Even if a company successfully fends off a hostile takeover attempt, it rarely marks the end of takeover speculation. That is especially true when the CEO of the company makes clear that there is a price that would be acceptable to the board. Illumina (ILMN) is currently in just such a situation, and just months after fending off Roche (OTCQX:RHHBY), the company may very well be back in play. Improving fundamentals, a solid financial position (on a standalone basis and relative to life science peers), and a discounted stock price are all factors that may make Illumina too tempting to resist for a larger healthcare company.
In this article, we will discuss these 3 points, Illumina's takeover defenses, and why we believe that Illumina may be a takeover target. For the record, unless otherwise noted, financial statistics and management commentary are sourced from Illumina's Q2 2012 earnings release, its Q2 earnings call, or its latest 10-Q filing. Financial data for Illumina's peers will be sourced from their respective 10-Q's, unless otherwise noted.
CEO's Comments: After All, Everyone Has a Price
Illumina did not fend off Roche's takeover because of a desire to remain independent. Rather, the takeover attempt, which ended with a $51 per share final offer, was all about price. This was the prevailing view at the time, and it was a view that was confirmed by Illumina CEO in an interview with Bloomberg, published last week. In that interview, CEO Jay Flatley stated that,
we [Illumina] never took an entrenched position that we wanted to be independent, it really came down to the pricing of the transaction. Had that bid risen into a range where we thought it was the right deal for our shareholders, then we would have supported the deal. But we never got into that range.
It is important to read that statement closely. Flatley is saying that the problem with Roche's bid was simply the price, not that Roche wanted to take control. This assumption can be extrapolated to assume that had Roche upped to offer, to something in the $60-$70 range, Illumina would have likely agreed to a deal. In addition, Flatley said that, "at no time during the process were we able [to] as board directors to debate what price we would take. Because the offer became public, we were very limited what we could discuss internally, because we had to disclose almost everything that we talked about." Disclosure requirements hampered Illumina's ability to debate internally what price was needed for a deal. With Roche now out of the picture (at least for the moment), there is nothing stopping Illumina's board from discussing what price is needed for them to approve a deal.
If earlier in the year, during the Roche bid, Illumina had a price that it would agree to, it makes sense that Illumina still has a price that it would agree to today. And aside from a poison pill (which is a board-level tactic, one that we will discuss later), Illumina's management team does not have any real ability to block a takeover. There is no dual-class stock structure, nor does the management team own a large piece of the company. The board is free to explore offers if they come in the door.
Taking Stock of the Stockholders: Support Exists for a Deal
Illumina's stock price, as well as its investor base further bolsters its takeover prospects.
(click to enlarge)While Illumina has outperformed the S&P 500 over the past 5 years, its stock price is still far below its 2011 high of $76.12 (the stock closed at $48.48 on September 21), and it is still below where it traded during Roche's hostile takeover attempt. That makes the total premium necessary to sway the board (or shareholders) smaller than it otherwise would be. Even if Illumina was trading at over $70 a year ago, offering $70 today, when the stock is trading below $50, would be an offer many shareholders would find too tempting to resist. A $70 per share price tag would represent a 44.389% premium to Illumina's September 21 closing price. Not many shareholders would be willing to give up a 44%+ premium for the opportunity to realize such gains years down the line.
Illumina's investor base is also rather concentrated, amplifying the company's susceptibility to a takeover. Capital Research and Baillie Gifford own over a quarter of the company, and Morgan Stanley owns 9.83%. Together, these 3 investors own 34.91% of Illumina, giving them a powerful voice in any takeover talks. Sources close to Baillie Gifford said that the company opposed Roche's offer on the grounds that it was too low, and that the company was open to supporting a deal at the right price. Sources close to Baillie Gifford have also told Reuters that most of the company's Illumina stake was bought in the $60's, and that the company would support an offer in that range.
As an investment bank, Morgan Stanley will almost always do whatever it can to make profits today (whether or not that is the proper approach is beyond the scope of this article). And given the fact that it owns nearly 10% of Illumina, Morgan Stanley cannot be overlooked in analyzing Illumina's takeover prospects. The firm will most likely support any deal with a large enough premium. Illumina's 7 largest investors together control 51.58% of the company, and any suitor would simply have to persuade these 7 in order to gain control.
Poison Pills & Takeover Defenses: Exploiting Loopholes
Illumina adopted a poison pill during Roche's hostile takeover attempt, and it remains in effect today. Under the terms of the plan, if any stockholder acquires more than 15% of Illumina's outstanding shares, the company can distribute rights to all other investors to purchase shares at 50% of the market price. That, and the fact that Illumina has a staggered board, makes a hostile deal difficult to pursue. However, there is a loophole in Illumina's corporate structure that mitigates the staggered board issue. In most cases, staggered board provisions are written into corporate charters, and changing a charter requires the consent of both the board and a majority of shareholders.
