By Ivan Deryugin
In the latter half of 2012, shares of Illumina (ILMN) saw increased volatility, owing to the twin combination of takeover speculation regarding Roche (RHHBY.OB), as well as concerns over the company's relationship with BGI, its largest customer. But in 2013, shares of Illumina are likely to see more stability, driven by continued investment in its product portfolio, a solid balance sheet, and the continued resiliency and growth of its customer base. Illumina's Q4 2012 earnings offer the company a solid base off of which to execute in 2013. In addition, a number of business aspects may pan out more favorably and quickly than expected, and perceived negatives (NIH spending cuts, academic customer base) may not affect the company as detrimentally as the bears anticipate.
Q4 Review: A Solid End to 2012
For the fourth quarter of 2012, Illumina posted pro forma EPS of $0.42, a 20% increase from Q4 2011. Revenues rose to $309.265 million, an increase of 23.67% driven by continued growth across all of Illumina's product lines. Illumina's pro forma operating margins slipped to 33.1% in Q4 2012, down from 35% a year ago, as Illumina ramped up investments in R&D, as well as its infrastructure to support future growth (more on that later). Gross margins fell in the quarter to 68.5%, down from 70.5% in the previous quarter and 70.2% a year ago. This decline was due to several factors. First Illumina experienced some non-recurring costs related to its extended warranty services. Second, the impact of inventory mix and variances in its manufacturing costs contributed to a decline in gross margin. And third, BlueGenome contributed to what CFO Marc Stapley called "margin dilution." However, he forecast a reversion to Illumina's historical gross margins, stating that the company is implementing protocols to better manage its inventory, as well as align its manufacturing capacity to better meet growing demand. Consumables revenue rose by 36% to $196 million in the quarter and now comprise 63% of total revenues, up from 57% a year ago. BlueGenome, Illumina's recently acquired cytogenetics screening company, contributed $7 million in revenues, exceeding Illumina's original expectations. And service revenues of $30.332 million rose by 54.17%. According to CFO Marc Stapley, service revenue growth was driven by increasing numbers of genomes analyzed for third party customers, as well as growth in maintenance contracts on Illumina's expanding installed base of sequencing systems. Illumina also stated that its contract with BGI is up for renewal in April, and that the company will be meeting with BGI to understand exactly what their intentions are regarding Complete Genomics and how they wish their relationship with Illumina to proceed.
Shielding Illumina from Macroeconomic Stress
One of the central bearish arguments surrounding Illumina is that the company's leadership position in genetic sequencing will not be enough to defend it against macroeconomic weakness, especially given that around 70% of the company's revenues are derived from academic markets. However, Illumina's performance in Q4 lends credence to the notion that the company can in fact overcome any macroeconomic pressure. On the company's conference call, CEO Jay Flatley spent a great deal of time on this issue. He laid out Illumina's performance in key geographic segments: product shipments in the Americas rose 20% in the quarter; shipments in Europe rose by 26%; and shipments in Asia rose 12%, including 30% growth in China. Of note is the fact that European shipment growth of 26% represents an acceleration from the 19% growth Illumina saw in Q3, suggesting that the company was able to overcome austerity measures on the continent. Illumina stated that its academic customers continued to display stable ordering patterns, despite continued uncertainty regarding funding for the NIH. CEO Jay Flatley believes that this is because an increasing number of NIH grants are being granted for research into genetic sequencing. Analysts pressed Illumina's executives on the call about what it is hearing from its academic customers, and CEO Jay Flatley stated: "our [academic] customers had very stable behavior, very stable ordering rates. And we're surprised, actually, how unaffected they seem to be by any of the macro conditions or the sequestration risk that still hangs out there. Obviously, we've been very pleased by that response." However, while Illumina's Q4 performance was strong across all geographies, the company is cognizant of the fact that its overweight exposure to academic markets does present risks, and the company has laid out a goal of having 50% of its revenue generated from non-academic customers within the next 5 years. And Illumina seems to be well on its way to achieving that goal. More than half of orders for its MiSeq sequencing systems are now from non-academic customers, and that percentage is likely to rise, both for MiSeq and HiSeq sequencing systems. In addition, Illumina's guidance offers the potential for upside should uncertainty over NIH funding be resolved. Under the existing sequestration framework, the NIH's budget is set to be reduced by 8.2%. However, there is bipartisan support for continued funding of NIH research grants, and resolutions passed in the House of Representatives have restored NIH funding to 2012 levels. Illumina's 2013 guidance of $1.55-$1.62 in pro forma EPS assumes a 2-4% cut in NIH funding. However, if NIH funding is restored to 2012 levels, there is room for guidance to be raised.
