Seeking Alpha
PropThink, PropThink (218 clicks)
Long/short equity, deep value, event-driven, research analyst
Profile| Send Message| ()  

By Ivan Deryugin

On the evening of March 14, Illumina (ILMN) announced that a federal jury found it guilty of infringing a patent held by Syntrix Biosystems relating to the company's BeadChip product line, fining Illumina $96 million based on a 6% royalty on all BeadChip sales between 2005 and September 2012 (Syntrix's lawsuit was filed in November 2010). While this a negative headline, the underlying facts of the case are not a material negative for the large sequencing company, and I believe that any meaningful pullback in shares of Illumina should be seen as a buying opportunity. This is supported by a several favorable developments within the genetic sequencing market.

First, a fine of $96 million does not present a material threat to Illumina's financial condition, given that the company ended 2012 with over $1.3 billion in cash and investments (the company has around $37 million in debt due in 2014, and around $800 million due in 2016). Second, Judge Benjamin Settle (of the U.S. District Court for the Western District of Washington) threw out Syntrix's claims that Illumina willfully infringed the patent in question (U.S. Patent Number 6,951,892) and "misappropriated" Syntrix's trade secrets (Illumina has said that it will appeal the ruling and continue to sell BeadChip products, and that no damages will be paid, if any are to be paid at all, until all appeals have been settled). Third, the length of the appeals process means that Illumina will likely have ample time to prepare itself for any negative outcome. Syntrix filed its suit in November 2010, and it has taken more than two years for the initial verdict to be reached. Shares of Illumina are down around 5% so far this year (driven in large part by Roche stating that a deal for Illumina is off the table), despite that fact that the company's key competitors have experienced multiple product delays.

AGBT 2013: Highlighting Illumina's Strengths

The annual Advances in Genome Biology and Technology (AGBT) conference was held in late February, and featured updates from all the leading genetic sequencing companies, including Illumina, Life Technologies (LIFE), Oxford Nanopore, and Pacific Biosciences (PACB). Illumina announced several notable R&D advances, including the ability of the HiSeq 2500 to sequence a human genome in under 24 hours in rapid-run mode. Illumina is also working on improving its read lengths, which some industry observers have seen as a key obstacle to further share gains. Using technology gained in the recent acquisition of Moleculo, Illumina demonstrated potential read lengths of over 10,000 base pairs (BP), more than 3x greater than the 2,900 bp read length of Pacific Biosciences' sequencing systems. Higher read lengths are critical in advancing metagenomic analysis, as well as the analysis of more complex genomes, including those of cancer cells and plants.

At AGBT 2013, Illumina laid out its case for sustained leadership in genetic sequencing, noting that 85% of the genetic data submitted to the National Center for Biotechnology Information is crated using MiSeq sequencing systems, and detailed a number of upgrades to both its MiSeq and HiSeq line of sequencing systems. On the MiSeq side, Illumina is rolling out upgrades (set to be available in the 2nd half of 2013) to boost read length to 2x300 bp, increase the number of reads, and is boosting total output to 15 GB (or 15 billion base pairs) in under 72 hours, up from 8.5 GB in 40 hours at the present. On the HiSeq side, new software and reagents have pushed total output to 300 GB in around 60 hours, at read lengths of 2x250 in rapid-run mode. While Illumina may not have unveiled any revolutionary products at AGBT 2013, the conference serve to highlight the company's core competency: A consistent ability to stay ahead of the competition through an unrelenting focus on incremental innovation and delivery of new applications and features to its customers. AGBT 2013 did more than just highlight continued progress at Illumina, however; it also demonstrated the continued stumbling and delays from the company's key competitors.

Life Technologies, arguably Illumina's largest and key competitor, provided updates on its own technology, the Ion Proton system, including its new Ion Proton PII system. Admittedly, Life has made a good deal of progress in resolving several issues relation to its sequencing franchise, namely the issue of homopolymer errors, which are a key issue when it comes to Life's semiconductor-based sequencing process (and Roche's sequencing technology as well). However, Life's Ion Proton PII system, seen by many as a meaningful competitor to Illumina, has been delayed. Life originally expected to launch the Ion Proton PII system in Q4 2012, but the system is now set to launch in mid-2013, and Life's much-touted $1,000 genome capabilities are likely to launch only in Q4 2013 or Q1 2014 (according to an analysis of Life's AGBT 2013 statements compiled by both UBS and Merrill Lynch). And Ion Proton now looks likely to break the 100 GB barrier only in the second half of 2014, or even early 2015, meaning that Life's ability to capture market share throughout the remainder of 2013 is set to be materially reduced, thereby giving Illumina several additional quarters of lead time to optimize its product portfolio and position itself to defend against Life.

