2024-01-19 10:00:10 ET
Summary
- Illumina's stock price has been in decline since its failed attempt to acquire Grail, leading to a 75% decline in share price.
- Activist investor Carl Icahn has been pushing for changes in Illumina's board and has launched a proxy battle against the company.
- Illumina plans to divest Grail and refocus on its core business, with new CEO Jacob Thaysen leading the way.
- There is so much up in the air at the company that I expect 2024 will not be long enough to determine which direction the company is headed - so expect some volatility, but not necessarily heavy gains or losses.
Investment Overview
Shares in Illumina ( ILMN ), the San Diego, California based gene sequencing and array based technology giant, had a terrific run for almost the entirety of the last decade. Illumina's stock price rose from ~$25 per share at the beginning of 2010, to nearly $450 by the end of 2020 - a gain of ~1,700%.
Investors who acquired shares during the 2000's or the early 2010's must have been delighted with their purchase when the stock price reached its all-time high of ~$500 in June 2021 - valuing the company at ~$80bn.
Ever since, however, the share price has been in near-constant decline, reaching its lowest price of just over $100 at the end of November last year. The source of the problem has been easy to trace - Illumina's ultimately failed attempt to acquire the genetic cancer testing company Grail, a company it once owned.
The GRAIL Debacle Sinks Illumina's Stock Price
According to a statement in Illumina's Q3 2023 quarterly report/ 10Q submission :
On August 18, 2021, we acquired GRAIL, a healthcare company focused on early detection of multiple cancers. GRAIL’s Galleri blood test detects various types of cancers before they are symptomatic.
We believe our acquisition of GRAIL will accelerate the adoption of next-generation sequencing based early multi-cancer detection tests, enhance our position in Clinical Genomics, and increase our directly accessible total addressable market.
The acquisition is subject to ongoing legal proceedings and, currently, GRAIL must be held and operated separately and independently from Illumina pursuant to the transitional measures ordered by the European Commission in the EC Divestment Decision, following the prohibition of our acquisition of GRAIL on September 6, 2022.
As I wrote in a note for Seeking Alpha comparing Illumina against arguably its closest rival, Pacific Bio ( PACB ) (although Illumina is the far larger company) last July:
Grail was actually founded by Illumina, but the company opted to spin out the company in 2016, while retaining a 15% stake in the business. Realizing its mistake in letting such a valuable business go, Illumina moved to reacquire Grail in late 2020 in a cash and stock deal worth $8bn, announcing in a press release that the Next Generation Sequencing ("NGS") oncology testing market was anticipate to grow to $75bn by 2035.
US and EU authorities both objected to the deal on anti-competitive grounds, with the Federal Trade Commission ("FTC") stating that "the deal would diminish innovation in the U.S. market for multi-cancer early detection (MCED) tests while increasing prices and decreasing choice and quality of tests".
Nevertheless, Illumina decided to complete the deal anyway, which led to a battle in the courts against both the FTC and European Commission, which the company ultimately lost - as per a December press release issued by Illumina:
On December 15, the U.S. Fifth Circuit Court of Appeals issued its decision in the matter of Illumina v. the Federal Trade Commission. Following a review of the Court's opinion, Illumina has elected not to pursue further appeals of the Fifth Circuit's decision.
As the company has previously stated, if it was not successful with either its European Court of Justice jurisdictional appeal or in a final decision of the Fifth Circuit, it would divest GRAIL.
Ultimately, the courts "issued an opinion in the case finding that there was substantial evidence supporting the Commission’s ruling that the deal was anticompetitive" (source: FTC press release), and now Illumina has no option but to divest Grail.
Activist Icahn Poised For A Boardroom Purge?
In 2022, Illumina recognised a $3.91bn goodwill impairment charge related to GRAIL, which meant the company reported a net loss of $4.4bn for the year, for earnings per share ("EPS") of $(28). On a non-GAAP basis, the company reported EPS of $2.12, compared to $5.90 for the prior year. Revenues increased by ~1% year-on-year, to $4.58bn, while R&D and SGA expenses both increased, to $1.3bn, and $1.35bn respectively.
In 2019, 2020, and 2021, Illumina earned net profits of $990m, $656m, and $762m, on revenues of $3.54bn, $3.24bn, and $4.53bn, which paints a picture of an inconsistent, perhaps, but growing and profitable company, addressing a substantial market opportunity. As such, arguably there was no need to pursue the acquisition of GRAIL, despite its significant potential in cancer testing.
One person who will be happy to see Illumina finally divest GRAIL is the activist investor Carl Icahn, who has built a small position in the company, and launched a proxy battle against the company last year, calling its decision to acquire GRAIL an "absurd and questionable purchase".
