My Thesis

Illumina (NASDAQ:ILMN) experienced several difficulties since 2022: first, the acquisition of Grail turned into a total fiasco (high operational cash burn and a forced divestment by the regulatory authorities). This led to a stressful but necessary management removal, pressured by Icahn. Finally, the end-market growth stalled for nearly two years, pressuring an elevated valuation in conjunction with an environment of raising FED rates.

After such a succession of disappointments, we can wonder: can the company fundamentals improve? I would say so.

In this report, I will go deeper into the details, discuss the main risk factors, and try to evaluate Illumina’s intrinsic value without Grail. I find that once this asset is sold, probably by the end of 2024 or early 2025, upside potential does exist. Liquidity-wise, my calculations indicate that the firm does broadly have sufficient resources to handle the transitory cash consumption, securing the business going concern. To me, it’s a BUY.

Company description

Illumina is the world leader in short-read DNA sequencing helping biotech companies, universities and testing centers around the world to visualize, collect data, and analyze genomic sequences. Such fragments are useful to detect early signs of rare diseases and cancers within human populations but can also understand key structures helping to develop better drugs. Two-thirds of its revenues are recurring and growing, through consumables sold and this increases to 80% if we include services. It developed the next-generation sequencing method which can sequence in parallel a large number of short-DNA fragments helping to drive the cost per sequencing at record low. Becoming dominant and controlling more than 80% of the instrument and consumable market, the previous management led by Francis DeSouza however made several mistakes.

The first one, in my opinion, was not to develop a sequencer within the fast-growing long-read segment. It sold its stake in Oxford Nanopore (OTCPK:ONTTF) back in 2013 and then attempted to buy Pacific Biosciences (PACB) at the end of 2018, which failed due to US regulatory blockage. In 2021, it acquired the early-stage blood cancer testing Grail for $8bn without the approval of US and EU regulators. As a reminder, Illumina span off Grail in 2016 and retained a 12% stake. In such a depressed context, Carl Icahn took a stake in the company during the first semester of 2023 and pushed for a large management and board change, which it succeeded as the new experienced CEO Jacob Thaysen from Agilent came into office in September.

Risk factors weighing on the stock

The first element weighing on the case is related to Grail’s forced divestment. The EU Commission regulatory authority blocked the transaction in September 2022 stating that such a deal would damper innovation and reduce possibilities within the emerging field of early cancer detection using blood samples. The firm was then hit in July 2023 by a EUR432m fine, representing 10% of its 2021 revenues, for taking over Grail without having received the regulatory green light.

Three conditions were required by the EU regulator: first, the obligation to separate operationally and accounting-wise Grail’s activities from Illumina’s core business. Second, it has to bring adequate funding to the entity so it can be viable, and lastly to sell this asset as soon as possible. The divestment method is up to Illumina and could be done through spin-off (and selling its majority stake) or by direct asset sale to a specific entity. To me, the concerning point relates to the funding requirement. During the Q3 conference call, the management confirmed that it has been asked to pay GRAIL for 2 and half years of adequate funding at the moment of divestment. As the management expects an EU decision on its court appeal to happen by mid-2024, probably, any asset sale won’t be realized before end-2024. Looking into details at Grail’s latest financials, we see that the annualized cash burn is close to $700m. Adding calendar 2024 to the 2.5y funding needs, we get 3.5 years of cash cushion which translates into a probable: $700m*3.5 = $2.4bn of cash needed.

Of course, core Illumina free cash-flows will help to fund one part of that amount. On a 9-month basis, Illumina consolidated FCF (CFO-CAPEX: including Grail losses) was $100m.

After the repayment of $1.3bn of short-term debt at expiration, the cash level decreased to $900m, which is not sufficient to cover the 2.5Y of Grail’s future funding need (~$1.8bn). According to my calculations, 2024’s free cash flow (including Grail’s operating cash burn) should not outpace $500m. Therefore, at least $500m additional cash is needed. Taking into account that there is a $500m bond in 2025 to mature, I think that Illumina would have to raise at least $1bn (via debt or equity: on a $18bn market cap). Finally, while uncertain in amount and timing, the sale of Grail should provide some liquidity for Illumina. It’s hard to know what could be a marked-to-market valuation for Grail, but a guess would tell me between $2bn and $3bn if we apply a 60-70% market cap correction (similar to what happened for nonprofitable listed biotech companies during that period). Still, this would not be zero, especially given the bright growth perspectives of this asset. In conclusion: the situation is difficult but not critical in my view and could be manageable.

