Genetic testing company Invitae (NVTA 0.94%) has seen its shares tumble from their highs despite aggressively ramping up its test volumes this year. The company is at the center of integrating genetics into healthcare, and this space still has so much potential.
However, sometimes a good story doesn't make for a good investment idea. Investors could buy the dip on Invitae, but they shouldn't ignore a major hang-up on its business model. Here is what you need to know.
The stock price has become reasonable
Invitae generates revenue by administering genetic tests while steadily also building a genome information database over time. The more tests it administers, the larger and deeper its data is, which it can eventually leverage to create new opportunities to help patients and generate new revenue streams.
2021 has seen a big step forward in the number of genetic tests it administers. Its billable volume in the third quarter of 2021 surged 89% to 296,000 tests, driving revenue up 66% year over year to $114 million.
If the company is performing, why has the stock fallen? Growth stocks across the broader market were popular in early 2021, including Invitae, which sported a price-to-sales ratio of 24 -- well above where it's traded over most of the past five years. That valuation has since dropped dramatically to just over 8, and the shares have fallen more than 70%. This isn't just a dip -- this is a collapse. The result is a stock that is now much more reasonably priced.
The red flag with Invitae
However, Invitae has yet to progress toward generating free cash flow despite ramping up its business for more than five years in the public markets. The more Invitae generates in revenue, the more its free cash flow losses grow as well.
Here's the problem. Invitae brought in $114 million in third-quarter revenue but spent almost as much ($93 million) on research and development and another $109 million on selling, general, and administrative costs. In other words, the costs to operate the business were 176% of revenue, which is worse than Q3 2020 when operating costs were 149% of revenue.
A young company often loses money as it invests for growth, but at some point the business needs to outgrow its expenses and begin generating free cash flow. Otherwise, the business model doesn't work.
Dilution could hurt investment returns
It's too early to say that Invitae's business can't work, but years of losses have caused the company to repeatedly raise money by issuing new shares of stock. This is common for companies in their growth stage, and the key for investors is that as a company begins to generate cash flow, it no longer needs to issue shares to fund growth.
We can see below that the number of Invitae's outstanding shares has nearly quadrupled over the past five years. When a company issues new shares, the existing shares are worth less. Think of it as a pizza cut into four slices, and then cut two more times to make 16 slices. The pizza didn't get bigger; the slices just got smaller.
Investors need to consider the company's repeated equity raises before buying the stock. Dilution hurts investor returns because it lowers the amount of earnings per share (EPS). The company could be making more money, but if it keeps issuing shares, the stock might remain stagnant if the new shares keep EPS from growing.
Invitae has $1.2 billion in cash after burning through $148 million this past quarter, so the company shouldn't need to raise more funds in the near future. However, investors who buy the dip on Invitae will need to monitor how quickly the business is burning cash to determine whether shareholders remain at risk of dilution.