Twist Bioscience Gets Stung by Short Report

Someone once said it’s easier to fool people than convince them they’ve been fooled. For those who invest with conviction, nothing damages one’s pride more than accusations of being conned. Investors must be wary of letting such emotions get in the way of objectivity. Anyone who dismisses an entire short report as biased one-sided tripe that’s solely meant for manipulation isn’t a good investor. Short reports always contain something interesting worth noting, but they need to be taken with a grain of salt as well. Interpreting a short report is a fine balancing act that needs to end with a statement of conviction.

Once Bitten, Twice Shy

Scorpion Capital first came into our lives a year ago when we published our piece on Why We’re Selling Berkeley Lights Stock which largely stemmed from confirmations – and lots of new information – presented in their short report. Just because BLI shares fell 89% since we sold our position doesn’t mean we did the right thing, but evidence seems to suggest there were indeed problems. Earlier this year, the CEO was demoted with no succession plan, something that implies he was forced out. The company missed their revenue guidance as Scorpion predicted, and this year they “expect full-year 2022 revenue to be approximately in line with 2021 full-year revenue.” So, the growth tailed off just as Scorpion predicted, and now the company has a new operating strategy, and they’re confident in the turnaround plan.

We are well on our way to transforming Berkeley Lights from a technology platform company into a growing, profitable, and sustainable life sciences tools and services company.

Credit: Berkeley Lights

Since the short report, they’ve been surviving, not thriving. We’re not keen on giving companies a second chance when they muck things up the first time around, so let’s move on to Scorpion’s next victim – Ginkgo Bioworks (DNA).

An Attack on Ginkgo Bioworks

Since Scorpion’s short report, shares of Ginkgo Bioworks have tumbled 79% vs a Nasdaq loss of 21% over the same time frame. Our piece titled Ginkgo Bioworks Responds to Short Seller Report talked about Ginkgo’s delay in responding to the report, and the subsequent DOJ inquiry that followed:

Shortly after the Scorpion Capital report came out, Ginkgo Bioworks received an informal inquiry from the Department OJustice (DOJ). In response, Ginkgo arranged for an independent investigation that found any “suggestion of fraud, reporting violations, accounting errors, or other wrongdoing contained in the short seller’s report were unfounded and importantly that no restatement of our financials was needed.” When pressed as to where the DOJ inquiry sits, Gingko’s CEO responded with “there’s not too much more I’d add at this point on it.”

Credit: Nanalyze

Another criticism made by Scorpion Capital surrounded “related party” Foundry revenues, something we shared concerns about in a piece titled Ginkgo Bioworks Stock Just Got a Whole Lot Riskier.

Our approach to Ginkgo Bioworks has always been to focus on Foundry revenues that do not come from related parties, something we detailed extensively in our piece on Ginkgo Bioworks Responds to Short Seller Report. Pure Foundry revenues for last quarter were $14.7 million or about 59% of total Foundry revenues. Compare that to last year when non-related party Foundry revenues came in $21.6 million or 62% of total Foundry revenues. So, based on last quarter, things aren’t getting any better for Ginkgo Bioworks, at least according to the metric we’re monitoring. Once the Zymergen acquisition has been rolled up into their financials, we’ll take another look.

We’ve always thought Ginkgo Bioworks has one of the most exciting stories out there. Being able to manipulate DNA means we can now wield the most powerful technology known to man – nature. Ginkgo’s Foundry is where AI meets synthetic biology, and all the possibilities come true. So that’s where we want to invest our dollars, not in some COVID-related testing service that came about during Ginkgo’s pandemic pivot.

The jury is still out on Ginkgo, which brings us to the topic du jour – Scorpion Capital’s report on Twist Bioscience (TWST).

Third Time’s The Charm

Earlier this year, we published a piece titled Challenges Ahead for Twist Bioscience Stock which talked about how “Twist is competing against some very established companies and spending a ton of money to do so, particularly on the sales side.” We also had “concerns around their business model taking a services approach as opposed to a hardware product/consumables approach,” and noted the razor-blade model on offer from hardware manufacturer DNA Script. As a result of that piece, we decided to hold off on accumulating any more shares of Twist Biosciences until further notice. Following the Scorpion short report, shares are trading at a 33% discount, so we read through the 238-page report to see what investors ought to be concerned about.

Scorpion Capital's short seller report headline on Twist Bioscience
Credit: Scorpion Capital

The report is broken down into seven sections which are paraphrased below:

  • Twist Bioscience is subsidizing customers by offering DNA synthesis services at less than cost
  • The flagship DNA chip on offer from Twist doesn’t work as advertised
  • Twist is incorrectly stating COGS by allocating some of it to R&D and CAPEX
  • Twist is a bottom-tier vendor with a poor reputation that services small, price-sensitive academic labs and biotech startups
  • Twist operates in a commodity, crowded, hyper-competitive space
  • Growth has peaked in NGS, TAM is miniscule because Twist cannot compete against large players, and 20 new companies are entering
  • Some of their Chinese investors are shady

A Price Dumping Strategy

Part one of the report accuses Twist Bioscience of operating “an unsustainable scheme that purchases growth with a price dumping strategy, by subsidizing customers with prices 50-90% lower than the competition.” In other words, they’re saying the cost of goods sold (COGS) must be false. Twenty research interviews point to unbelievably low prices with competitors questioning how the company will survive with new entrants pricing synthetic DNA 70% below Twist’s already bargain basement prices. The response from the company will likely be agreement. Of course, they compete on cost! The reason they can do that is because of the silicon chip they developed which provides them with a competitive advantage.

