PACB - Pacific Biosciences: Lacks Forward Upside Capture

• Pacific Biosciences has taken a punishment on the chart in FY22, having compressed down more than 86% in 12 months.
• PACB has de-rated as investors shift focus away from top-line growth stories and move onto bottom-line fundamentals.
• In that vein, PACB falls behind and valuations are unsupportive of the same.
• We price the stock at $3.60 and see more compelling value opportunities elsewhere.

Investment Summary

From the portfolio manager's desk

Here we examine Pacific Biosciences of California, Inc. ( PACB ) and its potential inclusion into a direction long-only, equity focused portfolio. We've taken a hard-data approach to identify any idiosyncratic risk premia that can be harvested to deliver risk-adjusted alpha.

As the market continues to price in a series of uncorrelated systematic risks in FY22, the high-beta and growth trade has unwound and capital has been redeployed towards low-beta, high quality strategies. As such, profitability, earnings quality, resiliency and fundamental momentum are each paramount in the forward looking landscape. These factors also underscore our investment strategy in FY22.

The following series of charts represents the systematic investment process we undertook to examine PACB for the visual benefit of investors. Net-net we price PACB at $3.60 and see further downside for the remainder of FY22. Without a directional view on the market, rate neutral, and advocate against PACB's inclusion into a long-only, equity focused portfolio.

Exhibit 1. PACB 6-month price action

Lumpy operating performance

A series of operating losses from FY15 to date has pressured top-down margins on a sequential basis. In more recent times, operating margins have remained bottom-heavy and are unattractive at a loss of more than 200% in the last print. It has grown revenues in a seasonal fashion over the past 2 years to date, as seen in Exhibit 2. FCF conversion has normalized at a loss of $25 million over this period and investors currently realize a -9% quarterly yield on this. This operating profit and FCF breakdown offers a lack of upside capture and brings little fundamental momentum into the investment debate, by estimation.

Exhibit 2. Seasonal quarterly operating performance, investors realize negative FCF yield

Meanwhile, PACB has demonstrated sound management over working capital in this timeframe. The cash conversion cycle has crept down from a peak in FY21 and now rests in-line with FY18 levels at ~120 days. The capital structure has shifted towards a more debt-inclusive setup, with debt now financing 55% of the capital base. In our estimate, this displays an element of resiliency and shouldn't be discounted. The company managed to hold the Maginot line with its liquidity position throughout the pandemic, and cash conversion is at pace with pre-pandemic levels.

Exhibit 3. PACB holding the fort with liquidity, pace of cash conversion

Exhibit 4. PACB working capital cycle breakdown, trends

With PACB expanding its balance sheet ROIC has also pushed north and came in at -3% last quarter. We are, however, in search for names generating positive return on capital. Whilst PACB has demonstrated it can manage working capital well, we're yet to see a substantial return on capital that warrants trading at 7.5x sales. This is incredibly important as PACB has a cost of capital of ~9%, and continues to print a loss from operating income down to the bottom line. In that sense, it remains unprofitable, and must continue to raise capital as a going concern.

Exhibit 5. Ideally, the search is on for names printing high levels of ROIC on a quarterly basis, not as seen below

We estimate that at its current burn rate it has around 17 quarters left when factoring in cash and all short-term investments. However, on cash alone, this sits at just 5.3 quarters, raising questions if there is sufficient cash runway to last the coming 2 years. The Altman Z-score of 1.8 also adds validity to this posture. This presents as a key risk in the investment debate. As shown above, PACB continues to realize a negative yield on its invested capital and is free cash flow negative. Indeed FCF is the lifeblood of a company and of corporate value. Henceforth we are unattracted to PACB's methodology in converting cash from the top-line.

Exhibit 6

Valuation

It's difficult to assign a firm value to PACB given the company's lack of profitability. Investors are no longer rewarding unprofitable companies even if growing the top-line. Alas PACB trades at 7.5x sales and 1.24x book value, roughly in line with and below the GICS peer median respectively. It also trades at ~1.01x EV/book value, which could represent some value for those interested in the long-term growth story of PACB, and are prepared to wait for future cash company flows. For reference, EV/book uses enterprise value in the calculation, factoring in PACB's corporate structure, whereas P/Book looks solely at share price. Nevertheless, at ~1.24x book we are theoretically paying ~$5, suggesting the stock could be overvalued by roughly 16%. Hence, we value PACB at $3.60 to reflect its estimated fair value.

Exhibit 7

Adding some upside potential to valuation is that the PACB share price has diverged from growth in its book value per share in recent times, as seen below. Since mid-2021, the pair have crossed and now PACB has diverged away to the downside. This dislocation could provide some exiting alpha potential should the market recognise this and the share revert back towards the average of this relationship. The question really then becomes if the stock can re-rate to the upside. Without the flesh to put on the skeleton, we believe this might not occur within a reasonable timeframe.

Exhibit 8. Divergence of bottom-line fundamentals to share price. This dislocation could provide a correction opportunity for mean reversion

Technical factors

On the charts, there's nothing remarkable to observe that suggests price action is set to reverse to the upside. Both on balance volume and momentum have shifted down in recent times, confirming the longer-term downtrend in stock price. PACB has also lost tremendous strength relative to the SPX suggesting the stock continues to attract sellers to this day.

We're hard pressed to call a bottom for the share and with a lack of additional risk premia to harvest at the company level, these charts confirm bearish price action, by estimation.

Exhibit 9. Technical studies confirm much of what has been found fundamentally – that there's a lack of forward upside capture on offer

The market has continued to pressure PACB downwards and trend indicators suggest further downside on the way.

In short

The market has spoken with PACB. It continues to de-rate the stock amid a shift in risk appetite and refocus on bottom-line fundamentals. In that vein, PACB doesn't align with our macro investment strategy as it demonstrates a lack of profitability and forward earnings quality. From this data-driven approach, we firmly believe there's a lack of upside capture in the name.

As a consequence, operating performance continues to lag peers and offers a lack of flesh to put on the skeleton. As investors step up in quality and resiliency, these are undesirable characteristics. We price PACB at $3.60 to reflect what we feel is fair value and look forward to revisiting the name into the future.

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