Castle Biosciences Inc Q1 FY2022 Earnings Call

Good afternoon, and welcome to Castle Biosciences First Quarter 2022 Conference Call. As a reminder, today's call is being recorded. We will begin today's call with opening remarks and introductions, followed by a question-and-answer session. I would now like to turn the call over to Camilla Zuckero, Vice President, Investor Relations and Corporate Affairs. Please go ahead.

Thank you, Operator. Good afternoon, everyone. Welcome to Castle Biosciences First Quarter 2022 Financial Results Conference Call. Joining me today is Castle's Founder, President and Chief Executive Officer, Derek Maetzold; and Chief Financial Officer, Frank Stokes. Information recorded on this call speaks only as of today, May 9, 2022. Therefore, if you are listening to the replay or reading the transcript of this call, any time-sensitive information may no longer be accurate. A recording of today's call will be available on the Investor Relations page of the company's website for approximately 3 weeks. Before we begin, I would like to remind you that some of the statements made today will contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements about our financial outlook, total addressable market and similar items referenced in our earnings release issued today, and statements containing projections regarding future events or our future financial or operational performance, including our expectations and assumptions related to the impact of the COVID-19 pandemic. Forward-looking statements are based upon current expectations and involve inherent risks and uncertainties, and there can be no assurances that the results contemplated in these statements will be realized. A number of factors and risks could cause actual results to differ materially from those contained in these forward-looking statements. These factors and other risks and uncertainties are described in detail in the company's quarterly report on Form 10-Q for the quarter ended March 31, 2022, under the heading Risk Factors and in the company's other documents and reports filed with the Securities and Exchange Commission. These forward-looking statements speak only as of today, and we assume no obligation to update or revise these forward-looking statements as circumstances change. In addition, some of the information discussed today includes non-GAAP financial measures such as adjusted revenue, adjusted gross margin and adjusted EBITDA that have not been calculated in accordance with generally accepted accounting principles in the United States or GAAP. These non-GAAP items should be used in addition to and not as a substitute for any GAAP results. We believe these metrics provide useful supplemental information in assessing our revenue and cash flow performance. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are presented in the tables at the end of our earnings release issued earlier today, which has been posted on the Investor Relations page of the company's website. I will now turn the call over to Derek.

