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10x Genomics: A Second Chance To Buy Into The Growth Story – 10x Genomics, Inc. (NASDAQ:TXG)

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Investment Thesis

10x Genomics (TXG) looks like a promising play within the expanding gene sequencing sector. The company posted a strong set of full-year financials with sales up by 68% from 2018 to $245.9 million, with its consumables division driving $206.9 million of this figure and instrument sales $34.9 million – a 4% yearly drop.

Similarly to bigger players in this sector such as Illumina (ILMN) and Qiagen (QGEN) – recently acquired by Thermo Fisher (TMO) in an $11.5 billion deal, TXG sells instruments, consumables and software to a broad range of clients, including 19 of the top 20 global pharmaceutical companies and 96 of the top 100 global research institutions, according to a recent company presentation.

TXG has sold more than 1,660 of its instruments since mid-2015, adding another 645 sales in 2019, and estimates that it pulls through ~$150k in consumables revenue from each instrument. Research derived from its products was featured in over 700 peer-reviewed publications in 2019, including important studies and breakthroughs in the fields of Alzheimer’s, cancer treatment, autoimmune and age-related diseases, and HIV and antibody discovery and vaccine development.

The company has forecast sales of $350-360 million and growth of 42-46% for 2020, and is targeting a near-term market it says is worth $13 billion as well as a wider $50 billion+ global market for life sciences tools. In order to achieve profitability, TXG will need to increase its operating and net profit margins significantly, and there are already signs that this is happening – total operating expenses as a percentage of sales decreased from 156% in 2018 to 88% in 2019.

I believe that the company is well-placed to both increase revenues and reduce its overall cost burden in 2020, and that makes the current depressed stock price a tempting entry point into owning some TXG stock. It may take more than one year for TXG to deliver positive EPS, and there are some further caveats to take note of – chiefly, ongoing litigation with sector rival Bio-Rad Laboratories (BIO) over patent infringement which could damage sales of TXG’s old and newer product lines, how much the company can grow its installed instrument base by, and whether its “halo-user” business model can work.

Based on the potential future adoption of the company’s products and services (and as a bonus, its attractiveness as an acquisition target), I would assign it a fair value price at a premium to current stock price ($57 at the time of writing), at ~$75. If you take the viewpoint that the market has seen the worst of coronavirus and will continue to recover, then TXG ought to display stronger-than-average share price growth in the near term, and over the longer term can potentially trade above $100 on its strong growth prospects amid increasing demands for its products. Hence, I am bullish.

Company Overview: Visium and Chromium platforms

(10x Genomics current product suite. Source: Company investor presentation)

TXG’s 2 major product lines are its Chromium platform, which enables single-cell analysis, and its Visium platform, which looks at spatial analysis – the “what” and the “where” of biological cell research. In order to use the Chromium platform, customers must also have access to one of TXG’s instruments, but Visium users do not require such access.

According to the company’s 10-K submission for 2019 a Chromium controller instrument costs $75,000, although an updated version – Chromium Connect – is being released, with a higher list price of $260,000 spoken about by TXG management during the Q419 earnings call in February.

Chromium’s unique GEM-code barcoding technology and micro-fluidic chips permit the Chromium platform to deliver high cell throughput – allowing researchers to look at up to 80,000 cells in one run – with a high cell capture rate of around 65% and low doublet rates (where 2 or more cells are mistakenly read as one).

Chromium caters for 4 different types of cell analysis: Single-cell gene expression, data from which has been used in more than 540 peer-reviewed scientific publications; Single-cell immune profiling, which allows researchers to study T and B-cell receptors at the single cell level; Single-cell ATAC – exclusively licensed to TXG from Stanford University – ATAC stands for “Assay for Transposase Accessible Chromatin using sequencing,” and is used in epigenetics and genome-regulation research; and finally, Single-Cell Copy Number Variation – used to examine the different DNA mutations of cancerous cells.

The Visium platform is designed to help researchers study the spatial relationship of biological analytes in tissues, which can be useful for identifying cell behaviour of both healthy and disease state tissue to better understand, for example, neurodegeneration (e.g. Parkinson’s) and whether T-cells have infiltrated or merely surrounded a cancerous tumor. Visium was launched in 2019 using technology the company acquired through the acquisition of Spatial Transcriptomics in 2018, for an undisclosed amount.

