Twist Bioscience Pursues Growth at All Costs. How Long Will Investors Tolerate It?

In recent years, promising start-ups have faced almost no obstacles to raising capital, so long as they pursued growth at all costs. Investors accepted significant losses in the present on the premise that these would translate to incredible market share in the future. The environment of easy money created many questionable valuations (see: WeWork), and even rare instances of outright fraud (see: Theranos). 

But the market shifted in 2019. Investors are thinking more objectively about the stories presented by start-ups and emerging companies, and are much more interested in profitable growth, or at least progress toward it, than empty promises of a big payoff down the road.

While tech companies such as WeWork, Uber, Slack Technologies, and others have been hit by this newfound skepticism, even swearing off the growth-at-all-costs mantra of years past, the field of synthetic biology has yet to (publicly) face its reckoning. If and when it does, Twist Bioscience (TWST +4.99%) might be the first to fall. 

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Revenue is growing, but operating expenses are growing faster

Twist Bioscience wields the leading technology platform for synthesizing DNA. This synthetic DNA is most often used in genetic engineering experiments or for creating reference probes for DNA sequencing applications. The company is also exploring the potential to use synthetic DNA for storing digital data and for designing biologic drugs.

The company recently reported fiscal first-quarter 2020 operating results for the three-month period ending Dec. 31, and announced it had settled a long-standing legal dispute with Agilent Technologies. The settlement avoided a costly jury trial, but cost the synthetic DNA pioneer $22.5 million. Investors were just pleased to be rid of the headache, and to have removed the largest source of uncertainty hanging over the stock. Shares soared on the announcement.

The immediate interpretation of this event is that the settlement will allow Twist Bioscience and Wall Street to focus entirely on growth and financial performance. A deeper dive, however, suggests investors might want to be careful what they wish for.

While the company touts impressive growth in revenue and gross profit, that means little when losses attributed to shareholders are growing even faster in absolute dollar amounts. Operating losses have now grown sequentially for eight consecutive quarters. 

Data source: Twist Bioscience press release. YoY = Year over Year.

When the Agilent legal settlement is excluded, normal day-to-day operations resulted in fiscal first-quarter 2020 operating expenses of $36.7 million. That was $14.2 million greater than in the year-ago period, which easily offset the $3.7 million improvement in gross profit in that span.

Swelling losses have had a real impact on shareholders: dilution. Twist Bioscience has tapped into the public markets multiple times since conducting its initial public offering (IPO) in late 2018, including an offering in late January that raised $48.2 million in net proceeds. Investors now know that was largely conducted to pay for the Agilent legal settlement, which will consume roughly half of the proceeds.

In a little over 15 months as a publicly traded company, multiple stock offerings from Twist Bioscience have increased the number of shares outstanding from 26.6 million to 35.4 million. That's an increase of 33%. Considering the business reported $103 million in cash at the end of December and expects to report a net loss of at least $129.5 million in fiscal 2020, investors should expect additional public stock offerings or convertible debt offerings -- and, therefore, additional dilution -- in the near future.

It might be tempting to think the company could just flip a switch and focus on profitable growth, but a closer look at SEC filings suggests that might not be possible.

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Is Twist Bioscience stuck?

Investors know Twist Bioscience as the company that makes synthetic DNA. It serves industrial and pharmaceutical customers that require (relatively) large amounts of DNA for high-throughput genetic engineering research. It's by far the best in the industry -- even supplying some of its competitors.

However, most of the company's growth and profits come from an entirely different market: next-generation sequencing (NGS) tools. In fact, NGS tools are expected to generate nearly as much revenue in fiscal 2020 as synthetic genes. It's a bit ironic that the company known for writing DNA is increasingly dependent on companies that read DNA, but there are two primary reasons for that.

First, despite all of the hype, the market for synthetic DNA is simply not very large and isn't very profitable (if it's profitable at all). Roughly 25% of the company's synthetic gene revenue in fiscal 2020 will come from a single customer. It's also worth noting that the business didn't begin generating gross profit until it ramped up sales of NGS tools.

Second, Twist Bioscience's technology platform is well suited for designing NGS tools. The company uses its ability to synthesize accurate DNA sequences to create high-quality target enrichment probes, which allow researchers to detect specific genetic sequences in biological samples.

But investors cannot conflate early success in the NGS market with being on the path to profitability. Sales of target enrichment probes are far from sufficient to offset losses from the remainder of the business. The company expects roughly half of fiscal full-year 2020 revenue to come from money-losing or low-margin products related to synthetic genes; the other half will comprise NGS tools.

Data source: Twist Bioscience. YoY = Year over Year.

Despite impressive revenue growth, Twist Bioscience expects to report a net loss of at least $107 million from day-to-day operations in the current fiscal year. That's exactly the same net loss reported in fiscal 2019, and it jumps to at least $129.5 million when the Agilent legal settlement is included.

That also suggests that Twist Bioscience might be stuck financially for the foreseeable future. In order to remain relevant in a money-losing market for synthetic genes and a very competitive market for NGS tools, it must spend significant sums of money on sales and marketing expenses, which are the main driver of operating losses.

In other words, although NGS products are responsible for most of the company's gross profit, they're also responsible for much of the company's operating losses. If the company stopped marketing its products as heavily in an attempt to pare losses, then it might not grow quickly enough to achieve breakeven operations. That suggests Twist Bioscience is pursuing growth at all costs because it doesn't really have any other options. That's not a very secure position for individual investors.

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Is this just the latest synbio trap?

Investors might be drawn to Twist Bioscience because of its industry-leading technology platform for synthesizing DNA. It can create products today for high-throughput genetic engineering experiments or NGS tools, while tomorrow's opportunities could span digital data storage in DNA or rational design of biologic drugs. 

But, to be blunt, publicly traded synthetic biology companies have a downright awful track record of living up to their lofty promises. The best product from the field to date has been hype, and that's led to terrible outcomes for individual investors who invested on storytelling alone. Shares of Twist Bioscience have rewarded investors with solid gains since the IPO, but swelling losses make it reasonable to question if and when the sentiment will turn negative.