Even casual investors are probably aware that we are in the middle of a genomic revolution. The ability to decode molecules of DNA and RNA and reveal the secrets of genetics and disease mechanisms is creating a stampede of companies seeking to cash in on knowledge of the genetic code by developing new medicines, crops, or even services to simply satisfy the curiosity of consumers.
Investors are looking to cash in, too. One of the best places to invest is with the companies that are making the "picks and shovels" of this gold rush -- the companies that make the machines that peer into the mysteries of the genome and the sellers of gene-sequencing instruments.
Two opportunities in the space are Illumina (ILMN -2.14%) and Pacific Biosciences (PACB). Which is the better investment now? The answer is not as simple as it may seem at first look.
Image source: Getty Images.
Other than making instruments for similar purposes, the companies are very different. Illumina is the dominant player in the space, with products that have performed 90% of all gene sequencing that has been performed to this point. That company has a market capitalization of over $45 billion and is wildly profitable. In contrast, PacBio, as it is commonly called, is worth about $640 million and has never made a profit. It has found success in some niches of the market, but it hasn't gained the widespread use and scale that Illumina has.
The companies have similar business models. Most of their sales come through consumables, the supplies that get used up every time the instruments are used. At the same time, growing consumable sales depend on a growing installed base of instruments, along with expanding usage of the machines.
How the technologies compare
Given that both companies make products that are intended for very similar purposes but utilize different technologies, investors would naturally want to know which technology is superior. You would think that in the long run, one technology would win out, and that investors should simply be able to bet on the winning horse. However, the answers aren't so simple.
Illumina's technology, called sequencing by synthesis (SBS), first involves chopping the DNA into lots of small pieces, attaching the fragments to a substrate, called a flow cell, and then cloning them over and over again to create a region on the flow cell of identical fragments. DNA consists of a long sequence of four molecules called nucleotides, and the process of reading the sequences of the fragments in the different regions of the flow cell create flashes of light in four colors which can be read by detectors. There are thousands of these regions in a flow cell, which are read all at once, and the sequences of the different fragments are pieced together by specialized software to get the big picture of the DNA.
PacBio's approach is called Single Molecule, Real Time Sequencing (SMRT), and rather than reading a patch of identical fragments, it actually reads individual DNA molecules directly. The company's sequencers have thousands of "zero-mode waveguides" -- essentially tiny microscopes that can see to the molecular level as the DNA is sequenced. This approach allows much longer reads than Illumina's SBS sequencers can achieve, and according to PacBio, it can detect subtle complexities in DNA that are missed in the massively parallel, short-read SBS technology.
Which technology is better? A case could be made that PacBio has the more powerful tool in the sense that it can detect things that Illumina's tech cannot, making it indispensable for some applications in research. But Illumina's approach is much cheaper, can do far more reads per run, and is good enough for the types of commercial applications that make up the biggest markets in sequencing. PacBio is bringing the cost of its products down, but essentially, Illumina was first to the "sweet spot" in the market, with the right combination of price, throughput, and functionality to get a huge lead over its competitors.
Stock performance and valuation
Illumina's stock has been steadily rising since late 2016 as usage of the company's instruments have driven growing sales of the supplies that are needed each time a user runs a sequencing job. The stock is up 38% in 2018 and has gained a market-beating 111% in the last three years.
PacBio's shares are far more volatile than those of its larger competitor, with a superior 61% gain so far this year. Over the long term, though, the stock hasn't done well; shares are down 40% from their price three years ago.
Comparing valuations of the two companies is a little challenging because PacBio has yet to turn a profit, but Illumina has had positive earnings for over a decade and regularly beats analyst profit estimates. Using the ratio of price to sales, it's not surprising that investors will pay up for Illumina's profitable business relative to PacBio's. Illumina sells for a pricey 14 times sales, while PacBio's shares can be had for half that multiple.
Growth prospects
Illumina's advantage of being the market-share leader in a rapidly expanding market has paid off with consistent and high growth that's highly likely to continue for a long time. In the most recent quarter, revenue increased 20% to $853 million, powered by a 22% rise in consumable sales, a 21% increase in services, and a 10% gain in instrument sales. Gross margin improved 2.3 percentage points over the period last year, to 71.1%, thanks to a growing proportion of consumables sales in the revenue mix. Earnings per share increased 37% to $1.52.
The company has the market blanketed with a wide range of sequencing instruments, from a new desktop model that sells for under $20,000 to the high-end NovaSeq at about $1 million each. NovaSeq, which was introduced in January 2017, is still early in its sales cycle and should fuel strong instrument and consumable sales growth for the next several years.
Consumable sales are driven by increased usage, and Illumina is benefiting from some long-term usage trends that are accelerating. Clinical applications such as non-invasive prenatal testing, which is driving the company's growth in China, precision medicine therapies for cancer, and tests for rare and inherited diseases are growing rapidly. Large-scale population studies are a tailwind for Illumina's more expensive machines, and consumer applications for gene sequencing such as Ancestry and 23andMe are exploding in popularity.
PacBio is also riding a wave of instrument sales thanks to a relatively new product line. The Sequel line of SMRT sequencers offered customers lower costs and higher throughput when it was launched in October 2015, and the company has been updating the product line with improvements that make the products even more attractive. Instrument sales in the second quarter grew a healthy 20%, but sales of consumables hit a speed bump, growing only 6% as declining sales of supplies for older machines offset a large portion of the gains from Sequel consumables. Overall, revenue grew 7.5% to $21.6 million, and the net loss declined 11.8% to $22.5 million, or ($0.17) per share.
PacBio is established in certain niche applications such as animal studies and crop research, and it's clearly making progress in making their products cheaper to use. Analysts expect 2019 revenue to rise a steep 44% from 2018. But the growth has not been a smooth ride, and the company is burning through cash. In September, it sold a secondary offering of its share, diluting the share count by 11% in order to raise more capital.
Image source: Getty Images.
The choice may seem obvious, but it isn't
The smaller market capitalization and lower valuation relative to sales might lead some investors to think that Pacific Biosciences represents a better opportunity than Illumina for a chance at a big gain. They may be right, but I think market leadership, steady performance, and excellent execution mean that Illumina has a much more predictable future, and make the stock worth the premium valuation for most long-term investors.
The wild card for PacBio investors is the payoff if the company brings the cost of operating its sequencers down to a threshold that opens up a major new market. Company executives believe they are close to that point. PacBio will be testing a new chip early next year that has 8 million zero-mode waveguides, eight times the number of its current Sequel system. The company believes a new model of Sequel with the chip will put the cost of sequencing the human genome in the ballpark of Illumina's products, about $1,000 per genome, one-seventh of what Sequel costs today.
PacBio believes reaching that price point will open up the market for large-scale human population studies for its instruments. The ability of PacBio's SMRT technology to detect subtle variations in genes that Illumina's SBS technology can't see would allow researchers to do a more complete analysis of genetic variation in large populations than is possible today. If that potential is reached, PacBio investors would be richly rewarded.
Illumina is the safer bet for long-term investors who want to profit from the genomic revolution, which is still in its early days. Risk-tolerant investors may want to consider Pacific Biosciences, which is a niche player and may always be, but could make a big breakthrough next year.