Another important issue comes from the increasing competition. In particular in China with MGI Tech which was formerly a subsidiary of BGI Genomics. MGI span-off in 2021, as its parent company was hit by US sanctions. Its revenues should be between $400m and $500m in the coming fiscal years according to analyst estimates while the firm is targeting the US market after it won the patent dispute with Illumina. Even if MGI sales are just one-tenth of its US rival, its growth profile seems important. During all recent quarterly conference calls, Illumina management cited increasing competition in China and price pressures. In the table below, we can see the decline of this region.

Could MGI compete from a technological point of view? Well, yes, according to a recent paper from Oxford Academics. This player should therefore not be understated in the long run. Another potential future threat could come from the American company Pacific Biosciences Revio sequencer whose first shipment just happened two months ago.

What valuation can we expect?

First, let’s start with the revenue generation. In FY23, I aligned myself with the revised management guidance stated in Q3, seeing a flat trend. Most of such disappointing results are attributed to macroeconomic weaknesses that impact the capex spending of customers. The CEO won’t display any 2024 guidance before the next quarter, but said that it is safe to assume no clear activity rebound is to be expected in the short term: as a consequence, don’t model any material rebound before 2025. Concerning the near term (>2028), I do set a 5% CAGR per year: in line with mature life science companies.

I modeled gross margins to gradually increase toward 2019’s levels: at 70% by 2026, as materials will increase in the mix and NovaSeq X ramp-up will be achieved. I don’t assume significant competition within the short-read market which could damper margins via pricing pressures, apart from within China which became less than 10% of total revenues. Then, I set R&D and SG&A expenses at 20%/sales as the firm indicated its willingness to cut costs and is in any case pushed to do so by the activist Icahn. All-in-all, I do believe Illumina’s free cash flow to revenues (cash conversion) can gradually return to 30% (2019 levels). Finally, I expect Grail to burn $700m cash in 2024, before the future spin-off. I don’t assume any cash-back from this asset divestment and take into account as debt: the EU fine and the 2.5 years cash injection required by the regulator.

Given this model, a terminal growth rate of +3%, and a WACC of 10%, I obtain a share price of $137/share implying a 20% upside potential given the market price of $114/share. To give more perspective, I implemented a sensitivity analysis, varying medium-term (2027-2033) growth rate and the discount rate:

We see that the recent stock price (below 100$) reflected a dire forecast (high discount rate and zero growth in the mid-term). My main target price is $137/share and could increase to $180/share if Illumina manages to grow again close to double-digit rates.

Considering relative value, we can see that Illumina (removing Grail) is actually much cheaper on a two-year horizon than leaders in the life sciences equipment market in terms of EV/EBITDA and cash-flow yields. According to my calculations on Illumina, the stock is at least 60% cheaper by using these metrics.

Technical analysis

Illumina’s chart has been a disaster and even broke recently a major 2014-2017 major support. Still, positive developments such as the setup of a new qualified CEO, and cost control measures in place in conjunction with margin expansion to come given the J-curve of the NovaSeq X could support Illumina’s Cash-flow generation already in 2024. Starting in 2025, post Grail asset sale, the profitability profile of the firm should progress materially. Thus, I do believe the stock price could bounce back materially and progress upward in the previous technical range.

Conclusion

Illumina is a contrarian call. I do believe the risks mentioned above are excessively priced by the market and that any positive news (business rebound, or positive milestones in the divestment of Grail) could help to re-rate the stock. The business can deliver again a solid cash-flow generation, north of 30% FCF margin. Normalized cash flow yields, post Grail divestment, give enough margin of safety and are well above what can offer major life science equipment companies. I do think the current stock price offers an interesting level to accumulate and benefit from a profitability jump post 2024 which should inevitably unlock value. To me, it’s a BUY.