Takeover Speculation & Developments at Roche
Before delving into Illumina’s quarterly results, it is important that investors be aware of new developments regarding Roche’s (RHHBY) sequencing ambitions. Early in the sale process regarding Life Technologies (LIFE), which was bought by Thermo Fisher (TMO) on April 15, news reports indicated that Roche was preparing a bid for Life as well. It appears that Roche did not make a definitive offer, however, that did not mark the end of Roche’s interest. Sources close to the bidding process regarding Life have said that the company engaged in talks with Sigma-Aldrich to be a part of a complex 3-way deal that would involve Sigma-Aldrich bidding for all of Life (a feat in and of itself, given that Sigma-Aldrich is said to have bid $12.5 billion for Life, despite possessing a market capitalization of just over $9.2 billion, and less than 70% of Life’s annual sales), and then selling the Ion Torrent business to Roche in order to finance part of the cost of the deal. If these reports are accurate, it implies that Roche is likely still interested in securing a larger presence in the genetic sequencing market. Roche’s internal sequencing efforts have also faced several setbacks, and on April 23, the company announced that it is restructuring its Applied Science & Diagnostic divisions, and in the process, ending development on multiple sequencing projects. Roche has ended a partnership with DNA Electronics to develop a semiconductor-based sequencing system, citing an “inability to disrupt the market with the product at launch,” and ended a partnership with IBM to develop a nanopore-based sequencing platform “due to the high technical risks involved.” As part of this restructuring, Roche is laying off 170 employees in Germany and the United States.
While Roche has reaffirmed its commitment to sequencing (and the broader life science business) alongside this announcement, the company’s prospects for taking market share in sequencing have diminished, and from a practical standpoint, the only meaningful way to do so at the present is through a takeover of Illumina. With Life Technologies set to become a part of Thermo Fisher Scientific (TMO), Illumina is one of only 2 remaining publicly traded standalone genetic sequencing companies [the other being Pacific Biosciences of California (PACB)]. For companies that wish to gain exposure to genetic sequencing, the list of potential targets has narrowed considerably in the last few months.
With a market capitalization of over $28 billion, buying Thermo Fisher to gain exposure to Life’s sequencing business is impractical and expsensive, especially considering that on a combined basis, Life’s genetic analysis division (which houses the company’s Ion Torrent business) will account for less than 9% of total sales. And given its quasi-government status, it is unlikely that BGI Shenzhen (which has taken control of Complete Genomics) will become an acquisition target. While investors should not buy shares of Illumina based simply on takeover speculation, it’s important to note that Roche’s interest in expanding its sequencing business has not waned, and it will be harder to expand its existing business now that Roche has reduced its sequencing R&D. The pool of potential sequencing acquisition targets has shrunk, suggesting that if Roche wants to stay in the game, it may need to head back to the negotiating table with Illumina (read more here).
Framing the Financials
It is important to note that for the quarter, Illumina posted a GAAP loss of 18 cents per share, driven by a 76-cent charge related to the patent infringement verdict against the company in the Syntrix Biosystems lawsuit. However, Illumina has not yet paid these damages. The company incurred a legal contingency charge as it appeals the case, and no damages will be paid until the appeals process is complete. Although the jury in the case found Illumina guilty of infringing certain Syntrix patents, it is Illumina’s BeadChip products that were found to be infringing Syntrix patents, not the company’s HiSeq and MiSeq sequencing systems. Additionally, Judge Benjamin Settle dismissed from the case Syntrix’s claims that the infringement was willful and that Illumina misappropriated Syntrix trade secrets. However, even with the legal contingency charge, Illumina’s financial position remains strong. The company ended the quarter with nearly $1.07 billion in cash & investments, which accounts for the takeover of Verinata, and the company’s debt load stood at $861 million in debt (in the form of convertible notes), of which just under $38 million is due within the next year, with the remainder due in 2016.
