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I'll give Illumina (NASDAQ:ILMN) management credit for at least one thing - in the wake of turning down Roche's (OTCQX:RHHBY) 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 (NYSEARCA: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 (NASDAQ:LIFE), Agilent (NYSE:A), Waters (NYSE:WAT), and Thermo Fisher (NYSE:TMO) have much less at stake, while Pacific Biosciences (NASDAQ: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 (NYSE:IBM) and General Electric (NYSE: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 (NASDAQ: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.

Source: Illumina Tries To Get The Kool-Aid Flowing Again