In relationships, it's important to keep the sex dirty and the fights clean. In DNA sequencing, it would be ideal to keep the samples dirty and the data clean. Oxford Nanopore Technologies (LON: ONT) and nanopore sequencing are the closest to this ideal technology.

The need to process dirty samples before generating data is a significant cost driver in DNA sequencing. It requires specialized labor, chemical reagents, and computational models. Imagine if you could spit in a tube and a machine could read the data in real-time, knowing what counts as human DNA and what is noise. Next-generation genetic testing and diagnostics could be conducted at Walmart or CVS. Results could be ready within 24 hours.

Nanopore sequencing could deliver us that future. But first, it needs to become a sustainable technology in an established commercial market with a relatively high standard for quality. Can the business rise above the Emirati Genome Project (EGP) and find commercial traction?

Refresher: What's a Successful Business Model in Lab Hardware?

Although lab hardware companies are known for selling instruments, they only become successful by selling the consumables needed to run the instruments. A DNA sequencer is a one-time purchase. The kits, enzymes, and other chemicals required to run the machines (the aforementioned consumables) are the not-so-secret secret to success. They represent high-margin, recurring revenue for the life of the lab instrument. A business cannot become profitable without them.

Case in point: Illumina may be known as a DNA sequencing company, but it generated 71% of full-year 2021 revenue from consumables. It's almost more accurate to think of Illumina as a chemicals company.

Revenue mix between instruments and consumables is the most important metric for investors interested in a lab hardware business. It's a simple, yet powerful, way to quickly gauge the success of a business or whether one is moving in the right direction. As a simple rule of thumb, investors want to see at least two-thirds of revenue generated from consumables before starting a position.

Consider 2021 breakdowns of popular lab hardware companies:

Oxford Nanopore stacks up to the peer group remarkably well despite its relative immaturity – or perhaps because of it. The business generated 67% of non-COVID revenue from consumables, 27.6% from instruments (the company tracks this as "starter packs," which includes some consumables), and 5% from other sources.

This has a lot to do with the company's unique commercial footprint. The most powerful nanopore sequencing machine, PromethION, costs only $310,000 (including starting consumables). That's over an order a magnitude lower than the most powerful Illumina machine – and the two are actually pretty comparable.

The simple rule of thumb suggests Oxford Nanopore meets the minimum benchmark for an investment, but things are rarely so simple.

Oxford Nanopore, EGP, and S3 Customers

Oxford Nanopore organizes customers in three strategic categories:

• S1 customers are "light touch" and typically generate less than $25,000 in sales. These include smaller scale operations and one-time purchases from customers such as DIYbio labs; individuals who might purchase a MinION USB DNA sequencer to play around with. Then again, customers as large as Gingko Bioworks have also purchased MinIONs, suggesting these may be initial purchases for larger and longer-term commitments to nanopore sequencing.
• S2 customers are "significant" and typically generate less than $250,000 in sales. These include any size customer who may purchase any size instrument, including MinION, GridION, or the powerhouse PromethION for multi-month projects. These could be a foothold into longer-term commitments from more serious customers.
• S3 customers are "strategic" and typically generate more than $250,000 in sales. These include customers who are purchasing the flagship PromethION instruments for multi-year projects. They represent choppy revenue upfront, but could emerge as important sources of recurring revenue over the long haul.

The company's goal is to sell as many instruments as possible upfront to create significant pull through for consumables revenue over longer periods of time. That's 110% the correct business model. Does the business have the correct customer mix?

Oxford Nanopore did an admirable job making the most of the pandemic. It developed unique diagnostic tests and signed a strategic collaboration with Nvidia to improve the PromethION product. This progress is demonstrated in the revenue mix, especially with S1 ("light touch") and S2 ("strategic") customers. However, the all-important S3 ("significant") customers have been more difficult to come by when the EGP (grey bars) is excluded.

To be fair, revenue from S3 customers has steadily progressed from £17 million in 2019 to £25.1 million in 2021, excluding the EGP. But that's not nearly as impressive as the growth in S2 customers, which more than doubled in that span. How many of these can be converted or upgraded into high-volume PromethION users in the next year or two? That may be the key to success in 2022 and beyond.

An additional wild card to watch is the strong U.S. dollar. Oxford Nanopore is based in the United Kingdom, which means it should have a monetary advantage compared to Illumina and PacBio in the DNA sequencing markets. Exports from the U.K. are more attractive right now compared to exports from the United States. Will that provide a meaningful, or sustainable, boost for the business?

What's an Attractive Entry?

Oxford Nanopore is currently valued at $2.78 billion, which is a bit rich considering it only had $151 million in full-year 2021 revenue. The current valuation is equivalent to 18x sales from the last fiscal year! The company could double revenue in 2022 and still be valued at 9x sales – near the high end of reasonable.

The technology platform and business are very intriguing, but the valuation may not be terribly attractive for an investor with a long-term mindset. It earns a steep premium as one of the United Kingdom's prized technology companies – a beneficiary of the nation's "Eight Great Technologies" initiative – but could tread water for the foreseeable future as it grows into its valuation. Then again, there's a strong chance Oxford Nanopore eats the global DNA sequencing market and becomes a $100 billion business. That could make any fuss over the current sub-$3 billion market cap laughable in the long run.

As mentioned directly above, a strong U.S. dollar could be a boon for the business in the near future, but it's too soon to grasp the consequences or the sustainability of the nudge higher.

Ol' Maxxie's Position

I don't own shares of Oxford Nanopore, but only because I don't own shares of any company listed off a major U.S. exchange. I also don't own shares of companies on the pink sheets or over the counter (OTC) markets due to low volumes and poor liquidity. If the company ever lists American Depository Shares (ADS) or the equivalent, then I would make room in my portfolio for the right price.

Further Reading

• United Kingdom's Eight Great Technologies, Synthetic Biology infographic (2013)
• January 2021 press release for collaboration with Nvidia
• Most recent Oxford Nanopore investor presentation  

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