One of the most pressing issues that the market faces today is what kind of impact the fiscal cliff will have on companies in the healthcare sector; the life science sector has been particularly impacted. These concerns have put pressure on the shares of many of those companies, but investors have been painting the sector with too broad a brush. One company in particular is posting solid growth and has proven itself to be resilient against weakness in all three geographic areas of concern for the markets: the United States, Europe, and China.
San Diego-based Illumina, Inc. (NASDAQ:ILMN) is one of the world’s leading genetic sequencing and testing companies, with just over $1 billion in revenues over the past 12 months. And although Illumina’s stock has dramatically outperformed the S&P 500 year to date, it is due in large part to the impact of Roche’s hostile takeover attempt early this year. Illumina’s shares remain well below their 2011 highs, even though the company’s fundamentals have never been better. Illumina’s Q3 2012 results are those of a company whose best days are ahead of it, and whose value the market is discounting. Unless otherwise noted, financial facts and management commentary will be sourced from either Illumina’s Q3 2012 earnings call or its Q3 2012 earnings release.
Overview
Illumina posted its Q3 2012 results after the markets closed on October 23. Its revenues of $285.874 million matched analyst estimates, and pro forma EPS of $0.41 beat estimates by 2 cents. Revenues grew by 21.39% year over year, and pro forma EPS grew by 86.37%. On a GAAP basis, Illumina’s EPS grew by just 46.67%. Illumina’s 2012 income statement has been filled with several extraordinary charges, which distort its GAAP earnings. Illumina’s move to new headquarters has resulted in the payment of double rent, as well as cease-use losses, and lease exit liabilities. In Q3 alone, the company had charges of 15 cents per share associated with relocating its headquarters. The company has said that these relocation charges are not expected to be material going forward. The second major driver of the discrepancy between GAAP and non-GAAP earnings are costs associated with fighting off Roche’s hostile takeover. This latest quarter included 3 cents of charges associated with the Swiss company’s tender offer, which are set to decline over the next several quarters.
Margins: Leading the Life Science Industry
As the table above shows, Illumina is the clear margin leader in the life science industry, at both the gross and operating level. Unlike its peers, Illumina has just two focus product areas: genetic sequencing and testing. Everything that the company does revolves around those areas, and Illumina’s decision to do so has paid off. Sequencing and genetics are the fastest growing areas of the diagnostics market. They grew at a 17% clip in 2011, and they are projected to be worth $25 billion within a decade, up from the $5.6 billion that they are worth today.
In Q3, Illumina’s gross margin came in at 70.5%, up from 68.9% in the third quarter of 2011. Though it declined sequentially (from 70.9%), it is because Illumina sold more sequencing systems in the quarter relative to consumables. Illumina’s Q3 operating margin came in at 35.1%, up from 29.3% a year ago, due to solid revenue growth and tight cost controls. SG&A expenses totaled 19.5% of revenue in Q3 compared to 22.2% a year ago. This allowed operating margins to expand, even though Illumina’s R&D spending rose by 12.49% as the company invested aggressively in its new sequencing systems. Illumina’s focus on a fast growing market, and its leadership position within that market, give it industry-leading margins, and they are expanding.
Competition: Beating its San Diego Neighbor
In sequencing, Illumina’s fiercest competitor is its neighbor Life Technologies (NASDAQ:LIFE), which is based in Carlsbad, just north of San Diego. Life, via its Ion Proton and Ion Torrent systems, has been making an aggressive push to compete with Illumina. And given that Life is almost 4 times as large as Illumina (based on sales), many investors assume that Life will surpass Illumina in the sequencing market. The results, however, tell a different story. Analysts pressed Illumina on its Q3 call about the effects of competition, and CEO Jay Flatley said:
Let’s take that [the high end sequencing market] first. Things are going really, really well with 2500 and the 2000 sales as we indicated in the script. We had very strong performance that exceeded our expectations in the high end of the market. And we essentially have no competition in that part of the market. In the desktop, I’d say, if anything, our competitive position has continued to improve there. The new launch of a competitive instrument into the field is, from any customer we’ve talked, to not performing to specifications. And so we’re not seeing our customers get distracted by that system. We’re seeing already some pretty heavy discount offers of that system into the marketplace. And our MiSeq product continues to perform really, really well. And we’re upgrading the output in the system, and the customers are continuing to get great data with BaseSpace enabled for storage and for data sharing. So all of the attributes, ease of use of our system continue to make it very, very competitive. And certainly, the output ranges that customers are achieving with this exceed the output ranges of any competitive systems in the desktop market.