Thank you, Camilla, and good afternoon, everyone. Thank you for joining us. Today, I will take you through execution and strategy highlights from the quarter, and then Frank will provide financial highlights for the period. And then we will take your questions. As always, I want to thank all of our Castle employees for their hard work during the quarter and continued dedication to our mission of improving health through innovative tests that guide patient care. We had a strong quarter, which we believe will provide us with significant momentum for the rest of the year. We delivered almost 70% growth in total test volume over the first quarter of 2021 and $26.9 million in revenue, which we attribute to our continued focus on our strategy and strong operational performance. We saw strong year-over-year growth in our core dermatology business and our combined dermatology test volume that is DecisionDx-Melanoma, DecisionDx-SCC and our comprehensive diagnostic offering of myPath Melanoma and DiffDx-Melanoma, which grew by 69% over the first quarter of 2021. We continue to make careful investments intended to further accelerate growth in our core dermatology business as well as investments in the two other pillars of our growth strategy, our pipeline initiatives and strategic opportunities. I will highlight across each of these pillars, starting with our strong core dermatology business. But first, I would like to emphasize that we entered 2020 with an estimated in-market U.S. total addressable market, or TAM, of approximately $540 million. Despite the COVID headwind with the launches of both DecisionDx-SCC and DiffDx-Melanoma tests in the second half of 2020, we entered 2021 with an estimated in-market U.S. TAM of just under $2 billion. And as of April 2022, following our acquisition of AltheaDx, we now have an estimated in-market U.S. TAM of just under $8 billion, made possible by maintaining our focus on our three pillars of growth. Test reports for our flagship gene expression profile test, DecisionDx-Melanoma, grew by 48% in the first quarter compared to the first quarter of 2021, with 6,023 test reports delivered. As we have discussed, COVID-19 impacts the diagnosis of cutaneous melanoma during 2020 and 2021 according to our analysis of third-party data. We continue to see the data trending in ways that are not back to pre-COVID levels. However, now two years later, we are considering these trends a new normal for now, anyway. We have made decisions that we believe will strengthen our resilience and position our business for growth despite potential headwinds related to reduced diagnoses, and we believe our success in our dermatology franchise is driven by strong execution on these growth initiatives. For instance, we doubled our dermatology-facing representatives in 2021 to the mid-60s, where it stands now. As we communicated to you in the first half of 2021, we made the active decision to double our dermatology-facing representatives by July 2021, so that we would enter 2022 with a commercial team that could take advantage of the promotional responsiveness that we see in this market. So we feel good about the strong momentum we have seen so far in 2022. As we discussed, we will continue to assess the size of our commercial team and a number of outside sales territories. Our assessments will include evaluation of our mix of outside sales territories, inside sales support, marketing and medical affairs, and we'll adjust our investments based upon these evaluations. As I noted earlier, we believe that our market is promotionally responsive. So we anticipate that our sales force expansion efforts, investments in R&D, our peer-to-peer programs, our interface with a leading dermatology electronic medical record system, modernizing medicine and our federal supply schedule contract with the VA, which was recently extended to include all of our skin cancer tests should position us well for growth across our suite of dermatologic tests for the remainder of 2022. Another significant dermatology highlight was the presentation of our expanded National Cancer Institute collaboration with the SEER program. This expanded real-world data showed improved survival for patients who have the benefit of the DecisionDx-Melanoma test, in addition to traditional clinical and pathological data compared to untested patients who only had access to traditional clinical and pathologic factors to determine their treatment and follow-up plan. Specifically, patients diagnosed with melanoma and who received the DecisionDx-Melanoma test had a 27% improvement in melanoma-specific survival compared to untested patients. Let me restate this number as it is important clinically. When controlling clinical and pathologic factors as well as socioeconomic factors, patients who have the benefit of having DecisionDx-Melanoma test results in addition to clinical and pathologic factors had a 27% improvement in melanoma-specific survival. Switching now to DecisionDx-SCC. We have discussed potential timing of Medicare coverage for this test. At this time, we remain uncertain on timing. However, we continue to plan for Medicare coverage prior to mid-2023. You will recall that the technical dossier for this test was submitted to MolDX for review to come out in the second quarter. We expect to continue to offer this test to patients as we believe it is the right thing to do. Our billing department continues to build payers and as per our process, we expect to continue to receive some payments in 2022. Now turning to our pipeline initiatives. We presented proof-of-concept data at the Revolutionizing Atopic Dermatitis 2022 Conference last month, which concluded that our noninvasive skin scraping technique produced sufficient RNA to assess reproducible gene expression for inflammatory skin disease pipeline tests that's currently in development to predict therapy response. Specifically, data in the proof-of-concept portion of our ongoing development and validation study identified preliminary fees of interest. Importantly, the study demonstrated strong technical reliability and interoperative accordance for a skin-scraping technique. So we feel confident about our noninvasive skin sampling approach. As you may recall, in 2021, we initiated a 4,800 patients prospective multi-center clinical study to develop and validate this pipeline test. We believe we are on track to have initial validation and development data in 2023, and we expect to launch this pipeline test by the end of 2025, which would add approximately $1.9 billion to our estimated U.S. TAM. As we move to our last growth pillar, strategic opportunities, we are excited to discuss the ongoing progress of our tissue cycle integration, as well as our recent acquisition of PGx and the IDgenetix pharmacogenomic test for mental health conditions. As I mentioned above, the acquisition of these two laboratories expanded our in-market estimated U.S. TAM by approximately $6 billion to now approximately $8 billion. As we mentioned on past calls, we believe strategic opportunities enable us to build franchises in two complementary markets with existing commercialized products that address a clear unmet clinical need and have already gained Medicare reimbursement as well as select commercial coverage, and we have made these acquisitions further into our long-term growth and value creation objectives. For the near and midterm, we will focus on assessment of other strategic opportunities from the position of building our three franchise markets: dermatology, gastroenterology, and mental health conditions. As it relates to our TissueCypher Barrett's Esophagus test, we have seen the positive reception from clinicians that we identified during our marketing efforts in the second half of 2021. In the first quarter, CMS granted ADLT, or advanced diagnostic laboratory test status, for the TissueCypher test. ADLT status requires that a clinical diagnostic laboratory test provide new clinical diagnostic information that cannot be obtained from any other test or combination of tests among other criteria. Of significant business importance is the fact that ADLT status exempts TissueCypher from what is called the 14-day rule, which simplifies the billing process for Medicare patients. We also announced in the first quarter an independent peer-reviewed article published in the Clinical Gastroenterology and Hepatology Journal. The study, a pooled analysis of 5 previously published clinical validation studies of 552 Barrett's Esophagus patients was led by Dr. Prasad Iyer, a recognized expert from the Mayo Clinic in the diagnosis and the management of Barrett's Esophagus. The analysis reinforces the ability of TissueCypher to significantly improve predictions of the progression to esophageal cancer or high-grade dysplasia in patients with Barrett's Esophagus compared to predictions based on clinical and pathology variables alone, allowing for more informed management decisions to occur. For instance, one analysis evaluated the impact on TissueCypher in combination with clinical and pathologic factors that are known predictors of progression in patients with non-dysplastic Barrett's Esophagus disease. This patient group is particularly concerning as we believe they represent approximately 348,000 endoscopies per year or approximately 91% of the intended use market for TissueCypher. We continue to make progress on our Pittsburgh laboratory enhancements, and we have signed our new lease to facilitate further progress for TissueCypher, which includes optimizing test turnaround time. You may recall our commercial team consists of 14 outside sales territories. Similar to our dermatology commercial team, we will continue to assess market response and determine what the appropriate commercial expansion will look like, but based upon our initial market research as well as initial provider response, we'd expect to add approximately 10 to 15 additional outside sales territories sometime in the third quarter, ending the year with approximately 25 to 30 outside sales territories. Let's turn now to our recent closure on AltheaDx and the acquisition of the IDgenetix test in late April. I want to reiterate our strategic focus and how this acquisition aligns well within this focus. Castle aims to transform patient management by providing actionable information in disease states with high unmet clinical needs. We accomplished this through four main factors. Number one, we identify high-value clinical decision points that are poorly served by current subjective features. Number two, we focus on clinical decision points where the diagnosing clinician is the treating clinician. Number three, we limit our investment to proprietary products. And number four, we analyze subsequent disease states or clinical decision points on the same diagnosing or treating clinician basis, thereby providing multiple high-value tests to the same customer and leveraging our commercial investment. We believe IDgenetix aligns with our strategic focus. Additionally, as you may recall from our April 4 announcement, IDgenetix previously only had Medicare coverage for use in patients diagnosed with major depression. As we enter into May, Medicare coverage to the IDgenetix multi-gene test now includes 7 additional mental health conditions for a total of 8. And as a reminder, a randomized controlled trial showed that patients diagnosed with depression who were assessed with the IDgenetix test showed a greater than 2.5 times improvement in remission compared to those patients who received the physician's choice without knowledge of other pharmacogenomic information. AltheaDx had a commercial team covering approximately 20 outside sales territories and all joined the Castle family. We are excited about the potential IDgenetix has to help patients diagnosed with mental health conditions. And we recently announced a collaboration with Camille Schrier, Ms. America in 2020 during Mental Health Awareness Month to promote the potential of genetic testing and the IDgenetix test to help improve treatment for mental health conditions. We look forward to updating you in the near term on our progress in IDgenetix. I will now turn the call over to Frank, who will provide details relating to our financial results and updated 2022 revenue guidance.

