CASTLE BIOSCIENCES INC 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of financial condition and results of operations together with our unaudited condensed financial statements and the related notes and other financial information included in this Quarterly Report on Form 10-Q and our audited financial statements and notes thereto as of and for the years ended December 31, 2019 and 2018 and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, including Critical Accounting Policies and Significant Judgments and Estimates, included in our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the Securities and Exchange Commission, or the SEC, on March 10, 2020. Unless the context requires otherwise, references in this Quarterly Report on Form 10-Q to “we,” “us,” and “our” refer to Castle Biosciences, Inc. Forward-Looking Statements The information in this discussion contains forward-looking statements and information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections. These forward-looking statements include, but are not limited to, statements concerning the impacts of COVID-19 on our business, our strategy, future operations, future financial position, future revenues, projected costs, prospects and plans and objectives of management. The words “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We may not actually achieve the plans, intentions, or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements that we make. These forward-looking statements involve risks and uncertainties that could cause our actual results to differ materially from those in the forward-looking statements, including, without limitation, the risks set forth in Part II, Item 1A, “Risk Factors” in this Quarterly Report on Form 10-Q and in our other filings with the SEC. The forward-looking statements are applicable only as of the date on which they are made, and we do not assume any obligation to update any forward-looking statements, except as may be required by law. Overview We are a commercial-stage dermatological cancer company focused on providing physicians and their patients with personalized, clinically actionable genomic information to make more accurate treatment decisions. We believe that the traditional approach to developing a treatment plan for certain cancers using clinical and pathology factors alone is inadequate and can be improved by incorporating personalized genomic information. Our non-invasive products utilize proprietary algorithms to provide an assessment of a patient’s specific risk of metastasis or recurrence of their cancer, allowing physicians to identify patients who are likely to benefit from an escalation of care as well as those who may avoid unnecessary medical and surgical interventions. Our lead product, DecisionDx-Melanoma, is a proprietary multi-gene expression profile, or GEP, test that predicts the risk of metastasis or recurrence for patients diagnosed with invasive cutaneous melanoma, a deadly skin cancer. We estimate more than 130,000 patients are diagnosed with invasive cutaneous melanoma each year in the United States. We launched DecisionDx-Melanoma in May 2013. We also market DecisionDx-UM, which is a proprietary GEP test that predicts the risk of metastasis for patients with uveal melanoma, a rare eye cancer. We launched DecisionDx-UM in January 2010. Based on the substantial clinical evidence that we have developed, we have received Medicare coverage for both of our products, which represents approximately 50% of our addressable patient population. We also have two late-stage proprietary products in development that address cutaneous squamous cell carcinoma, or SCC, and suspicious pigmented lesions. We expect to commercially launch our SCC proprietary GEP test, DecisionDx-SCC, at the beginning of September 2020. As it relates to our proprietary GEP test for suspicious pigmented lesions, we believe we remain on track to launch this test in the second half of 2020. These indications are areas of high clinical need in dermatological cancer and, together, represent an additional addressable market of approximately 500,000 patients in the United States. We have processed over 60,000 clinical samples since commercial launch and our annual revenue increased from $22.8 million in 2018 to $51.9 million in 2019. For the six months ended June 30, 2020, our revenue was $30.1 million compared to $19.5 million for the six months ended June 30, 2019. 20 Table of Contents The numbers of DecisionDx-Melanoma and DecisionDx-UM test reports delivered by us during the six months ended June 30, 2020 and 2019 and for the year ended December 31, 2019 are presented in the table below: DecisionDx- Melanoma DecisionDx-UM Total Q1 2020 4,574 361 4,935 Q2 2020 3,008 306 3,314 For the six months ended June 30, 2020 7,582 667 8,249 Q1 2019 3,232 360 3,592 Q2 2019 3,691 376 4,067 For the six months ended June 30, 2019 6,923 736 7,659 Q3 2019 4,126 356 4,482 Q4 2019 4,480 434 4,914 For the year ended December 31, 2019 15,529 1,526 17,055 For the three months ended March 31, 2020, new ordering clinicians (first time ordering a test) for our DecisionDx-Melanoma test grew by 43% compared to the same period in 2019. However, for the three months ended June 30, 2020, new ordering clinicians for DecisionDx-Melanoma decreased by 43% as compared to the same period in 2019, and for the six months ended June 30, 2020, new ordering clinicians for Decision Dx-Melanoma decreased by 6% as compared to the same period in 2019. We believe this is reflective of the impacts of the COVID-19 pandemic, as discussed further below. For additional information on the metrics we disclose, refer to “Information about certain metrics ” below. Since our inception in 2008, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, discovering product candidates, conducting clinical study activities to generate evidence demonstrating the clinical validity, clinical utility, economic benefits, and patient outcomes of our products, and commercialization activities for those products. We currently market two proprietary GEP products and generate substantially all of our revenue from those activities. The principal focus of our current commercial efforts is to distribute our molecular diagnostic testing products through our direct sales force in the U.S. The number of test reports we generate is a key indicator that we use to assess our business. A test report is generated when we receive a sample in our laboratory, the relevant information relating to that test is entered into our Laboratory Information Management System, the genomic profile of the sample is performed and a report providing the results of that profile is sent to the physician