Illumina: A Valuation From Outer Space?

| About: Illumina, Inc. (ILMN)

There's something about a high-flying stock with the type of technology that only a Martian could engineer that piques the interest of most investors. That's because these equities have a lot of growth behind them, and that is where the action is if you want to make money. Warren Buffett suggests to stay within your "circle of competence," which basically translates into, "invest in what you know" -- but that is difficult in the space-age world in which we live, where technology advances at the speed of light.

Illumina (NASDAQ:ILMN) is one of those stocks that seems to have invaded us from the outer limits. The maker of next-generation DNA sequencers has had a torrid advance in the last six years, rising from $2 in 2005 to its current price of $70. Illumina has always intrigued me and I've followed it closely for years, but have refrained from buying it because I've been of the bearish persuasion of late. Recent developments in the security have made me take a closer look at it -- and I still like what I see.

These developments are the facts that it's been downgraded twice in the last six weeks (which I like as a value investor because it tends to bring the price down) and Illumina's inclusion in the Investor's Business Daily top 50 stock picks, where it ranks 25. This seems like it could be conflicting information if you are a momentum investor -- but if momentum is what you want, momentum is what is has. Illumina's ranking has pegged the meters in the Investor's Business Daily evaluation process with relative price strength and earnings growth near 100 on a scale that can go no further. This company is a direct play on "personalized medicine," and I can see why investors are enamored with the stock.

Personalized medicine is a relatively new but rapidly-advancing field of healthcare that utilizes a patient's unique genomic, genetic and environmental information to determine what medication is best suited for him. It is already being used with some cancer patients to evaluate their likelihood of serious reactions to prescribed pharmaceuticals. Besides cancer, personalized medicine is also attempting to fight heart disease and diabetes. Other markets that Illumina is tapping for an expansion of business are forensics and agriculture, both in their infancy stages in regards to genomics.

What I find most impressive is that, in addition to its current client base of large laboratories, Illumina is launching a scaled-down but more affordable sequencer for smaller labs, which should be a boon for revenues. To complement the new sequencer, a beefed-up R&D budget has contributed to numerous new products coming to market. Citigroup Global Markets (NYSE:C) estimates that Illumina commands a 50-60% share of the key growth areas in the life sciences research market, while its closest competitor, Life Technology Corporation (NASDAQ:LIFE), has only a 20% slice.

I like my stocks inexpensive on a P/E basis, and Illumina gives me the heebie-jeebies where valuations are concerned. But you may be from a different school, so let's get some perspective, because this stock has legs -- for now.

At its current quotation of roughly $70/share, Illumina has a P/E Ratio of 51 for 2011 and 42 for 2012, based on the average earnings estimates of the 23 analysts who cover the stock as reported on Yahoo Finance. Those may seem high, but when you look at the PEG (price/earnings/growth) ratios, Illumina looks much more affordable. With a five-year CAGR at an impressive 27.5%, the 2011 PEG ratio is 1.8, while 2012's is 1.53. That's not out of the stratosphere, and if you use the rule of thumb to sell when the PEG ratio reaches 2, there's still room to run. So what's not to like about it?

If you are a value investor, what would seem to be a plus for a momentum investor is a negative for you; that negative is its inclusion in the Investor's Business Daily top 50 stock picks. Stocks on this list usually have a fairly short shelf life and come back down to lower price levels in the matter of a month or two, according to my casual observations. Sometimes they stay up there longer, but for a majority of stocks in the IBD 50, the party doesn't last very long. You may be able to pick up Illumina at a much more advantageous price in the not-too-distant future, especially if we get a market correction in the near term.

Another red flag for Illumina is what appears to be one of its big strengths: Its installed customer base. According to Citigroup Global Markets: "Roughly 72% of Illumina's revenues come from the academic and government end markets .... Because of its higher dependence on those markets, any large swings in government stimulus could have greater impact on Illumina relative to its peers."

In a Februray 25 ValueLine analysis, it reports: "... Management believes that funds made available to the National Institutes of Health through the American Recovery and Reinvestment Act of 2009 should continue to beef up orders until 2012." That only gives it 10 more months until Illumina's clients need more funding. If the GOP has its way, there may be some cutbacks -- and that would put pressure on the stock.

As a value investor, Illumina is out of my price range, but I am continuing to monitor it. With its lofty P/E Ratio, it could get whacked if it misses a quarter on either the sales or earnings side. I realize this is a tail event with low probability, but it's how I shop for good companies that get slightly ahead of themselves. That's how I bought Cisco (NASDAQ:CSCO), EMC and Oracle (NASDAQ:ORCL) back in the boom. If you are a momentum investor and a member of the Illumina fan club, then this would be a terrific stock to put in your portfolio ... if you are nimble enough to get out at the appropriate time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am short the market with leveraged ETFs.