Lab hardware is a difficult business. There always seems to be a rotating cast of companies riding waves of hype and investor fervor (think PacBio and Bionano Genomics), but the number of companies worthy of investment can usually be counted on a single hand. Unfortunately, PacBio and Bionano Genomics don't make the cut.

What makes the operating environment so difficult? Customers will only purchase an instrument if it generates useful data within an experimental workflow, boasts ease-of-use that makes it easy to automate and train lab technicians, creates enough value to justify its significant upfront expense, and operates frequently enough to justify ongoing expenses. Companies need to deliver all of that while optimizing revenue mix.

The idea is to sell as many machines as possible. Although each instrument sale represents one-time revenue, a useful lab instrument will be used relatively frequently. Each boot up represents an opportunity to generate revenue by selling the customer the plastic cartridges, reagents, and other consumables required to run an experiment. Consumables revenue is accompanied by very high gross margins.

In essence, lab hardware companies are chemical and plastic suppliers that happen to sell instruments.

Investors shouldn't consider owning a lab hardware business until consumables revenue comprises at least 67% of the total revenue mix. The publicly-traded companies that currently hit the mark are Oxford Nanopore Technologies (>67%), Illumina (71%), and 10x Genomics (85%). That's it. That's the list.

As the stock chart of 10x Genomics indicates, there's more to investing in lab hardware stocks than crossing the threshold for consumables revenue. It's been a wild ride and the worst may not be over, but there's reason to believe better days are on the other side of the recession.

The Leader in Single-Cell Analysis

Think of a cell as a chemical computer. A cell's genome contains the instructions for producing proteins with specific functions, but only if certain conditions are met in the surrounding environment. The surrounding environment is affected by temperature, pH, and nearby cells – all of which are adapting to inputs from the environment to which they belong and affect. The dynamic interactions of these multicellular systems drive the complexity of biology.

Single-cell analysis seeks to understand the omics and cell-cell interactions for individual cells within a larger system. Despite being called "single-cell analysis," the approach is really about understanding the roles of specific types of cells within larger and more complex networks.

Whereas traditional DNA sequencing mostly answers the "what?", single-cell analysis seeks to answer the "what?", the "where?", and eventually the "when?".

• Traditional DNA sequencing: If I took a sample of cancer cells from a tumor and ran them through a DNA sequencer, then I could read the cancer's genome. This is like taking one chemical computer, unplugging it from the wall, and taking it apart to understand what's inside at that moment in time.
• Single-cell analysis: If I took a cross section of the tumor, labelled the individual cell types, and ran them through a DNA sequencer; then I could understand how these cells respond to the changing conditions of their environment. This is like taking many chemical computers interacting with one another, unplugging them from the wall at the same time, and taking them apart to see what's inside at that moment in time.
• Single-cell analysis (next-generation): We don't always know where all the cell types are located within a tissue. We're also still discovering new types of cells. Therefore, if I took images of the tumor tissue (the room of chemical computers) and then applied single-cell analysis, I could begin to understand how gene expression changes depending on the physical location of the cells within the tumor. I could also discover new types of cells. If I repeated this at different points in time (representing different environmental conditions), then I could begin to understand how gene expression changes over both space and time.

This is what makes 10x Genomics so valuable. It provides lab instruments and tools that prepare biological samples for single-cell analysis. The offerings generate high-quality data for relatively large cellular systems and can be integrated into existing experimental workflows. For example, the company's products can be used seamlessly in combination with Illumina sequencers. That has no doubt helped to power revenue growth.

The company has three distinct platforms to enable single-cell analysis:

• Chromium for Single Cell Gene Expression. (Identify the "What?" across many cells at the cellular level.) This instrument helps to label individual cells within a sample containing hundreds or thousands of cells. The processed sample can then be run through DNA sequencing instruments, but the data generated will now be organized based on the individual cell types. Customers can then analyze and interpret the sequencing data using software provided by 10x Genomics. Watch a video.
• Visium for Spatial Gene Expression. (Identify the "Where?" across a very small number of cells, but at the molecular level for more detail.) This isn't an instrument but a unique rectangular slide (think of a slide for a microscope) that helps to visualize where gene expression is occurring within a tissue sample. Cross sections of the tissue sample are labeled, imaged to provide a 2D map of the sample, then run through a sequencing instrument. The sequencing data will be organized based on individual cell types and can be mapped back onto the visual data. Think of it like night vision goggles, but for viewing the molecular profiles of cells that aren't visible when you're just staring at a tissue sample with the naked eye. Watch a video.
• Xenium for In Situ Analysis. (Identify the "What?", "Where?", and "When?" across a very large number of cells at the molecular level.) This instrument is meant to be used in conjunction with Chromium and Visium platforms. It can be used to build a 3D map of a tissue sample by peeling back the tissue layer by layer, labeling and sequencing at each cross section. It provides the most data at the highest level of detail of all the platforms. Xenium hasn't launched commercially, but is expected to hit the market in late 2022 or early 2023.

