Why Investors Are Paying a Premium for Ilumina, Inc.

By Cory Renauer Markets Fool.com

Now that the average stock in the benchmark S&P 500 is trading at about 25 times trailing earnings, it's hard to find great companies people aren't paying a premium to own. Priced at about 53 times trailing earnings, though, shares of Illumina, Inc. (NASDAQ: ILMN) stand head and shoulders above an already expensive crowd.

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Image source: Getty Images.

To the uninitiated, rapidly contracting costs associated with DNA sequencing makes Illumina's industry seem like a poor place to look for rapid growth. Let's take a closer look at how building increasingly efficient machines helped Illumina exceed expectations in the past to understand why investors are ready to pay a premium for the stock now.

A healthy relationship

Driving down sequencing costs hasn't been doing wonders for the competition, but leading the downhill charge has done wonders for Illumina's growth story. It's hard to overstate the inverse relationship between sequencing costs and the company's recorded revenue. With the rollout of Illumina's HiSeq X series, Illumina brought the cost of sequencing down to an unbelievably modest $1,000 per genome. The rapid plummet spurred demand, and the company's top line climbed at a mind-boggling 62% annual growth rate over the past several years.

Unfortunately, the relationship has its limits. In order to fully enjoy the available savings, most laboratories need to invest roughly $10 million into 10 HiSeq X unitsand keep them churning out data. It appears the number of facilities with enough resources and needs to justify such an investment hit a saturation point recently. During the first three quarters of 2016, instrument sales fell 20% from the prior-year period. During the same period, sales of consumables used by previously installed instruments helped pick up the slack with a 22% rise that drove total revenue 9% higher.

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Approaching another Model T moment?

While it's nice to see consumable sales can offset losses to instrument placement saturation, that's not why investors are willing to pay a steep premium for Illumina shares. At the year's most watched healthcare conference this year, the company announced a new sequencer that could open up the vast clinical market.

NovaSeq 6000 DNA sequencer. image source: Illumina.

Illumina contends its latest sequencer line, NovaSeq, will eventually enable a tenfold reduction to just $100 per genome. In the meantime, lower per-sample consumable costs for an $850,000 NovaSeq 5000 gives smaller labs a means to sequence an entire human genome at a $1,000 price point. That could be cheap enough to entice clinical laboratories that never dreamed of bringing genome sequencing in-house to play a role in the precision medicine revolution.

New instrument sales soared the last time Illumina launched a sequencer that swiftly cut costs enough to put its instruments within the means of mid-sized laboratory operations. Around 7,500 installed machines is an impressive feat, but NovaSeq's price point positions Illumina to increase the number of instruments requiring high-margin consumables several times over in the years ahead.

Just how expensive?

NovaSeq's recent unveiling helped Illumina stock notch a 25% gain so far this year. Even ahead of the run-up, the stock looked expensive, but the recent price of about $160 per share is 53 times trailing earnings per share. To see a solid return over the long run, investors would need to see some outstanding profit growth in the coming years.

Some back-of-the-envelope figures illustrate just how expensive the stock is right now.Illumina became a market darling by increasing earnings per share by about 953% over the past decade. If it could somehow repeat its past success, and the price settled to a "normal" multiple of 20 times earnings in early 2027, investors would enjoy a 13.6% annual rate of return over the next decade.

Image source: Getty Images.

On the other hand, I could be wrong about low-cost demand going forward; after all, we are in uncharted waters here. If Illumina stock falls to the same P/E ratio as the average stock in the broad market S&P 500 index (about 25 times trailing earnings) in the near term, a purchase at recent prices could result in a 53% loss.

Illumina intends to begin shipping the $985,000 NovaSeq 6000 in March, and the $850,000 NovaSeq 5000 in the middle of the year. One thing is certain: The stock will soar or swoon on news of their uptake. If you don't have an iron stomach, I suggest waiting for a pullback or a clear signal the lower-cost sequencers are indeed a game changer.

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Cory Renauer has no position in any stocks mentioned. You can follow Cory on Twitter @coryrenauer or LinkedIn for more healthcare investing insight.The Motley Fool owns shares of and recommends Illumina. The Motley Fool has a disclosure policy.