Growth and Commercial Strategy

TXG has a diversified customer base, with no single client responsible for more than 10% of its revenues, although in both 2018 and 2019 sales to academic institutions accounted for 70% of the company’s revenues. The bulk of these clients utilise funds obtained from government research grants, hence TXG ultimately derives much of its revenues from government research funding (which helps to explain why published research from experiments using its equipment is an important success metric for the company). TXG makes 43% of its total sales abroad, with Germany and China both representing large markets.

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Because TXG’s product suite covers a wide area of healthcare R&D – from Alzheimer’s, to cancers, to auto-immune diseases such as HIV – and because its technology is improving in efficiency and scale, the company is targeting rapid growth and a switch from a core DNA focus to address all areas of biology and gene expression.

(Different applications of TXG technologies. Source: Company investor presentation.)

TXG also has the advantage of having insight into where its customers are making the most significant breakthroughs and discoveries – information which the company uses to inform its product development, as in with a recently launched capability within Chromium to enable measurement of gene expression and epigenetics together from the same cell, a feature which TXG CEO Serge Saxonov highlighted on the recent Q419 earnings call as one of the most demanded by customers.

TXG is also making its technology available for more niche experiments and studies at lower price points – for example, using targeted sequencing where customers use just a subset of genes rather than a full cell transcriptome. In this way, the company hopes to target tens of thousands of new users using numerous different smaller sample combinations for its single-cell research.

Management is also aiming to increase throughput for each experiment. When Chromium was first launched in 2016, the platform allowed labs to perform experiments on up to 1,000 cells routinely, but this figure has increased to 10,000, and management believes that a figure of up to 10 million will soon be achievable – which brings a variety of new experiment types into play, including large-scale cohorts and population scale management.

For Visium, management anticipates that growth will come from the platform’s use by pathologists who will be able to combine Visium use with immunohistochemistry (“IHC”) from the same tissue sample, allowing the simultaneous study of hundreds or possibly thousands of proteins together, optimising the data and creating a bridge between the disciplines of pathology and high-throughput molecular analysis. In addition, having detected a high unmet need to provide for formalin-fixed, paraffin-embedded (or FFP) samples, which are commonly used by pathologists, TXG is due to release a version of Visium that caters for FFP in the near future.

Halo Users

By making its Visium and Chromium platforms more versatile, TXG is able to address a market of “halo users” – users who do not own an instrument but have access to one, and want to use Chromium of Visium to carry out experiments. Halo users ought to increase the individual pull-through of each instrument, and this has been the trend to date, with consumables revenue accelerating by 92% year on year to $204 million, or 83% of all revenues.

(TXG instruments, consumables and services revenue. Source: Company 2019 10-K submission.)

Growth of instruments sales (-5%), however, represents a slight concern, since the company’s products are designed to work together, meaning revenues can only grow as large as the maximum output of the total instruments available for use.

TXG management says sales were lower in 2019, as the company released a full-featured, lower-priced product in early 2019. TXG sold 645 instruments in 2019 to bring the total sold to above 1660, and management says it expects to sell at least as many again in 2020, with pull-through rates of $150,000 per instrument likely maintained or increasing. Management also revealed that gross margins on newer product lines will be slightly lower owing to higher costs of production and sales.

The company is certainly in a growth phase currently, attempting to rapidly expand and refine its products to meet growing demand. As such, TXG increased its spending on R&D in 2019 to $83 million from $47.5 million in 2018, and on SG&A from $88 million to $131 million over the same period. This 57% total increase in spending appears to be justified when we consider that total revenues grew by 66% over the same period.

The company is making progress towards profitability, but given its ambitious growth plans (which include increasing spending), I would not expect to see TXG make a profit in 2020 or 2021. TXG’s net loss margin in 2019 was -12.7%, which is manageable, and in fact, the company may well have made a profit last year were it not for the additional costs of ongoing litigation which is placing a high financial burden upon TXG.