Life Technologies is already discounting its sequencing systems to generate consumer demand, even though its systems are already priced lower than Illumina’s. Customers understand that Illumina’s systems have better quality and performance, and they are willing to pay a premium to take advantage of those factors. MiSeq launched 12 months later than Life’s desktop sequencing platforms, and despite a higher price, it already has 50% unit share (per CEO Jay Flatley), and a far higher revenue share. If Illumina can continue to execute as it has in Q3, those market share figures should continue to increase.
Geographic Results: Macroeconomic Weakness? Where?
Investors in the life sciences industry have been forced to deal with the twin worries of NIH funding cuts and macroeconomic stress in 3 key markets: Europe, China, and the United States. Illumina’s results, however, seem to show none of these stress points. In Q3, the company posted solid product shipment growth across all key geographies. Product shipments in the United States grew 19% in the quarter, accelerating from the 18% growth rate posted in Q2 2012. Shipments to Europe also grew 19% during the quarter, and shipments to China rose by 79%, up from a 50% growth rate posted during Q2 2012 (overall Asian shipments were up 21%). While Illumina did not disclose its Q2 European product shipment growth, it did note that its European business remains stable, and that shipments to Spain and Italy grew sequentially during the quarter. How many companies can claim not only sequential growth in Spain and Italy, but also 19% growth in Europe as a whole? Not many. Illumina is riding a secular growth story, one that has proven to be resilient to macroeconomic stress.
In China, Illumina, like most life science companies, is benefitting from the government’s push to expand healthcare access to the western part of the country. This is an integral part of the country’s current 5-year plan, and it will probably feature prominently in future 5-year plans as well. Expanded access to social services and general job security are part of the implicit social contract that exists between the Communist government and the people of China. The life science industry as a whole, in fact, confirms that China is a source of strength. PerkinElmer (NYSE:PKI), for example, is very upbeat about growth in China, as its leadership in the neo-natal testing market makes it the medical sector’s choice for expanding screening of pregnant women and newborns. Waters (NYSE:WAT) stated on its own Q3 2012 conference call, “General concerns that we have recently heard regarding a slowing of economic growth in China are not apparent in our third quarter results or in the outlook that we have in the fourth quarter.” And Thermo Fisher (NYSE:TMO) posted 20% growth in China in Q3. Companies that operate in both life sciences and industrials, such as Danaher (NYSE:DHR), or Sigma-Aldrich (NASDAQ:SIAL) do note weakness in China’s industrial sector, as does PerkinElmer (where industrials make up 7% of overall sales). But for “pure” life sciences companies such as Illumina, macroeconomic stress in China is nowhere to be found. In the United States, concerns about the fiscal cliff, and specifically the 8.2% cut to NIH funding that is part of the automatic spending cuts slated to go into effect in 2013, have pressured shares of life science companies for some time. Here, companies in the sector have reported different things, and it is due to differing product lines and areas of strength. Danaher, for example, has said that customers are slowing down ahead of the NIH’s cuts. Water has also said that demand in the United States was more constrained than the company anticipated during the latest quarter.
Illumina, however, appears immune to these macroeconomic pressures. Product shipments grew 19% during the quarter, a slight increase from the 18% growth rate posted in Q2, and on Illumina’s Q3 call, Flatley said, “We’ve seen no erratic customer behavior based on macro conditions whatsoever in the third quarter.” Illumina’s leading position in the genetics market is shielding it from macroeconomic stress, as researchers and healthcare professionals, both in the United States and around the world, turn to genetics to solve their healthcare challenges. Critics will point to the fact that 70% of Illumina’s end markets are academic, and that if NIH cuts do in fact go through as planned, Illumina will be impacted to a far larger degree than its peers. While it is true that Illumina is more dependent than peers on academic markets, its reliance is dropping, and that forms another pillar for the bullish thesis surrounding the company.
