PACB - Pacific Biosciences of California

[writser]

Pacific Biosciences is a smallish biotech company that manufactures systems for (real time) gene sequencing. Revenue the past five years was ~$90m usd. In November last year a competitor, Illumina, announced it would acquire PACB at $8 per share or a ~80% premium. The buyer is a much larger company and the deal is not subject to financing conditions. Total merger consideration is roughly $1.2b. PACB has to pay a $43m fee if the merger is terminated and ILMN has to pay $98m if they don't consummate the merger (though as far as I understand they don't have to pay up if the deal fails due to antitrust issues). The vote seems a formality given 13% insider ownership, lack of protests so far from large shareholders (owning ~32%) and the huge premium offered. The deal is expected to complete 'mid 2019'.

 

The way I see it basically the only risk (apart from some black swan events) is that regulators block the deal due to concerns about the competitiveness of the sequencing space. Both EU and US regulatory approval is required. Illumina is, as far as I can see, by far the largest player in the genome sequencing space. According to this article Illumina had 2017 revenue of $2.75b while the #2 only had ~$400m revenue in this space. So yeah, you should probably be concerned a bit. On the other hand, PACB is only a very small player - acquiring it shouldn't change the competitive landscape that much over the next few years. Also, both companies specialize in slightly different technologies: "short-read" v.s. "long-read" sequencing (interesting Forbes article). Not sure if that's very relevant for antitrust considerations: in the end they're both sequencing methods.

 

Anyway, yeah, there's a chance that regulators will block and/or delay this deal. But common sense tells me that a $44b US company buying a $500m US company (before the deal announcement) that is developing technologies that are currently a bit speculative isn't a super big problem. Several other big players are active in the sequencing market (Thermo Fisher Scientific, BGI genomics - a Chinese company, Agilent) so it's not like Illumina is crushing its small competitors. It seems unlikely the Trump administration would block such a deal.

 

Shares traded as high as $7.80 after the deal was announced but have since slided to ~$7.37 now. I've seen no relevant news regarding antitrust issues in the meantime so I'm not sure what the market is doing. Looks like shares have been sold down a bit in the December panic. At the current price upside is ~8.5% or ~18% annualized if the deal closes mid-year. Even if regulatory issues cause a delay of a few months the IRR should be satisfactory. I bought a few shares. Small position - just based upon a 'common sense' approach which could be completely wrong. I'm absolutely not an expert in this space nor in antitrust concerns.

 

As always, any thoughts would be appreciated.

[Foreign Tuffett]

This is a must-read:

 

https://seekingalpha.com/article/4226863-illumina-inc-ilmn-ceo-management-presents-citis-2018-global-healthcare-conference-transcript?part=single

 

- "it's complementary technology, its markets that we don't play in today."

 

- "at this point given the level of revenues that PacBio has in China, we don't believe it needs to go for regulatory approval. But I would never say never that that's never going to be the case where China decides to look at it, but at this point we don't believe it should go up for regulatory approval."

[writser]

Thanks for the link. They expect US regulatory approval to take 7-9 months so exactly mid-year seems a bit optimistic. Probably July / August is a more conservative estimate (and that's ignoring EU approval).

[Hielko]

If they think that US approval takes 7-9 months it probably also means that they don't expect to get this transaction rubber stamped.

[Gregmal]

I'm familiar with this space and a lot of the companies in it, and all I'd say is that when it comes to regulatory stuff, you are in the Wild West. While I think this goes through, it would be a big mistake to assume no/little revenue= no regulatory hurdles.

[writser]

For sure it is risky and maybe I'm being too optimistic / naive. Hence the small position. On the flip side a 10% cash spread makes up for a lot of uncertainty and places you in the company of deals like Shire / Takeda, Sprint / T-Mobile or NxStage medical. Can't help but think I'd rather be long PACB.

 

On a related note, BMY today announced the acquisition of CELG. Another risky biotech deal. This one is much bigger ($50b), partially paid in stock with a possible CVR payout. Current spread: 16% - 27% depending on how you value the CVR. Might or might not be interesting - haven't looked at it in detail.

[Foreign Tuffett]

FTC second request for info. Not a good sign.

 

https://www.sec.gov/Archives/edgar/data/1299130/000119312519001735/d677749d8k.htm

[Jurgis]

My heavily discounted $.02 thoughts on this: on one hand, I'd think this should be approved; on another hand, I don't like that PACB is money losing IMO richly valued business.

 

Running Kelly on this assuming .08 increase on success and .4 drop (a bit generous?) on failure, Kelly swings to gains at ~85% chance of approval. This might be reasonable expectation of success.