TXG’s (potential) Achilles’ heel – Patent litigation with Biorad

TXG’s solid business model and the innovative products that it sells into a high-growth market against limited competition with high barriers to entry mark the company out as one to watch, but it is worth adding an asterisk here given that a number of ongoing court cases between TXG and sector rival Biorad could mean that TXG has to discontinue some, or possibly even all, of its product lines.

In November last year, a jury in Delaware found against TXG and in favour of Bio-Rad laboratories that TXG willfully infringed 7 patents owned by Bio-Rad as a result of its acquisition of RainDance Technologies. As a result, TXG has been forced to pay $35 million in damages to Bio-Rad, and although it can continue to sell them, the company must pay Bio-Rad 15% of all revenues derived from sales of the micro-fluidic chips and other consumables that infringed.

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Further legal challenges are underway, and in essence, Bio-Rad is accusing nearly all of TXG’s products of being in breach of its patents. Clearly, if the courts rule against TXG (which is also suing Bio-Rad for patent infringement in a separate case), the company will have to redesign and remodel its entire product line. In fact, TXG has already begun doing so with its NEXT-GEM family of products that management believe will be able to replace all of its legacy products by the end of the year – but the catch here is that Bio-Rad is also accusing TXG’s NEXT-GEM products of patent infringement.

If TXG were faced with the prospect of discontinuing a brand new product line and disrupting the work of its research clients at the same time, it would deal a serious blow to the company’s business model and ability to continue operating. When assessing the legal risk, however, it is worth noting that Bio-Rad’s latest legal challenge (against the NEXT-GEM product line) came immediately before the TXG IPO, which raised nearly $400 million – and trial costs, fines and small royalties aside, the litigation has not materially affected any other aspect of the business to date.

Although TXG claims to have 700 patents of its own either issued or pending, disputes with Bio-Rad (and potentially other gene sequencing technology companies) are not likely to end in the near term and could result in hefty fines, disruption to business and withdrawal of products. Investors may have to accept the reality that litigation is a feature of a business like TXG’s that relies on technological innovation, and factor in likely damages into their valuations and forecasting for the company – as the company itself has done.

Looking at the issue from a more positive perspective, the legal problems may dissipate as TXG grows and is able to assert more authority against its larger rivals. Or, if the likes of Bio-Rad are unable to win in the courts, they may consider making a bid to acquire a company like TXG – great news for shareholders.

Competition – A good time to disrupt the disruptors

The major players in the gene sequencing market include Bio-Rad, Illumina and Qiagen – which was recently acquired by Thermo Fisher for $11.5 billion – providing evidence of the value the wider healthcare industry sees in this market. Other smaller companies include Pacific Biosciences (PACB), Oxford Nanopore Technologies and Novogene. According to Grand View Research, the single-gene sequencing market was worth $731 million in 2016 and is expected to grow at a CAGR of 14.6% until 2025.

(Share price performance of selected gene sequencing stocks vs. S&P 500. Source: TradingView)

Despite its usefulness and growing market size, however, the stock price performance in the sector has been underwhelming recently. This is due to the steady, rather than overwhelming, growth of larger companies Qiagen, Bio-Rad and Illumina – all 3 have grown revenues but appear to have suffered from high costs, struggles in overseas markets including China (where TXG made $29 million of sales last year) and, in my view, a struggle to identify the specific needs of its client base and where and how their products can deliver the most value.

As we can see from the chart above, TXG share price had outperformed its rivals significantly in the short time it was listed pre-coronavirus, and I see this as a very positive sign. I believe the gene sequencing market – a sector that is highly regarded – had reached something of a saturation point, with larger providers struggling to innovate or unlock new use cases for their products.

A young company that is more agile, with a sizable R&D budget, is therefore optimally placed to disrupt this market and provide the fresh ideas that this sector – undoubtedly valuable, but still somewhat unproven – needs. In some ways, the current litigation between Bio-Rad and TXG may be symptomatic of the disruption and democratisation of the gene sequencing industry – a much-needed step that will make the industry more fragmented and accessible, in my view.

