Illumina - 40% Correction Has Not De-Risked The Investment Thesis Enough

| About: Illumina, Inc. (ILMN)
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Illumina is the leader in gene sequencing technology, a field which has the potential to change healthcare.

Following a very strong growth performance over the past decade, growth has slowed down in quite a dramatic way in 2016.

While shares have seen a big re-set since 2015, valuations are still very high although I recognize that part of it is driven by continued M&A rumors.

I only see real appeal start to emerge around the $100 mark, making me a very patient investor at this point.

Illumina (ILMN) has turned out to be a great growth story which is seeing some struggles at the moment. Coincidentally, this is not the first slowdown witnessed in a period of decade long expansion. While a big correction from 2015 highs seem justified amidst general ¨healthcare¨ valuation multiple compression and slower growth, it could again provide food for takeover rumors which have often surrounded the company.

The issue which I have, despite the great leadership position, past growth track record, strong balance sheet and growth prospects, as well as potential for M&A, is simply the still steep valuation. While valuation multiples have come down a lot, one can hardly call a 40 times earnings multiple as attractive, certainly as revenue growth has slowed down to their single digits. As such, I am patiently waiting if shares see a further retreat towards the $100 mark.

Focusing On Genetic Analysis

Illumina was founded back in 1998 and has focused on delivering sequencing and array solutions for genetic analysis. So what does this mean?

Each cell in a human body has a set of instructions, called DNA. THe complete set of DNA is called a genome. The DNA itself is comprised out of nucleotide bases called A,C,G & T, which based on their order determine the DNA sequence.

Differences in the DNA sequence create generic variations and make that humans are not all alike in terms of or hair color, length etc. Yet genetic modifications also have drawbacks, which makes people more or less susceptible to diseases. It also means that similar drugs have differential impact on their ability to solve diseases.

Understanding the sequencing more completely can potentially revolutionize healthcare, allowing for both preventive and more precision-based healthcare.

What Does Illumina Do?

Illumina is perhaps best known from it sequencing systems. This includes machines like HiSeq X, NextSeq, MiSeq and MiniSeq, most of which have subsequent versions. The sales of these instruments generate 25-30% of sales and the different versions are used for different applications. The price of these machines, ranging in the +$1 million category seems very steep, yet technological advancements make that the costs of analyzing genomes has come down a lot. This is no understatement, while previous versions of Illumina´s machines could sequence a gene at a million, this costs has dropped to $1,000.

While sales of machines to some customers can be lumpy, Illumina has ¨solved¨ this by building a consumable business, which is responsible for roughly 60% of sales. These consumables consist among others out of preparation & sequence kits, aiding customers to maximize the ability to understand the genome which they are testing.

Key competitors in the market for sequencing include Affymetrix which has been acquired by Thermo Fisher, which in its turn is a very large competitor of Intelligent. Other players include Qiagen, Roche and Agilent, among others.

Besides the core business of Illumina, the company has been instrumental to a very interesting project called ¨GRAIL¨. Holding a majority stake in this venture, which is furthermore backed by some high fliers, GRAIL aims to launch a cancer screening test by 2019. If it succeeds, it has a potential very lucrative business in its hands, although it depends on the probability of success, future market shares, and pricing, among others.

Encouraging, GRAIL is in the process of raising a billion investment round, as indicated in early 2017. What is less encouraging is that Illumina´s +50% stake in GRAIL would be cut to 20% following the investment round, implying that its stake is valued at roughly $700 million.

Speculator Growth

A little over a decade ago, Illumina reported its first profitable year. The company reported operating profits of $38 million on $185 million in sales in the year of 2006. The market appraised the emerging business a roughly $2 billion market value at the time which was equivalent to 10 times sales. Than again, this could be justified given the spectacular growth rates reported by Illumina as revenues were on track to double in 2007.

Growth has been very spectacular ever since, with revenues surpassing the $500 million mark in 2008, exceeding the $1 billion mark in 2011, to surpass the $2 billion mark in 2015. With exception of incidental costs in 2013, these growing revenues were accompanied by expanding operating margins, seen around 25% in recent years.

The spectacular growth displayed by the company attracted Roche into making an attempt to buy the company. In January of 2012 the Swiss attempted to acquire the company for $5.7 billion. While this marked a healthy 43% premium, following a difficult 2011, Illumina rightfully rebuffed the $44.50 offer.

The M&A boom in the wider healthcare sector which followed, resulting in increasing valuation multiples, pushed shares up to a high of $220 in 2015. That +$32 billion valuation was again driven by continued M&A speculation, yet nothing materialized.

At this moment of time, shares have fallen back to a level of $135 per share. Part of this correction has been the result of valuation multiples having come down across the wider healthcare and pharmaceutical sector. More worrisome is the fact that growth slowed down. Topline sales growth, reported at 31% in 2014, had slowed down to a still respectable 19% in 2015.

