Bottom Fishing Biotech
Analyzing the PacBio investment opportunity
Estimated Reading Time: ~9 minutes
The 2020 and 2021 biotech markets were a speculative rollercoaster driven by animal spirits. The pendulum has now swung in the other direction, with many companies shedding 80% or more of their market value in short order.
Pacific Biosciences of California (PACB) (“PacBio”) is one such company:
PacBio develops next-generation DNA sequencing systems. The Company’s technology has long captured the imagination of investors. Indeed, at the time of the Company’s IPO in 2010, it had not yet even released a commercial product.
In its early years, the Company struggled with operational missteps and missed timelines. But it continuously improved its core technology's accuracy and commercial viability.
In 2018, Illumina (ILMN) – the leader in the DNA sequencing systems with $4.5bn of 2021 revenue – announced a $1.2bn takeover of PacBio ($8 / share). But after 14 months of regulatory purgatory, the FTC rebuffed the deal, fearing the combination would stifle competition. The companies abandoned the merger in 2020.
There have been a couple of key developments since the merger’s break.
PacBio de-risked its balance sheet by raising cheap capital during 2021’s buoyant equity markets. The Company raised $900mm in convertible debt from Softbank (1.5% convertible note due 2028; convertible at $43.50 / share). Today, the company has $960mm of cash on its balance sheet. Management has publicly disclosed that it will not have to access the capital markets again before it becomes cash flow positive.
PacBio launched its commercialization efforts in earnest, backed by a revamped executive suite (new CEO, CFO, COO – mostly Illumina alumni). Early results have been encouraging.
Make no mistake that this is a risky, venture-style bet. PacBio’s technology is intriguing, but it’s in the very early stages of commercialization. The technology may not fulfill its promise and competitive pressures are mounting.
Background on DNA Sequencing Technology
“According to the SDI Global Assessment Report, sequencing technologies are expected to be the most dominant life sciences instrument for research as a percentage of dollars spent.”
– Illumina Q2 2019 Earnings Call
I’m a finance person, not a science person. I’ll try to give you some scientific background without getting too far over my skis.
The completion of the Human Genome Project in 2003 put DNA sequencing technology on the map. Subsequent advancements in technology and increases in throughput have substantially reduced the cost of genome sequencing:
Reducing the cost of DNA sequencing is critical as it influences the viability, scope, and scale of genetic research projects.
Today, only a small portion of the variants detected in the human genome have a clearly ascribed function. We are still in the early innings of genetic research and its subsequent commercialization. Though the future is promising, this is still a nascent technology.
Some use cases for DNA sequencing technology have already reached commercial adoption. Take clinical diagnostic testing. Both liquid biopsy and prenatal screening utilize next-generation sequencing technology in real-world clinical settings. Both are multi-billion dollar industries today. It’s not hard to imagine a future in which your annual health check-in is accompanied by a diagnostic test, ran on a simple blood sample, to detect any presence of early-stage disease in your DNA (selected genetic disorders: cancer, Alzheimer’s, Parkinson’s).
Human diagnostics are the tip of the iceberg. There are real-world genomic applications across plants, animals, infectious diseases, and microorganisms. Not to mention emergent applications such as gene therapy and CRISPR.
There are two primary types of DNA sequencing technology: short-read and long-read.
Short-read technology has been predominant in the United States for the last decade. Most current clinical use cases, such as liquid biopsy, use short-read technology. Simply put, short-read is highly affordable and scalable. Illumina is the dominant player in the short-read sequencing market.
PacBio’s technology is based on long-read sequencing. Accurate long-reads can range across a longer portion of the genome and provide a more comprehensive view. In certain applications, long-read technology provides specific findings that short-read cannot. Historically, there were two drawbacks to long-read technology: accuracy and price. PacBio was the first to solve the accuracy issue, with its newest technology demonstrating over 99.99% accuracy. But to date, long-read technologies haven't been economical. And therefore, they haven't been broadly adopted. We are only beginning to cross the cost thresholds that can enable widespread adoption.
“When you think about our customers, you've got Illumina instruments, and usually, they have also a PacBio instrument there. So they are really pleased about the integration of the two technologies together and the complementary benefits.”
– Sam Samad, Former CFO of Illumina, at Piper Jaffray Healthcare Conference (December 2018)
Illumina’s terminated takeover of PacBio was an attempt to bridge the gap between short and long-read technologies. Bundling short and long-read would have allowed Illumina to cover nearly all customers in genomics. And it could have leveraged its commercial scale to drive sales growth for PacBio’s long-read sequencers.
The merger proxy reveals that this takeover was not the result of a competitive process. Illumina, clearly impressed with PacBio’s latest technology, moved quickly to acquire the business for its own before a competitor had the chance.
The Illumina takeover is a great data point on both the viability and value of PacBio’s technology.
“If you bring in long-read sequencing, complement it with short-read sequencing, you can get essentially for lack of a better term, a perfect view of the genome.”
