Shares of Illumina (ILMN) have risen over 85% since our in-depth November 1, 2012 initiation of coverage, and for good reason: the company has, for several quarters in a row, proven that its core academic markets are steady in the face of continued headline risks, and that it is creating an increasingly diverse revenue base. The company’s Q3 results, which included beats on revenue and EPS, as well as raised full-year guidance, highlight that even with its shares at an all-time high, Illumina should remain a facet of a balanced healthcare portfolio.
Broad-Based Growth
For Q3, total revenues grew by 25% to $356.8 million, beating consensus estimates by $13.58 million. EPS grew by 9.76% to $0.45, with costs being the primary driver of the divergence between sales and profits. Gross margins shrunk 30 basis points to 70.2% due to incremental dilution from Illumina’s slate of recently acquired companies, as well as a lower mix of consumables (quarters with a higher proportion of system sales do shrink gross margins, but broaden Illumina’s installed base, leading to higher consumables sales over time). But surging R&D spending, which rose by 34.49% to over $61 million, caused the bulk of Illumina’s tepid earnings growth. That, combined with a rise in SG&A tied to expanded sales efforts (to further penetrate international markets, where Illumina has lagged Life Technologies) and other investments, pushed down operating margins to 32.1%, down 270 basis points from Q3 2012, but up 10 basis points sequentially. Naturally, CEO Jay Flatley opened the earnings call with discussion about the company’s academic markets. Given the government shutdown, this is a point of concern for investors. However, as in previous quarters, Illumina demonstrated that its academic exposure continues to be an asset for the company, not a liability. Flatley noted that, “While the shutdown was very unfortunate for a few of our customers, we have not seen a material impact on spending patterns. Importantly, for most customers, external funding was flowing as expected during the shutdown. With the government now open and operating under a continuing resolution, we’re seeing customary purchasing patterns. We expect this to continue going forward as customers and grant allocations maintain preference for sequencing over other technologies, as has been the case for the last few years.” Total sales in North America grew by 25% during the quarter, suggesting that the impact of the shutdown has indeed been muted. This performance places North America in the middle of the geographic pack; sales in Asia-Pacific rose by 22%, but sales in Europe rose by 27%, a figure made all the more impressive by the continent’s continued macroeconomic uncertainty.
In addition, Illumina saw strong growth across product lines. System sales grew 21% to $100 million, and we note that Illumina’s sales grow in part through a virtuous cycle: the larger its installed base of sequencing systems, the more consumables revenue the company can generate. Total consumables sales grew 22% to $216 million, representing well over 60% of total sales. Crucially, system sales were driven by solid demand for HiSeq systems, both through the completion of HiSeq 2500 upgrades, as well as organic orders, with the top-end HiSeq 2500 accounting for 80% of total orders. MiSeq shipments also saw year-over-year growth, but orders did fall sequentially due to an above average number of multi-unit orders in Q2 2013. Illumina’s burgeoning service segment, covering most of Illumina’s recently acquired businesses, also saw solid growth, with total sales rising over 62% to $38.197 million (and up over 17% sequentially). Management noted several pockets of strength within the segment, including demand from agricultural and ordinary customers for genotyping services, as well as maintenance contracts on Illumina’s growing installed base. In conjunction with its Q3 results, Illumina raised its guidance for 2013; the company now expects sales to rise by 22%, versus 20% previously, and EPS of $1.76 at the midpoint of its guidance range, versus a prior midpoint of $1.70.
The Road Ahead: Repositioning Illumina for a Genetic Future
But perhaps more important than the numbers themselves is the long-term transformation that has been taking place at Illumina, from a company focused on helping research the role of genes and genetics in healthcare, to one focused on helping customers utilize genes and genetics to treat patients. As recently as 2012, over 70% of the company’s sales were generated from academic customers. In Q3 2013, the percentage of sales from the academic space dropped to 55% for the company as a whole, and just 50% in the HiSeq line. The MiSeq product line already generates a majority of its sales from non-academic customers, with CEO Jay Flately specifically noting that sales to the pharmaceutical industry are accounting for a growing portion of sequencing system sales. Illumina is repositioning itself as not simply a provider of sequencing systems, but as a provider of a genetics ecosystem, via a broad range of systems, as well as a growing ecosystem of applications hosted on BaseSpace. Illumina hosted a meeting of 120 developers at the 2013 ASHG (American Society of Human Genetics) annual meeting (running from October 22-26), and has launched a native API for developers to craft BaseSpace applications. Analysts on Illumina’s earnings call pressed for information on BaseSpace, determined to find out it the business is profitable. Management said that BaseSpace revenue is largely immaterial at the moment, but we remind investors that this is not the point of BaseSpace, and if Illumina were focusing on it as a profit center, it would be cause for concern. In any business, focusing on how to generate them does not make great profits. Focusing on running a great business makes great profits. Apple chooses to virtually give away software to drive sales of its hardware, and we believe that in time, BaseSpace could play a similar role for Illumina. Management has made no secret of the fact that it sees BaseSpace as an important aspect of Illumina’s business going forward, and for the last several quarters, every single earnings call has featured discussions of BaseSpace. Verinata is also continuing to grow, and on October 14, Illumina announced the release of new options for the verifi test that allow for the testing of fetal aneuploidy in twins. CEO Jay Flatley pledged to deliver more information about Verinata when the company delivers Q4 results in January.
Several days before its earnings release, Illumina disclosed that a meaningful reorganization has been taking place at the company, which we believe highlights its shift towards a future as a commercially focused healthcare company, with a decently sized academic business. First, Jay Flatley is stepping down as President of Illumina in order to spend more time on corporate strategy and vision; a new President will be named in due course. Secondly, Illumina will be reorganized into five separate divisions, each with a clear commercial focus.
