I'll give Illumina (ILMN) management credit for at least one thing - in the wake of turning down Roche's (RHHBY.PK) buyout bid, they know they have to keep analysts and investors excited about the company's prospects, or the stock will suffer. Unfortunately, while Illumina's technology is largely first-rate, the expectations for this business still seem pretty aggressive.
A Great Quarter … Oh Wait, What?
There was a lot of hoopla when Illumina raised its guidance for this first quarter. Here's the problem - the raised estimate was only about 5% higher than the Street, and the reported revenue number of $273 million still represented a 3% year on year decline.
Instrument revenue fell 30%, but held up sequentially (FLAT), while consumables grew by double digits for both periods (up 17% annually and 20% sequentially). HiSeq pull-through improved nearly 10%, to almost $300,000 a year (in other words, a HiSeq machine in the field generates about $300,000 in annual consumables revenue).
All in all, sequencing is doing okay, while the microarrays business is seeing lower instrument sales and higher consumables/assay sales.
Gross margin fell on a GAAP basis by about 20bp, while rising almost a point on an adjusted basis. Operating income fell 29% year on year (GAAP), whereas adjusted numbers (which back out merger expenses, takeover defenses, etc.) show an 11% decline. On a sequential basis, adjusted operating income held steady.
Where Are The Signs Of Momentum?
There are a few things that seem to me to be missing if this was truly a strong quarter for Illumina. For starters, with such strong consumables sales why wasn't the gross margin better? Also, while that 1.1 book-to-bill looks and sounds nice, I'm willing to bet that there was a meaningful forward pull on consumables ahead of announced price increases.
I'm also concerned about some macro factors. Illumina management seems optimistic about government budgets, but I think there's still room for things to get worse. With roughly 80% of sales tied to academic and govt spending (which is often one in the same), that's a big worry. By comparison, Life Technologies (LIFE), Agilent (A), Waters (WAT), and Thermo Fisher (TMO) have much less at stake, while Pacific Biosciences (PACB) is almost completely dependent upon this category.
Another macro worry for me is the health and fate of the microarray business. This is still a pretty substantial part of Illumina's business, but interest in GWAS seems to be fading as the approach has yet to really garner a lot of clinically useful information.
Sequencing Good, But Whither Diagnostics?
My biggest concern regarding Illumina is whether the company can successfully migrate from being a top-notch provider of research tools to a dual-threat with a strong clinical/diagnostics business as well. Thus far, the company's attempts to enter diagnostics have been over-complicated, over-priced, and over-promoted.
Why does this matter? Well, Illumina already has about 60-70% sequencing share and I'm not sure they can push it much higher given the competition from Life Tech, Pac Bio, and Oxford Nanopore (in which Illumina holds a stake), to say nothing of the oft-rumored interest of IBM (IBM) and General Electric (GE) in sequencing. While Illumina has done a fantastic job in high-throughput and has answered Life Tech's challenge in desktop sequencing with the MiSeq, I just don't see this as a safe place to generate excess profits.
Diagnostics could be worth billions to Illumina, but the company has to build platforms that combine robust capabilities with reasonable costs and hands-on time. Consider the example of Cepheid (CPHD) - a small company that has established a leveragable presence in hospitals on the basis of a very elegantly designed platform. Moreso than anything else, this is where the Roche combination would have created the most value - what with Roche's capabilities in marketing/commercialization and assay/kit development.
The Bottom Line
Many sell-side analysts are treating Illumina's success in diagnostics as a fait accompli and forecasting accelerating revenue growth over the next few years. While I do believe that there are cogent reasons to think that academic/government sequencing spending can rebound in the coming years, I'm just not sold on Illumina's capabilities in the clinic.
Accordingly, while I do believe Illumina can deliver double-digit compound growth in free cash flow over the next decade, it's not enough to move the fair value much above today's price.
Disclosure: I am long RHHBY.PK.