who ordered the test. We bill third-party payors and patients for the tests we perform. The majority of our revenue collections is paid by third-party insurers, including Medicare. We have received Local Coverage Determinations, or LCDs, which provide coverage for our tests that meet certain criteria for Medicare and Medicare Advantage beneficiaries, representing approximately 60 million covered lives. As it relates to DecisionDx-UM, we have contracts or have received positive medical policy decisions from additional payors representing approximately 83 million covered lives. A ‘‘covered life’’ means a subscriber, or a dependent of a subscriber, who is insured under an insurance policy for such an insurance carrier. On May 17, 2019, the Centers for Medicare & Medicaid Services, or CMS, determined that DecisionDx-UM meets the criteria for existing advanced diagnostic laboratory test, or ADLT, status, also referred to as “existing ADLT” status. Accordingly, in 2021 the DecisionDx-UM Medicare rate will be set annually based upon the median private payor rate for the first half of the second preceding calendar year. Specifically, the median private payor rate from January 1 to June 30, 2019 will be used to set the Medicare rate for the calendar year 2021. We submitted this data in January 2020. Note that our rate for 2020 will be set by Noridian Healthcare Solutions, LLC, or Noridian, our local Medicare Administrative Contractor, or MAC. Also, on May 17, 2019, CMS determined that DecisionDx-Melanoma meets the criteria for ‘‘new ADLT’’ status. Accordingly, from July 1, 2019 through March 31, 2020 the Medicare reimbursement rate was equal to the initial list price of $7,193.00 . From April 1, 2020 through December 31, 2021, CMS notified us that the rate will also be $7,193.00, which was calculated based upon the median private payor rate for DecisionDx-Melanoma from July 1, 2019 to November 30, 2019. B eginning in 2022, the rate for both DecisionDx-UM and DecisionDx-Melanoma will be set annually based upon the median private payor rate for the first half of the second preceding calendar year. For example, the rate for 2022 will be set using median private payor rate data from January 1, 2020 to June 30, 2020. 21 Table of Contents To date, in addition to the revenue generated from the sale of our products, we have financed our operations through our initial public offering of common stock in July 2019, or the IPO, a follow-on public offering of common stock in June 2020, private placements of preferred stock, convertible promissory notes and bank debt. We believe that our existing cash and cash equivalents and anticipated cash generated from sales of our products will be sufficient to fund our operations for the foreseeable future. However, we have based these estimates on assumptions, including those related to the impact of COVID-19 on our financial condition, that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. Our net income (losses) may fluctuate significantly from period to period, depending on the timing of our planned development activities, the growth of our sales and marketing activities and the timing of revenue recognition under Accounting Standards Codification Topic 606, Revenue from Contracts with Customers , or ASC 606. We expect our expenses will increase substantially over time as we: • execute clinical studies to generate evidence supporting our current and future product candidates; • execute our commercialization strategy for our current and future products; • continue our ongoing and planned development of new products; • seek to discover and develop additional product candidates; • hire additional scientific and research and development staff; and • add additional operational, financial and management information systems and personnel. Furthermore, we expect to continue to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses. Impact of COVID-19 Pandemic We are continuing to closely monitor the impact of the COVID-19 pandemic on our business and are taking proactive efforts designed to protect the health and safety of our workforce, continue our business operations and advance our corporate objectives. We are providing the following update with respect to the impact of COVID-19 on our business: • To date, we have maintained uninterrupted business operations with normal turnaround times for our delivery of test reports. We have implemented adjustments to our operations designed to keep employees safe and comply with federal, state and local guidelines, including those regarding social distancing. • We have experienced declines in orders and test report volume beginning primarily in April 2020, which we believe is linked to delays and/or cancellations in patient visits, resulting in reduced diagnostic biopsies and thus reduced diagnoses of cutaneous melanoma in response to COVID-19. Orders for our lead product, DecisionDx-Melanoma, declined 45% in April 2020 and 39% in May 2020, each compared to the same periods in 2019. However, we saw year-over-year growth in the month of June 2020, with orders increasing by 10% compared to the same period in 2019, and also saw year-over-year growth in the month of July 2020. We believe the improvement in DecisionDx-Melanoma test orders since April 2020 is driven in part by the reopening of dermatology practices and rescheduled patient visits, coinciding with the easing of state and local government restrictions. Overall, for the second quarter of 2020, test reports delivered for DecisionDx-Melanoma decreased 18.5% compared to the second quarter of 2019. For our uveal melanoma test, DecisionDx-UM, test report volume decreased by 18.6% for the second quarter of 2020 compared to the second quarter of 2019. • In the second quarter of 2020, COVID-19 negatively impacted our year-over-year number of new ordering clinicians for DecisionDx-Melanoma. The largest impact was seen in April, improving sequentially throughout the remainder of the quarter. The improvement, over April figures, of our year-over-year number of new ordering clinicians for DecisionDx-Melanoma continued in July 2020. • Our future results will be dependent upon the extent and duration of the COVID-19 crisis as well as the impact of ongoing state and local government restrictions, which are beyond our control, and which may be eased and/or reinstated from time to time depending on the circumstances, potentially impacting the flow of future patient visits. • Based upon an analysis of our supply channel and current inventory levels, we believe we have adequate access to reagents and consumables needed for testing patient samples, and we expect to continue providing normal turnaround times for delivery of our test reports. 