Pacific Biosciences of California Inc (PACB)

[Paulieme]

PacBio Not Back To Square One But Definitely Back To A 'Show Me' Story.|Jun. 21, 2017 Summary

PacBio has been hammered by slower adoption of its new Sequel systems and Roche deciding to walk away from the clinical diagnostics partnership.

Chemistry and software updates are boosting the performance of Sequel, and there are demanding applications like plant and cancer genomics where PacBio's technology is particularly well-suited relative to competing approaches.

PacBio looks undervalued even on the assumption that its technology is always just a niche player, but this is very much a "show me" story, driven by system placements.

Good news has been hard to find at Pacific Biosciences (NASDAQ:PACB) for a while. Roche's (OTCQX:RHHBY) decision to terminate its agreement with PacBio to develop and market PacBio's technology for the clinical diagnostics market was a major setback in terms of both near-term cash flow prospects and public perception around the value of the technology platform. What's more, with the launch of the Sequel and subsequent reports on its real-world performance, PacBio has once again shown that it struggles to develop and launch systems that deliver the hoped-for performance from Day One.

PacBio shares have fallen close to 60% since my last update on the company, and it I believe the Street has soured too much on the company's prospects in core genomics research. The ongoing improvements in the performance of PacBio's systems should continue to drive adoption, but my fair value estimate of around $6 assumes mid-term revenue growth in the mid-to-high 20%'s and longer-term growth in the mid-20%'s, as well as the ability to earn strong free cash flow on revenue in the $500 million to $600 million range (similar to my expectations for diagnostics company GenMark (NASDAQ:GNMK)). There are absolutely no guarantees that PacBio can hit those targets, nor any guarantees that the markets will grow as hoped or that PacBio's technology won't be supplanted by its rivals. As a high-risk show-me story in an expensive market, though, it is at least worth a look again.

After Spending Tens Of Millions Of Dollars, Roche Walked Away

Despite spending over $100 million on upfronts, milestones, and internal R&D under a 2013 agreement to develop PacBio's single molecule real-time (or SMRT) sequencing technological for the clinical diagnostics market, Roche announced in December of 2016 that it was walking away from the agreement.

Neither Roche nor PacBio has spoken with particular clarity regarding all of the reasons why Roche made this decision, but there were likely multiple factors. First, and as mentioned by PacBio management on more than one occasion, the regulatory environment around the diagnostics market is different now than it was in 2013. At the time of the deal, it seemed very likely that the FDA was going to ratchet up its regulatory oversight of diagnostics, forcing a shift away from its much less stringent approach for lab-developed tests to a more standardized FDA-cleared test structure.

That shift has not happened, as the FDA has elected to maintain a lighter hand with respect to lab-developed tests. With that, potential customers looking at using next-gen sequencing (or NGS) for diagnostic testing are still more interested in buying platforms and reagents and developing their own tests - a structure that really doesn't fit with Roche's diagnostics business model. To that end, I'd note that HLA typing was thought to be one of Roche's main initial interests and Histogenics (NASDAQ:HSGX) is now PacBio's largest customer - owning around a dozen machines that it uses for HLA typing with its own developed tests.

Bears can (and do) argue that Roche's decision was motivated by the realization that the technology isn't viable for clinical diagnostics. The run costs are high (as are the sample requirements) and it is not especially fast or simple to use. Given those dynamics are very important in real-world labs today (as seen with companies like GenMark, bioMerieux (OTC:BMXXY), and others), it is possible that Roche saw a steep uphill climb in driving adoption.

I tend to come down on the side of the regulatory environment, as well as Roche's own internal options. I do believe the market for NGS-based diagnostics today lends itself much more to customized lab-developed tests and not the FDA-approved, "out of the box/one size fits all" assays that Roche is structured to develop and sell. I'd also note that Roche's internally-owned Genia technology could perhaps lead to faster, cheaper results and the company is expected to give more information on its plans for Genia in clinical diagnostics this year. It may be the case then, that Roche used the PacBio collaboration as backup plan while it assessed the viability of its Genia platform and that it decided that it would rather go forward with Genia (which it owns completely) than work with PacBio.

Working To Live Up To Expectations

The launch of the Sequel platform was supposed to be a major step forward for PacBio, offer not only a more functional system for users (with meaningfully greater throughput, read lengths, and price/performance) but a more profitable platform for PacBio.

