TMO - Twist And Short

Summary

• Twist operates in a trendy space, with good growth, but atrocious margins.
• As profits are not in the company’s DNA, losses are likely to continue.
• Although the stock is down a lot, it still trades at a healthy valuation.
• The stock has limited downside protection if its largest shareholder is forced to sell.

Introduction

Aging fans of the Beatles may remember the song "Twist and Shout." In a time when the Internet existed only as a defense network, there really wasn't a way to look up song lyrics. So unable to catch every word, melody and musical accompaniment ruled the day. Recently, I decided to look up the words to the song and was amazed at how little sense they made. "Well, shake it, shake it, shake it, baby, now" repeated three times, for instance. Really, John Lennon?! And then I looked at the financials of Twist Bioscience ( TWST ) and realized they were no better. Selling and administrative expenses that exceed revenue? That's one way to run a business, but not a sustainable one.

We just closed out a bad year for profitless firms. However, one year is a short time for the effects of a decade of loose monetary and fiscal policy to be reversed. Profits may be coming back into focus but there are still too many investors and companies who believe that they don't matter. Meanwhile, employees continue to sell stock they are compensated with. Easy money is not coming back any time soon, and I expect the stocks of loss-making companies to continue to trend down.

Company background

On February 28, 1953, Francis Crick walked into The Eagle pub in Cambridge, England with his colleague James Watson, and declared, " We have discovered the secret of life ." A bit of hyperbole may have been justified, as they had deduced the double-helix structure of DNA - two twisted strands held together by hydrogen bonds between complementary nitrogenous bases. And to give credit where it's due, they had seen an X-ray diffraction image of DNA fiber taken in Rosalind Franklin's lab that confirmed their hypothesis.

Twist is thus a catchy and appropriate name for a company that makes synthetic DNA . Virtually any DNA sequence can be designed and artificially produced. An advanced chip can be made with thousands of reaction sites for DNA synthesis. This has applications in drug discovery, vaccine development, chemical production, and possibly even data storage. Twist also makes tools for next-generation sequencing, or NGS , which involves fragmenting DNA into small pieces, sequencing them, and reassembling the result.

Apart from Twist, other companies in the space include Azenta ( AZTA ), DNA Script, GenScript, Danaher ( DHR ), Merck ( MRK ), Illumina ( ILMN ), Agilent ( A ), and Thermo Fisher ( TMO ).

Twist was founded in 2013 and is headquartered in South San Francisco, CA. It has close to 1,000 employees. It recently opened a large manufacturing facility in Wilsonville, Oregon. The company generates 60% of its revenue from the Americas, 30% in EMEA, and 10% in APAC.

Twist financial overview

For the fiscal year ending September 2022, the company generated $204 million in revenue, up 54% YoY. Gross margin came in at 41%. R&D was a high 59% of revenue, while SG&A was a shocking 105% of revenue. Operating income was a loss of $249 million (-122% operating margin).

The company currently has 56.5 million shares and a market capitalization of $1.4 billion. It has no debt and $0.5 billion of cash (thanks to periodic equity issuances). It thus has an enterprise value of $0.9 billion, amounting to 4x its annual revenue.

The company spent $102 million of capex in the last year, compared to $17 million of depreciation, and so free cash flow was worse than its net income. Most of the spending was for a new manufacturing facility, so it is likely that capex will come down in the future, but depreciation will rise as the capitalized expenses get written off.

For the coming year, the company expects $265 million in revenue (30% growth) at a 40% gross margin, and operating expenses increasing to $365 million. This would result in an operating loss of $260 million (including stock compensation) and cash depleting to $300 million.

While most loss-making companies are making tentative steps of proclaiming that they expect to be profitable in a year or two, Twist is bravely putting forward a forecast for its fiscal 2024 that involves continued losses. It expects revenue of $350 million (32% growth), gross margin increasing to 49%, and modest growth in operating expenses, resulting in an operating loss of $215 million and a cash balance of $170 million. I would regard the acceleration in revenue growth and gross margin to be aggressive, but possibly achievable. However, one would still be left with a company losing 60 cents on every dollar of revenue. There seems to be no credible path to profitability here.

