ONTTF - Oxford Nanopore: Illumina's Formidable Challenger

Summary

• Oxford Nanopore is well-positioned to take advantage of the growing demand for DNA sequencing services and capture a growing share of the market.
• The company is developing innovative, affordable, and cost-effective sequencing technologies that will fuel the growth of third-generation DNA sequencing services.
• The company is yet to find profitability, but its balance sheet is strong enough to support management plans to pivot into profitability.
• Nonetheless, investors considering investing in the company should consider its current valuation and the risks to its business.

Investment Thesis

The need for more optionality in the gene sequencing device market has become apparent. End uses have been expanding rapidly, and new applications are being developed all the time. Companies with established technologies may be challenged to keep up with changing customer demands, especially as new devices enter the market. No gene sequencing device is perfect, and many tradeoffs exist between price and performance in terms of error rates and read lengths. Each consumer is now hunting for a device that best matches their needs. To find it, they will likely examine multiple models before making a final decision. Emerging device manufacturers such as Pacific Bio ( PACB ), Oxford Nanopore ( OTCPK:ONTTF ), Singular Genomics ( OMIC ), and many others are capitalizing on these gaps in the market. The industry certainly has the capacity for multiple technologies beyond Illumina ( ILMN ).

ONTTF took this market opportunity one step further, launching MinION (pictured above), a small portable sequencing device aimed at a niche market of researchers and clinicians working in resource-limited settings where the cost of reagents, consumables, and lab space is prohibitive. The device found great success during the pandemic when users across the globe needed a cheap and quick way to sequence the genomes of patients affected by the virus.

The company's PromethION is a larger platform intended for clinical diagnostic applications. The PromethION can sequence an entire human genome in just a few hours. It is the only device other than Illumina's NovaSeq with enough throughput to support the needs of large labs doing routine genetic diagnostics at high volumes.

ONTTF's mission and strategy to make gene sequencing simpler and more accessible have paid off, with more than 7,000 active devices currently in service. For comparison, ILMN, which has a 70% market share of the market, has an installed base of 23,000.

Oxford Nanopore stock is trading at a lower valuation than its peers but still below the healthcare sector's median. There might be an opportunity to speculate on a rebound after the shares selloff in recent months. I believe ONTTF can leverage itself into profitability within a reasonable timeframe, at least on a non-GAAP basis (TTM operating cash outflows currently stand at £35 million on £200 million TTM Sales.) With £618 million in cash and marketable securities, ONTTF has enough time and resources to pivot into profitability, in my view.

Revenue and Profitability

Last month, ONTTF released preliminary 2022 results showing £200 million in full-year revenue, representing an annual growth rate of 50%. This figure includes sales from the COVID-testing program and a £50 million settlement with the UK National Health and Social Care service. Adjusting for COVID contributions, core revenue sales grew to £147 million, representing a 16% YoY growth, standing at the lower bound of management guidance last summer. Management plans to publish its full-year annual results on March 21, 2023.

Management's 2023 revenue guidance stands at £190 - £220 million, representing annual core segment growth between 30-50%, far exceeding last year's 16% YoY change. Thus, it seems that management expects exponential growth in the medium run. The company's business model relies heavily on consumable sales, offering a reliable stream of recurring income and mitigating the risks of the longer instrument sales cycle. ONTTF doesn't report separate accounts for device and consumable sales, but it's common in the industry to price consumables at a higher margin than device sales. For example, Bionano Genomics ( BNGO ) offers its Saphyr devices at no cost under a multi-year consumable purchase agreement.

Oxford Nanopore's pricing and product portfolio strategy have historically focused on maximizing its product penetration among academic labs and research companies will limited budgets. The price of its MinION sequencer starts at $1000. However, this strategy might change in the medium term as the company grows into commercial markets with higher capacity needs. To my knowledge, PromethION is the only product other than ILMN's NovaSeq series with enough throughput to support high-volume, population-scale screening.

Management's interest in production-scale sequencing is evident in its collaboration with Bio-Techne announced to development of a workflow for Carrier Screening, which provides proof of principle that commercial products in the clinical diagnostic space could be developed based on Nanopore technology. Molecular diagnostics is now dominated by established players such as Illumina, whose products are enough literature evidence of their reliability, making it easier for commercial labs to obtain regulatory clearance to market their lab tests. ONTTF is up to a good start in this regard, thanks to its focus on accessibility, which allowed thousands of researchers to publish data verifying the scope of its technology.

Balance Sheet

Since its inception, ONTTF raised a total of $1.15 billion, $440 million from the 2021 IPO, with the remaining balance arising from multiple private funding rounds prior to going public. Right before its listing, the company was valued at around $3.5 billion, 40% above the current valuation, according to IP Group, one of ONTTF's early backers.

Out of this raised sum, the company now sits on $700 million in cash and marketable securities, demonstrating a conservative cash burn rate, especially in light of recent investments in sales & marketing and innovation and its multi-product portfolio.

The company made significant improvement in cash burn in recent quarters, with TTM Operating Cash Outflow standing at $43 (£35) million, the lowest since 2014. This gives the company sufficient runway to continue to expand operations as it continues to build out its global presence, sales teams and strengthen its pipeline of new products.

Valuation

Based on the current customer mix, which is heavily tilted toward small labs and academics, the company is generating around 40,000 in consumables sales per device. During the last earnings call, management stated that it expects gross profits to exceed 60% by 2023. Based on these estimates, the company needs to nearly double its installed device base to generate enough gross profit to cover current expenses. This is achievable but will require a lot of effort and resources from the company and likely a lengthy period of time. From a comparable valuation view, at 10X Price to Sales, ONTTF is not cheap (third from the top in the chart below).

One should also note that historically, foreign companies traded at a discount to businesses listed on US stock exchanges due to investors' perception that foreign markets are less efficient and less transparent compared to the US. For example, ONTTF releases two earnings reports per year, compared to four for its US counterparts.

Summary

Oxford Nanopore is a promising player in the nanopore sequencing market. The company has a strong balance sheet with substantial cash reserves, enabling it to fund R&D efforts without raising additional capital. In my view, its solid balance sheet and modest cash burn make it easier for ONTTF to pivot into profitability in an acceptable time frame.

Management's focus on enhancing accessibility to gene sequencing by offering its device at low start prices allowed the company to amass a sizable user base of more than 7300 active users, mostly researchers with limited budgets. Although consumables sales per device are below its peers, this consumer base contributes to the academic and research literature necessary for ONTTF to expand into the production-scale population-screening market, including clinical diagnostics, its largest commercial opportunity.

The company is not cheap, trading at a Price to Sales ratio of 10x. However, it remains an attractive investment opportunity due to a strong business model that positions it at the forefront of the nascent market for personalized medicine. Moreover, it remains a better value compared to its peers. After a lackluster performance in the past twelve months, I believe the ticker has reached the bottom. As we advance through this year and the next, share performance will depend on the company's ability to commercialize its products and generate significant revenue growth successfully.

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