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Investment Thesis
Illumina, Inc. (NASDAQ:ILMN) shares gained traction yesterday (Wednesday, Sept. 28) along with the market, rising 7.5% on above-average volume to $201 (the highest since the Fed’s rate hike decision last week). Still, shares are down 47% year-to-date (“YTD”), underperforming the broader index, falling to mirror the rising prospects of a recession.
On the surface, Illumina’s ticker movement might seem irrational, given its exposure to defensive sectors like health care and its high revenue stability derived from its ink-and-cartilage business model. But a closer look at the company’s fundamentals paints a different picture. Beyond valuation multiples contraction (mirroring changes in financial models, capital costs, currency, and all economic factors outside ILMN’s control), rising interest rates directly affect the company’s customers.
As you probably know, one of the significant drivers of ILMN’s financial performance is the growth in the molecular diagnostics market. However, the rising cost of capital affects its clientele, many of which are growth-oriented businesses that now face pressures to turn to profitability as the cost of money increases. One also can’t ignore the impact of borrowing costs on general economic activity, including lab expansion decisions. We’ll dive into details in the next section, but the main conclusion is that the decline in ILMN’s stock is justified. Although the ticker might offer an opportunity as spreads narrow, rising interest rates directly impact the company’s revenue in ways unique to its business model, as discussed in more detail below.
Revenue Trends
One of the advantages of ILMN’s business model is that the company gets most of its revenue from consumables rather than from equipment. This removes the risk of obsolescence associated with older-generation technologies by smoothing out revenue predictability. Its gene sequencers are one of the most widely used in the industry and are a key component of any lab performing genetic tests.
Clinical genetic diagnostics is a key area of growth for ILMN. A rising number of medical associations are beginning to recommend universal genetic screening for different diseases as more data emerge linking gene testing to health status. Establishing reimbursement pathways for laboratory testing can be a daunting task for healthcare providers and a major challenge for ILMN’s customers, including Invitae (NASDAQ:NVTA), Myriad Genetics (NASDAQ:MYGN), EXACT Sciences (NASDAQ:EXAS) and Natera (NASDAQ:NTRA). Insurance is critical to ILMN’s clinical lab customers, who have been pushing public and private payors to expand coverage to new Laboratory Developed Tests “LDT” for the better half of the past decade. This sentiment was captured during NTRA Q1 earnings call by an Analyst asking:
Can you give us a refresher around how long it takes to earn coverage under an umbrella LCD and what that implies or how quickly you can start getting paid and from the new indications in oncology and transplant pursue? Stephanie Yan, Cowen
The clinical gene testing industry has been engaged in pricing wars since the U.S. Supreme court made DNA non-patentable, a ruling that resulted in an explosion of competition and lower test prices. Since the 2013 ruling, almost all gene testing companies have been unprofitable, spending heavily on R&D to establish reimbursement pathways for highly unpatentable laboratory-developed tests “LDT” to expand their product portfolios and build biobanks that, in return, allow the establishment of scientific research to further push on the reimbursement agenda.
For many years, ILMN profited from this growth-focused strategy. However, as the era of free money ends, the gene testing sector is facing renewed pressures to achieve profitability. ILMN alluded to these dynamics during its latest earnings call
Some customers experienced supply chain pressures that delayed their lab expansions and others manage inventory and capital more conservatively. Francis deSouza, ILMN CEO, Q2 2022 Earnings Call.
I don’t disagree over the long-term prospects of ILMN, which form the basis of growth-focused funds such as Softbank and Ark Invest, who have significant positions in the gene testing market, namely NVTA (which, in my view, lags behind its peers in many ways). Still, one should be mindful of the challenges of the industry that impact ILMN’s growth prospects, not to mention their direct impact on Grail.
Illumina Valuation
When valuing a company, it’s essential to start with a bottom-up approach by estimating its underlying intrinsic value and then adding on the value of its potential future growth opportunities to come up with a final total. ILMN’s share price mirrors investors’ aggregate view of the ticker’s fair value, incorporating expectations based on various factors, including analyst forecasts, earnings estimates, future growth opportunities, etc… However, this aggregate view of valuation almost always differs from yours or mine.
