Why is Foundation Medicine up +95%?

In a July 2013 article, we highlighted the proposed IPO of a cancer genomics company called Foundation Medicine (NASDAQ:FMI). Their flagship product, FoundationOne, provides a fully informative genomic profile obtained from a tumor sample which helps physicians make treatment decisions for patients with cancer. By identifying the molecular growth drivers of their cancers, the oncologists can then match these profiles with targeted therapeutic options. This test creates two distinct revenue channels for Foundation Medicine.

The first channel is the traditional doctor-patient test where a biopsy is sent to Foundation and then a full genomic profile of the tumor is made available to the physician via an online informatics platform which was developed in consultation with Google Ventures. The real value here is the growing database of information about treatment effectiveness against different genetic variants of tumors. Over time the data will increase the accuracy, effectiveness and coverage of the platform’s recommendations using known cancer drug combinations. 60% of Q3 2014 revenues were from this revenue channel. FMI expects this channel to continue being the majority source of revenues going forward.

The second channel is the sale of tests to pharmaceutical companies that are looking to test new drugs they are developing against tumors with different genetic profiles. 40% of Q3 2014 revenues came from this channel.

Overall Q3 2014 revenues for Foundation came in at $16.4 million, a +100% increase compared to Q3 2013. Foundation’s revenues for the first three quarters of 2014 are at $42.3 million which is a +119% increase when compared to the same period in 2013.

 Before and After the IPO

Prior to the IPO, we noted that the company had strong backing, strong revenue growth, rapid and broad adoption of their test products, and extensive partnerships with key companies in the industry. While the IPO shares popped +89% on the first day of trading to close at $35.65, they stagnated over time falling to as low as $18.25 per share. Investors who accumulated at these levels would be quite happy today. Yesterday, Foundation’s shares closed up +95% to $46.74 on news of a new strategic partnership with Roche.

 The Roche Agreement

The transactional part of the newly announced Roche agreement involves two parts. The first is that Roche will purchase 5 million newly issued shares from FMI for $50 per share giving Foundation $250 million in cash in addition to the $84 million they already have on hand. The message this sends to investors is that Roche, presumably an expert in the valuation of biotech companies, feels that FMI is worth $50 per share at this point in time. The second part of the agreement is that Roche plans to purchase approximately 15.6 million shares from existing investors at a price of $50 per share through a tender offer. This second part contains a degree of uncertainty as the final purchase price of the tender could be more or less than $50 per share. Upon completion of the entire transaction, Roche will have spent just over $1 billion investing in FMI and will own 56% of the company.

Why didn’t Roche just acquire FMI outright? Well firstly, FMI does business with Roche’s competitors. Should Roche acquire the company outright, this could present some conflicts of interest. Secondly, FMI can still work very nimbly as a small entrepreneurial company while enjoying the advantage of Roche’s capital and resources. Thirdly, Roche can exercise majority control and ownership but can still have the option to decide to what extent they want to engage with FMI based on their evolving corporate strategy.

The agreement also described a 5-year commitment to the broad utilization of FMI’s molecular information platform for Roche’s pipeline assets. The agreement also gives Roche exclusive rights to commercialize all of FMI’s commercial products along with any products developed under the R&D collaboration agreement outside of the U.S. FMI will continue to focus on the U.S. market with Genentech. FMI is also eligible for an additional $150 million in milestone payments over the five-year period.

For current and prospective investors, this agreement provides huge validation for Foundation Medicine (NASDAQ:FMI) as a company. The continuation of rapid revenue growth going forward will help validate the success of this collaboration for FMI. In the meantime, a line has been drawn in the sand as to what Roche perceives as a current “fair price” of $50 per share and this should provide excellent support for the share price going forward.

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