Diversifying the Customer Base
As of the end of Q3, 30% of Illumina’s revenue comes from non-academic, and non-government markets, and that number is increasing. More than half of Illumina’s MiSeq sequencing systems were sold to non-academic and non-government customers in Q3, and as orders for single systems turn into orders for multiple systems, Illumina’s non-academic and non-government revenues will begin to make up a greater and greater portion of the company’s overall revenue.
Illumina’s push into genetic testing, via its takeover of BlueGenome, will also serve to lessen its dependence on academic and government markets. BlueGenome allows Illumina access to the cytogenetic and developmental abnormality testing market. BlueGenome’s products are also used in in vitro fertilization clinics, a market that lies outside of academia and government. Illumina will likely provide more color about its pathway to further reducing reliance on academia and government when it reports fourth quarter results in late January.
Valuations & Takeover Prospects: Why the Two Are Linked
Illumina updated its full year 2012 guidance when it released its Q3 results, calling for pro forma EPS of $1.54-$1.59, which represents growth of 20.38% from fiscal 2011’s pro forma EPS of $1.30 at the midpoint of guidance. At the midpoint of guidance, Illumina trades at 30.63x fiscal 2012 earnings. The valuation may seem stretched, given that Illumina is set to grow at “just” 20% in 2012, but investors need to keep in mind that Illumina’s growth is artificially depressed. It is depressed not by a weak product portfolio or weak customer demand, but by Illumina’s size. Of the 6 companies mentioned above, Illumina is by far the smallest, and its primary competitor in sequencing, Life Technologies, is almost 4x larger (based on sales). Life simply has more resources to invest in a global sales force. At a recent Morgan Stanley life sciences conference, Illumina’s CEO stated that the company is, however, winning in the geographies it competes in.
But Illumina’s growth is stymied by its size. It simply does not have the proportions needed to invest in geographic expansion at the same rate as Life Technologies. That realization could bring back suitors, including Roche. Large healthcare players may be eyeing Illumina, considering the possibilites that a successful growth company could have with access to a much larger balance sheet. When Roche launched its hostile takeover of Illumina, it was motivated not only by the strength of Illumina’s growth prospects, but by the idea that Roche’s global reach would allow Illumina to expand even more under its umbrella. While Illumina shareholders rejected Roche’s offer, Flatley has openly stated that the company has no entrenched desire to stay independent, which implies that the board will accept an offer if it is at the right price. And if the board, for some reason chooses to reject an offer that shareholders find appealing, Illumina’s takeover defenses are no match for a well-prepared acquirer and shareholders that want a deal to go through. Illumina’s takeover defenses consist of both a poison pill and a staggered board, however, the company’s bylaws have a fatal loophole in them, one that Roche has already tried to exploit, and one that another suitor could exploit as well.
The provision that creates Illumina’s staggered board is written into its corporate charter, which requires the consent of both investors and the board if it is to be changed. However, the size of Illumina’s board is written into its bylaws, which can be changed with simple shareholder approval. A suitor needs to gather the support of two-thirds of Illumina’s investor base to amend the charter, and can then propose to expand the board until enough seats are filled with new directors. Thus, Illumina’s takeover defenses can be essentially nullified. This is merely a contingency plan, however. In the event that an acquirer has an offer on the table that two-thirds of the company’s investors approve of, it is unlikely that the board will choose to reject it.
Conclusions
Illumina’s best days are ahead of it, even if it remains an independent company. Its growth potential, however, is such that a suitor may feel compelled to step up to the table and make an offer that the company cannot refuse. Even though Illumina’s shares are up sharply in 2012, they are still well below their historical highs, despite the fact that Illumina’s prospects have never been better. If a large healthcare company, be it Roche or some other player, wants to participate in the growth of the sequencing and genetic diagnostics markets, there are few better ways to do so than by buying Illumina. But, they will need to strike quickly. Sooner or later, Illumina’s shares will revert back to and surpass their 2011 highs, making a takeover much more expensive. Illumina’s investors, however, win regardless of what happens. Either the company will be acquired at a decent premium (most analysts estimate that $70 per share is needed to sway Illumina’s board; shareholders may accept an offer in the $60’s), or it continues to execute its growth strategy as an independent company, both of which will deliver value for its investors in the long run.