22 Table of Contents • We continue to believe our cash and cash equivalents, including the approximately $79.5 million of net proceeds we received from our recent public offering of common stock, and anticipated cash generated from sales of our products, will be sufficient to fund our operations for the foreseeable future. In response to COVID-19, the United States government has passed legislation and taken other actions to provide financial relief to companies and other organizations affected by the pandemic. On April 10, 2020, we received an automatic payment of $1.9 million from the U.S. Department of Health and Human Services, or HHS, pursuant to the Coronavirus Aid, Relief and Economic Security Act enacted on March 27, 2020, or the CARES Act, out of relief funds allocated by HHS to healthcare providers to reimburse for healthcare related expenses or lost revenues attributable to COVID-19. On April 16, 2020, we received an advance payment of $8.3 million, or the Advance Payment, from CMS under its Accelerated and Advance Payment Program, which was recently expanded to provide increased cash flow to service providers during the COVID-19 pandemic. See “Sources of Liquidity” under the Liquidity and Capital Resources section below for more information on these payments. As conditions are continuously evolving, we are unable to predict whether orders and test report volume will improve in the coming months or the extent to which our results of operations, financial condition or cash flows will be impacted. Accordingly, the order and test report data presented above is not necessarily indicative of our results of operations that can be expected for future interim periods or for the year ending December 31, 2020. For more information on the potential impact of the COVID-19 pandemic on our business, see the risk factors included under “Risks Related to Our Business” and the other risk factors included in Part II, Item 1A., “Risk Factors,” of this Quarterly Report on Form 10-Q. Factors affecting our performance We believe there are several important factors that have impacted and that we expect will impact our operating performance and results of operations, including: • Report volume. We believe that the number of reports we deliver to physicians is an important indicator of growth of adoption among the healthcare provider community. Our revenue and costs are affected by the volume of testing and mix of customers. Our performance depends on our ability to retain and broaden adoption with existing prescribing physicians, as well as attract new physicians. In the near term, our report volume may continue to be negatively impacted by the effects of the COVID-19 pandemic, as the crisis evolves, as discussed above. • Reimbursement. We believe that expanding reimbursement is an important indicator of the value of our products. Payors require extensive evidence of clinical utility, clinical validity, patient outcomes and health economic benefits in order to provide reimbursement for diagnostic products. Our revenue depends on our ability to demonstrate the value of our products to these payors. • Gross margin. We believe that our gross margin is an important indicator of the operating performance of our business. Higher gross margins reflect the average selling price of our tests, as well as the operating efficiency of our laboratory operations. • New product development. A significant aspect of our business is our investment in research and development activities, including activities related to the development of new products. In addition to the development of new product candidates, we believe these studies are critical to gaining physician adoption of new products and driving favorable coverage decisions by payors for such products. Information about certain metrics The following provides additional information about certain metrics we have disclosed in this Management’s Discussion and Analysis of Financial Condition and Results of Operation. Test reports delivered for DecisionDx-Melanoma and DecisionDx-UM represents the number of completed test reports delivered by us during the reporting period indicated. The period in which a test report is delivered does not necessarily correspond with the period the related revenue, if any, is recognized, due to the timing and amount of adjustments for variable consideration under ASC 606. We use this metric to evaluate the growth in adoption of our tests and to measure against our internal performance objectives. We believe this metric is useful to investors in evaluating the volume of our business activity from period to period that may not be discernible from our reported revenues under ASC 606. We also sometimes present, on a limited basis, data on the number of orders received. We believe order data can provide additional insight on current demand trends, particularly during the COVID-19 pandemic, when considered in conjunction with test report volume. However, orders received in a particular period do not necessarily correspond with actual delivered test reports or reported revenues for the same period or subsequent periods. 23 Table of Contents New ordering clinicians for DecisionDx-Melanoma represents the number of clinicians who ordered the DecisionDx-Melanoma test for the first time during the reporting period specified. We believe this metric is useful in evaluating the effectiveness of our sales and marketing efforts in establishing new relationships with clinicians and increasing the adoption of our DecisionDx-Melanoma test. We also believe this metric provides useful information to investors in assessing our ability to expand the use of the DecisionDx-Melanoma test. Since this metric is based upon the reporting period in which an order is placed, it does not necessarily correspond to the reporting period in which a test report was delivered or in which any revenue was recognized. Components of the Results of Operations Net Revenues We generate revenues from the sale of our products, primarily from the sale of DecisionDx-Melanoma and DecisionDx-UM. We bill third-party payors and patients for the tests we perform. Under ASC 606, we recognize revenue at the amount we expect to be entitled, subject to a constraint for variable consideration, in the period in which our tests are delivered to the treating physicians. We have determined that our contracts contain variable consideration under ASC 606 because the amounts paid by third-party payors may be paid at less than our standard rates or not paid at all, with such differences considered implicit price concessions. Variable consideration is recognized only to the extent it is probable