Conor McNamara, CFA, equity research analyst with RBC Capital Markets

Illumina’s 2.5-year quest to acquire Grail for $7 billion is on the proverbial ropes and facing potential knockout blows. The latest came this week from the U.S. Federal Trade Commission (FTC), which on Monday ordered the sequencing giant to divest itself of the cancer blood test developer, touching off another skirmish in activist investor Carl Icahn’s proxy battle for the company.

The FTC concluded in an Opinion and Order that Grail falling under Illumina control “may substantially lessen competition in the relevant United States market for the research, development, and commercialization of MCED tests,” using the acronym for multi-cancer early detection. The order reversed the decision last September of Chief Administrative Law Judge D. Michael Chappell, who ruled in Illumina’s favor against the FTC challenge to the Grail acquisition.

The FTC has joined the European Union in fighting the Grail acquisition on antitrust grounds. Illumina has appealed to the European Commission not to make binding an order directing the company to divest itself of the cancer blood test developer. The EC blocked the deal in September 2022, concluding (like the FTC) that the purchase would stifle innovation and reduce choice in the emerging market for blood-based early cancer detection tests. Three months later the Commission issued a Statement of Objections laying out measures to undo the deal. A final EC decision is expected this spring.

Illumina’s battles with regulators, coupled with the bear market of the past two years, have cut into the price of the company’s stock significantly. Illumina’s shares closed Wednesday at $230.92, down 56% from the stock’s five-year high of $524.84 reached August 16, 2021 and 22% below the $295.50 price on September 18, 2020, the last trading day before the Grail acquisition was announced, touching off a 12% one-day decline to $270.13.

The decline of Illumina shares, in turn, has sparked Icahn’s proxy battle to change Illumina’s board, and thus the company’s direction. At the company’s upcoming annual meeting, Icahn, his Icahn Partners, and 13 affiliated entities and individuals plan to nominate three allies to the company’s nine-member board who he has said would “bring a badly needed dose of sanity to Illumina’s boardroom.” Icahn has stated his case through open letters to shareholders criticizing management for fighting regulators over Grail to the detriment of the stock price, and for increasing its insurance protection to board members before they approved the purchase. Illumina has responded with statements decrying Icahn’s proxy plan and criticizing the nominees as lacking relevant skills and experience to serve on its board.

Conor McNamara, CFA, an equity research analyst with RBC Capital Markets specializing in healthcare research and life science tools and diagnostics, recently discussed Icahn’s proxy battle against Illumina, and the company’s strengths and challenges, with GEN Edge.

(This interview has been lightly edited for length and clarity).

GEN Edge: Carl Icahn plans to nominate three allies to the board of Illumina at its annual meeting. The board itself has nine members. How can three allies be as disruptive to the current management as Icahn would want if they’re not a majority?

Conor McNamara: That’s a great question! I think just having additional board members that have a point of view will have a say in the board meeting, so they obviously have that vote. Can they push a majority? No, it’s still comes down to the entire board. But three folks from Icahn’s camp will obviously have some sort of sway with the board.

GEN Edge: According to Illumina’s proxy filing, the board tried to reach a compromise with Icahn to appoint a single Icahn ally and one mutually agreeable “highly qualified, independent” candidate. Icahn turned down that proposal. Yet Illumina has said publicly that it didn’t consider the Icahn allies to be qualified for the board. So why would they consider even one of the three?

McNamara: I don’t know the exact answer. But I think obviously, this is causing some disruption. So, if you can move on from the public battle with Icahn—if it means giving one seat to one of his colleagues, and then one to someone else—if you can move forward, then you could focus on things that are more important to the business. Obviously, anything that moves the process forward is good. So, it appears that that was a step by Illumina to try and negotiate something to move past this.

GEN Edge: What has made Illumina vulnerable to a challenge from Carl Icahn?

McNamara: Obviously, what Icahn says is, the most important thing is what he calls the $50 billion of market cap destruction. But the stock price has underperformed the broader market, and that’s a function of a lot of investors not liking the fact that Illumina had decided to make the acquisition of Grail, because Grail is a liquid biopsy company, trying to develop and get approval for a cancer test.

Historically, Illumina has been the provider of the technology to liquid biology companies to make those tests. ‘Call us a picks-and-shovels company’ is what they like to say. That means they provide the tools to the research companies that don’t want to develop these tests. When you buy into a test-making company, you bring on regulatory risk, and reimbursement risk, and approval risk. A lot of investors didn’t necessarily like that. Illumina’s stock price was down as much as 12% the day they announced the Grail acquisition, and it has been an overhang on the stock ever since.

On top of that, ahead of the NovaSeq X launch, you’ve seen that the revenue growth has slowed, the margins have declined, and there’s been news about potential competition leading up to this launch. All that, along with Grail, has pressured the stock and led to underperformance.

