Illumina: A Turnaround Play
Investment Thesis
Refocused strategy – Spin-off of Grail allows renewed focus on core Illumina business operation
Revenue growth potential – Transition to NovaSeq X series progress well
Improving margins – There are signs of recovery in terms of non-GAAP gross profit margin and operating margin
Valuation upside – Conservative estimates suggest there’s approx. 57% average margin of safety based on share price at the time of writing (December 2024)
Disclaimer:
The information provided in this blog post is for informational purposes only and should NOT be construed as financial advice. Investing in stocks and ETFs involves risk, and there is no guarantee of profits. Past performance is not indicative of future results. It is important to conduct thorough research or consult with a qualified financial advisor before making any investment decisions. The author is NOT a financial advisor and is sharing his personal experiences and opinions only.
Additionally, please note that the author holds a position in the discussed stock, and his view may be biased as a result.
Business Overview
DNA is a molecule found in every cell of every living organism. It contains the genetic code that determines an organism's traits, such as eye color, hair color, and height. DNA is also responsible for passing on traits from parents to offspring.
Sequencing DNA means reading the order of the "letters" in the genetic code. This information can be used in many ways, including:
Understanding diseases: Identifying genetic mutations linked to diseases like cancer or Alzheimer's.
Developing new medicines: Creating targeted therapies based on a person's unique genetic makeup.
Improving healthcare: Personalizing medical treatments and predicting an individual's risk for certain conditions like cancer.
Agriculture: Improving crop yields and developing disease-resistant plants.
Illumina develops and manufacture machines (they called it “instrument”) that can quickly and accurately read DNA sequences. These machines have revolutionized the field of genomics, making it possible to study DNA on a large scale at lower costs. There are 3 categories of instruments developed by Illumina:
High-throughput
Mid-throughput
Low-throughput
Along with the instruments are its consumables – flow cells and reagents. The former are glass substrates where sequencing reactions occur. While reagents are chemicals used in the sequencing process.
The company generates revenue by selling these instruments and consumables. A bulk of its revenue is from consumables. This business model is like the “razor and blade” business where the blade gets replaced regularly after usage, giving the company a recurring income.
Illumina also sells a wide range of products to support various aspects of DNA sequencing activities. Below is an illustration of a typical workflow of DNA sequencing & the products offered by Illumina across the workflow:
Apart from the above, the company also provide other services such as:
Sequencing service: for customers that wish to outsource DNA sequencing workflow
Training: Tutorial on how to operate the machine
Support: Maintenance of instruments
Its target customers are in:
Research & Applied: This includes academic labs, research centers, government institutions, biotech and pharma companies
Clinical: This includes oncology, reproductive healthcare and Infectious disease & microbiology testing
Below is an overview of its financial as of June 2024:
Illumina seems like a good business to invest in but the market seems to think otherwise. Since Aug 2021, the company’s share price has fallen 82% from its peak of $526 to just $89. At the time of writing (December 2024), the share price has recovered some ground to $134.96.
What Happened? The drama from Grail Acquisition…
In Sep 2020, Illumina proposed the acquisition of Grail for a consideration of $8 billion. Grail is a healthcare company that focuses on developing diagnostic tests for multi-cancer early detection. This proposal prompted the US Federal Trade Commission (FTC) and EU regulators to launch anti-trust investigations due to concerns over potential monopolistic effects.
Despite the ongoing investigations, Illumina proceeded to close the deal in August 2021 without considering the potential consequences. Both the US FTC and EU regulators subsequently ordered Illumina to divest Grail. In addition, Illumina was slapped with a record fine of €432 mil from EU regulator for hastily closing the deal.
Although Grail has significant potential for future growth, it remains a loss-making business with substantial R&D expenditures. Consequently, Illumina incurred a total of $4.7 billion in goodwill impairment related to the Grail acquisition across fiscal years 2022 and 2023. This contributed to Illumina reporting substantial losses.
The acquisition of Grail was also criticized by activist investor Carl Icahn, who launched a proxy fight and successfully secured a seat on Illumina’s Board of Directors. Unsurprisingly, the company’s CEO, Francis deSouza, resigned shortly thereafter.
With an activist investor now influencing the Board, Illumina finally spun off Grail in June 2024. I believe this drama has diverted the management’s focus from its core business, resulting in stagnant revenue since 2021.
Fun Fact: Grail was founded by Illumina in 2016 & was later spun-off in the same year!
Macro Headwinds
This flattish revenue is also the result of below macro-environment that Illumina is facing at the beginning of 2022:
Unfavorable exchange rates as USD strengthened against other currencies
Lower covid surveillance demand as the world recovers from pandemic
China market disruption as the country strive to achieve zero covid cases
China market faces strong competition in mid-throughput
Russia-Ukraine war has led to company unable to conduct business due to sanctions
These macro headwinds have affected its customers’ funding priorities. Thus, limiting the demand for instruments and consumables.