that a significant reversal of revenue will not occur in future periods when the uncertainties are resolved. Variable consideration is evaluated each reporting period and adjustments are recorded as increases or decreases in revenues. Variable consideration for Medicare claims that are not covered by an LCD, including those claims subject to approval by an Administrative Law Judge, or ALJ, at an appeal hearing, is deemed to be fully constrained due to factors outside the Company’s influence (i.e., judgment or actions of third parties) and the uncertainty of the amount to be received is not expected to be resolved for a long period of time. For these fully constrained claims, we generally recognize revenue upon receipt of a favorable appeal decision. Due to potential future changes in Medicare coverage policies and appeal cycles, insurance coverage policies, contractual rates and other trends in the reimbursement of our tests, our revenues may fluctuate significantly from period to period. Our ability to increase our revenues will depend on our ability to further penetrate our target market, and, in particular, generate sales through our direct sales force, develop and commercialize additional tests, obtain reimbursement from additional third-party payors and increase our reimbursement rate for tests performed. In the near term, our financial performance will be highly dependent on reimbursement for DecisionDx-Melanoma. The use of DecisionDx-Melanoma is not yet broadly covered under positive coverage policies, although many third-party payors have begun to reimburse for this test. Cost of Sales The components of our cost of sales are material and service costs, personnel costs (including salaries, bonuses, benefits and stock-based compensation expense), equipment and infrastructure expenses associated with testing samples, electronic medical records, order and delivery systems, shipping charges to transport samples, third-party test fees, and allocated overhead including rent, information technology costs, equipment depreciation and utilities. Costs associated with performing tests are recorded when the test is processed regardless of whether and when revenues are recognized with respect to that test. As a result, our cost of sales as a percentage of revenues may vary significantly from period to period because we do not recognize all revenues in the period in which the associated costs are incurred. We expect cost of sales in absolute dollars to increase as the number of tests we perform increases. Gross margin, calculated as net revenues minus cost of sales, and gross margin percentage, calculated as gross margin divided by net revenues, are key indicators we use to assess our business. Research and Development Research and development expenses include costs incurred to develop our genomic tests, collect clinical samples and conduct clinical studies to develop and support our products. These costs consist of personnel costs (including salaries, bonuses, benefits and stock-based compensation expense), prototype materials, laboratory supplies, consulting costs, regulatory costs, electronic medical records set up costs, costs associated with setting up and conducting clinical studies and allocated overhead, including rent, information technology, equipment depreciation and utilities. We expense all research and development costs in the periods in which they are incurred. We expect our research and development expenses to increase in absolute dollars as we continue to invest in research and development activities related to developing enhanced and new products. 24 Table of Contents Selling, General and Administrative Selling, general and administrative, or SG&A, expenses include executive, selling and marketing, legal, finance and accounting, human resources, billing and client services. These expenses consist of personnel costs (including salaries, bonuses, benefits and stock-based compensation expense), direct marketing expenses, audit and legal expenses, consulting costs, training and medical education activities, payor outreach programs and allocated overhead, including rent, information technology, equipment depreciation, and utilities. We expect continued increases in SG&A expenses related to compliance with the rules and regulations of the SEC and The Nasdaq Stock Market LLC, or Nasdaq, investor relations activities, and additional insurance expenses. Other administrative and professional services expenses within SG&A are expected to increase with the scale of our business, but selling and marketing-related expenses are expected to increase significantly, consistent with our growth strategy. In the near term, we expect these increases may be partially offset by temporarily reduced spending on travel and field-based sales activities as a result of the COVID-19 crisis. Other Operating Income Other operating income consists of the automatic payment from HHS pursuant to the CARES Act, as discussed above. Interest Income Interest income consists primarily of earnings on cash and cash equivalents, including money market funds. Interest Expense Interest expense is attributable to borrowings under our term debt, revolving line of credit and the convertible promissory notes issued in January and February of 2019, or the Q1 2019 Notes, and also includes the amortization of debt discount and issuance costs. Other Expense, Net Other expense, net reflects changes in the fair value of (i) our convertible preferred stock warrant liability and (ii) the embedded derivative associated with the Q1 2019 Notes. Income Tax Expense Our financial statements do not reflect any federal or state income tax benefits attributable to the net losses we have incurred, due to the uncertainty of realizing a benefit from those items. As of December 31, 2019, we had federal net operating loss carryforwards of $57.4 million, of which $43.5 million will begin to expire in 2028 if not utilized to offset taxable income, and $13.9 million may be carried forward indefinitely. Also, as of December 31, 2019, we had state net operating loss carryforwards of $42.2 million, which begin to expire in 2028 if not utilized to offset state taxable income. 