Pacific Biosciences (PACB) – Merger Arbitrage – 5% Upside

Current Price – $7.61

Acquisition Price – $8 in cash

Upside – 5%

Expiration Date – TBD (expected mid 2019)

This idea was shared by Ilja.

 

DNA sequencing machine maker Illumina is acquiring biotechnology company Pacific Biosciences for $8 in cash per share. The acquisition has been approved by both boards and is still subject to regulatory as well as PACB shareholder approvals. The later condition shouldn’t present any challenges as more than 50% of the votes are owned by insiders and 6 largest shareholders who have raised no objections so far one month after the announcement. Regulatory approvals are likely to pass as well, due to different technologies both companies are working on (meaning not direct competitors).

I do not believe Illumina is likely to walk away from the transaction as this is a relatively small (albeit the largest so far) acquisition for them ($40bn vs $1bn market caps). Also termination fee stands at $43m. The main reason for the spread is time left till expected closure (6+ months) as well as somewhat uncertain regulatory approval.

 

Background

Illumina is $40bn DNA sequencing company, which has such people as Jeff Bezos and Bill Gates on its investor list. ILMN focuses on “short read” technology - reading short pieces of DNA and assembling them, however it has certain shortcomings, that are covered by “long read” technology, which is provided by PACB. Long read is much more expensive, however the recent breakthrough in Pacific’s technology and their newest chip that should be released next year is expected to significantly reduce the costs. Illumina commented on this in the most recent call:

The biggest driver around the timing, frankly the exciting innovations that have come out of PacBio over the past few months, and that are planned to come out over the next year… They’ve been able to dramatically improve the accuracy of their offering as well as the total output of their sequencer.

This interview/PR with the Illumina CEO provides further insights into the rationale behind the merger.

Although PACB previously had struggles with delivering their promises on time (the company had some delays when introducing the first version of the chip in the previous years), the CEO of Pacific stated that this time the launch of their newest chip is conservatively planned and Illumina added that after going through the target company’s roadmap and spending the few last weeks looking deeply into PACB technology, they feel comfortable about the future.I am not an expert on biotechnology, but if an industry leader - $40bn company says they want to buy it, that is good enough argument for me.

This is the largest deal so far for Illumina and it packs a high 79% premium to the last closing price of PACB. Pacific Biosciences has been burning $86m on average each year since 2010 and relies on continued equity issuances to support operations. At the end of last quarter the company had just over $15m left on its balance sheet. So in the absence of takeover either sales would need to pick-up fast (newly developed technology could be catalyst for that) or additional funding would be necessary.

It is not clear if any other parties have been interested in acquiring PACB and how competitive the bidding process was as the proxy has not been published yet.

 

PACB shareholder approval is very likely

Since there has been almost a month after the announcement and no objections have been received so far I am assuming, that main institutional shareholders will vote in favor of the deal. 5 largest shareholders (excluding index fonds) own 32% (end of Q3 figures). Insiders have another 13.4%.

Magnetar Financial (hedge fund) has recently acquired over 6% of PACB. Despite having a shady history with the CDO crisis 10 years ago, they have an excellent track record of investing into M&As. Since mid 2016 they have invested into 14 mergers of which 9 have successfully closed and 5 (3 of them including PACB are quite new, other 2 are working on regulatory approvals) are still in the process.

So if we take top 5 institutional holders, Magnetar and insiders, we already have more than 50% of the votes.

 

Regulatory approvals

This is probably the main concern and the reason it might take up to mid 2019 for this transaction to close. When asked to comment about this in a recent call, Illumina has not given any clear answers except that they are working on it and noted that ILMN operates in short read segment while PACB - in long read. Having this in mind, I expect there to be no major problems with regulatory approvals.

 

Previous Illumina acquisitions

This is the largest acquisition for Illumina, however by far not the first one. Unfortunately, I was unable to track down any other interesting information about the previous mergers as in regards to that, the company is not sharing much in their press releases. Anyway, I suppose that after the previous 12 acquisitions the management should have enough experience to close this one out.

24 COMMENTS

  1. work 22

    Anti-trust from what i hear is the main issue. I don’t know about the product overlaps, or what divestitures ILMN could make, but that’s arguably the reason for the wider than normal spread. Probably requires more digging.

  2. Austin

    This actually worked well — and surprisingly quickly. Bought @ $7.60 last Thursday and sold @ $7.82 as soon as the market opened this morning.

  3. lngtrminvestor1

    Any thoughts on the FTC second request? What’s the break up fee here? Thanks

    1. dt

      It might be non-news or it might be important, only FTC and the companies know. Keeping in mind that both companies operate in closely related fields, FTC additional scrutiny seems to be quite normal. It’s a bit encouraging, that merger closure has not been extended.