APAC and China market are hit the hardest compared to other region. From 2009 to 2020, the average revenue contribution from both markets has been approx. 18% of total revenue. But this has drop to just 9% as of fiscal year 2023.
Transition to NovaSeq X Series
In addition to facing macroeconomic headwinds, Illumina has been navigating a transition to its newly announced NovaSeq X series instruments since 2022. Customers using the previous version of high-throughput instruments (NovaSeq 6000) have been reducing their purchase of consumables as they migrate to the new high-throughput instruments, with plans to ramp up sequencing activity again once the transition is complete.
Can Illumina Turnaround? Maybe…
From 2009 to 2019, Illumina was growing at CAGR of 18%. Since then, its business has been flattish. For the company to revert back to its growth story, it needs to resolve the above 3 challenges.
Now that Grail’s spin-off has completed, there’s 2 more challenges to overcome:
Macro Headwinds
These are uncontrollable by the company. It will continue to affect customers’ purchasing behavior. With 2025 expected to be more challenging due to Trump 2.0, I think Illumina’s growth will continue to be tapered.
One concern is Illumina’s China market. Even if the Chinese government showing initiatives to revive the economy, Illumina still needs to overcome the strong competition in the mid-throughput segment.
In 1Q24, the management has brought in new leader to manage China market. This needs to be monitor closely.
Transition to NovaSeq X
Based on the company’s August 2024 strategy updates, there are approx. 2,180 active high-throughput instruments installed as of 30th June 2024. So far, they have shipped a total of 527 NovaSeq X series as at end of 3Q24. This means the migration is only at roughly 24% completion.
Already there are signs that this transition to new instrument has been progressing well as of 3Q24, for instance:
Out of the 527 installed base, 40% are from clinical customers. This is good as clinical market tends to be more stable in terms of sequencing activities, especially in the oncology test which is the fastest growing segment
Approx. 35% of consumables revenue is from NovaSeq X. The management anticipates almost half of consumables revenue will be transition to NovaSeq X by mid-2025
This transition matters to Illumina because I believe historically high-throughput instrument & its consumables represent the largest portion of the company’s revenue. Unfortunately, the company does not provide such breakdown. I can only make my assumption.
Other Recovery Signs
When it comes to turnaround play, monitoring the financials closely for recovery signs is key. In the August 2024 strategy updates, the management highlighted some recovery signs besides the transition progress to NovaSeq X:
Non-GAAP gross margin has been improving from 66% in FY2023 to 70.5% as of 3Q24
Non-GAAP operating margin also seen improving from 20% in FY2023 to 22.6% as of 3Q24
In addition to the above, I noticed the company’s free cashflows have been improving. As of 9M24, it generated a free cashflows of $374 mil which is higher than FY2021. Perhaps it could recover back to pre-covid level of free cashflows by FY2026, which then allow the company to buy back more shares.
Another big positive for Illumina is that they avoid paying the €432 mil fines as the EU court has ruled in favor of Illumina on September 2024, stating the EU regulator has no jurisdiction over the acquisition. While this comes after Illumina has spun-off Grail, I think it’s a blessing in disguised. With Grail under Illumina, it would make the financials look bad.
Nonetheless, looking at the below financial targets for FY2025 to FY2027 set by the management, it seems like Illumina’s historical double digit growth rate (CAGR at 18%) will not happen anytime soon.
Valuation
Before Illumina faces all the above challenges, its 14-year median price-to-sales & price-to-operating cashflows were at 11.8x and 43x, respectively.
Assuming Illumina would turnaround & go back to its pre-Grail valuation as above, I think the intrinsic value will range from $293 to $335. Below are some additional assumptions made:
Revenue will be flattish despite management anticipating it will grow at high single digit. This is because I’m trying to be conservative in my valuation
Cashflow from operation will return back to pre-covid level (within the range of ~$1,000 mil). Considering the growing free cashflows in its latest 9M2024, I think it is achievable
What can go wrong?
There are 3 things that I will monitor closely:
Installed base of NovaSeq X – This will have direct impact on Illumina’s consumables revenue. Unexpected slowdown in the transition would impact the company’s future consumables demand
Macro headwinds – Though beyond the company’s control, this plays a significant role in Illumina's turnaround narrative. Any additional economic headwinds could further constrain customers' funding
China market – If Illumina is able to overcome the stiff competition here, it would be a bonus for them. As of FY23, China account for just 9% of total revenue
Disclaimer:
The information provided in this blog post is for informational purposes only and should NOT be construed as financial advice. Investing in stocks and ETFs involves risk, and there is no guarantee of profits. Past performance is not indicative of future results. It is important to conduct thorough research or consult with a qualified financial advisor before making any investment decisions. The author is NOT a financial advisor and is sharing his personal experiences and opinions only.
Additionally, please note that the author holds a position in the discussed stock, and his view may be biased as a result.