Illumina Stock Upgraded: What You Need to Know

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Illumina (NASDAQ: ILMN) stock is on a tear.

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Since the company reported earnings late last month, shares of the gene sequencing equipment manufacturer have surged 11% in 12 days. Half that gain, though, appeared only this morning, after analysts at British banker Barclays Capital announced they're upgrading shares of Illumina to overweight and assigning this $258 stock a $300 price target.

What's making Barclays so bullish on Illumina? Here's what you need to know.

What Illumina said

Let's begin with the earnings report. Last month, Illumina released its fiscal Q1 2018 numbers, and the results appeared mixed at first.

On the one hand, Q1 2018 sales surged 31% in comparison to Q1 2017, and pro forma profits more than doubled. On the other hand, net income from continuing operations plunged 43% year over year. My fellow Fool.com colleague and healthcare maven Keith Speights, however, reassures that this latter number is nothing to worry about, because it "stemmed from the one-time impact in the first quarter of 2017 of spinoff GRAIL repurchasing its stock from Illumina." (As a one-off event, that cash infusion was obviously absent from Q1 2018 results, which explains the apparent drop-off in profits.)

More important is the fact that cash flow increased 52% year over year (i.e., faster than sales grew), and free cash flow nearly doubled in comparison to Q1 2017 levels.

Good news: Get used to it

These were pretty spectacular results, and they explain why Illumina shares jumped. As for the second wind the stock is exhibiting this morning, though, that owes to Barclays' insistence that the good news isn't over yet.

After conducting a "proprietary NovaSeq customer survey," explains Barclays in a note covered today on StreetInsider.com (subscription required), the banker is convinced there's "substantial elasticity of demand with customers who have adopted the NovaSeq system." That means Barclays believes Illumina is free to charge more to upgrade customers from its legacy HiSeq gene-sequencing systems to its new line of NovaSeq systems (which can cost nearly $1 million apiece), and customers will still gladly pay the price.

In Barclays' view, this price elasticity among Illumina's customers sets up the company to enjoy "multiple years of double-digit growth."

Why pay more?

Why would Illumina's customers be willing -- eager even -- to pay $1 million to upgrade their old machines?

According to the company, the new NovaSeq machines are more efficient, and have the potential to drive down the cost of sequencing a person's DNA to as little as $100 a head, which may make economical sense to healthcare providers and to pioneering marketers of personal DNA services such as 23andMe and Ancestry.com.

For more budget-conscious customers, though, Illumina is also developing a line of "iSeq" gene-sequencing machines that could cost as little as $20,000 up front. Illumina believes there could be a market for as many as 50,000 such machines -- a potential $1 billion-dollar opportunity for the company.

And even that is just the start. One of the lesser-noticed trends revealed in Illumina's Q1 report, writes Keith, is that sales of "consumables" tied to NovaSeq -- the DNA test prep kits and other one-use items that go into the DNA-sequencing process -- surged 60% sequentially between Q4 2017 and Q1 2018. Illumina CEO Francis deSouza said that the "trajectory of our sequencing consumables business is very exciting." It's a trend that should only strengthen as the cost of DNA sequencing comes down (i.e., as more NovaSeq machines get sold), and strengthen even more once cheap iSeq machines begin flooding the market.

High expectations lead to high prices

Barclays isn't alone in thinking Illumina's growth prospects look strong. S&P Global Market Intelligence reports that analysts on average forecast 17% annual earnings growth at the company over the next five years.

Such growth doesn't come cheap, of course. Valued on its $567 million in trailing earnings, Illumina stock sells for a heady valuation of 63.5 times earnings. Even valued on its more robust $645 million in trailing free cash flow, it's not much cheaper (55.8 times free cash flow).

Still, with momentum on its side and little competition in sight, that high price tag doesn't seem to concern Barclays much. Could be it's going to take more than a rich stock price to slow Illumina down.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Illumina. The Motley Fool has a disclosure policy.