Illumina and CapWealth Advisors Chief Investment Strategist John Lueken Featured in Barron’s Magazine

Illumina’s stock rose tenfold from 2008 to July 2015. The stock has declined since that high, but we believe it has plenty of upside in the near future. Read the full text of the article below or see the online article here.

Biotech Star Illumina’s Bright Future Is in Its DNA

The company’s shares could rise 50% as labs and cancer centers adopt its gene-sequencing gear.

By Leslie P. Norton

March 19, 2016

CapWealth Advisors Chief Investment Strategist John Lueken

CapWealth Advisors Chief Investment Strategist John Lueken

Sometime soon, in the next decade or so, your doctor will prescribe a medicine that is customized specifically for you, based on your genetic makeup. She will be able to do this because her laptop will contain your entire genome. The sequencing of your DNA code will probably have been done on instruments supplied by Illumina, a San Diego–based company that currently has a 70%-plus share of the gene-sequencing market.

Indeed, the role that gene sequencing will play in customized medicine, infectious disease, bio-surveillance, and food safety is the main reason that Illumina’s shares (ticker: ILMN) rose tenfold, to $240, between 2008 and last July.

Since then, the shares have given back a substantial portion of their gains, partly due to the collapse in health-care and biotech stocks, and partly due to an outlook for slowing growth. Further complicating things, Illumina surprised the Street last week, announcing that longtime CEO Jay Flatley, 63, will step down in July and become executive chairman. Flatley, who joined the development-stage company in 1999, grew it to a $22 billion corporation. The stock sank 9%, to $147, on the news.

Even at that price, Illumina isn’t a cheap stock. It trades at 34 times 2017 earnings estimates, compared with 23 times for the Nasdaq Biotech Index. But some smart money managers see the pullback as an opportunity to buy shares of a company that dominates a rapidly expanding market. “These shares are substantially depressed,” says John Lueken, chief investment strategist at CapWealth Advisors in Franklin, Tenn. “The adoption curve for next-generation sequencing will continue to ramp over the coming five years. It has a huge first-mover advantage.” He thinks the shares could rise 50% in a year or so.

Illumina makes machines that decode the order of the four chemical building blocks in a DNA molecule. These gene sequencers, which can read vast amounts of data, are sold at prices as low as $50,000, for a system that serves molecular biologists, pathologists, and oncology researchers, to $10 million, for one designed for large sequencing projects like Genomics England, which is sequencing the genomes of 100,000 people for the National Health Service. Dubbed “the world’s smartest company” by MIT Technology Review in 2014, Illumina has driven down the cost of sequencing a genome to $1,000 from $100 million in 2001.

Flatley, who holds a master’s degree in engineering from Stanford University, joined Illumina after founding, taking public, and selling Molecular Dynamics, which is now owned by General Electric. An outspoken evangelist for gene sequencing, he fended off a $51-a-share hostile takeover bid from Roche in 2012. Since then, revenue has nearly doubled, to $2.2 billion last year, and earnings have more than doubled, to $495 million, or $3.32 a share.

IN THE PAST THREE YEARS, Flatley hired a number of executives from seasoned companies to help steer Illumina as it grows larger, including Francis deSouza, Illumina’s president, who will become CEO in July.

Raised in Ethiopia and Dubai by a multi-ethnic family—his father is half-Indian, half-Portuguese—deSouza was accepted to Massachusetts Institute of Technology at 16, the first person in his family to attend college. Prior to Illumina, he was president of products and service at Symantec (SYMC), which bought a software company he founded in 2006.

In an interview last week, deSouza, now 45, struck an optimistic note. Previously, the majority of Illumina’s customers were researchers, he said. “In the next decade, the majority of the market will be more clinic- and patient-focused,” which already accounts for 40% of revenue. As Illumina sells to applied markets like police labs, in vitro fertilization clinics, and cancer centers, software will be important to make genomics accessible.

