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There aren't many companies that have done what Illumina, (NASDAQ: ILMN ) has done. Illumina does not have monopoly share, but it also doesn't have much to worry about today in terms of competition. I have my doubts as to whether Thermo Fisher Scientific (NYSE: TMO ) is truly prepared to invest the sort of sums into R&D that it will take to make Life Technologies Corp. (UNKNOWN: LIFE.DL ) a true neck-and-neck long-term rival, and Oxford Nanopore has struggled to deliver its systems to market on time.
The biggest problem with Illumina is the price. I realize growth investors are famously ambivalent about valuation, but it looks to me as though the market is pricing in over 20% long-term free cash flow growth for Illumina. At that pace, the company would have well over $5 billion in revenue in 2022 and the sort of free cash flow margins that even the best med-tech, pharmaceutical, diagnostics, and life sciences companies struggle to match.
Stretching The Lead In NGS
Based on the data I've seen reported by Illumina, Life Tech, and others in the tools industry, I believe Illumina has something in the neighborhood of 70% market share in the sequencing market, and likely even more in the high-end next-generation sequencing (NGS) category. Life Technologies has struggled to close the gap in terms of error rates, throughput, or ease of use, and while Pacific Biosciences of California (NASDAQ: PACB ) has made great strides in fixing the problems with its platform, it is effectively a niche device at this point.
Oxford Nanopore and its nanopore sequencing approach has long been tapped as a potential spoiler to Illumina's run at the top, but Oxford has struggled to deliver a real-world commercial device. It likely made the right decision to wait until the platform is right before launching (particularly given the sizable hit to its reputation that PacBio took with its flawed platform at launch). Even now, Oxford Nanopore's MinION is only available through a limited early access program.
Illumina likewise has relatively little to fear at present in the desktop sequencing market. Life Tech got a jump with the Ion Torrent buy and its Personal Genome Machine platform and managed to grab a majority share at one point, but Illumina has since come roaring back with its MiSeq platform.
... And bringing it into new markets
Academic/research sequencing is actually a slower-growing market than many investors appear to believe, and one of the keys to Illumina's long-term growth outlook has long been its ability to extend its technology into the diagnostics market. Illumina's initial efforts in diagnostics were clunky, expensive and, at least in my opinion, over-hyped. But while Illumina may make mistakes along the way, this company has a strong record of learning from those mistakes and adapting.
NGS is now starting to become a valid approach in the diagnostics market, and the long-term opportunity in areas like oncology could ultimately reach nine or ten digits. Illumina has also been more than willing to augment its business through M&A. The acquisition of Moleculo, Verinata, and NextBio has added a variety of tools, technologies, and tests to Illumina's portfolio, and I believe that sequencing is gaining share in testing markets like HLA genotyping, cystic fibrosis, and newborn screening.
Illumina doesn't rule the roost in diagnostics like it has in sequencing. Illumina's pricing could yet be an obstacle, and reimbursement and capex trends do still favor Cepheid, Becton Dickinson, and Qiagen. What's more, combo approaches like MALDI-TOF with next-gen sequencing could give the combined Thermo/Life a leg up.
Will The Competitors Step Up Their Game?
Qiagen definitely wants to have a place at the table as sequencing enters the clinical diagnostics market, though the company does not have its own sequencing platform. Given an already-significant presence in the molecular diagnostics market (one of the five largest), I wouldn't rule them out particularly as they are trying to focus on more cost and capex-efficient approaches.
PacBio is also trying to get its house in order. The company has made significant strides in improving its platform, and the company signed a comprehensive agreement with Roche (NASDAQOTH: RHHBY ) in human diagnostics that gives it a particularly strong marketing partner (and one that tried very hard to acquire both Illumina and Life Tech).
Last and not least is Thermo/Life. As I said before, I have my doubts as to whether Thermo Fisher is really prepared to invest the kind of cash into R&D that its going to take to keep pace in NGS and take these platforms/technologies in to clinical diagnostics. If Thermo tries to do it on the cheap, Illumina is likely to be a prime beneficiary.
The Bottom Line
Where I break ranks with the generally bullish sentiment on Illumina is at the point of valuation. Unless you're willing to accept a very low rate of expected return and use a low discount rate, Illumina needs to grow its free cash flow at a 10-year compound rate of 20% or more. Even then, we'd be talking about an Illumina in 2022 that has over $5 billion in revenue and an exceptional free cash flow margin. The diagnostics market is arguably big enough to support that sort of growth, and Illumina has the technology leadership, but it's a demanding standard. With that, I can't see enough value in these shares to prompt me to buy.
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