Illumina: DNA Sequencing Dominance

I try to read through one 10-K a day as a habit that keeps the boundaries of my circle of competence expanding constantly. Sometimes I come across a company that I like for one reason or another and going forward, I will try to post interesting ideas from time to time. If you are interested in my latest ideas, check out issue 51 on Appfolio and Planet Fitness as well as one of my favorites, issue 33 on (Brookfield Asset Management's CEO) Bruce Flatt's talk at Google.

This week, I wanted to share a few notes on Illumina ($ILMN), but first a shout out to Nusair Bawla for the tip as well as David Gardner for connecting us through the Motley Fool podcast!

At a high level, Illumina sells genetic sequencing machines, consumable products that are used in the sequencing process, and ancillary services to researchers and clinicians (medical as well as agricultural). In trying to understand a new company in a new industry that I am admittedly a know-nothing in, I have relied on a few reports Nusair sent me to get up to speed on the basics of the genetic sequencing market as well as the latest 10-K. The biggest questions that will impact Illumina as a company in my mind are if 1) the market for genetic sequencing will continue to grow significantly and 2) if Illumina can capture a meaningful, profitable piece of the growth. 

Market growth

We are just beginning to unlock the potential for genetic research to impact medicine and agriculture as the cost of genetic sequencing continues to fall due to technological breakthroughs from the likes of companies like Illumina. Per Grand View Research's piece on next generation genetic sequencing, the NGS market is poised to grow over 10% annually going forward, with Illumina and Pacific Biosciences leading the pack in terms of installed sequencing machines:

"Most service providers employ platforms from Illumina, PacBio, and Oxford Nanopore Technologies."

According to ARK Research, genetic sequencing costs could reach the long desired level of $100 per run in the next decade according to Wright's Law of production costs (see below for a great paper on long run predictive power of Wright's Law), which would mean an exponential increase in the number of sequencing runs per year (translated: $$$$ for more machines, consumables, and services). 

Competitive Position

Illumina is the absolute market leader in terms of sequencing machines, with roughly 75% market share, and Morningstar believes that due to their machines' high throughput rates that potentially up to 90% of genetic sequencing runs come out of an Illumina machine today. Back in late 2018, they also announced a buyout of Pacific Biosciences to compliment their suite of short-read genetic sequencing machines (I'll spare you the technical details, but suffice it to say, they plugged holes in their product offering with this merger). The company generates enough free cash that if there are technological threats on the perimeter of their moat, they have a legitimate option to simply acquire the competitors. They also have the capacity to invest this free cash flow in up and coming startups, as they have in GRAIL, an early cancer detection company.

Valuation

As of 3/28/19, Illumina traded at $305/share, roughly 54x trailing free cash flow. They have grown cash from operations at roughly 18% over the past 5 years and EPS at about the same rate. Notably, their returns on equity have been north of 20% for the last 4 years. While the future seems bright for this market leader, the valuation seems a bit rich. But with markets at near all time highs, I wouldn't mind a pullback to open a small position on the cheap. Disclosure - I am not long this security but may purchase shares in the future. 

Notes:

*Illumina 10-K

*As of the 2018 proxy filing, Illumina's CEO owned $20M  worth of stock with most of his salary paid in equity comp and their chairman owned roughly $100M worth of stock, so it seems that they like to eat their own cooking.