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How Illumina (ILMN) Stacks Up Against Warren Buffet's Acquisition Criteria

11/8/2016 6:46:30 AM

How Illumina Stacks Up Against Warren Buffet's Acquisition Criteria November 8, 2016
By Mark Terry, Breaking News Staff

Warren Buffett doesn’t really hide his investment strategy. He’s a long-term investor and each year in his annual letter to Berkshire Hathaway shareholders, he explains what he’s looking for. Brian Feroldi, writing for The Motley Fool, takes Buffett’s criteria and applies them to Illumina (ILMN) to see how the company compares.

Buffett’s list has six points—large purchases of at least $75 million in pre-tax earnings, consistent earnings power, strong return on equity with little or no debt, management in place, a simple business, and an offering price. Feroldi essentially discards the sixth, because the typical investor isn’t buying the company, they’re buying the stock, and all stocks meet this point.

So, to compare the five first points to Illumina:

#1. $75 Million in pre-tax earnings. Illumina passes this hurdle without taking a breath. At its recent third-quarter financial report, Illumina showed $607 million for the quarter alone, up 10 percent from the same period in 2015. Total sales in 2015 were more than $2.2 billion, and had $583 million-plus in earnings before taxes.

#2. Consistent earnings power. Well, no. The company’s done a great job of growing top line over the last decade, but profits haven’t always been consistent with revenue growth, and in 2008, during the economic crash, Illumina didn’t hold steady. Feroldi writes, “While the company has been solidly profitable over the last five years and should continue that trend into the future, it is not clear to me that Buffett would be willing to overlook Illumina’s profit dip in 2008.”

#3. Strong equity return and low debt. Buffett apparently prefers to invest in companies that create high returns on capital without having a lot of debt. Here things get a little complicated for Illumina, although Feroldi says the company passes. “Illumina’s return on equity has soared recently as its business has started to scale, but the company has taken on more than a billion dollars in long-term debt to get there.”

But since the company has more than $1.4 billion in cash, it has no problems covering the interest on its debt.
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#4. Management in place. The company’s chief executive officer, Francis deSouza, has only been on the job for a couple months, although he started as president in 2013. Before that he was on the board of Citrix, chairman of MedHelp, which was acquired by Physicians Interactive, and president for Products and Services for Symantec. So deSouza’s bone fides would likely please Buffett. And the company’s former chief executive, Jay Flatley, is still executive chairman of the board of directors, and chairs two of Illumina’s subsidiaries, Helix and Grail.

#5. A simple business. No. Feroldi writes, “Buffett is famous for avoiding businesses that he doesn’t understand, which is why he primarily invests in companies with simple business models like candy makers, newspapers, insurers, and home builders.”

There isn’t much simple about Illumina’s business. It develops and markets gene sequencing equipment that is used by researchers and diagnostic laboratories worldwide. They’re expensive. And they’re complicated. And the industry itself is changing constantly, with a massive push toward faster, cheaper, more reliable, more sensitive, smaller. With a trend toward personalized medicine, genomics, and pharmacogenomics that depends on gene sequencing, there is likely only going to be an increase in demand in the near future, although there will probably be a point at which the newer generations don’t offer much over previous iterations. But that’s a good number of years away. And meanwhile, sequencing requires reagents and other consumables and services to operate that give Illumina a consistent and recurring revenue stream.

For all that, Feroldi suspects Buffett wouldn’t buy Illumina in this category. And overall, because Illumina only hits three of the five categories on Buffett’s list, he didn’t think Buffett would buy Illumina.

“Of course,” Feroldi writes, “just because Illumina might not appeal to Warren Buffet doesn’t mean that it isn’t worth owning. After all, Illumina remains the leader in its industry, and management believes that the genomic testing market could eventually exceed $20 billion in annual sales.”

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