Leader in Genomic Sequencing Illuminates the Way

As the current leader in genomic sequencing,

Although Illumina management's preview of 20% revenue growth and adjusted earnings per share of $3.12-$3.18 for 2015 falls modestly below our expectations, we don't anticipate any change to our fair value estimate at this time. Management has a history of kicking off the new fiscal year with a conservative tone, and we think new product announcements, including the next evolution of HiSeq instruments, along with ongoing strong equipment and consumables sales among all instrument product lines should enable Illumina to outpace 20% growth during 2015. Additionally, Illumina will begin selling the HiSeq X in a smaller five-instrument bundle, which should continue to expand the market in this highest-throughput category. Despite management's somewhat subdued growth outlook, the company expects gross margin near 73% in 2015, which is considerably healthier than our prediction. Although the evolution of the genome sequencing market remains uncertain, especially in the clinical prenatal testing and oncology fields, we think Illumina's technology advancements continue to support its narrow economic moat.

Technological advancements in the sequencing industry have brought down the cost of assembling one genome from nearly $3 billion and 13 years by completion of the Human Genome Project in 2003, to almost $1,000 and a matter of days following the announcement of Illumina’s HiSeq X in early 2014. Further innovation should continue to push down these costs, enhancing accessibility to this technology. With the number of sequenced human genomes likely in the low hundreds of thousands, we also see plenty of opportunity for increased demand, especially in oncology and reproductive health. We estimate that the genome sequencing market opportunity exceeds $20 billion.

Likely demand growth for genome sequencing places Illumina as the clear winner for the time being. Illumina’s on-instrument solid phase amplification and fluorescently labeled sequencing-by-synthesis technology support one of the most versatile platforms in the industry. By nearly every measure--sample preparation time, run costs, turnaround time, read lengths, throughput, and error rates--Illumina squashes the current competition. It also offers a strong assortment of sample preparation and post-run data analysis tools, including its open-source and cloud-based data storage and genome assembly software.

In the near term, we think Illumina can continue its leadership in driving down sequencing costs, but threats from disruptive technologies will remain a concern. Ongoing improvements in the company’s flow cell density, chemistry processes, and camera speeds should support throughput and cost improvements. While some emerging technologies have made big promises, we’re unconvinced for now that these emerging systems can dethrone Illumina. In the meantime, Illumina pursues its own innovative methods.

Our Fair Value Estimate Is $220 per Share

Our fair value estimate for Illumina is $220 per share. We assume that Illumina can sustain its high revenue growth thanks to three primary factors. First, improving macroeconomic conditions should ease customer research budgets and allow greater shifts in funding resources toward sequencing technologies. As the leading sequencing technology in the market, Illumina should benefit from this increased spending on sequencing. Second, we think Illumina will continue to gain market share from

We also project that margin expansion will grow Illumina’s bottom line faster than top-line results. Sales of higher-throughput instruments should pull through greater amounts of higher-margin consumables. Additionally, management continues to shift a portion of its manufacturing operations to Singapore, which will likely continue to lower the company’s annual tax liability. While salesforce requirements, especially in the clinical diagnostic market, may sustain relatively high operating costs in the near term, we think opportunities for greater operating leverage exist over the long term. Our projections culminate in an operating margin and average return on invested capital near 40% and 30%, respectively, by 2018. We estimate Illumina’s cost of equity at 10%.

Illumina Is Dominating the Genome Sequencing Market Illumina is likely closing in on nearly 75% market share in the genome sequencing market, by our estimate, as its consistent innovation and competitive advantages grow its instrument installed base. While Illumina has essentially monopolized the high-throughput research market, with over 90% of sequenced genetic material likely coming off an Illumina machine, it faces more competition in the benchtop segment (smaller labs and clinical applications). It has nonetheless pulled ahead of its main competition from Thermo Fisher's Ion Torrent platform (which Thermo Fisher gained by acquiring Life Technologies). And Illumina has essentially decimated Thermo Fisher's older SOLiD and Roche's 454 sequencing platforms. For these reasons, in addition to Illumina's rising switching costs and high barriers to entry, we award the company with a narrow economic moat. We realize that Illumina is a young company susceptible to disruptive technologies, such as nanopore devices, but we view such threats as remote.