Thank you, Derek, and good afternoon. First quarter revenue was $26.9 million, an increase of 18% over the first quarter of 2021. Overall, the increased revenues primarily reflect both higher report volumes for our DecisionDx-Melanoma and DecisionDx-UM test, partially offset by lower revenue adjustments related to tests delivered in prior periods. We believe the higher volumes are attributable to a combination of increased patient flows from the easing of COVID-19 restrictions and the effects of our dermatologic sales force expansion last year. Excluding the effects of revenue adjustments related to tests delivered in prior periods, adjusted revenue was $26.3 million, an increase of 50% over the first quarter of 2021. For the three months ended March 31, 2022 and 2021, we recorded net positive revenue adjustments of $0.6 million and $5.3 million, respectively, related to tests delivered in previous periods associated with changes in estimated variable consideration. We are raising our full year 2022 revenue guidance and now anticipate generating revenue between $118 million and $123 million, which we believe will be driven by further consistent execution on our growth plans and in particular, the AltheaDx acquisition. Our gross margin during the first quarter was 71.7% compared to 86.7% in the first quarter of 2021. Our adjusted gross margin, which excludes the effects of intangible asset amortization related to our acquisitions and revenue associated with test reports delivered in prior periods was 77.4% for the quarter compared to 82.7% for the same period in 2021. As you saw in the first quarter, we continue to expect our gross margin percentage to be negatively impacted in the near and mid-term by increased spending on investments to facilitate and support anticipated growth and report volumes in advance of obtaining reimbursement coverage for several of our tests. These investments may include additional laboratory personnel and related resources. Additionally, as we have discussed, our GAAP gross margin may also continue to be negatively impacted by amortization of intangible assets associated with recent acquisitions for the remainder of 2022. Our total operating expenses, including cost of sales for the quarter ended March 31, 2022, were $51.4 million compared to $27.1 million for the first quarter of 2021. The largest driver of the increase was higher SG&A, which increased by $12.3 million compared to 2021, attributable in large part to higher personnel associated with our increased head count, including expenses related to salaries, bonuses, benefits, and stock-based compensation. These higher personnel costs were primarily attributable to the expansion of our sales and marketing teams as well as administrative support functions. Further, in connection with our acquisition of Cernostics, we hired an initial commercial team of 14 outside sales territories along with internal sales associates and medical science liaisons to support our launch of the TissueCypher Barrett's Esophagus test. The remainder of the increase in SG&A was primarily associated with training events, meetings, travel, and other general increases. R&D expense increased by $4.9 million in the first quarter compared to the first quarter of 2021 and was primarily associated with increases in personnel costs including increases in stock-based compensation attributable to additional head count to manage longer clinical studies and increases in other expenses associated with increased clinical study activity. Total stock-based compensation expense, which is allocated among cost of sales, R&D and SG&A, totaled $8.4 million for the first quarter compared to $4.9 million for the first quarter of 2021. Operating expenses this quarter also included a change in fair value of contingent consideration of $2.6 million or $0.10 per diluted share and is related to the remeasurement of the liability for earn-out payments in connection with our acquisition of Cernostics. This expense could vary from quarter to quarter depending on any changes in assumptions and valuation results. Further, we had amortization of acquired intangible assets for the three months ended March 31, 2022 of $1.6 million, which is related to the developed technology we acquired in May 2021 and December of 2021 attributable to myPath Melanoma and TissueCypher test, respectively. Our net loss for the first quarter of 2022 was $24.6 million compared to a net loss of $4.3 million for the first quarter of 2021. Basic and diluted loss per share for the first quarter was $0.97 compared to basic and diluted loss per share of $0.17 in the first quarter of 2021. Adjusted EBITDA for the first quarter was negative $11.4 million compared to a positive $0.9 million for the comparable period in 2021. Net cash used in operating activities was $21.4 million for the three months ended March 31, 2022, that was primarily attributable to the net loss of $24.6 million, accrued compensation of $6.9 million and increases in accounts receivable of $2.7 million, partially offset by stock-based compensation expense of $8.4 million and a change in fair value of contingent consideration of $2.6 million as well as depreciation and amortization of $2.2 million. Finally, we had cash and cash equivalents at March 31, 2022, of $309 million and no debt. I want to reiterate that we believe our strong balance sheet positions us well for continued growth and value creation. I'll now turn the call back over to Derek.

