Market Overview

PropThink: Illumina Third Quarter Results Highlight Solid Growth Prospects


By Ivan Deryugin

One of the most pressing issues that the market faces today is what kind of impact the fiscal cliff will have on companies in the healthcare sector; the life science sector has been particularly impacted. These concerns have put pressure on the shares of many of those companies, but investors have been painting the sector with too broad a brush. One company in particular is posting solid growth and has proven itself to be resilient against weakness in all three geographic areas of concern for the markets: the United States, Europe, and China.

San Diego-based Illumina, Inc. (NASDAQ: ILMN) is one of the world's leading genetic sequencing and testing companies, with just over $1 billion in revenues over the past 12 months. And although Illumina's stock has dramatically outperformed the S&P 500 year to date, it is due in large part to the impact of Roche's hostile takeover attempt early this year. Illumina's shares remain well below their 2011 highs, even though the company's fundamentals have never been better. Illumina's Q3 2012 results are those of a company whose best days are ahead of it, and whose value the market is discounting. Unless otherwise noted, financial facts and management commentary will be sourced from either Illumina's Q3 2012 earnings call or its Q3 2012 earnings release.

Overview

Illumina posted its Q3 2012 results after the markets closed on October 23. Its revenues of $285.874 million matched analyst estimates, and pro forma EPS of $0.41 beat estimates by 2 cents. Revenues grew by 21.39% year over year, and pro forma EPS grew by 86.37%. On a GAAP basis, Illumina's EPS grew by just 46.67%. Illumina's 2012 income statement has been filled with several extraordinary charges, which distort its GAAP earnings. Illumina's move to new headquarters has resulted in the payment of double rent, as well as cease-use losses, and lease exit liabilities. In Q3 alone, the company had charges of 15 cents per share associated with relocating its headquarters. The company has said that these relocation charges are not expected to be material going forward. The second major driver of the discrepancy between GAAP and non-GAAP earnings are costs associated with fighting off Roche's hostile takeover. This latest quarter included 3 cents of charges associated with the Swiss company's tender offer, which are set to decline over the next several quarters.

Margins: Leading the Life Science Industry 

As the table above shows, Illumina is the clear margin leader in the life science industry, at both the gross and operating level. Unlike its peers, Illumina has just two focus product areas: genetic sequencing and testing. Everything that the company does revolves around those areas, and Illumina's decision to do so has paid off. Sequencing and genetics are the fastest growing areas of the diagnostics market. They grew at a 17% clip in 2011, and they are projected to be worth $25 billion within a decade, up from the $5.6 billion that they are worth today.

In Q3, Illumina's gross margin came in at 70.5%, up from 68.9% in the third quarter of 2011. Though it declined sequentially (from 70.9%), it is because Illumina sold more sequencing systems in the quarter relative to consumables. Illumina's Q3 operating margin came in at 35.1%, up from 29.3% a year ago, due to solid revenue growth and tight cost controls. SG&A expenses totaled 19.5% of revenue in Q3 compared to 22.2% a year ago. This allowed operating margins to expand, even though Illumina's R&D spending rose by 12.49% as the company invested aggressively in its new sequencing systems. Illumina's focus on a fast growing market, and its leadership position within that market, give it industry-leading margins, and they are expanding.

Competition: Beating its San Diego Neighbor

In sequencing, Illumina's fiercest competitor is its neighbor Life Technologies (NASDAQ: LIFE), which is based in Carlsbad, just north of San Diego. Life, via its Ion Proton and Ion Torrent systems, has been making an aggressive push to compete with Illumina. And given that Life is almost 4 times as large as Illumina (based on sales), many investors assume that Life will surpass Illumina in the sequencing market. The results, however, tell a different story. Analysts pressed Illumina on its Q3 call about the effects of competition, and CEO Jay Flatley said:

Let's take that [the high end sequencing market] first. Things are going really, really well with 2500 and the 2000 sales as we indicated in the script. We had very strong performance that exceeded our expectations in the high end of the market. And we essentially have no competition in that part of the market. In the desktop, I'd say, if anything, our competitive position has continued to improve there. The new launch of a competitive instrument into the field is, from any customer we've talked, to not performing to specifications. And so we're not seeing our customers get distracted by that system. We're seeing already some pretty heavy discount offers of that system into the marketplace. And our MiSeq product continues to perform really, really well. And we're upgrading the output in the system, and the customers are continuing to get great data with BaseSpace enabled for storage and for data sharing. So all of the attributes, ease of use of our system continue to make it very, very competitive. And certainly, the output ranges that customers are achieving with this exceed the output ranges of any competitive systems in the desktop market.

