In a world where retail investors can organize to deliver very painful outcomes to professional investors making short bets (betting a stock will decline in value), many short-focused funds have publicly pledged to stop playing the game. Scorpion Capital is not one of them.

There's certainly a lot of mischief and shenanigans in professional shorting. Case in point: Scorpion Capital quietly built a large short position in Twist Bioscience, then published a report accusing the company of various misdeeds and fraud. It did so a few days ahead of the fiscal full-year 2022 business update when management is in a quiet period, limiting what it can say in response, to maximize the damage. The ability to short a stock provides a healthy balance in the market and ensures more realistic pricing. If I can bet a stock will rise in value, then you should be able to take the opposite bet. But the process described above is manipulative and unhealthy for markets.

Nonetheless, the short report provided certain bits of information that cannot be dismissed as easily as the analogies to suicide bombers (really) or filtered through the lens of jealously in the competitive landscape. That made it easy to calmly and quickly make a decision to manage risks by simply exiting the position.

The Signal in the Noise

Scorpion Capital's short report on Twist Bioscience is 236 pages long. I've only read the executive summary spanning 23 pages. It's true most of the information is biased, misleading, or simply inaccurate. However, a few things ring true with varying levels of impact. In fact, some information fills in gaps in my modeling and the company's financials that Scorpion Capital failed to make connections between. It's difficult for an objective observer to dismiss these connections.

Let's separate the signal from the noise by evaluating the most important arguments in the short report:

• Tech Platform is Nothing Special (low impact): There are many players in the competitive landscape. Everyone has to play by the same rules dictated by chemistry. The short report alleges many ex-employees or customers aren't impressed with the company's technology platform, as it isn't differentiated. The chemistry might not be, but the small form factor (pooling oligos into tiny wells embedded on a silicon chip vs. a 96-well plate) provides meaningful separation.
• Selling Prices (low impact): Twist Bioscience has gobbled up market share by undercutting competitors on selling prices. That's hardly a new approach in capitalistic markets. It certainly isn't fraudulent. It's not news to customers or the competitive landscape. Is it sustainable? Well.... that depends on how quickly the unit economics can catch up with the price points being offered to customers. The company has been generating higher product gross margins as it generates more revenue. But this leads into the next point…
• Miscategorizing Expenses (it depends): Scorpion Capital alleges Twist Bioscience is categorizing cost of product sold (COGS) as operating expenses, thereby inflating the reported gross margins. That's difficult to prove, but the company's R&D expenses have been increasing at an uncomfortable rate. Some of this can be attributed to preparing the Factory of the Future and ramping activities with wholly owned drug development assets, but fiscal third-quarter 2022 R&D expenses jumped 86% from the year-ago period. It doesn't make much sense for the business to be increasing operating expenses this deep into the market correction. For what it's worth, this accounting trick happens more than you think. I identified a similar flaw in industrial biotech company Solazyme many years ago. It eventually collapsed.
• Production Challenges (moderate to high impact): Scorpion Capital alleges the manufacturing process of Twist Bioscience is complex, expensive, and requires a surprising amount of manual labor. I've heard similar things from current and former employees. This isn't necessarily a showstopper, but it suggests scaling orders and revenue could soon reach a speed limit. Manual processes are also one of the largest sources of errors (this is why automation and reproducibility are so important in synthetic biology), which leads into the next point…
• Quality Control (moderate to high impact): Scorpion Capital alleges Twist Bioscience products suffer from poor quality. This isn't exactly a secret among customers or the field of synthetic biology. The company has even publicly discussed this challenge with investors. During the fiscal fourth quarter of 2021 the company encountered manufacturing delays after discovering it was accidentally introducing flawed DNA sequences into customer orders. The company said none of the products were shipped to customers, but many orders within that period were delayed, creating a significant backlog that needed to be cleared. This problem becomes more difficult to hide as the numbers grow larger. This leads into the next point…
• Customer Churn (high impact): Scorpion Capital alleges multiple competitors initially worried about Twist Biosciences stealing customers have been able to win back customers more recently. This is one of the most important pieces of information in the short report. A few years ago I heard some customers receive product that didn't contain any DNA #oops. The problem may not be solved as 2022 comes to a close. An uncomfortable number of customers have left the ecosystem due to quality control problems. The business shipped products to 1,900 customers in the fiscal third quarter of 2022, compared to 2,000 customer in the previous quarter and 1,836 customers in the year-ago period. That never made much sense to me. If this challenge proves more durable, then new product launches and entering new market verticals (synthetic genes, NGS, biopharma, etc.) can only counter sluggish customer growth for so long. This is not a good market environment to significantly reduce investor expectations.
• Ginkgo Bioworks Economics (no impact): Scorpion Capital alleges Twist Bioscience loses money when it sells synthetic DNA to Ginkgo Bioworks. That's difficult to prove. It's hardly unusual for the largest customer by volume to receive better pricing. Either way, orders from Ginkgo Bioworks represent roughly 10% of total revenue, so it wouldn't have a significant impact on overall gross margin.

Do I think Twist Bioscience is the next Theranos or Worldcom? No. Do I think it faces unique challenges? Yes, same as every other business. Should this be dismissed as "just another short report"? Mostly, but there are faint signals amongst the noise.

Objective investors can acknowledge the risk profile has increased due to the added uncertainty, especially within important metrics.

• Operating expenses are too high.
• Selling prices could be unsustainable if Twist Bioscience fails to deliver technical improvements and manufacturing capacity increases.
• The ability to deliver manufacturing capacity increases is complicated by an unusual amount of manual labor embedded in production processes and quality control issues. That latter may already be driving customers away.
• Customer churn is a significant problem and makes certain allegations in the short report more plausible. Achieving success with new product launches and entering new markets can help to offset customer churn, but doesn't directly address the underlying problems.

Importantly, the increased risk profile amplifies the valuation risk. Solt DB Invest modeling suggests Twist Bioscience will struggle to earn a valuation much higher than $2.25 billion by the end of 2023. Therefore, it makes more sense to calmly and quickly make the decision to exit positions.

Shares could jump when the business reports fiscal full-year 2022 operating results and issues revenue guidance for the year ahead. In this scenario any share gains are unlikely to be sustainable. Exiting positions now still makes sense. Even if the company executes and puts the short report behind it, investors should almost certainly be able to open new positions near or below current prices within the next 12 months.

Shares could also get crushed if fiscal full-year 2023 revenue guidance disappoints, which will rightly or wrongly lend credence to the short report.

We often make investing more complicated than it needs to be. Manage risks and make companies earn a spot in your portfolio.

Solt DB Invest will continue to provide coverage of Twist Bioscience. Margin of safety ranges will be reintroduced when it's appropriate to do so.

Further Reading

• November 2022 short report from Scorpion Capital
• November 2022 company update recommending exiting positions (the shorter version of this article)
• July 2022 company update initiating coverage of Twist Bioscience