Thank you, Frank. In summary, we're off to a great start in 2022, delivering strong year-over-year growth in our core dermatology business and a laser-like focus on strategy execution. We continue to make thoughtful investments to accelerate growth, and we are seeing results from those investments. I would like to conclude today by thanking our Castle team. I thank you for your continued interest in Castle. Now we are happy to take your questions. Operator?

Our first question today comes from Puneet Souda at SVB Leerink.

I have a question regarding guidance. You outperformed our expectations by about $1 million, and I believe you also exceeded consensus. You're anticipating $2 million for AltheaDx, which seems to justify the increase in guidance at the midpoint when you combine these two factors. Given the positive momentum in the market, is there anything that makes you cautious? Is it still the impact of COVID? Are there challenges with access? Is there anything else contributing to your confidence? It seems to me that you would be feeling more assured at this stage, especially with the current market conditions and the hope that we are moving beyond the COVID situation.

That's a great question, Puneet. Derek here. I'll add some context, and Frank can chime in if needed. First, it's just the first quarter. You're correct that we finished last year with very strong momentum, especially in our dermatology business. We're still in the early stages of launching both TissueCypher and AltheaDx, which just closed this quarter. There's some cautiousness regarding the new product opportunities from a launch perspective, but we don't see any indication of reduced access for representatives. Do you want to...?

I would just remind you that the range, the Althea revenue guide was $1 million to $3 million rather than in a single midpoint. And I think that the revised guidance reflects our enthusiasm and excitement about the tremendous execution in our core derm business that we continue to see.

Okay. That's helpful. And then Derek, maybe taking a step back, when you look at the AJCC guidelines overall, where DecisionDx-Melanoma is today, the momentum that you've had in the data generation that you've had for the last few years. The fact that DecisionDx-Melanoma and, correct me if I'm wrong, it's mid-teens to high teens penetrated in the market. At what point do you think you can approach the AJCC guidelines and potentially, we can see a potential or inclusion of this test longer-term into the guidelines?

