ILMN - No Longer A Momentum Play Pacific Biosciences Looking To Reaccelerate Growth In 2023

Summary

• PacBio's fourth quarter numbers were ugly, but that was expected as the company prepares for the launch of its next generation of long-read sequencers and its entry into short-read sequencing.
• The Revio long-read sequencer offers another significant step up in throughput and cost-per-result, and I believe it is a compelling offering relative to competing for native and synthetic long-read technologies.
• The Onso short-read sequencer could prove particularly useful for oncology (liquid biopsy) and point mutation research, given its enhanced sensitivity and could expand share-of-wallet with long-read customers.
• PacBio is still several years away from profitability and cash flow breakeven, but continues to make progress in its core markets.

The last couple of years were wild ones for a lot of life sciences companies, and as if often the case after wild parties, the hangover has been painful. On top of momentum investors fleeing the space, Pacific Biosciences (PACB) has had to deal with operational challenges like the impact of the pandemic in China (a large market), lengthening sales cycles, and a lot of noise in the market that has forced customers to pause and sort out their real needs and the real capabilities of the long-read systems available in the market.

Down less than 10% since my last update , PacBio has fared quite a bit better than rivals like Illumina ( ILMN ) and Oxford Nanopore (ONTFF) and other sequencing-adjacent companies like 10x ( TXG ), but the two-year comparisons are still pretty brutal. I continue to believe in the core technology and long-term opportunity at PacBio, but it's taking longer and costing more to build the business, leading to a lower fair value, though I still see worthwhile upside from here.

An Ugly Quarter Before The Next Wave Begins

PacBio's fourth quarter wasn't disappointing relative to recent expectations, though the full year was well short of initial expectations a year or so ago, as the company saw weaker demand for systems and lower pull-through, as well as disruptions to the sales cycle from new products introduced late in the year.

Revenue declined 24% in the fourth quarter (and declined about 2% for the full year), with instrument revenue plunging 62% ahead of the launch of the new Revio and Onso sequencers. Consumables revenue improved 11% year over year about 4% sequentially, with pull through (consumables per installed device) down about 15% year over year but up about 2% sequentially and improving every quarter after a big reset in the first quarter of 2022 caused by the pandemic and reduced demand from China.

Gross margin plunged almost 28 points, with the company seeing much weaker margins on instruments ahead of the launch (pre-launch costs, less efficient manufacturing, etc.).

Including the post-quarter stock offering, the company heads into 2023 with close to $1B in cash on the books ($973M), which should be about enough to get the company to cash flow breakeven.

Revio Should Be A Big Step Forward For Advancing Native Long-Read Sequencing

The biggest recent development at PacBio is the unveiling of Revio, the company's new long-read sequencer. While harnessing the same underlying technological approach as the Sequel II, the Revio highlights one of the underappreciated advantages of PacBio's approach - as the technology is underpinned by semiconductor technology (nanophotonic devices called zero-mode waveguides), the company can leverage improvements in semiconductor capabilities to drive more capable systems.

To that end, the Revio is the first sequencer to use Nvidia 's (NVDA) GPUs and the throughput of its new SMRT cell is 15x higher than the Sequel II, with no compromises in accuracy, lower consumables requirements (including no external nitrogen), and an improved workflow.

To reduce it to more understandable numbers, PacBio management claims that the Revio allows a user to run 1,300 complete human genomes per year at 30x coverage for a cost of less than $1,000, something PacBio management claims would cost around $1,200 with the Oxford Nano PromethION or more than $1,200 with Illumina's new synthetic long-read sequencing. As you might imagine, these assumptions are not universally agreed upon, and Illumina claims the cost of their technology is "well under $1,000" (though I'm not sure at what coverage level).

As PacBio has improved their systems, increasing the throughput, improving the workflow, and decreasing the cost per result, the market has responded and long-read sequencing is growing strongly, underpinned by demand from a range of markets including agriculture, microbiology, and human genetics (including diagnostic applications like oncology). It's still less than 10% of the total sequencing market, but it's closing in on that threshold and likely to accelerate as more tests harnessing the technology come to the market.

PacBio's Short-Read Entry Looks Like A Promising Diagnostics-Driven Opportunity

Once a long-read sequencing pure-play, PacBio has thrown its hat into the ring for next-gen short-read sequencing with its Onso platform (based on technology acquired in the Omniome deal). The basic gist of Omniome's sequencing-by-binding (or SBB) technology is that it has lower limits of detection than competing technologies and more sensitivity/accuracy at a lower cost.

PacBio is pricing the Onso at $259K, on par with other mid-range systems, but it offers Q40 accuracy versus Q30 from competing systems (meaning a 1-in-10,000 error rate versus 1-in-1,000). Coupled with a faster time-to-result, this should make Onso an appealing option for diagnostic applications like liquid biopsy and in research applications targeting rare single-nucleotide variations.

PacBio is offering attractive bundled pricing for labs who order both the Revio and Onso, and I believe Onso can succeed beyond diagnostic and rare mutation applications. The reality is that virtually any lab using long-read sequencers like the Sequel II will also be using short-read sequencers, and PacBio has a chance here to gain some incremental share-of-wallet with long-read customers.

The Outlook

The PacBio story has long been a "hurry up and wait" sort of situation where investors continue to wait for the growth of long-read sequencing to drive instrument and consumable demand to a point where PacBio can actually make money.

Management is targeting cash flow breakeven in FY'26 (along with gross margin above 55%), but I think the company won't reach annualized FCF breakeven until FY'27 and full-year positive FCF in FY'28 (and I don't expect 55%+ gross margin until FY'27). This isn't actually much of a change relative to my prior model - while my FCF number for FY'28 is a little smaller now (and my FCF loss in FY'27 is a little larger), the basic path to profitability and positive FCF hasn't changed.

That's not to say that there haven't been changes to my model. I'm expecting a longer revenue ramp and I'm expecting the company to burn more cash to get there. Coupled with a higher discount rate, that drives my DCF-based fair value from around $20 to $13.50, even though I'm still looking for long-term annualized revenue growth of around 30% and long-term FCF margins in the 30%'s.

The Bottom Line

Every iteration of PacBio's technology has seen meaningful operational improvement and has made long-read sequencing incrementally more viable. I have never believed that long-read sequencing will be the right approach for everything (there are many applications where it's just more than is needed to get the job done), but I do believe it's a meaningful market and one that PacBio is best-placed to lead. It may be a while before we see another run in life sciences again, but I do think PacBio continues to have positive investment merits for aggressive/risk-tolerant investors.

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