Pricing Still A Long-Term Risk, But Illumina Continues To Build A Sequencing Fortress

By Stephen D. Simpson, CFA | August 15, 2013 AAA

Between the disruptions created by Thermo Fisher's (NYSE:TMO) acquisition of Life Technologies, Roche (Nasdaq:RHHBY) all but raising the white flag in sequencing, and Oxford Nanopore's ongoing commercialization challenges, Illumina (Nasdaq:ILMN) continues to build on its already considerable lead in the sequencing space. I do maintain my concerns about the company's ability to maintain pricing on a long-term basis, as well as reimbursement pressures in diagnostics, but it's hard to find much fault with a business that can be driven by ongoing sales of high-margin reagents and consumables.

No Slowdown Here
When Illumina reported results back in late July, it was another “more of the same” quarter of strong revenue growth. Reported revenue rose 23% (up 19% on an organic basis), as sequencing revenue was strong on 37% growth in system revenue and 26% growth in consumables (versus 17% overall growth in consumables).

Margins were a little mixed, but positive on balance and relative to expectations. Gross margin (GAAP) fell about four points from the year-ago period), while GAAP operating profits grew 40% (with two points of margin expansion). By the more commonly-used non-GAAP methodology, gross margin declined by about 130 basis points, while operating income rose by about 10%, as both R&D and SG&A spending accelerated ahead of revenue growth.

SEE: A Look At Corporate Profit Margins

AACC Points Out Some Concerns, But Also Ample Opportunities
I don't want to make a big deal out of the recent American Association for Clinical Chemistry (AACC) meeting, as it wasn't a highly significant meeting for Illumina. Still, I think there are at least a couple of interesting puts and takes.

First, money still matters to clinical customers. There appears to be growing interest in those systems that can “do it all”, but with relatively modest pricetags and equally modest footprints. On balance, that's good for Cepheid (Nasdaq:CPHD) and Becton Dickinson (NYSE:BDX) and not so good for Illumina, but I don't think there was ever any expectation that even benchtop sequencing was going to catch on with hospitals in a big way (as opposed to reference labs).

On the other hand, the potential utility of next-gen sequencing in diagnostics is getting more visible. There was a fair bit of attention at AACC on Bruker's (Nasdaq:BRKR) MALDI-TOF mass spec and its applicability in clinical microbiology, with next-gen sequencing (Illumina's MiSeq) used as a back-up for organisms not identified through mass spec. The Methodist Hospital System in Texas highlighted that results could be attained in one to four days (allowing for faster treatment) and savings of up to $20,000 per patient were realized. With those kinds of potential savings, it's not hard to justify the upfront capital costs, particularly when the average per-test costs are pretty low.

Going Beyond The Lab
Building on that theme to some extent, Illumina highlighted with its second quarter earnings that about 40% of its system shipments were to “applied” markets outside of its core academia-based research market. That means more systems are getting deployed into areas like clinical diagnostics and agriculture – the next market that is to drive Illumina's growth.

At the same time, Illumina continues to pretty much have its way in the market. Life Tech's Ion Torrent platform is a legitimate rival to Illumina, but there are almost certainly going to be disruptions tied to Thermo's acquisition of the company and it remains to be seen what sort of R&D commitment and/or internal returns Thermo will demand from the sequencing business. At the same time, while Oxford Nanopore remains a looming presence with what should be excellent technology, the company's challenges in bringing its technology to market highlight how difficult it is to compete here, not to mention the challenges that Oxford will likely face if they try to go into diagnostics as well.

The Bottom Line
With opportunities like Verifi and Moleculo still on the way and a potential multi-billion dollar addressable market in diagnostics, I understand why Illumina remains a favored life sciences growth stock. It certainly also doesn't hurt that Roche is presumed to still be waiting in the wings and willing to buy Illumina were a stumble to send the stock down again.

Between the strong share in sequencing, the growth opportunities in diagnostics, and the “Roche put”, these shares are, not surprisingly, pretty richly valued. If Illumina can continue to deliver results above expectations, growth investors won't care, but a quick look at a long-term chart should remind investors of the consequences if the company hits a slow patch with its growth plan.

Disclosure – At the time of writing, the author owned shares of Roche

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