 

Personally, I won't buy, but I'm probably not a good role model on this.  8)

 

 

[Hielko]

FTC second request for info. Not a good sign.

 

https://www.sec.gov/Archives/edgar/data/1299130/000119312519001735/d677749d8k.htm

I think that was going to be expected. While I do think that this deal should be approved it's for sure one that will not get rubber stamped.

[writser]

Market seems to agree with that because shares hardly budge upon the news.

[Foreign Tuffett]

Market seems to agree with that because shares hardly budge upon the news.

 

Market being up big is probably a confounding factor. Opened lower, but then got dragged back up to flattish.

 

All that said, you are surely right that the market wasn't surprised by the second request notice.

[Foreign Tuffett]

Based on the price action, the market is increasingly skeptical that this will close on time, or even at all.

 

Quote from yesterday's Illumina CC:

"And on the PacBio side, so where we are is we got the second request from the FTC as we expected. And so we are in the information gathering phase. And so the process in general is going as we expected and we still expected [sic] to be a midyear close."

[writser]

Not sure if it's a relevant data point but company released q4 results today. Snippet from the press release:

 

As previously announced, each of the Company and Illumina have received a request for additional information and documentary material, commonly referred to as a “second request,” from the United States Federal Trade Commission (the “FTC”) in connection with the merger.  The FTC’s “second request” has the effect of extending the waiting period applicable to the consummation of the Merger until the 30th day after substantial compliance by the Company and Illumina with the “second request,” unless the waiting period is extended voluntarily by the parties or terminated sooner by the FTC.  The Company and Illumina continue to expect the merger to be completed in mid-2019.  During the three months ended December 31, 2018, the Company recognized approximately $8.2 million in operating expense in connection with the Merger Agreement.

 

Since the announcement of the FTC second request shares traded as high as $7.40 and as low as $6.70 on basically no news afaik. Uncertainty leads to volatility. Unfortunately it also leads to hard decision making.

 

Still an interesting idea (I continue to hold a small position) but risky.

[Gregmal]

IDK about the merger, but the business results look downright ugly. Definitely wouldn't want to own this if there's a deal break.

[writser]

From the Barclays Global Healthcare Conference (March, 18):

 

So these 5 focus areas that I've talked about continue to be fueled by research and transnational efforts. And our proposed acquisition of Pacific Biosciences would enable us to add complementary technology to our portfolio to better serve our customers' needs.

 

[..]

 

We believe this will lead to novel insights that expand the clinical utility of genomic information. We continue to expect the transaction to close in mid-2019.

[wisowis]

"UK Government Investigating Illumina's Proposed Acquisition of Pacific Biosciences"

 

https://www.genomeweb.com/sequencing/uk-government-investigating-illuminas-proposed-acquisition-pacific-biosciences

 

 

[Gregmal]

I recently went long this. After speaking with a number of consultants and then doing some follow ups, essentially, the case that should and will be made is that Pacific Bio is not a business that can survive on a standalone basis. Their operating history certainly supports this, and if competition is a concern for approving the deal; seeking to exist certainly doesn't help. This issue in regards to Illumina is a lack of pure-play competitors and the winner take all dynamics within many areas of genomics. Illumina is being given a hard time because people need to cover their asses, but barring anything totally asinine, this will go through the extra reviews, but should close early 2020. At $6 entry I see maybe $1.25 downside and $2 up, with probably 90% likelihood(lazy guesstimate, certainly not an exact formula derived percentage) the deal closes or we get a nice quick bounce up that provides and acceptable IRR on it's own.

[writser]

Given your analysis I assume you made this a 50%+ position?

[Gregmal]

~30bp.

 

No interest in owning PACB on a deal break for the reasons stated above.

[writser]

Assuming you mean basis points (bps), your sizing seems completely at odds with your analysis. I am way more skeptical about this deal than you are but my position is three times as large. The expected value of a ~90% good outcome (with a significant part of that being a deal close early 2020) is already way higher than the current stock price - even if you assume a zero in case of a deal break. But you are even more optimistic since you only see $1.25 downside. According to the Kelly criterion you should bet ~400% of your portfolio here. Even if you use 1/2 or 1/4 Kelly and dial down all your estimates you should still make this a huge position. So you talk with all the consultants, do your follow ups, do the due diligence, come up with these numbers but you only make it a 0.3% position? What causes the disconnect here? Are you a pussy? Nah, don't think so. I think that your initial post in this topic oozes far more confidence than you actually have (and implies far more due diligence than you actually have done :P).

