For years, I hated the grow-at-all-costs business models followed by emerging growth companies. They work – until one day (or a quarterly update) they stop working. All it takes is a disappointing rate of revenue growth or a downgrade in forecasts for Wall Street analysts to issue significantly lower price targets. The little guy is usually the one who ends up getting hurt. That means you, dear reader.
One of my favorite examples over the years was the genetic testing company Invitae (NVTA) – Get the report from Invitee Corp.. The deeply unprofitable company invested heavily in growth and acquisitions, which forced it to issue new shares to raise capital and keep the lights on. Example: the number of shares outstanding increased by 440% during the five-year period ending in March 2022.
The grow-at-all-costs economic model worked when interest rates were artificially low and money was cheap, but Wall Street is suddenly more nervous about the approach given a less accommodative macro environment. As a result, shares of Invitee are down more than 75% since the start of 2022.
Believe it or not, despite my historic hesitations, I let my guard down and jumped on the bandwagon alongside an old friend and colleague by starting a position in May 2021. It didn’t go well. Here’s why I sold my position in Invite and what I learned from the disaster.
This metric trumps revenue growth in 2022
While earnings growth was the focus of growth stocks until recently, investors are now focusing more on earnings quality. How fast can a business grow its gross margin, and how much will it impact the income statement to fund the business from operations, rather than external sources?
Wherever a company is in its growth trajectory and at the end of 2021, it must now focus on operational efficiency. The transition will be easier for some companies than for others. Unfortunately, Invitee is likely to struggle.
The genetic testing company achieved a gross margin of just 21.5% in the first quarter of 2022. It was the lowest since at least the end of 2017 and far behind its peers. NeoGenomics (NEO) – Get the report from NeoGenomics, Inc. faces its own challenges, but still delivered a gross margin of 32.6% in the first three months of this year. A myriad of genetics (MYGN) – Get the report from Myriad Genetics, Inc., the closest comparison to the business of Invitee, turned 70.9% of revenue into gross profit over the same period. Exact Sciences (EXA) – Get the report from Exact Sciences Corporation led the pack with a gross margin of 72.3%.
Why is this important? Deteriorating income quality reduces the benefit of income growth. Recent historical comparisons illustrate this well.
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- Q1 2022: A gross margin of 21.5% means the company turned $124 million in revenue into $26.5 million in gross profit.
- Q4 2018: A gross margin of 53.4% means the company turned $45.4 million in revenue into $24.2 million in gross profit.
In other words, Invitae increased its quarterly revenue by about 173% in three years, but its gross profit only increased by 9.5%. Worse still, quarterly operating expenses rose from $50 million to $240 million during this period, a 380% increase. Shareholders simply don’t see any benefit from revenue growth or platform scale.
What happened ? Most operational inefficiency is due to poor cost control and the financial impact of acquisitions. There may not be a miracle solution.
Invitee’s workforce has grown from 364 at the start of 2017 to more than 2,900 at the start of this year, largely due to acquisitions. Amortization of goodwill and intangible assets – also driven by acquisitions – is an increasingly important component of cost of goods sold. Unless there is a significant one-time impairment, these expenditures are generally expensed over an eight-year period. This is problematic given that many acquisitions have taken place at high valuations.
For example, Invitae acquired ArcherDX for $1.4 billion, roughly 20 times revenue in 2020. The acquired liquid biopsy tools are at the center of a patent infringement lawsuit, which forced the company to rebrand certain products and may also have contributed to recent delays. It doesn’t help that Invitee has a market valuation of around $800 million today. If the ArcherDX acquisition doesn’t pay off in the next few years, the company will miss its lofty revenue growth projections and will be in for a big financial hit.
Can Invitae turn the tide?
Management aims to maintain revenue growth at nearly 40% per year while limiting expenses. The stock price decline and skeptical questions from analysts on the latest quarterly earnings conference call suggest that Wall Street isn’t giving the company the benefit of the doubt.
Revenue growth and billed testing volume declined in the first quarter of 2022 compared to the last three months of 2021. This was the first time that testing revenue declined sequentially since the first quarter of 2019, excluding of the period taken at the start of the pandemic. It’s probably a temporary trend, although I thought the same about declining gross margin when I bought stocks in May 2021.
Invite has little margin for error. The company plans to rapidly reduce cash burn, extend the cash trail through the end of 2023, and generate positive operating cash flow by 2025. Success will depend on maintaining a meteoric pace of revenue growth in an increasingly competitive landscape for genetic testing and demonstration of success. from unproven parts of the business, including new liquid biopsy products and data revenue.
Could Invitae turn the tide? Absolutely, but it will probably be a work of several years. My decision to sell was easy. It wasn’t a big position in my portfolio, I lost faith in the company and there are just too many better opportunities on my radar. Even if you’re a long-term investor, it’s important to stay objective.