Oxford Nanopore: Attractive Long-Term Growth, Possible Buyout Scenario

Thesis

Oxford Nanopore Technologies plc (OTCPK:ONTTF) creates the technology required for studying and analyzing molecules. DNA sequencing, medical diagnosis, and drug discovery are just some of the applications for these innovations. When considering ONTFF as a stock, I find its long-term growth story appealing, and its current valuation (6x forward revenue) is even more compelling than it was a year ago, when it was trading at around 10x forward revenue.

Nonetheless, FY23 could be more challenging, as I anticipate a more rapid decline in COVID-19 sequencing revenues in 2023. Business-wise, I still believe that ONTFF offers a very attractive long-term growth outlook, with structural growth drivers revolving around the expanding DNA sequencing market, increasing share of the sequencing market, and possible expansion into adjacent areas, in particular proteomics. On top of these two perspectives, I also wouldn't rule out the possibility that the company could be acquired in the medium term. As such, I am recommending a buy rating.

2H22 results

Adjusted EBITDA loss for the second half of fiscal year 22 was £24 million, and cash flow for the year was $558 million, a decrease of $60 million from the beginning of the year. According to management's FY23 guidance, LSRT underlying revenue growth of more than 30% is expected in 2023, and gross margin in excess of 60%. This 30% increase in revenue should translate to a 16-30% increase in FY23 after adjusting for EGP, COVID sequencing, and FX.

The short-term outlook appears to be volatile and softer, as management notes a softening of orders in March due in large part to a drop in COVID-19 sequencing as a result of a change in China's zero COVID policy. Personally, I do not think the short-term forecast is particularly promising. For perspective, if we assume revenue can grow at the mid-point of guidance, 23%, it implies around £181 million in FY23 LSRT revenue, which is below consensus estimate of £186 million. That said, this seems to be mainly driven by the falling off of the COVID test, which means that this is a normalization phase, which the market might look past.

Long-term outlook

I think it's reasonable to examine the ONTFF North Star in light of our discussion of the near-term financial cadence. I expect ONTFF's very strong top-line growth to translate into very strong bottom-line performance as a result of the company's promising longer-term operating profitability outlook. Specifically, I believe ONTFF will become competitively profitable by the latter half of the decade, with the electrical sequencing technique being the primary driver of this improvement in gross profit margin compared to traditional optical methods. For comparison's sake, ONTFF competitor Illumina, Inc. (ILMN) has achieved a gross margin of close to 70%. Even with ongoing reinvestment in R&D, I expect to see significant operating leverage, which will turn the high gross margin into attractive EBIT and earnings growth.

Oxford Nanopore Technologies plc also embeds an interesting call option. I believe ONTFF has a strategic appeal, which longer term could see the company become a target for larger acquisitive companies in the DNA sequencing space. ONTFF has listed with an "anti-takeover share" awarded to CEO Gordon Sanghera, valid for 3 years, in order to prevent a premature take-over attempt. However, beyond late 2024, I believe the likelihood of ONTFF becoming a target cannot be discounted. The DNA sequencing space has seen significant consolidation over the last few years. For instance, Illumina wanted to acquire PacBio 5 years ago at an implied premium of 70%, but the deal was ultimately terminated due to anti-trust objections.

Aside ILMN, there is also plenty of acquisition history by the bigger names like Thermo Fisher Scientific Inc. (TMO) in the sequencing space. While it is virtually impossible to time and quantify the magnitude of this purchase, it serves as a floor to valuation, as I believe there will be interested parties.

Conclusion

In conclusion, Oxford Nanopore Technologies plc offers a very attractive long-term growth outlook with structural growth drivers revolving around the expanding DNA sequencing market, increasing share of the sequencing market. Although the short-term outlook appears to be volatile and softer, with a decline in COVID-19 sequencing revenues expected in 2023, I believe this is a normalization phase. I expect Oxford Nanopore Technologies plc to become competitively profitable by the latter half of the decade, with the electrical sequencing technique being the primary driver of this improvement in gross profit margin. Additionally, ONTFF has the potential to become a target for larger acquisitive companies in the DNA sequencing space, serving as a floor to valuation. Therefore, I recommend a buy rating for Oxford Nanopore Technologies plc stock.

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