      Regarding termination fees, I think neither party is liable to pay anything if merger breaks due to antitrust (but I might be reading the legal language incorrectly). See page 94 of the proxy.

      https://www.sec.gov/Archives/edgar/data/1299130/000119312518342511/d646626dprem14a.htm#toc646626_19

  4. lngtrminvestor1

    A few other items here: from today’s ILMN 4Q earnings call:

    “And on the PacBio side, so where we are is we’ve got the second request from the FTC as we expected, and so we’re in the information gathering phase. And so the process in general is going as we expected and we still expect it to be a midyear close.”

    From the proxy- doesn’t sound like there were other suitors:

    “The Pacific Biosciences Board considered that during the strategic partnership discussions, only one company other than Illumina had expressed any interest in acquiring Pacific Biosciences (and that interest was highly preliminary), and that company had subsequently determined not to pursue an acquisition.”

  5. Jamal.Sydney

    Curious if anyone has been following this one recently? Spread’s gotten much bigger since mid-May, and the only recent news I’ve seen is both companies commenting in their 1q earnings reports and at conferences they still expect a mid-year close. Maybe I’m missing some new update on the antitrust situation? I know there was a report about the UK authority investigating, but that was in mid April and the stock didn’t really move on it.

  6. lngtrminvestor1

    This one is getting messy- maybe an opportunity.

    The CMA has decided, on the information currently available to it, that it is or may be the case that this merger has resulted or may be expected to result in a substantial lessening of competition within a market or markets in the United Kingdom. This merger will be referred for a phase 2 investigation unless the parties offer acceptable undertakings to address these competition concerns. The full text of the decision will be available shortly.

  7. dt

    I think the risk/reward on PACB/ILMN merger is now attractive despite pushed out timeline and continuing inquiries by regulators:
    – Upside to the offer price is 28%.
    – Downside to unaffected price ($4.5) is also 28%.
    – Ilumina will be liable to pay $98m termination fee if merger fails due to Antitrust issues. Gross termination fee if taken whole lowers the downside to $5.14 or to 18%. (my previous comment on termination fees was incorrect as I misread the legal language).
    – Approvals from US and UK antitrust regulators remain outstanding. I am unable to add any further color on likelihood of these passing besides what is already covered in the write-up. The key point is that both companies operate on different technologies (short read vs long read gene sequencing) and operate in somewhat different markets – therefore merger will not cause reduced competition. Illumina’s willingness to pay $98m termination fee in case antitrust approval fail adds confidence. This article from gene sequencing expert nicely summarizes antitrust question and the way regulators should approach it:

    About five minutes after Illumina announced their intention to acquire PacBio, my phone started ringing with market analysts, fund managers, and journalists all looking for the answer to one question: Will this merger pass anti-trust review? While I can’t say whether it WILL, I can emphatically say that it SHOULD. Read on to see why I think so.

    Full read on: https://allseq.com/illuminas-acquisition-of-pacbio-no-brainer-for-ftc-cma/

    Latest developments from regulators

    UK – 18th Jun 2019

    On June 18, 2019, the Competition and Markets Authority of the United Kingdom (“CMA”) announced the completion of its Phase 1 review of the Merger and that it will refer the Merger for a Phase 2 review if the Company and Illumina are unable to address the CMA’s concerns. The Company and Illumina will continue to work cooperatively with the CMA. The Company and Illumina expect the Merger to be completed in the fourth quarter of 2019.

    https://www.sec.gov/Archives/edgar/data/1299130/000119312519175329/d766989d8k.htm

    US – 10th May 2019

    As recently as earlier this month, staff at the U.S. Federal Trade Commission were interviewwing scientists and purchasers of the DNA sequencing machines as the agency’s review of the Pacific Biosciences/Illumina merger proceeds

    https://ctfn.news/stories/may-10-2019-ilmn-pacb-142757

    US – 4th Jan 2019

    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.

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

  8. lngtrminvestor1

    I’m concerned about whether the break price of $4.50 still stands- 1Q’19 revenues were down 25% y/y and I wonder if the pending acquisition is weighing on the saleforce/ customer base. At 3/31 they had ~$80M of cash and investments and they burned $30M in the quarter- there would likely be dilution coming as a stand-alone entity.

    1. dt

      Fair point – actually all three quarters (Q3’18, Q4’18 and Q1’19) have seen negative growth of -15% to – 22%. However, the company did a commercial launch of their Sequel II system at the end of April 2019. The new system has 8x DNA sequencing throughput compared previous Sequel I. Trial sites have already acquired those and it might have a positive effect on sales going forward.