- Life Sciences: This will become Illumina’s main division, housing its “core platform technologies,” as well as products that serve customers in agrogenomics, complex disease, and metagenomics.
- Reproductive & Genetic Health: Verinata, BlueGnome, and Illumina’s cytogenetics business will be folded into this division, which will be headed by Illumina’s current CCO.
- Oncology: Highlighting Illumina’s growing sales to the pharmaceutical and biotechnology industries, this new division will be headed by Illumina’s Chief Medical Officer to drive sales across the oncology market, ranging from both research of new drugs to customized treatments for cancer patients.
- Enterprise Informatics: This division will focus on products that offer the ability to store, analyze, and share genetic information; Illumina has said that it will target the growing precision medicine industry.
- New & Emerging Markets: Highlighting Illumina’s penchant for tuck-in deals, this division will focus on new genetics markets, and will presumably be authorized to quickly acquire strategic start-ups. On its earnings call, the company stated that it continues to expect a handful of tuck-in deals each year, and that it regularly looks for new opportunities across the sequencing and genetics industries for potential new deals.
A re-invigorated focus on these 5 markets will serve two purposes. The first is to accelerate Illumina’s push into the commercial healthcare sector across a diverse slate of markets, and give these divisions increased autonomy to pursued deals and sales in their respective areas. The 2nd is that a decrease in academic sales (as a proportion of total sales) will serve to quell one of the few remaining points of potential criticism regarding and investment in Illumina. With nearly 19% of the company’s float sold short, there is a subset of investors that continue to believe that Illumina’s exposure to academic markets is a material risk for the company, and one that will cost it and its investors dearly. And while this may be a risk in the sense that it could happen, we believe that Illumina has done as much as any company can in proving the resilience of its academic customers. If a government shutdown and potential default, as well as ongoing stress in Europe cannot derail its academic markets, then what can? And as Illumina’s exposure to the academic sector continues to fall, the importance of this issue will decline.
Competition: Managing Emerging Threats
For much of 2013, Illumina has seen a confluence of positive news regarding its competitors. Life Technologies has been sold to Thermo Fisher (TMO), a company that is not known for its furious pace of R&D innovation (the acquisition is on track to close in early 2014). As a frame of reference, Thermo Fisher spent just 3% of revenue on R&D in Q3 2013, versus 17.18% for Illumina. Pacific Biosciences of California (PACB) has been struggling to deploy its sequencing systems, and Oxford Nanopore has seen one delay after another. However, in recent weeks, there have been several developments involving Illumina’s competitors. On September 25, Pacific Biosciences and Roche (RHHBY) inked a new agreement to develop and sell new sequencing systems. For Roche, this represents perhaps the last remaining opportunity to make a meaningful mark in genetic sequencing, other than conceding and attempting to buy Illumina once again. Given Roche’s string on failures in sequencing (most recently, Roche scrapped a number of sequencing projects in April), it can be assumed that Roche recognizes that it needs to succeed with this collaboration. As part of the deal, Pacific Biosciences will receive $35 million upfront, up to $40 million in development milestones, and then royalties tied to sales of instruments, software, and consumables. Although Pacific Biosciences management team has said it has seen an increase in interest in its sequencing platforms after the Roche deal was announced, it remains to be seen if Roche can succeed where Pacific Biosciences has not; the company installed six 6 PacBio RS II systems, down from seven sequentially. We will be looking at news flow from Pacific Biosciences closely in the months to come to see if the deal with Roche leads to a change in its competitive position.
Oxford Nanopore has also seen progress, and is finally poised to release its MiniION platform to customers, albeit on a highly limited scale (as a reminder, Illumina owns 15% of Oxford Nanopore). Beginning in late November, researchers can request to receive a MiniION sequencer after paying a $1,000 deposit, which will be returned after Oxford Nanopore receives the MiniION. As with Pacific Biosciences, the impact of Oxford’s move is unlikely to be material for Illumina. If anything, this may be a negative for Pacific Biosciences, given that Oxford’s technology also utilizes the high read-length (but low throughput) technology of Pacific Biosciences. First, Illumina owns 15% of the company, allowing it to participate in at least some of Oxford’s upside potential. Second, Illumina may move to acquire the reminder of Oxford should it see a need to do so. We note that as part of recent arbitration proceedings related to their 2009 collaboration agreement, Illumina has, until the end of 2016, the right to match any offer made for Oxford Nanopore’s assets, including offers for its Nanopore sequencing technology (however, Oxford’s CEO disputed comments that suggested that Illumina has the right to match offers made for shares of Oxford Nanopore). In addition, Illumina inked a licensing deal with the University of Alabama and the University of Washington this month related to Nanopore sequencing technology developed by scientists at the universities. The deal gives Illumina exclusive global rights to develop products based on this technology, and with 50% of Illumina’s R&D spending devoted to its sequencing platforms, it is all but certain that Illumina is examining ways to develop commercial-stage Nanopore sequencing technology of its own.
Conclusions
Even at all-time highs, we believe ILMN continues to offer long-term appeal for investors. The company is positioning itself for the next stage in its corporate life cycle – that of a commercial healthcare company. Illumina’s reorganization should allow it to more rapidly pursue that vision, and its commitment to research & development and staying at the forefront of genetic sequencing has not waivered, as evidenced by an increase of over 30% in R&D spending. For the time being, Illumina’s competitive position remains solid, as are its growth prospects in the remainder of 2013 and 2014. We expect the company’s revenue diversification and sequencing innovation to continue in 2014, and believe that Illumina is far from reaching its full potential in the global genetics and sequencing markets.
In connection with ILMN, PropThink has taken a long position.