Disappointing 2016

With shares peaking at $220 in the summer of 2015, investors have seen a meaningful retreat at current levels of $135, with the stock being down nearly 40%, trading at levels last seen in early 2014.

The reason is the disappointing operating performance over the past fiscal and calendar year of 2016. When releasing the 2015 results, Illumina guided for revenue growth of 16% and non-GAAP earnings of $3.55-$3.65 pre share for 2016. This guidance was comforting for investors, with the stock still trading at $200 at the time.

The first shock came in April of last year when it became evident that first quarter currency-adjusted sales were up by just 7%, prompting sales to fall to $135. The disappointing numbers forced the company to cut the revenue guidance towards 12% with earnings seen at $3.35-$3.45 per share. Shares rebounded to their $160s in July when it became evident that second quarter revenue growth accelerated to 11%. On the back of this improved momentum, management upped the earnings guidance to $3.48-$3.58 per share.

This optimism faded again when third quarter revenue growth was stabilizing at 10%, as the company reduced the earnings guidance to $3.27-$3.32 per share. Disappointing revenues resulted from a 26% drop in instrument sales which fell to $106 million. Of course, this does not bode well for medium to long term consumable trends.

Worse, Illumina guided for flat to slightly increasing revenue growth on a sequential basis. Assuming a flat revenue number of $607 million, revenue growth is expected to slow down to 2.5% on an annual basis, being a dismal prospect for equity investors. Illumina blames the disappointing results on uncertainty regarding funding of academic institutions, but tried to reinforce the market by saying that part of the shortfall in sales would be made up in early 2017.

While it is true that international sales make up half of revenues and the dollar recently gained some strength, it is evident that more factors are at play. The roughly $3.30 per share non-GAAP guidance is not that comforting either, as GAAP earnings are seen just shy of $3 per share.

Appeal? Management Thinks So, Might M&A Come Back?

Illumina has seen periods in the past during which growth slowed down, notably in 2010-2012, which at the time pressured shares as well. Shares lost more than half their value in 2011, prompting Roche to buy the company on the cheap in early 2012.

Management made smart moves at the time by refuting a deal and buying back stock. As a matter of fact, management is now becoming a buyer of the stock as well, as Illumina announced a $250 million buyback program recently. This however represents just little over a percent of the outstanding float.

Perhaps management recognizes that it needs to protect itself against prays again, after Thermo Fisher was reported to have offered $30 billion for Illumina in 2016, in a deal which would value the company at around $200 per share.

Thermo has been very aggressive in dealmaking in this area having bought Affymetrix and Life Technologies. An attempt to go after Illumina could perhaps even trigger a bidding war with Roche. Yet the valuation is very steep. Thermo bought Affymetrix in 2016 in a $1.3 billion deal which valued the company at 3.7 times sales.

The $15 billion mega purchase of Life Technolgies, which closed in 2014, revealed how aggressive Thermo Fisher really was. That worked out to roughly 4 times sales, as both Affymetrix and Life Technologies were growing sales at a non-demanding pace.

For your reference, Illumina trades at 8 times sales and roughly 25 times adjusted EBITDA, even after the stock has fallen quite a bit already. So while the valuation has been re-set, it can hardly be called cheap, yet Illumina is the undisputed leader in a growing marketplace.

Perhaps management can make some more dramatic moves if it likes to fend off competitors making a move for the company. The company operates with a net cash balance of $500 million, allowing for more aggressive buybacks or potential bolt-on M&A. The company could even borrow another $1.5 billion on top of the current net cash balances, and still operate with a modest 2 times leverage ratio. The additional $2 billion firepower would be sufficient to buy back a tenth of the outstanding shares.

Final Thoughts, Not Tempted Yet

While M&A can never be ruled out, the stand-alone valuation is high. This even the case for an undisputed industry leader with a stellar growth track record and great growth prospects. That being said, current earnings power come in at just $3 per share on a GAAP basis, or potentially a bit higher if the company would use some leverage to buy back stock. Even in the latter case, the shares are not cheap at a 40-45 times earnings multiple, for an earnings yield which is comparable to the yield on a Treasury bond.

That means that this valuation is based on growth and not so much current earnings power, and it is this growth which is really non-existing at this point in time, based on the Q4 outlook. So while the valuation has been re-set in a big way already, it can just as easily be argued that the valuation in 2015 was being exuberant.

Using a maximum of 25-30 times earnings, while accounting for the potential usage of some leverage to please investors, I see fair to appealing value at a range of $80-$100 per share. While shares are not cheap at those levels, I am willing to attach a premium given the track record, growth prospects, leading positions and the fact that M&A rumors undoubtedly will emerge again.

Until then, I wait patiently, but add the name to my watch list.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.