And Illumina's staggered board is indeed written into its charter. But, the number of directors that Illumina will have is written into its by-laws, which can be changed without the consent of the board. An integral part of Roche's takeover prospects was to not only install its own directors into the slots up for re-election in 2012, but to also expand the size of Illumina's board, and take control of those seats as well.
Illumina has made a hostile deal tougher to push through, but it is not impossible. A suitor would simply need to gather a majority of Illumina's investors to its size, and do what Roche planned to do, albeit with a higher offer. However, we believe that any offer at or around $70 would be a friendly deal. If we accept that fact that Illumina's board has a price, then a price around $70 would make sense, negating the need to pursue a hostile takeover ($70 is the price most analysts say is needed to sway Illumina's board).
Arriving at $70: Can it be done? Who are the Potential Suitors?
Another question that still needs to be answered is whether or not a $70 bid for Illumina is doable. Based on a calculation of Illumina's enterprise value, we believe that it is doable.
Illumina Enterprise Value
|Equity ($70 * 122,989,010 Outstanding Shares)||+$8,609,230,700|
In total, a takeover of Illumina would be valued at just over $8.1 billion, assuming a bid of $70 per share. In our view, such a deal is doable, and we break down Illumina's EV/EBITDA ratios for the next 3 years, using data from UBS.
While these represent premium EV/EBITDA ratios, we believe that Illumina deserves a premium valuation (even if 33% of its customers are exposed to NIH cuts; more on that later), and note that Illumina may very well agree to an offer below $70, which would push the EV/EBITDA ratio lower. Illumina deserves a premium for several reasons, which we outline below.
1. A solid balance sheet, with net cash and actual assets: The non-stop pace of M&A in the life science industry is to be expected. It is an industry that lends itself to M&A, for scale gives most companies an advantage. And yet, that comes at a cost, for it has weakened many balance sheets across the sector, filling them with both debt and goodwill. Of the 6 main pure-play life sciences companies [which we define as Illumina, Life (LIFE), Thermo Fisher (TMO), Sigma-Aldrich (SIAL), Waters (WAT), and PerkinElmer (PKI)], only Illumina and Waters have net cash on their balance sheets.
Cash, Equivalents, and Investments
Net Cash (Debt)
Net Cash (Debt) per Share
Net Cash (Debt) as a % of Share Price
Goodwill as a % of Total Assets
The continuous M&A in this sector has piled on billions in debt onto the balance sheets of most companies, and inflated their assets with goodwill. Life Technologies, for example has over half of its assets in the form of goodwill. PerkinElmer has almost 55% of assets in goodwill, and Thermo Fisher is nearing 50%. Most companies in the sector also have net debt. Illumina and Waters are the exceptions, with cash making up over 8% of Illumina's current market capitalization, the highest ration in the industry (based on the company's September 21 closing price). Illumina also has a balance sheet that is comprised of actual assets, as opposed to goodwill, with goodwill making up just under 14% of total assets (only Waters has a lower ratio). While it is true that goodwill does not simply vanish overnight, it is important to remember that it is an intangible asset, and in general, a balance sheet stuffed with goodwill is weaker than one without, especially when the goodwill-inflated balance sheet also has net debt.
2. Industry-leading operating margins:
On a GAAP basis, Illumina's 15% operating margin is nothing special. But, it is important to remember that over the past year, Illumina's GAAP expenses have been dramatically inflated, due in large part to costs associated with fending off Roche's hostile takeover. In addition, Illumina has incurred large expenses related to relocating its San Diego headquarters to a new building, expenses that are ending soon.
TTM GAAP Operating Income
TTM GAAP Operating Margin
TTM Non-GAAP Operating Income
TTM Non-GAAP Operating Margin
On a non-GAAP basis, Illumina's 34.1907% operating margin bests the next 2 companies, Life and Waters, by nearly 5 percentage points, and we believe that as Illumina continues its roll-out of new sequencing machines, that margin will rise.
On the company's Q2 2012 conference call, management reaffirmed its 2012 revenue guidance and raised its 2012 EPS guidance to $1.50-$1.60, up from $1.40-$1.50. At the midpoint of new guidance, Illumina is trading at 31.277x 2012 EPS as of this writing, and at 45.161x 2012 EPS based on a $70 per share offer. While that may seem like a steep valuation, it is important to remember that were Illumina part of a larger organization, the company could expand faster into new markets.
During a recent Morgan Stanley investor conference, Illumina's CEO stated that the company is winning in the sequencing market in the geographies where it is competing, and that a relatively smaller international footprint is causing Illumina to leave revenue and profits on the table. Geographic expansion becomes more doable if Illumina is part of a larger company, a fact that investors should not forget.
