Has Illumina taken the wrong path in its Grail quest?
In September, the world’s biggest genome sequencing company hosted Barack Obama, Bill Gates and other luminaries at its annual forum in San Diego, predicting its latest generation of machines would help “change the world”.
Illumina could make the case that it had already done so with its existing technology. It provided the machines that in 2020 decoded the genetic sequence of the virus that causes Covid-19, enabling researchers to develop vaccines and drugs in record time.
Surging demand for its technology and a pandemic-era biotech investment boom caused the market capitalisation of the company — which has an 80 per cent share of the sequencing market — to peak at about $75bn in August 2021.
But as chief executive Francis deSouza took the stage in San Diego to introduce his guests and Illumina’s new NovaSeq X Series, there were signs the outlook was darkening.
In August it reported a quarterly loss, weighed down by the legal costs of an unsuccessful patent battle with Chinese rival BGI group, which is now free to enter the US market. A month later the EU blocked Illumina’s $8bn acquisition of Grail, a cancer test developer that was initially founded by Illumina but spun off in 2017.
Since then, the company has downgraded its profit forecasts and announced it is cutting 5 per cent of its 10,000 workers. And within the next few weeks Brussels is expected to hit it with a fine of up to 10 per cent of revenues or about $450mn, for closing the Grail deal despite opposition from regulators.
Analysts say the bad news is prompting investors to question the company’s strategy of buying Grail, which Illumina forecasts will generate an operating loss of $670mn in 2023 on revenues of $90mn to $110mn. Illumina shares are hovering near five-year lows and it is now worth $33bn.
Dan Brennan, analyst at Cowen, an investment bank, said many investors are not “fans of the deal” and it came up in almost every conversation he had with them.
He said Illumina has over the past decade been an attractive, high-growth investment because it sells its sequencers at high prices (up to $1.25mn each) and has recurring revenues from the reagents and other products required to operate them. Grail is a riskier business because it is burning lots of cash and there is uncertainty about whether its technology will be a commercial success, said Brennan.
Grail, which counted Jeff Bezos and Gates among its early backers, has developed one of the world’s first early detection blood tests. The test, which it named Galleri, aims to detect up to 50 different types of cancer, including many that are not part of national screening programmes. It is being tested in trials, including a UK National Health Service study involving 140,000 people.
In an interview with the Financial Times, deSouza said Illumina was right to buy Grail and press ahead with completion of the deal, adding it was “in the interests” of shareholders because of its high growth potential.
“The stakes are really high here in terms of human lives. This isn’t just another deal: if Illumina prevails it can bring Grail’s life-saving test to countries beyond just the US and the UK, which is what Grail is planning to do,” he said.
DeSouza said Illumina has a “huge amount of respect” for regulators but insists it will fight the EU’s order blocking the merger in court, arguing Brussels has no jurisdiction as Grail has no revenues in the bloc. Any EU fine for “gun jumping” — closing the deal despite opposition from regulators — would likely be similar to the $300mn break fee in the merger contract it signed with Grail, he said.
But Illumina’s course of action angered senior EU officials, including competition commissioner Margrethe Vestager, who said at the time: “Companies have to respect our competition rules and procedures.”
The EU’s prohibition of the merger is a test case for regulators, which are seeking to expand their powers against “killer acquisitions” — where big companies buy small innovative rivals before they become serious contenders, thereby undermining competition.
Grail’s competitors argue the deal would leave them unable to compete on fair terms with a combined Illumina/Grail, because they are reliant on its DNA sequencing technology. Illumina has said the deal is not a killer acquisition because Illumina and Grail are not rivals. It also said it has no plans to cut off rivals from its sequencing technologies.
Critics say Illumina’s dogged pursuit of Grail is misguided because it is soaking up management attention when competition in its core business is rising and the high cost of funding the cancer test company is having an effect on earnings. This month, the company forecast profits will be between $1.25 and $1.50 a share this year, well below Wall Street forecasts of $2.53.