Customer switching costs are slowly rising in the sequencing market, as Illumina becomes the most widely adopted platform. Customer orientation around laboratory workflows (including quality control, sample preparation methods, and study protocols such as CLIA certification in the U.S.) and support from industry publications are difficult hurdles for competitors to quickly overcome. We think these factors will become even more important as genome sequencing becomes more accessible to smaller research and clinical laboratories possessing less technical expertise and fewer resources. Over the next few years, the FDA will likely become increasingly involved in regulating the rise of sequencing technologies in the clinical diagnostic market, which will require evidence of accuracy and reliability backed up by published research. Illumina’s MiSeq is the first and only FDA-approved genome sequencing instrument on the market, and management soon expects its HiSeq and NextSeq instruments to follow suit. Management is also in discussions with the agency for an FDA-approved oncology panel specific to its instruments.

We imagine that Illumina’s industry-leading innovation will continue to keep the company a step ahead of competitors, especially in the larger high-throughput market. Thanks to additional advances in flow cell density and read length to boost throughput, along with faster cameras and chemistry processes to improve sequencing cycle times, we think Illumina’s devices will continue to lead the industry in sequencing costs, speed, and throughput. Illumina has also made significant investments in sample preparation technology and in its cloud-based data storage and open-source analysis software, BaseSpace. Illumina possesses nearly 800 issued and pending patents in the U.S. for its technology.

While we admit that the threat of an emerging sequencing platform could derail Illumina’s trajectory, we think Illumina’s dominance in the high-throughput market, expected limitations of new technologies, and Illumina’s ongoing innovation and capital allocation should preserve the company’s growth opportunities and returns on capital. Due to high thresholds for a competitor to directly blunt Illumina’s essential monopoly of the high-throughput portion of the market, we don’t envision any threats to this segment in the near future. Sales of Illumina’s high-throughput HiSeq machines compose nearly 50% of the company’s sales, by our estimate. We think there’s more risk for Illumina in the benchtop market, but based on our knowledge of emerging technologies, we’re skeptical that any competitor could make serious inroads over the next few years.

Genome Sequencing Technology Has Significant Advantages Over Existing Molecular Tests Genome sequencing has a number of inherent competitive advantages that make it a powerful technology and a potentially disruptive force in the diagnostics market, in our opinion. First, genome sequencing's ability to directly read DNA eliminates the need for test menus. For example, a diagnostic lab currently needs to use a separate in-house LDT or diagnostic kit to run various tests, such as PCR, for different biomarkers of interest. If evaluating a lung cancer patient, a pathologist might select multiple tests to evaluate odds of success for various treatment courses. Genome sequencing, however, eliminates the need for multiple tests since its DNA readings can easily be scaled to specific test needs. Genome sequencing is capable of sequencing a whole human genome, only protein-encoding portions of the genome (called exome), or other specific sections of the genome through targeted library preparation.

Second, genome sequencing is highly accurate. Because of on-instrument PCR and a high number of reads per run (called coverage), genome sequencing uses extremely high throughput and repetition to produce accurate results, generally on par with or better than most current molecular tests. In noninvasive prenatal testing (NIPT), for example, genome sequencing on Illumina’s machines appears more accurate at detecting trisomy 21 (Down syndrome) than conventional serum screening tests.

Third, we think genome sequencing has a much higher barrier to entry than other segments of in vitro diagnostics. From our perspective, barriers to entry are high in genome sequencing because of the intersection of three highly technical fields required for reading genetic information--biochemistry, electronic instrumentation, and complex data analysis. While venture capital still easily flows into this nascent market, getting an actual product to market has proved extremely difficult for numerous contenders. Sizable hurdles exist in manufacturing scalability, development of molecular enzymes needed for processing and amplifying genetic material, microfluidic engineering, complex software algorithms for assembling massive amounts of data, and supportive customer services. Companies attempting to transition sequencing techniques from a small-scale setting into the high-throughput needs of research labs and diagnostic clinics have mostly failed addressing accuracy, ease of use, and machine durability requirements. It’s possible that Illumina will face a new entrant down the road, but it seems far ahead of competition at this point, which enhances its economic moat.

