Not So Illuminated

 | Sep 23, 2011 | 10:30 AM EDT
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I really like following the life-sciences-instruments companies because of the dense technical jargon, as well as the spectacular flameouts that happen like clockwork. Take Illumina (ILMN), for example. The stock has dropped 44% since mid July on "conservative" guidance and fears over government budget cuts. On Monday the company presented at the UBS Global Life Science Conference and tried to talk the stock (back) up.

Illumina is a maker of genetic-analysis tools and related consumables. Its machines are fantastically cutting edge and phenomenally expensive -- all the elements you need for a volatile stock. (If you like following the semiconductor equipment space, you'll love following this industry!)

Illumina's products simplify genetic analysis and are used by scientific researchers worldwide. While it would seem as though big pharmaceutical companies are major buyers of the company's products, they really aren't. The big customers are members of the academic research community, who really drive the company's revenue growth.

For example, up here in Massachusetts, we battle it out with California for the most National Institute of Health (NIH) grants. In 2010, of the $22.2 billion NIH budget, Massachusetts received $2.4 billion. Labs around Boston, such as those at the Broad Institute, are stuffed to the gills with Illumina's HiSeq DNA sequencers. Each year Broad sequences more than 50 billion base pairs of DNA, which you can download from their website for free.

The HiSeq is used in the highest throughput research environments, since it can achieve 5Gs -- that is, sequence 5 entire genomes. With the HiSeq you just need to spend 2.5 hours prepping your sample and set up the machine, and it will sequence the entire sample in about four days. Just last month, the company announced it was partnering with Oxford University to sequence the entire genome of 500 individuals with rare diseases. Using the old technology, it took researchers 10 years to sequence one entire human genome. The human genome has 3.2 billion base pairs.

The company's flagship product, the HiSeq 2000, costs $700,000 and uses about $500,000 of consumable reagent and chemistry kits a year. The company's latest product, the MiSeq, costs $125,000 and is targeted at lower throughput labs and wealthy individuals who want to build their own dinosaur zoos. In the second quarter, Illumina received 135 orders for the MiSeq, which uses approximately $40,000 to $60,000 worth of consumables per year. Illumina's primary competitor in the "desktop" sequencing market is Life Technologies (LIFE).

Illumina has an estimated 60% market share of the $950 million sequencing market -- a market that is growing in the high teens. The so-called "next-generation sequencing" market has been taking share from the microarray business since Illimina's solutions offer much faster results. Microarrays are collections of DNA that are attached to a substrate, called a gene chip and read by a machine. The leader in the microarray business is Affymetrix (AFFX). Microarrays are a $900-million-a-year business, but the market is not projected to grow very much -- flat to 2% -- over the next few years.

While the Street was looking for 28% revenue growth, management guided to 25%. Sales of the company's newly released v3 Reagent kits have been slow, as researchers are using up their v2 kits before purchasing new consumables. Management believes that, once those older kits are used up, labs will begin stocking v3 kits quickly. The stock was also hit by investors concerns of large government budget cuts. Illumina gets about one-third of its revenue from U.S. labs dependent on NIH funding. Another third comes from European researchers who are dependent on European Union government funding.


With all the uncertainty around government spending here in the U.S. and Europe, it's very difficult for the stock to move higher at this juncture. I believe, at best, that the stock will bounce around until we know how next year's NIH budget will look. Management believes Congress is unlikely to cut the NIH budget by more than 1% to 3%, since no politician wants to be seen as cutting cancer research. However, I believe it could be more than 3%.

I'm also concerned that the MiSeq product may cannibalize sales of the HiSeq, since the MiSeq is so much less expensive. With such a large price differential, budget-conscious scientists may opt for the cheaper solution.

Taking all of this into consideration, I believe it will be difficult for the company to realize its 25% revenue growth plans. Buyers of the stock may end up with the wrong sequence.

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