Conclusion – Many signs here of a strong growth company, but litigation makes any investment speculative

Many observers felt that TXG’s value was baked into its IPO price, which ended up higher than forecast, at $39 per share rather than the $33 initially proposed. But the stock jumped on its first day of trading by nearly 50% and hit a high of $107 at the end of January.

As mentioned above, the recent market collapse has dragged TXG’s price back down to $61 at the time of writing. In the past couple of days, owing to the market’s recovery on the back of government stimulus in what has been a relatively encouraging week in terms of backing away from the bear market precipice, TXG stock has gained slightly, and hence, I believe the worst-case scenario may have passed and the stock may start to gain value rapidly.

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That is the short-term case for owning some TXG stock, but the longer-term one is perhaps more persuasive. Although it has long been regarded as the “next big thing” in healthcare, as I have mentioned, some big players in the gene sequencing sector have struggled for growth recently, suggesting a fresh approach is required, and I believe TXG – amongst others – can provide that fresh impetus.

By converting its “halo users” into instrument buyers, TXG has an obvious “try before you buy” route to growth – and once a company does buy an underlying instrument, its spend on consumables also tends to increase as it commits to more experiments. TXG’s clients’ success in publishing research derived from the company products is a positive sign, as is the company’s willingness to spend on R&D and SG&A in the short term to optimise its growth prospects and try to steal a march on the competition.

TXG has sufficient funds ($424 million at end of 2019) to continue operations until such a time as profitability is achieved without the requirement of raising further funds (although I would not rule this out), whilst also making complementary acquisitions if necessary and continuing to cover litigation expenses. It is this final concern that worries me the most, since TXG has already lost one major patent dispute case to Bio-Rad, and should it lose the case concerning its NEXT-GEM suite of products, the company will be almost back where it started and unable to satisfy its clients’ demands.

On balance, however, I can live with this level of risk, since I believe that as the gene sequencing market is disrupted, the patent landscape will change and, I expect, level out, permitting more product lines to be developed and sold without fear of legal challenges. Although TXG may be hit with further fines in the current climate, I think the NEXT-GEM product lines – crucial to the company’s progress over the next five years – will survive.

My remaining concern would then be ensuring that sales of instruments continue to increase at a steady rate. This will be dictated by market forces in the private sector and funding trends in the public, both of which carry strong tailwinds, in my view, given the current strong focus on immunology-based treatments for most disease types and the intensely competitive nature of the drug development industry, which I can see creating strong demand for TXG’s products.

In this respect, sales of the new Chromium Connect will be worth looking at closely when the next set of earnings is released. Although priced at $260,000, TXG’s CCO, Brad Crutchfield, commented during the Q419 earnings call that “that’s well within the capital constraints of virtually any customer who would be contemplating higher throughput single-cell experiments” – I’d be inclined to agree with that statement.

Finally, from a financial perspective TXG is in a solid position with just $110 million of liabilities and current assets of $605.9 million. With guaranteed recurring revenue streams of its consumables lines from its 1,600+ instruments, and its NEXT-GEM products coming on-line rapidly in 2020 revenue growth of 44% to $355 million (as forecast by the company) would be a creditable goal to reach and set a path towards realising profitability, based on my estimates, in 2023. If the company can overcome its legal struggles and ease its R&D and SG&A spending at the same time, I believe that a net profit margin >5% and profits in the triple-digit millions ought to be achievable by 2025.

Based on an expected market rate of 10%, beta of 1.23 and a risk-free rate of 1.6, I arrive at a weighted average cost of capital (“WACC”) of 11.5% and a fair value price of $75 for TXG. However, I believe that the company may well trade above this figure on acquisition expectations and the huge promise and scale of the gene sequencing market. As I have mentioned when covering some of the sector’s other stocks like Bio-Rad, Qiagen and Illumina, I have felt that all 3 companies, to a greater or lesser extent, had hit the buffers at the end of 2019.

TXG’s entry into the market, however, plus the acquisition of Qiagen by pharma giant Thermo Fisher, have re-lit the touch paper and opened up the possibility of more agile products and services serving the gene sequencing market, at greater scale and with more context for scientists and researchers. If you can handle the legal Sword of Damocles hanging over it, TXG looks a solid investment into a promising sector at just the right phase in the company’s growth.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TXG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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