That's an excellent question. I'd like to clarify that AJCC focuses primarily on diagnostic workup. Until the last update around December '17 or January '18, Oncotype for breast was only included in the diagnostic workup guidelines at that time. Modifying the AJCC diagnostic criteria is likely a long-term process because they aim to align with WHO standards. Regarding the NCCN guidelines, we believe our ongoing collaboration with the National Cancer Institute/SEER study is a significant real-world, large prospective dataset. This research indicates that when clinicians can integrate our test results with other standard care information, such as clinical and pathological features, they tend to make somewhat better decisions that lead to longer patient lives. This finding is quite important. Since this is a large third-party study, it should carry weight. We expect the NCCN Committee members to review this data and follow the practices of over 5,000 U.S. clinicians who currently incorporate it into their work. However, as you know, the diagnostic figures for melanoma can be somewhat uncertain. We estimate that we exited last year with around 18% to 20%, closer to 20%. Is that correct?

Reduced number of diagnoses.

Reduced number of diagnoses. So we're already sort of testing last year, one in five patients. And doing some assessment work, it looked to us like things like Oncotype DX for breast cancer, for example, didn't get incorporated into NCCN guidelines for breast cancer hit around 30%. So we're going to just a year or two away from there. So I think that will be around the corner is my expectation because clinicians are using our test in record numbers to help treat their patients. And although we do recognize NCCN as being a lagging indicator of adoption, that labyrinth is coming pretty close from our perspective.

Our next question comes from the line of Catherine Schulte with Baird.

First, you mentioned melanoma diagnosis aren't yet back to pre-COVID levels. Where were they for the quarter? And then you mentioned you're considering this the new normal, why don't you think that will rebound to pre-COVID levels? And does that change how you think about the ideal ultimate size of your sales force if diagnoses and/or rep access is going to be different going forward versus pre-COVID?

A lot of you have no questions there, Catherine. First, we don't believe we have accurate first quarter diagnosis numbers based on the vendor we've been using. We think that there hasn't been any pullback. There’s no indication from a sales force access perspective; they were noted in the market in January or February that Omicron had any significant impact. The question is we’ve been in this situation for about seven quarters, and we keep wondering when we will get back to diagnosing around 130,000 patients a year instead of approximately 110,000 or 115,000. In the short term, I can’t say when they will return, whether it's due to a decrease in telehealth over time or if we should. We wanted to be as transparent as possible and indicate that for now, we should probably consider the normal patient flow to be what it is. Unfortunately, patients who had delayed diagnoses, largely due to the implementation of telehealth, face challenges, especially older patients who find it difficult to navigate telehealth for melanoma screening. This is concerning from a patient care perspective. Until we see a return to in-person primary care activity, we would expect a gradual increase of these patients as they self-diagnose a melanoma that is now larger than it would have been in a typical primary care interaction a year or two ago. However, predicting a rush to catch up with all these missing patients is challenging from our perspective, which we have always tried to communicate openly.

Got it. You did.

In terms of size of the sales force question that is tarred there, I don't think it impacts that. We have such a large untapped medical need in melanoma. As you know, we're just now scratching the surface for squamous cell carcinoma, and we also have our myPath and DiffDx tests. Those are all largely at the same customers. So a few thousand less melanoma patients doesn't necessarily change the opportunity we have to really impact patient care who have skin cancer or one of the right of skin cancers in the dermatologist practice. So I think that doesn't impact our planning or decision-making process.

Okay. Got it. And then for squamous cell, had those volumes drop sequentially. So I'm just curious if you could talk through what you're seeing with that test? Is there seasonality there? Just a little surprised to see that given it's so early in the launch and given the sales force expansion. So any color on what you're hearing in terms of doc feedback would be great.

Yes. Catherine, it's Frank. The physician feedback is tremendous. It's the clinical utility of our squamous cell test may wind up being even more compelling than the clinical utility of our melanoma test, which is, of course, well published and well validated. Important to remember, the reps, our area managers are still directed to focus most of their time on the melanoma test. And given where we are in the reimbursement journey, we certainly don't want to have a squamous report at the expense of the melanoma. Now if a physician and many of them do, if they want to talk about squamous, the area managers are well equipped, well trained, and they'll do it. But we are guiding them fairly heavily to focus the majority of their interactions on melanoma. So we're quite happy with where the squamous volume was this quarter. It may bounce around a little bit. I think that the real measure is going to be once we get the reimbursement puzzle fixed there, I think you'll see that start tracking angles and trends like melanoma.