Life Technologies is not the only company to see setbacks in its battle against Illumina. Oxford Nanopore, the British startup seen by many industry observers as a future meaningful competitor to Illumina (which owns 15% of the company), is also experiencing delays. Oxford Nanopore, which generated meaningful press coverage at AGBT 2012, was notably absent at AGBT 2013. While the company's management team was present, they provided no projections as to the commercial availability of their sequencing systems or updated data regarding the specifications of Oxford Nanopore's systems. However, the company's CTO Clive Brown did state that the company's systems will be delayed by about five months due to quality issues relating to one of the company's sensors. In addition, Oxford Nanopore is working to address issues regarding the accuracy of its sequencing systems, with a goal of lowering its error rate down to 1% from a current 4%.

Oxford Nanopore now promises to release early access data on its sequencing systems sometime during the course of 2013, as opposed to its prior forecast to begin selling its sequencing systems by the end of 2012. Illumina investors should not underestimate the potential implications of this. Within the broader life sciences sector, it is difficult for companies to gain meaningful market share once the majority of customers within a particular segment have established their laboratory and/or research routines around a particular company's product and service offerings (hence the above-average rate of M&A within the sector; the easiest way to gain market share is to acquire it). Every month that Oxford Nanopore is not selling its sequencing systems is another month that potential customers are turning to Illumina to meet their growing sequencing needs. The delays at Oxford Nanopore have had an effect on both the company's present and future valuation.

Buried within Illumina's Q4 2012 earnings is a $2.7 million impairment charge for "a cost-method investment," which is most likely a charge related to Illumina's 15% stake in the company. And analysts at London-based Numis Securities cut their estimates of Oxford Nanopore's future by 25% to $1.5 billion, citing risks related to the rollout of the company's nanopore sequencing technology. In simple terms, nanopore sequencing works by immersing a nanopore (in essence, a microscopic hole) in a conducting fluid and then passing a current through it. The resulting current is highly sensitive to changes in the structure of the nanopore, which can be altered when DNA passes through it. Researches can therefore detect which bases are passing through the nanopore based on how the nanopore reacts, thereby producing a genetic sequence. Illumina itself has already begun working on several different sequencing technologies, including nanopore sequencing, even as it continues to accelerate its investments in its SBS chemistry.

During the company's Q4 earnings call, CEO Jay Flatley stated that Illumina has begun to divert R&D funding towards nanopore research, due to the fact that its "partnership" with Oxford Nanopore has gone in "a different direction." Illumina, through the acquisition of Moleculo, is beginning to develop long-read sequencing technology as well. Moleculo's technology allows for read lengths of more than 10,000 bp, and Illumina noted that it saw a very positive response to Moleculo at JPMorgan's 2013 Healthcare Conference, as well as the 2013 Plant and Animal Genome meeting.

The delays at Life Technologies and Oxford Nanopore do more than give Illumina months of additional runway to update its own sequencing systems and make progress in developing new technologies. They also serve to highlight the company's technological lead in the sequencing market. Even as it works to maintain its lead in the market of today with its SBS chemistry, Illumina is meaningfully investing in other sequencing technologies in order to ensure that it remains the market leader. And with the sequencing market poised to grow at over 17% yearly through 2016 (when it will reach an estimated $6.6 billion in size), Illumina will capture a large portion of this growth.

Read more in our previous article and see why ILMN hasn't yet outgrown its prospects. In addition, you can read about Life Technologies' ongoing "buyout" possibilities.

Source: Genomics Conference Illustrates That Illumina Is Outpacing The Competition

Additional disclosure: PropThink is a team of editors, analysts, and writers. This article was written by Ivan Deryugin. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article. Use of PropThink’s research is at your own risk. You should do your own research and due diligence before making any investment decision with respect to securities covered herein.You should assume that as of the publication date of any report or letter, PropThink, LLC and persons or entities with whom it has relation ships (collectively referred to as "PropThink") has a position in all stocks (and/or options of the stock) covered herein that is consistent with the position set forth in our research report. Following publication of any report or letter, PropThink intends to continue transacting in the securities covered herein, and we may be long, short, or neutral at any time hereafter regardless of our initial recommendation. To the best of our knowledge and belief, all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable, and not from company insiders or persons who have a relationship with company insiders. Our full disclaimer is available at www.propthink.com/disclaimer.