Illumina's Business Hangs On Government Funding Of Its Clients

| About: Illumina, Inc. (ILMN)

Twenty years ago, expressions like "artificial intelligence," "virtual reality," and "the world wide computer matrix" were something out of some far-flung science fiction movie. No more. They are part of our everyday lives in the world as we know it. Genetic engineering can also be included in this category, and that's where Illumina (NASDAQ:ILMN) comes into play. It develops and manufactures tools for analysis of genetic variation and function, better known as gene sequencers. Illumina has a 60% share of the estimated $950 million next-generation sequencing market.

Turn back the clock to early 2009, and Illumina CEO Jay Flatley discusses one of the primary uses for mapping out the human genome in a Sunday Times of London posting, Genetic Mapping of Babies by 2019 Will Transform Preventive Medicine:

Every baby born a decade from now will have its genetic code mapped at birth...A complete DNA read-out for every newborn will be technically feasible and affordable in less than five years, promising a revolution in healthcare... a genome sequence should be available for less than $1,000 in three to four years.

That time is now. 23andMe is a Silicon Valley company backed by Google (NASDAQ:GOOG) that offers genomic sequencing for under $1,000. According to a September, 30, 2011, Motley Fool article, "The Real Winners of $1,000 Exomes," 23andMe uses Illumina gene chips. The article also goes on to say, "The service will compete with Illumina's whole genome sequencing, which starts at $7,500 for medically relevant sequencing." You can infer from that that Illumina has the superior product, but for how long? Additionally, will the lower-priced competition cut into profits and margins?

Granted, we are a long way from all newborns getting their DNA sequenced, not only from a cost issue, but a privacy perspective (think of the 1997 movie Gattaca). I'm a believer that each and every one of us will be getting our DNA sequenced in the not too distant future, because the pharmaceutical industry is probably lobbying for it. Personalized medicine is a byproduct of genomics where you can see if a patient is predisposed to certain diseases. It can save and extend lives, but there is a certain dystopian aspect to it if it isn't regulated properly.

My last article on Illumina, from March 1, 2011, discussed its dynamics as a player in personalized medicine, as well as my conviction that the stock was overpriced. At that date, the stock was selling for $70/share, and it has since come crashing down to $39, a loss of over 40%. I'm not clairvoyant. It had a high P/E Ratio, the market has corrected, Illumina missed an earnings number, and now there are worries about government stimulus funding to its clients in the academic industrial complex. That adds up to spontaneous combustion on Wall Street.

The stimulus funding must make management break out in a cold sweat, because 80% of Illumina's clients are in academia. However, you wouldn't know it from Flatley in the April 26, 2011, Q1 conference call:

In general, we believe our funding environment is stable. We're no longer directly tracking stimulus-related funds, as they become more challenging to parse out, but believe that funding should benefit our customers through the end of next year.

That's a fairly significant cushion. Flatley goes on to say:

Recently, the 2011 NIH [National Institutes of Health] budget was passed with about a 1% reduction in spending from 2010 levels, but weighting the worst-case scenarios, product and congressional negotiations, and remaining in line with our expectations. Overall, we believe that the allocation within the NIH budget will continue to favor genetic analysis tools, and in particular next-generation sequencing.

To his point, earnings did increase from $1.06/share in 2010 to a projected $1.47/share in 2011, according to Yahoo Finance. Illumina was selling for $70 at the time of that conference call, and continued to climb until early July, when it hit $76. I'm not a short-term momentum player (although it's nice to have momentum in your portfolio), and there's a shop-worn bit of investing wisdom that when momentum is working, it works; when it doesn't, it doesn't. Right now it's like the stock was invaded by an alien microbe or hit with a Biblical plague. In the snap of a finger, investors cut it loose as a punitive measure.

Although the fire has gone out of Illumina, my take is that it is an excellent company, and this may be a good entry point for patient investors. Based on earnings estimates for 2011 and 2012, the P/E Ratio for Illumina is 27 for the current year (which is almost over) and 22 going forward. Earnings growth for next year is expected to be 25%, and 31% based on a 5-year compound annual growth rate. Just using the much more conservative growth rate of 25%, we get a PEG Ratio of under 1. And that's what you're looking for if you're a value investor.

Analysts seem to like Illumina. Of the 22 analysts that cover the security, 15 have a buy or strong buy rating, 6 have a hold, and, only one says it is an underperform. However, these figures are about the same from three months ago, when the stock was selling for twice its value, so take that for what it's worth. Buying the stock now may be an act of larceny, but only if the government gravy train keeps on rolling for its clients.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am short the market with inverse ETFs.

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