The strong revenue growth and lucrative margins of Illumina's (ILMN) core sequencing business has attracted ample competition over the years. It's testament to the quality of Illumina's technology (both acquired and internally-developed), though that a lot of these competitive attempts have only served to highlight the attributes and advantages of the company's approach.
I certainly have my questions and doubts about Illumina. I do think the company was caught a little flat-footed by the success of Life Technologies' (LIFE) Ion Torrent products, and my talks with several people in academic/research labs do lead me to believe they rushed their high-throughput products to market (leading to some unhappy customers). Last and not least, I think that Street expectations for sequencing-driven clinical diagnostics could be ambitious. All of that said, though, it's hard not to acknowledge and appreciate the business that Illumina is building here.
In Tough Times, A Strong Quarter Means Even More
For all of the talk about sequestration and pressures on sequencing lab budgets, Illumina doesn't seem to be feeling much of a pinch. Revenue rose 21% this quarter (and 18% on an organic basis) to $331 million - about 7% higher than the average of the sell-side guesses. Growth was relatively balanced, as both instruments and consumables were up by double-digits. Sequencing continues to drive the business, with revenue up 32% (about 70% of the total), as instrument sales rose just 7%, but consumables rose 40%.
Because of charges and items tied to acquisitions and an adverse patent ruling, Illumina's margin performance was messed up this quarter. Making matters worse, it seems like no two analysts factored in these events the same way, so relative performance attribution is a little trickier.
In any case, adjusted gross margin improved slightly (20bp) from last year and seemed to come in line with most expectations. Non-GAAP operating income rose about 15%, and did appear to beat expectations. While the company is spending more on SG&A and R&D, that's not altogether surprising given the company's stated plans with respect to product launch support and development.
Demand Seems Solid, And Illumina's Rivals Could Be In Flux
Contrary to expectations that sequestration was going to hurt demand for big-ticket life sciences equipment, Illumina doesn't seem to be doing too badly. Although MiSeq orders were down sequentially, it sounds like that had at least something to do with an end-of-year rush that elevated the starting comp. Encouragingly, HiSeq orders have recovered, and management talked of clients seeing capacity constraints.
It may well be the case, then, that Illumina's sequencing equipment has become a priority item in what is otherwise a tough environment. To be sure, it's not as though life sciences companies like Thermo Fisher (TMO), Waters (WAT) or Life Tech are reporting torrid life sciences demand (outside of demand for Life Tech's sequencing products, that is). If that's the case, it would speak very encouragingly to where sequencing now sits within university/lab budgeting priorities.
While this is all going on outside the company, so too is a competitive rearrangement. As has been amply reported, Life Tech agreed to sell to Thermo Fisher. While Thermo has been saying the right things about wanting to keep and support Life Tech's sequencing business, you have to wonder whether there will be any disruptions (and/or if Thermo really wants to spend what it needs to spend to stay competitive in the next-gen sequencing market).
At the same time, Pacific Biosciences (PACB) has all but disappeared from the consciousness of many researchers (and investors), and we're all still waiting to see exactly what Oxford Nanopore can do. Roche (OTC:RHHBY), the one-time bidder for Illumina, just announced that it is dissolving its Applied Sciences Business group and ending two sequencing partnerships (returning a semiconductor-based approach to DNA Electronics and ending a nanopore-based development project with IBM (IBM)). While Roche is not abandoning sequencing - the company is creating a dedicated unit that will pursue both internal and external possibilities - it's hard to see how they'll be relevant again without a meaningful acquisition.
In brief review, then, Illumina has some of the best proven technology around, has the best market share in the group, and is seemingly the only real player that isn't seeing major turbulence right now. Even with my complaints about Illumina's past practices, it's hard to argue that this doesn't give them a window of time to really put some distance on the field.
The Bottom Line
With its willingness to support multiple product platforms (including sequencing, microarrays, and qPCR) and use acquisitions to gain testing technologies and distribution capabilities, my skepticism about Illumina's ability to become a real player in clinical diagnostics is waning. That said, I do believe investors should appreciate at least one potential risk - reimbursement for diagnostics is likely to come under more scrutiny and more pressure. Just as health insurance systems have realized they can't handle the full cost of supporting diabetes care (which has led to nasty reimbursement cuts in testing), I worry the same will be true here down the road.
In the meantime, this strong earnings report has sent Illumina to a new high. On the basis of my assumptions of low teens long-term revenue growth and mid-teens free cash flow growth, these shares aren't particularly cheap. Even so, I'm not going to tell anybody they need to rush to sell shares in a company that seems to have worked out a lot of its operational kinks and is extending its lead in an attractive, fast-growing market.