Mr. Market sent shares of engineered biology conglomerate Intrexon (NYSE: XON) soaring after first-quarter 2017 financial results were released. There were encouraging signs for investors: Operating loss shrank by one-third compared to the year-ago period, marketable products appear to be gaining traction, and total revenue grew nearly 24%. That's all the good news a story stock needs to make a run.
However, while a quick glance at the quarterly results appears to reinforce the idea that progress is being made, a deeper dive into what is fueling revenue growth uncovers some worrying signs of instability. Simply put, the dependency on questionable and risky revenue sources only deepened last quarter. It's what you -- and the rest of the market -- likely missed in Intrexon's quarterly report.
Image source: Getty Images.
By the numbers
The single biggest complaint I hear from investors about Intrexon is that it's really, really complex. So let's break down the problems posed by risky revenue sources in the simplest terms and go from there. The engineered biology conglomerate generates three types of revenue:
- Service revenue: comprised entirely from bovine embryo transfer and in vitro fertilization procedures, as part of the wholly owned Trans Ova subsidiary
- Product revenue:almost entirely consists of selling pregnant cows, again as part of Trans Ova
- Collaboration and licensing revenue:includes rent collected from licensed technologies, up-front payments from new collaborators, and payments for research and development activities conducted within collaborations
The first type of revenue exists purely as a holdover from the Trans Ova acquisition. More services may be added in the future, but it doesn't figure to be an important driving force in the business.
The second type is the most important for the company's long-term success. After all, selling real products in real markets is the ultimate goal of lab research. The good news is that self-limiting insects, genetically enhanced fruits, and animal feed ingredients offer promising opportunities to expand this category by the end of the decade. Product revenue should be the primary focus of analysts and investors for gauging progress, but the story stock is being graded on the third type of revenue -- which also happens to be the riskiest at the moment.
Before we dive into the reasons as to why, consider how each type of revenue contributed to Intrexon's top line in the most recent quarter:
Note: Totals may not add perfectly due to undefined revenue not listed. Data source: Securities and Exchange Commission filings.
As you can see, total revenue grew nearly 24% year over year, but it was driven almost entirely by collaboration and licensing revenue. There's nothing inherently bad about this practice. Extracting value from uncommercialized technologies is a pretty smart way to buy time to build more reliable revenue streams by commercializing products of your own. But Intrexon's way of doing business raises a few red flags.
To simplify this third type of revenue, let's break down the collaboration and licensing segment into the following five categories:
- Blue-chip companies: large companies that have leadership positions in their industries and are drawn to Intrexon's technology portfolios
- Intrexon-created funds: comprised of three projects related to transportation fuels and Type 1 diabetes
- Ziopharm (NASDAQ: ZIOP): the partner is completely dependent on Intrexon technology for advancing oncology drug candidates
- Small- and micro-cap companies: partners with market caps up to $1 billion
- Harvest Fund entities: start-ups created by Intrexon within its Harvest venture capital arm that use wholly owned technologies
Ideally, a significant portion of revenue would be derived from blue chip partners. That's especially true if Intrexon were a leader in the field of engineered biology as it continuously touts. Today these partners -- of which there are two -- comprise the second-smallest portion of revenue (and it's close).
Intrexon-created funds would be a great way to generate value from big ideas within the company's R&D labs, but to date most, if not all, revenue has been generated from investors buying equity stakes within these ventures. Meanwhile, the company has invested just $667,000 combined in the three projects to date.
Ziopharm is a company with a poor history of execution, including no successfully developed drug candidates, and is completely dependent on Intrexon. The conglomerate has a high level of dependence on this single partner, which should be particularly worrisome for investors. Fully 20% of total revenue in the first quarter of 2017 came from Ziopharm. What happens if it fails?
Apparently, that potential scenario wasn't lost on Intrexon, which last summer restructured and greatly reduced its ownership of profits from future products marketed by Ziopharm. It wasn't exactly a vote of confidence in the partner. However, the new profit structure doesn't change the short-term risks posed to the business should the partner fail.
Finally, while the bottom two categories are nice to have, they should not contribute large percentages of segment revenue. That's not to be confused with largedollar amounts of revenue. But if these questionable and risky entities that lack transparency contribute more revenue than, say, blue-chip partners, then it should be a red flag. Unfortunately, that's exactly how the first quarter of this year played out.
Data source: SEC filings.
This isn't a short-term, one-quarter hiccup for Intrexon, either. The composition of the company's risky revenue machine has been heavily weighted to the least desirable categories for the last two years. Here's the breakdown for full-year 2016:
Data source: SEC filings.
Unfortunately, few analysts are discussing this dynamic of the company's growth while bidding up shares since financial results were announced.
Long story short
Revenue growth is certainly important, but if most of it hinges on companies that are likely to fail (small- and micro-cap partners, Harvest start-ups, and perhaps even Ziopharm) or lack transparent structures (Intrexon-created funds, Harvest start-ups), then investors need to be aware of the short- and long-term risks to the business. The first major fracture may have already started growing.
Consider that in 2015 micro-cap partners contributed $26.3 million in revenue, or 15% of the full-year total. That dropped to $19 million in 2016 and is likely to fall further in 2017. While that's great news, the reason for the decreases are not: The micro-cap partners failed or are quickly headed toward failure. Intrexon was able to mask this threat by increasing revenue from Ziopharm in subsequent quarters, but trading one risky source of revenue for another will not be sustainable forever.
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