For years I have detested the growth-at-all-costs business models followed by emerging growth companies. They work – until one day (or quarterly update) they don't. All it takes is one disappointing revenue growth rate or downward revision in guidance for Wall Street analysts to issue sharply lower price targets. The little guy is usually the one that ends up getting hurt. That means you, dear reader.
One of my go-to examples over the years was genetic testing company Invitae (NVTA). The deeply unprofitable business invested heavily in growth and acquisitions, which required it to issue new stock to raise capital and keep the lights on. Case in point: the number of shares outstanding increased 440% in the five-year period ending March 2022.
The growth-at-all-costs business 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. Shares of Invitae have declined over 75% since the beginning of 2022 as a result.
Believe it or not, despite my historical hesitations, I let my guard down and hopped on the bandwagon next to a former friend and colleague by starting a position in May 2021. It didn’t go well. Here's why I sold my position in Invitae and what I learned from the disaster.
This Metric Trumps Revenue Growth in 2022
Whereas revenue growth was the priority for growth stocks until recently, investors are now more focused on the quality of revenue. How quickly can a business increase gross margin, and how much will trickle down the income statement to fund the business from operations, rather than external sources?
Regardless of where a business was in its growth trajectory and the end of 2021, it must now be laser-focused on operating efficiency. The transition will be easier for some companies than others. Unfortunately, Invitae is likely to struggle.
The genetic testing company delivered a gross margin of only 21.5% in Q1 2022. That was the lowest since at least late 2017 and far behind peers. NeoGenomics (NEO) is dealing with its own challenges, but still delivered a gross margin of 32.6% in the first three months of this year. Myriad Genetics (MYGN), the closest comparison to Invitae’s business, turned 70.9% of revenue into gross profit in the same period. Exact Sciences (EXAS) led the pack with a gross margin of 72.3%.
Why does this matter? The deterioration in the quality of revenue reduces the benefit from revenue growth. Recent historical comparisons illustrate this well.
- Q1 2022: A gross margin of 21.5% means the business turned $124 million of revenue into $26.5 million in gross profit.
- Q4 2018: A gross margin of 53.4% means the business turned $45.4 million in revenue into $24.2 million in gross profit.
In other words, Invitae grew quarterly revenue roughly 173% in three years, but gross profit grew by only 9.5%. Worse, quarterly operating expenses grew from $50 million to $240 million in that span, an increase of 380%. Shareholders simply aren’t seeing any benefits from revenue growth or the platform’s scale.
What the heck happened? Most of the operational inefficiency is being driven by poor cost control and the financial impact from acquisitions. There may not be a quick fix.
Invitae’s headcount has swelled from 364 at the beginning of 2017 to over 2,900 at the beginning of this year, driven in large part by acquisitions. Depreciation of goodwill and intangibles – also driven by acquisitions – is an increasingly large component of cost of goods sold. Barring a large, one-time write down, these expenses are typically expensed over an eight-year period. That’s problematic considering many acquisitions occurred at elevated valuations.
For example, Invitae acquired ArcherDX for $1.4 billion, or roughly 20x full-year 2020 revenue. The acquired liquid biopsy tools are at the center of a patent infringement lawsuit, which forced the company to rebrand certain products and may have contributed to recent delays, too. It doesn’t help that Invitae has a market valuation of roughly $800 million today. If the ArcherDX acquisition doesn’t pay off in the next few years, then the business will miss its lofty revenue growth projections and need to take a large financial hit.
Can Invitae turn it around?
Management aims to keep revenue growth humming along near 40% per year while simultaneously keeping a lid on expenses. A declining share price and skeptical questions from analysts on the most recent quarterly earnings conference call suggest Wall Street isn’t giving the company the benefit of the doubt.
Revenue growth and the volume of tests billed declined in Q1 2022 compared to the final three months of 2021. It was the first time test revenue declined sequentially since Q1 2019, excluding the period caught in the beginning of the pandemic. It’s likely a temporary trend, although I thought the same thing about slipping gross margin when I purchased shares in May 2021.
Invitae has little room for error. The business plans to quickly reduce cash burn, extend the cash runway to the end of 2023, and deliver positive operating cash flows by 2025. Success will depend on maintaining a blazing pace of revenue growth in an increasingly competitive landscape for genetic testing and demonstrating success from unproven parts of the business, including new liquid biopsy products and data revenue.
Could Invitae turn it around? Absolutely, but it will likely be a multi-year slog. My decision to sell was easy. This wasn’t a large position in my portfolio, I lost confidence in the business, and there are simply too many better opportunities on my radar. Even if you’re a long-term investor, it’s important to remain objective.