Icahn attempted to have Illumina's then CEO, Francis De Souza, removed from his position - according to CNBC , Icahn reportedly commented:
I guess it would be hard to find someone who could lose $50 billion of shareholder value in a matter of months yet still get paid 87% more for a grand total of $26.8 million in 2022.
De Souza survived the campaign against him, but opted to resign his position anyway in June last year. Icahn has given his approval to the decision to appoint Jacob Thaysen, formerly of Agilent Technologies, in his place. According to Illumina's press release :
Since 2018, he (Thaysen) has overseen the unit responsible for Agilent's market-leading analytical instrument portfolio, informatics, and cell analysis franchise.
During that time, he drove the division's revenue and significantly improved its operating profit. In 2022, that division, Agilent's largest, had revenue of approximately $4 billion, more than 50,000 customers, and an operating margin of approximately 30%
Sound familiar? Illumina's core business also drives revenue of $4bn - $5bn per annum, and serves nearly 10k customers.
Shortly before the CEO's departure, on Icahn's instigation, Illumina shareholders voted to oust the company's Chairman John Thompson, with Andrew Teno, a portfolio manager at Icahn Capital, joining the company’s board in place of Thompson.
But Icahn did not stop there. In October last year, it was revealed the activist had launched a lawsuit against former CEO De Souza, and several Illumina board members, and is seeking damages for $476m - the same amount as the fine imposed on the company for jumping the gun when completing the Grail deal without the EC's permission.
In December, shortly after Illumina announced it would divest Grail after losing its court case against the FTC, Icahn wrote, in a letter to investors:
Our campaign at Illumina has had three main goals. We accomplished the first goal with the removal of prior Chairman John Thompson and CEO Francis deSouza. Our second goal was to encourage Illumina to divest GRAIL.
Now, after a 75% decline in share price, or $55 billion in market value destruction, and years of expensive litigation across two continents with not a single victory to show for it, Illumina has finally decided to divest GRAIL.
We hope that the GRAIL divestiture happens in a way that will truly open a path for Illumina to be successful again. We have major misgivings that as long as this current board remains in power, even if there is a divestiture, it will come with far too many strings attached.
Why should stockholders trust the legacy conflicted directors with the GRAIL divesture process? Our third goal is to remove these legacy conflicted directors.
In summary, Icahn appears to be winning key battles against Illumina and may be aiming to gain full control of the boardroom, by removing those current Directors who "sat idly by as the core business deteriorated under prior CEO Francis deSouza", and who according to Icahn:
Broke the law – as evidenced by the €432 million maximum possible European Commission fine – by closing the GRAIL acquisition in the face of an explicit prohibition by EU regulators.
How Big A Blow Is Losing GRAIL? New Management Set To Refocus On Core Business
It is an interesting question as to whether Icahn truly believes that the Grail acquisition was a bad idea, or whether the problem lay in the execution of the deal, as the cancer testing kits the company designs and manufactures have long been viewed as potentially highly lucrative, not to mention of massive importance to the goal of identifying and treating patient's cancers earlier.
Grail's Galleri diagnostic can use a blood sample to detect up to 50 different types of cancers, and studies have shown that its "specificity for cancer signal detection was 99.5%", and concluded that "results support the feasibility of this blood-based MCED test as a complement to existing single-cancer screening tests".
With that said, updated analysis from a key Grail study has shown that the percentage of patients with positive test results who actually had cancer had fallen from 45%, to 38%, and perhaps as a result, securing reimbursement for Grail test kits from health insurers has been challenging for the company, with most kits sold direct to consumers for ~$950.
The launch of Grail has not been without issues - for example, it was reported last year the company had erroneously informed ~400 customers that a cancer signal had been detected in their tests. Revenue wise, although it is early days, GRAIL's performance has arguably been slightly underwhelming, with the company generating $62m across the first nine months of 2023, up from $32m in the prior year. In terms of expense, R&D costs associated with Grail were $254m across the same period, and SG&A $271m, as Grail funds the largest-ever clinical study of a multicancer detection test in the UK, amongst other expenses.
As another Seeking Alpha poster has eloquently argued , where the majority of Illumina's core business is high margin, allowing the company to drive healthy net profits, of ~27%, 20% and 17% across the past three years, Grail consumes significant amounts of cash without generating much in the way of revenue, and let's not forget the ~$4bn impairment charge Illumina was forced to recognise last year.
What seems clear is that under new CEO Jacob Thaysen, whose experience at Agilent arguably makes him more suitable for selling Illumina's existing suite of products than converting Grail from a promising product to a mainstream brand, the company is committed to divesting Grail, and refocusing attention on other key products - as Thaysen recently stated during a fireside chat at the JP Morgan Healthcare conference:
The infrastructure we built over the last 25 years, our global reach, our compelling offerings around the world and our deep partnership with many of our customers and our deep commitment, to disciplined innovation will continue, to drive genomics and multi-omics forward for decades.
