Genomics Illuminated

Illumina Inc.’s (Illumina) recent rejection of a proposed $8.5B buyout by pharmaceutical behemoth Roche, an offer worth 34 times expected 2012 net income, illustrates the company’s noteworthy potential. CEO Jim Flatley dismissed the Roche offer, stating it “dramatically undervalues Illumina and does not adequately reflect Illumina’s singular position in an industry poised for extraordinary growth.” Flatley was referring to the personalized healthcare industry – the future of pharmaceuticals. Though despite Flatley’s confidence, Illumina is facing increased competition with new entrants competing largely on price, driving down industry margins. While management is optimistic about the future, Illumina’s future may be more dim than Flatley thinks.

The Company

Illumina is the largest manufacturer of genomic sequencing machines, that examine the variations and make-up of DNA. Illumina sells its products to a wide variety of institutions ranging from academic to biotechnology clients. These customers use Illumina’s technologies in order to better understand causes of diseases and how to effectively treat them.

Illumina has two business segments: Life Sciences and Diagnostics. Life Sciences – all products and services relating to the research markets, is the source of most revenues. On the other hand, Diagnostics – comprised of all opportunities in the emerging molecular diagnostics field, is a largely inactive division operating in an infant but growing market, and currently composes less than 10% of all revenues.

Since 2008, Illumina has grown organically and through acquisitions; its bottom line has grown 283% from $39M to $151M. With total revenues exceeding $1B and cash equivalents of $1.4B, Illumina has the cash required vertically integrate through acquisition and maintain a strong position in the personalized medicine market.

Advancements in Personalized Medicine

Personalized medicine refers to medical treatment that is tailored to individuals’ unique characteristics. Technological advancements have enabled a deeper understanding of what differentiates us genetically. For example, the study of human genetics has made it increasingly clear what components of our DNA are linked to specific personal features. By identifying and analyzing our unique makeup, it is now possible to determine if a patient is susceptible to a particular ailment. This proactive approach to evaluating an individual’s health represents a drastic change to the traditional method of treating health concerns after symptoms have materialized. The critical concept is that personal differences are recognized and considered to provide an unprecedented level of customization. Drug manufacturers can then design a unique pharmaceutical, improving quality of care as treatment is based on a patient’s personal condition as opposed to a generic patient profile.

Technological advancements have dramatically reduced the cost of sequencing the human genome from $3M down to $4,000 per sequence. Consequently, demand has increased from individuals seeking to have their genome sequenced. With the sequencing process becoming increasingly accessible, PwC fore- casts the therapeutic, medical device, and diagnostic aspects of the personalized medicine industry to grow from $24B in 2009 to $42B in 2015.

A Changing Industry Sequence

Illumina’s market share currently stands at 60% in what the company defines as the “next-generation” sequencing market. Demand for its Hiseq 2500 machine (priced at $740,000) and its forthcoming Miseq machine (priced at $125,000) is expected to rise within the academic field, with current sales projected to increase 30% to 50% in the next five years, especially in clinics. These trends have led to predictions that Illumina’s total revenues will grow 10.4% organically, and 4.6% through their recent acquisition of Verinata in the short term.

Illumina’s success has attracted new market entrants including Life Technologies, Pacific Biosciences, and Beckman Coulter. Their products compete on features such as required resources per run, time per run, and cost per instrument. Although these technologies use different sequencing chemistries, competitors’ machines are capable of reading sequences in comparable sizes at a similar pace to Illumina’s.

Though performance differs, all of these machines suffice to meet the needs of most customers. Consequently, JP Morgan predicts “pricing pressures caused by competition and increased demand will result in lower priced instruments.” With technology rapidly advancing, competing products will soon provide equal utility to consumers, and Illumina will be forced to lower its prices in order to remain competitive.

Technology Commoditization

The personal computer (PC) market illustrates the potential consequences of technology commoditization as firms begin competing primarily on price. In that space, hardware components became cheaper to manufacture over time as economies of scale were achieved and competition intensified; PC companies
were eventually forced to lower prices. The personalized medicine industry, meanwhile, is currently dominated by monopolies derived from strong patent protection – there are numerous ways to sequence a genome. Genetic sequencing machines are competing on speed, but over time these sequencing machines may mirror the fate of PCs, as margin erosion leaves a once lucrative industry relatively commoditized.

Illumina prides itself on being an innovative technology producer, yet its revenue growth is expected to taper off and remain steady at 8% in the longer term. Illumina has correctly recognized that remaining a technology pure-play is not a viable option and consequently is actively expanding its diagnostics business. Management has noted that they maintain a goal of becoming a leader in genomic-based diagnostics. They have fueled these ambitions through the acquisitions of players including BlueGnome and Verinata.

Vertically Integrated Healthcare

Illumina’s increasingly relevant Diagnostics division should be involved in three stages of the personalized medicine process: sequencing, interpreting, and testing. Illumina is already a market leader in the first stage via their acquisition of Verinata. But to really drive value they need to expand their offerings in the second stage through a Knome acquisition and in the third stage through an acquisition of A&G. In the short-term, Illumina can use strong product sales from Life Sciences to fund Diagnostic’s development, achieving a necessary change in organizational focus prior to the negative impact of technology commoditization in the long-term. Illumina’s entrance into the services industry is a drastic change requiring new capabilities. However, this endeavor is feasible as the necessary competencies can be added via the aforementioned acquisitions.

