Illumina Selloff Creates an Entry Opportunity

Genetic analysis specialist Illumina (NASDAQ:ILMN) dropped 11% last week following softer than expected second-quarter results. Both revenue and earnings fell short of the consensus estimates ending a streak of five straight quarterly earnings beats.

The challenging pandemic environment weighed on performance as patients canceled or delayed genetic testing causing oncological and prenatal test volumes to be down.

Illumina's sequencers have played an important role in learning more about the COVID-19 virus. In December 2019, the company began working with the CDC in China and its next-generation sequencing (NGS) machines were used at the Shanghai Public Health Center to sequence the first complete genome of the novel coronavirus.

Nevertheless, many investors headed for the exits after the Q2 report. But we've seen these dips before. Those that are patient will reap the rewards of investing in an outstanding company that is the clear leader in its fast-growing field.

What Does Illumina Do?

San Diego-based Illumina makes integrated systems that are used to sequence and analyze DNA. It sells its gene sequencing machines and services to a range of customers including academic institutions, genomic research centers, hospitals, and laboratories. The products accelerate and simplify the genetic analysis process. They are used to develop genetic-based therapeutics for a range of medical conditions.

Illumina's sequencing machines are big and expensive. It shipped more than 2,400 systems in 2019, the most in company history. This brought its global installed base to over 15,000.

However, since it is such a big-ticket item, its customers tend to buy one or two machines and then hold off for a while before upgrading to new models. So, there is an upgrade cycle similar in nature to that of Apple's iPhone.

The high price, low sales volume nature of the business means a couple of machines can make all the difference in the company's quarterly results. And therefore, investors should pay little attention to the quarter to quarter performance and instead focus on the longer-term growth pattern and the growth that lies ahead.

What are Illumina's Growth Prospects?

Illumina earns most of its revenue from consumables. These are the array-based testing materials that are used to conduct the genetic tests. The more its machines are used, the more money it makes. Think the Gilette razor/razor blade business model, but on a much larger scale.

Illumina's high-end machines have historically been the HiSeq and HiSeq X. It recently launched the NextSeq2000 an NovaSeq machines which offer a significant increase in density and throughput in addition to lower operating costs.

Illumina is undergoing a multiyear product transition upgrading its existing user base to NovaSeq. The company initially estimated that it would complete this conversion by 2024 but has since withdrawn the forecast due to the pandemic.

At the same time, it has launched a series of less expensive desktop machines including the MiniSeq, iSeq, and Next Seq which have been well received by the market. More importantly, these introductions have opened Illumina to a broader market by allowing it to cater to smaller labs that have more modest budgets.

A broadening customer reach is also being driven by a fast-declining sequencing cost per genome. In 2010 this cost was over $15,000 but has since come down to approximately $800. A further reduction in sequencing cost will make Illumina's products even more affordable and expand its addressable market.

Illumina products have several health care applications including genetic disease research, prenatal testing, and much more. The opportunity for NGS to inform cancer care is perhaps its largest growth opportunity. The use of sequencing in early cancer screening has a current adoption rate of less than 1% globally. As projects like the Bill Gates and Jeff Bezos-backed GRAIL cancer detection blood test progress, it has the potential to impact about 100 million lives.

Is Illumina Stock a Buy?

Illumina has a dominant 70%-plus share in a market that is set to explode over the next 10 years. In the meantime, it is continuing to invest in its platform to improve both the functionality and accessibility of its next-gen DNA sequencing products.

Illumina now trades at 57x forward earnings which reflects its lofty growth expectations. It also makes it prone to market selloffs in the event of disappointing headlines as we saw recently. Its P/E multiple is considerably above that of its peer group which includes companies like Thermo Fisher Scientific.

The company has a high likelihood of delivering on its growth expectations as the genetic sequencing field continues to expand. It is also at a favorable point of the product replacement cycle with many more customers expected to upgrade to NovaSeq over the next few years. The upgrade to the must-have, more expensive NovaSeq and expansion of its customer base by launching new desktop sequencers should drive meaningful growth over the next several years.

The premium valuation is warranted given its above-average growth metrics and relative financial strength. Illumina has a healthy balance sheet with a 29% debt to equity ratio.

The impact of the pandemic on Illumina's financials will likely dissipate in the back half of the year. Heading into 2021, the company should be well-positioned to generate at least the 21% earnings growth it produced in 2019.

The second quarter was mildly disappointing but did little to change Illumina's long-term fundamental growth story. Corrections in the share price have repeatedly proven to be good entry opportunities and the latest drop is no exception. The company deserves a pass for the quarter and investors can expect the stock to resume its upward trajectory.