With that said, Illumina essentially has two options when it comes to divesting GRAIL - complete a sale to another company - while its unlikely Illumina would recoup the $7bn it spent on the company, there have been rumours that companies would be interested in doing a deal - or attempt to spin out Grail into a separate entity.
The latter option would involve Illumina providing Grail with at least two-and-a-half years funding in advance, and the company has said it would consider working with a sponsor who could provide the funding required, or issue debt and fund the spinout itself, potentially putting its investment grade credit rating in doubt.
In 2023, Illumina has provided updated forecasting for $4.5bn of revenues, down 2% year-on-year, with a GAAP operating margin of (24%) for the full year, and non-GAAP operating margin of 5.3%, but the non-GAAP operating margin for Illumina's core business is expected to be 19.8% for the year, which again clearly seems to point to where the company's strength lies.
Admittedly, management sounded only lukewarm about prospects for growth in 2024, as CEO Thaysen told the audience during his fireside chat at JP Morgan:
There are some macro-economical headwinds right now. And that's what we, therefore, be a little bit conservative in our outlook, because our customers are conservative in their purchasing decision. Should that change during the year, we are extremely well positioned to drive the momentum. So do you have more?
Concluding Thoughts - Back To Basics, Or Gamble On Spinout? Either Way, Share Price May Remain Depressed In 2024
CEO Thaysen sounded highly enthusiastic about the prospects for Illumina's latest high throughput instrument NovaSeq X during the fireside chat:
The NovaSeq X has actually been the most successful launch in the history of Illumina. We have received 900 orders since launch, and we have shipped 350, 390 orders since launch, and we have shipped 352 instruments in '23 and thereby also entering '24 with a healthy backlog of 38 instruments.
With Illumina operating a "razor and blade" sales model, placing instruments with academic research facilities, biotech companies, and pharmas, and then selling "consumables" separately - consumables drove $689m of revenues in Q3 - the more NovaSeq X systems it places, the more long-term sources of recurring revenue it earns.
In many ways, this is arguably a more attractive business model for Illumina - selling an established product with demonstrable use cases - than attempting to build an entirely new such product from scratch, and then secure approval, then reimbursement, and then launch a multi-billion dollar marketing campaign, stomaching heavy losses for 3-5 years before Grail finally starts to turn a profit.
In summary, I would draw a few conclusions about Illumina, and Grail. Firstly, its fair to say Illumina never truly deserved the $80bn valuation it earned during the pandemic years - a time during which many companies' valuations became skewed by the market's view on whether it could help support the fight against COVID - clearly, the market believed Illumina had a role to play.
When that sentiment proved to be largely incorrect, and pandemic fears subsided, Illumina's share price slumped to its lowest price in six or seven years, as the company, in my view, over-committed on the Grail buyout.
Sure, Illumina had helped create the company, and saw how important and lucrative a product like Grail could be, and how it could help bolster flagging growth at the company, but ultimately, the deal was flawed, Illumina was warned, and the company, after choosing to ignore those warnings, has paid the penalty.
The role that Carl Icahn may - or may not play - going forward, depending on whether his interest in Illumina is fleeting, or long term, is hard to determine, as is whether the activist is acting in the best interests of the company, or of its shareholders.
Icahn wants to remove most of the current board of directors and replace them with people he trusts, but the activist was dealt a major blow yesterday as a court ruled the company must remove confidential information from its lawsuit that may have been shared by Board member Temo, the Icahn loyalist. A Judge ruled:
It is undisputed that the complaint contains information from Illumina that is protected by the attorney-client privilege
This raises the prospect of Icahn ultimately being defeated, and what may happen then is anybody's guess. It is not inconceivable that Illumina reverses course and attempts to go down the spinout route - a move Icahn would surely not endorse - and raises its debt levels to do so, encountering the wrath of the market, and leading to an even more depressed share price.
Unfortunately, none the scenarios I envisage in 2024 - a protracted battle for control of the company in the courts, a focus on the core product suite and NovaSeq X, and attempting to reignite growth over the long-term, starting with incremental gains in 2024, or an attempt to spinout Grail rather than accept a bid from another company - while offering volatility, offer a solid base for investing.
As such, although I expect to see some share price volatility in 2024, I expect to see Illumina begin 2025 valued at about the same as at the start of 2024, with a similar set of problems, and options. Aiming for a cancer moonshot, or taking a pragmatic approach to incremental growth. If it is the latter, once all the Grail, and boardroom issues, are resolved, Illumina, with its +$4bn per annum of revenues, and return to profitability, would be valued about right today, in my view, with good long-term growth prospects - but if you are considering investing, I would advise waiting until the dust from a very difficult 2022 and 2023 has settled.
For further details see:
Illumina: Volatility Galore, But Not Much Prospect Of Progress In 2024