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Should I buy Novacyt shares at under 400p?

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Novacyt (LSE: NCYT) shares are up nearly 10%, as I write. The Covid-19 testing specialist said its sales rose by 230% to £277.2m in 2020. Novacyt’s share price has risen by 60% over the last year, but the stock remains nearly 70% below January’s high of 1,190p.

The stock has slumped as the outlook for the business has become increasingly uncertain. The company is involved in a legal dispute with the NHS that relates to 45% of last year’s sales. Novacyt also faces a tougher market outlook, with demand for Covid-19 testing falling.

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A record-breaking year

Novacyt had an incredible year in 2020. The company generated a pre-tax profit of £132.4m on sales of £277.2m. This growth was driven by the company’s role as one of the main suppliers of Covid-19 PCR testing kits to the Department for Health and Social Care.

It was a profitable business — Novacyt’s operating profit margin hit 60% in 2020. The company was able to repay all of its debts and ended the year with net cash of £91.8m.

Unfortunately, this strong performance has been spoilt by a messy dispute with the NHS .

Bad news for shareholders

Investing in companies that are involved in legal disputes can be risky, as the eventual outcome is often unpredictable. I’m worried about the potential impact of the NHS on Novacyt shares.

The firm’s share price crashed in April when the company first revealed this problem. Details are scarce, but today’s results did include an update on this situation.

The 2020 revenue affected by the dispute is £129.1m. From what I can understand, the NHS is asking for a refund. However, Novacyt is hoping to be able to settle the case by replacing some products under warranty. The company reckons this might cost “a maximum of £19.8m.”

To make matters worse, this dispute is now affecting product sales in 2021. Novacyt says invoices for £49m of product delivered to the NHS this year remain unpaid.

I don’t like this situation at all. The only good thing I can see is that Novacyt’s £92m net cash balance gives the firm some breathing space. However, I suspect that much of this cash will be needed to resolve this legal claim.

Novacyt shares rely on growth hopes

However, I can see two reasons to be optimistic about the outlook for Novacyt shares. Firstly, I think the stock may still be cheap. The latest management guidance is for sales of £100m in 2021, excluding the disputed NHS sales. CEO Graham Mullis expects to be able to maintain a gross profit margin of 70% on these sales.

My sums suggest this values the stock at around 10 times 2021 forecast earnings. That seems reasonable to me.

The other reason for optimism is that Novacyt is continuing to develop new non-Covid products for the “respiratory, transplant and infection disease markets.” Success here could help to offset a continued decline in Covid-19 testing.

Would I buy Novacyt shares at under 400p today? Personally, no. The combination of legal risks and the firm’s dependency on Covid-19 testing makes it too risky for me. Although the shares could recover well, I think a gradual decline is more likely.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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