TWST stock valuation and recommendation

I believe that a company that grows by being unprofitable will find it hard to turn over a new leaf and emphasize profits. If it's not in your DNA, it's hard to get to! However, I will assume that the company can get to a modest 3% GAAP operating margin at some point in the future.

A 3% margin on $265 million of expected revenue this year would mean normalized annual operating profit of $8 million. Due to the company's substantial net operating losses (accumulated deficit of $800 million and counting), I will assume that the company will never pay taxes. Thus, the company would generate $8 million in after-tax operating income or $0.14 per share. I will apply a generous 50x multiple in recognition of its growth to arrive at a per share value of $7 for the business. Then I will add back the $5 per share of cash on the balance sheet expected at the end of this year, for fair value for the shares of $12. Thus, I believe there is more than 50% downside from the current share price of $25. There are no meaningful comparables for the company as most of its competitors are either private, in a similar loss-making position, or part of larger companies.

In a bull case, the company will surprise to the upside with a 6% operating margin in the long term. This would result in normalized annual operating profit of $16 million this year. I will apply an inflated 70x multiple on the per share profit of $0.28 to come up with a value per share of $20 for the business. Adding back $5 per share of cash would result in fair value for the shares of $25. I hate to present a bull case with no upside, but it is hard to get the numbers to work here.

In a bear case, the company will never get to profitability and will eventually run out of money. It may do some more equity issuances and prolong the pain. It is unlikely to be able to raise any debt without the ability to service it.

I recommend that investors sell any existing positions in TWST stock before employees continue to sell the copious amounts of stock they are awarded ($80 million worth in the last year) or short the stock. The short interest is moderate at 15% of float and the shares are not hard to borrow. With a professional account, your broker will pay you a short rebate linked to the Fed Funds rate. The rebate is generated by investing the sale proceeds in the overnight market (less the broker's fee). Thus, you can get paid more than 3% a year for holding the short position.

Mispricing/variant view

I believe the primary source of mispricing here is people taking a big-picture thematic view of the prospect of synthetic biology changing the world. We also have many investors who pay no attention to a company's financials or attempt to determine how much in profits a company could generate in the future.

TWST's largest shareholder is ARK Investment Management, holding about 12% of outstanding shares. This firm had its moment in the sun when the growth stocks it owned went up during the Covid easy money boom. It still has its fans who have sent it more money even as its funds have lost more than half of their value in the past year. I believe at some point, the faithful will lose faith in an investment philosophy that eschews profitability and focuses on revenue growth. If ARK faces redemptions, they will have to sell whatever they own. These sales, when added to those of Twist's employees, could cause a rapid drop in TWST stock. The company could use some of its cash balance to stem the decline, but unless it can get to profitability, it will be wasting its money and decreasing its fundamental downside.

Rounding out the shareholder list are companies like Vanguard, Blackrock, and Fidelity that seemingly own every stock, and whose investment decisions are mainly dictated by inflows into and outflows from the funds they manage.

External ratings

Seeking Alpha's quantitative system gives Twist a composite rating of 2.53, between a hold and a sell, with a D+ for valuation and C for profitability, offset by a B for growth. Wall Street analysts are positive on the company with a rating of 4, equating to a buy. Their price targets have been neatly following the stock lower since 2021.

Risks are manageable

Shorting a stock has many risks and you need to be able to stomach mark-to-market losses. I recommend a large number of small positions. The main risk in shorting structurally unprofitable companies is the company being acquired by a larger firm, or a private equity or sovereign wealth fund on the back of fanciful projections. Fortunately, this is a diversifiable risk as there is not enough money in the investing world to buy every loss-making company. In this case, I consider it unlikely that someone will want to take on hundreds of millions of dollars in annual operating losses.

The fundamental risk here is that the company could continue to show impressive growth while improving its margins to a level far above what I have projected. I don't see this as likely, but it is a possibility.

Conclusion

A short position in TWST is recommended as the company continues to generate losses and its employees sell their shares. A sale by its largest shareholder would be hard for the market to absorb and could put additional pressure on the stock. The company's cash balance provides some downside protection in the near term but is fast depleting due to the company's operational losses.

Pre-emptive disclosure

Writing a short thesis on a stock on a public forum is an invitation for blowback from employees and holders of the stock. I welcome respectful comments from eponymous readers. If you are a holder or employee, you would be better off directing your energies towards having your company become profitable.

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