First Stage: Sequencing

The process begins when a patient visits a health care provider for a diagnosis. The healthcare provider, seeking to better understand the patient’s condition, refers the patient to Illumina. The patient then visits an Illumina clinic where the company uses its current technologies to perform the sequencing process upon the individual’s DNA.

Second Stage: Interpreting

Next, the genetic strand is interpreted. Illumina’s recent acquisition of Verinata allows them to screen fetuses as early as 10 weeks for diseases such as Down’s syndrome, but the firm currently lacks the technology needed to interpret a whole genome sequence for more prominent diseases such as cancer. Given Illumina’s lack of proprietary technology and relevant expertise, developing this capability internally would be difficult. Acquiring Knome is preferable and recommended.

Knome’s knoSYS device contains pre-installed templates for breast cancer that allows for successful interpretation of whole genome sequences when screening for this disease among others. Illumina currently pays Knome each time an Illumina customer uses Knome’s devices. This acquisition would eliminate all licensing fees and enable them to offer a more comprehensive service.

Third Stage: Testing

Once the genetic strand is interpreted, the testing phase detects the presence of targeted diseases. Many companies, have identified markers for diseases. Rather than looking to test for all conditions, Illumina should start by acquiring a niche player such as A&G Pharmaceuticals (A&G). A&G has offerings in oncology; specifically, they can test for and monitor breast and lung cancer in real-time.

A&G is developing a both a screening test and drug (GP88 monoclonal antibody) for breast cancer once detected but before expression – this drug would be a first foray for Illumina into the emerging business of theranostics – where a company both diagnoses and treats a condition. A&G is planning to generate a quick win from their breast cancer test – this test would be the main value-driver for Illumina. Also, A&G is approaching Phase I of bringing the GP88 to market, though the risk of failure so early in the drug development lifecycle is extremely high. The potential added benefits of successfully developing drugs such as GP88 would not be the primary focus of an A&G acquisition, however. Illumina should acquire firms such as A&G for their proprietary technology, which can be incorporated into Illumina’s testing services. If drugs being developed by acquired firms do reach later stages of development, Ilumina can choose to sell these properties to pharmaceutical firms; partner with pharmaceutical firms to develop the drugs; or examine the feasibility of developing the drugs in-house. These considerations can be made in the future once Illumina has made progress developing a strong diagnostics division. With a sizable cash position of $1.4B, several of these acquisitions are possible. The acquisitions of A&G and other similarly situated firms would increase the thoroughness of Illumina’s testing, providing customers with a wider range of information.

Partnering With Pharmaceutical Companies to Develop Personalized Treatment

The acquisition of A&G also notably enables Illumina to enter the therapeutics market. Broadly, therapeutics refers to caring for a patient comprehensively by both preventing disease as well as addressing specific problems. Illumina’s DNA analysis presents information unique to an individual, which can be used to provide personalized therapeutic treatment. Illumina should enter this space by partnering with pharmaceutical companies such as Pfizer. A licensing strategy would be attractive to these companies as Illumina is essentially bringing business directly to them. Illumina would license its analysis of an individual’s genetic information to large pharmaceutical companies whom could then manufacture a personalized drug.

A licensing model is the best strategy here, as Illumina is ill equipped to become a large scale drug manufacturer. Although some of Illumina’s acquisitions may be developing early stage pharmaceuticals, if Illumina were to aggressively enter drug manufacturing they would alienate the firms they hope to license
heir services to. Furthermore, these firms already have the competencies and vast resources required for drug development, marketing, and distribution.

How Illumina's acquisitions fit with a theranostics orientation

How Illumina’s acquisitions fit with a theranostics orientation

Finally, Illumina should accentuate its strong movement into the molecular diagnostics field by standing up its Diagnostics segment as a separate business unit from Life Sciences. Different talent and processes are required to succeed in a patient-facing business than in one that focuses upon research. This will also help to isolate Illumina’s healthy Life Sciences unit from the challenges that will arise when integrating acquired firms; and from the more volatile, high-growth nature of the diagnostics market.

Preventative Medicine for Illumina’s Corporate Strategy

The acquisitions of Knome and A&G represent the incorporation of biotechnology, pharmaceutical, and theranostic services into one model under the Illumina name. This vertically integrated approach enables Illumina to capture value at three different points: sequencing, interpretation, and testing. Rapidly developing its Diagnostics business also ensures Illumina withstands the threat of its technology production becoming increasingly subject to pricing pressures. Over time, the cost of Illumina’s services and custom drug manufacturing will represent a cheaper alternative to the status quo of reactively treating patients once their ailments have materialized. Insurance companies will see the value in preemptively addressing clients’ unique health concerns. This revolutionary form of healthcare is still developing; however, as the cost of genomic sequencing continues to decline, Illumina can position itself to shine as it capitalizes on the impending personalized medicine boom.