Doug Schenkel, of Cowen & Co., says deSouza “brings unique skills on the technology side and a track record of entrepreneurship” that will drive growth, particularly with software tools to help with data interpretation.

Illumina’s sales have grown at a 20% annual clip over the past five years, and earnings have grown even faster, up 28% a year. Growth has since decelerated. For 2016, Illumina expects revenues of about $2.58 billion, up 16% from $2.22 billion, and earnings per share of $3.55 to $3.65, up around 8%. Free cash flow is expected to be $547 million, up 6%. Illumina executives dismiss the slowdown as cyclical. Its new low-end machines aimed at smaller labs are cannibalizing sales of more-expensive machines, and economic weakness is hitting Asia-Pacific sales. Meanwhile, costs for new ventures like Grail, which is developing a liquid cancer biopsy, will dilute earnings for some time. In 2017, analysts on average expect earnings to grow 20%, to $4.31 a share, on a 16% rise in revenue, to $2.98 billion.

About 90% of Illumina’s revenue comes from selling machines and the sequencing kits that accompany them, as well as sequencing paraphernalia to be run on other companies’ machines. Instrument warranties and other services provide the rest. Customers include research centers, universities, government labs, and hospitals, as well as drug, biotech, and agricultural companies.

Roche Holding and Pacific Biosciences of California also sell gene-sequencing machines, but John McPherson, a genomics researcher at UC Davis Comprehensive Cancer Center in Sacramento, Calif., says that Illumina dominates the market: “Their position is pretty secure for the next two to three years or longer.” Adds Morningstar analyst Michael Waterhouse: “By nearly every measure—sample-preparation time, run costs, turnaround time, read lengths, throughput, and error rates—Illumina squashes the current competition.”

THE BULL CASE FOR ILLUMINA rests on its market dominance, as well as the growing addressable market for machines. Today, applications are moving from research to the clinic. After sequencing “tens of thousands” of human genomes, “we’re now doing real analysis with the clinical or disease status that is associated with individuals,” says Stacey Gabriel, director of the Genomics Platform at the Broad Institute of Harvard University and MIT, a major Illumina customer. Illumina has said that the addressable market is at least $20 billion; oncology alone is $12 billion.

That market could grow even larger with Grail, an Illumina-controlled joint venture launched this year to develop a liquid biopsy that can effectively detect DNA in cancer cells floating in the bloodstream, which would require Illumina’s high-speed sequencing machines. The $100 million venture, led by Jeff Huber, a former Google executive, is also being funded by Bill Gates and Jeff Bezos. The test, which will cost between $500 and $1,000, is designed to screen healthy people and detect cancer while it’s still easy to treat. At least half of cancers in the U.S. are diagnosed at Stage III and Stage IV, llumina says.

It’s expected to reach the market in 2019. The addressable market for Grail is estimated at $20 billion or more.

FLATLEY IS STEPPING down to spend more time “doing much more active evangelism about what next-generation sequencing will bring,” he says, including meeting frequently with regulators and payers. As Illumina’s customers move into clinical applications, there will be regulatory and reimbursement hurdles. Already, the Center for Medicare & Medicaid has set reimbursement for a limited amount of next-generation genetic sequencing. That’s “a good first step…toward formalized reimbursement,” Barclays analyst Jack Meehan wrote in a recent report.

Cowen’s Schenkel believes that a series of new product launches in the next year will bolster sales. He thinks that Illumina could be worth $200 by year end, or 44 times his 2017 forecast of $4.50 a share. The consensus target price on the Street is $183.

Lueken of CapWealth expects Illumina to post revenue of $8.6 billion and cash flow of $1.8 billion in 2024. Discounting that back, he arrives at a 2016 price target of at least $230 a share. Flatley’s decision to step down leaves Lueken sanguine. “This gives him the time needed to build Illumina’s global partnerships and expand the addressable market,” he says.