To help put this into context, one could ask themselves if they had $30 billion (ILMN’s market cap at the time of this writing) to invest in return of $630 million annually (ILMN’s FWD net income,) which translates to 2.1% earnings yield, would they invest in the company or buy a risk-free, 2-year treasury bond currently yielding 4.3%?
How did the market come up with ILMN’s extensive valuation? Growth appears to be a fundamental part of ILMN’s value proposition in the eyes of its shareholders, mostly institutional investors. However, while the gene revolution has brought abrupt and disruptive technologies to the hands of scientists, inefficiencies and frictions in the US healthcare market have hindered the adoption of many of these new technologies, as discussed above. For example, despite the clinical necessity of gene testing for patients with neuro-developmental disorders, only a fraction undergo such tests. Thus, ILMN’s revenue tailwinds from the gene revolution will likely be moderate at best until these deficiencies are addressed through incentives and mandates for earlier detection of developmental disorders. This is mirrored in the company’s slowing revenue growth in recent quarters.
Recent Developments
One might ask, what is on the minds of ILMN’s management these days? Well, the developments in the gene testing industry are one thing, as mirrored in the CEO’s comments during the latest earnings call. Challenges facing the Grail acquisition are also a factor. However, I believe that the value and importance of the deal have been put out of proportion, given the challenges facing the industry. I believe that management found in Grail an opportunity to meet the expectations of its growth-hungry shareholders. However, given the market dynamics and historical figures of the industry, this growth would have been mostly unprofitable, as mentioned in previous articles found here and here.
Management is currently hosting the inaugural Illumina Genomics Forum in San Diego, and it is shaping up to be one of the most exciting in the industry, featuring a speakers panel that includes names such as Barak Obama, Bill Gates, and Anne Wojcicki, the co-founder of 23andme. For four days, starting Wednesday, 28 September, ILMN management will host the event, allowing participants to discuss topics surrounding recent developments in the world of genomic technology with key opinion leaders in the space. As mentioned in a previous article discussing Bionano’s (BNGO) efforts to introduce a new gene imaging device, change in the healthcare sector can be difficult, given the herd mentality in the sector, characterized by an elite group of opinion leaders shaping standards of care. I believe that events like the Illumina Genomics Forum are an opportunity for the company to influence the industry to adopt gene testing as a primary care tool. The topics to be discussed resonate with the former president, whose landmark Affordable Care Act set a new direction for healthcare towards preventive care, including preventive screening. Here is a quote from the insurance exchange website:
Most health plans must cover a set of preventive services — like shots and screening tests — at no cost to you. This includes plans available through the Health Insurance Marketplace®.
Before we conclude our analysis, a quick note on ILMN’s China production facility is due. China-based BGI Genomics (SHE: 300676) emerged as a formidable competitor to ILMN, representing a threat to the company’s international operations, contributing to more than half of its revenues. Earlier this year, a U.S. court ordered ILMN to pay BGI $350 million for patent infringement, demonstrating the latter’s technological position.
I believe it was a strategic necessity for ILMN to enhance its China footprint with the first production facility in Shanghai. The facility now produces 16 reagents, with plans to expand production lines to include all ILMN’s instrument and consumables products within the next five years.
Summary
In summary, I am not confident that ILMN will be able to maintain growth at its current rate in the face of disruptions in its end markets, namely gene testing, and to a lesser extent, rising competition from the likes of BGI and Pacific Bio (PACB). The ticker will likely demonstrate high volatility (in both directions) as its institutional investors adjust their financial models as the Fed continues tuning its monetary policy with inflation data. I believe the Grail acquisition was meant to invigorate revenue growth but remain skeptical over profitability given the commodity-like nature of gene testing and the intense competition, combined with aggressive pricing policies to build biobanks.
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