GH - Oxford Nanopore: Ultra-Long Reads In A Short-Term Slump

2024-01-17 21:22:40 ET

Summary

• Shares of Oxford Nanopore declined by 33% after slower than expected growth in the second half of 2023.
• Positive outlook on the company, but profitability not expected until 2026.
• Challenging market with slow adoption of new technology, but new product launch and unique features offer potential.

Investment Thesis

Last year, we expressed optimism over Oxford Nanopore's ( OTCPK:ONTTF ) 'ONT' outlook as an emerging third-generation gene-sequencing 'TGS' company at the beginning of its journey in an expanding market. ONT devices can process ultra-long reads on native DNA, giving them an advantage over their peers in research and, increasingly, clinical applications.

Since our last piece, shares have declined by 33%, with much of this attributed to last week's 20% drop. This downturn followed the company's announcement of FY 2023 preliminary results that fell short of expectations.

The company cited delays in customer orders and the termination of its purchase agreement with the Emirati government, its largest customer.

Rising interest rates have significantly impacted the life sciences equipment market. Key institutional customers down the supply chain, such as gene diagnostic companies, are struggling. Naturally, this caused a ripple effect to their suppliers. To provide context, it's noteworthy that not a single company among the numerous multi-billion dollar entities within the genomic diagnostics sector has achieved profitability. This includes prominent firms such as Exact Sciences ( EXAS ), Natera ( NTRA ), Guardant ( GH ), and Myriad ( MYGN ), among others, which often prioritize aggressive growth strategies over immediate profitability. This approach is necessary to establish market positions in a nascent market. Historically, these companies have relied on equity funding to fuel their growth and support operations. However, this funding source has dried up with the Fed's aggressive rate hikes. Many companies have used up their cash reserves, setting the stage for a tough 2024 in the life sciences sector.

The key point here is that the caution in ONT's preliminary end-of-year results signals industry-wide challenges, not company-specific issues. The company's shares in the past year matched that of other gene sequencing device makers like Illumina ( ILMN ) and Pacific Biosciences ( PACB ) but lagged behind the overall biotechnology sector.

We maintain a positive outlook on ONT, acknowledging the speculative nature of this opportunity. Our optimism is based on ONT's long-term prospects, weighed against short-term macroeconomic challenges. We anticipate ONT to outpace the overall biotech market in sales growth, albeit at a rate slower than its historical average.

Despite not foreseeing a clear profitability path until 2026, we are confident in the company's long-term prospects, established market niche, and unique technology platform.

Market Position

The performance of sequencing technologies is highly application-dependent, varying based on the specific needs of different projects. There are no benchmarks or golden standards in the TGS market, at least yet, that would help investors assess the competitive dynamics clearly.

This also suggests that companies like ONT may need to focus on particular niches where their technology's unique features offer the most advantage. For ONT, this likely means targeting projects where its distinct capabilities, such as ultra-long reads or epigenetics, can be most leveraged. Thus, investors should be careful not to make decisions solely based on individual research publications citing the superiority of one instrument over the other.

On the other hand, this exact application-dependent performance creates a strategic investment opportunity. Investors have the chance to support early-stage TGS companies that are developing unique solutions for particular market gaps, potentially replicating the investment success seen by early ILMN backers.

We believe that ONT's unique technology lends it a strong market position in the TGS market, demonstrating notable proficiency in the four primary comparison metrics: Accuracy, Read Length, Speed, and Cost.

ONT's pricing strategy is a key differentiator and directly aligns with its goal to make gene sequencing widely accessible. For example, Flongle and MinION devices, retailing for $1700 and $2300, offer unparalleled portability and affordability, giving ONT a competitive edge in attracting smaller laboratories, educational institutions, and individual researchers seeking cost-effective yet reliable sequencing solutions.

Cost per base varies depending on the scale and nature of the sequencing project. For smaller-scale or targeted sequencing projects, ONT's platform can be quite cost-effective, especially with portable devices like MinION. However, for large-scale sequencing projects requiring high depth and coverage, other platforms might offer cost-efficient solutions.

The cost difference between ONT and its closest peer, PACB, also stems from the device design. For example, ONT designs its products as either portable or benchtop. In contrast, PACB targets a different segment of the market by specializing in industrial-grade sequencers that are useful for reference labs that require large-scale sequencing capabilities.

This strategic difference in product design underlines the unique positioning of each company in the sequencing market, catering to specific needs and applications within the field of genomic research. It is worth noting that PACB has recently alluded to potentially launching a benchtop TGS device, and in the future, ONT may enter the industrial-grade sequencer market.

Cash Outflows, Balance Sheet, and Path to Profitability

ONT operations depend on equity capital for funding. The company's first-ever Capital Markets Day last October was a strategic move, likely in response to its falling stock prices. This event underscores management's concern over its financial position. Lower stock price amplifies dilution impact, a critical factor for a growth-oriented company such as ONT.

Reducing expenses at this stage would risk the significant progress the company has made toward gaining market acceptance. This is a critical phase where financial commitment is key to solidifying its emerging market position. For example, continued investment in research is important to sway opinion leaders who play a pivotal role in shaping industry Golden Standards and Guidelines.

Moreover, for ONT, R&D expenses are crucial not merely for growth but for survival. These costs are fundamental to staying relevant in rapidly changing markets. For example, depending on the market's acceptance of Revio, ONT will have to respond with new products just to maintain its market share.

Given this context, we anticipate that ONT's operating expenses will rise in tandem with revenue. At this point, our analysis suggests roughly $100 million in cash outflows per year. As of June 2023, the company held $477 million in cash, which is just enough to get it through 2026, when management expects to break even. This small cushion for error is not ideal, but at the same time, it isn't a cause for alarm. Also, bioMerieux, a French clinical diagnostic company, injected $70 million in ONT for a 3.5% market share. Finally, we believe that ONT remains a valuable asset, and an exit opportunity via M&A can't be ruled out.

Final Thoughts - How Might We Be Wrong?

Despite current market challenges and the recent downturn in its stock price, ONT holds a strong position in the TGS market. Its unique technology, strategic pricing, and ultra-long read capabilities set it apart.

In 2024, we expect ONT growth to slow YoY but remain above the market's. The company appears to have enough dry powder to withstand current market pressure.

Investors should keep an eye on ONT's continued innovation and market adaptation strategies. The primary risk is technological obsolescence. The gene-sequencing industry is rapidly evolving, with new breakthroughs and technological advancements occurring frequently. ILMN, for example, is making bold moves in the long-read market, leveraging its established presence within the sector. Moreover, if equity prices remain subdued, this might create a fear cycle, where lower equity increases dilution risk while dilution risk pushes ONT prices lower.

Despite these risks, we believe that genomic research and precision medicine is still a nascent industry, and the room for growth is enormous. We see an opportunity to replicate the returns of ILMN's early backers. But that doesn't come without risk, requiring a long-term perspective that extends beyond year-over-year macroeconomic challenges.

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