Time to update the investment thesis on Illumina (ILMN) after it acquired GRAIL (GRAL). To understand this deal, recent events and the investment thesis, I go back to the start of 2017 when I last covered the shares, and to gain some perspective.
After hitting a peak at $220 in 2015, shares had fallen to $140 at the start of 2017. I concluded that after a 40% pullback, appeal was increasing, yet unfortunately, I was not able to pull the trigger with the valuation a bit too steep for me. While the company has great leadership, growth M&A track record and solid growth prospects, I found a 40 times earnings multiple a bit too steep with revenue growth having slowed down to single digits at the time.
A Lot Happened?
Founded in 1998, Illumina has been focusing on delivering sequencing and array solutions for genetic analysis. The basic promise is that understanding the sequencing has the potential to revolutionize healthcare, both in terms of preventive healthcare and precision-based healthcare.
Illumina’s sequencing systems generated about 25-30% of sales at the time, with the consumables business being far more predictive than lumpy systems sales, generating about 60% of sales at the time. The company was of course operating in a tough competitive field including Qiagen (NYSE:QGEN), Thermo Fisher (NYSE:TMO), Roche (OTCQX:RHHBY) (OTCQX:RHHBF) and Agilent (NYSE:A), among others. In fact, Roche tried to acquire the company back in 2012 at levels in the forties, valuing the company at $5 billion and change at the time. Thermo Fisher reportedly tried to acquire the business for $30 billion in 2016, as it pursued the acquisition of Qiagen this year, although Thermo Fisher has made quite a few (large) deals in recent years.
Besides the core business, the company has been working on an interesting project which it called GRAIL. The company had other shareholder in the venture as well, with Illumina at the time holding a majority stake in the business. After spinning the business out and “inviting” other shareholders, Illumina’s stake was cut 20% at the time, with that stake valued around $700 million.
The company has seen strong growth with sales steadily rising from $200 million in 2006, to a billion in 2011, and $2.4 billion in 2016. The company reported GAAP earnings of $3.10 per share, translating into a 45 times earnings multiple, as the company held a small net cash position. While the valuation multiples were coming down a bit after speculation boosted the valuation in 2015 and 2016, after shares came down, I still found shares a bit expensive. This was despite the fact that there was everything to like about the underlying business and its potential.
The company has seen solid growth in 2017 amidst solid organic growth, product and technology approvals and more partnerships. Full-year sales rose 15% to $2.75 billion, with growth accelerating throughout the year, as revenues rose another 21% in 2018 to $3.33 billion. Earnings nearly doubled compared to 2016 with GAAP earnings coming in around $5.50 per share.
Other than a failed takeover attempt for Pacific Biosciences (NASDAQ:PACB), the focus has been on delivering on organic growth and innovation. Nonetheless, revenue growth slowed down to 6% in 2019, with sales advancing to $3.54 billion. Earnings improved sharply towards $6.75 per share, although this was in part inflated by a one-time benefit, with earnings otherwise trending around $6.50 per share.
The strong growth led to shares rising back to $300 again in 2018, and while exhibiting some volatility around this level, it is actually the level at which shares trade today. Net cash balances have risen to $2.3 billion, basically around $15 per share. With operating assets trading around $285 per share, valuation multiples come in around 44 times, the same multiple at which they traded in 2017.
The company has been hit by COVID-19 as well with double-digit revenue declines in the second quarter, yet the company remains profitable and, of course, operates with a very strong balance sheet. So, even if this year might become a “lost” year, the future of the business remains strong.
Big News – GRAIL
In September, big news was announced as the company reached a deal to acquire GRAIL in a cash and stock deal valued at $8 billion. Note that GRAIL has recently been valued at $6 billion in a private equity round as the company was on the verge of going public again.
Illumina is well aware and attracted to the Galleri multi-cancer screening test, for routine and broadly available blood-based screening to detect cancer in an early stage, allowing for cheaper, but more importantly, more effective treatment. The company expects a launch of Galleri as a commercial test in 2021 as the question is how big the revenue contribution of this potentially transformative technology can be for Illumina.
The overall NSG oncology opportunity is expected to grow at a CAGR of 27% to $75 billion in 2035. Note that while the $8 billion deal tag is steep, Illumina held 14.5% of the shares, indicating that it needs to pay nearly $7 billion for the remaining 85.5% stake. The impact of screening is very important, far more important than developing drugs which are effective in a later stage of the disease. After all, Illumina claims that nearly 80% of patients diagnosed in a late stage have died 5 years after diagnosis, vs. just 11% for those who are diagnosed in an early stage.
GRAIL itself estimates that a 1% reduction in cancer mortality might be worth hundreds of billions in the US thanks to better quality of life, productivity and survival, indicating the real potential of the company and technology, and value for society at large.
A $3.5 billion cash component means that the company will operate with net debt just around a billion, very manageable given the size and profitability of the company. The company will issue $4.5 billion worth of stock, meaning that about 15 million shares will need to be issued, marking about 10% dilution given a current share count of 148 million shares. Dilution will come in a little lower, as the company does not need to pay for the shares held by Illumina already. Note that investors of GRAIL will not be capped from their entire upside; they are set to receive royalties depending on the revenue generation in the 12 years to come.
Shares of Illumina fell from $350 to $270, down more than 20% in the week following the announcement of the acquisition, although the move cannot be seen in isolation. The deal announcement came alongside a correction in technology and highly-valued stocks, yet an $80 per share move lower over the time frame of basically a week, coinciding to a $12 billion reduction in the value of the firm, looks like quite an overreaction.
Nonetheless, reality is that the technology is unproven, with no revenues and just significant losses at this point in time. Under normal conditions, this company is set to earn about $7 per share this year, and while the strong net cash position will turn into a very modest net debt load overnight, reality is that I like the potential of GRAIL to be added back to Illumina.
Shares are certainly not very cheap, yet trading at a similar earnings multiple as back in 2016. I have to conclude that interest rates have fallen meaningfully between this period of time, as the company has made further progress in cancer detection at the time, making me more comfortable to consider shares at current levels than the risk-reward in early 2017.
With shares trading at $260 just a few days ago, such levels look quite compelling as I look forward to initiating a position if shares gradually fall towards the $250 mark again.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.