AGB 2020.6 - Illumina (ILMN)
Instruments Lead the Business but Consumables Extract Value
Subscribe to AGB - One analysis of a good business every two weeks.
Disclaimer: As a generalist, we ran into some challenges analyzing Illumina but it was rewarding nonetheless. We try to keep most of the science to a basic level of understanding. Looking past all the technical stuff is a highly defensible business model with an increasing mix towards recurring revenues. The genomic sequencing market is still in its early stages of adoption and Illumina, as the leader in providing the “picks and shovels” for the industry, is well positioned to benefit from its growth.
When genomic sequencing is mentioned, many people think of direct-to-consumer (DTC) companies like 23andMe and Ancestry.com. These companies are well known from their marketing campaigns and because of the novelty factor of genetic testing but they don’t actually use genomic sequencing technology to run their tests. Instead, these companies do genotyping, which compares small sections of a person’s genome to references samples to measure any variances using a technology called Microarrays. Illumina happens to participate in the Microarray business and calls many DTC companies its customers, but the Microarray segment is a small and shrinking part of Illumina’s revenues (just 13% in FY19).
Genomic sequencing (87% of revenues in FY19) is a much more comprehensive process. Illumina’s sequencing instruments use an electro-chemical process to find the exact order of the nucleotide bases (A, C, G, T) of a person’s DNA. This used to take years to do, but a human genome can now can be sequenced in a matter of days. In layman’s terms, sequencing is creating the blueprint of the genome piece by piece whereas genotyping is comparing small sections of the genome (less than 0.1%) to find variances.
That’s not to say that genotyping isn’t useful. It can be used to determine if a person could be more susceptible to certain diseases or other genetic abnormalities based on variances in their genome. But the main drawback is that you need to know where to look and what to look out for to come up with meaningful outcomes.
As mentioned before, sequencing is a time intensive and expensive process but both the run times and costs have come down dramatically, thanks to Illumina. For reference, The Human Genome Project took 13 years and cost almost $3B by the time it was completed in 2003. Since then, the cost per genome reached $15k in 2010 and just $1k in 2014. Currently, users of Illumina’s high-end NovaSeq instrument can achieve sub $600 genome sequences in just a few days.
As the cost of sequencing has come down, new applications have opened up and become more economically feasible. For example, in 2010 when the cost per genome was close to $15k, most genomic sequencing was done for the exome instead of the whole genome. The exome is comprised of sections of the genome that have to do with proteins, which is very useful to sequence. But it doesn’t give you the whole picture as the exome only makes up 1% of a person’s genome. As we reached $1k cost per genome, whole genome sequencing has become more common. With a sub $600 cost per genome other applications such a population genomic sequencing and cancer sequencing have become economically more feasible.
It’s still early days for genomic sequencing. The number of genomes sequenced in research labs (60% of Illumina’s revenues) and clinical hospitals (40% of revenues) has grown exponentially. Over 1.5 million genomes have been sequenced as of 2019, which is still less than 0.02% of the human population. Other species can be sequenced as well as plants and agriculture. Monsanto has been sequencing the genomes of its crops for over a decade.
Why is it a good business?
Illumina has a first mover’s advantage in a nascent industry, which has one of the highest odds of growing into a multi-billion dollar market. That advantage is defended from two sources of power, first by the 1,400+ patents that the company holds and second by the expanding installed base whose switching costs are growing by the year. With its installed base of over 15k active Illumina instruments, Illumina is estimated to command over 70% market share. Thermo Fisher Scientific is the #2 player in the market with almost 25% share.
Illumina can extend its lead because it has the largest R&D budget of any company focused on genomic sequencing. The company has already proven that it has the research and manufacturing prowess to consistently improve sequencing throughput and lower costs for the end user, thereby expanding the market.
Illumina instruments are typically refreshed every 7-10 years, with many mid-cycle upgrades in the years between. The biggest jump at the high-end of the market was from HiSeq to NovaSeq in 2017. With each jump, the cost of sequencing goes down dramatically. The heaviest users of the NovaSeq system can expect to achieve sub $600 sequencing of the human genome.
With its business lead successfully defended against upstarts, Illumina is able to extract the most value out of the genomic sequencing market through its consumables segment. There are two main pieces to the consumables segment: library prep (15% of consumables revenue) and reagents kits (the remaining 85%). Many companies produce library prep solutions and it’s not required for a customers to use Illumina’s library prep offering.
However, it is required that the reagent kits used for sequencing be made by Illumina. The company has certain IP protections on its instruments and reagent kits. But even if the patents rights are ignored, the Illumina instruments themselves have a mechanism to recognize an Illumina reagent kit from a third party kit. The instruments just won’t start a sequencing run with a third party kit. Also, from the end customer’s point of view, it may be foolish to potentially degrade the outcome of a sequencing run to cut costs on reagent kits.
