Analyzing The Roche Offer To Illumina

| About: Illumina, Inc. (ILMN)

Illumina (NASDAQ:ILMN) Profile and Quick Financials:

Illumina, a sequencing company based in San Diego, operates in the sequencing market. This market is somewhat related to the molecular diagnostics market but in reality it is more of an R&D tool industry at the current time. Illumina's clients are diverse however genomic research centers, academic institutions, and governments tend to be the largest customers. In addition to sequencing, they also offer PCR (polymerase chain reaction). It remains a small player in that market however.

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Figure : GAAP Operating Income from filings

They are the Best in Sequencing:

Illumina has been the best on the market for quite some time. It has been the leader in sequencing since surpassing Affymetrix, Inc (NASDAQ:AFFX) some years ago. It still dominates the market in revenues and technology but Life technologies (NASDAQ:LIFE) has gained some traction. Its technology puts them, in my opinion, as still the number one option for institutions and firms for research and development.

A stumble:

While I believe its long term outlook is strong, the Company has been hit extremely hard by reductions in research expenses particularly by governments, universities and other research institutions. While many people might notice the gains in revenue year over year, the more troubling figures are the quarterly revenues. 2011 4th Quarter revenues of 250 Million are down from the 4th quarter of 2010 of 261 Million. Not a great statistic for a "growth company." The most troubling is the reduction in installation revenue which is the leading indicator for consumable revenue.

Stock Price:

While the reduction in global R&D budgets has put a stop to the exceptional growth the company has experience, I believe the market hit the company too hard with the selloff that sent the stock from ~75 dollars a share in July to 25 dollars in December. I anticipate better than expected R&D budgets over the long term as government and research institutions will need to conduct research. Illumina, having the best product should benefit as research budget will increase of over the long term.

For the valuation, I used a P/E to get a range and a DCF for a more concrete value. For the quick range based on earnings I used four midcap diagnostics companies. Life technologies, Cepheid, Myriad, and Qiagen trade around 11X 70X 16X and 16X next year's earnings respectively.

I believe a reasonable range based on next year's earnings of 1.50 per share is between 30 to 38 dollars a share. This is based on a multiple between 15 and 25.

I have a price target of about $36 per share done by a DCF. This is based on a 10 percent discount rate and a 4 percent continuing growth rate. This point lies in the basic and unscientific P/E range. This is much higher than the market was pricing the stock in December, however below today's value of slightly over 50 dollars a share.

Facts of the Current Situation:

On January 24th Roche (OTCQX:RHHBF) made an unsolicited offer directly to the shareholders of Illumina for $44.50 dollars a share. The stock jumped the next day to around 55 dollars per share. The offer was rejected and a poison pill resulted because of Illumina's advice from Goldman Sachs. The negotiations were started at the end of December during a time when Illumina's stock was at a very low price. On February 24th the offer from Roche was extended to March 13.

Analyzing the Value After the Offer:

My belief is that the fair value of the stock as a standalone entity is somewhere between 30-40 dollars. However company could be much more value to Roche. If Roche believes Illumina's technology has utility for eventual companion diagnostics applications, this technology could actually have double the value. This is based on the fact that Roche could dramatically improve pharmaceutical pipelines and could block competitors from the best in sequencing technology.

In Illumina's Favor:

  • The market's reaction-When the stock price jumped 24 percent above the offer price it is obviously the market believes the offer to be inadequate. The market can be both an arbitrator and a self-fulfilling prophecy.
  • Its stock price a year ago-While Roche continues to mention that this company received a very nice offer of 77 percent over the stock price when negotiation began, the offer is still over 40 percent below its 75 dollars a share price in July.
  • The strong CHF/Strong economy- A couple months ago I stepped off the train in Switzerland. I stepped into a McDonalds and spent amount 14 USD for a "value meal." You could say the swiss franc is overvalued based on the "Big Mac Index."
  • Functions as a standalone company- This Company's business has stabilized and the uncertainty around global research spending has subsided. The company continues to install its instruments and we can expect consumables to continue to contribute revenue even if the installations are no longer growing at the rate we expected a year ago.

In Roche's Favor:

  • Roche is cheap-Roche could have continued its negotiations with Illumina however it choose to go direct to the shareholders because the belief it could get it for a lower price. Roche also has a reputation as being somewhat cheap.
  • Recent stock price-Illumina's stock price crashed in the 2nd half of 2011. This is not the best scenario when a company's stock valuation includes pricing for lots of growth. While I believe the business has stabilized, it is no longer the growth stock it was in the past.
  • Limited rival bidding-Roche remains the most aggressive pharmaceutical company on the personalized medicine front. I don't believe other companies are willing to make a bet on a sequencing company of over 5 billion dollars.
  • Opportunistic nature of Roche-Remember Roche sat and waited over a long period of time for Genetech. They can wait for the stock price to fall before going directly to shareholders again.

Valuation Including the Bid:

Overall I believe Illumina has the greater leverage. Its technology is the top of the market. The market is growing and its product positioning is strong. Roche has publically showed its interest in the company and the market knows that Roche is being cheap.

The stock price in December was a multiyear low which resulted from a market overreaction. Even if Roche were to completely walk away, I believe the fair price of the company is closer to 36 dollars a share. The fact that Roche showed this much interest in the first place means they must believe in the sequencing technology. I believe this stock could easily be worth at least the 44.5 offer price as an independent company within two years given its position in the sequencing market.

At this point however I do not believe Roche walks away from this deal. It has already shown its colors. This means the low price for this stock is closer to $44.5 per share. Given the market's reaction I believe Roche must raise its bid for the company. I give it only a five percent chance they completely walk away.

Since Roche is interested in Illumina this most likely means one important fact. This probably means they believe Illumina's sequencing technology can provide help for clinical trials and that it might be possible for FDA approved companion diagnostics. This implies dramatic synergies much higher than the 44.5 initial offer price.

The day after Roche went directly to the shareholders, the stock price rose to 55 dollars per share. I believe that 55 dollars per share is the most likely base price given an acquisition scenario. 75 dollars represents the 52 week high another bench market for acquisitions. The two companies could also meet in the middle at around 65 dollars per share. These three scenarios are my estimated probability and prices for Roche's offer to Illumina.

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Figure : Estimates for within a year

Fair Price

Given my standalone valuation plus acquisition potential, I believe the stock should be worth $60 per share. Yet given the longer duration this scenario may take, I believe this price needs to be discounted based at Illumina's cost of equity which I have at 10 percent. Therefore I believe Illumina's stock should be bought at a price below 54.50 dollars per share based on the assumption that this scenario will likely drag on. This is particularly true with the higher offer scenarios.


Buying a stock during acquisition negotiations is always risky and I'm assuming anyone buying or selling this stock (or options) knows the risks. Take caution: given the higher volumes and stock price increase prior to the offer, I believe this stock has major trading on insider information (like many if not all deals).


Given its ability to function as a standalone company, and given that Roche will probably not walk away from this deal, I believe the risks are worth the reward. Some analysts in fact have this company valued at its current price even as an independent company. This is especially true since if Roche believes the company has value to them, it would be because it thinks Illumina's technology can be used in clinical trials. In this scenario, the value of the company is much higher. I see a deal happening at a price higher than the initial offer and I believe it will happen within a year.

Disclosure: I am long ILMN.

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