Illumina (NASDAQ:ILMN) has been an investor favorite for more than a decade, and over the past decade it's been one of the market's best-performing stocks, with total gains exceeding 5,000%:
A stock with a history of outperformance can often continue its winning ways, and I recently explored several reasons why Illumina might continue to reward investors in the future. But it's also worth considering the other side of this coin. What might cause Illumina to lose its wings and drop from its lofty perch? Let's take a look at three reasons why Illumina's streak of outperformance might come to an end in the near future.
Valuation, valuation, valuation
Illumina has never really been "cheap" in a value-investing sense, and its current triple-digit P/E ratio is higher than all but 14 stocks on the S&P 500 (SNPINDEX: ^GSPC), most of which belong to either tax-advantaged entities or companies coming off of massive one-time write-offs. Illumina's price to free cash flow ratio, which has typically been much lower than its P/E, is still nonetheless higher than all but 40 of the S&P 500's components:
A high valuation is not necessarily a sign of impending doom, as longtime Amazon.com shareholders should know. But this exception is so rare that it only serves to emphasize a general rule of the stock market: valuations tend to not remain sky-high forever. It generally doesn't matter much whether a stock's P/E comes back to earth because the company has boosted its bottom line or because investor sentiment has changed, because it's very rare to see a company with a triple-digit P/E maintain strong stock performance when its valuation drops significantly.
Illumina's earnings per share have grown by 160% over the past five years, but its P/E has also risen at the same time. Should Illumina's P/E ratio fall by half in the next five years, it would have to boost its EPS by more than 700% to sustain the same share-price growth it has enjoyed over the past five years. Simply keeping its share price stable would require a doubling of EPS if Illumina's P/E ratio falls by half. This is certainly possible, but investors tend to not buy stocks because they expect them to stay at the same price.
Competition will only intensify as costs drop
Today, Illumina has a commanding lead in the genome sequencing industry, as roughly three-quarters of the next-gen sequencers sold are Illumina machines. But it's far from certain that Illumina will maintain its dominance, particularly in a field that has changed so rapidly in the past decade.
Illumina's fiercest challenge came for years from Life Technologies, which is now a part of Thermo Fisher Scientific (NYSE:TMO), a diversified biotechnology equipment company with roughly twice Illumina's market cap, but with nine times the revenue, nearly seven times the net income, and nearly six times the free cash flow:
Life Technologies' sequencing business makes up only a fraction of Thermo Fisher's revenue, but its deeper resource base and superior financial strength could pose a huge challenge to Illumina -- particularly if Life Tech researchers hit on a breakthrough that makes its sequencing offerings more effective than Illumina's.
And Thermo Fisher isn't the only real threat to Illumina's dominance. For the past two years, privately held Oxford Nanopore has made a lot of news with technology that it claims can sequence a genome for less than $1,000 using a handheld device that can fit on a USB stick. Other sequencing companies have failed to make much of a dent in the market, but large med-tech companies like Roche (which tried and failed to buy Illumina last year) have also yet to make serious inroads into sequencing. If any of these megacap med-tech companies hit on the right combination of price and productivity, Illumina's lead could vanish in a hurry.
Illumina's technology might become obsolete
Remember Zip drives? Or HD-DVD? Or pagers? These and many other technologies were once very popular -- more popular by far in the public mind than Illumina's sequencers -- and the general consensus was that they would stick around for a while. Instead, all three are now prime examples of dead-end technology, which is simply a technological format that once seemed destined to dominate its market before a superior alternative with broader applications came along.
Illumina's sequencing technology is the industry's favorite, but all it takes is the development of a better, cheaper, faster alternative to knock the king off his throne. There aren't a lot of clear challengers right now, but continued development could result in one of Illumina's competitors leapfrogging its technology, or might even result in the development of an as-yet-unknown alternative, similarly to the way Zip drives were blown out of the water by CD-ROMs and later by thumb drives.
Oxford Nanopore and its nanopore sensors have been a highly visible alternative, but the company's offerings haven't quite caught fire in the marketplace yet. Roadblocks to nanopore technology's widespread use include the difficulty of controlling the speed of DNA movement through the pore sensor, and the lack of a high-fidelity sensor zone in the pore. Nanopores have been on the table as a sequencing technology since before the first genome was sequenced, but its drawbacks have thus far prevented it from grabbing market share from Illumina.
IBM (NYSE:IBM) has also been developing genome-sequencing technology based around semiconductor sensors for nearly a decade, but a high-profile collaboration with Roche led to a similarly high-profile failure last year when Roche effectively backed out of the genomics business. These public disappointments only serve to highlight the difficulty of actually developing something that can beat Illumina at its own game -- but that doesn't mean large, well-funded competitors will stop trying.
Three good reasons?
It's no accident that Illumina has been the world leader in genome sequencing for years, but its current position may be more akin to the last manufacturers of mainframes before the PC's launch. Smaller, cheaper, and more efficient sequencing tools could be right around the corner, ready to capture share from a seemingly unbeatable incumbent. Are these reasons enough to stay away from Illumina's stock today? For many investors, the answer is still no, but tomorrow could change everything -- it often does for companies on the bleeding edge of technology.
Alex Planes has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Illumina, and Thermo Fisher Scientific. The Motley Fool owns shares of Amazon.com and International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.