Illumina customers typically fill out purchase orders 6 months to a year in advance and draw down on the orders in accordance with predetermined ship schedules. Illumina has the ability to view activity on connected instruments and determine whether these instruments are ahead or behind their projected usage schedules. There are typically annual price increases for the reagent kits.
Below are the expected consumables attach rates or pull-throughs by each instrument for FY20:
Returns on capital?
Over the past 10 years, Illumina has spent 63% of its capital on R&D, 25% in capex and 14% in M&A. R&D is mainly spent on improving the low, mid and high-end sequencing instruments for the next iteration of existing instruments or new instruments altogether. The advances have allowed new methods of sequencing, higher throughput and increased data output.
Most of the improvement has actually come from advances in the camera technology, both in image quality and smaller form factors. These advances have allowed Illumina instruments to interrogate the DNA on flow cells with much more accuracy, thereby reducing the number of runs required to complete a sequence. The R&D advances also apply to the consumables. The flow cells in the reagent kits are better clustered and can put more sequences together in a single run, thereby increasing the output per consumable used.
Capex is spent on improving the manufacturing capabilities of the company. Scalability is important when dealing with highly complex instruments and consumables. Illumina does all of its manufacturing outside of China, mostly from its facilities in California and Singapore.
M&A has been good for Illumina, starting with Solexa in 2006. With Solexa came the technology to lead the growth of the Next-Generation Sequencing market. The acquisition of Verinata Health in 2013 gave Illumina a head start in the Non-Invasive Prenatal Testing (NIPT) space, which is projected by JPMorgan to reach a market size of $5.4B by 2020. Edico Genome was acquired in 2018, which gave Illumina the DRAGEN software platform, which helps customers analyze the results of their sequencing runs.
Illumina also invests capital directly into start-ups within the genomics ecosystem. The company has an independent venture arm called Illumina Ventures and a separate Accelerator program. Illumina Ventures has a commitment from the company for $100M and $160M for its first two funds. Illumina Ventures has invested from the seed stage up to Series C rounds. One of its early investments was in Twist Biosciences which is now a publicly traded company with a $3B market cap. Illumina’s Accelerator gives capital to start-ups in the form of convertible notes and credits to use Illumina sequencing reagents in exchange for equity. The Accelerator invests in all areas of the genomic ecosystem such as diagnostics, therapeutics, synthetic biology and software.
The general idea of going the venture and accelerator route vs. waiting for many of these start-ups to grow into real companies and then acquiring them outright is that Illumina wants to help expand the ecosystem. The company’s view is that if genomics as a whole gets larger, receives more attention and increases usability, it’s going to be a win for Illumina.
Given that the installed base continues to grow and the number of sequencing runs increases each year, it’s no surprise that the returns on capital of the business are very attractive. The company’s competitive barriers in the form of IP protection and switching costs combined with its recurring consumables business makes the returns on capital very steady. The 5-year average return on incremental capital including R&D spend is roughly 25%.
Illumina has many areas to reinvest its capital and they’re all necessary for the company to continue on its growth trajectory. The most important form of capital reinvestment is R&D because Illumina needs to maintain its technological lead over the competition. Even though its IP portfolio is robust, Illumina must continue to improve the performance of its instruments and consumables to reach the $100 genome and beyond. With lowered costs to sequence come new use cases that will expand the growth potential for the company. The NovaSeq platform should be able to reach the $100 genome within the next few iterations. Software development is also an important use of R&D capital because it can only help extend Illumina’s lead over its competitors. Similar to Apple with mobile devices, Illumina can solidify its position within its installed base by both offering world class hardware and software.
The next most important use of capital is capex because Illumina does most of its manufacturing in house. An ever increasing installed base of users require more advanced library prep and reagent kits. What’s impressive about Illumina’s growth potential is that as the cost of sequencing goes lower, new areas or applications become more economically feasible and lead to growth vectors that weren’t possible before.
For example, population genomics is just becoming a possibility with the sub $600 genome. The NHS (based in the U.K) reached its goal of sequencing 100k people in 2019. Initial discussions for the program started in 2012/2013 but sequencing only started to happen in 2018/2019 due to the lowered costs. The NHS has now increased their target to 500k genomes to be sequenced and plans to implement genomic sequencing as part of standard of care in the U.K. Other population genomics programs are All of Us in the U.S. and the Million Veterans Program.
