Illumina Stock Is Investible Despite The GRAIL Issue (NASDAQ:ILMN)

Digital screen with DNA strands and data background. Double helix structure. Nucleic acid sequence. Genetic research. 3d illustration.

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Illumina’s (NASDAQ:ILMN) share price has tumbled by about three times during the last year. This includes a vertiginous drop on May 5 when the net income fell by 41% for the first quarter of 2022 when compared to 2021. Such adverse news pertaining to the bottom line in current market conditions where the value strategy has the upper hand is being punished by the market, but the $7.1 billion GRAIL acquisition also has a role to play in the downside.

Illumina stock price
Data by YCharts

Thus, for investors, I start by analyzing the financial results, but the ultimate aim of this thesis remains to assess whether, in a market dominated by inflationary pressures and recession risks, Illumina remains a valid investment.

The Financials

First, the revenues of $1.22 billion for Q1-2022 were up by 12% compared to Q1-2021. This resulted from sequencing equipment orders growing by 20% on a year-on-year basis, with sales from consumables growing by 13% despite some impact from China’s lockdowns. This country accounts for about 10% of Illumina’s revenues, with Q1 suffering from a $10 million revenue shortfall as a result. The shortfall is expected to reach $35 million in Q2.

Now, considering the revenue scale of Illumina, this represents only a slight headwind.

Second, on the expenses front, there was a 0.3% compression of non-GAAP gross margins due to higher freight costs due to supply chain constraints. The company is not expecting a further deterioration in the second half of the year and at 70.2%, I consider that gross margins are still healthy.

Third, operating expenses (on a non-GAAP basis) increased by 20% due to increased staff and research expenses. Now with extra volumes expected to be shipped in H2-2022, relatively more revenues will be spread on the same expenses, in turn leading to higher operating margins, from 14% in the first half of the year, to 17% in H2.

However, the bright picture I have painted up to now is tainted with the operating loss of $134 million sustained due to the GRAIL acquisition. As a result, Illumina obtained a net income of only $169 million, or a 41% fall when compared to last year as I mentioned earlier. This translates into a $1.07 EPS (diluted) as shown below.

Illumina surprise and estimates

EPS Surprise and estimates (www.seekingalpha.com)

Still, the company managed to beat the consensus of $0.89 and its shares should normally have been rewarded, but, the fact that they went down suggests that market participants seem to be more concerned by the lower consensus EPS of $0.65 for the second quarter of 2022, as well as regulatory news in connection with GRAIL.

A Synergistic Acquisition, With Risks

GRAIL is a diagnostic company that produces oncology tests. What differentiates it from others is that it has produced a single test called Galleri, which can detect about 50 different cancer types at various stages of evolution with just one blood draw. This test cost around $1000 each and allows patients to circumvent the classical battery of tests which can cost much more and have to be performed over a longer period of time.

Illumina acquires grail

Corporate website (grail.com)

After signifying its intent back in August 2020, Illumina pressed on with acquiring GRAIL despite competition watchdogs expressing some reserves. Also, some analysts were not convinced, arguing that it would have made better sense for Illumina to opt for a partnership with GRAIL or even license its product. However, to justify the purchase option, Illumina expects that the acquisition can drive wider adoption of Galleri by using the company’s eight years of experience in getting reimbursement from health authorities throughout the world for over 1 billion people.

Now, with 10 million people dying of cancer every year with 600,000 in the U.S. alone and with cases of cancer on the rise, there should be more revenue synergies. But there is more in terms of cost synergies with Illumina producing the machines needed to identify cancer biomarkers (indicators of related conditions) and Grail producing the test kits. The merged entity should provide end-to-end services and better engage with customers, given that their combined workforce masters all aspects of genetic sequencing.

However, this vertical integration whereby one company acquires another across the same value chain, or its customer in the case of Illumina. With the latter already possessing significant market power, comes the problem of market concentration. This brings us to regulations, with both regulators in the EU and the U.S. being against the deal on antitrust concerns. The basis for objection by the FTC (Federal Trade Commission) is that Illumina is the “only provider of DNA sequencing that is a viable option” for early detection of MCED or multi-cancer early detection in the U.S.

Discussion

Now, in response, Illumina has pledged to reduce its prices and allow GRAIL’s rivals (or oncology testing labs) continued access to its technology. The company’s lawyers have also affirmed that the takeover would not block competitors and, in accordance with regulatory requirements, its operations have not yet been merged with Illumina. However, the regulatory impasse could drag on for years as Illumina may have to make further concessions to government attorneys whose objective is not to impede progress in cancer diagnosis. The company could also be forced to unwind the acquisition.

Now, if viewed from another angle, regulators’ actions against Illumina show the overreliance of oncology diagnostic laboratories on its sequencing solutions, and this, despite the fact that the company faces competition from Pacific Biosciences (PACB) and Oxford Nanopore (OTC:ONTTF). For this matter, MCED is a new field of study for early-stage cancer diagnostics that identifies the problem before the actual symptoms occur, and it is gaining popularity, especially when provided as part of the standard of care screening testing like mammography for example.

Furthermore, oncology testing represents a market size of $75 billion with a penetration of only 4%, signifying that there are huge opportunities. Therefore, in the event that Illumina has to split up with GRAIL, there should be some interest in the diagnostic play among large pharma and biotechs looking to expand their oncology divisions.

Oncology testing market

Company presentation (www.seekingalpha.com)

Furthermore, as a supplier of the high throughput NovaSeq equipment which permits these types of tests, Illumina is already benefiting from the increased penetration of genomic profiling for oncology diagnostic tests. Thus, related NovaSeq shipments accounted for nearly 40% of total sales in Q1, with revenues from consumables increasing by 20% on a year-on-year basis.

Thus, in the worst-case scenario that Illumina has to dispose of GRAIL on regulatory grounds, it still makes for a valid investment due to demand for oncology testing equipment and consumables. More important than growth, there is profitability.

Profitability And Key Takeaways

Looking at profitability, even with its net income falling, Illumina’s margin of 15% as shown in the table below remains well above the health sector’s median margin of -1.93%.

ILMN profitability grade

Profitability grades (seekingalpha.com)

Superior margins deserve to be rewarded in an economic environment where high inflation is inflating the cost of doing business. Equally important, the company had cash amounting to $1.35 billion at the end of Q1. Thus, the genome play is investible, but momentum indicators point to further downside, possibly towards the $175-$180 level, with an upside appearing more feasible from November after the company reports third-quarter results. As discussed in the financials section above, and illustrated in the EPS chart, this upside will result from an increase in profitability.

As for a price target, after falling by 50% since the beginning of 2022, Illumina’s stock could easily climb to the $225 level by the end of the year based on a 30% upside. This remains below Wall Street’s analyst’s ratings of $249.

In the meantime, referring to the FTC case timeline, there should be no shortage of volatility-inducing events as lawyers and regulators fight it out in the federal courts. As a matter of fact, the stock’s downside dates back to mid-August 2021 and coincided with members of the public having access to the Illumina/GRAIL trial via teleconference.

Finally, as a key enabler of genome sequencing for cancer diagnostics, Illumina remains a valid investment as this is a huge market and the company remains a profitable one too. Also, with cancer being a priority area of healthcare, it is unlikely for a recession to curtail labs’ need for sequencers. There has been some noise with the departure of its CFO at a crucial period, and there should be more as the U.S. and European antitrust watchdogs bring further reservations. Still, for the one focusing on the long term, this is an opportunity not to be ignored, but it is better to wait till November.

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