25 Table of Contents Results of Operations Comparison of the three months ended June 30, 2020 and 2019 The following table summarizes our results of operations for the periods indicated (in thousands, except percentages): Three Months Ended June 30, Change 2020 2019 (unaudited) Net revenues $ 12,715 $ 10,739 $ 1,976 18.4 % Cost of sales 2,146 1,993 153 7.7 % Gross margin 10,569 8,746 1,823 20.8 % Gross margin percentage 83.1 % 81.4 % Operating expenses and other operating income: Research and development 2,704 1,317 1,387 105.3 % Selling, general and administrative 10,392 6,821 3,571 52.4 % Other operating income (1,882) — (1,882) N/A Total operating expenses, net 11,214 8,138 3,076 37.8 % Operating income (loss) (645) 608 (1,253) (206.1) % Interest income 38 5 33 660.0 % Interest expense (769) (1,693) 924 54.6 % Other expense, net — (189) 189 100.0 % Loss before income taxes (1,376) (1,269) (107) (8.4) % Income tax expense — — — — % Net loss $ (1,376) $ (1,269) $ (107) (8.4) % Net Revenues For the three months ended June 30, 2020 net revenues increased by $2.0 million, or 18.4%, to $12.7 million compared to the three months ended June 30, 2019 primarily due to higher per-unit revenues partially offset by reduced test volume and reduced revenue adjustments related to prior periods. The overall revenue increase is primarily attributable to higher DecisionDx-Melanoma test revenues, partially offset by lower DecisionDx-UM test revenues. Our 2020 per-unit revenues benefited from the attainment of “new ADLT” status for our DecisionDx-Melanoma test, effective July 1, 2019, which resulted in a higher Medicare reimbursement rate for the test, as described above. Offsetting the benefits of higher per-unit revenues were lower test report volumes. For the three months ended June 30, 2020, we experienced an 18.5% decrease in total DecisionDx-Melanoma and DecisionDx-UM test reports delivered, compared to the three months ended June 30, 2019, which we believe is the result of delays and/or cancellations of patient visits due to the COVID-19 pandemic. For the three months ended June 30, 2020 and 2019, we recorded net positive revenue adjustments of $2.3 million and $3.3 million, respectively, related to tests delivered in previous periods, associated with changes in estimated variable consideration. The positive revenue adjustments include the recognition of revenue for certain tests delivered in prior periods for which no revenue was recognizable originally, but was recognized upon cash collection of payments for the tests in the respective periods. Cost of Sales Cost of sales for the three months ended June 30, 2020 increased by $0.2 million, or 7.7%, compared to the three months ended June 30, 2019, primarily due to higher personnel costs associated with additional headcount in our laboratory testing operations, partially offset by a decrease in expenses for supplies and services, consistent with the lower test report volume. Our gross margin percentage was 83.1% for the three months ended June 30, 2020, compared to 81.4% for the same period in 2019, with the improvement primarily a result of increased operating leverage on the higher revenues. Due to the nature of our business, a significant portion of our cost of sales expenses represent fixed costs associated with our testing operations. Accordingly, our cost of sales expense will not necessarily increase or decrease commensurately with the change in net revenues from period to period. 26 Table of Contents Research and Development Research and development expenses increased by $1.4 million, or 105.3%, for the three months ended June 30, 2020, compared to the three months ended June 30, 2019, primarily associated with increases in personnel costs attributable to additional headcount as well as higher expenses for clinical trials. Selling, General and Administrative SG&A expense increased by $3.6 million, or 52.4%, for the three months ended June 30, 2020 compared to the three months ended June 30, 2019. Approximately 78% of the increase is attributable to higher personnel costs, particularly due to increased headcount. In early 2019, we expanded our sales organization from 14 territories to 23 territories and implemented an additional expansion to 32 territories beginning in December 2019. The higher personnel costs also reflect expanded headcount in our administrative support functions. The remainder of the increase was primarily associated with higher professional fees, higher insurance expense, increased board of director compensation and other general increases. These increases were partially offset by reduced travel costs and reduced spending on events and conferences, due to cancellations and travel restrictions associated with the COVID-19 pandemic. Stock-based compensation expense included in SG&A expense was $1.2 million for the three months ended June 30, 2020 compared to $0.1 million for the same period in 2019. Other Operating Income Other operating income for the three months ended June 30, 2020 of $1.9 million consists entirely of the automatic payment received from HHS for relief funds pursuant to the CARES Act. Interest Expense Interest expense decreased by $0.9 million, or 54.6%, for the three months ended June 30, 2020 compared to the three months ended June 30, 2019. The decrease is primarily attributable to interest expense on the Q1 2019 Notes during the three months ended June 30, 2019. The outstanding principal amount and accrued interest on the Q1 2019 Notes converted into shares of common stock in connection with the IPO in July 2019. Other Expense, Net Other expense, net for the three months ended June 30, 2019 consisted of the change in fair value of our liability for convertible preferred stock warrants and the change in fair value of the embedded derivative liability associated with the Q1 2019 Notes. In connection with the IPO, the preferred stock warrants became exercisable for common stock and are no longer adjusted for changes in fair value and the Q1 2019 Notes converted into shares of common stock. 27 Table of Contents Results of Operations Comparison of the six months ended June 30, 2020 and 2019 The following table summarizes our results of operations for the periods indicated (in thousands, except percentages): Six Months Ended June 30, Change 2020 2019 (unaudited) Net revenues $ 30,133 $ 19,456 $ 10,677 54.9 % Cost of sales 4,537 3,591 946 26.3 % Gross margin 25,596 15,865 9,731 61.3 % Gross margin percentage 84.9 % 81.5 % Operating expenses and other operating income: Research and development 5,617 2,711 2,906 107.2 % Selling, general and administrative 21,470 12,868 8,602 66.8 % Other operating income (1,882) — (1,882) N/A Total operating expenses, net 25,205 15,579 9,626 61.8 % Operating income 391 286 105 36.7 % Interest income 336 26 310 1,192.3 % Interest expense (1,533) (2,717) 1,184 43.6 % Other expense, net — (222) 222 100.0 % Loss before income taxes (806) (2,627) 1,821 69.3 % Income tax expense — — — — % Net loss $ (806) $ (2,627) $ 1,821 69.3 % Net Revenues Net revenues increased by $10.7 million, or 54.9%, to $30.1 million due to a combination of higher per-unit revenues and increased test volume, partially offset