      Drop in revenues over the last few quarters might have been caused by customers delaying the purchase in anticipation of upcoming more powerful sequencing system.

      I have too little knowledge to judge whether this will work out as expected in terms of improved PACB sales, but at least it is not a company with now prospects and just declining revenues in sight.

  9. lngtrminvestor1

    Haven’t seen any news but this is getting worked this morning.

  10. work 22

    UK CMA raised more competition concerns today, that’s why the stock is down this Friday july 19th

  11. ryanwalex

    This merger was extended to 3/31/20
    https://www.sec.gov/Archives/edgar/data/1299130/000119312519254987/d811596d8k.htm

    Additionally Illuminia is making payments to PACB.

    “On September 25, 2019, the Company, Illumina and Merger Subsidiary entered into Amendment No. 1 (the “Amendment”) to the Merger Agreement. The Amendment, among other things, extends the End Time (as defined in the Merger Agreement) to December 31, 2019, subject to Illumina’s unilateral right to extend the End Time to March 31, 2020. In addition, the Amendment provides that Illumina will make cash payments to the Company of $6 million on or before each of October 1, 2019, November 1, 2019 and December 2, 2019. If Illumina elects to extend the End Time, then Illumina will make cash payments to the Company of $6 million on or before each of January 2, 2020, and March 2, 2020, and a cash payment of $22 million on or before February 3, 2020. The Company will use these payments, which are collectively referred to as the “Continuation Advances,” to fund its continuing operations. Up to the full amount of the Continuation Advances actually paid to the Company are repayable without interest if (1) the Merger Agreement is terminated and (2) within two years of termination, the Company enters into certain change-of-control transactions with a third party or raises at least $100 million in equity or debt financing in a single transaction (with the amount repayable dependent on the amount raised by the Company). “

  12. Dan T

    Pacific Biosciences: UK’s CMA provisionally finds that the proposed merger between Illumina (ILMN) and PacBio will result in a substantial loss of competition
    6:43 AM ET, 10/24/2019 – Briefing.com

    Down 9% today. Does this change the regulatory approval picture?

  13. Terence

    Price down to $4.70, close to pre-merger or “unaffected” price of $4.50 on 11-1-18.

    1. nostradamus

      As someone noted above, whether that unaffected price still carries any meaning is up for debate. Problem I see is when this deal breaks (and it looks like it) there’s a real bankruptcy risk for PACB. Or they might find financing from somewhere (if their tech is as unique as it seems), survive and thrive, but it’s a risky bet. Investors in M&A are usually not known for their agressive risk taking.

  14. Zulu Investment Partnership

    Whenever in doubt with the merger prospects, the second safety is how the company looks on a fundamental basis, and unfortunately it’s a red flag for both, in our opinion.

  15. dt

    PACB shares somewhat recovered after Illumina submitted revised remedy proposal to UK CMA offering to open all PACB IP to third parties following the merger. This was one of the key concerns voiced by UK regulator. CMA in turn has extended inquiry into the case until Feb’20.

    Good overview of the revised remedy proposal can be found here:

    https://www.genomeweb.com/sequencing/illumina-expands-ip-offer-help-save-pacbio-deal-oxford-nanopore-cries-foul#.XeNqspMzaCg

    The original proposal, which Illumina submitted on Nov. 7, had offered a “perpetual, royalty-free, irrevocable, sole license” of certain PacBio patents to either Oxford Nanopore Technologies or to any interested third party for use in the nanopore sequencing field.

    Under the amended proposal, Illumina now offers “a perpetual, royalty-free, irrevocable license to any of Illumina and PacBio’s pre-closing patents and patent applications to any interested third party undertaking for use in the field of single-molecule, native long-read sequencing systems and associated sequencing chemistries.” The offer would also extend to relevant IP filed within 12 months of the closing date of the merger, and it would include any in-licensed patents held by Illumina or PacBio as of the closing date.

    According to Illumina, this proposal “would be a fully effective, reasonable, and proportionate undertaking to remedy the [substantial lessening of competition] provisionally identified by the CMA.

  16. dt

    FTC opposes Illumina / PACB merger.

    https://www.wsj.com/articles/federal-trade-commission-challenges-illuminas-proposed-acquisition-of-pacific-biosciences-11576618091

    Illumina is not giving up yet:

    “We strongly disagree with the FTC’s decision and will continue to work through the regulatory approval process as we consider next steps,” an Illumina spokesman said. “We believe that the acquisition will benefit the industry and customers.”

    It is not clear if FTC’s objection reflects the remedy proposal submitted to UK CMA or whether this is purely on the original transaction terms.

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