The field of genetics is the new scientific frontier. Genetic testing, in particular, could one day play a vital role in how we understand, prevent, and treat disease. Invitae (NVTA -72.22%) has been at the forefront of the industry for years.
However, investors who bought at the company's IPO in 2015 and and have held since then are down roughly 50% on their investment today. How does a biotech leader perform so poorly as an investment? Let's take a look at Invitae's struggles through two simple illustrations.
The search for operating leverage
It's common for new, growing companies to lose money. Oftentimes, a young company will invest heavily in itself in order to grow revenue, or will increase the volume of goods to spread out costs. The hope is that these heightened expenses will one day pay off: When a company reaches the point where revenue grows faster than spending, the business trends toward turning a profit. This is known as "operating leverage."
Image source: Getty Images.
You can see in the below chart that Invitae has successfully grown its revenue over the years. The company went from generating $25 million in 2016 to bringing in $460 million in 2021. That amounts to an incredibly impressive 1740% revenue growth over five years! But look at how free cash flow (FCF) goes further into the negative as revenue grows larger. In other words, Invitae is burning through cash as it earns more revenue.
NVTA Revenue (TTM) data by YCharts.
That revenue and FCF are moving in opposite directions suggests Invitae's business model is flawed. The company is unable to find any operating leverage, as FCF has sunk further into the red despite enviable revenue gains.
What's worse, this issue has repercussions: the problem with always burning cash is that you eventually run out and need to find more.
Resulting dilution
It's difficult for unprofitable companies to borrow money because they don't produce any cash with which they can pay their bills. Instead of borrowing, most companies in this situation will issue new shares of stock in order to raise the money they need. Invitae has done this a lot, which is unsurprising given that the company has been public for so long without making money. You can see in the below chart how the number of Invitae's total shares has massively increased over time.
NVTA Average Diluted Shares Outstanding (Quarterly) data by YCharts.
When more stock is issued, it doesn't make the business worth more. Rather, it lessens the value of each share. Imagine cutting a pizza into more slices: The pizza itself doesn't get bigger, but instead each piece gets smaller. In stocks, this concept is called dilution.
In Invitae's case, the stock price has come under pressure despite solid revenue growth because management has issued so many shares. If the number of shares had stayed relatively stagnant over the years, investors who bought in at Invitae's IPO would likely be up on their initial investment. However, the number of Invitae shares has increased more than tenfold since then.
Investors shouldn't automatically panic when more shares are issued; it's normal practice for growing companies. However, investors should ensure that a company is making progress and on track to becoming profitable. If a company can't improve its financials over time, investors' returns can be ruined by excessive dilution -- even if the company continues to grow, as Invitae has.