I wouldn't worry about quarter-over-quarter performance, especially this quarter. Since we launched the squamous cell test only in late August 2020, we don't have significant non-COVID oral patient flow experience. Assuming the patient flow for squamous cell is similar to that of melanoma, prior to COVID, the number of patients diagnosed and report growth from the first quarter to the fourth quarter was not substantial and typically remains stable. This situation is consistent with past trends. We've also seen only positive impacts from the decisions we are making regarding our tests and patient care. If squamous cell follows a similar seasonal pattern to melanoma, which seems likely, we don't expect an increase in diagnosis rates for melanoma. We anticipate that our report growth will be stronger in the second quarter than in the first, a slight increase in the third quarter compared to the second, and then the third to fourth and fourth to first quarters should remain stable. This is typical, and it's important to note that we are currently investing around 10% effort into launching this product, which is a comfortable position for us given our current reimbursement status.

Our next question comes from Mason Carrico with Stephens.

First, could you walk through some of the growth dynamics in the quarter for your dermatology portfolio specifically? Any color you can provide on growth you're seeing from growth in new clinicians adopting use of the test versus increases in utilization?

Yes, it was really twofold. We had a strong quarter regarding new ordering physicians, which is a key metric for us that we actively monitor and influence; the results of our area managers are significantly affected by this. The reason is that when we successfully engage a physician and they start using the test with a few of their patients, we usually find that after reviewing the data and understanding the benefits, they tend to expand its use to a broader group. So, we had an excellent quarter in terms of new ordering physicians, along with ongoing volume and uptake from our existing doctors. As Derek mentioned, we are still finding it challenging to pinpoint the exact number of clinicians that we can target nationally, mainly due to the various subspecializations within dermatology. However, about half of the targetable doctors used the test in the last year. This one out of two rate is nearing the standard of care. As we see our penetration levels continue to rise, physicians will notice that their peers are using the test and benefiting from it. Additionally, this quarter, we achieved one of the most significant data points from a study, collaborating with NCI and utilizing SEER data, and we are working diligently to get that published as it is a crucial objective for us. We plan to enhance the dialogue surrounding this even further.

Got it. That's helpful. On your IDgenetix test, in the sense that it incorporates drug-to-drug interaction. I was wondering, one, is that unique to IDgenetix versus some competitor tests out there? And also, is there a general percentage of patients with major depressive disorder who are on one or more medications?

I'll address the first question and then clarify the second one later. Regarding the first topic, four clinical studies have been conducted using pharmacogenomic tests for patients with depression. Out of these, two yielded negative results, both of which focused solely on drug-gene interaction reporting. Myriad's GeneSight test had a study with positive outcomes, showing improved remission and response rates compared to doctors' choices. However, it only reports drug-gene interactions. On the other hand, AltheaDx's early scientists chose to highlight both components, believing doctors should see a summary of not only the patient's current medications but also how their genetics affect treatment options. As a result, the AltheaDx study showed positive improvements in both remission and response rates. I want to be careful not to undermine the validity of study comparisons, but when looking at the GeneSight study, the level of responses seemed less robust than what was observed in the AltheaDx study. This could be attributed to various factors, like study design or site selection. From our viewpoint, we aim to be transparent about our protocol design and how straightforward it is for clinicians to order our IDgenetix test. We provide one lab report that encompasses everything they need, unlike other tests that require doctors to seek additional information online. This is a significant advantage for us. However, the main opportunity lies not in capturing market share but in helping those who have previously lacked access to pharmacogenomic testing make better choices from the start. We believe we have a strong competitive edge that’s easy to convey. Regarding patients on multiple medications, many of those with anxiety and the newly approved conditions, recently covered by Medicare, tend to be on several drugs, which increases the value of our test for both clinicians and patients.

Our next question comes from Thomas Flaten with Lake Street Capital Markets.

Sticking with IDgenetix, from a rep productivity perspective, obviously, the guide is pretty marginal at this point, but 20 feet on the street, what kind of productivity could you get out of that team without a significant expansion in the say, near to intermediate term?

Yes, Tom, this is Frank. We anticipate expanding that group as we increase our volumes. Having Medicare coverage will enable us to scale appropriately as volumes grow. I can't specify when we might expand, but it's clear there are many uncovered areas we can explore. We will use our usual structure of area managers, medical science liaisons, and inside sales associates to penetrate that market. It's too early to determine when a representative is generating enough business to warrant scaling down a territory. However, in our behavioral health efforts, we plan to follow a similar approach as before, where we want our area managers to spend about half their time acquiring new physicians and the other half providing information and support to those already using the test. We will provide more insights as we move forward.

And out of curiosity, are those territories built around high prescribers of a certain basket of meds? Or anything you can share about how those territories are built or designed?

With millions of potential patients and only about 20 sales stores, our initial strategy was based on large geographical coverage. We expanded this scope late last year and earlier this year to focus on quicker responsiveness. The key opportunity lies in moving forward after the next few months, as we work on integrating our teams and aligning our commercial and medical strategies. We anticipate making significant strides by March towards the end of this year. This is also why we are setting modest expectations to avoid making hasty decisions for the wrong reasons, allowing us to make thoughtful choices for the right reasons.

