Even at All-Time Highs, Illumina’s Q2 Results Support Continued Upside

Since we initiated in-depth coverage of Illumina (ILMN) on November 1, 2012, shares of the gene sequencing company have soared over 66% through the close of trading on July 24, outstripping the 44% rally in the NASDAQ Biotechnology Index. And that assumes that the NASDAQ Biotechnology Index is even the proper benchmark for Illumina; the S&P Healthcare Select Sector Index is up just over 27% over the same time frame. But, even with shares closing at an all-time high of $81.56 on the 24th, there’s further long-term upside in this name. As the company’s Q2 results demonstrate, Illumina is continuing to grow its business both domestically and internationally, and with a number of new offerings in its product pipeline, Illumina is poised to further solidify its dominance of the growing genetic sequencing market.

Q2 Results: Growth on All Fronts

Illumina posted record revenue of $346.094 million in the second quarter of 2013, with sales growing over 23% year-over-year. Services revenue, which includes the recently acquired Verinata, soared nearly 50%, and services now account for 9.42% of sales, up from 7.76% a year ago. Product revenue, including Illumina’s core sequencing products, grew over 21% as the company continues to overcome macroeconomic uncertainty around the world and grow its customer base. The company largely held the line on gross margins during the quarter; consolidated pro forma gross margins came in at 69.5%, down 140 basis points year-over-year due to the impact of several acquisitions and a lower mix of consumables, due to higher than expected sequencing system growth (more on this later). However, gross margins expanded 30 basis points sequentially due to increased efficiencies within the company, according to CFO Marc Stapley. Operating margins also fell, down to 32.3% from 36.7% a year ago, due to several factors, including a full quarter of Verinata operations, as well as continued increases in headcount, R&D, and SG&A. R&D spending surged over 42% in Q2 2013, consistent with management’s pledge to boost spending on new products and services, and something that we view as essential to Illumina’s long-term success. With Life Technologies (LIFE) in the process of being absorbed by Thermo Fisher (TMO), and many of Illumina’s other competitors set back by delays and uncertainty, the company cannot afford to squander an opportunity to push ahead with further innovation. However, despite surging business investments, Illumina is still seeing earnings growth, with pro forma EPS of $0.43 growing by 7.5% year-over-year. Notably, Illumina raised its full-year forecasts for both sales and earnings. The company now projects full-year revenue growth of 20%, and pro forma EPS of $1.70 at the midpoint of guidance, up from a prior outlook of 15% revenue growth and pro forma EPS of $1.58 at the midpoint of guidance.

Illumina’s raised outlook and solid Q2 performance is driven by several factors, including continued growth across all geographic regions and increasing non-academic sequencing demand. In the second quarter, Americas sales increased 22%, and European sales grew 19%, highlighting Illumina’s potential in Europe despite continued economic uncertainty. Notably, Asia-Pacific sales grew 36%, driven by growth in Japan. But perhaps most important is the fact that on the first 2 quarters of 2013, 40% of total product shipments were to non-academic customers, placing Illumina well on its way towards meeting its goal of generating half of all revenue from non-academic customers within the next five years.

Sequencing Growth Continues

As in prior quarters, Illumina’s growth continued to be generated by strength within its core sequencing business. CEO Jay Flatley noted that total sequencing revenue rose 33% year-over-year, driven by 37% growth in sequencing system sales and 26% growth in consumables. Although a higher mix of system sales relative to consumables pressured gross margins in the quarter, we note that in the long run, this is a positive development. The core of Illumina’s business model, which grants it industry-leading gross margins, is selling consumables to an expanding installed base of sequencing systems, and as utilization rates grow for these new systems, Illumina will be well-positioned to increase its consumables revenue growth rate. In addition, the company outlined its view of price increases for consumables, stating that it expects to have “moderate price increases on an annualized basis.”

The company continues to execute in both its MiSeq and HiSeq sequencing divisions. As in the first quarter, over half of all MiSeq systems were sold to non-academic customers. CEO Jay Flatley noted a multi-unit order from HistoGenetics, a leading provider of HLA testing services. Although Illumina does not disclose specific MiSeq shipment numbers (the company has historically been wary of disclosing specific shipment figures for competitive reasons), CFO Marc Stapley did note that MiSeq unit shipments grew on both a sequential and year-over-year basis, even when taking into account abnormally high shipments in Q2 2012 due to the clearing of shipment backlogs. Management noted that MiSeq ASP’s remained stable during the quarter, and that the MiSeq won 80% deals in which it competed head-to-head with other sequencing systems, most likely those from Life Technologies. In early July, Illumina secured a CE mark for its MiSeqDx cystic fibrosis system, which consists of an advanced MiSeqDx sequencing system in combination with two cystic fibrosis assays. The system is designed to allow for rapid identification of variations on patients’ CFTR (cystic fibrosis conductance regulator) genes. Within the HiSeq division, Illumina continues to show progress as well. During the quarter, 45% of all HiSeq shipments were to non-academic customers. Notably, 75% of HiSeq orders placed during the quarter were for the high-end HiSeq 2500, and Illumina has completed 85% of all HiSeq 2500 upgrades. The company has also reiterated its forecast for rolling out updates to its HiSeq line, which will allow for sequencing runs of 300G in 60 hours, as well as updates to its MiSeq line that will allow runs of 15G; both updates are set to be introduced by the end of the year. Alongside with pending updates to both the HiSeq and MiSeq, Illumina continues to add features to BaseSpace, its sequencing cloud platform. Developers now have the capability to charge for their BaseSpace applications, a feature that will potentially lead to a wide variety of value-added applications, with several already available.