Believe it or not that's the simplified description of each platform. The company routinely launches new tools to expand the utility of each, such giving customers the ability to sequence DNA or RNA or proteins, or understand what happens to CRISPR-edited cells. There's a pretty high ceiling to what's possible.

Many companies tried to pounce on the emerging opportunities of microfluidics and single-cell analysis. 10x Genomics blew all of them out of the water. Despite only launching its first product in mid-2015, the business generated $490 million in full-year 2021 revenue. Consumables represented an astounding 85% of sales.

Most important, the single-cell pioneer wasn't pursuing a growth-at-all-costs business model. 10x Genomics reported a combined operating loss of $169 million in the three-year period spanning 2019 to 2021. PacBio topped that in 2021 alone. Invitae douses investors with a larger operating loss every quarter.

The relatively efficient operations suggested 10x Genomics was only another year or two away from achieving breakeven or profitable operations. If it pulled back on growth investments, then it might have been able to reach those milestones sooner.

Of course, that's no longer the expected trajectory.

A Strong U.S. Dollar Cometh

10x Genomics is being pummeled by belt-tightening from customers and global currency headwinds. Second-quarter 2022 operating results were particularly painful. Total revenue declined from the year-ago period. The geographic distribution of sales makes it clear that a strong U.S. dollar is biting into growth.

• Revenue from U.S. customers grew 8% in Q2 and 11% in the first half compared to the year-ago periods.
• Revenue from customers in Europe, Middle East, and Africa (EMEA) dropped 11% in Q2 and 4% in the first half compared to the year-ago periods.
• Revenue from customers in China dropped 29% in Q2 and 18% in the first half compared to the year-ago periods.
• Revenue from customers in Asia Pacific rose 7% in Q2 and 15% in the first half compared to the year-ago periods.
• Revenue from China, Asia Pacific, and the Americas (excluding the U.S.) each declined at least 33% in Q2 compared to Q1.

As recently as April 2022 management expected full-year 2022 revenue of roughly $615 million. By July 2022 the company sharply reduced full-year 2022 revenue guidance to only $510 million at the midpoint. That meant year-over-year revenue growth expectations shriveled from 25% to only 4%.

Growth coming to a screeching halt forced the company to announce a little belt-tightening of its own, including laying off about 8% of its global workforce and slowing spending elsewhere. The balance sheet remains healthy and operating losses are still manageable. Meanwhile, recent additions to the Chromium and Visium platforms and the upcoming launch of the Xenium platform (assuming it isn't delayed) provide opportunities to scale the business. Even if revenue growth remains subdued by currency headwinds and the recession, the company may still be able to seed customer labs with new instruments. That would provide a larger base for generating consumables revenue and accelerate the recovery coming out of the recession.

The challenge for investors is what happens in between – and things could get worse before they get better.

On the one hand, the worst appears to be over. Most (maybe even all) of the excess from the liquidity bubble has been squeezed out of shares. The business was somehow valued near $22 billion at its peak! The current valuation of $3 billion is much more reasonable and provides an attractive margin of safety should Xenium live up to expectations in the coming years. The current valuation might be laughably low in that scenario.

On the other hand, the U.S. dollar has only become stronger since the close of the second quarter. That means investors might not be surprised to see full-year 2022 revenue guidance lowered slightly more and for full-year 2023 revenue guidance to be disappointing.

It'll be important to watch consumables revenue and competition. My understanding is consumables from other companies can be used on instruments from 10x Genomics, which is not a common capability in lab hardware. That could impact the most important source of revenue for the business should customers seek out lower cost "off-brand" consumables. This doesn't appear to be having much of an impact yet and may never, but it would be potentially destructive to growth.

Price Targets & Allocation

(Revised lower from August 10, 2022.)

10x Genomics is considered a Growth (Quality) position. Current price targets for the company are as follows:

• Current Price (market close October 7):  $28.57 per share
• Prioritize Below:               $21.25 per share
• Midpoint:                            $25.50 per share
• Caution Above:                  $29.75 per share
• Allocation Range:              Up to 5%

10x Genomics reported 113.92 million shares outstanding (95.05 million Class A shares and 18.87 million Class B shares) as of July 29, 2022. The price targets above assume 120 million shares outstanding, which prices in 5% "leaky" dilution from stock-based compensation.

What changed?: The "Caution Above" price target was lowered to account for lower full-year 2023 revenue modeling and a lower valuation multiple for the foreseeable future. The "Midpoint" price target (formerly "Attractive Near" price target) was dragged lower as a result.

• The previous "Caution Above" market valuation was $4.59 billion, or $38.25 per share.
• The new "Caution Above" market valuation is $3.57 billion, or $29.75 per share.

The "Prioritize Below" price target and share count used in modeling did not change.

Ol' Maxxie's Position

10x Genomics has a 2.5% allocation target in my portfolio, although it was 5% this summer. I downsized this position to increase my stake in AVITA Medical. My current plan is to build a larger position of 10x Genomics in the next few years.