Cementing Illumina's Sequencing Leadership Position
Illumina's core sequencing revenue grew by 35% in Q4 2012, and revenue from sequencing consumables grew by 56%, driven by both higher utilization of Illumina's sequencing systems, as well as a larger installed base. Revenue from Illumina's sequencing systems grew by 6% year-over-year, with growth driven by MiSeq sales. Flatley stated that Illumina received over 300 MiSeq orders, and that its market share is well above 50%. In fact, Illumina received more MiSeq orders than it could fill. In addition, HiSeq is continuing to gain traction. Illumina launched the HiSeq 2500, its newest HiSeq sequencing system, in October, and expects that around 35% of its HiSeq installed base will upgrade to new models. On the company's conference call, Stapley said that Illumina is changing the way that it reports pull-through, a measure of how much consumables revenue is generated per sequencing system, due to wide variations from quarter to quarter, which are primarily driven by seasonality (for example, pull-through falls in summer months as many researchers go on vacation). He stated, "due to the fact that seasonality and the timing of budgeting cycles can cause significant quarterly fluctuations in the pull-through rate, going forward on a quarterly basis, we plan to give qualitative commentary comparing against our projected annualized pull-through levels."
For 2012, HiSeq pull through was $320,000, and $50,000 for MiSeq. For 2013, CFO Stapley expects pull through to range between $300,000-$350,000 for HiSeq systems, and between $45,000-$50,000 for MiSeq systems. Illumina's executives were pressured on the call as to why MiSeq pull-through guidance implies a drop at the midpoint, which is an issue for Illumina given the importance of consumables utilization in driving both revenue and operating margin growth. Stapley said that for MiSeq systems, $50,000 in pull-through is "a number we've always targeted." In any case, Illumina's MiSeq pull-through guidance is likely to be conservative. The product line is relatively new, and Illumina's historical data indicates that as its sequencing systems age, output rises on each system. Because the MiSeq launch is still in the early stages, there are many customers that are either developing relevant assays or determining how best to utilize their MiSeq systems. Stapley indicated that there is a possibility that as the company moves through 2013, its MiSeq pull-through has the potential to rise as the raw usage of its MiSeq systems increases. BaseSpace, Illumina's app ecosystem and data-sharing platform for its sequencing systems, is also gaining traction. Around 70% of Illumina's installed base is now connected to BaseSpace. Half of those customers are uploading and sharing their sequencing data, and almost all sequencing customers connected to BaseSpace are uploading health and quality information, allowing Illumina to monitor the quality of its installed base and diagnose problems much more rapidly than before.
For Illumina, 2013 will be a year of investment in its core sequencing business. Christian Henry, head of Illumina's genomics business, stated that what limited Illumina's ability to deliver MiSeq systems in Q4 2012 was not a lack of manufacturing capacity. Rather, it was a lack of raw materials, an issue that the company is rectifying by accelerating deliver of the raw materials needed to manufacture MiSeq sequencing systems. Furthermore, Illumina will be investing in its sales force and marketing this year. There have been multiple data points that show that in most head to head competitions against its competitors, namely, Life Technologies (LIFE), Illumina emerges victorious. However, its relative size (Illumina's sales are around a third of Life's) has caused Illumina to leave sales on the table. Flatley pledged to rectify this situation in 2013 and the years ahead, stating that the company will be expanding its sales force by over 50 employees to reach more customers and better compete against Life. But perhaps most important is Illumina's pledge to not only maintain its R&D spending, but increase it, with a particular focus on new chemistries. On a GAAP basis, Illumina spent 18.4% of revenue on R&D (15.4% on a non-GAAP basis) in its latest quarter; by contrast, Life Technologies spent 9.31% of revenue on R&D (Life does not break out non-GAAP R&D expense) in its most recent quarter (the company reported Q4 2012 earnings on February 4).
