Pacific Biosciences: Weak Sentiment, But Future Looks Strong (NASDAQ:PACB)

The shift away from high-multiple growth names in life sciences has been brutal, with many names down 50% or more over the last year. This list includes Pacific Biosciences (NASDAQ:PACB) (“PacBio”), which has dropped another 60% or so since my last write-up on this sequencing company. Although I think PacBio is in even better shape now than a year ago from a long-term perspective, the reality is that sentiment has shifted and this is the risk that goes with owning shares valued at double-digit multiples of future revenue.

Between improvements to its long-read sequencing technology and the addition of a short-read technology platform, I believe PacBio has an even stronger long-term outlook, and while there is (and likely always will be) chatter about what competitors in the space are doing, so far none have come close to PacBio where accuracy is concerned. Long-term revenue growth of over 30% is hardly a humble assumption, but I do think PacBio shares look undervalued today.

Another Step Toward The Ag Opportunity

I’ve long maintained that plant and animal genetics is a major long-term opportunity for PacBio, particularly given that plant genomes are long and complex, full of repeating data that fowl up short-read sequencing. This market is already around 30% of the business mix for PacBio, and the company just took another step forward in this market.

The company announced an agreement with Corteva (CTVA), the combined/former DuPont and Dow ag units, to develop customer end-to-end workflow solutions for plant, pest, and microbe sequencing. This project will initially be focused on DNA extraction and library preparation, and it underlines some of the value in the company’s ongoing focus on improving sample prep (including DNA extraction) and workflow solutions, as these are underrated limiting/gating factors in many labs.

The opportunity for a longer-term engagement here is also meaningful. Corteva does an extensive amount of sequencing work every year, and the opportunity to make more use of PacBio tools and technologies to expand its long-read sequencing efforts is not a trivial one for PacBio.

Expect Ongoing Noise About Competitive Offerings

One of the newer developments in the PacBio story is the concern over whether Illumina (ILMN) may become a bigger threat in the long-read space. Illumina has made it clear that they view long-read sequencing as an important part of the future of sequencing – they did try to buy PacBio, after all – and now they are looking to the Infinity platform to unlock that opportunity.

Infinity is not a new sequencing platform technology, but rather a new integrated workflow (SBS chemistry, data analytics, and a novel assay) that can run on existing systems and that Illumina believes will create accurate read-lengths of up to 10kb.

While Illumina’s Infinity is a new, synthetic long-read technologies have been tried before (several times in fact), and prior attempts have always fallen well short of PACB’s technology in terms of accuracy, as well as in functionality for analyzing structural variants, tandem repeats, methylation, and so on. I’m sure there are use-cases where Infinity will be a “good enough” solution, particularly for labs that don’t need to do long-read sequencing on a frequent basis, but I don’t see Infinity as a true head-to-head competitor in more than 20% or 25% of PacBio’s core use-cases, if that.

Illumina isn’t the only company looking to advance synthetic long-read technology, but I don’t see any of them presenting much of a threat and for similar reasons – compromised accuracy, limited applicability to analyzing structural variants, and so on.

PacBio Enhancing Its Own Technology And Expanding Its Portfolio

Meanwhile, PacBio continues to work on enhancing its own platform. The company will be introducing some new products this year that will increase the utility and competitiveness of the system. New prep and binding kits will reduce the amount of DNA needed for a run, as well as reducing hands-on time by more than 60%. For many labs, sequencing is pretty literally a volume business, and workflow improvements like this are typically well-received.

PacBio is also launching new informatics package that will allow users to simultaneously perform sequencing and methylation detection in a single workflow. No other system offers that functionality, and the extra work needed to study methylation can be cumbersome. Last and not least is a new gene editing QC workflow solution – not a particularly large market opportunity today, but one that could become more significant as gene editing develops.

One of the biggest changes at PacBio since my last update almost a year ago was the acquisition of Omniome and the company’s eventual entry into short-read sequencing. PacBio is currently refining and improving Omniome’s base chemistry, including a new clustering method that achieves longer reads and lower error rates, and has achieved an accuracy level of Q40 or above for 90% of reads (that means 1 error in 10,000 bases). That’s an order of magnitude higher than what Illumina achieves with its NextSeq platform, and I believe it will make for a compelling platform.

Beta testing for a commercial system should take place later this year, with a launch slated for the first half of 1H’23. I’m not looking for PacBio to go head-to-head with Illumina across the short-read sequencing landscape, but I do think this system could be quite competitive in diagnostic markets, including oncology (detection, MRD testing, and therapy planning), and prenatal testing. I also see attractive opportunities for bundling/cross-selling, as PacBio will be the only company in the market with both short-read and long-read technologies.

Near-Term Challenges Are Not Trivial

PacBio didn’t do sentiment any favors with a weak guide with fourth quarter results, including a 2022 revenue target that was 9% below the Street. Management blamed disruptions due to COVID-19, and while this is plausible to a point (particularly with PacBio’s greater exposure to academic labs), other large players didn’t call out similar challenges.

It’s also well worth noting that the company is spending aggressively to build the business. The company was fairly close to some of my old estimates for FY’21 (revenue was about 2% light, GPM was 30bp better), but core opex spending was $15M (or 7%) higher than I expected, with the company spending more on R&D than I expected.

I think it makes sense to spend on R&D and SG&A to accelerate business development, and the company did quite well with system placements in 2021 (171 versus my 175 estimate), but eye-popping reported losses have a way of getting more scrutiny when the market shifts from growth to value (as it has over the last six to 12 months).

Continuing to build the business will require strong execution, but I think the management team is up to it. Launching a new short-read platform will be a real test, but I think the company continues to perform well in long-read, with that progress underlined by numerous partnership announcements over the last year. I’d also note that for all of the chatter around Oxford Nanopore (OTC:ONTTF), there remain meaningful accuracy issues with that platform technology – systemic errors that don’t vanish with repeated runs (as they do with PacBio) and that I believe create a ceiling for adoption.

The Outlook

A slower ramp for new system placements and consumables pull-through does lead to lower revenue expectations for FY’22 and FY’23 than my prior model, but I believe this is more of a deferral than a loss and the company will pick it up later. I have also added revenue from short-read sequencing into my model and, combined with a more bullish long-term outlook for long-read sequencing, that drives my FY’31 revenue estimate from $1.2 billion to $1.8 billion. All told, that’s a long-term revenue growth rate a bit above 30%.

I’ve increased my loss assumptions over the next five years given the company’s entry into short-read sequencing and its ongoing investments into R&D and SG&A. That pushes cash flow break even back three years and closer to $850M in revenue. I still believe that at full scale this business can generate FCF margins in the high 20%’s to low 30%’s.

Given the nature of cash flow modeling, higher upfront losses hurt valuation more than the big increases in long-term revenue and FCF. That, and a higher discount rate, drive my DCF-based fair value from around $23.50 to $20.

The Bottom Line

PacBio still trades at a robust premium to forward revenue, but I believe most of the hype has left the valuation. The road to building the long-read sequencing market is certainly not smooth and risk-free, and competitors like Illumina are still credible threats, but I believe the arguments for long-read sequencing are getting stronger, and that PacBio’s value/performance proposition is getting better. I’m also excited to see what the company can do with a highly accurate short-read platform. These shares are too risky for many investors, but for those who can take the risk, I think the valuation is quite interesting today.