Vaporware?

Scorpion claims that Twist’s DNA chip – 10,000X throughput and lower cost – is just plain fraudulent, and that “Twist’s workflow requires the same steps as every other commodity DNA manufacturer.” To utilize the entire capacity of a chip, Twist allegedly needs to batch orders which delays delivery time. The alternative is partial utilization which increases COGS. Even then, the chip is said to only make “negligible volumes of DNA” with the output having a very high rate of errors. Manual intervention is required throughout the process, which means using Twist’s chip actually requires more effort than just manual work. Again, the key allegation here is that COGS isn’t being reflected properly by the company.

Revenue Growth and Profitability

This is where the report moves to some very specific accusations which are as follows:

  • Twist is misclassifying COGS
    • as an R&D expense
    • as CAPEX via two vehicles:
      • a) its purported “Factory of the Future,”
      • b) its “DNA Storage Initiative”

Just because management mentioned “gross margin” 15X on their last earnings call doesn’t mean they’re fudging their numbers. The main concern we have – one that’s mimicked by Scorpion – is that costs are very high with no evident path towards profitability. In their recent earnings call, Twist Bioscience doubles down on their commitment to spend heavily on CAPEX and R&D with guidance provided for the next two years based on current cash.

Twist's fiscal 2023 and 2024 Guidance
Credit: Twist Bioscience

The two sentences at the bottom of the slide regarding profitability aren’t reassuring. The first says they’re working on it, while the second is a long way off with $40 million in Biopharma revenues expected for 2023. An August investor deck mentions – twice – that they’ll hit EBITDA breakeven when the core business (Synbio and NGS) hits $300 million, so we’re holding them to that.

The recent earnings call wasn’t overly compelling with Twist making no comment on the short report, but fielding many questions relating to it. The call was kicked off by the Chief ESG Officer who is responsible for the money they wasted on a lengthy and largely meaningless ESG report, and who sets aggressive goals like “increase the percentage of women and racial diversity by 3% by December 31, 2022.” (Suggesting that hiring managers take into account sex and race when making hiring decisions should be a terminable offense.) After reading through her script, she passes it to some French fellow who speaks in such a strong accent that even the AI algorithms transcribing the call ran into problems. In a nutshell, Twist Bioscience is spending heavily on R&D, their Factory of the Future in Portland, and DNA data storage, despite the fact that easy capital has dried up.

DNA Data Storage

Several years ago, Twist Bioscience and Netflix collaborated on a dog and pony show that highlighted the potential for DNA storage. Intuitively, it’s hard to believe this is close to being economically viable. Writing the data is one step, then you need DNA sequencing machines to read the data, all while employing error-correction methods to ensure data integrity. It’s no easy task, and the first application would probably be the global market for tape storage which is said to be between $2.75 to $5 billion. Twist labels this opportunity “archival storage,” and attributes a $35 billion total addressable market to it. Maybe the bigger question is just how realistic this aspiration is given current technological advancements. (We’ll follow up on this topic in a later piece.)

In the latest earnings call, management wouldn’t describe what contribution DNA data storage might have to the $350 million they’re guiding towards for 2024. Assuming the $100 million plus investment can’t manage to commercialize their DNA data storage technology, we need to know this company can survive based on their core business activities.

What to Watch For Going Forward

The short report has proved to be somewhat of a blessing. Twist Bioscience needs to think carefully about how their actions support the claims being made in the short report which makes lots of accusations based on hearsay. Our concerns haven’t changed. Twist Bioscience spends a massive amount of money on SG&A/R&D which – while serving to propel revenue growth – isn’t a prudent approach to be taking when the availability of easy capital has dried up. Scorpion’s report points to several conclusions:

  • Twist will never be able to operate a profitable business -> losses will not decrease over time
  • Revenue growth will stall -> Twist won’t hit their 2023 / 2024 guidance

That brings us to the below numbers, noting that it’s quite odd for a company to give guidance for two years looking forward in the face of strong macroeconomic headwinds.

  Revenue Losses
2022 $204 $235
2023E $265 $260
2024E $350 $215
Credit: Nanalyze

Cash is important to pay attention to. At the end of Fiscal 2023, Twist expects to have $300 million in cash remaining. At the end of Fiscal 2024, they expect to have $170 million in cash, which means they’ll have burned $130 million in 2024. This implies they’ll have enough cash to make it through 2025 at which time we’d expect them to have achieved profitability.

Providing such detailed guidance so far into the future seems to be in direct response to the short report, but the line in the sand has been drawn. The investments being made in the Factory of the Future are expected to show results, and investors need to hold the company accountable to these estimates. Any stutter on revenue growth will be punished because it will affirm Scorpion’s accusation.

While ARK Invest largely dismissed the short report, we believe it raises some important points about how much money Twist Bioscience is investing in future growth while shares outstanding increase and easy capital dries up as a result of today’s bear market.

Conclusion

It’s never fun to wake up to a short report on a stock you’re holding. Notable short sellers always elicit a sharp response from investors which only creates price action noise as shares enter a tug-of-war between bulls and bears. We’ll have a powwow here at Nanalyze to digest what we’ve learned today and decide what to do with our half-a-position in TWST. Scorpion has mimicked some of our concerns, but much of the report is hearsay and speculation. Twist Bioscience now needs to hit their revenue targets and increase visibility around when they’ll be profitable or Scorpion’s concerns will be validated.

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