So far though, the experience with the Sequel has been a lot like the company's experience with the initial launch of the RSII - actual performance has been less impressive than hoped. Actual read lengths for the Sequel started off around a half to a third lower than what was available with the RSII, with weak throughput as well. PacBio has subsequently introduced software and chemistry updates that have improved the performance, but read lengths are only starting to surpass the old RSII system. Even so, read lengths of 10kb-plus (and some users report lengths of over 20kb on a relatively regular basis) are still quite good compared to other commercialized systems, and especially when factoring in the real-world accuracy (errors with PacBio tend to be random and disappear with re-runs, while competing systems have errors that are more systemic and persistent).

This is disappointing but not necessarily as disastrous as it may sound. My late wife was a genetics researcher and it was basically par for the course for these sequencing systems to reach the market later than expected (Oxford Nanopore being perhaps the best example) and to offer less functionality out of the box than the company had promised - even Illumina (NASDAQ:ILMN) has had this issue more than once. Provided that PacBio's software and chemistry updates can continue to upgrade the performance of the system (and management is planning additional releases this year, as well as a new higher-capacity SMRT cell for next year), it won't radically impair long-term adoption. Moreover, as seen at recent genetics research meetings (like ASHG and AGBT), there are a lot of papers being published using PacBio's technology and machines.

Will The Market Continue To Develop?

PacBio has a market share in the low to mid single-digits today, while Illumina remains the dominant player in the space (Thermo Fisher (NYSE:TMO) is still in the game as well). PacBio has never tried to be a real head-to-head competitor with Illumina (or Thermo), and I believe management knows better than to go that route.

PacBio's strength lies in serving markets that are not well-served by competing shorter-read technologies. In particular, PacBio's approach works better in areas like plant genomics where the size and complexity (as well as the amount of repeating data) confounds short-read technology and in the study of structural variation in DNA - a growing area of interest in oncology research that demands longer read lengths.

I also believe PacBio still has credible opportunities in clinical diagnostics, but it will be a slower, harder climb without Roche's support. As I said before, Histogenics has become a bigger customer now that Roche has walked away and I believe there are other users who will step up and use PacBio's technology to develop their own lab-developed tests in areas like oncology, virology, and HLA typing.

The Opportunity

The loss of Roche's support is a blow to my long-term modeling expectations, but it should not be fatal for PacBio. Clinical diagnostics was always just part of the story, and PacBio's opportunities to leverage growth in human genomics research, plant genomics research, microbial genomics research, and oncology research remain intact, not to mention the fact that I don't believe the clinical diagnostics opportunity has gone to zero.

I believe PacBio can get to $300 million in revenue in 2021, but that is not a conservative estimate and "can" is by no means the same as "will". So too with my longer-term estimate of over $800 million in revenue with high teens FCF margins. Hitting these targets is going to require ongoing performance improvements (tied to software and chemistry upgrades), not to mention healthy funding for research and a competitive environment in which PacBio's approach is still highly competitive.

In essence, I believe PacBio is once again a "show me" story that will be driven by real evidence of system adoption and utilization. Unfortunately, management has chosen to clam up regarding system placements and orders - a move that I believe is not only shareholder-unfriendly, but denies shareholders key information regarding the health and progress of the business. Even so, the quarterly results in instruments and consumables will tell the tale regarding adoption and utilization.

Factoring in the company's cash burn and the need for further financing in the future, I come up with a discounted fair value of over $6 today. I would also note that PacBio is trading at less than 3x forward revenue. That level is well below what small-cap growth companies in life sciences typically trade at, and PacBio is still growing, with revenue up 30% in the first quarter and expected to be up close to 20% for the 2017 fiscal year. But PacBio has earned its skepticism and the market is unforgiving when unprofitable growth stories encounter serious issues and revise their growth expectations lower (as PacBio has done more than once).

The Bottom Line

PacBio is a high-risk speculation and a bet on the ongoing growth in demanding genomics research applications like structural variation. Buying PacBio also means believing that management will continue to drive improvements in system performance such that the company actually can capture that addressable market in more demanding applications that need longer read lengths. None of this is certain, but today's valuation really doesn't suggest a lot is expected, and this may be worth a look again from more risk-tolerant investors.

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Disclosure: I am/we are long RHHBY.

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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