Genome Sequencing Threat to Established Diagnostic Players Creates Opportunity Genome sequencing has penetrated only a small portion of the clinical diagnostic market, but its market opportunity and growth trajectory will probably remain very high as accessibility to this technology expands. Genome sequencing's capability to quickly read the entirety of an individual's genetic makeup will likely present large opportunities in newborn screening, as well as other possibilities in adult populations, such as detecting predisposition to various disorders and diseases. Currently, genome sequencing is used primarily for higher-risk pregnancies (predominately resulting from high maternal age), representing only a fraction of the nearly 200 million global pregnancies per year. Noninvasive prenatal testing presents an approximate $1 billion to $2 billion market opportunity as it reaches average-risk patients and gradually replaces the current serum screening process for disorders like Down syndrome. Similar to the oncology gene panel, we think genome sequencing is approaching price competitiveness for targeted, simpler genetic screens. As sequencing costs continue to fall over the long term, we think NIPT will eventually expand to whole-genome sequencing, potentially pushing this market toward $6 billion due to the great amount of information and quality of genetic content provided by the test.

The costs of sequencing exomes on Illumina’s MiSeq or NextSeq instruments have already largely become competitive with numerous molecular diagnostics, in our view, which should begin to accelerate clinical market adoption. Illumina continues to increase read lengths of DNA and speed per cycle, which lowers costs per sample by improving instrument throughput. As we previously mentioned, sequencing’s capability to read large amounts of DNA negates the need for multiple molecular tests that target specific gene segments. Thanks to ongoing innovation, genome sequencing costs should also continue to fall, making this technology even more price-competitive.

Illumina and numerous others, including other test manufacturers like

Regardless, the high pullthrough of consumables used during the run will remain proprietary to Illumina and Thermo, and broad market acceptance of gene panels nonetheless grows the installed base for their instruments. Since associations between genetics and the diagnosis of conditions and successful administration of drug therapies will likely continue to increase, the gene panel market appears to be a good opportunity for Illumina and a negative for current gene-based tests and companion diagnostics. Illumina received FDA approval of its MiSeq machine in November 2013 in anticipation of clinical evolution of genome sequencing, with FDA approval on its other machines like NextSeq following shortly. Illumina has also announced gene panel test partnerships with Johnson & Johnson, AstraZeneca, Sanofi, and Amgen (for Vectibix).

Management Faces a Tall Order in Sustaining Illumina's Leadership We rate Illumina's stewardship rating as Exemplary, based on the company's history of shrewd capital allocation. Nevertheless, we acknowledge that management faces a tall order in the quest to sustain the company's leadership amid the blistering pace of development and a field of potentially disruptive technologies in the industry. One serious misstep or the failure to acquire a realizable disruptive technology could meaningfully inhibit Illumina's long-term success. Illumina's management team is likely more cognizant of these threats than anyone else, however, and we think management has excelled at driving industry innovation and picking winners through capital deployment.

In our view, Illumina’s innovation through high research and development spending, combined with prescient and well-timed acquisitions, has upheld impressive growth and returns on capital for this company. Illumina’s dominance in the sequencing market largely stems from the 2007 acquisition of Solexa, which gave Illumina the foundation of its fluorescently labeled terminator sequencing-by-synthesis chemistry in all of its sequencing machines. More recent acquisitions, including Epicenter Technologies, NextBio, and Moleculo, have addressed some of Illumina’s platform weaknesses while other acquisitions, including BlueGnome and Verinata Health, have helped lay the groundwork for growth in diagnostics. Illumina’s leadership in pushing the sequencing innovation curve while also building out its sample prep and data analysis has positioned it as the preferred sequencing platform.

Jay Flatley currently leads Illumina as CEO, a position he has held since 1999, over which time Illumina has experienced tremendous growth. Flatley was previously the co-founder and CEO of Molecular Dynamics from 1994 until its sale in 1998. Marc Stapley, previously with