On January 24, Roche (RHHBY.PK) made an unsolicited offer directly to the shareholders of Illumina (ILMN) for $44.50 a share. The stock jumped the next day to around $55 per share. The offer was rejected and a poison pill resulted because of Illumina's advice from Goldman Sachs.
The offer from Roche to buy out Illumina completely changed the landscape for pricing of many medical tool and molecular diagnostics companies that specialize in first sequencing and second PCR (polymerase chain reaction). This event marks another flexion point in the shift to personalized medicine. There are three major points that shake up this subsector.
- This is a sequencing/microarray company and not a PCR company. While sequencing technology is sometimes used in clinical trials, sequencing companies have more hurdles in FDA approvals for companion diagnostics. To my knowledge there have been zero sequencing IVD approvals as opposed to an estimated 50-plus PCR molecular diagnostic approvals.
- Roche leads this market. According to its filings it controls the MDx market with over 30 percent market share. Not only does it lead in revenue but also in reputation. If Roche believes sequencing can play a much larger role in clinical trials or as a companion Dx, many other firms, particular Big Pharma and biotechs, must take another look at the possibilities.
- The size of this offer. For Roche pharmaceuticals this might be small, but for the medical tools/diagnostics industry it is large. At $5.7 billion this type of investment is more serious with larger financial consequences. Roche would not make this offer if was just for the business in its current state and not for synergies.
This completely changes the way the subsector should be viewed. In addition to values as standalone companies these companies now have huge buyout premiums. Here's how some of the companies in the molecular diagnostics/sequencing subsector reacted to the news on that day:
(Click charts to enlarge)
The market has adjusted since then with some prices falling back to normal like Pacific Biosciences. There have also be other stock price catalysts since then that I would like to point out. Here's movement from the offer in January to Friday.
I tried to look at the overall market to see if the market reacted too aggressively or not aggressively enough in pricing these names for buyout premiums.
The companies that should be affected the most by this offer I believe are those with sequencing technology. Other factors could be pharma relationships in place, and smaller market capitalization. Looking at these factors I believe the market priced the premium as follows:
Here's a quick explanation:
Did the Market Overreact?
The market can overreact sometimes in terms of M&A and give ridiculous valuations to sectors. If the M&A possibilities are correctly priced in the market this is not a problem for long-term investors. I think that happened with Affymetrics (AFFX), Qiagen (QGEN), Complete Genomics (GNOM) and Pacific Biosciences (PACB).
I don't want to spend more for a company because the market overreacted to M&A fever, and I might want to find stocks I that believe might have under priced the M&A possibilities to get that extra small chance of upside in an already well functioning company.
Good companies with Possible Overpricing
Unfortunately this additional complication has added to the complexity of valuation. This additional premium needs to be accounted for when looking at good longer-term investments because a DCF will now show a lot of good firms are overvalued. This will also make good companies with strong prospects priced a little bit out of reach from what you might want to pay.
Cepheid (CPHD) might currently be in the category. It is expected to see huge growth over the next couple years. Its offering, the GeneXpert system, has a menu that is scalable and is expected to gain market share in a growing market. The company traded at a pretty high multiple even before the January Roche offer. The additional 5 percent jump after the Roche offer to Illumina, in addition to the buyout premium after an analyst at Goldman Sachs said it has buyout potential last year, makes the company less attractive in my opinion. This company is no greater a buyout target than before the offer yet costs 5 percent more.
Genomic Health (GHDX) is another company that I really like but might be in this category. It's the prototype personalized medicine company. It has found a way to get its products reimbursed in the U.S. (though not in Europe). The current offering has been successful and it has in its pipeline a product, the Oncotype Dx Prostate, that has a total market potential of almost $900 million. The asking price of the Oncotype Dx sells (asking price) at about $3800 dollars, although if you model the company you will notice it receives less than that on a per test bases. The Oncotype Dx offer continues to expand and the company's market potential will grow. Its stock jumped over 3 percent the day after the Illumina offer was announced. It was later even mentioned by name by analyst from JMP securities that it might be an interesting acquisition, causing more speculation. This leads me to believe it is priced into the stock and makes buying the stock with the buyout premium possibly unattractive.
Life technology (LIFE) now seems like a more attractive buy. The market does not believe its technology or offering is comparable to llumina's judging by its reaction. I think the market may be slightly wrong however. It's one of the better plays in personalized medicine and has interesting partnerships already in place including a larger one with GSK. Surprisingly, its stock moved only 3.8 percent after the offer. Its technology is the major rival to Illumina's, and it's been picking up sales in the now stabilized research/medical tools subsector. Some might believe it is too big with too many parts to be a buyout target. Nevertheless, Roche's offer to Illumina, means it is not impossibly big. Its offering is more similar to Illumina and it jumped less than others in the subsector. This might mean there a little bit of an extra return if you already like the name.
Knowing exactly how the market is predicting the M&A buzz is difficult, however it is clear the market is pricing M&A into many stocks in the sequencing and MDx subsector. If you like the name make sure the stock hasn't been driven up too high with M&A speculation that seems to be running wild in this sector. I believe the otherwise good companies Genomic Health and Cepheid might have seen some market overreaction. I believe Life Technologies might have seen market under reaction.
Disclosure: I am long ILMN.