Illumina and Cannibalizing Your Customers
Customer lock-in, the struggles of monopolies, and ASML.
Illumina is, predominantly, a provider of NGS machines and related consumables. These machines enable the sequencing of massive amounts of DNA/RNA at one time, leading to a vastly improved understanding of genomes and disease. Critically, the company’s brought the cost of sequencing down significantly since began offering its instruments: it cost over $100,000 to sequence a single human genome in 2009; on Illumina’s most recent sequencer it costs $2001 As costs have come down, demand has grown substantially. Illumina hasn’t achieved its dominant position by boxing out competitors; it’s instead built the best product and benefited as a result.
It’s accurate to describe the company as a kind of platform, but one that has some drawbacks. For one, it’s a platform whose success is dependent on continuing to lower prices. Sequencers, like certain semiconductor chips, aren’t at all a commodity, but they are a business where succeeding means innovating by driving down costs while improving capabilities and performance. While this is great news for the sustainability section of the company’s annual report, it does lead to the continued question of whether price deflation will spur increased demand in the future. This is a problem that a tech platform like Shopify or Stripe doesn’t really face: typically the tech strategy is to keep prices low, get the product into the hands of as many people as possible, and then raise prices over time.2 Secondly, Illumina’s a platform with an interest in getting into some of the businesses that its own customers are in, a temptation that tech companies tend not to grapple with. Stripe wouldn’t have gotten into the fitness machine market even if Peloton wasn’t down over 85% since its IPO Shopify might (and has) copy ideas from third-party applications that perform well in its app store, but it’s unlikely to start competing with Red Bull on the energy drink front or Allbirds on the sneaker front. Illumina’s not like this. When its customers are using sequencers for an opportunity that looks lucrative, it leads to the natural question of why Illumina can’t offer this product itself. Management also has unique insight into where sequencing prices are trending in future years, and what products might be enabled by these lower prices. This is what spurred the incubation of Grail, the provider of an early-cancer detection test, Galleri, that screens for over 50 different types of the disease. At the time of Grail’s founding in 2015, Illumina management knew the price of sequencing made a multi-cancer detection test uneconomical, but that this wouldn't be the case in the future. Consequently, the startup was offered heavy discounts on sequencing reagents based on where it was thought prices would eventually go. Grail was spun-out in 2017, but then bought back in 2021. Given that Illumina now counts many other early cancer detection companies as customers, this acquisition caught the attention of both the European Commission and the FTC. Their documents from the investigation give one lots of reasons to be bullish on the company:
1. Its high-throughput sequencers are not only best in class, but at a price point that makes applications like liquid biopsy financially feasible.3 Using a sequencer at a higher price point can render the unit economics of a test unworkable.4
2. Tests are tailor made for specific sequencers, which makes switching out sequencers a difficult task:
“The minimum steps required to switch…an MCED [multi-cancer early detection] test in development to a new NGS platform include: adapting its library construction process to make the library compatible with the new platform; generating substantial training data on the new platform using the updated assay; updating the analysis software to mitigate the error rates associated with the new platform; performing analysis steps to adapt the new sample preparation to be compatible with the new instrument; and locking the new system and redoing the validation of each changed component”
3. Once a diagnostic test that uses an Illumina sequencer gets FDA approval it can’t switch out sequencers for a competitor without getting its test re-approved. Switching sequencers before FDA approval is equally a pain, as it inevitably elongates the approval timeline.
4. Illumina doesn’t only sell sequencers; it also sells the consumables that are required for these sequencers to run. I can’t sequence a DNA sample without consumables, and new consumables are required for each sample that I run. Crucially, a portion of these consumables are sold only by Illumina.
There are a few additional factors that make it difficult for a startup to compete head-to-head with the company, even if your sequencer is less error-prone or offers a lower price point:
5. Reputational barriers make it difficult to go with an upstart. This is “No one ever got fired for buying IBM” but applied to life science tools.
6. NGS sequencers break often, making exceptional customer service a must have. A startup that can sequence a genome at lower cost or more accurately than an Illumina machine but that doesn’t have the resources to get a technician out to a customer quickly is in trouble.
7. Given that this isn’t a tech company, supply chain resiliency matters! Illumina’s size and position in the market means it’s less likely than a startup to run into supply chain issues with consumables.
Put briefly, Illumina provides customers with a superior product (at least when the FTC wrote its initial decision) that they’re very unlikely to churn off of. In light of this, you might be surprised to learn the company’s stock is down over 50% in the past five years. Some of the explanation for this decline comes down to the decisions of former management, which one wouldn’t describe as sound. The company spent nearly 8B on its acquisition of GRAIL, despite the European Commission actually prohibiting the transaction ahead of time. Management recently did divest the business after direction from the FTC, but only after spending a billion dollars plus supporting it over three years. This turned operating income negative from 2022 on, and also included a nearly 4B impairment charge for fiscal year 2023. To compound misfortune, Grail currently trades at a market cap of under 500mm, suggesting that Illumina’s former CEO Francis deSouza probably shouldn’t pursue a career in active investment management.