[Gregmal]

Assuming you mean basis points (bps), your sizing seems completely at odds with your analysis. I am way more skeptical about this deal than you are but my position is three times as large. The expected value of a ~90% good outcome (with a significant part of that being a deal close early 2020) is already way higher than the current stock price - even if you assume a zero in case of a deal break. But you are even more optimistic since you only see $1.25 downside. According to the Kelly criterion you should bet ~400% of your portfolio here. Even if you use 1/2 or 1/4 Kelly and dial down all your estimates you should still make this a huge position. So you talk with all the consultants, do your follow ups, do the due diligence, come up with these numbers but you only make it a 0.3% position? What causes the disconnect here? Are you a pussy? Nah, don't think so. I think that your initial post in this topic oozes far more confidence than you actually have (and implies far more due diligence than you actually have done :P).

 

I have preset position limits for specific types of investments. This is standard for these. A few things.

 

1) These are not investments really. They are speculations. I view them as alternatives to cash. Maybe you can make a case for the MON/NXPI/CAB(potentially AGN) deals as investments with short term upside in a deal close, and long term opportunity in a deal break, but the EXXI/RSYS/PACB stuff is a pure game of playing hot potato with poo poo. Allocating 1% to the bad deals and who knows how much to the good ones IMO is a quick way to tie up all your capital in stuff with a rather static profile. Although I dont know how big the merger stuff is in terms of your investment strategy. I generally allocate about 5% of the portfolio this this stuff and SPAC's.

 

2) I edited my original post simply because when I read it I immediately know I'd likely have some spreadsheet warrior get hung up on the "how do you derive a 90% confidence" remark, and miss the gist of my post.

 

3) If you are strictly looking to express something as maximizing your return and betting the house when the book says the numbers are there, I dont know... its like betting hard with a high count in blackjack. OK. But again that's gambling. Ill do that with small sums. Not my investment money. Heck if we wanted to maximize returns in this space, you could have just bought ILMN back in December when all the uncertainty started, and made 25%+ or CRSP and doubled your money, or quite a few other genetic plays.

 

4) My initial read on this as shown in the first posts here was spot on. I thought there'd be bumps here. That has largely played about. I find $6 with a 4-6 month wait time to get an outcome much more deserving on my time than sitting on this at $7-$7.5, holding for a year, waiting through 20%+ mtm losses, only for what? 10% IRR. No thanks.

 

5) Kind of in relation the first couple points, but this is not a playing field where you or I have any real edge. I mean look at the real guys in this space. The legends like Perry.. they're spending $3-$4M per deal on their guys at Skadden Arps, Cravath, etc for around the clock regulatory/legal insight. I manage money for some folks who work at big firms like that, and particularly a few in the UK who have an interesting handle on some of these things. We have investments in a lot of the genetic stuff, so this situation has come up from time to time which is where I've been able to kind of get comfortable here, vs the situation months ago. But nevertheless, to really be a meaningful player with these, you need much more by the way of resources than you or I are willing to dedicate, and as such will never have a real edge. In respect of that, I see zero reason to ever make these "bets" meaningful allocations in the portfolio. You've(jokingly I presume) made remarks prior about your strategy being "buy and hold on for dear life" and "hopefully a short term trade doesn't become a long term investment"... which is fine and all, but that sort of stuff doesnt work when you manage other peoples money. Although I probably would(actually I have) done shit like that with my own money.

[writser]

My portfolio is currently ~50% mergers and special situations. Maybe even more depending on what label you put on certain stuff. That percentage is not set in stone. It tends to be a bit lower but I currently have a few large positions in special situations that I think are very attractive. Also, I don't see any no-brainer investments at the moment. Gotta try to make money somwhere ..

 

I dont know... its like betting hard with a high count in blackjack. OK. But again that's gambling. Ill do that with small sums. Not my investment money.

 

Why not? Because investing is morally preferable to gambling? Because the bible says gambling is evil? I don't make that distinction. Also, what you call gambling is simply math. You can prove that you can make money in single deck blackjack and you can prove that there is an optimal bet size. You can calculate the volatility of your blackjack strategy and adjust your bet size accordingly to get a risk/reward you are comfortable with. Much easier than investing. If I could put my money to work at such a blackjack table I'd empty my brokerage accounts (apart from the fact that it would be mind-numbingly boring to play blackjack all day).

 

A bit of an aside but at the trading desk I once had a senior colleague who made the (dubious) statement: "I don't give a shit what I have to do to make money. If the market pays me to sit here all day with a banana in my ass I'll do it". Maybe that's a bit extreme but it raises a valid point :) . So many market participants don't keep an open mind when it comes to making money. "I don't look at IPO's, that's not Value Investing", "I never invest in Chinese companies, they're all frauds", "I only want quality compounders", "I don't do short term trades, that's just speculation", "I don't gamble with my investment money", "I have preset position limits for this type of situation", etc. Imo all these rules are meant to be broken if a situation has an attractive enough risk/reward.