by reduced revenue adjustments related to prior periods. The overall revenue increase is primarily attributable to higher DecisionDx-Melanoma test revenues, partially offset by lower DecisionDx-UM test revenues. For the six months ended June 30, 2020, we experienced a 7.7% increase in total DecisionDx-Melanoma and DecisionDx-UM test reports delivered, compared to the six months ended June 30, 2019. While we saw a year-over-year increase in test reports delivered of 37.4% during the first quarter of 2020, we experienced a year-over-year decrease in test reports delivered of 18.5% during the second quarter of 2020, reflecting the impacts of the COVID-19 pandemic, as discussed above. Our per-unit revenues benefited from the attainment of “new ADLT” status for our DecisionDx-Melanoma test, effective July 1, 2019, which resulted in a higher Medicare reimbursement rate for the test, as described above. For the six months ended June 30, 2020 and 2019, we recorded net positive revenue adjustments of $1.0 million and $2.8 million, respectively, related to tests delivered in previous periods, associated with changes in estimated variable consideration. The positive revenue adjustments include the recognition of revenue for certain tests delivered in prior periods for which no revenue was recognizable originally, but was recognized upon cash collection of payments for the tests in the respective periods. Cost of Sales Cost of sales for the six months ended June 30, 2020 increased by $0.9 million, or 26.3%, compared to the six months ended June 30, 2019, primarily due to higher personnel costs associated with additional headcount in our laboratory testing operations and increases in expenses for supplies and services, which were attributable to the overall higher activity levels. Our gross margin percentage was 84.9% for the six months ended June 30, 2020, compared to 81.5% for the same period in 2019, with the improvement primarily a result of the increased operating leverage on the higher revenues. Due to the nature of our business, a significant portion of our cost of sales expenses represent fixed costs associated with our testing operations. Accordingly, our cost of sales expense will not necessarily increase or decrease commensurately with the change in net revenues from period to period. 28 Table of Contents Research and Development Research and development expenses increased by $2.9 million, or 107.2%, for the six months ended June 30, 2020, compared to the six months ended June 30, 2019, primarily associated with increases in personnel costs attributable to additional headcount, higher expenses for clinical trials and higher advisory board expenses. Selling, General and Administrative SG&A expense increased by $8.6 million, or 66.8%, for the six months ended June 30, 2020 compared to the six months ended June 30, 2019. Approximately 67% of the increase is attributable to higher personnel costs, particularly due to increased headcount. In early 2019, we expanded our sales organization from 14 territories to 23 territories and implemented an additional expansion to 32 territories beginning in December 2019. The higher personnel costs also reflect expanded headcount in our administrative support functions. The remainder of the increase was primarily associated with higher professional fees, insurance expense and increases in board of director compensation. Stock-based compensation expense included in SG&A expense was $2.4 million for the six months ended June 30, 2020 compared to $0.2 million for the same period in 2019. Other Operating Income Other operating income for the six months ended June 30, 2020 of $1.9 million consists entirely of the automatic payment received from HHS pursuant to the CARES Act. Interest Income Interest income increased by $0.3 million for the six months ended June 30, 2020, compared to the six months ended June 30, 2019, primarily as a result of higher average balances of cash and cash equivalents, which were primarily attributable to proceeds from the IPO in July 2019. Interest Expense Interest expense decreased by $1.2 million, or 43.6%, for the six months ended June 30, 2020 compared to the six months ended June 30, 2019. The decrease is primarily attributable to interest expense on the Q1 2019 Notes during the six months ended June 30, 2019, partially offset by increased amortization of debt discount and issuance cost on our banking credit facility during the six months ended June 30, 2020. The outstanding principal amount and accrued interest on the Q1 2019 Notes converted into shares of common stock in connection with the IPO in July 2019. Other Expense, Net Other expense, net for the six months ended June 30, 2020 consisted of the change in fair value of our liability for convertible preferred stock warrants and the change in fair value of the embedded derivative liability associated with the Q1 2019 Notes. In connection with the IPO, the preferred stock warrants became exercisable for common stock and are no longer adjusted for changes in fair value and the Q1 2019 Notes converted into shares of common stock. Liquidity and Capital Resources Sources of Liquidity Our principal sources of liquidity are our cash and cash equivalents and cash generated from sales of our products. As of June 30, 2020 and December 31, 2019, we had cash and cash equivalents of $179.8 million and $98.8 million, respectively. To date, in addition to the revenue generated from the sale of our products, we have financed our operations through the IPO, a follow-on public offering of common stock in June 2020, private placements of preferred stock, convertible promissory notes and bank debt. Our long-term debt is described further below. June 2020 Follow-On Public Offering On June 29, 2020, we issued and sold 2,000,000 shares of our common stock in a follow-on public offering at a price of $37.00 per share. We received approximately $69.1 million in net proceeds, after deducting underwriting discounts and commissions and offering costs paid or payable by us. In connection with the offering, we granted the underwriters a 30-day option to purchase up to 300,000 additional shares of common stock at the public offering price, less underwriting discounts and commissions. On July 2, 2020, we issued and sold an additional 300,000 shares of common stock pursuant to the underwriters’ exercise in full of their option to purchase additional shares, which resulted in additional net proceeds to us of $10.4 million. 