by $3.2 million in 2019, compared with a $1.2 million decrease in Q3 2018; nine-month adjustments were positive $2.4 million and $0.6 million, respectively. These adjustments can make period comparisons less representative of underlying activity.
- A consolidated Medicare appeal involves 2,698 DecisionDx-Melanoma claims. Hearings occurred in April and May 2019, but no ruling had been issued by the filing date; related revenue remains fully constrained until adjudication.
- Disclosure controls were assessed as ineffective at a reasonable-assurance level because of material weaknesses in journal-entry review, accounting expertise and controls over ASC 606 variable consideration. Remediation efforts were underway but not complete.
- Other key risks include potential changes to Medicare and commercial coverage, uncertainty over laboratory-developed-test regulation, dependence on a single laboratory, product adoption and development risks, and the possibility of future financing needs. The company reported no litigation expected to have a material adverse effect.
Important facts for investors to verify
- Whether test volume, reimbursement and collections support revenue growth, and how much reported revenue reflects variable-consideration adjustments.
- The status and financial outcome of the Medicare consolidated-claims appeal, and the effect of any ruling on revenue and covenant calculations.
- Ongoing compliance with lender revenue covenants, repayment terms and available liquidity as principal payments begin in 2020.
- Progress in remediating material weaknesses and whether disclosure controls are later determined to be effective.
- Actual reimbursement rates for DecisionDx-Melanoma and DecisionDx-UM, including future ADLT rate-setting and any potential Medicare recoupment.
- Execution and timing of the planned 2020 product launches, sales-force expansion and associated spending.