Life Technologies is already discounting its sequencing systems to generate consumer demand, even though its systems are already priced lower than Illumina's. Customers understand that Illumina's systems have better quality and performance, and they are willing to pay a premium to take advantage of those factors. MiSeq launched 12 months later than Life's desktop sequencing platforms, and despite a higher price, it already has 50% unit share (per CEO Jay Flatley), and a far higher revenue share. If Illumina can continue to execute as it has in Q3, those market share figures should continue to increase.

Geographic Results: Macroeconomic Weakness? Where?

Investors in the life sciences industry have been forced to deal with the twin worries of NIH funding cuts and macroeconomic stress in 3 key markets: Europe, China, and the United States. Illumina's results, however, seem to show none of these stress points. In Q3, the company posted solid product shipment growth across all key geographies. Product shipments in the United States grew 19% in the quarter, accelerating from the 18% growth rate posted in Q2 2012. Shipments to Europe also grew 19% during the quarter, and shipments to China rose by 79%, up from a 50% growth rate posted during Q2 2012 (overall Asian shipments were up 21%). While Illumina did not disclose its Q2 European product shipment growth, it did note that its European business remains stable, and that shipments to Spain and Italy grew sequentially during the quarter. How many companies can claim not only sequential growth in Spain and Italy, but also 19% growth in Europe as a whole? Not many. Illumina is riding a secular growth story, one that has proven to be resilient to macroeconomic stress. 

In China, Illumina, like most life science companies, is benefitting from the government's push to expand healthcare access to the western part of the country. This is an integral part of the country's current 5-year plan, and it will probably feature prominently in future 5-year plans as well. Expanded access to social services and general job security are part of the implicit social contract that exists between the Communist government and the people of China. The life science industry as a whole, in fact, confirms that China is a source of strength. PerkinElmer (NYSE: PKI), for example, is very upbeat about growth in China, as its leadership in the neo-natal testing market makes it the medical sector's choice for expanding screening of pregnant women and newborns. Waters (NYSE: WAT) stated on its own Q3 2012 conference call, "General concerns that we have recently heard regarding a slowing of economic growth in China are not apparent in our third quarter results or in the outlook that we have in the fourth quarter." And Thermo Fisher (NYSE: TMO) posted 20% growth in China in Q3. Companies that operate in both life sciences and industrials, such as Danaher (NYSE: DHR), or Sigma-Aldrich (NASDAQ: SIAL) do note weakness in China's industrial sector, as does PerkinElmer (where industrials make up 7% of overall sales). But for "pure" life sciences companies such as Illumina, macroeconomic stress in China is nowhere to be found. In the United States, concerns about the fiscal cliff, and specifically the 8.2% cut to NIH funding that is part of the automatic spending cuts slated to go into effect in 2013, have pressured shares of life science companies for some time. Here, companies in the sector have reported different things, and it is due to differing product lines and areas of strength. Danaher, for example, has said that customers are slowing down ahead of the NIH's cuts. Water has also said that demand in the United States was more constrained than the company anticipated during the latest quarter. 

Illumina, however, appears immune to these macroeconomic pressures. To continue reading, click here.

See this report in full at PropThink.com.

About PropThink

PropThink is an intelligence service that delivers long and short trading ideas to investors in the healthcare and life sciences sectors. Our focus is on identifying and analyzing technically-complicated companies and equities that are grossly over or under-valued. We offer daily market coverage, weekly feature stories, and a newsletter to investors who subscribe on PropThink.com. To learn more, follow us on Twitter or visit us at http://www.propthink.com.

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