In a recent GenomeWeb article by Tony Fong, “Sequenom’s CEO ‘Puzzled’ by Illumina’s Buy of Verinata, Lays out 2013 Goals at JP Morgan,” Harry Hixson, Sequenom’s CEO, expresses puzzlement over why its major supplier, Illumina, is acquiring a Sequenom competitor in Non-Invasive Prenatal Testing (NIPT), and thus apparently competing with one of its major customers.
In a JP Morgan interview on January 8, 2013, Illumina CEO Jay Flatley said:
In terms of our market strategy in NIPT: we plan to leverage the Verify test to drive new applications while continuing to supply instruments and reagents to all the NIPT players. In fact, we are working very hard to reinforce our relationships with our existing customers in this field. We plan to partner to help with distribution of the Verify test, and we intend to outlicense the foundational IP broadly and hopefully through that method expand the market more quickly and resolve some of the underlying uncertainty in this marketplace.
Harry Hixson, Chairman & CEO at Sequenom, comments on the Illumina move in his JP Morgan interview:
I get a call from Jay Flatley and he tells me that he is going to acquire Verinata. And so anyway my mind starts thinking about all of the ramifications of that. We’ve met for two, two and a half days now with analysts, investors and everyone asks us the question, “what do you think this means?”, and then they follow it up with “we don’t understand it”. And I would say at this time that Sequenom is puzzled. I would like to read some quotes from Jay’s press release…. And he also says “we are working very hard to reinforce our relationships with our existing customers in this field”. I might add, I’m waiting for the call – the second call.
Illumina’s move appears to be putting Sequenom in an uncomfortable position, a move that is puzzling both its customers and investment analysts. Is there a clear strategy behind what Illumina is doing?
Two explanations come to mind. (I’m curious if anyone has any other theories?) One is that existing products and markets will not enable Illumina to sustain desired growth and so they are entering new markets, including selling to the customers of their customers. The other is that Illumina is deliberately shaking up a conservative diagnostics market in order to drive demand. That is, Illumina is driving quicker adoption of high throughput sequencing for clinical applications by providing both prenatal testing as well as whole genome sequencing services.
Why is this move so interesting (i.e., why do I care)? Many of us in the bioinformatics world feel the competitive pressure of spending large R&D costs to serve a relatively small market of research scientists whose goal units are generally disconnected from revenue generation. If Illumina has a way to break out of the economic limits of the research market, we want to learn from them. Let’s look at the limits to growth in research genetics.
The Genetics Research Market
Various estimates I’ve seen indicate that Illumina has 70-80% of its revenues coming from academic and government research. This may well be higher, as revenue realized from commercial labs may have a substantial fraction of their volume ultimately serving academic research pursuits. Further, Illumina apparently owns an estimated 80% of the NGS sequencing market (though a recent GenomeWeb article says Life Technologies claims it has 60% of the Desktop Sequencing market).
Given NIH provides most of the dollars for US academic and government research and that the days of steady NIH budget increases appear to be on hold for the foreseeable future, the academic and government research market is unlikely to significantly grow over the next several years.
Why is the commercial market such a small proportion of Illumina’s revenue, and must it remain that way? ISI Group, drawing on data from Instrument Business Outlook, shows the total worldwide genetic tools market comprising sequencing, microarrays, PCR, flow cytometry, in-vivo imaging, high content screening and informatics to be an estimated $11B in 2012. This represents about a quarter of the ~$45B life sciences tools industry serving all sectors. According to this same report, 27% of this $45B is academic and government, with 24% biopharma, and the rest made up of hospitals, CROs, and other miscellaneous categories. Sequencers and microarrays make up about 25% of the genetic tools market.
With microarray spend being displaced by sequencing for both DNA and RNA, and with an increasing proportion of PCR being substitutable by Next Generation Sequencing (NGS), it would appear that there is $5B in market share available for Illumina to fight for. However, even with decent market growth, there is no way for Illumina to continue the 83% compound annual growth rate (CAGR) it sustained over the last 10 years.
