Editor’s Note: Seeking Alpha is proud to welcome DZ Research as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to learn more “
The goal of this article is to assess the competitive landscape of Pacific Biosciences of California (NASDAQ:PACB), determine the company’s valuation, and assess whether liquidity or solvency risks exist through supplemental credit analysis. I find that the company can outperform the long-read indexing market in the coming years while demonstrating strong operating leverage. My calculations indicate increasing cash flow generation after 2026 which allows for significant potential upside for equity holders. Meanwhile, credit risk seems limited to me.
PacB’s technological advances within long-read sequencing were recognized by Illumina, which was trying to acquire the Californian company in 2019. Since then, the product updates from the Sequel II to the Revio have been quite impressive. However, competition cannot be underestimated and will be intense. The main direct competitors are Illumina, Oxford Nanopore (OTCPK:ONTTF) and Beijing Genomics Institute (BGI). Illumina launched a product in March 2023 that allows long-read sequencing, but at a cost of $1,350 per complete genome: more than Oxford Nanopore’s $1,200 per sequencing and PacB’s $1,000 per test. Note that the strengths of PACB include not only the lower cost per genome for longer sequence reads, but also the highest read quality for ONT (Q33: >99.9%) versus Q22 (>99%) Can be trusted. Meanwhile, Roche (OTCQX:RHHBY), collaborating with Illumina, may enter the NGS sequencing market thanks to the acquisition of Stratos Genomics made in May 2020.
PACB is now also present in short-read sequencing, thanks to the acquisition of Omniome in 2021. Its sequencer is called Enso and is scheduled to begin shipping in the second quarter of 2023, but management expects revenue to be minimal this year and will accelerate through 2024. It has a deeper resolution (Q40, meaning 99.99% accuracy) which allows fewer false positives. PACB announced the acquisition of Apton, a high-throughput short-read sequencer firm, for $110 million in August 2023 to enhance its portfolio against Illumina.
The main revenue driver is expected to be Revio, given its excellent performance on long-read DNA sequencing. It integrates GPU chips (Nvidia) and, according to the Q1 conference call, allows for major improvements with respect to the previous Sequel II generation: “That’s 400 gigabytes per 24 hours running on the Ravio. To put this in perspective, the Sequel IIe generates only 30 gigabases of sequence in 30 hours,
I suspect that long-read sequencing will not only be a good complement to short-reads, but will also be a potential option for Illumina to join the NGS market at some point. This is achievable because long-read sequencing costs well below the $1,000 level and can analyze much more information related to genomics. Ravio product launches have exceeded expectations and reached new customers, as one third of the new backlog (up from 76 in Q1) came from new customers.
Now it will be a question of controlling the execution (production, shipment) and supply-chain well to avoid any delays or cost inflation. Gross margins are expected to decline this year as better production yields are achieved and increased client throughput drives material utilization (accretion effect). Funding needs will also be important, but we will see later that current cash levels should be sufficient to deal with the 2023-2026 cash burn generation.
What valuation can we expect?
First, let’s acknowledge that since the firm is expected to break even in cash-flow after 2026, P/E and EV/EBITDA ratios cannot realistically be employed, making EV/Sales possible and long-term DCF. The model can be discarded. Starting with multiples to revenue, we see that PACB is priced at 18X for FY23 but should reach 8X by 2026 due to its high growth profile. Compared to peers in the DNA sector, its EV/Sales ratio for 3 years of forward growth is actually quite good, as can be seen below:
Trying to access the intrinsic value of PACB, I set up a 2-stage DCF model (10 years, then infinite) to model the different stages of the business (scaling/acceleration and sustainable growth).
I used revenue generation in line with management projections as the first hypothesis: revenues to exceed $500 million by 2026 with a 2022-2026 CAGR of more than +40%. Meanwhile, its direct competitor ONT is aiming for growth of more than 30% per year. middle term.
Then, regarding gross margin: I expect 60% (high end of management target) and a gradual improvement in the long term, reaching 70%. In comparison, its rival Oxford Nanopore should reach 60% this year and aims for more than 65% by 2025. Illumina has enjoyed very large scale gains, but typically at 65-70% gross margin levels.
Moving to operating expenses: I model bringing R&D/sales and SGA/sales levels down to 25% and 22%, respectively, by 2030. In comparison, Illumina’s expense levels as a mature company and before additional expenses prior to the Grail merger were: 18.5% RD/sales and 23.5% SGA/sales from 2018 to 2019. PACB management expects non-GAAP OPEX to grow only +5%/year from 2022 to 2026 as most R&D and commercial workforce expansion lags.
Finally, I used a 5% CAPEX to sales ratio, which has been Illumina’s low-end level.
Using these inputs and company data, I reach FCF neutrality by 2027, i.e. a year later than management expects.
I have a target price of $19/share, which represents an 80% upside potential given current market prices. We understand that the model has a large spectrum of outcomes and forecast uncertainties due to the company’s rapidly growing profile. Therefore, I applied a sensitivity analysis:
We can see that the current stock price implies revenue growth of only 10% per year after 2026: this seems pessimistic to me.
Are we at risk of raising large capital?
Applying credit analysis, we can see that: The debt profile reflects two convertibles to be repaid by 2028 and 2030 respectively, which is sufficient to prevent any liquidity issues. Until then, the interest payments are significantly lower, as the coupon was negotiated during the low interest period in 2020. With regard to the solvency issue, the projected free cash flow generation should be sufficient to repay both the loan principals. If PACB were to miss my FCF projections, I still don’t expect any major capital raising (other than an M&A program) as the debt wall isn’t happening before 2028.
Several risks could impair my positive thesis. The first thing that comes to my mind is related to company competition. As discussed, Oxford Nanopore is a current serious competitor within long-read sequencers, while Illumina, despite being a latecomer to this sub-market, has formidable financial and technological resources at its disposal to catch up. . The second relates to the size of the addressable market: while 2026 revenue forecasts appear achievable given the strong dynamics of new backlog, the mid- to long-term trend is uncertain: it is still possible that the short-read market will remain dominant, leaving Read briefly as a niche market.
In summary, I believe PACB represents an attractive investment proposition. Its prospects for gaining a larger market share in the rapidly growing long-read sequencing market are real and, in my estimation, it has enough financial resources to avoid any major capital raising. My fair value estimate is $19/share, which implies an 80% upside for the stock. Of course, there are increased risks associated with the business case, but the risk/reward ratio seems acceptable.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these shares.