Illumina’s sequencing services business continues to grow as well; we note that services revenue includes both the FastTrack sequencing business as well as other service sales, making it difficult to gauge sequencing service revenue growth from headline figures. In the second quarter, the company sequenced 2,500 genomes, representing year-over-year growth of more than 233%. However, those 2,500 genomes represented a sequential drop from the 4,000 genomes sequenced in the first quarter, due to the timing of projects. As a reminder, Illumina’s FastTrack division is likely to experience lumpiness from quarter to quarter because of the timing of certain projects. However, although the company saw a sequential drop in sequenced genomes, Illumina received orders for more than 6,000 genomes, setting a new record for the company. Those 6,000 genomes include the initial 1,000 genomes of the Department of Veteran’s Affairs Million Veteran Program, a research program being conducted by the department to sequence the genomes of 1 million veterans to build a comprehensive healthcare database on how genetics affect the health of the nation’s veterans.

Academic Markets: Sequencing as a Shield

Since late 2011, when Illumina’s business and share price were materially affected by weakness within academic markets, critics of the company have argued that this remains an area of concern for the company. However, this assumption fails to capture certain nuances within the academic market.

In late 2011, the issue facing Illumina, as well as a number of other life science companies was not one of actual funding levels per se. Rather, it was more about high levels of uncertainty related to future levels of academic funding. For academic customers, uncertainty over future funding may often be worse than a simple reduction in funding, for it makes it more difficult to initiate projects due to the possibility that funding may be exhausted halfway through, leaving those customers with neither finished work nor the funds to start other projects. Such uncertainty is not conducive to conducting academic research. Naturally, the issue of Illumina’s academic customers was brought up on the company’s earnings call. As in prior quarters, CEO Jay Flatley stated that for the time being, Illumina is not seeing signs of disruptions within its academic customer base. Flatley noted that the company is seeing that dollar (as well as euro) share is moving further towards sequencing research. We do not dispute the existence of challenges within the academic market, particularly in the United States, but believe that Flatley’s claim that Illumina is “mort than holding our own here” rings true, particularly in light of commentary from several of Illumina’s life science peers.

Both Sigma-Aldrich (SIAL) and Thermo Fisher reported their Q2 2013 results alongside Illumina, and both companies noted that domestic academic markets remained challenging during the quarter. Sigma-Aldrich CEO Rakesh Sachdev noted that although consolidated academic and government sales returned to year-over-year growth during the quarter, it was due to a recovery in Europe and Asia (he specifically noted strength in China as well as improvements in macroeconomic sentiment in Europe), domestic academic sales continue to remain weak, falling in the low single digits on a year-over-year basis, offsetting mid-single digit growth in Europe, and high-single digit growth in Asia. Thermo Fisher CEO Marc Casper noted that Thermo Fisher experienced similar dynamics during the second quarter, stating that although the company saw international growth in academic and government sales, domestic markets were pressured by sequestration, adversely affecting laboratory product and service sales. While Illumina does hold meaningful academic exposure, for the time being, the company’s sequencing business is shielding the company from the headwinds faced by its life science peers, and assuming that market dynamics do not worsen, we believe that Illumina will continue to see growth in academic sales, even as it continues its efforts to diversify its customer base.

Long-Term Projects, Long-Term Potential

Continued growth in Illumina’s core sequencing business is far from the only development that took place during the second quarter at Illumina. In conjunction with its earnings, the company announced the acquisition of Advanced Liquid Logic (also known as ALL) for $96 million. ALL is a spinoff of Duke University, in order to gain control of ALL’s digital microfluidics technology. This technology allows for the manipulation of droplets within a microfluidic cartridge via a precise array of electrodes in order to control both the size and position of each droplet. ALL’s technology is ideal for handling low sample volumes, a growing area of focus for Illumina. Given that ALL has around 100 issued patents, and nearly 200 pending patent applications, we suspect that the prime motivator for this deal, at least in the near-term, was to gain control of ALL’s intellectual property, with a long-term focus on integrating ALL’s technology into its sequencing systems. CEO Jay Flatley pledged that Illumina would continue to be an active acquirer, with a focus on small, tuck-in deals such as ALL that bring new technology to Illumina in order to maintain the company’s innovation track record.

