When it comes to analyzing potential investments, I spend a good amount of time on assessing the up- vs downside potential of a certain investment. I have no problems investing in a bad company if the pay-off seems asymmetric enough. A company might be fundamentally horrible in my opinion but if I can get it for basically free + there’s a fairly good probability that something remotely positive can happen, the upside can be really great. However, even better in my opinion are good companies that are already cheap on a fundamental basis, but also have a decent chance of extreme upside given certain catalysts. One example is IP Group (IPO UK), a company which I was lucky to find in April of last year and where the story seems to keep on improving.
IP Group is basically a listed venture capital firm. The company has relationships with many leading universities where it (co-)invests in early stage (and almost always pre-revenue) companies where the focus is on promising IP, mostly in the therapeutics, medtech, cleantech and technology sectors. Like the average venture capital firm, IP Group’s portfolio consists of many investments where plenty will be zeros, some will be ‘ok’ and a few (hopefully) will be home-runs.
Companies like IP Group are generally assessed based on Net Asset Value (NAV), where the NAV is simply said the value of the company’s investments, taking into account other assets like cash and debt on the company balance sheet. As can be seen from the picture below, IP Group’s own assessment of its NAV at 30 June 2020 was ~GBP 1.2bn, or GBp 109 per share, half of which was comprised of cash and a few investments. This NAV, and perhaps your own NAV estimate based on your sum-of-the-parts assessment, can be compared with the company’s current market valuation. IP Group is currently trading at around its mid-year NAV estimate.
Since then (IP Group reports half-yearly) the company’s stake in listed company Ceres Power was sold and consequently its cash balance increased. IP Group now has a very strong balance sheet with plenty of fire-power and runway to cover its opex. But let’s focus on the interesting part.
The graph above shows the top 20 holdings’ end of June valuations (Ceres Power now exited). As these are private companies, the values are mostly based on the latest funding rounds. It’s generally difficult to assess the fairness of these valuations as we don’t have enough information. Also, these valuations can significantly lag current market valuations if things move fast. And that’s where things get interesting.
IP Group has many interesting catalysts going forward, but the most interesting one relates to Oxford Nanopore (ON), IP Group’s biggest holding by far. IP Group owns 15% of ON, currently on the balance sheet for GBP 258m and thus implying an equity valuation of ~GBP1.7bn for ON. ON is widely considered to be the market leader in the most advanced class of DNA sequencing, ‘third-generation sequencing’ or long-read sequencing. I definitely cannot say I’m an expert in this field, but that’s not the point here. I will leave it to the reader to learn more on ON.
We don’t have many financials available on ON, but we know revenues are growing tremendously. Since 2016 revenues have been more than doubling every year. The latest actuals are for 2018 which show ~USD 48m revenues. Estimates floating around for 2019 and 2020 are around USD 80m for 2019 and USD 170m for 2020. While revenues prior to 2020 where mostly from the sale of devices and consumables, basically all of the growth in 2020 was from the Diagnostics segment which accelerated strongly as a consequence of the Covid crisis. Analyst estimates for 2021 revenues are >USD 300m. Further confidence on the latter is provided by relatively recent GBP 113m UK order for ON’s Lampore Covid test as well as another large order from the UAE. I understand orders from other countries such as Germany are in the pipeline as well.
Given the acceleration in 2020 one might believe it to be reasonable to have a big jump in ON’s implied valuation from recent private transactions. That has however not been the case. Even after the news of the major UK order and the CE mark (which opens the European market), ON’s implied valuation in the latest October funding round was stable. Another interesting fact is that transactions in 2020 included the liquidation of the UK fund Woodford. It is well known that Woodford had to sell investments at bargain prices. This means 2020 transaction valuations for ON might have been (further) artificially depressed.
The most important catalyst (other than continuing to grow revenues at a fast pace) is the potential upside to ON’s valuation from an IPO. ON was rumored to go public in Q1 2020 but that was put on hold for obvious reasons. Now ON is again talking about going public.
To see how crazy the upside might be we can look at the only other serious competitor in third-generation sequencing, Pacific Biosciences (PB). PB is a US public company (PACB US) with a market cap of USD 8.0bn, net cash and 2021e revenues of USD 133m, up from USD 79m in 2020 (2019 revenues where USD 91m). PB’s market cap increased ~10x over the past year after the covid increased awareness of the importance and potential of sequencing. Again, I’m certainly no expert in the field but my understanding from research is that ON’s tech is superior and more scalable than PB’s tech. Also, ON has been able to grow its revenues much faster. As such, a premium compared to PB might be warranted. But even excluding a potential premium, taking PB’s current market valuation as a base would lead to an implied equity value for ON of USD 15bn to USD 20bn. At these valuations IP Group’s stake would be valued at USD 2.3bn to USD 3.0bn. Compared to a current market cap of USD 1.7bn for IP Group, we can see the large potential upside to IP Group’s share price from a listing of ON.
This exercise is of course a relative pricing one; PB might be vastly overpriced. But the point here is to show the very large ‘right tail’ potential of an investment in IP Group. Even if an IPO of ON would not fetch the above valuation, the gap to IP Group’s assessed USD 360m stake of ON in its NAV is very big and as such we have a pretty large margin of safety. And that’s assuming the rest of IP Group is fairly valued, which in my opinion it is not – but that’s another discussion.
On the other hand, long read sequencing today is ‘hot’ and an IPO of ON would certainly draw attention and flows from companies like Ark Invest, which will in itself draw even more attention towards the stock. What if ON would indeed trade at a premium to PB?
As always, do your own due diligence.
ToffCap