Our next question comes from Kyle Mikson with Canaccord.

Staying on the topic of acquisitions, the current total addressable market of your legacy term business has significantly increased through these acquisitions and product launches. However, the legacy business remains below $2 billion in total addressable market. I understand that the pipeline suggests potential growth of $5 billion to $6 billion, but you've also added $1 billion from Cernostics and $5 billion from Althea, which I assume are major factors behind these acquisitions. I'm curious what gives you confidence in your ability to successfully penetrate these additional total addressable markets that you've introduced over the past year. It would also be beneficial to discuss this in relation to your goal of reaching cash flow breakeven by 2025, especially before launching some of these upcoming tests in the dermatology area.

So clarify what you're thinking about with the word incremental. The incremental as in Cernostics incremental to dermatology or incremental in dermatology. I just want to make sure we're answering the question correctly.

Sure, Derek. The $1 billion from Cernostics and the $5 billion from Althea represent significant opportunities for Castle. What gives you confidence that you can effectively penetrate those markets, considering they are relatively new businesses?

That's a great question. Our view is that during the COVID period, we assessed whether we should remain solely focused on dermatology or consider expanding beyond that once we established adequate infrastructure and support. We wanted to explore opportunities that would allow us to leverage our expertise, looking for areas with high unmet clinical needs that could be addressed through advanced micro-diagnostics. We specifically wanted to see if there were multiple potential products we could develop. We realized that working independently would lead to a lengthy and uncertain development timeline, particularly in securing reimbursement. We aimed to identify complementary areas to Castle’s strengths. For instance, in gastroenterology and our TissueCypher test for Barrett's Esophagus, there is a significant unmet clinical need. Gastroenterologists express concerns over the inadequate predictive value of pathology for determining which patients with Barrett's Esophagus will progress, leading to both undertreatment and unnecessary repeat endoscopies. Our analysis revealed a promising opportunity in Barrett's disease, supported by clinical data from Cernostics prior to our acquisition, providing us a chance to meet the needs of gastroenterologists. Additionally, we noted the existence of Medicare reimbursement and some commercial payer coverage, which indicated a lower risk for integration and growth in 2023 and the subsequent years. We believe that by 2025, we could have multiple tests targeting the same customers in gastroenterology similar to what we achieved in dermatology. Regarding the Althea opportunity, we found a large unmet need, and the product profile appeared to be highly competitive. We see potential for it to drive substantial growth in the next few years, similar to our expectations for TissueCypher. The design of the product, particularly its integration of drug interactions, should simplify the prescribing process for doctors and be appealing to our customer base. Execution will be crucial for both our mental health and GI businesses. We demonstrated our capability to launch the melanoma test and other products successfully, which should alleviate concerns about execution risk. We are focusing on consistent and effective execution while leveraging digital marketing advancements from AltheaDx across our other lines. We are optimistic about integrating our efforts over the next few months and are looking forward to the contributions from these acquisitions from 2023 to 2028.

Okay. Just sticking with Althea maybe the new indications for IDgenetix under the coverage expansion. I assume that's going to be the kind of $1,500 rate as for depression. Can you just talk about any off-label use of the test in these newly reimbursed areas to date? And ultimately, is there any material upside through the '22 revenue or maybe gross margin expectations that you provided here today? I don't think they're baked in. And if you could quantify the milestone payment, was that in connection with this reason catalyst, that'd be helpful.

After addressing some of those questions, I know Frank will cover more. Regarding the expanded indications, these are disease states that AltheaDx mentioned before the expanded Medicare coverage. The main expansion wasn't about the MolDX program indicating that there’s now added value for these patients; rather, it involved a review of data for these indications. The primary goal of IDgenetix is focused on what the Clinical Pharmacogenetics Implementation Consortium (CPIC) does. CPIC is a semi-governmental organization made up of academics, pharmaceutical companies, and currently involved FDA personnel. They assess what we know about interactions between FDA-approved drugs, drug-drug, or drug-gene interactions. They aim to create an evidence-based list that clinicians can refer to on the CPIC website to understand potential interactions for specific diseases and age groups. Therefore, CPIC serves as a central resource for the potential use of a test like IDgenetix. However, it's important to note that what I've described isn't part of what doctors are compensated for; they are compensated to see patients. The true value of CPIC hasn't been clearly recognized, but there is potential to examine acknowledged drug-gene or drug-drug interactions that could be included in future reports. CPIC is one consortium that can help us evaluate if certain interactions align with our current customer base and assist in developing data to demonstrate our ability to measure these interactions with specific diseases. I wouldn't classify any use of the IDgenetix test as off-label; we only report interactions that are pertinent to patients with a specific disease or diagnosis today. We can certainly expand that as we develop more data over time. Did I address that part of the question, Frank?

