Is This $5 Billion Biotech IPO a Buy?

Single-cell analysis took a little while to arrive, but the analytical approach is finally proving its worth in biology labs across the globe. It's also starting to power considerable growth for companies well-positioned to capture the opportunity. That includes 10X Genomics (NASDAQ: TXG), which recently completed a successful initial public offering (IPO).

The company has enjoyed triple-digit year-over-year growth, and strong investor appetite for IPOs has handed the laboratory hardware business a $5 billion market valuation. It offers a slick lineup of products to customers and expects to continue growing at a healthy clip. Despite the relatively great start to life on the public market, the company faces serious patent-infringement suits from Bio-Rad Laboratories (NYSE: BIO). Is 10X Genomics a buy?

A 96-well plate in a biology lab being filled with samples.

Image source: Getty Images.

What is single-cell analysis?

10X Genomics has built a leading technology platform in single-cell analysis. The technique allows researchers to better understand the complexity of a biological sample, such as a tissue sample being studied during drug discovery or drug development experiments. 

Let's stick with that example. Historically, researchers have been able to interrogate a tissue sample at the global level. It was possible to determine what genes were expressed, what proteins and immune cells were present, and what metabolites were excreted within the sample. But the next level of granularity -- where in the sample are genes, proteins, immune cells, and metabolites active -- was out of reach.

Single-cell analysis provides information on individual cells within a sample and allows for global data to be mapped spatially. That can allow researchers to tease out previously undiscovered cellular communication pathways for a particular disease and identify targets for novel drug candidates. The technique has become invaluable for immuno-oncology, cellular medicine, and moving beyond the genome (DNA) to understand the transcriptome (mRNA) and proteome (proteins).

The business

10X Genomics is a laboratory-instrument developer. That means it generates revenue by selling instruments to labs (a one-time source of revenue), and then by selling the consumables required to operate each machine (a recurring source of revenue). Here are the company's main products:

  • Chromium instruments for single-cell analysis
  • Visium instruments for spatial genomic analysis
  • All of the consumables to actually operate Chromium and Visium machines
  • Software solutions for interpreting data generated from Chromium and Visium machines

As discussed in the next section, 10X Genomics has done well leveraging its combined software, hardware, and biology expertise to drive impressive growth. But there's one serious problem summarized by a single sentence in its S1 filing: "We are currently involved in litigation matters related to substantially all of our products."

A gavel and a Lady Justice statue on a table with bookcases in the background..

Image source: Getty Images.

In late 2018, a jury found that 10X Genomics willfully infringed certain patents owned by Bio-Rad Laboratories, specifically with the use of Gel bead in Emulsion (GEM) microfluidic chips that power all Chromium instruments and substantially all of the company's revenue. The company was ordered to pay $35 million in damages for sales of Chromium instruments through the jury decision and has been setting aside 15% of worldwide sales as an estimated royalty for sales afterward. The single-cell analysis start-up accrued $55.3 million in total liabilities from the lawsuit through the end of June 2019.

10X Genomics has developed a new solution, called the Next GEM microfluidic chips, to get rid of the headache. The new chip works differently from the GEM microfluidic chips involved in the Bio-Rad lawsuit referenced above. The business expects the new microfluidic chips to constitute substantially all Chromium sales by the end of 2020, but that may not be enough. Why not?

First, the company isn't sure all of its current consumables will work with its new Next GEM microfluidic chips. That could significantly stunt growth. Second, 10X Genomics may have to stop selling certain high-growth consumables products involved in the Bio-Rad lawsuit with or without new chips powering Chromium instruments. Third, Bio-Rad filed a new patent infringement lawsuit against 10X Genomics and its Next GEM microfluidic chips the day before the IPO.

As if all that weren't bad enough, 10X Genomics qualifies as an emerging growth company under the JOBS Act. That means it has reduced disclosure requirements compared to other publicly traded companies and doesn't have to adopt certain accounting standards at this time. That lack of transparency should be a red flag for investors, especially given the ongoing legal challenges.

By the numbers

Despite the serious legal challenges to the company's intellectual property, Wall Street has happily rewarded 10X Genomics with a market cap of $5 billion. The company's healthy growth -- pretty rare for a lab-hardware developer -- explains the excitement.

Metric First-Half 2019 First-Half 2018 Change 
Revenue $109.4 million $59.1 million 85%
Gross profit $80.4 million  $50.6 million 59%
Operating expenses $93.8 million $71.5 million 31%
Operating income ($13.4 million) ($20.9 million) N/A
Cash from operations $13.4 million ($20.2 million) N/A

Data source: SEC filing.

10X Genomics has done a great job executing the business model of every successful lab-hardware business: grow the installed base of instruments and monetize each instrument with recurring consumables sales. In fact, consumables revenue comprised 84% of total revenue in the first half of 2019 -- a very good sign for the business and investors.

At the end of June 2019, the company counted an installed base of 1,284 instruments that had brought in an average of $81,000 in consumables revenue per machine in the first six months of the year. That works out to $162,000 per instrument on an annualized basis, compared to $148,000 in consumables revenue per instrument achieved in 2018.

While improving operational results are encouraging, it doesn't quite seem to make up for the elephant in the room.

Investors should pass on this stock

If investors ignore the patent infringement lawsuits brought by Bio-Rad, then 10X Genomics has a lot to offer those with a long-term mindset. Of course, investors cannot ignore the serious issues facing 10X Genomics. A successful IPO armed it with more than $350 million in cash, which could be deployed to acquire new companies or technologies, but that strategy would be rife with its own risks.

It's also worth pointing out that 10X Genomics is valued at an unreasonable premium. Shares are trading at 26 times sales, compared to just 4.4 times sales for Bio-Rad. Even Illumina, which itself is valued at a healthy premium, trades at just 12.8 times sales. Therefore, investors should pass on this stock until shares trade at a more reasonable level and the uncertainty clears up.

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Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Illumina. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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