Did Roche Just Hand Illumina Pacific Biosciences’ Head on a Platter?

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While Illumina (ILMN -4.65%) shares have mounted a solid rally recently off of good news from the JP Morgan Healthcare conference, shares are still down around 6% over the last year. However, recent news regarding a competing company may be a glimmer of hope for this giant of genomics. Last month, Pacific Biosciences of California, Inc (PACB -10.57%) announced that pharma giant Roche (RHHBY -0.03%) had elected to terminate its development, commercialization, and license agreement for the development of supply diagnostic products with Pacific Biosciences. As Pacific Biosciences is one of only a handful of companies which operate within the genome sequencing market, this blow for Pacific Biosciences could provide a boon for Illumina's future market dominance.

The genome sequencing market

Illumina and PacBio both manufacture and distribute genome sequencing machines. Illumina produces the popular sequencing platforms HiSeq X Five/Ten and HiSeq 2500/3000/4000 systems which are used to rapidly sequence genomes on a large scale. Illumina also produces the NextSeq 550 and iScan system arrays which are further utilized in genotyping analysis. PacBio, meanwhile, produces the PacBio RS II and Sequel Systems which operate using PacBio's SMRT (single molecule real time) Cell technology. While Illumina is undoubtedly the pack leader within the genomics sequencing market, PacBio has managed to differentiate itself with its more accurate long-read genome sequencing machines.

Roche and Pacific Biosciences

In 2013, PacBio entered into a collaboration agreement with Roche to develop products based on PacBio's SMRT Cell technology for use within the human in vitro diagnostics market. The expectation would be for PacBio to manufacturer diagnostic products using SMRT technology which would then be distributed and marketed by Roche. As part of this agreement, PacBio was eligible for several developmental milestone payments from Roche, the final of which was paid out in the fourth quarter of 2015.

While Roche's termination of their collaboration agreement did come as a surprise to Pacific Biosciences' management, this is not the first time Roche has tested the waters of the genomics/diagnostics market and decided against. Roche's prior fumbled attempt at buying Illumina as well as their shuttering of their own internal gene sequencing subsidiary 454 Life Sciences both come to mind. Why the continual back-and-forth on genomics for Roche? Only Roche could tell you.

What this means for Pacific Biosciences

While Roche's termination of their collaboration agreement did come as a surprise to Pacific Biosciences, PacBio's management has mentioned in their follow-up call that this news is unlikely to affect its financial results in the near-term. Management has projected product and services revenue growth between 40% and 60% for 2017. In order to achieve this growth, however, PacBio will require hiring additional sales teams, as they can no longer rely on Roche to distribute and market their products. However, as a small silver lining, Pacific Biosciences is now free to commercialize products based on the Sequel sequencing platform into the clinical research and sequencing market directly or with other distribution partners.

While PacBio does offer a differentiated product as compared to Illumina, the combination of Roche's lack of confidence in the company along with Illumina's market dominance in the genotyping space makes me hesitant to call PacBio a buy -- even at recent low valuations. In order to gain my vote, PacBio will have to prove their products are both superior to Illumina's and, more importantly, that customers are willing to pay the higher price tag. For now, I'd hold back on picking up shares.