As a Roche (RHHBY.OB) shareholder, I've been waiting for a while for the company to do something with its life sciences research business, and its sequencing business in particular. The company took a well-known run at Illumina (ILMN) and made a lesser-publicized joint bid for Life Technologies (LIFE). With the options getting narrower, particularly with respect to systems that could be commercialized on a near-term basis, Roche made its move - signing a development and marketing agreement with Pacific Biosciences (PACB) covering sequencing, consumables, and related diagnostics products for the in vitro market.
I'd be curious to know if Roche has made any overtures toward Oxford Nanopore, but that's neither here nor there at this point. For Pacific Biosciences, this is a major public affirmation of the progress the company has made to recover from system performance and reliability problems that took a once-ballyhooed story to almost flirting with bankruptcy. PacBio has already been a great pick for me (having recommended the stock in an Alpha-Rich piece here), but I wouldn't assume that there is all there is left in the story.
A Soft-Sell?
Roche isn't buying PacBio, but then it really doesn't have to at this point. The two companies agreed to a comprehensive agreement that will see PacBio develop sequencing-based systems and consumables built around its Single Molecule Real Time (SMRT) technology for the clinical diagnostics market.
Under this agreement, PacBio gets $35 million upfront, up to $40 million in milestones, and Roche as a marketing partner. PacBio will sell these systems and products exclusively to Roche, who will then market and distribute them globally.
PacBio was pretty clear that this was a focused partnership agreement and nothing more. Realizing that the company didn't have the resources to move into clinical diagnostics, the company started looking for partners earlier this year. Equity in the company was not on the table as part of the agreement, and management did not explore a buyout of the company as part of the process.
Leaving aside that it was PacBio driving this process, I can see a few reasons why Roche didn't go all-out and buy PacBio. First, while PacBio has made a great deal of progress in improving the read length, accuracy, and throughput of its systems, it isn't a given yet that the company can develop a system that can truly go head-to-head with Illumina and Life Tech in the clinical diagnostics market. If PacBio fails, Roche can walk away only $35 million to $75 million poorer. If it works, Roche has exclusivity and can always bid on PacBio later.
Second, I don't believe Roche (or any other likely partner/bidder) would be willing to pay 100% for what PacBio could become. As I wrote a few months ago, there is significant potential for PacBio's approach in markets like plant genetics and food safety, but those are not markets where Roche has keen interest or deep roots. Likewise, PacBio is still very early in its turnaround process and likely couldn't get full value in a buyout today.
Not Much Else To Go On For Now
Unfortunately, but not surprisingly, there were not many other details available at this point. The deal is highly exclusive, as Roche will not develop other competing technologies for the clinical diagnostics market. PacBio management was less clear as to whether Roche was permitted to develop assays for other platforms, but I doubt that Roche would be looking to develop assays for other companies' sequencing platforms.
There was likewise no detail on transfer pricing or anticipated margins for either partner under this agreement. I'd be surprised if PacBio would agree to lock in gross margins below the 60% to 70% range, and that sort of range would still give Roche a very worthwhile potential margin as well. Of course, there is a wide range of options in how this deal could have been structured, with differing margins for systems ("boxes"), consumables, assays and so on.
Murky, But Good
Assessing how this deal changes PacBio's future prospects and fair value is a little like looking at a blurry photo of Kate Upton or Hugh Jackman - you can't really see everything clearly, but you can probably see enough to know that things look pretty good.
I previously valued PacBio at $4.50 per share on the basis of assuming that the company could attain half of its potential addressable market in 2022 (10% of the overall market, or about $685 million in revenue) with a free cash flow margin of 18%. The possibility of generating significant amounts of revenue from Roche now has to be added to the picture.
Roche generated over $1 billion in revenue from molecular diagnostics in 2012, and this market has been growing at a high single-digit rate. In addition, numerous analysts and research groups have estimated that the market for clinical diagnostics based on next-gen sequencing could reach $4 billion by 2018. Let's say that it's $4.5 billion in 2022 and that PacBio and Roche together can get 10% of that - far less Roche's 2012 share in the MDx market of 32%, but accounting for competition from Illumina, Life/Thermo Fisher (TMO) and other current diagnostics players like Abbott (ABT), Hologic (HOLX), Becton Dickinson (BDX). If half of that revenue goes to PacBio, even a lower free cash flow margin of 12% on that revenue would increase the fair value by two-thirds to $7.50.
Obviously there's a lot of guesswork and uncertainty there. We don't know what the revenue/profit splits will look like, and we don't even know if PacBio will succeed in developing a technologically, let alone commercially, viable system or menu of assays. But then again, assuming only 10% of the future sequencing-related diagnostics market isn't exactly an aggressive assumption either.
The Bottom Line
Not buying PacBio around the time I initially recommended it is definitely a big regret of mine for 2013. I didn't have surplus cash sitting around and I didn't want to sell a stock I liked just to buy another, riskier, stock I liked. On the other hand, holding on to Roche has been working out pretty well.
With PacBio having done so well since mid-June, including today's big run on this Roche deal, I'm a little less enthusiastic than I was before - I still like the stock and I think it could do pretty well from here, but approximately 25% undervaluation isn't as exciting as 40% to 50%. These shares will likely pull back at some point, though, and that would be a good time to take another look at a company that seems to be finally on a path towards realizing a lot of its formerly exciting potential.
Disclosure: I am long RHHBY.OB. 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. (More...)
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