It makes sense that someone would come in and say, ‘Hey, something’s not right. Here, let’s try and fix this.’ The best example is, you could just look at their [earnings per share]. They were earning $6.50 in 2019, and their guidance for 2023 is $1.50. If you’re a growth stock, that’s a pretty significant decline in EPS, and the company needs to have a good response to that. So, Carl Icahn stepped in. He has highlighted one of those issues, the Grail acquisition.

GEN Edge: Yet the market as a whole has declined, and we’ve seen all sorts of companies report lower earnings per share and lower results. How much has Illumina underperformed the market?

McNamara: Since the day the deal was announced until the day that Icahn published his first open letter, the market was down 12% and Illumina was down 62%. So of that $50 billion in market cap decline that Icahn has talked about, we called out about $17 billion, which was more market related relative to the S&P. Then, if you look at the whole genomic space, it’s probably even more than that. But of that $50 billion, it’s not all related to Illumina but specific issues, including Grail.

GEN Edge: Where did Illumina go wrong in moving to acquire Grail? Was the mistake based on the idea of expansion into cancer detection by NGS? Or was the mistake one of execution in terms of charging ahead despite running into this opposition from antitrust regulators?

McNamara: As a shareholder, we would prefer Illumina without Grail, because then you’re focused on this “picks-and-shovels” business. It’s like you’re providing the equipment to the developers of these tests, and you’re not taking a binary risk on one specific test, whereas Grail is taking that. So, if you’re a provider of the tools, we typically do not like such companies changing their business model, where then you pivot, and now you’re taking that risk.

If you look back now and see the distraction that Grail has caused, especially as we’re leading into the NovaSeq X launch, it looks like it was probably not the right decision to pursue Grail like they did. So the question is, what do they do from here?

GEN Edge: What can Illumina do? They’re waiting on an appeal decision in Europe. They’ve said if that doesn’t go their way, they’ll go ahead and divest, although there has been skepticism about whether the company will really do that.

McNamara: I think the company’s tone has changed. As recently as its 2022 Investor Day [in October], they had said they’re going to go down two paths. They were going to continue to appeal and fight this, and they continued to plan to integrate and own Grail. But in their most recent press releases, they’ve stepped away from the idea of owning and integrating Grail.

What they’re waiting on now is just the final divestiture order from the EU, which will state all of the terms as to how they’re going to divest the company: How quickly do they have to do it? Can they retain any type of investment? All of the aspects of how that takes place. So, depending on that order, if the terms are fine by Illumina, then they’re going to go down the divestiture path, which means they’ll either try to sell the business or spin it out into its own company.

The problem is, we don’t know what those terms are, and if the terms are too prohibitive, that would make it nearly impossible for Illumina to do that without causing some sort of disruption or destruction to either Grail or Illumina. Then, of course, they’re going to appeal that, because you can’t just say we’re going to do exactly what the EU says, because we don’t know what those terms are.

It’s our belief that, as long as those terms are manageable, they’re going to go down the divestiture path. But if they’re not, they are pursuing a jurisdictional appeal because they’re a U.S.-based company, but this is the EU FTC that’s making the decisions. So if they are prohibited, they’ll go through a jurisdictional appeal.

GEN Edge: To what extent are Illumina’s vulnerabilities caused by growing competition from rivals such as Singular Genomics, Element, PacBio, and MGI. All have made announcements of new sequencing systems and other products.

McNamara: That’s part of what folks are worried about, that’s the reason that that revenue has slowed. It’s our view that the competition is going to have a very difficult time taking any share from Illumina, and all of the companies you mentioned fit into that boat. First off, short-read technology is Illumina’s primary technology, whereas PacBio and Oxford Nanopore are primarily in long reads.

In the short-read technology, this is a very difficult thing to swap out, because if you’re a genetic sequencing lab or a genomics lab, and you’re running an Illumina box, you’ve built your entire lab around that, both on the front end from the sample prep side and on the back end from the data analytics. Swapping out a box like a Singular or an MGI box, you’d have to disrupt your entire lab process, and you’d have to retrain the entire lab—all the staff have to change the way that the sample prep is done. And then, you’d have to retrain on what comes out on the back end on the data analytics.

So if you’re in the middle of a long-term study, and you swap out your box, all of the data that you’ve produced for that study are now out the window because you can’t complete a study on a different box. Again, if you were a lab that has some revenue-generating sequencing that you’re doing, then anything that you’re doing or generating revenue for now has to go on hold because you have to revalidate. Are labs going to do that to save a couple of hundred thousand dollars upfront? No, we don’t think so. We think it’s a much more difficult sell as far as swapping out the box.

Illumina has built this great moat around their technology, and how it’s used. So, we just don’t think the competition is going to have much of a much of a headwind.

GEN Edge: How much is R&D spending a factor?

McNamara: Illumina spends $1 billion a year on R&D. [the company reported R&D expenses of $1.321 billion in 2022, up 11.5% from $1.185 in 2021]. Some of the smaller players, if you look at the combined amount of money they’ve raised to date total, it’s less than $1 billion. So Illumina spends a lot more to stay ahead of the technology on the R&D side.

