We view Illumina (ILMN), the DNA sequencing instrument maker, as a top-pick in the healthcare space. The DNA sequencing market is expanding fast, from academic research labs to clinical physicians, and will benefit in 2014 from increased academic research spending following the 2013 spending cuts. Speculative appeal is also part of the story: the scarcity of sequencing assets has increased following several sector transactions, and Illumina is likely to keep attracting large pharma groups' attention.
Impressive results despite public spending cuts in 2013
Despite Sequestration and Government Shutdown concerns, Illumina continues to deliver at a strong pace as illustrated by its pre-announced Q4 performance, with revenues up 25% and 4% above consensus and EPS expected slightly above the $0.41-0.43 range. Additionally, the company provided an initial guidance for 2014 that includes revenue growth of 15-17%, above consensus +13%, and EPS of $2.00-2.06 vs. consensus $2.05.
In a tough year for public spending, the group relied on the private (non-academic) segment which is rising much faster than expected (c.45% of shipments vs 30% in 2012). This confirms that sequencing instruments are making a real impact in the clinical diagnostics arena.
An expanding market: from academic research to clinical diagnostics
Deciphering DNA sequences is essential for all branches of biological research (notably disease research and drug development), as it helps to understand the genetic triggers of diseases like cancer, predict risk and then diagnose and treat disease. Next-generation sequencing (NGS) allows researchers to ask virtually any question to the genome, transcriptome, and epigenome of any organism, for a much lower cost (from $8.9 million in July 2007 for a genome to less than $1,000 with NGS) and much shorter time frames (2 weeks).
Falling costs and rapid turnaround times have been increasing interest in the physician community for genome sequencing, as the results can now be obtained quickly enough to impact how physicians treat their patients. This is a significant growth driver for equipment makers, as the market is expanding from research labs to clinical physicians.
Mass adoption is coming for DNA sequencing, with the following applications: cancer research for individualized diagnostics and personalized drugs, DNA fingerprinting for identification of humans and animals, agriculture and livestock research for healthier crops and livestock…
Though it currently accounts for just $5.6bn of the $44bn diagnostics market, genetic testing is the most dynamic segment with 17% growth last year according to Koncept Analytics, and is expected to grow to $25bn within a decade, i.e. a 16% CAGR.
The ultimate, longer-term promise is personalized medicine: DNA sequencing is expected to make the realization of personalized medicine possible; i.e. targeted drugs with a genetic marker so that you know exactly if the drugs are going to work. This suggests that the market for sequencing instruments could expand well beyond the academic world and clinical physicians to large healthcare companies.
Academic research spending recovery to give a boost to Illumina in 2014
The spending momentum is likely to continue in the private sector, but we believe that the academic research spending recovery expected in 2014 will also help Illumina sustain its current growth trends.
Indeed, Sequestration looks like an old story, at least for Illumina. House and Senate budget negotiators have just unveiled an omnibus spending bill for 2014 in which National Institutes of Health (NIH), the nation's medical research agency which provides research grants (that are spent notably on sequencing products), would receive the biggest increase from FY 2013 spending levels, i.e. +4% to $29.9bn.
We are thus confident in the group revenue momentum, while the mix shift towards consumables (revenues up above 30%) is clearly supportive of margin expansion going forward.
An Illumina - Roche tie-up the next catalyst?
It's no secret that Illumina was on Roche's (OTCQX:RHHBY) M&A list, with the Swiss drugmaker trying to take control of the U.S. company 2 years ago. Despite the transaction failure (due to price considerations), the sector's speculative appeal has remained strong, with the takeover last year of Life (LIFE) by Thermo Fisher (TMO).
This transaction, and the acquisition of Complete Genomics by BGI Shenzhen, have dramatically changed the DNA sequencing competitive landscape as both Thermo Fisher and BGI are now extremely serious competitors for Illumina. At the same time, Roche, which has long been interested in DNA sequencing, has seen its already weak competitive position in sequencing weaken further.
In all, we believe that Roche could finally try to meet Illumina's price expectations if it does not want to be sidelined from the promising genetic diagnostics business as the scarcity of sequencing assets is increasing. Illumina could also make a step towards Roche, as the competitive landscape is becoming more tricky with 2 major competitors emerging.
In conclusion, we are buyers of Illumina, for long-term fundamentals and M&A appeal.