Compounder Fund: Illumina Sell Thesis - 06 Dec 2023
Data as of 04 December 2023
We first invested in Illumina (NASDAQ: ILMN) for Compounder Fund’s portfolio in July 2020. Our investment thesis for the company can be found here. In mid-November this year, we completely exited Illumina. This article describes our Sell thesis for the company.
When we first invested in Illumina, the company, which manufactures and sells machines and consumables that are used to analyse DNA, had a long history of generating free cash flow and growing its business profitably. We were optimistic that this could continue, as the market for DNA analysis was huge, and we thought it’s likely that the overall market would continue expanding in the years ahead. One of the many promising areas we noted was in oncology – the study of cancer – and it included Illumina’s acquisition of GRAIL, a company that develops blood tests (a liquid biopsy) for the early detection of cancer. The acquisition of GRAIL ended up being a massive headache for Illumina, and was one of the key drivers behind our decision to part ways with the company.
Illumina first announced its intention to acquire GRAIL in September 2020; at the time, Illumina’s management valued the liquid biopsy company at US$8 billion. After the announcement, regulators in the USA and European Union had antitrust concerns and tried to block the acquisition. Nonetheless, Illumina’s management pressed ahead and completed the deal in August 2021 even before regulators in both jurisdictions had given the greenlight. The total purchase price for GRAIL ended up being US$9.7 billion; included in the sum was US$2.9 billion and US$5.0 billion that Illumina paid in cash and shares of itself, respectively. The GRAIL acquisition also resulted in goodwill of US$6.1 billion on Illumina’s balance sheet. Unfortunately, a series of problems started appearing after the deal was consummated. Here’s a timeline of the major events:
- In the third quarter 2022, Illumina recorded a US$3.9 billion impairment of goodwill that was related to GRAIL.
- In February 2023, Illumina reported its results for 2022 and GRAIL’s revenue for the year was US$55 million; management’s initial guidance for GRAIL’s 2022 revenue, given in the 2021 fourth-quarter earnings update, was for a range of US$70 million to US$90 million.
- In March 2023, activist investor Carl Icahn started a proxy fight at Illumina, accusing the company’s leaders of making a poor decision in acquiring GRAIL. The fight has to-date, resulted in the June 2023 resignation of Francis de Souza as Illumina’s CEO, and Icahn suing current and former directors of Illumina in October this year for breaching fiduciary duties during GRAIL’s purchase.
- In the third quarter of 2023, Illumina recorded a US$712 million impairment of goodwill that is related to GRAIL. All told, Illumina has so far logged US$4.6 billion of GRAIL-related goodwill impairments in 2023. Moreover, management’s guidance for GRAIL’s revenue for 2023 was reduced to the “low end of the [US]$90 million to [US]$110 million range”; the initial guidance given in the 2022 fourth-quarter earnings update was for GRAIL’s 2023 revenue to “be in the range of [US]$90 million to [US]$110 million.”
- Although US courts ruled in September 2022 that there was nothing wrong with the GRAIL acquisition from an antitrust standpoint, the European Commission eventually ordered Illumina to divest GRAIL in October 2023. Illumina has flexibility in how the divestment occurs. But if GRAIL is spun-off as an independent entity, Illumina must capitalise the liquid biopsy company with two-and-a-half years of funding at the time of the spin-off.
We have a few conclusions from the timeline above. First, GRAIL was nowhere near as good a business as Illumina’s management had initially believed (we had committed the same mistake too). Second – and more importantly – Illumina’s balance sheet could be severely weakened because of the European Commission’s order to divest GRAIL. For perspective, GRAIL’s operating loss in the first nine months of 2023 is US$1.4 billion – extrapolating this operating loss for a two-and-a-half year period results in a figure of US$4.7 billion. So Illumina could potentially be on the hook for a multi-billion sum to capitalise GRAIL if it is spun off. This is not a trivial amount of money for Illumina. The company had only US$927 million in cash but US$1.5 billion in total debt as of 1 October 2023 (it’s worth noting that the net-debt position is a legacy of the GRAIL acquisition). We have no view on the future movement of interest rates, but rates are high today compared to the past decade. If Illumina has to provide billions in capital to GRAIL in the near-future while rates remain high, the company’s financial health is at risk if management decides to borrow. If management decides to raise equity, then we are faced with the risk of unpalatable dilution since Illumina’s market capitalisation was less than US$16 billion at the time of our sale in mid-November 2023.
Meanwhile, there’s also the possibility that Illumina is no longer capable of growing its business at a healthy clip in the years ahead. Jacob Thaysen, 48, was appointed as Illumina’s CEO in September this year following de Souza’s aforementioned departure. Thaysen seems like a good fit with Illumina – he has a long history in the genomics and life sciences industry, and was most recently president of Agilent Technologies’ Life Sciences and Applied Markets Group. During Illumina’s 2023 third-quarter earnings conference call, Thaysen commented that Illumina’s “2024 results will look very similar to 2023.” There was also the following exchange between Thaysen and an RBC analyst, Conor McNamara:
“[McNamara] If I look at kind of what you’ve said about 2024 from pre-pandemic levels from 2019 to 2024, that would imply an annual growth rate on the core business of about 5%, which is roughly in line with the overall life science tools market despite the fact that you guys have consistently spent about 20% of sales in R&D… do you think that you guys — you can drive a return to growth above historic life science tools growth levels?
[Thaysen] I want to be careful on coming with too many comments right now, I’m 40 days into my work here — to my job here. But I think I still believe that Illumina has a better growth opportunity than many of the other life science tools company. And I will come back and give you more insights when I’m ready for it in — later in 2024. But I don’t think that Illumina is in a place where it’s in the level of many of the other companies right now. But it’s too early for me to give you a clear guidance. But yes, so wait and see.”
In our view, Thaysen’s aforementioned comments in Illumina’s 2023 third-quarter earnings call indicates his lack of confidence in the company’s ability to return to a higher growth rate in the years ahead.
Illumina’s stock price has reflected the mounting troubles the company has faced with the GRAIL acquisition and its growth prospects, falling from the average price of US$387 at our initial investment in July 2020 to our average sale price of US$94 when we exited last month. The big decline in Illumina’s stock price might lead someone reading this to ask: “Couldn’t you have sold Illumina earlier?” It’s a valid question. Our response will be something we shared in Compounder Fund’s Owner’s Manual:
“And on the topic of selling stocks, we will typically sell a stock in Compounder Fund’s portfolio if we find that the investment thesis is completely broken, or we have made a big mistake in our analysis. But we will be very slow to sell. The slowness is by design – it strengthens our discipline in holding onto the winners in Compounder Fund. Holding onto the winners will be a very important contributor to Compounder Fund’s long run performance.”
Given all the above, we decided that our analysis of Illumina was wrong and that Compounder Fund’s capital in the company would be better utilised if it were invested in other companies that we think have a significantly more attractive reward-to-risk ratio (in this case, they would be Paycom Software and The Trade Desk).
And here’s an important disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation; they are merely our thoughts that we want to share. Compounder Fund owns shares in Paycom Software and The Trade Desk. Holdings are subject to change at any time.