Illumina's technological leadership in sequencing is a direct result of its R&D spending. While Life has to spread its R&D out amongst a wide variety of product lines and business divisions, Illumina's R&D is concentrated on its sequencing business, and even its non-sequencing related business lines have clear ties to genetics.
Capturing New Business Opportunities
Even as Illumina cements its leadership in the sequence market, the company is branching out into new markets, further reducing its reliance on academic customers. Through several targeted acquisitions, such as BlueGenome and Verinata, Illumina is expanding into diagnostics. The $350 million takeover of Verinata (with up to $100 million in additional milestone payments through 2015) has put Illumina into the fetal chromosomal abnormality screening business, and Illumina has struck a distribution agreement with PerkinElmer (NYSE:PKI) to match Verinata's industry-leading test with PerkinElmer's well-established distribution network. At this point in time, Verinata's tests screen for three trisomies (13, 18, and 21), and several sexual chromosomal abnormalities (such as Turner's syndrome), and while Illumina did not state that Verinata would be expanding to other conditions, Stapley left the door open for such an expansion, stating that this is "something to focus on in the future." In addition to its core sales force expansion, Illumina is expanding its BlueGenome sales force as well, which was acquired during Q3 2012 for $88 million. As a reminder, BlueGenome is a U.K. based company that specializes in cytogenetics and preimplantation genetic testing, and its genetic screening business complements Verinata's. These two businesses are likely to continue to ramp up in 2013, and begin contributing to earnings in 2014. Verinata will dilute 2013 non-GAAP EPS by $0.20 before becoming accretive in 2013. BlueGenome is set to be neutral in terms of EPS accretion/dilution in 2013, and is forecast to also become accretive in 2014. Illumina is executing on a variety of fronts, and the company is using its leading position in sequencing to diversify into new genetic businesses, insulating itself from any unexpected weakness in sequencing, and leveraging its genetics expertise into a growing market; the addressable market for non-invasive pregnancy testing (Verinata's specialty) is estimated to be worth $600 million in the United States alone.
Financials, Estimates, and Valuation
Illumina continued to maintain an industry-leading balance sheet, ending Q4 with net cash of $507.831 million ($157.831 million when taking into account the pending closure of the Verinata deal). During Q4 2012, Illumina repurchased 496,000 shares for around $25 million, and has just over $165 million remaining on its buyback program. For 2013, Illumina is forecasting pro forma EPS of $1.55-$1.62 ($1.58 at the midpoint). While this does represent flat growth relative to 2012, it is important to note that this guidance incorporates the 20-cent impact from the Verinata deal; excluding the dilution from this deal would result in EPS growth of 11.95%. Illumina's 2013 earnings are further impacted by multiple investments that the company is making across all aspects of its business, including sales, manufacturing, and R&D, all critical investments designed to support future growth. The payoff of these investments is reflected in 2014 consensus estimates, which call for Illumina to post EPS of $1.98, representing growth of 25.32% relative to the midpoint of the company's 2013 guidance (2015 and 2016 estimates of $2.32 and $3.05 in EPS imply growth rates of 17.18% and 31.47%).
And, as Illumina's management team stated on the company's Q4 conference call, there is room for upside to these estimates if the uncertainty surrounding NIH funding is resolved (Illumina's guidance assumes a 2-4% reduction in NIH funding). Based on the company's closing price of $50.87 on January 30, Illumina trades at 32.17x estimated 2013 earnings, and 25.69x estimated 2014 earnings. While these are not levels that can be considered undervalued, there is room for upside to these estimates if Verinata and BlueGenome are more accretive than expected, and Illumina is able to reap the benefits of an expanded sales force faster than expected.
Illumina is solidifying its leading position in genetic sequencing; is diversifying away from academic markets; and is expanding into new genetic lines of business. The company is investing aggressively in all aspects of its business, and its robust financial position gives it the ability to maintain these levels of investment, or even expand them if the opportunity arises. In 2012, investors set aside Illumina's core business and instead focused on merger speculation, as well as the drama surrounding BGI and Complete Genomics. In 2013, however, investors can return to focusing on Illumina's core business, which is set for sustained growth in the years to come.
Disclosure: I am long ILMN.
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