Stock of the week: Illumina

Summary:

• Illumina (ILMN.US) is unquestionable leader in DNA sequencing industry

• The company keeps making significant R&D investments

• Strong cash flow may allow company to conduct dividend payouts once industry stabilizes

• Illumina looks more efficient than its major competitors

• Inverse head and shoulders pattern can be spotted on the chart

Biotechnology industry is undoubtedly a profitable one given rising awareness of how important people’s health is. Success in this field is to a significant extent a matter of innovation and getting ahead of competitors in terms of developing new drugs. However, before a proper drug can be recommended to a patient, illness must be diagnosed. This is where Illumina (ILMN.US), the US biotechnological company, steps in.

As Illumina’s operations grow so do their R&D expenses. Maintaining a relatively stable share of R&D expenses in comparison to revenue allowed the company to stay ahead of its competitors. Source: Bloomberg, XTB Research

Illumina was founded in 1998 and its core operations focus on providing instruments and services needed in DNA sequencing and analysis. Thanks to constant innovation Illumina managed to drag down cost of sequencing a DNA of a single person from around $100 million in 2001 (when the first DNA was sequenced) to just $1000 now. Moreover, the company executives believe that in just two years they will develop machines that are able to sequence a single DNA for $100. Figures are looking impressive but one may ask why DNA sequencing even matters. Prevention is a keyword here. Scientist believe that vulnerability to a bulk of diseases depends on one’s genetic predisposition. Academics claim that it is true for sickness like for example heart diseases, diabetes or various types of cancer. As one can see aforementioned disorders are certainly not the ones that can be cured immediately or even at all. Having said that, early diagnosis or determining whether one is vulnerable to particular disease may not only limit potential damage but even save one’s life.

As capital expenditures in the biotech sector are typically small companies like Illumina generate a significant free cash flow in relation to operating cash flow. Source: Bloomberg, XTB Research

As Illumina is a leader and a pioneer in the field of DNA sequencing the company has huge potential. This potential has already began to materialize as Medicare and Medicaid, two major US federal healthcare agencies, announced earlier this year that they will start reimbursing DNA tests. Of course this does not mean that Illumina will secure all of the orders from the two federal agencies but given that 9 out of 10 of all DNA sequenced in history attributes to Illumina, the scope for a revenue boost is huge. One may argue that once the machines are bought by various institutions Illumina may suffer from lack of demand for their products. This is the place where Illumina’s major source of revenue takes the stage - consumables. Every DNA sequencing process requires certains chemicals to be used. These chemicals are sold by Illumina separately and ensure the company will have sufficient operating cash flow to conduct further research and stay afloat once the demand for new sequencing instruments declines.

Selected financial data for Illumina and its major competitors. Source: Bloomberg, XTB Research

While it is hard to find many companies that focus solely on the DNA sequencing business we can construct a peer group with companies named as major competitors in Illumina financial statements. This group includes BGI Genomics, Agilent Technologies, Pacific Biosciences of California, Qiagen and Thermo Fisher Scientific. Taking a look at the table above one can see that Illumina’s liquidity and leverage metrics are more or less in line with industry medians. However, the company seems to be outperforming its peers when it comes to profitability and operational efficiency - margins and rates of return are way higher than industry averages or medians. Cash flow to net income ratio higher than one indicates that company’s earnings are of good quality (net income mostly derived from operations rather than borrowing or divestiture). Spare for Thermo Fisher Scientific, Illumina also generates highest free cash flow per share what allows company to conduct further investments. Additionally, ability to generate excess cash flow may allow company to pay dividends in the future once the industry stabilizes and matures (Illumina does not pay dividends now and that is typical for growth companies).

While Illumina’s revenue constantly rose throughout the past decade its earnings saw some bigger volatility. Nevertheless, the company had only two quarters of losses since the beginning of 2008. Source: Bloomberg, XTB Research

Illumina’s latest financial report (for Q3 2018) was released on 23 October. The company managed to exceed market median estimate in every earnings metrics with net income reaching $227 million (over 23% above consensus estimate) and EBITDA at $297 million (19% above estimates). As the revenue growth remaining in line with prior quarters such a strong beats can be ascribed to the effect of the US tax overhaul as sales came in “only” 3% above median estimate. The company did not recognized any significant risks associated with the ongoing US-China trade conflict (company earns less than 10% of its revenue in Asia-Pacific region). The company has been identifying possibility of lagging behind competitors in terms of innovation as well as unfavourable regulatory changes as major risk factors for years and similar stance was reiterated this time. However, given Illumina’s significant share in the market in the past few years the first mentioned risk does not seem to be a concern for now. Some kind of regulatory hurdles may arise in the US due to the fact that the two major federal healthcare agencies are interested in reimbursing DNA sequencing but so far no major regulatory action took place in this field.

Illumina (ILMN.US) stock marched higher throughout most of the 2018. However, the stock plunged at the end of September. Nevertheless, the price managed to enter an upward price channel later on and break back above the 50-session moving average. One may notice that the latest price action resembles the inverted head and shoulders pattern with the upper limit of the price channel serving as neckline. Source: xStation5