 

Anyway, back on topic:

 

I edited my original post simply because when I read it I immediately know I'd likely have some spreadsheet warrior get hung up on the "how do you derive a 90% confidence" remark, and miss the gist of my post.

 

Frankly, I think you miss the gist of your own post. You come up with some grand statements and numbers that, even if they are ballpark correct, mean that PACB is the opportunity of the decade. It doesn't matter if the upside is $2 or $1.50. It doesn't matter if the downside is $1.25 or $2 and it doesn't matter if you estimate the success rate is 90%, 80% or even 70%. In all cases you should bet the house because this would be a stellar opportunity. Yet your allocation is only ~0.1% of what is mathematically proven the optimal position size, given your assumptions. When I press you on that, you say, well, this is only speculation, I'm playing hot potato and I have no real edge in this playing field. That is what I was trying to point out: your analysis oozed far more confidence than you actually have, so I thought it was a bit disingenuous (that's maybe a bit too strongly phrased - don't know a better word).

 

I agree with you that our edge in this space is very small and sized accordingly. Still, I think there's a psychological edge here, and I think that it comes from the fact that lots of investors think: "Regulators can do crazy things, I don't like the uncertainty, this company is shit and I don't want to be caught with my pants down by my investors if this deal fails to materialize". Hell, your own analysis shows this is the best opportunity of the year yet you only make it a 0.3% position.

 

Also, Perry can pay whatever he wants to whoever he wants but if he buys a 5% stake in PACB worth ~$45m and then spends $4m on lawyers I'm pretty sure I will outperform him in the long run. Not to mention that it would take him a week or longer to buy / unload his stake. I am way more flexible and that's an edge in itself. In general I agree with you that the market tends to be somewhat efficient (which should actually make PACB an average investment - not a money-losing investment, so that's not too bad) but if you believe that the smart guys spending millions on lawyers always have a big edge on you you should probably stick to index funds? I read that you recently bought some shares of Burford. Don't you think you run into exactly the same problem there? A hedge fund tracking all their lawsuits probably has a huge edge over you. In fact I'd say the risk is even worse there. At least regulatory approval is a bit of a black box.

[Gregmal]

Good points and I think we agree more than maybe we both realize.

 

There isn't a moral issue at all with gambling. Me, with my personal money, have even made a handful of sports related bets when I thought the odds were off. I actually just got a notification from IBKR stating something to the effect(I skimmed the email) that they are rolling out a play money sports betting platform where you can trade odds. IE You think -200 is off so you buy it and then can flip it if the spread narrows to -160.

 

I try to keep David Tepper in mind when investing/speculating. His style(his results which are hands down better than anybody including Buffett since the early 90's) more or less resembles your banana loving colleague. Name of the game is to make money. Motherf*cker bought SNAP IPO when everyone else was whining about it being garbage and when asked said, "I thought it would go up"...

Thats why I keep certain percentages of my portfolio available to literally do anything. But I also think staying within our own circle of competence is important and picking out long term or medium duration investments would be moreso what I consider mine rather than short term merger plays. The biggest edge I think an investor has is time/patience. That edge simply does not exist with these things.

 

If you've seen some of the other threads(CRSP/EDIT, MDXG, BTC, etc), I am quite comfortable going outside the normal "value investor" box and even sharing thoughts on it, while getting criticized by the other badge wearing, underperforming, value investor police, which seem to enjoy rolling up to my posts with their sirens on and screaming "what are you doing sir? You are not acting like a value investor".

 

The rationale behind these type of things is if you do 100, over time you make more than you lose. But at the same time, each one of these is different. It'll probably take a long time to do 100 of them, and even within that sample size you probably have 90% of the scenarios being quite unique. How many times have you seen a hold up with a no revenue dumpster fire being acquired by a $55B company? Or Cabelas getting the green light, but Staples/Office Depot getting squashed? So I give myself room to participate, but since it is not what I consider my core strength I make sure I dont start getting crazy and as such, have position limits for both entry and final positions.

[SHDL]

I think this is an interesting discussion so here’s a little take: 

 

At a very high level there are two strategies one could follow when it comes to position sizing. 

 

One strategy (the “Thorp strategy”) is to think really hard about both the upside and downside of each bet and how likely each outcome is, and then use some variant of the Kelly criterion to determine its optimal position size.  There is a sense in which this is the “mathematically correct” thing to do; however it can be difficult to use in practice when you only have a vague view about the probability distribution of returns and it is costly (in terms of time/effort/money/etc) to sharpen that view.