In Q1, grew total revenue by 21.33% to reach a record $330.958 million, beating consensus estimates by over $20 million. Product revenue grew by 15.86%, and service revenue (which Illumina says will house its Verinata business), more than doubled, rising 103.03% to $34.788 million. Although Illumina did not disclose the exact run rate for Verinata, CFO Marc Stapley noted that Illumina’s Q1 results include 5 weeks of Verinata financials. Service revenue now comprises 10.51% if Illumina’s total revenues, up from 6.28% a year ago. In addition to growing its service business, Illumina has improved the profitability of the business as well. Service gross margin expanded to 56.48% in Q1 2013, versus 50.01% a year ago. Product gross margin also expanded year-over-year, rising to 69.62%, versus 68.65% a year ago (these are GAAP margins, for Illumina does not break down the allocation of non-GAAP adjustments between its segments). For Illumina as a whole, gross margins expanded by 20 basis points year-over-year to 69.2%, and expanded 70 basis points sequentially. Organic revenue grew by 18% in Q1 2013. Therefore, backing in an 18% growth rate to Illumina’s Q1 2012 results reveals that Verinata & BlueGnome contributed just over $9 million of revenue in the quarter (Verinata for only 5 weeks), and although Illumina did not disclose concrete details regarding Verinata, the company did note that testing volumes have either met or exceeded internal forecasts. Pro forma EPS rose 27.78% to $0.46, helped in part by a lower tax rate, beating consensus estimates of 39 cents. Illumina’s tax rate came in at 27.5% in Q1 2013, versus 31.2% excluding the impact of the R&D tax credit and other charges & credits Operating margins contracted, but that is not surprising. As we laid out in our last report on Illumina, the company has committed itself to increasing its investments in all aspects of its business: particularly R&D and sales force expansion. And in Q1 2013, these investments were well underway, with growth in both R&D and SG&A expenditures, both on an absolute basis as well as a percentage of revenue. On the company’s conference call, Illumina’s CFO Marc Stapley outlined that the company boosted hiring across multiple R&D departments, with a particular emphasis on bioinformatics & engineering. He also noted that key areas of focus within R&D include the company’s BaseSpace platform, updated sequencing platforms, and new initiatives to increase the integration capabilities of Illumina’s products. Although Illumina’s operating margins have fallen slightly, they are falling by design, for the company is making necessary investments in its business, investments that will drive meaningful profit growth in the years to come.
End Markets: Resiliency & Opportunity
Much of the bearish thesis regarding Illumina has centered on its exposure to the U.S. academic markets, as well as other academic markets around the world. 70% of the company’s revenue is derived from academic markets, with around 35% of total revenue coming from NIH-dependent customers. This is likely the primary cause for the fact that nearly 23% of Illumina’s float is sold short, despite the fact that the company continues to report stable demand within these academic markets. Once again, CEO Jay Flatley spoke at length about end market trends around the world, in a continuing effort to assuage concerns regarding Illumina’s exposure to global academic markets. Given that other life science companies such as Sigma-Aldrich (SIAL) have warned of softness within academic research markets, many investors assume that Illumina would also be affected. However, such an outcome has not occurred. On the company’s conference call, CEO Jay Flatley stated, “To date, we've not been impacted and our business remains robust. We continue to see significant interest in our platforms and ordering patterns from our academic and government customers are stable.” [Emphasis added] Illumina’s end markets are stable, and growth is continuing across the company’s different geographic markets. Shipments to the Americas grew by 28% in Q1, shipments to the Asia-Pacific region grew by 21%, and shipments to Europe grew by 16%, something that we believe highlights the resiliency of Illumina’s end markets. Within the United States, Illumina has been able to overcome the softness seen by other NIH-dependent companies. It is incorrect to see the NIH-funded research market as a homogenous entity, where each and every company rises and falls equally. Although it is true that the broader research market is facing headwinds, Illumina is not. Funding for sequencing-based grants has been growing at double digit rates for the past several years, and reached a 4-year high in 2012, according to CEO Jay Flatley. In addition, the company sees funding environments as stable in Europe, despite the macroeconomic pressures facing the continent, and the funding environment in Asia is said to be improving. However, as this most recent quarter once again demonstrated, Illumina’s long-term growth potential lies not in academic markets, but in growing commercial markets.
Q1 2013 continued the diversification trends seen in Q4 2012. 40% of all HiSeq orders placed in this quarter were to first time buyers, including an unnamed Japanese pharmaceutical company, as well as the Tohoku Genome Center, and in the company’s MiSeq business, Illumina reports continued expansion outside of the company’s core academic markets, with Britain’s Health Protection Agency placing a “multi-unit” order for MiSeq systems during Q1 2013. 25% of the HiSeq installed base has now upgraded to the HiSeq 2500; as a reminder, the company expects that up to 35% of the total installed base will upgrade. MiSeq unit orders continued to grow sequentially (when normalizing for an extraordinarily strong Q4 2012), and pricing remained stable. From a competitive standpoint, MiSeq continues to capture the majority of the market, with the system winning over 80% of head-to-head competitions.
