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Illumina Inc. (NASDAQ:ILMN)

Q4 2008 Earnings Call

February 03, 2009; 05:00 pm ET

Executives

Jay Flatley - President & Chief Executive Officer

Christian Henry - Senior Vice President & Chief Financial Officer

Peter Fromen - Senior Director of Investor Relations

Analysts

Quintin Lai - Baird

Tycho Peterson - JP Morgan

Ross Muken - Deutsche Bank

Bill Quirk - Piper Jaffray

Dough Schenkel - Cowen & Co.

Marshall Urist - Morgan Stanley

Derik De Bruin - UBS

Un Kwon-Casado - Pacific Growth Equity

Isaac Ro - Leerink Swann

Zarak Kurshid - Caris & Co.

Tony Butler - Barclays Capital

Davis Bu - Goldman Sachs

Matthew Scalo - Canaccord Adams

Operator

Good day ladies and gentlemen and welcome to the quarter four 2008, Illumina Inc. earnings conference call. My name is Nisal and I will be your coordinator for today. At this time all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions)

I would now like to turn the presentation over to your host for today’s call, Mr. Peter Fromen, Senior Director of Investor Relations; please proceed sir.

Peter Fromen

Thank you, Operator. Good afternoon everyone and welcome to our fourth quarter 2008 earnings call. During the call we will review our financial results released today after the close of the market, offer commentary on our commercial activities and provide financial guidance for the first quarter and fiscal 2009, after which we will host a question-and-answer session. If you have not had a chance to review the earnings release, it can be accessed in the Investor Relations section of our website at www.illumina.com.

Presenting for Illumina today will be Jay Flatley, President and Chief Executive Officer; and Christian Henry, Senior Vice President and Chief Financial Officer. This call is being recorded and the audio portion will be archived in the Investor section of our website.

It is our intent that all forward-looking statements regarding financial guidance and commercial activity made during today’s call be protected under the Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties and actual events or results may differ materially from those projected or discussed.

All forward-looking statements are based upon current information available and Illumina assumes no obligation to update these statements. To better understand these risk factors, we refer you to the documents that Illumina files with the Securities and Exchange Commission, including Form 10-Q and 10-K.

Before I turn the call over to Christian, I want to let you know that we will be presenting at the Barclays Global Healthcare conference in Miami, Florida, which is scheduled for March 10 to the12, and also at the Cowen Healthcare conference in Boston, Massachusetts, which is set for the week of March 16. For those of you unable to attend any of the upcoming conferences, we encourage you to listen to the webcast presentations, which will be available through the Investor Relations section of our website.

With that, I will now turn the call over to Christian.

Christian Henry

Good afternoon everyone and thank you for joining us today. During today’s call I will review our fourth quarter financial results and provide guidance for the first quarter and full year of fiscal 2009. Jay will then discuss our commercial progress and provide an update on the state of our business and the markets.

We concluded 2008 with a strong fourth quarter performance. We reported our 30th consecutive quarter of revenue growth with total revenues of $160.9 million. This represents 43% year-over-year growth and 7% sequential growth. Product revenue was $152.8 million and grew 51% over the fourth quarter of last year and 9% sequentially. Once again, our microarray and sequencing product lines contributed nearly equal absolute dollar growth to our total revenue number.

Consumable revenue totaled $98.6 million for the quarter compared to $56.2 million in the fourth quarter of 2007, and $90.2 million last year. This represents growth of 76% year-over-year and 9% sequentially.

Consumables growth was driven by strong demand for Infinium HD BeadChips as well as sequencing kits. In fact, total sequencing consumables grew 24% sequentially and over 200% from the fourth quarter of last year. Sequencing consumables growth was driven by the rapid expansion of our Genome Analyzer installed base and the migration of these installed systems into the production status.

Q4 instrument revenue exceeded $50 million for the first time, coming in at $51.2 million. This compares to $41.8 million in the prior year period and $46.8 million last quarter. This represents year-over-year growth of 23% and 9% sequential growth, as we saw strong demand across all of our systems. During the quarter, we shipped a record number of units for each of the Genome Analyzer, iScan, and BeadExpress platforms.

