Survey: Life Sciences Could Be In For A Rough Year

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by: Stephen Simpson, CFA

Investors hoping for a quick turnaround in battered life science companies like Illumina (Nasdaq: ILMN), Pacific Biosciences (Nasdaq: PACB), and Affymetrix (Nasdaq: AFFX) may want to consider new information that suggests the next twelve months could be just as bad, if not worse. A recent survey from GenomeWeb and Mizuho indicates that research labs are battening down the hatches in expectation of poor funding trends and may well be spending less money (and spending that money differently) in the near future.

The Money Tree Is Looking Bare

For all of the talk about how life science discoveries in fields like genomics and proteomics has, is, and will influence Big Pharma and biotechnology, the reality is that it is not companies like Pfizer (NYSE: PFE) and Novartis (NYSE: NVS) that really make up the bulk of this sector's customer base. Life sciences is really an academic lab market – and those labs depend upon the federal government for an exceptionally large percentage of their funding needs. With stimulus spending in the past and the likelihood of lower funding levels for organizations like the National Institutes of Health and sub-institutes like the National Cancer Institute becoming more and more real, the situation is starting to get a bit scary.

According to the GenomeWeb/Mizuho survey, the general consensus expectation has moved to a 2% funding decline for next year – down from a 2% increase just one quarter ago. Roughly 55% of the respondent expect flat funding, but about 10% expect declines of 10% or more versus less than 5% who expect increases of 10% or more. In order to make it through, labs are cutting back on personnel, but also revising their equipment purchase expectations down.

Some Animals Are More Equal Than Others

When budgets get tight, spending cuts are never uniform across the board. Certain areas of research hold up better than others (cancer, for instance), and certain research applications hold up better. To that end, RNA sequencing and next-gen sequencing look strong, but areas like microarrays and immunoassay could be weak.

According to this survey, Illumina is actually looking fairly strong with respondents suggesting that they will spend even more on this company's systems and kits. Close behind, Life Technologies (Nasdaq: LIFE) also seems to be in good shape vis a vis these plans – helped no doubt by the buzz around the company's Ion Torrent technology.

On the flip side, investors in companies like Affymetrix, Caliper (Nasdaq: CALP) (which is being acquired by PerkinElmer (NYSE: PKI)), and Waters (NYSE: WAT) appear to be on the wrong side of the spending fence.

Affymetrix in particular would seem to have some real issues. A new CEO brings the hope of a turnaround in the business and the end of an unfortunate series of missteps, but the company is losing share to rivals like Agilent (NYSE: A) and serves a market (microarrays) that seems to be increasingly out of favor.

The Grey Areas

Perhaps most frustrating of all for investors are the companies that fit into the grey area of life science lab prioritization. Fluidigm (Nasdaq: FLDM) and Luminex (Nasdaq: LMNX), for instance, do not seem to be high these respondents' list of priority equipment – even though both companies are arguably built around saving money for labs and increasing their research efficiency. In the case of Luminex, for instance, growth in research lab utilization is an important part of the long-term bull thesis; the company is doing well in diagnostics, but the research side of the business is not as strong.

Pacific Biosciences is likewise in a tricky place. The company has not seen the initial orders that it expected and recently chose to lay off more than a quarter of its employees. While I have talked to a number of researchers that are very excited about the technology that Pac Bio offers, the reality is that the purchase orders just are not there. As is also the case with the much smaller WaferGen (Nasdaq: WGBS.OB), it just does not matter how good the technology is if nobody buys it and management has to struggle to find capital to keep going.

Along similar lines, nobody seems too excited about the platforms or products at Becton Dickinson (NYSE: BDX), Bio-Rad (NYSE: BIO), or Roche (Nasdaq: RHHBY.PK). Again, keep in mind that this is the research market we are talking about. All of these companies are doing relatively well in diagnostics, but they are losing ground in the research market and Roche in particular is probably coming to a point where they need to make a decision whether they want to seriously compete in this arena.

The Time For A New Approach?

Though it is a tiny company, perhaps this is the environment where Complete Genomics (Nasdaq: GNOM) can shine. Complete Genomics is trying to emerge as a leader in outsourced sequencing. The arguments here are compelling – labs no longer need to acquire hundreds of thousands of dollars of equipment or hire people to do the sequencing themselves. What's more, although the initial uptake has been slow, plenty of lab managers speak positively of the concept.

While there is of course competition here (Illumina and Life Tech, to name two), this could be the chance for outsourced sequencing to show its stuff. Testing companies like Quest Diagnostics (NYSE: DGX) and LabCorp (NYSE: LH) have done well with their outsourced models – freeing hospitals from having to invest in technology and technicians in exchange for a slight delay in results – and it makes sense that many academic labs could go the same route. Of course, it's new and different and researchers can be surprisingly stubborn, particularly when data/information security concerns approach something like paranoia among many researchers.

The Bottom Line

Illumina has taken a pounding of late as investors re-evalute whether a company that is so beholden to external funding decisions should carry such a high multiple. Ultimately, though, this company should be a market share winner and it looks as though the stock has been pummeled enough to be worth a look. Much more aggressive investors may want to consider Pac Bio – things have not gone to plan here yet, but the technology is impressive and the probability of a buyout (say, perhaps, by Roche if it thinks it can leverage the technology) offers some support.

Broadly speaking, though, this is a time for caution. Overall activity looks like it will be no better than stagnant, and that will create a tough market for even quality names like Life Tech, Agilent, and Techne (Nasdaq: TECH), to say nothing of more stressed players like Affymetrix.

Disclosure: I am long OTCQX:RHHBY.