Illumina A Long-Term Buy, With Caveats

Summary

• Illumina's stock price is in a slump.
• Q2 2019 results and Q3 guidance were weak.
• Long term, the gene-sequencing demand trend should kick back in.

Illumina (NASDAQ:ILMN) is practically synonymous with gene-sequencing equipment. Over the past decade, its stock has had a phenomenal upward run, climbing from $32 per share to a 52-week high of $380.76 on July 5, 2019. Then revenue growth paused, sending the stock to a 52-week low of $263.30 on September 9. It has bounced upward a few dollars these last few days.

Data by YCharts

Illumina has almost always had a high P/E ratio, implying investor confidence in ever-increasing earnings. Despite the drop in the stock price, the P/E stands near 45, implying perhaps more confidence than Q2 results and current y/y growth rates would warrant. However, I believe the gene-sequencing business is still relatively early in its growth arc. My thesis is that, for those who understand the risk, this may be one of the rare opportunities to buy Illumina at a reasonable price. However, it would be a stretch to call Illumina undervalued. There is the danger that Q2 results are a warning signal that the growth curve for DNA sequencing equipment is flattening. If that is true, continued slow growth in earnings might result in an even lower stock price as the high P/E becomes less defensible.

Illumina Q2 2019 results

Illumina Q2 2019 revenue was $838 million, down 1% from $846 million in Q1 and up 1% from $830 million in the year-earlier quarter. That is the crux of the argument to sell Illumina. Most companies with near-flat y/y revenue growth would be lucky to have a P/E of 15. On that basis, Illumina's stock should be about one-third of its current price. However, the quarter is likely an anomaly. Slide 7 from the Q2 presentation illustrates the rapid revenue growth followed by the pullback:

GAAP diluted EPS was $1.99, up 27% sequentially from $1.57, and up 41% from $1.41 year earlier. That looks a lot better, as 41% EPS growth would typically justify a high P/E. Checking and comparing with the non-GAAP numbers can give some insight. Non-GAAP diluted EPS was $1.35, down 16% sequentially from $1.60, and down 6% from $1.43 a year earlier. Non-GAAP net income excludes a $92 million unrealized gain from a strategic investment that completed an initial public offering. Conservative investors typically are suspicious of non-GAAP results, which are typically higher than GAAP results. In this case, GAAP results are substantially higher because they include a gain on an investment, which is a one-time event. The non-GAAP EPS results are more in line with the revenue results. A more detailed reconciliation of GAAP and non-GAAP numbers can be found in the press release.

The cash balance ended at $3.2 billion, while long-term debt was $1.1 billion. Cash flow from operations in the quarter was $143 million. Illumina does not pay a dividend. In the quarter it did not repurchase stock, but it has in the past.

Illumina slices and dices its results in more detail at its analyst conference. The main categories are equipment sales, consumables sales, and service revenue. It makes two kinds of equipment, sequencers and microarrays, but lumping them together makes sense for a first-order analysis, especially since the vast majority of the revenue is from sequencer sales, consumables, and service. In Q2, service revenue was $134 million, down 15% y/y from $157 million. Since the number of units to be serviced should have increased y/y, this is a cause for concern.

Equipment systems sales in Q2 were $138 million ($129 million sequencing, $9 million array). That was up about 4% from a year earlier, but is still slower growth than in the past. Consumables revenue was $566 million, up just 1% y/y, with microarray consumables down 13% y/y but sequencing consumables up 3% y/y. Consumables tend to lead growth because new sequencers are added each year, and use per sequencer has increased, at least in the past. So this slow growth is also a cause for concern.

Growth Scenarios: bump in the road, or really slowing

So why the stalled growth? Note that growth began to stall in Q1, so it is not simply a one quarter phenomena. There are several applications for DNA sequencing, including DTC (direct to consumer), population genomics (studies of large population samples), NIPT (noninvasive prenatal testing), and doctor-ordered screening for cancer and other disease mutations.

DTC revenue was significantly lower than expected. This may be because the initial thrill of getting a gene analysis, for ancestry or health, has worn off. Also, the machines used have become more efficient over time. Population genomics was weak, but that was probably due to the lumpiness of these large, government-funded programs. A delay in a single program can have an impact on Illumina's revenue. Management also mentioned that revenue was beneath expectations for the lower end machines, for no clear reason. High-throughput machines carry the highest price tags.

The argument for slow growth to be likely in the future would be that certain markets, like DTC, are already saturated. In other markets Illumina has grown to such a large base that a high y/y growth rate for revenue or profits has become more difficult.

I agree with Illumina management that this slowdown is temporary, though I am not able to predict just how fast growth will be going forward, or when we will see a return to growth. Currently, of the 18 million annual new cancer patients in the U.S., less than 10% have their tumor sequenced. Given the number of mutation-specific therapies on the market and in the pipeline, I would expect this to gradually trend to 100%. Growth should continue to be strong until the cancer market becomes saturated. NIPT growth should also continue until it becomes routine.

A recession could affect Illumina as well. Capital spending budgets at hospitals and other institutions usually become constrained during recessions. This would likely only become a significant problem if we had a prolonged and deep recession.

Guidance Revision

At the Q2 earnings conference Illumina lowered full-year 2019 guidance. Illumina now expects y/y revenue growth of approximately 6%, and GAAP diluted EPS of $6.41 to $6.51. Non-GAAP diluted EPS is expected to be between $6.00 and $6.10. Q3 2019 revenue is expected up 3% y/y. While the y/y guidance numbers promise a return to growth, it is not to the higher level of growth seen in the past decade. I would not be surprised if full-year 2019 y/y revenue growth does not even reach 6%, given how bad Q1 and Q2 were.

Conclusion

Using a metric like P/E, compared to the current revenue or profit growth rate, indicates that Illumina's stock is not cheap, even if it is selling at a heavy discount to its recent highs. A P/E of 45 implies a return on capital of just over 2%, if earnings remain flat. I think earnings will return to growth, at least for a couple of decades, driven by the increased therapeutic value of sequencing the genomes of individuals. My caveat, in addition to the ones mentioned above and the usual ones that apply to any investment, is that the growth rate is not likely to be at the high levels we saw in the first part of this decade. I see no reason to pay over $300 per share for the stock at this time, even with the intent of holding it for multiple years. I would like to see revenue growth back up at 8-10% per year sometime in 2020 to justify the current P/E. [ILMN closed at $289.66 on September 9, the day this article was written.]

Despite all the caveats, this is the most reasonable price for Illumina in the past decade. For anyone who has been wanting to buy, now is likely the time. If and when revenue starts climbing again, the stock could become very expensive again.

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.