Services and other revenue which includes genotyping and sequencing services as well as instrument maintenance contracts was $7.6 million compared to $11.4 million in the fourth quarter of last year and $9.7 million last quarter. While we have recognized an increase in the maintenance contract revenue and the sequencing service revenue, we are seeing more of our genotyping service revenue move to our Illumina certified CSPro-certified customers.

As a reminder, CSPro is a collaborative program through which we certify third party service partners using Illumina products to ensure delivery of performance and data quality equivalent to that attainable from our internal services offering. We have seen success across both service business models and recognized comparable profitability between the two.

Before discussing our gross margins and operating expenses for the quarter, I’d like to note that we recorded a pretax amount of $11.0 million related to non-cash stock-based compensation. This impacted our EPS by a tax adjusted amount of $0.06 per pro forma diluted share in the fourth quarter. Our fourth quarter stock compensation expense was lower than usual, due to a favorable year-end catch-up adjustment. I will give more clarity to our option expense estimates when I provide guidance.

In my discussion of operating expenses, I will highlight both our GAAP expenses which include stock compensation expense and other non-cash charges and the corresponding non-GAAP figures. I encourage you to review the GAAP reconciliation of non-GAAP measures also included in today’s earnings release.

Total cost of revenue for the quarter was $57.3 million compared to $40.8 million in the fourth quarter of 2007. The fourth quarter of 2008 costs includes stock based comp expense of $1.1 million, compared to $1.2 million in the prior-year period. Excluding this expense and $2.7 million associated with the amortization of intangibles, non-GAAP gross margin was 66.7%. This compares to 64.6% last quarter and 65.5% in the fourth quarter of 2007.

On our last call I mentioned that we launched new reformulated sequencing kits and recognized an inventory reserve against obsolete components of the old kits. With the reserve behind us, the sequential increase in gross margin was driven by the significant improvement in sequencing gross margins as a result of this reformulated sequencing kit. During the quarter, we also saw improved ASPs on the Genome Analyzer and we saw stable pricing in the array market.

The increased mix of consumables led by the strong up-tick of both our BeadChips and sequencing kits drove gross margins higher on a year-over-year basis as well. As a matter of fact, we saw consumable pull through on the Genome Analyzer at the high end of our forecasted range of 150 k to 200 k per installed instrument.

R&D expenses were $28.3 million in the quarter compared to $20.1 million in the fourth quarter of ‘07, including $3.8 million and $3.0 million respectively, in non-cash stock compensation expense. Excluding stock comp expense and the $0.9 million of accrued contingent compensation associated with the Avantome acquisition, R&D expenses were $23.6 million or 14.7% of revenue, compared to $17.1 million or 15.2% of revenue in the prior year period and $23.4 million or 15.6% of revenue in the third quarter.

Sequential research and development spending remained relatively flat, as we offset some of the costs eliminated with the successful introduction of the Singapore manufacturing, with the full quarter absorption of Avantome’s R&D expenses. On a year-over-year basis, the increase in R&D spend was primarily attributable to our increase in headcount.

SG&A expenses were $39.2 million, compared to $30 million in the fourth quarter of 2007, including stock compensation expense of $6.9 million and $5.4 million, respectively. Excluding these non cash expenses, SG&A was $32.3 million or 20.1% of revenue compared to $24.6 million or 21.9% of revenue in the prior year period and $31.4 million or 20.9% revenue in the third quarter of this year.

GAAP operating profit for the fourth quarter was $36.1 million and includes non cash expenses that I just outlined. Excluding these expenses, our non-GAAP operating profit for the quarter was $51.5 million or 32% of revenue compared to $32 million or 28.5% of revenue in the fourth quarter of last year. This represents a year-over-year operating profit growth of 61% versus top line growth of 43%, highlighting the solid leverage that the business generated during the quarter.

