Illumina's $1.2 Billion Deal Is Money Well Spent

Illumina's (ILMN -1.28%) flexing its muscle as a giant in gene sequencing by acquiring the much smaller Pacific Biosciences of California (PACB -7.48%). The acquisition could weigh down Illumina's profit in the short term, but it could also pay off handsomely if growing demand for long-read sequencing from biopharmaceutical companies increases.

In this clip from The Motley Fool's Industry Focus: Healthcare, analyst Shannon Jones and contributor Todd Campbell discuss why Illumina wants to buy PacBio and how this deal could pay off for investors over time.

A full transcript follows the video.

This video was recorded on Nov. 7, 2018.

Shannon Jones: We've been talking about things that are novel. Things that are actually novel and are having a true impact here is a company called Illumina -- our listeners will recognize them as the gene sequencing giant -- ticker ILMN.. They made big news on the M&A front also last week, announcing a big deal to acquire a smaller competitor. I'm excited, Todd. We're finally starting to see the M&A ramp up. It has been really quiet, especially after so much hype went into 2018 with the impacts of tax reform, that all the biotechs and pharmaceutical companies would do M&A. We're finally getting some noteworthy deals here.

Todd Campbell: Yeah. To me, this was a very surprising deal. Pacific Biosciences has been around a long time, Illumina has been around a long time, but they operate in slightly different parts of the gene sequencing market. PacBio has really been... I don't want to say an afterthought company, but it's a much smaller company than Illumina. Illumina makes gene sequencers that represent about 90% of all of the gene sequencing that's been done since the Human Genome Project in the 1990s. It's absolutely, 100% a Goliath. It has over 11,000 of its gene sequencing machines installed globally, and its sales are estimated to eclipse $3 billion this year.

When you put that in perspective, PacBio's sales last quarter were $18 million. They have less than a $100 million run rate, compared to a $3 billion run rate. They have a fraction of the penetration that Illumina has within these researchers and these drug companies and these academic institutions and such that are doing all this fascinating, next-generation work in evaluating the genes in our body, figuring out how to apply those lessons learned to things like medications that could really move the needle on outcomes.

Jones: This was a surprising deal, but if you think about it, it makes strategic sense when you look at the different tech behind the two companies. Illumina has been dominant on short-read sequencing. For PacBio, it's been long reads. If you think about genomic sequencing, to use a metaphor that one of our colleagues used, it's like a jigsaw puzzle. Long reads allow researchers to have fewer puzzle pieces that they have to put together. So for Illumina, it actually makes a lot of sense to not only dominate in the short-reads, but now be able to take these complex pieces of genomic sequencing data, put them together, and hopefully solve some of the more complex gene therapy issues that we've been seeing, as well.

Campbell: Yeah. Whenever you research anything or do anything, a lot of times, you can get the gist of it by spending less time on it. That would be like short-read. It's functional, quick, and, in the case of Illumina's sequencing, it's a lot cheaper than long-read. Long read is like doing a deep dive into a subject matter and finding out absolutely everything that you can possibly find out about it. In the past, you haven't needed to have that level of granularity in gene sequencing. However, as we get more and more involved in things like gene editing and really sophisticated gene therapies that are extremely targeted, it's becoming more and more important to have as thorough a look at the DNA and RNA as possible, to make sure that you're not suffering any off-target events or anything else. I think what Illumina is saying is, "We absolutely dominate the short-read space. By buying PacBio, we're going to get a really big footprint in the long-read space."

If you think about Illumina's business model, they're so heavily embedded worldwide. Their market teams have 22 offices globally. Many times, one of their clients will have a bunch of their own Illumina machines and then one or two PacBio machines. This is going to give them an opportunity to introduce PacBio to a lot more people, right ahead of some really interesting technology that PacBio was about to launch. Next year, they were planning on launching a brand-new chip that could significantly increase throughput for long-read while also decreasing prices, making them far more competitive with short-read.

Jones: You've got them now expanding on the technology front and trying to get ahead of the competition. Speaking of competition, this is a field that's increasingly becoming more crowded. In addition to PacBio -- thankfully, they've now acquired them -- you've also got Chinese company BGI, you've got Oxford Nanopore Technologies, Roche, Thermo Fisher Scientific. They're already offering sequencing and molecular diagnostic products and services. Amgen actually took out a recent equity stake in privately held Oxford as well, so they're now getting into the game. It's interesting to see a big biotech jumping up to the playing field. Also, focusing on BGI, they plan to offer a human whole genome sample sequencing in less than 24 hours, and it costs less than $300, by 2020. BGI can already perform next generation sequencing for close to $600.

Again, Illumina, as many of our listeners will know, is trying to continue to bring down the cost of gene sequencing, but their competitors are right on their heels. I think this makes a really smart and strategic move to try to stay ahead of the competition.

Campbell: Another thing that's important is, there are drawbacks to both short-read and long-read. Long read is not perfect by any stretch or measure. A lot of times, when you'll do long read, you'll also do short read to fill in the gaps for where the long read doesn't come up with the information you need. The idea now of being able now to have a one-stop solution, where you're able to get my long-read done by Illumina and my short read done, may give it a competitive advantage against some of those other companies that you were just talking about. That could become increasingly important because, by PacBio's estimates, the market they were targeting is going to grow from about $660 million last year to $2.5 billion by 2022. That's significant growth, especially when you consider that Illumina's sales are tracking about $3 billion. This could be almost equal to where they are today just in additional long-read sales.

Jones: Todd, I'm going to use the word. I'm going to use the word synergies here. [laughs] I hate that word when it comes to M&A, but this is actually one instance where I think the synergies could actually happen for a change, and actually make sense. What else should investors be watching, especially when it comes to PacBio?

Campbell: PacBio has had some delays in product launches in the past, and some stumbles. It'd be really important to see how that progresses. This deal won't close until 2019. It does have to still get approval for this combination. Like I said, Illumina is the market share leader. Illumina was asked on their conference call, "Do you think you can get this through regulators?" From Illumina's perspective, the answer is yes, because they're a short-read company and PacBio is a long-read company. It'll be interesting to see if regulars agree with that assessment.

You're also going to want to see, once the combination is done, can they deliver on the timeline of releasing this new technology from PacBio that will, indeed, drive down the cost and increase the speed, making it more useful to researchers? You mentioned synergies. I think most of the synergies are going to come from scale and manufacturing, that type of thing. They're not saying, at this point, what the impact could be on the bottom line in 2019. But investors should know that PacBio is losing money. Integrating it will create some sort of a headwind that's going to have to be offset, either by increased sales growth because of greater penetration in the future from these new products, or from some cost cutting somewhere along the way.

Jones: Lots to look forward to in 2019. It's really setting up to be a crucial year, not just for biotechs but also on the gene sequencing end as well.