And finally, the NovaSeq X brought the cost to sequence the whole genome from $600 to $200, which is a significant price improvement for customers. Whereas, for a few of the smaller players, that was their entire pitch.

Back to the long-read comment that I made earlier. There is going to be other technology that’s going to be effective in the sequencing market. And we think a lot of these technologies are actually complementary to what Illumina is doing. Because you’re taking a sequencing market, which is still in its infancy, and you’re adding different ways to look at sequencing samples. And these other technologies will play a role. We think that the smaller players and then the long read will have a role in the market, but they’re not necessarily taking share from Illumina. They’re helping expand the market.

GEN Edge: Illumina has guided investors to expect a bounce back year because of NovaSeq X sales installations. To what degree, then, is Icahn jumping the gun and playing his hand at least a couple of quarters early, before any numbers show one way or other whether NovaSeq X made a difference?

McNamara: My sense from reading some of the things from Illumina, they just may not be aware of how impactful this launch is going to be to the numbers. They may look at some of the decline, the declining revenue growth, the declining margins, and they think the business is struggling, where in reality, they’re just at the start of this launch.

I don’t know why Mr. Icahn chose to do this now, because the timing does seem a bit weird. I think the most important thing is that the company can execute on this launch.

GEN Edge: Given that, is there any way to gauge how strong or tenuous Illumina’s position in the market is?

McNamara: They launched NovaSeq X at the Innovation Roadmap session of the annual Illumina Genomics Forum in September. We spoke to some potential customers and they were very excited about the promise of it. We spoke to the same customers after, and they said they hadn’t bought the box yet, but they said it looked like it’s a game changer.

From what we’ve heard, customer feedback is very, very strong. The company is guiding to 40-50 box placements in Q1 with 300 for the year. So, we’ve written notes that we expect them to be beating [Wall Street consensus] numbers. We’ll see as they announce quarterly results.

GEN Edge: Given the balance of the potential strength of NovaSeq X, plus the vulnerabilities we discussed earlier, like Grail, and increased competition, how safe is Francis deSouza’s position as CEO, and why?

McNamara: Obviously, [it depends] if he can execute on this launch, which has been a big focus of his for the last five years. He spent a lot of time at the 2022 Investor Day and the Innovation Roadmap, talking about how big the market is, and how NovaSeq X is going to help. So if he could execute on this launch, and could get past the Grail distraction, I don’t see any reason why he’s not the right person for Illumina, because this is a very important launch.

If the launch goes poorly, and the stock continues to underperform, he does have a duty to shareholders to think about what’s best for the stock price. If the stock price continues to underperform, obviously, that’s something that needs to be taken into consideration. But I do think a good NovaSeq X launch is going to go a long way for both the stock price and [deSouza’s] future with Illumina.

GEN Edge: Are investors really clamoring for change, given things like Grail?

McNamara: I think the easiest way to tell is what happened to the stock price, and the stock price did sell off when they announced they were buying Grail. When Icahn stepped in to say he was going to push for Grail to be gone, you saw the stock price respond positively. I think that’s your best indicator that there are a lot of shareholders that think that the company should focus on its base business and not Grail.

GEN Edge: Is it simply a stock bounce back, or does Icahn want a change in direction as well, going back to basics?

McNamara: I think he’s like any investor. He’s hoping to maximize his return on his investment in Illumina, and if he has to get involved to make that happen, then he’s going to do that. I think he owns just under 2% of the company. So, if the stock does well, that’s great for him. And I think that’s what he’s trying to push for.

GEN Edge: What should Illumina consider, if anything, as ways to maximize shareholder value? Is it simply a matter of getting out of Grail? Should they spin off some of their operations?

McNamara: I think one is to focus on earnings growth. They’ve spent a lot of money on R&D, and between that and Grail, that’s brought their earnings per share down from $6.50 in 2019 to $1.50 guidance for 2023. So, they need to figure out how to maximize earnings power. If your R&D is not being used to drive future revenue growth, you may bring that down. They do spend 20% of their sales on R&D.

It’s our view that this market’s at its infancy, so there’s a chance to capitalize on a growing market. The company is going to earn a lot more money without Grail. So that’s one thing that they have to consider: We’re of the view that maybe Grail is not the right thing for them.

Finally, one of the things they have to ultimately consider is, would Illumina be better in a larger organization? They’re selling products into research labs, and there’s a lot of larger organizations that have that. So, could a larger organization more efficiently enter those markets? That’s the potential. So, you just have to look at all things. But I don’t think there’s anything outside of Grail that we’ve necessarily viewed as not core or something that they should divest.

GEN Edge: What lessons can Illumina already take from this whole dispute with Icahn?

McNamara: That’s a great question. I think when they first announced the Grail acquisition, they should have been more aware about how the stock responded, and they should have focused a bit more on what shareholders might want, versus what was necessarily what they were looking to do with Grail. I think that the stock price performance has told them that maybe Grail is not the best thing to do. I think they should be more focused on, how do we maximize returns? And how do we focus on running this business as efficiently as possible?

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