DNA-sequencing leader Illumina swung to a loss in Q2 2022. Contributions from Grail didn’t help.
Illumina (ILMN) – Get Illumina Inc. Report second-quarter 2022 results suggest the integration of Grail is proving painful. And given the confluence of headwinds facing Grail’s business, shareholders might begin questioning that strategy..
In September 2020 Illumina, a leader in DNA sequencing, said it would acquire Grail, a former spinout, for $8 billion. It completed the acquisition of the liquid-biopsy developer in August 2021, over the objections of trade regulators in the U.S. and Europe.
A strong U.S. dollar, delays in expanding customer labs, multiple legal fines, and general customer caution due to tightening financial conditions combined to move the business to a quarterly operating loss.
If investors exclude the one-time fines — and they may not be one-time — then Illumina would’ve reported operating profit of just $26 million for Q2 2022. That’s what happens when your liquid-biopsy subsidiary contributes an operating loss of $187 million.
By the Numbers
Illumina is one of the best lab-hardware businesses ever created. The San Diego company’s DNA-sequencing instruments dominate the global market, which provides a large installed base for generating recurring revenue.
The lab-hardware business model is akin to the razor-and-blade and printer-and-ink models. Indeed, the company generated 70% of its Q2 2022 revenue from consumables, the chemicals and kits needed to operate its instruments.
For comparison, peers PacBio (PACB) – Get Pacific Biosciences of California Inc. Report and Bionano Genomics (BNGO) – Get Bionano Genomics Inc. Report leaned on consumables for 41% and 22% of revenue, respectively, in the three months ended June 2022.
Consumables revenue is accompanied by solid margins, which drove Illumina’s 69.3% gross margin in the most recent quarter.
Staying with the comparison above, PacBio and Bionano Genomics delivered gross margin of 45.7% and 22%, respectively, in the same period. Consumables revenue is the differentiating factor.
If only it were that easy.
Maximizing gross profit is important because it trickles down the income statement to self-fund operating expenses. Of course, that all falls apart when operating expenses swell due to self-inflicted wounds and macroeconomic headwinds outside your control.
Illumina’s gross margin narrowed 190 basis points (1.9 percentage points) in Q2 2022 from the year-earlier period due to various macroeconomic headwinds. Those headwinds prompted the company to reduce full-year 2022 revenue guidance to a growth midpoint of 4.5% from 15% previously.
It gets more complicated when investors dig into the trajectory of operating expenses.
Was the Grail Acquisition Worth It?
Operating expenses for the core business, which excludes Grail, declined in the quarter from the year-earlier period. But the company had to set aside $609 million for multiple legal contingencies.
First, Illumina set aside $156 million to settle patent-infringement litigation with BGI, China’s DNA-sequencing titan. Second, the business set aside $453 million in preparation for a potential fine from the European Commission.
Regulators across the pond have sued to block (and now unwind) the acquisition of Grail. They fear a combination of the global leader in DNA-sequencing machines and one of the front-runners in the emerging field of liquid-biopsy tools will create unfair economic advantages for the competitive landscape.
Essentially, Grail will be competing with many of Illumina’s DNA-sequencing-instrument customers. Will that create incentives to provide discounts to Grail and charge more to certain customers?
The business could be fined 10% of combined revenue indefinitely for violating the order to immediately unwind the acquisition. The amount set aside in Q2 2022 represents roughly one-tenth of revenue since the acquisition was completed. The amount will grow each quarter.
That gets worse when investors consider that Grail contributed just $12 million of revenue and an operating loss of $187 million during the three months ended June 2022.
So was the Grail acquisition worth all this trouble?
Illumina argues in favor. Assuming the transaction isn’t undone, the combined company would be positioned as a major player in a multicancer-screening opportunity that could be worth tens of billions of dollars by 2030. Capturing even 10% of that would double Illumina’s annual revenue.
Then again, that scenario requires investors look only at the financial numbers and ignore the “ends justify the means” dilemma.
It’s important that international business rules are respected. It’s also possible that regulators are overstepping. It’s a tough call for Illumina shareholders.