Yes. And Kyle, the milestone or contingent consideration potential payments are based on revenue growth and reimbursement performance.

Our next question comes from Mark Massaro from BTIG.

I wanted to ask about gross margins. So Frank, you talked you'll make in lab personnel and amortization of intangible assets from acquisitions. Legacy Castle, you guys are quite unique with 80% gross margins. So can you just maybe help us at a high level think about your mid- to long-term gross margin trajectory and when you think you might be able to get back to those potential 80% gross margins? Or is this mid- to high 70s, you think maybe the new normal?

Yes. I will separate that from a GAAP gross margin, which includes the amortization of intangible assets from acquisitions. That will change due to that amortization. However, in terms of adjusted gross margin, when you are not compensated adequately for your service, it negatively impacts gross margin. Once the reimbursement process for repairs or corrections is improved, we expect to return close to the gross margin levels we had previously. IDgenetix also operates on Quad Studios, allowing for similar throughput and workflow. Therefore, it is a matter of ensuring reimbursement aligns with volume, which is something we are diligently working on.

One exercise is to consider that when you're not appropriately paid for your service, it negatively impacts gross margin. When we have the reimbursement path for repaired or fixed services, we expect to regain close to the gross margin we had previously. IDgenetix operates similarly to Quad Studios in terms of throughput and workflow. Therefore, it's essential for reimbursement to align with volume, which is something we are actively addressing.

Sorry, continue, Derek.

I was going to say, for example, one exercise that we don't do in our filings is just take the volume for the tests that you believe have reasonable reimbursement, such as the DecisionDx-UM test, our DecisionDx-Melanoma test and our myPath Melanoma test and just use those as your test report denominators and the buyback into the cost of goods, and you'll see it sitting up where you expect it to go and be. So I think it's a matter of progress on reimbursement that lets that volume that we're producing reports on today that aren't being reimbursed appropriately that will move the needle right as Frank said.

Okay, that's helpful. I think your R&D outlook for the year includes an investment between $65 million and $80 million in 2022. Can you provide a breakdown of this investment among dermatology, gastrointestinal, and mental health? You mentioned that gastrointestinal could be a new area where you might add additional indications over time. How are you considering adding those either organically or through acquisitions? Also, could you share details about the pipeline that you acquired?

Yes, I believe your R&D spending will be significant, Mark. We will ensure that we clarify this for you. We haven't specified how much is allocated to each category. However, I can assure you that we will continue to aggressively support our end market dermatology testing and TissueCypher in IDgenetix. We have seen great success in creating internal signatures. While our UM test was licensed, our three dermatology tests, excluding the myPath component of our comprehensive diagnostic offering, were all developed in-house. We have a high level of confidence in our R&D team's capability to develop these signatures. The challenge lies in identifying a clinical question that physicians need answered. If we can achieve that, we are confident in our ability to deliver. Additionally, we have recognized relevant questions in the gastrointestinal area. Once we identify a question from a group of physicians, we are confident in our ability to create a signature for it. We aim to expand our GI product offerings and are actively working on several initiatives. The potential with these physician groups is substantial. As we learned from our squamous cell quick update, educating physicians about the benefits of gene expression profile diagnostic testing makes it easier to illustrate the value when new patients come in.

Okay. That's great. One last one for me. You guys have a strong balance sheet with over $300 million of cash. You have been acquisitive recently. You've got new channels where you could plug additional assets into valuations have declined significantly in the last three months. How do you look at the environment for potential tuck-ins at this current time?

I think it's important to acknowledge that while we never want to rule anything out, we see a real opportunity to integrate and advance our efforts in three main areas: gastrointestinal, mental health, and dermatology. We have established that dermatology is a key driver of our near to mid-term core revenues, and one of our growth strategies includes exploring external opportunities like TissueCypher and IDgenetix. Additionally, a key aspect we appreciate about dermatology is the potential to leverage gastroenterology in our mental health outreach. So, from an acquisition standpoint, we are consistently evaluating options, but it seems more likely that if we proceed with additional movements, we will concentrate on expanding our current outreach efforts to maximize the value of our commercial investments. Would you like to add anything? This wraps up our second quarter 2022 earnings call. Thank you once again for joining us today and for your continued interest in Castle Biosciences.

Thank you, everyone, for joining us today. This concludes our call. You may now disconnect your lines.