More recently, Illumina’s business has struggled in China, which historically has accounted for 10%-ish of revenue. Management’s put this down to the macro environment and increased competitive pressures from BGI Genomics, which can undercut Illumina on pricing for mid-throughput instruments. Illumina’s most recent sequencers, the NovaSeqX and NovaSeqX Plus, were rolled out in 2023, and investors still aren’t confident in what their demand profile looks like over time. In the short term, rolling out a new sequencer means a hit to both margins and revenue. Margins fall both because instruments are lower margin than consumables and because NovaSeqX consumables aren’t yet at a place to enjoy economies of scale. Revenue falls because the NovaSeqX/X Plus allow customers to sequence the same amount of RNA/DNA at a lower price. As said above, Illumina lowering the cost of sequencing has only led to increased demand up to this point, but it’s unclear how long this will continue for. There’s always a chance that the expected additional sequencing activity doesn’t happen, or doesn’t happen as much as expected . Management doesn’t think this is an issue yet, citing increased interest in both single-cell sequencing and spatial analysis (both of which enable a greater understanding of individual cells and require a lot more sequencing). There’s good reason to think they’re not bluffing given the company’s recent acquisitions of Fluent Biosciences and Partek, both players in the single-cell analysis space. That said, this ramp up in customer activity doesn’t happen overnight. Currently, company forecasts are for NovaSeqX/X Plus consumables to make up half of high-throughput consumable volumes at some point this fiscal year, and half of high-throughput revenues by mid-2025.
Importantly, China’s not the only place where competition has increased. At the time the FTC wrote its initial complaint Element Biosciences didn’t yet have a commercial sequencer and Ultima hadn’t emerged from stealth with 600mm in funding and the claim that it could sequence a human genome for $100. Element is primarily competing on the mid-throughput front, comparing its Aviti device to Illumina’s NextSeq2000. Ultima seeks to challenge Illumina’s high-throughput business, and its agreements with Lapcorp and Quest that have a noted focus on oncology applications suggest some early levels of success. Both of these companies claim to undercut Illumina on price, to which management’s response has been to emphasize cost of overall workflow rather than only cost per Gb sequenced. At least according to them, Illumina compares more favorably once you factor in its data analysis tools and customer service capabilities. There’s certainly some truth to this, but it’s likewise true that Illumina used to unequivocally be a leader in cost, and that this was a key part of the FTC’s concerns around the Grail acquisition. On the mid-throughput side, it’s clear that price matters enough in China that management had to cut prices to better compete, a move they indicated is a potential lever for the rest of the world, too.
It's possible that Illumina’s core business is at least becoming more commoditized than it was once was, and that management is aware of this but unable to do all that much about it given the regulatory scrutiny they’re under. They tried to fight off commoditization with the PacBio acquisition in 2018, but that was blocked by the FTC.5 The Grail acquisition would’ve, at least in theory, been a nice way to move to a more favorable part of the value chain, and meant the company would seriously benefit from commoditizing a critical MCED test complement. Illumina acquired a non-invasive prenatal testing (NIPT) business, Verinata, back in 2013, but is a key supplier for Natera, a competing offering that’s done incredibly well as of late. It’s unlikely they could put their foot on the gas here without pissing off existing customers and attracting regulatory attention. In many ways Illumina sits in an enviable position: it still is by far the dominant sequencing player with over 25k instruments installed globally, and customer lock-in gives it a very stable revenue base. This dominant position, however, has put a bullseye on its back from regulators and startup founders alike. It’s not inaccurate to think of Illumina as a kind of ASML for the bio world but with lower capital requirements. These lower capital requirements make a world of difference; the venture market has now reached a size where investing hundreds of millions of dollars in an upstart competitor can make sense, particularly if you agree with Illumina management and think there’s plenty more sequencing to be done as prices drop.
Disclaimer: The information in this post is not intended to be and does not constitute investment or financial advice. You should not make any decision based on the information presented without conducting independent due diligence.
That $100,000 figure is from Ensemble Capital’s most recent quarterly letter.
This actually wasn’t the case in Stripe’s case, where an intentional decision was made to have prices on the higher end to force the team to build a great product. You can read more about that here.
It’s important that the FTC’s investigation focused on Illumina’s high-throughput instruments rather than its mid-throughput and low-throughput ones, which did have some competition at the time the decision was written.