Illumina is also continuing to expand Verinata’s addressable market. As of July 23, Verinata’s verify test is now available to 170 million covered lives within the United States, and on July 1, Illumina inked an agreement with Teva (TEVA) to commercialize the test in Israel, which covers an initial 25,000 lives, with more to come as the 5-year agreement progresses. Management noted that it has added Blue Cross Blue Shield to its list of payers, which already includes Aetna and UnitedHealth, and that 60 million lives are now contracted for verifi. Illumina is now in discussions with the FDA on how to design the necessary clinical trials to submit a pre-market approval application (also known as a PMA) for the NIPT market. PMA’s cover Class III medical devices that “support or sustain human life, are of substantial importance in preventing impairment of human health, or which present a potential, unreasonable risk of illness or injury.” We note that Verinata’s existing business is set to become accretive to EPS in 2014, and that the global NIPT market is estimated to be a $1 billion global opportunity. We expect further color on Verinata during the remainder of 2013 as the company continues to increase coverage of verifi and make progress in its discussions with the FDA.

Financials & Valuation: Can the Stock be Supported?

With shares of Illumina closing at an all-time high on the back of its Q2 earnings, critics of Illumina, who have admittedly been wrong about the company’s academic exposure, are likely to point to its valuation when arguing against the stock. And with shares trading at 48x estimated 2013 EPS, shares of Illumina do appear rich on the surface. However, when compared to its peers, Illumina’s valuation becomes much more reasonable, in light of its growth prospects, particularly when it comes to revenue growth. We acknowledge that when it comes to peer comparisons for Illumina, truly accurate comparisons are somewhat difficult to make. With Life Technologies set to be taken over by Thermo Fisher, and Complete Genomics taken over by BGI, Pacific Biosciences of California (PACB) is Illumina’s only remaining standalone competitor, and given that Pacific Biosciences is not yet profitable, P/E comparisons cannot be made. And although Illumina, with annual sales of well over $1 billion, is part of the top tier of life sciences companies, it is the only pure-genetics company within that list; peers such as Sigma-Aldrich and Thermo Fisher have much more diversified business lines. The table below compares Illumina to Pacific Biosciences, Thermo Fisher, Sigma-Aldrich, PerkinElmer (PKI), and Qiagen (QGEN); the latter four are all life science companies with over $1 billion in annual sales.

Illumina Peer Comparisons (in Thousands of $)




























































































































































Illumina Pacific Biosciences Thermo Fisher* Sigma-Aldrich PerkinElmer Qiagen
2012 Sales $1,148,516 $25,983 $12,509,900 $2,623,000 $2,141,454 $1,254,500
2012 EPS $1.59 ($1.69) $4.94 $3.85 $2.06 $1.08
2013 Sales $1,378,219 $27,230 $12,890,000 $2,700,000 $2,160,000 $1,300,000
2013 EPS $1.70 ($1.37) $5.34 $4.10 $2.04 $1.06
2014 Sales $1,510,000 $34,840 $13,420,000 $2,820,000 $2,280,000 $1,370,000
2014 EPS $1.99 ($1.18) $5.74 $4.40 $2.39 $1.15
2013 Revenue Growth +20% +4.8% +3.04% +2.94% +0.87% +3.63%
2013 EPS Growth +6.92% N/A +8.1% +6.49% -0.97% -1.85%
2014 Revenue Growth +9.56% +27.95% +4.11% +4.06% +5.56% +5.38%
2014 EPS Growth +17.06% N/A +7.49% +7.32% +17.16% +8.49%
2013 P/E 47.98x N/A 16.97x 20.25x 16.57x 19.58x
2014 P/E 40.99x N/A 15.79x 18.87x 14.14x 18.04x
Shares Outstanding 138,000,000 60,823,575 363,500,000 120,239,314 111,937,640 241,450,000
Closing Price, July 24 $81.57 $2.71 $90.61 $83.02 $33.80 $20.75
2013 P/S 8.17x 6.05x 2.56x 3.7x 1.75x 3.85x
2014 P/S 7.45x 4.73x 2.45x 3.54x 1.66x 3.66x

*Estimates are for Thermo Fisher’s current standalone business

While it is true that Illumina trades at a premium to its peers on both a P/E and P/S basis, we believe a premium is warranted. Illumina is set to grow revenue by double digits in 2013, amidst single-digit growth for its peers, and in 2014, revenue growth will once again outpace most of its peers. EPS growth will be near the top of its peer group, with PerkinElmer set to grow 10 basis points faster, aided by somewhat mild comparisons due to declining EPS in 2013. In addition to this, Illumina’s margins are among the highest in the life science industry at both the gross and operating level, something we believes also warrants a valuation premium. And as forward estimates rise in the days and weeks to come, Illumina’s forward multiples are likely to decline.

Conclusions

Even at all-time highs, shares of Illumina offer long-term upside. The company continues to execute, in both its core sequencing business and in making progress in diversifying its revenue base for the long run. Illumina continues to make move away from academic markets, and to date has shown resilience amidst uncertainty within the domestic academic market, something that cannot be said for many of the company’s peers. If the company’s Q2 results are any indication, Illumina should continue to capture the majority of the growing global sequencing market, generating meaningful revenue and EPS growth in the long run.

In connection with ILMN, PropThink has taken a long position.