On the company’s conference call, Flatley spoke at length about the opportunities that Illumina has within the pharmaceutical industry. The opportunity for Illumina lies not in the sale of traditional sequencing systems to pharmaceutical companies, but in outsourced sequencing, which is becoming a more meaningful part of Illumina’s business mix. Service revenue more than doubled in Q1 2013 (and gross margins expanded as well), and this division now makes up over 10% of Illumina’s total revenue. Flatley sees ample potential within this market, particularly in oncology. Illumina shipped over 4,000 genomes in Q1 2013, a 60% sequential increase, including one project of over 1,000 genomes. It is likely that as 2013 progresses, this division will become a more and more meaningful part of Illumina’s overall business, and we expect more color on the company’s Q2 2013 conference call. Companion diagnostics are another “emerging opportunity” for Illumina, and Flatley disclosed that the company is in talks with multiple global pharmaceutical companies regarding the creation of companion diagnostic programs.
Overall, Illumina’s business performed well this quarter, and the company’s revenue breakdown once again highlighted the long-term potential of the business model. Instrument revenue grew by only 11% in the quarter to $88 million, and comprised around 27% of revenue. Consumables revenue, however, grew by 19%, and comprised 62% of revenue, versus 63% sequentially and a year ago. CFO Marc Stapley noted that increasing customer utilization once again drove consumables revenue growth, with pull-through coming within the forecasted ranges that the company provided on its Q4 2012 conference call ($45,000-$50,000 for MiSeq, and $300,000-$350,000 for HiSeq). Illumina’s customers faced capacity constraints this quarter, a trend that manifested itself at both academic and translational customers, something that is being driven by continued demand for sequencing products and services, with an upward bias towards larger sequencing centers; many of these centers have, over the last several quarters, boosted their sequencing output to full capacity, according to Illumina.
Finally, Illumina provided incremental color on Verinata, and the market potential for NIPT (non-invasive prenatal testing). Aetna (AET) now covers Verinata’s verifi test, thereby allowing Aetna’s 20 million members to access it. Negotiations with other payers are ongoing, and we expect more color when Illumina reports Q2 2013 results. Illumina believes that the global NIPT market has the potential to reach $1 billion, particularly if it can break into selling IVD-based products directly to laboratories and hospitals. While investors should not view this as a near-term driver of earnings for Illumina (Verinata is set to become accretive to EPS in 2014, and the decree of accretion has yet to be determined), Verinata represents another source of revenue (and in the long run, earnings) diversification for Illumina, and early data points regarding the business are positive.
Critics of Illumina are likely to point to the fact that the company declined to raise full-year guidance alongside its Q1 2013 earnings release, and merely reiterated its existing guidance for 2013. For critics, the read-through is that business will be worse than expected through the remainder of 2013. And this issue arose on the company’s conference call, with analysts questioning why the company is not raising guidance in light of an above-consensus quarter. Flatley responded by stating that Illumina believes it is too early to provide a guidance update, and that in any case, updating guidance every quarter “defeats the purpose of trying to get the annualized guidance.” Illumina’s management team has a track record of attempting to discourage short-term thinking regarding its business, and on prior conference calls, has made a point of reminding analysts and investors to observe the company through an annual prism. That being said, Flatley left the door open for potential guidance revisions later in 2013, noting that the company will not update guidance “until we feel like we need to do that.” As part of its guidance modeling, Illumina interviews many of its customers as to how they are absorbing the impact of the sequester, and Flatley, in response to continued questions regarding the company’s customer base, stated that, from a guidance perspective, the company is currently feeling “neutral” with regards to the potential impacts of the sequester, reminding investors that Illumina’s existing guidance for 2013 incorporates potential impacts from the sequester. In our view, Illumina is exhibiting prudent conservatism with regard to its guidance, and on balance, it is better for the company to be more cautious than wildly optimistic.
As the company’s Q1 results demonstrate, Illumina’s standalone prospects are bright, and the company has shown that it is much more resilient in the face of broader academic market headwinds than many investors believe. With a strong financial position, and continuing investments in its business, Illumina is likely to maintain its leadership in the rapidly growing genetic sequencing market, and should deliver long-term profits to investors.
In connection with ILMN, PropThink has taken a long position.