– Sam Samad, Former CFO of Illumina, at Citi Global Healthcare Conference (December 2018)
Historically PacBio’s technology has not scaled in a way that drives mass adoption. But recent results suggest progress - look at the recent growth in its install base:
At the same time, PacBio reported an acceleration of operating losses in the last five quarters. Two factors drive this:
The previous management team was focused on developing the very best technology. But the company had limited infrastructure to go out and sell its product. The number one priority of the new management team has been building out its internal sales force infrastructure.
PacBio is attempting to reverse Illumina’s playbook and add short-read sequencing capabilities to its existing long-read platform. It acquired Omniome in 2021, a developer of a proprietary short-read DNA sequencing platform. Q4 ‘21 was the first full quarter inclusive of Omniome’s R&D and SG&A overhead. PacBio is planning to commercially launch the first platform using its technology in the first half of 2023.
I feel this is an appropriate place to reiterate that this is a risky, venture-style bet.
PacBio operates a razor-razorblade business model. It sells DNA sequencing instruments (the razor). And it also sells single-use consumables that are necessary to run DNA samples through the instruments (“consumables”):
As consumables generally carry higher gross margins than instruments, the company should benefit from gains in gross margin as its product mix changes.
PacBio serves an array of customers and use cases:
Human Germline (~33% of revenue)
The fastest-growing application for PacBio. Focus areas include rare and inherited diseases, carrier screening, population genomics, and other research initiatives.
Plant and Animal (~30% of revenue)
The historical bread and butter of PacBio. Potential to accelerate breeding progress, decrease susceptibility to climate change, pests and diseases and increase yield potential.
Infectious Disease and Microbiology (~20% of revenue)
Used to provide a more complete genetic picture of viruses and microorganisms. Current applications include pathogen surveillance solutions.
Oncology and Emerging Applications (10% of revenue)
Emerging applications like gene therapy, CRISPR, and synthetic biology.
The holy grail for PacBio is whole-genome sequencing for human clinical diagnostic applications. Recall my example of your annual health check-in being accompanied by a routine diagnostic test. But the Company must make significant progress in lowering the cost of its sequencing for this to be feasible.
Competition and Valuation
PacBio’s primary competitor in long-read technology is Oxford Nanopore (LSE: ONT). Oxford, which received funding from investors including Oracle, went public in a blockbuster IPO last year, only to see its stock price slide. Like PacBio, its sequencing technique is more accurate than short-read technology but also considerably more expensive.
Notably, Illumina announced its own in-house long-read product in January (dubbed “Infinity”). Though still in development, news of Illumina’s planned release sent shockwaves through the industry, as its considerable R&D budget and commercialization capabilities instantly make it a worthy competitor.
Short-read technology has a longer list of competitors. The industry leader is Illumina. But new entrants such as Ultima Genomics and Element Biosciences offer incredibly cost-effective short-read technologies. BGI Genomics (SHE: 300676) is an industry leader based in China. And life science giants such as Thermo Fisher (TMO) have their own short-read sequencing technology.
Due to its early stage, PacBio is a difficult one to value. A multiple approach discounts its long-dated growth opportunity. But a DCF requires a crystal ball’s worth of assumptions. The investment decision requires a subjective judgment call on the viability of the underlying technology and the ability of management to execute. And even then, there are several existential risks.
But I’ll highlight two data points in regards to valuation:
Illumina’s proposed acquisition of PacBio, valued at $1.2bn. Although much has changed since the announced transaction in 2018, the takeover valuation provides a valuable reference point in triangulating PacBio’s value today. For reference, PacBio’s current market cap is ~$1.1bn.
PacBio trades at a discount relative to its publicly-traded peer Oxford Nanopore – 8x EV / LTM revenue vs. 15x (according to S&P Capital IQ as of 6/29/22).
PacBio has an exciting technology but is in the early stages of its commercialization.
Execution by management will be a critical factor in its future success. The new management team has done an admirable job of providing reliable forward guidance and hitting its targets. But competition in the long-read space is growing, particularly with Illumina’s announcement they will be entering the space with their in-house product.
Q2 and Q3 2022 system deliveries will be critically important. Continued momentum in its installed base will accelerate PacBio’s time to breakeven cash flow and restore investor confidence in its growth story.
If PacBio struggles to commercialize its technology, it will likely draw M&A interest from other life science companies with an interest in genomics (think: Thermo Fisher, Agilent, Danaher, Roche, Qiagen).
As I mentioned, this venture bet is burning a lot of cash. If you find the technology intriguing, the best bet may be to take a VC approach and buy a basket of stocks rather than trying to pick one winning horse. Where is the bottom in this stock? I’m not sure it has been established yet. It found support at $4, but it will likely breach this level if macro conditions continue to deteriorate. If the market affords me the opportunity to buy this technology at such valuations, it may be time to rig my lure and go fishing.
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This article is not investment advice. The statistics and analyses herein are the author’s opinion and should not be relied upon as fact. Do your own diligence before making any investment decisions. The author retains the right to buy, sell or otherwise transact in any security without prior notice.