A nervous energy has gripped both investors and the DNA sequencing industry as a whole. Illumina (ILMN -2.07%), the undisputed king of reading the genetic alphabet, has found itself in an unfamiliar position: Regulators are casting a suspicious eye on a proposed acquisition. Considering the $42 billion sequencing titan has been built on scooping up promising peers and competitors, no one thought the proposed $1.2 billion acquisition of Pacific Biosciences (PACB -45.32%) would be any different.
But a lot has changed since the announcement was made in November 2018. Shares of Pacific Biosciences entered the final week of July trading 33% below the proposed acquisition price of $8 per share. The reckoning has been swift, too, with shares down 28% since the United Kingdom's Competition and Markets Authority (CMA) opened an investigation into the acquisition at the end of April. That signals a strikingly pessimistic stance by Wall Street and shows that analysts are grappling with growing uncertainty about the transaction.
While the proposed acquisition could still proceed as planned, or with terms that are modified to be acceptable to all parties involved, individual investors might want to consider what happens if the deal falls apart.
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What would it mean for Pacific Biosciences?
Any scenario where regulators torpedo the acquisition would have devastating -- and perhaps existential -- consequences for Pacific Biosciences. The business reported an operating loss of $102 million in 2018. That was the worst performance in the last five years, and operations have actually deteriorated since the end of last year.
The business reported an operating loss of $30 million in the first quarter of 2019, compared to an operating loss of $24 million in the year-ago period, while revenue declined 15% year over year. Pacific Biosciences exited March with just $83 million in cash, which is only enough to fund operations until the end of 2019 at the current pace of cash burn.
On the one hand, management said the increase in operating expenses in Q1 was almost entirely related to the pending acquisition. There's also no denying that Pacific Biosciences wields a DNA sequencing technology platform that's valuable to the scientific community. The company's long-read approach opens a window into the estimated 9% of the human genome Illumina's short-read approach is blind to, while also proving valuable for non-human genomics applications. If Pacific Biosciences can succeed in driving down the high cost of its approach, then it may be able to secure financing to keep the lights on.
On the other hand, there's no indication Pacific Biosciences has met the ambitious cost-reduction goals it laid out just before the Illumina acquisition was announced. It recently had its second patent revoked by the European Patent Office (EPO), which took issue with the company's claims to "single molecule sequencing" -- the core claim of its platform. The company's long-read approach is also under pressure from United Kingdom-based startup Oxford Nanopore, which was handed a decisive victory by the EPO's decision. The startup is playing a not-so-subtle role in recent events, and proving to be a thorn in the side of Illumina, too.
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What it would mean for Illumina
Illumina doesn't need to acquire Pacific Biosciences, but it would need to reconfigure its long-term strategy if the proposed transaction falls through. That's because the titan's approach to DNA sequencing is beginning to max out its technical potential. Short-read sequencing is only getting better through larger, more expensive machines equipped with better computing technology. It requires a massive upfront investment. And the regions of the human genome it cannot read are now thought to harbor answers to the pathology of autism, Alzheimer's, cancers, healthy aging, and other unexplored frontiers in medicine.
The proposed acquisition was supposed to help address that shortfall. Even if the technology upgrades promised by Pacific Biosciences took more time and money than expected to implement, Illumina wields an abundance of patience and cash. The proposed acquisition was likely also a little defensive in nature, as the rise of nanopore sequencing threatens to upend both short-read and long-read sequencing, which have to be combined to gain full insight into a genome.
If Illumina cannot respond to Oxford Nanopore by acquiring Pacific Biosciences, then it will need to devise another way to address its long-read shortcomings. And the options aren't great -- a handful of other long-read and nanopore-based approaches are being developed, but Pacific Biosciences and Oxford Nanopore are the respective leaders.
Therefore, a pivot probably makes the most sense. Illumina might abandon its pursuit of long-read sequencing capabilities and instead double down on genetic testing. Investors might balk at the idea at first, but consumer- and clinical-based products and services are likely to represent a far larger market opportunity 10 years from now than selling machines and chemical reagents.
The business has already planted some of these seeds by signing genetic testing partnerships with biopharmaceutical companies and launching its own genetic tests in select regions. Illumina could accelerate those efforts by acquiring one of many profitable genetic testing companies and/or a promising liquid biopsy platform. If long-read sequencing is off-limits, then acquisitions in genetic testing markets might be the only way for the titan to grow into its $42 billion market valuation, which is several times larger than the global sequencing market.
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Is this just nature taking its course?
If technology evolves according to natural selection, as some have observed, then it's not unreasonable to assume nanopore sequencing could become the dominant approach for reading DNA. While Oxford Nanopore is working through cost and accuracy bottlenecks, there's a visible path to a leading market share -- and it might be traversed sooner than Wall Street expects.
Consider that nanopore sequencing can improve performance while scaling down in size, reduce total sequencing costs by orders of magnitude from existing technologies, travel to the jungle or Mars, enable smartphone-sequencing applications, and read the entire human genome. Illumina can't do any of that.
Therefore, if the ongoing CMA investigation concludes that the proposed acquisition of Pacific Biosciences reduces competition in the market, then investors with a long-term mindset might see it as a blessing in disguise -- for Illumina, anyway. The sequencing titan likely would be better served by future-proofing its business by focusing on niche sequencing services and genetic testing products rather than bulky, prohibitively expensive machines. Investors who own shares of Pacific Biosciences might find themselves in a less fortunate position, although Oxford Nanopore might find its path to domination a little easier than expected. But that's only if the acquisition is abandoned, of course.