Given a fixed spend on experimentation in academic/government life sciences research with flat expected growth, fighting to take market share away from other smart competitors (each fighting for their share of that same sandbox) is an uphill battle. It may give short turn returns, but ultimately you will eventually run up against the physics of a limited market. Perhaps this is why Illumina, and most everyone else in the field of genetics research, is eyeing the greener pastures of clinical genetics or diagnostics.
The Diagnostics Market – Greener Pastures
According to Bloomberg, the total diagnostics market today is around $44B, of which $5.6B is genetic testing. However, when a number like $5.6B is reported by healthcare providers, that is the reimbursable charges made by providers to patients and insurers. Many genetic tests are reimbursed at around $3,000, including cytogenetic assays. Consider, however, that for a cytogenetic microarray based test, an equipment and consumables vendor like Illumina might make $50-$300 for the microarray. Whole exome or genome sequencing is more expensive, but for widespread adoption it will likely have to come in line with being profitable for healthcare providers to order tests for around the current $3,000. So even if you are the provider of supplies for the entire $5.6B market, you might bring in revenues less than 10-20% of that or under $1B. So despite 17% annual growth of that market, the question becomes do you want to be the organization receiving $50-300/test by providing equipment and consumables, or the one receiving $3,000/test by providing the one stop solution reimbursable through health insurance?
Illumina’s 2011 annual report says, “the Company is organized in two operating segments for purposes of recording and reporting our financial results: Life Sciences and Diagnostics… The Company will begin reporting in two reportable segments once revenues, operating profit or loss, or assets of the Diagnostics operating segment exceeds 10% of the consolidated amounts.” They appear to be organized to go after diagnostics – it remains to be seen if it is mainly through hardware and consumables or other business models.
Absent some consumer genetics play, for Illumina to do well by its shareholders and grow from a $1B company to a $10B company in the years to come, it almost seems forced to enter the diagnostic testing market as a laboratory service, instead of just providing the equipment and consumables. It thus seems unavoidable that it will more and more come into conflict with its diagnostic laboratory clients who likewise see the potential of that market.
Supplier Becoming a Competitor
So what does it mean for a company like Sequenom to see their supplier becoming their competitor? Or similarly, what does it mean for a core lab that makes its revenues running samples on Illumina HiSeq instruments to see Illumina providing a CLIA sequencing service for whole genome and tumor normal pair sequencing? While Illumina may downplay that they are not in the space of single gene tests or exomes, ultimately it is expected that more and more testing will converge to whole genome coverage, leading to a future collision.
The main fear is that Illumina as the supplier is in a position to out-compete on price. Normally price is a weak competitive advantage among manufacturers, as the time it takes to match a competitor’s price is negligible, and there is the deterrent of a price war in which nobody wins. However, in the case where one competitor cannot manufacture the goods, but must acquire them from the competition, competition on price becomes viable for the manufacturer with the built-in asymmetric advantage. This will lead to the disadvantaged party searching for alternate suppliers, and thus the rise of additional manufacturing competition who are willing to stick to being suppliers and not selling the diagnostics directly. These will be smaller sequencing hardware companies who initially don’t have the growth limitations of Illumina, but who, if they eventually succeed, will be in the same conundrum Illumina is in now. Illumina could alleviate these fears by being the most expensive CLIA service in the market, but that puts them in conflict with increasing the revenues of their diagnostics operating segment.
On the other hand, perhaps they intend to shake the market just enough to get genetic testing labs to start adopting high throughput sequencing en masse to drive demand, then back off and stick to the fundamentals of selling equipment and consumables, licensing their tests and stepping back to let others do distribution.
Perhaps from a scenario planning standpoint they don’t even have to decide at the outset which strategy they ultimately go with – they can probe and test, and will gain regardless. That is, whether they displace their customers and take the market (in which case those customers are not around to complain), or drive a reactive market surge from customers/competitors that lifts all boats and then back off, smooth ruffled feathers, and reap the rewards of a larger market, it seems like they could win either way.
Like Hixson and investor analysts, I’m also puzzled. What do you think?