Illumina Inc: How Long Can a Miracle Go On?

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Feb 07, 2014

Illumina Inc. (ILMN, Financial) is a leading developer and distributor of next-generation integrated systems used for the large-scale analysis of genetic variation and function. It applies innovative DNA sequencing as well as an array of technologies to provide information that could be used to improve drugs and therapies, customize diagnostics and treatments, and cure diseases. The firm is developing a wide line of products that "can address the scale of experimentation and the breadth of functional analysis required to achieve the goals of molecular medicine."

What does this mean? For example, sequencing is being used in cancer diagnosis and treatment. How? In some cases, the physician can get the patient's tumor sequenced and may prescribe drugs that target specific mutations in the patient's cancer. That is, Illumina is bringing us closer to personalized medicine (called "molecular diagnosis") everyday.

Last year, this stock experienced stellar growth: It nearly doubled its price, and continues to swell. Illumina is thus now not a cheap stock. The question is then how long can its "miracle" growth go on? Is it time to sell, or is it still time to buy and get what you pay for?

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A True Leader

Over the past 10 years, Illumina has benefited from the fast-growing emerging space of sequencing, genotyping and gene expression markets, and expects now to enter the market for molecular diagnostics. Not long ago, DNA sequencing has been used primarily for research purposes. Illumina's technology is the gold standard, as 90 percent of the world's DNA sequencing output is produced on its instruments. Although its products and services are expensive, the company's systems offer solutions for both the low and high ends of the market. This means that customers can chose what kind of performance and metrics best satisfy their data and budgetary needs. Furthermore, if sequencing makes the transition from the research setting into widespread diagnostic and clinical application, this could potentially mean a long runway for growth, potentially a $2 billion-plus market by next year.

Currently, the company operates in two core segments: microarrays, which accounts for 40 percent of sales, and DNA sequencing, which does for 60 percent. It is the market leader in both categories and about half of its revenue is generated outside the U.S., in Europe and the Asia -Pacific region. The core of Illumina's business model is being a one-stop shop for genetic research. It has built and installed base of low-margin instrumentation, and earns significantly higher returns through its single-use consumables. Its microarray and services make up for the rest of its portfolio and round up the "razor/blade" business model, creating a sticky customer base and preserving returns in the long run —Â both components crucial in the life sciences industry.

In spite of Illumina being currently the undisputed leader in the genetic research market, its competition has recently intensified as a new range of promising technologies has come to existence from other powerful players. This, naturally, poses a potential risk. If the use of semiconductor chips in DNA sequencing —Â which has demonstrated great promise for fast and inexpensive sequencing, as opposed to optical detection —Â proves to be superior, then Illumina's technology and products could become obsolete.

Innovation is then a natural key to success for Illumina. The company must continuously innovate or it will not be able to keep pace of boiling technological advancement as other firms challenge it and want to take over the market as well. However, Illumina has a proven track record of innovating. This is mostly due to the fact that it spends significantly more than other companies in research and development. Fifteen to 20 percent is allocated to R&D and a long history of acquisitions, which make its focus on innovation unparallel to any other.

Most of Illumina's products are sold to academic research facilities, applied markets, as well as the molecular diagnostics channel and the consumer genomics market. Although Illumina currently receives a large portion of sales from academic and government end users, and a restricted funding environment could weaken its growth, this seems highly unlikely.

The most robust growth is expected for when this technology meets diagnostic and clinical applications in molecular medicine. Illumina is armed with one of the most established technologies in the life sciences industry, and demand for its high-end sequencing technology is very strong. This suggests further rapid growth and a company well-positioned to maintain a large share and expand its dominance presence in the next-generation sequencing market, a relatively new and unexplored market.

What You Pay Is What You Get

This stock is certainly trading at a premium price, and there is no doubt that those who invested early in it got the best of Illumina. However, it might not be too late. Stanley Druckenmiller (Trades, Portfolio), Jim Simons and Steven Cohen still think that this stock is worth its price and have recently taken a stake in this company.

 Illumina, Inc. Industry Median West Pharmaceutical Services, Inc. (WST, Financial)
P/E 180.60 24.10 29.50
Market Capital 19.06 B - 3.2 B
ROE 11.50 7.10 11.10

Illumina has a strong balance sheet and therefore, the capacity to re-invest in its business, repurchase shares, acquire new technologies or enter into new partnerships. It also generates high profit margins, which are likely to expand thanks to new development in DNA sequencing applications and from its "razor/blade" business model as well.

Disclosure: Vanina Egea holds no position in any stocks mentioned.