Another clinical area that shows promise is NIPT, which is already being used to prescreen genetic abnormalities of babies in the fetal stage. NIPT accounted for 10% of Illumina’s consumables revenues in 2019 and is growing at a rapid rate. JPMorgan estimates that the market for NIPT could reach $5.4B by 2020. Oncology is another big growth opportunity for the company, already accounting for 20% of consumables revenues. The estimates for the Oncology market is $70B-$80B by 2020.
While it’s lumpy, the reinvestment rate for the company ranges between 40% and 55%. This is due to the timing of large acquisitions and the impact of the investment/sales of certain strategic initiatives. We estimate that growth in intrinsic value has been approximately 12% annually over the past 5 years. Excluding the Covid related slowdown in 2020, the company should be able to maintain a similar growth rate over the medium term. We have to consider that the growth potential for the end market is much larger than most companies that we’ve analyzed.
What else is important?
Product cycles matter
While there are many different instruments with similar sounding names at the low, mid and high tiers, the high tier instruments are what drive the company’s financials. That’s because the instruments themselves are so disparate in price and the pull-through of consumables is much larger for the high-tier. Customers spend 7.5x more in consumables for the high-tier vs. the mid-tier and over 50x vs. the low-tier.
The HiSeq was such a big leap forward in genomics technology and the NovaSeq launch was just as impressive. As seen in the chart above, instruments revenue growth typically turns negative ahead of a large product launch like the HighSeq2500 (2012) and the NovaSeq (2016). This is because customers hold off until the next best thing is released. Production ramp usually takes a few quarters and demand usually outstrips supply early on.
However, product cycles may matter less in the future because consumables revenues continues to grind higher from increasing usage by existing customers and the adoption from new customers. Because consumables continue to outpace the growth in instruments and services, the revenue mix will mean future product cycles will have a smaller impact on the financials. But as we know, the market recognizes that expansion of the installed base of instruments is what’s going to drive growth of intrinsic value over the long-term.
Microarrays and DTC
While genetic testing using genotyping technology was an interesting fad that showed nice growth between 2016 and 2019, we don’t see this segment growing much for Illumina. The DTC business decreased almost 30% for Illumina in FY18 and another 15% in FY19. The company expects that segment to shrink another 15% in FY20. The DTC business was 8% of revenues for Illumina in FY18 and is expected to be just 3% of revenues in FY20.
There are many possible reasons for the slowdown. The low hanging fruit may be picked already. Consumers that would be interested to know about the variances in their genetic makeup have probably taken a test already. Furthermore, the business model is flawed in a way. Consumers rarely find a need to retest because their genetic make-up doesn’t change. These consumer companies have to come up with a significant improvement for a consumer to take the test again. So we’ve seen the large players such as 23andMe and Ancestry.com pullback in the past year.
Covid-19 has negatively impacted Illumina’s FY20 financials due to the government related shutdowns around the world. Many research labs (60% of revenues) remain empty or at reduced capacity. Customers initially stock piled more consumables inventory ahead of the virus spreading across the world but instrument purchases were pushed out.
The positive impact from Covid-19 is that more genomic sequencing will be done to research and fight against infectious diseases in the future. After the initial spread of Covid-19, Illumina created CovidSeq in just 60 days. This is a diagnostic test and viral sequencing (for positive cases) that runs on the NovaSeq system. It’s a $20 per test revenue opportunity for Illumina. These tests are much more comprehensive than the PCR tests that are more commonly being administered now. Subsequent to the initial launch, Illumina has simplified some of the workflow and extended the testing capabilities to NextSeq (mid-tier) instruments. This will allow local labs to conduct CovidSeq tests. As we know, PCR testing takes up to 10 business days to get results back whereas CovidSeq can be completed in matter of hours.
There are two main areas that Illumina as a company can inflect upwards. First, is hitting it big with Illumina Ventures or Illumina Accelerator. As we’ve discussed before, Illumina has the opportunity to expand the genomic ecosystem with its two start-up investing arms. What gives Illumina an advantage is that the company can offer more than just financial capital. The company can also provide introductions to their suppliers and customers along its supply chain and Illumina can offer access to discounted sequencing runs to help facilitate research and development. Furthermore, Illumina can have a first look at these companies and can opt to acquire them outright.
The second way that Illumina has potential is on the software side. Currently, Illumina offers BaseSpace and DRAGEN software to its customer base. BaseSpace is interesting because it offers a solution to analyze, store and share genomic sequencing data. Illumina has the potential to offer both cutting edge hardware and software to the industry, similar to what Apple has done with iOS. It’s still early days, but Illumina can solidify its position through the development of software.
If you made it this far, I hope you received some value from reading our analysis. Please subscribe to the free newsletter (if you haven’t already) and share with anyone that would find it valuable. Thank you for your support!