29 Table of Contents We expect to use a portion of these proceeds to further support and accelerate our research and development activities, including two important studies that we have recently commenced to support our DecisionDx-Melanoma test. Relief Funds and Advance Payment On April 10, 2020, we received an automatic payment of $1.9 million from HHS pursuant to the CARES Act out of relief funds allocated by HHS to healthcare providers to reimburse for healthcare related expenses or lost revenues attributable to COVID-19. This automatic payment was calculated by HHS in proportion to the providers’ share of Medicare fee-for-service reimbursements in 2019 and was applicable to all facilities and providers that received Medicare fee-for-service reimbursements in 2019. As determined by HHS, the funds will not need to be repaid. On April 16, 2020, we received an advance payment of $8.3 million from CMS under its Accelerated and Advance Payment Program, which was recently expanded to provide increased cash flow to service providers during the COVID-19 pandemic. The Advance Payment will be applied to all future Medicare claims we submit for reimbursement beginning August 14, 2020 (120 days after the Advance Payment was issued). If the Advance Payment is not fully recovered by CMS within November 12, 2020 (210 days of the issuance of the Advance Payment), we will make arrangements with our MAC for CMS to recoup the remaining balance. Funding Requirements Our primary uses of capital are, and we expect will continue to be, compensation and related expenses, clinical research and development services, laboratory and related supplies, legal and other regulatory expenses, general administrative costs, and interest and principal payments on our debt. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on the commercialization of our existing products, the development of our future product candidates, the potential commercialization of our product candidates, should their development be successful, and general administrative costs. Additionally, we anticipate using a portion of our capital resources to fund the expansion of our facilities in support of our growth strategy. Since our inception, we have incurred significant operating losses and negative cash flows. We had an accumulated deficit of $53.0 million as of June 30, 2020. Our ability to generate revenue sufficient to achieve sustained profitability will depend heavily on the successful commercialization of our currently marketed products and the products we plan to launch in the future as well as our spending on research and development activities. Although we generated positive operating income during the year ended December 31, 2019 and for the six months ended June 30, 2020, we expect to incur additional expenses and operating losses in the future as we invest in the commercialization of our existing products, the development of our future product candidates and the commercialization of our product candidates. We believe that our existing cash and cash equivalents and anticipated cash generated from sales of our products will be sufficient to fund our operations for the foreseeable future. However, we have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. There are numerous risks and uncertainties associated with developing genomic tests, including, among others, the uncertainty of: • successful commencement and completion of clinical study protocols; • successful identification and acquisition of tissue samples; • the development and validation of genomic classifiers; and • acceptance of new genomic tests by physicians, patients and third-party payors. Because of the numerous risks and uncertainties associated with research, development and commercialization of product candidates, we are unable to estimate our exact working capital requirements. Our future funding requirements will depend on and could increase significantly as a result of many factors, including those listed above as well as those listed in Part II, Item 1A., “Risk Factors,” of this Quarterly Report on Form 10-Q. We do not currently have any committed external source of funds. In the event additional funding is required, we expect that we would use a combination of equity and debt financings, which may not be available to us when needed, on terms that we deem to be favorable or at all. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making acquisitions or capital expenditures or declaring dividends. As a result of the COVID-19 crisis and actions taken to slow its spread, the global credit and financial markets have experienced extreme volatility, including 30 Table of Contents diminished liquidity and credit availability, declines in consumer confidence, declines in economic growth, increases in unemployment rates and uncertainty about economic stability. There can be no assurance that further deterioration in credit and financial markets and confidence in economic conditions will not occur. If equity and credit markets deteriorate, it may make any necessary debt or equity financing more difficult to obtain, more costly and/or more dilutive. If we are unable to raise additional funds through equity or debt financings or other arrangements when needed, we may be required to delay, limit, reduce or terminate our product discovery and development activities or future commercialization efforts. Long-Term Debt Our long-term debt balances are presented in the table below (in thousands): June 30, 2020 December 31, 2019 (unaudited) Term debt $ 25,854 $ 26,688 Unamortized discount and issuance costs (1,113) (1,566) Total long-term debt 24,741 25,122 Less: Current portion of long-term debt (10,000) (5,833) Long-term debt, less current portion $ 14,741 $ 19,289 We have a Loan and Security Agreement, or the 2018 LSA, with Oxford Finance LLC, or Oxford, as collateral agent, and Oxford and Silicon Valley Bank, or SVB, as equal syndicated lenders, or the Lenders. The 2018 LSA consists of a $25.0 million secured term loan credit facility, or the Term Loan. The Term Loan bears interest at a floating rate equal to the greater of (1) 8.55% and (2) the 30-day U.S. LIBOR rate as reported in The Wall Street Journal on the last business day of the month that precedes the month in which the interest will accrue, plus 6.48%. The applicable interest rate on the Term Loan was 8.55% as of June 30, 2020 and December 31, 2019. We were permitted to make interest-only payments on the Term Loan through May 31, 2020. As required, we began to repay the principal in 30 equal monthly installments of $833,333 each beginning on June 1, 2020. All unpaid principal and accrued and unpaid interest are due at maturity on November 1, 2022. We are also obligated to make an additional final payment of 6.75% of the aggregate original principal amount, or $1,687,500, upon any prepayment or on the maturity date. We have the right to prepay