Reducing Illumina's Fair Value Estimate on Near-Term Outlook Disappointing Again

Senior Equity Analyst

Julie Utterback

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Illumina aims to transform human health practices through its leadership of genomic sequencing and related applications. The firm provides a broad range of instruments and related consumables to help researchers and clinicians identify and understand genetic variations. The scale of these projects can be wide, such as population genomic initiatives being pursued in many countries, or narrow, such as noninvasive prenatal screening. We believe Illumina will continue to benefit from the rapidly expanding applications of genomic sequencing tools through its own innovation and select acquisitions. 

Over the past decade or so, technological advancements in the sequencing industry have largely been led by Illumina and brought down the cost of assembling one genome from nearly $3 billion in the 13-year Human Genome Project completed in 2003 to $1,000 after Illumina introduced HiSeq X in early 2014. Further innovation, like the NovaSeq, continue to push down these costs, and Illumina expects its new NovaSeq X Series to eventually enable the $100 genome, which could greatly increase the accessibility of genomic sequencing. At a lower cost, genome sequencing could have wide appeal in clinical applications beyond current strongholds in oncology and reproductive health.

Threats from disruptive technologies may never fully disappear, though. For example, new or cheaper sequencing tools may eventually displace Illumina's stronghold in genomic sequencing. Overall, we remain unconvinced that emerging systems will fully dethrone Illumina's sequencing technologies, though, given the switching costs associated with its large installed system base and its own development initiatives. Additionally, the company's recent bet on Grail's liquid biopsy technology exposes the company to a new risk of disruptive technologies in the very large but nascent preventative care testing market for cancer. So while Grail's technology looks like it will have a first-mover advantage and should have a decent runway to expand before competitive forces materially alter that target market, future entrants may eat into its liquid biopsy potential, eventually.

Business Strategy & Outlook

We believe Illumina operates with a narrow moat around its genetic analysis tools and services. Since purchasing Solexa with its Genome Reader instrument in 2007, Illumina’s continued innovation significantly reduced the cost of sequencing, thereby enabling the rapid expansion of sequencing applications. While disruptive technologies remain a high-risk concern in this innovation-driven industry, we think the firm’s differentiated technology, ongoing innovation, and large installed system base create significant entry barriers for competitors. Therefore, we expect Illumina to generate economic profits for at least the next decade. Admittedly, the recent acquisition of Grail adds some pressure on Illumina to execute and keep returns on invested capital above capital costs.

Illumina relies on intangible assets, such as the more than 1,800 issued or pending patents in the United States as of early 2022, to keep competition at bay. After application, patents enjoy 20-year terms, which keeps competitors from directly copying the technology for a long period of time. Beyond the legal power of patents, even slightly differentiated technical features can cause an end user to prefer one tool over a similar tool in the company’s precise scientific end markets, so we think those other intangible assets contribute to Illumina's competitive advantages, too. Additionally, even similar tools have been difficult for other firms to engineer, given the complexity of this field, leaving Illumina the dominant player in high-throughput applications and with competition in lower-throughput fields, such as Thermo Fisher Scientific.

In general, the differentiated properties of Illumina’s tools affect the cost, accuracy, and speed of the various tests they enable, and those product features create intangible assets that inform decisions to use those tools in specific applications. Thanks to its strong emphasis on internal innovation, including spending nearly 20% of sales on research and development on average during the past five years to advance its sequencing technology and lower the cost per genome, Illumina should remain relevant to end users for the foreseeable future. For example, after the Human Genome Project took 13 years and $2.7 billion to complete in 2003, Illumina’s technology helped reduce the cost of whole genome sequencing faster than Moore’s law in semiconductors--to $1,000 by 2014. This pace of cost reduction and innovation has been unparalleled in the field and has created significant entry barriers for potential rivals, in our opinion. The firm is not resting on its laurels, either; with the new NovaSeq X Series (launching in 2023), Illumina aims to enable a roughly $200 genome including bioinformatics onboard the system, which means the company has reached $100 genome based solely on sequencing.

Illumina also benefits from switching costs. For end users wishing to use an Illumina sequencing system, dedicated reagents and flow cells from Illumina are required, and most of Illumina’s sequencing consumables (64% of the company’s sales in 2021) are dedicated. With its large installed base of sequencers, Illumina should be able to count on significant revenue streams from related consumables going forward. The useful life of its instruments likely extends between 5 and 10 years, and as long as Illumina’s sequencing tools remain relevant, it should be able to count on substantial consumable revenue for the useful life of its instruments. The relevancy of Illumina’s sequencing technology also appears likely to continue for a relatively long period. Illumina's genomic sequencing technology enjoys extensive citations in industry publications, and workflows are developing around its systems that need to be repeated consistently. Therefore, we think end users would need a significant reason to jump ship from Illumina’s tools from a reproducibility and end user training perspective. These switching costs should be pervasive in life science labs, but they may be even more important in clinical labs because regulators play a role in ensuring test accuracy and workflows need to be standardized for a less skilled workforce.

Nonetheless, disruptive technology remains a key ongoing threat, which keeps Illumina's moat rating narrow rather than wide. For example, BGI Genomics, which operates primarily in China due to ongoing intellectual property disputes with Illumina (another part of its ESG risks), announced in early 2020 that its custom-built technology can sequencing a genome for $100. If BGI is allowed to operate more widely, Illumina's dominance of the genomic sequencing market may dissipate somewhat. Other new startups like Ultima and Element look set to enter the fray with cheap technology, too. In general, other sequencing techniques could emerge that eclipse Illumina's technology eventually. So while we think Illumina's advantages are likely to lead to economic profitability for at least the next 10 years, we remain uncertain that those advantages will extend for the next 20 years, given the ongoing disruptive technology risk in this field.

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Illumina

Illumina, Inc. engages in the development, manufacturing, and marketing of life science tools and integrated systems for large-scale analysis of genetic variation and function. It operates through the Core Illumina segment, which serves customers in the research, clinical and applied markets fields, and enables the adoption of a variety of genomic solutions. The firm's products include instruments, kits and reagents, selection tools, and software and analysis. Its services include sequencing and microarray services, proactive instrument monitoring, and instrument services, training, and consulting. The company was founded by David R. Walt, John R. Stuelpnagel, Anthony W. Czarnik, Lawrence A. Bock, and Mark S. Chee in April 1998 and is headquartered in San Diego, CA.

Earnings data Q2 2023

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Icahn Enterprises

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