Quantifying Illumina's Oncology Upside

Illumina ("ILMN") is the dominant provider of next generation sequencing (NGS) platform. The company provides an entire ecosystem of machines, consumables, software, and services. It's a bit of a razor and razorblade model, with sequencing consumables making up about 60% of revenue.

Analysts tend to worry about how many machines the company will sell this year and next year. I prefer to think in terms of end markets - after all, that is what drives instrument and consumable sales.

I will focus on oncology because I believe that will be the main contributor to the company doubling its revenue.

Oncology is not one, but three separate growth vectors. The three are 1) therapy selection, 2) monitoring, and 3) screening/testing. A couple slides from IR here give you a sense of relative market sizes.  The first is from Illumina, the second from Guardant Health.

The units are different, but we can tell that 1) all three are big markets, and 2) for now, therapy selection is the smallest but most penetrated market (and even then still very early innings); early screening is the largest but least mature market.

Let's think about how ILMN will participate in each of these markets.

1) Therapy selection. Precision medicine is revolutionizing medicine. Old medicine is a lot of trial and error - we don't really know how this drug treats this disease, but we know empirically (through clinical trials) that drug A is correlated with improvement in symptom B, so doctors prescribe it.

New medicine is different. We want to know what exactly is causing cancer. How does it impacts the specific patients in question? How will this specific patient react to this drug?

This is where DNA/RNA sequencing is required. Sequencing of patients' tumor samples allows us to move beyond some homogeneous view of cancer and into specifics of how the tumor works and how best to treat it.

That is the essence of companion diagnostics ("CDx"). CDx is in growth tornado mode and most, if not all, developers of these CDx does sequencing with Illumina machines. An example is Foundation Medicine which, through its parent Roche, has a partnership deal with Illumina to create more companion diagnostics.

Note that even companies who are skeptical of use of sequencing in early screening markets admit that sequencing makes sense for therapy selection. See below note from Exact Sciences (which uses PCR technology for screening, but think sequencing makes sense for therapy selection).

2) Monitoring. I believe the paradigm that prevails will work like Natera's Signatera (see diagram below).

Note that the process starts with sequencing of Tumor tissues. This is where Illumina's platform comes in. Natera would then use the data obtained from that step to create a personalized PCR assay, which is then used for on-going blood test monitoring (less invasive than requiring a solid tumor sample).


3)  Early Screening. I'm not convinced that sequencing will be required for this market and will (at least for now) not give credit to Illumina for this.

Screening is about testing for known diseases, for this PCR would do a cheaper and faster job. Cost of sequencing will likely come down a lot, so I think ultimately it comes down to the speed advantage of PCR.

I also get the sense that PCRs can be more distributed location wise. So instead of sending samples to some central lab for sequencing, it's faster to just have some sort of PCR at a location closer to patients.

To summarize this section, I believe Illumina's sequencing will 1) own the therapy selection market,  2) get parts of the economics in the monitoring market, and 3) get none of screening market (that's my assumption for now anyways).


Quantifying the Upside

So how do we quantify all of this for Illumina? My approach is figure out how much each of the 3 oncology vectors contribute to the company's consumables revenue right now, then scale those numbers up to some estimate of eventual market penetration.

From ILMN's 4Q19 transcript, we know that:

1) Oncology is about 20% of sequencing consumables.
2) Clinical versus research split is about 40%/60%.
3) Within oncology, therapy selection is by far the largest driver. Monitoring is nascent and screening is even earlier.
4) Oncology therapy selection is about 8% penetrated.

So if I take the $2.1bn of of sequencing consumable revenue in 2019, attribute 20% to oncology and 40% to research, that get us to $166mm of oncology clinical consumables revenue. I'll just assume all of that is therapy selection and $0 from monitoring and screening.

This $166mm is the basis of our analysis. I'm going to throw out some numbers just to demonstrating the thinking process and ball park the upside. The output is below.

Allow me to explain.

Ok, so $166mm of oncology treatment selection revenue for 2019. That market is about 8% penetrated now, where do we think it'll be in a few years? I'm assuming 60% here, so that scales up to $1,245mm of treatment/therapy selection revenue 5-10 years out (as shown in table above)

How about monitoring revenue? From the TAM presentation slides above, both Illumina and Guardant Health pegs the monitoring market at about 2.5x that of therapy selection. But remember, I think the Signatera paradigm (as explained above) will become standard, and Illumina only participates in the upfront sequencing and not the on-going monitoring.

Let's say 1/4 of the value from each monitoring treatment accrues to the sequencing platform provider - Illumina. (Plug in your own assumptions).

So my estimated monitoring revenue is the $1,245mm treatment selection revenue * 2.5 * 1/4 = $778mm.

I gave no credit to oncology screening opportunities, but that could change. Finally, for oncology research revenue I just take the present estimate of $249mm and give it a 3x to reflect the early inning nature of overall oncology market.

Layering in other assumptions for NIPT market and other sequencing consumbles, I can see Illumina's sequencing revenue go up to $7bn in a few years. The bulk of these gains come from oncology market shifting toward precision medicine and exploding upward.

Conclusions - about Valuation and Risks

The stock is around $270 at the time of this analysis. I get to about $2.5bn EBIT 5-7 years out and ILMN is thus trading at <15x EV/EBIT in years 5-7 (with interim cash flows lowering that EV). This is a decent price for what is essentially a monopoly that participate in growth markets.

The analysis here implies that Illumina's revenue will re-accelerate at some point - because the end markets will explode upwards.

Those revenues are Illumina's to lose, provided that the company retains its dominant competitive position. For now, Illumina is further entrenching its ecosystem by partnering with Roche and Qiagen to create 3rd party tests.

Risks

The only challenger on the horizon is Thermo Fisher with its Ion Torrent systems. There is also some small chance that the short-read nature of ILMN's machine could become a problem later. (Their failed deal with Pacific Biosciences would have given them strength in long-read market and remove this risk, but the deal failed).