Illumina’s former CEO Jay Flatley also questioned the economics of the $8bn takeover, which was negotiated in 2020 near the top of the market.
“If they had waited a year then it would have been a $2bn acquisition,” said Flatley, who was chief executive for 17 years until 2016 and then chair until 2021.
“In retrospect, it would have been better to wait and realise that the market was sizzling hot at the time and therefore it was overpriced.”
Flatley, who persuaded deSouza to join Illumina in 2013, told the Financial Times he did not think the deal was a “strategic mistake” but operationally it had not gone the way management had hoped. It is a “huge disappointment” and investors want it spun back out, he said.
“Some investors frankly don’t care how much Illumina is going to get for it. In some ways it’s kind of a sunk cost. If they can spit it back out, then the earnings numbers get back to where they should be,” he said.
“If nothing happens on this in the next year, I think the grumbling will probably get louder . . . Francis is at the point of that spear.”
DeSouza said Illumina would be pragmatic. “I think Grail continues to represent a unique opportunity and delivers an important product in arguably the largest genomics market we’ll see over the next decade. But we still have to work through the regulatory process.”
It is not the first time Illumina has been tripped up by its M&A strategy. In January 2020, it was forced to abandon its $1.2bn takeover of rival Pacific Biosciences following opposition from regulators.
The departure of Sam Samad, Illumina’s former chief financial officer, has also unnerved some investors, analysts said. Joydeep Goswami, Illumina’s chief strategy and corporate development officer, has done the job in the interim since July, while the company seeks a replacement.
Four of Illumina’s largest investors — Baillie Gifford, Vanguard, BlackRock and Edgewood — all declined a request for comment.
One investor, who spoke on condition of anonymity, said Grail was a “natural extension” of Illumina’s technology and worth pursuing. Another said the company was “blindsided” by the EU and would likely be forced to spin off Grail.
A final EU court ruling on the Grail takeover could take years. In the meantime, abandoning it would be challenging for Grail in particular. It scrapped a planned initial public offering at a time when markets were booming following Illumina’s approach in 2020.
Raising money in the current environment to fund research is far tougher for firms without strong revenue streams. But there is also pressure on Illumina to diversify. It is launching the NovaSeq X into a market that is attracting new entrants at a good rate.
At a JPMorgan healthcare conference this month Element Biosciences, a company founded by several former Illumina executives, announced its sequencers can read a whole human genome for as little as $200.
Twelve years ago, the process cost around $10,000. Illumina’s benchmark in 2020 was around $600 but it plans to reduce this to $200 with its new machine.
Another early-stage company Ultima Genomics has said it can cut sequencing costs to $100. MGI, which was spun out from BGI last year through an IPO, has begun selling its sequencers in the US market following the expiration of key Illumina patents last year.
“Illumina has really been dominating the market for more than a decade and customers need competition,” said Molly He, a former Illumina executive who is chief executive and founder of Element Biosciences.
She said Illumina started offering Element customers big discounts when the company entered the market last year. But Element has also benefited from increased interest in its products from Grail competitors that use DNA sequencing, she added.
“They [customers] are obviously worried about what is going to happen after Illumina acquires Grail: would they still have access to high quality, low cost sequencing?”
Illumina said discounting was a standard business practice and rejected any suggestion that its ownership of Grail would influence its relationship with customers of its DNA sequencing business. But this was a key concern highlighted by European authorities when they blocked the Illumina/Grail merger.
Vijay Kumar, analyst at Evercore ISI, an investment bank, said it was a “big, bold and aggressive” move by Illumina to acquire Grail because Illumina was paying $8bn for a company with very little revenues at the time. But the decision to close the Grail acquisition despite opposition from Brussels was a gamble, he said.
“Francis bet big on this,” Kumar said. “Ultimately the buck has to stop with the CEO.”
This article has been updated to correct the spelling of Baillie Gifford