Lightning Genetics (FLGT) has been one of the more intriguing stocks that has been hit hard by Covid-19. Before the pandemic, Fulgent was a relatively small genetic testing company, with annual revenues of $ 33 million in 2019.
With the pandemic, however, that all changed. Demand for testing has reached the stratosphere, and Fulgent’s revenue has soared to $ 1.0 billion in the past 12 months. The company reaped huge profits from it, loading its balance sheet with cash. In addition, it was able to take advantage of the momentum of Covid-19 testing to open up distribution channels with new customers and also sell its main test products to them.
While the company had a lot to do in 2021, traders got ahead, at one point by offering the stock up to $ 200:
Stocks returned to the $ 100 mark last spring and have now hovered around that number since then.
In April 2021, I warned investors that Fulgent stock looks expensive even after falling 50% from its most recent high. This is because once you got past the temporary income from Covid-19 testing, there was quite little for the rest of the business.
Since this article, FLGT stock has risen from $ 90 to $ 81 as the market has risen. So this call delivered alpha. Having said that, I expected FLGT stock to fall more than $ 80, and my initial level of decline was admittedly not fully reached.
That’s because things have improved noticeably for Fulgent since last spring. On the one hand, unfortunately, Covid-19 continues to mutate. Delta and now omicron have extended the lifespan of Covid-19 tests. If the pandemic becomes something that mutates for years to come, the Fulgent stock is likely to be a winner over today’s price. By early 2021, however, there were reasonable hopes that the vaccines would quickly clear the virus and leave Fulgent dependent only on its little baseline testing activity.
Speaking of this testing business, although it is still small, it is rapidly gaining momentum. It also helps weed out some of the more important downside scenarios for the stock. As such, I am no longer bearish on FLGT stock. That said, it’s still a more complicated and difficult situation than bulls can realize. Here is why I have a neutral stance on the company.
Where will the test money go?
The central question for Fulgent shareholders here is what ends up happening to the exceptional cash flow being generated right now. It’s wonderful that the company is trading at something like a 15-20% return on earnings this year. But will this cash ultimately benefit the shareholders as much as possible?
The easiest way to answer yes would be to have an aggressive stock buyback or dividend program. However, that doesn’t appear to be in the cards.
An exchange on Fulgent’s latest conference call should make this clear. Here’s Oppenheimer’s Kevin DeGeeter talking to Fulgent CFO Paul Kim:
DeGeeter: “[You’ll have] almost a billion dollars on the balance sheet by the end of the year, yes, the equivalent of over 40% of current market capitalization. What do you think of the buybacks or just the management of the balance sheet here? Just sort of given the profile of the current balance sheet versus the current share price? “
Kim: “The buyout and other options are definitely things we can look at. But our main focus is to invest in this business and execute our post-COVID merger and acquisition strategy. “
Before Covid-19, Fulgent was not a particularly successful company, at least judging by its bottom line. The business was not profitable every year until 2020, when Covid-19 testing began. The company appears to have structural advantages, such as low cost testing compared to its peers. However, the bears were concerned that its core market might be a commodity that would never support particularly high profit margins.
The Covid-19 pandemic, however, created such a massive demand for testing that the nature of the commodity of the product simply did not matter. There was more demand than existing suppliers could ever have imagined. Exceptional profits followed. But under normal market conditions, is Fulgent a leading operator who can remain highly profitable? Only time will tell.
The bull’s case from there is that Fulgent has developed a large number of new client relationships and has impressed potential partners with his strong execution throughout the Covid crisis. This, in turn, should give him new legs as he seeks to expand his non-pandemic business.
The operating results confirm this. The company generated more than $ 40 million in base revenue in the third quarter; which was up several hundred percent from the same period in 2019. In annualized terms, that’s over $ 160 million in such sales. Some of this base income includes contractual income related to Covid testing, so the pure non-Covid number is a bit smaller than that. However, whatever the exact figure, the core business is growing at a rapid rate.
Let’s be generous and assume the company keeps this positive growth out of Covid and gets $ 250 million in recurring revenue over the course of its sustainable operations. The company made about 50% gross profit before the pandemic, so let’s say there’s $ 125 million in gross profit annually. Before the pandemic, the company was slightly in deficit, but we’ll assume the generous scale advantages of being much larger and will give it a 20% net income margin. This would represent approximately $ 50 million in annual net income.
Fulgent’s market cap is now just under $ 2.5 billion, which would be roughly 50 times the post-Covid hypothetical profit outside of core business. Now, of course, there is the issue of cash, which is expected to be close to 40% of market cap after the next quarter. Ex-cash, we’re talking closer to 30 times the profits from post-Covid testing, which is likely a fair price for a fast-growing company in an attractive industry like this.
If we knew that shareholders would get a $ 1 billion cash distribution as a special dividend, I think you might feel comfortable with the valuation here. Fulgent is far from a bargain based on its recurring income. But there is enough to support a reasonable assessment, and you have the option in case omicron isn’t the latest variant and the Covid-19 tests take longer than expected.
That said, instead of using the billion dollars on dividends or buybacks, it looks like management is going to reinvest that capital back into their core business and / or buy other test companies. This adds a big question mark to the equation.
Fulgent could buy something that increases profits and turn it into a high value stock here. Or he could buy something that doesn’t work and waste the money. It is easy to make ill-advised acquisitions in this industry.
As noted above, management made the most of their Covid-19 opportunity, but didn’t have much track record for capital allocation decisions before that. In addition, Edwin Dorsey of The bear cave released a cautious report on Fulgent last year, for example, which highlighted potential conflicts of interest within the company. Dorsey also noted purchases such as a $ 5.4 million private jet, which might not be how shareholders of the company would prefer their capital to be spent.
So, I’m generally left with the same takeout I got from last spring when I labeled the FLGT stock as a sale. The action is not cheap despite the apparent very low P / E ratio. When you look at the core business, there is enough here to warrant a solid valuation, but I can easily come up with scenarios well below $ 80 if management missteps in M&A.
Omicron has extended the company’s exceptional cash-generating period by at least a few months, adding to the amount of money management will have available for its next M&A and investment budget. And the company delivered better execution on its core business than the Bears expected around this time last year.
In other words, things are going in the right direction for Fulgent. With the stock falling to $ 80 instead of over $ 100, I think you can make a reasonable case for a hold or a neutral outlook. If another wave of Covid hits, the stock is likely to be working from here. And if the next M&A or major investment wins, Fulgent could also have an edge.
However, please look beyond the mere 5x P / E ratio before making an investment decision. It’s far from an obvious buy at this price. Downside scenarios have been reasonably mitigated due to improved omicron and core business, but management has more to prove.