the Term Loan at any time, subject to a prepayment fee of up to 1.50% and an early termination fee of $497,000. On May 10, 2020, we entered into a fourth amendment of the 2018 LSA, or the Fourth Amendment, to, among other things, modify the covenant structure under the 2018 LSA such that we are now required to comply with either (i) a trailing three-month revenue target or (ii) a liquidity ratio, in both cases measured quarterly. We requested the Fourth Amendment from the Lenders so that our liquidity position would also be considered when determining compliance, due to the impacts of COVID-19 on our revenues. The liquidity ratio covenant requires that the ratio of (i) unrestricted cash and cash equivalents (as defined in the 2018 LSA) held at SVB or its affiliates to (ii) the outstanding obligations under the 2018 LSA be at least 2.00 to 1.00. As of June 30, 2020, we are in compliance with the covenant by satisfying the liquidity ratio test, with a liquidity ratio of 6.89 to 1.00 as of June 30, 2020. Our ability to further amend the terms of the 2018 LSA is subject to the approval of Oxford and SVB. Accordingly, should we seek to amend the 2018 LSA, there can be no assurance that an amendment would be available on terms acceptable to us or at all. For additional information on the 2018 LSA, refer to Note 7, “Long-Term Debt,” in the accompanying notes to our unaudited condensed financial statements included in this Quarterly Report on Form 10-Q. 31 Table of Contents Cash Flows The following table summarizes our sources and uses of cash and cash equivalents for each of the periods presented (in thousands): Six Months Ended June 30, 2020 2019 (unaudited) Net cash provided by operating activities $ 13,250 $ 1,770 Net cash used in investing activities (2,256) (424) Net cash provided by financing activities 69,920 11,643 Net change in cash and cash equivalents $ 80,914 $ 12,989 Operating Activities Net cash provided by operating activities was $13.3 million for the six months ended June 30, 2020 and was primarily attributable to the receipt of the Advance Payment of $8.3 million described above, stock compensation expense of $3.2 million and decreases in accounts receivable of $2.3 million, partially offset by the net loss of $0.8 million. The $1.9 million in relief funds from HHS discussed above were received and recognized in income during the six months ended June 30, 2020 and therefore also benefited net cash provided by operating activities during the period. Net cash provided by operating activities was $1.8 million for the six months ended June 30, 2019 and was primarily attributable to decreases in accounts receivable of $3.6 million and net non-cash charges of $1.9 million (consisting primarily of $1.3 million in amortization of debt discount and issuance costs, stock compensation expense of $0.3 million, depreciation expense of $0.2 million and change in fair value embedded derivatives of $0.1 million) and increases in other accrued liabilities of $0.9 million, partially offset by the net loss of $2.6 million and decreases in accrued compensation of $1.8 million. Investing Activities Net cash used in investing activities for the six months ended June 30, 2020 and 2019 consisted entirely of purchases of property and equipment. The increase in purchases of property and equipment in the current year compared to the prior year is primarily associated with expansion of our facilities. Financing Activities Net cash provided by financing activities was $69.9 million for the six months ended June 30, 2020 and consisted primarily of $69.5 million in proceeds from our June 2020 follow-on public offering of common stock (net of underwriting discounts, commissions and offering costs, excluding $0.5 million of offering costs that were incurred but not paid as of June 30, 2020) and cash received associated with our equity compensation plans of $1.2 million, partially offset by principal repayments on the 2018 LSA of $0.8 million. Net cash provided by financing activities was $11.6 million for the six months ended June 30, 2019 and consisted primarily of $11.7 million in net proceeds from the issuance of the Q1 2019 Notes, $1.8 million of net proceeds associated with an increase in the Term Loan in connection with an amendment to the 2018 LSA, partially offset by principal repayments of $1.8 million our line of credit. The line of credit was terminated in June 2019. Off-Balance Sheet Arrangements We do not currently have, nor did we have any off-balance sheet arrangements, as defined in the rules and regulations of the SEC, during the periods presented. Critical Accounting Policies and Significant Judgments and Estimates During the six months ended June 30, 2020, there were no significant changes to the information discussed under “Critical Accounting Policies and Significant Judgments and Estimates” included in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the year ended December 31, 2019. 32 Table of Contents Recent Accounting Pronouncements Refer to Note 2, ‘‘Summary of Significant Accounting Policies,’’ in the accompanying notes to our unaudited condensed financial statements included in this Quarterly Report on Form 10-Q for a discussion of recent accounting pronouncements. JOBS Act Accounting Election We are an emerging growth company within the meaning of the Jumpstart Our Business Startups Act, as amended, or the JOBS Act, enacted in April 2012. Section 107(b) of the JOBS Act provides that an emerging growth company can leverage the extended transition period, provided in Section 102(b) of the JOBS Act, for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. We have elected to use this extended transition period and, as a result, our financial statements may not be comparable to companies that comply with public company effective dates. We also intend to rely on other exemptions provided by the JOBS Act, including without limitation, not being required to comply with the auditor attestation requirements of Section 404(b) of Sarbanes-Oxley Act of 2002, as amended, or Sarbanes-Oxley. We will remain an emerging growth company until the earliest of (1) December 31, 2024, (2) the last day of the fiscal year (a) in which we have total annual gross revenue of at least $1.07 billion or (b) in which we are deemed to be a ‘‘large accelerated filer’’ as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock held by non-affiliates exceeded $700.0 million as of the prior June 30 th , and (3) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. Item 3. Qualitative and Quantitative Disclosures About Market Risk. As a smaller reporting company, we are not required to provide the information required by this Item.