 

The other strategy (the “LLN strategy,” where LLN stands for the Law of Large Numbers — in the probability theory sense, not in the CNBC sense) is to fill your portfolio with a large number of small, similarly sized, and (hopefully) uncorrelated bets whose expected returns meet a certain threshold.  This can be suboptimal if you have strong (and correct) views about the relative attractiveness of each bet, but it has the advantage that you only need to be right about the expected/average returns (and not the entire probability distribution of returns) for it to work.

 

Given the pros and cons, I think Gregmal’s decision to follow the LLN strategy in this instance is reasonable given that (a) it’s quite costly to form a well informed opinion about the distribution of outcomes (as discussed), and (b) the maximum upside is somewhat limited anyway.  My guess is that the probability distribution he laid out above (+2 w.p. 0.9; -1.25 w.p. 0.1) isn’t really meant to be a highly accurate description of his beliefs but rather some rough numbers he used to decide if the expected return meets his internal threshold. 

 

Also another thing to note is that even if one were to follow the Thorp strategy, optimal position sizes are really sensitive to how good one's outside options are.  For instance if you’re offered a lottery ticket with a 20% expected one year return, how much of that you want to buy depends a lot on whether you’re starting from 100% cash or whether you already have have a portfolio in place that you can confidently predict will earn, say, a mid-high teens annual return on average.  Basically the better you like your existing portfolio the less you want to gamble (which I guess is somewhat obvious once you put it that way).  And the bar becomes even higher if you’re sitting on large unrealized capital gains that are going to be taxed the moment you sell something you own.

 

[Gregmal]

I think this is an interesting discussion so here’s a little take: 

 

At a very high level there are two strategies one could follow when it comes to position sizing. 

 

One strategy (the “Thorp strategy”) is to think really hard about both the upside and downside of each bet and how likely each outcome is, and then use some variant of the Kelly criterion to determine its optimal position size.  There is a sense in which this is the “mathematically correct” thing to do; however it can be difficult to use in practice when you only have a vague view about the probability distribution of returns and it is costly (in terms of time/effort/money/etc) to sharpen that view.

 

The other strategy (the “LLN strategy,” where LLN stands for the Law of Large Numbers — in the probability theory sense, not in the CNBC sense) is to fill your portfolio with a large number of small, similarly sized, and (hopefully) uncorrelated bets whose expected returns meet a certain threshold.  This can be suboptimal if you have strong (and correct) views about the relative attractiveness of each bet, but it has the advantage that you only need to be right about the expected/average returns (and not the entire probability distribution of returns) for it to work.

 

Given the pros and cons, I think Gregmal’s decision to follow the LLN strategy in this instance is reasonable given that (a) it’s quite costly to form a well informed opinion about the distribution of outcomes (as discussed), and (b) the maximum upside is somewhat limited anyway.  My guess is that the probability distribution he laid out above (+2 w.p. 0.9; -1.25 w.p. 0.1) isn’t really meant to be a highly accurate description of his beliefs but rather some rough numbers he used to decide if the expected return meets his internal threshold. 

 

Also another thing to note is that even if one were to follow the Thorp strategy, optimal position sizes are really sensitive to how good your outside options are.  For instance if you’re offered a lottery ticket with a 20% expected one year return, how much of that you want to buy depends a lot on whether you’re starting from 100% cash or whether you already have have a portfolio in place that you can confidently predict will earn, say, a mid-high teens annual return on average.  Basically the better you like your existing portfolio the less you want to gamble (which I guess is somewhat obvious once you put it that way).  And the bar becomes even higher if you’re sitting on large unrealized capital gains that are going to be taxed the moment you sell something you own.

 

Exactly. I use both. But in the case of something like this, where the wager is dictated by probability, the million dollar link in that chain comes down to whether you have correctly assigned your probabilities to certain outcomes. With something like this, I could very well be WRONG in assigning outcome probabilities. Because it is not my core investment strategy, I am not willing to wager significantly on my assigned probabilities being THAT CORRECT. However if something is right in my wheelhouse and I am oozing confidence in the probability of a favorable outcome, I have no problem betting the house.

 

FRPH for instance I took a 5% position to a 30% position and then back to a 5% position solely to capitalize on the stock bouncing from $48 to $54 as my work told me this was almost a guarantee given the valuation. I have little confidence that there is equal certainty PACB will definitely get back to $7, despite thinking that there is a very high likelihood it does, all things considered.