Illuminating Illumina

• Email
• Share
• Print

How should I put this? On the surface things look really good. Huge revenue increase, some great new products, and you've got an outstanding quarter, right? So said Motley Fool Stock Advisor recommendation Illumina (Nasdaq: ILMN) when it released earnings yesterday. But if you dig in just a little bit ...

Illumina sells DNA sequence analysis equipment, both sequencers (instruments that read the sequence of the nucleic acid) and marker analyzers. These are used by scientists who work on getting sequences of different DNA genomes, as well as measuring variations in different sequences. Remember the Human Genome Project? Well it could have been done a lot faster and cheaper with the instruments Illumina and its competitors, like Affymetrix (Nasdaq: AFFX), sell. But of course, the technology wasn't as advanced back then.

But their business model isn't as intimidating as all that. In fact, it reminds me of the classic one by Gillette. You know, the "razor blade" one. Sell the razor for a little and make a killing on selling the disposable blades. Except Illumina sells the instruments for a lot and then keeps on selling the disposable "chips" and chemicals used by the instruments over and over and ... well, you get the idea. It's a common strategy. Invitrogen (Nasdaq: INGN), the soon-to-be new owner of Applied Biosytems (NYSE: ABI), and Sequenom (Nasdaq: SQNM) both do the same thing with their DNA analysis products.

Illumina has been kicking butt and taking names this past quarter doing just that. Revenue grew by 54% over last year, topping $150 million. Consumable sales accounted for 60% of that at $90 million, growing from just $53 million a year ago. Gross margin grew 180 basis points, as they managed to sell more higher margin products this quarter than a year ago.

However, net income fell from $14.5 million last year to negative $7.3 million this year. Why? Well, they acquired Avantome for $26 million in cash up front along with up to an additional $35 million if certain milestones are met. They paid for that using proceeds from a (split-adjusted) eight million share offering last summer that brought in $343 million. As part of the acquisition, they had to take a $24.7 million charge on the acquired in-process research and development costs, and that wiped out their net income under GAAP.

So how do you compare apples-to-apples and see whether they met or missed the $0.16 earnings per share expected by analysts? Management conveniently backs out that R&D expense, along with other items like stock-based compensation and the amortization of intangible assets, to come to a non-GAAP net income of $28.6 million or $0.22 EPS, some 29% higher from last year. Fantastic! They beat estimates!

Except that there's something called "FAS 123(R)," an accounting practice on the books since 2006, which requires including stock-based compensation in figuring net income. In fact, one of the analysts covering the company, Doug Schenkel of Cowen said during the conference call, "the reality is that consensus expectations typically do include the impact of stock [compensation]." So if we put that back in, EPS was actually $0.15.

Which means that Illumina missed expectations -- maybe if they hadn't grown stock-based compensation by 47% since last year, they wouldn't have. Why does Illumina management continue to report "what would have happened" if stock-based compensation wasn't included? They've done so each quarter this year. Affymetrix doesn't.

Dig into the numbers, Fools. Doing so will help you see what's actually happening at companies before you invest.