With all this in mind, who are the potential suitors for Illumina? For starters, Roche is likely still interested. Historically, Roche has had success when it comes to hostile deals (Genentech and Ventana are just a few example). Losing the Illumina bid may cause Roche management to try again, if for no other reason than pride. But, there are other suitors as well. Deutsche Bank names Siemens (SI) and Johnson & Johnson (JNJ) as potential buyers, given the fact that they have business lines that are complementary to Illumina's. Abbot Labs (ABT), Phillips, and Becton, Dickinson (BDX) have also been named as potential suitors.
However, Johnson & Johnson and Abbot are unlikely to jump in right away. Johnson & Johnson is currently digesting its $19.7 billion takeover of Synthes, and Abbot is in the process of splitting itself apart, and is unlikely to make any large corporate moves until the process is complete. However, we believe that these 2 companies remain potential buyers, given the growth potential of the sequencing market, and Illumina's other growth channels, such as Down Syndrome testing.
What About Standalone Prospects?
We own shares of Illumina, due to our belief in the company's strong takeover prospects. That being said, that alone is not enough to own a company's stock. The fundamentals must be there as well. And with Illumina, we believe that they are.
Illumina's non-GAAP operating margin expanded to a record 36.7% in Q2 2012, due to continued improvements in gross margins as well as cost discipline. Illumina's CEO and CFO were upbeat on the call, and they do not see the fiscal cliff as being a long-term drag on business. They note that the NIH has strong bipartisan support, and CEO Flatley stated that,
while there's no clarity on sequestration and the NIH budget for 2013 remains uncertain, we continue to believe that the worst case 8% funding reduction is an unlikely scenario. The Obama administration has proposed a flat NIH budget for 2013, while last month, the Senate Appropriations Committee approved $100 million increase to the NIH budget for next year. More recently, the House Committee on Appropriations released their fiscal year 2013 Labor, Health and Human Services Funding Bill, which proposed roughly flat NIH funding year-over-year. While these are all positive indicators, we don't expect any budget clarity until a few months after the election. We also believe that our U.S. academic customers are better prepared than last year for budget challenges and are planning accordingly. In light of that, it's our view that the overall funding dynamics this year are considerably more favorable than last year, and we've considered a range of potential budget outcomes in formulating our annual guidance.
Illumina's guidance may prove to be conservative, if planned NIH funding cuts are reversed. Illumina's revenues are also becoming more recurring in nature. In Q1 2012, consumables revenue exceeded instrument revenue for the first time, and that trend continued in Q2 2012. The more revenue comes from consumables, the more visibility Illumina has. Furthermore, Illumina is also reducing its reliance on academic markets, with a continued "evolution" towards more applied, clinical, and commercial markets.
Shipments within the United States rose 18% this quarter. Canadian shipments rose 15%, and Brazilian shipments grew over 100%, making Brazil a top 12 market for the first time (keeping in mind that Illumina's first Brazilian office was opened in Q1 2011). Europe is also not much of an issue, and Illumina has said that business remains stable. Interestingly, shipments to both Spain and Italy rose sequentially in Q2 2012. Given the obsession that analysts have with regards to the fiscal cliff, multiple analysts pressured Illumina's management on what it is seeing in terms of customer behavior.
CEO Jay Flatley stated that he talks with Illumina's VP of sales every week so that he can process any early warning signs of changing behavior, and that the company simply isn't seeing anything worrisome at this point in time. While that may change as the year progresses, we feel that fiscal cliff worries have been priced in at this point (Illumina has underperformed the S&P 500 over the past year, rising just over 16%, compared to a rally of over 28% for the S&P 500). We view funding-related drops as long-term buying opportunities, for we believe that Illumina's best days are ahead of it.
In our view, the comments made by Illumina's CEO make it clear that the company has a price at which it will agree to a deal. When that is combined with a discounted stock price (relative to historical prices), an investor base that has telegraphed that it supports a deal at a right price, improving fundamentals, and loopholes in takeover defenses, we believe that Illumina may very well be in play. We see several companies as ready to step in and make an offer, friendly or hostile. As we have seen during the Roche episode, the issue for investors was price. Had the offer been $71 instead of $51 (or even $61), Roche would have won the battle.
Given the fact that Illumina's fundamentals are steadily improving, potential suitors are running out of time. Illumina's stock price will climb back to its prior highs sooner or later, and by that point the price needed to take control will be much higher than where it is today. Either way, Illumina's investors come out ahead. Either the company is taken over at a good premium, or they continue to hold shares of a company with industry-leading margins, a solid balance sheet, and good growth prospects, both here in the United States and abroad. It is why we own shares of Illumina, and why we believe that long-term oriented investors can illuminate their portfolios with profits by adding to or initiating positions in Illumina.
Additional disclosure: We own shares of LIFE via the First Trust NYSE Arca Biotechnology Index Fund.