Illumina: Missed March Opportunity, Good Long-Term Prospects

Summary

• Illumina's sales have been hurt by the pandemic.
• Current y/y growth rate would normally earn a lower P/E ratio.
• Illumina's investors are betting on a return to stronger revenue growth.

Illumina (NASDAQ:ILMN) has long been one of the biotechnology equipment success stories. It makes DNA sequencers, which are essential equipment for modern medical research and diagnosis. However, sales growth has paused. The stock dropped to a 52-week low of $196.78 in mid-March, but like me, you probably opted out of that buying opportunity. In my case, it was because Illumina still had a high P/E ratio, which has now risen to near 52. To justify the current ratio, Illumina will need to return to more rapid growth. I think much of the growth for sequencer sales is still in the future, but right now medical equipment budgets are strained by the pandemic. In this article, I will look at Q1 results for patterns that may tell us about the future. My conclusion will be that the current price of the stock is fine for long-term investors, but short-term buyers are at risk buying now if Q2 and Q3 results continue to show a decline in demand.

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Illumina Q1 2020 Result Highlights

Illumina's Q1 2020 results were released on April 30. Revenue of $859 million was up just 2% from Q1 2019. Traditionally that is the kind of growth one might expect from an older industry and might result in a stock price based on a price-to-earnings ratio of 10 to 15. But for Illumina it is an abnormally low growth rate. Before the pandemic hit, in Q4 2019, the y/y revenue growth rate was 10%.

Illumina has healthy margins on its DNA sequencing machines, but the margins on supplies needed to operate the machines, and on maintenance services, are even fatter. The margins held up on a non-GAAP basis, but the GAAP numbers were hit pretty hard. GAAP earnings were $173 million, or $1.17 per share, down 28% y/y. Non-GAAP earnings (which exclude selected non-cash items) were $243 million or $1.64 per share, up 3% y/y. Cash flow from operations was $281 million, up 42% from $198 million a year earlier. The main difference between GAAP and non-GAAP accounting was $92 million in expenses related to the termination of the PacBio acquisition in January 2020.

Illumina does not pay a dividend but did repurchase $178 million in common stock during Q1. That indicates management's confidence in the cash position, which ended the quarter at near $3.3 billion. That confidence did not extend to guidance for 2020, which was withdrawn.

The main reason for the lack of revenue growth was failure to sell more sequencers, particularly in China, which has been a large market. CEO Frank deSouza said it appeared the Chinese market had bottomed in March. Since much of the sequencing is done at academic and research institutions, and many of them have been closed in the US and the EU, I expect a Q2 impact in those regions similar to what was seen in Q1 in China. The magnitude of the impact, however, is yet to be determined.

DNA Sequencing: the long view

DNA sequencing has become a core medical technology. Many early applications just looked at a few genes. Over time it is expected that the medical industry will move toward complete genetic sequencing for all patients. It just makes sense. Hospitals, clinics, and research institutions will continue to build capacity over time.

Against that backdrop, the current pause in revenue growth is likely just a blip. I would not be surprised if Q2 y/y growth is again low or even negative. How long it will take to get back to normal growth is not possible to predict, but it could be as early as Q3. For normal growth we are likely looking at something in the 8% to 12% range. Also, be aware that growth is somewhat dependent on the introduction of new machine models. It is also dependent on capital budgets, which could be impacted by the need to buy other capital equipment or drained by pandemic-related financial issues.

If there is a big caveat, I would say it is government health budgets, which have been a key supporter of genetic testing. It is possible some governments will pivot more funds overall to medicine, which will be a plus. It is also possible, for instance, in the United States, that the huge fiscal deficits being run up this year will give way to fiscal restraint in 2021. Sequencers will need to justify their benefits and costs compared to other forms of medical spending.

Conclusion

My guess is that Illumina stock will remain in the $300 to $325 range until significant events occur. Illumina has done well for a lot of investors, with fairly consistent longer-term gains. For instance, in 2012 it was in the $50 per share range. However, I believe that Illumina needs good quarterly reports to stay in the current range. At some point, if it is not growing revenue and earnings, the current P/E ratio begins to look excessive. Given its prior growth trajectory, I would be surprised Illumina's revenue does not start growing again as the pandemic winds down. If the stock dipped significantly again, like it did in March, I could be a buyer, as I think the longer term, post-coronavirus prospects are good.

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.