Our non-GAAP Q4 tax rate of 28.4% reflected the retroactive extension of the US R&D tax credit, which reduced our quarterly pro forma tax rate by approximately 400 basis points. The tax credit is extended forward for the entirety of 2009 and we estimate that it will be recognized ratably each quarter and is factored into our full year guidance.

In addition, we generated a larger tax benefit than anticipated due to the net income recognized through our Singapore facility. During the quarter, we brought our Singapore facility up to full production, manufacturing more than 30,000 chips at yields equivalent or slightly better than that in San Diego. As a consequence, our shipments from Singapore exceeded our plan, resulting in a favorable impact to our tax rate in the fourth quarter.

On a GAAP basis for the fourth quarter we reported net income of $28.9 million or $0.22 per diluted share compared to a net loss of $4.1 million or $0.04 per diluted share in the prior year period. Excluding the impact of non cash stock comp expense, the amortization of intangibles, the accrual of contingent compensation related to Avantome and net of pro forma tax expense, non-GAAP net income was $39.4 million or $0.31 per diluted share compared to $22.5 million or $0.19 per diluted share in the fourth quarter of 2007. This represents 75% growth in net income year-over-year.

Reviewing the cash flow statement and the balance sheet, we generated $49.4 million in cash flow from operations during the quarter, compared to $11.9 million in the prior year quarter and $27.3 million in the third quarter. Backing out roughly $15 million for CapEx during the quarter, we generated approximately $35 million of free cash flow or $0.27 per pro forma fully diluted share, compared to the fourth quarter of last year when we generated $0.02 of free cash flow per share.

AR DSO was 75 days during the quarter, which is up from the fourth quarter of last year, due to a higher percentage of our sales coming from territories outside of the US, which incur longer collection times. However, the metric was in line with last quarter.

Depreciation and amortization expenses were approximately $7.7 million and we used about $70.8 million of cash to buy back 3.1 million shares of stock during the quarter, and ended the fourth quarter with approximately $687 million in cash and investments.

I’ll now provide financial guidance for the first quarter and the full year of fiscal 2009. Going forward, we will exclude the charges associated with the adoption of FSP APB 14-1, which requires us to record incremental non cash interest expense related to our convertible debt outstanding.

Consistent with our previous calls, guidance will exclude certain non cash charges, including stock comp expense related to 123R, the amortization of intangibles and acquisition-related charges. For additional details, please refer to the table in our earnings release that reconciles our non-GAAP guidance to the related GAAP figures.

We expect fiscal 2009 revenues to be between $690 million and $720 million, representing growth between 20% and 26% over the 2008 results. We expect gross margins for the full year to range in the mid 60s. We expect non-GAAP earnings per share to be between $1.10 and $1.20, and this assumes pro forma diluted weighted average shares outstanding of approximately $133 million.

We expect non-cash stock comp expense for the year to be approximately $60 million or $0.30 per tax adjusted pro forma diluted share, and as a reminder the pro forma diluted share calculation excludes the double dilution resulting from the accounting impact of our convertible debt. The fourth quarter and full year 2008 impact on shares is included in the reconciliation of GAAP figures that accompanies today’s release.

In the first quarter we expect to see revenues range between $158 million and $164 million, which represents year-over-year growth of 30% to 35%. We expect first quarter non-GAAP earnings per share to range between $0.23 and $0.26, assuming pro forma fully diluted weighted average shares of approximately 131 million. We expect non cash stock compensation expense for the quarter to be approximately $14 million or $0.07 per tax adjusted, pro forma diluted share.

We anticipate a non-GAAP annualized tax rate of approximately 33% for 2009; however, our actual tax rate will be highly dependent on the shipments made out of our Singapore manufacturing facility to international locations. We expect capital expenditures for the full year to be approximately $50 million. We expect the full year impact of adopting FSP APB 14-1 to be approximately $19.5 million or $0.10 per share.

Now at this point, I’d like to turn the call over to Jay for some remarks on our commercial activity during the quarter, before we begin the Q-and-A session. Jay.

Jay Flatley

Good afternoon, everyone. We’re very pleased with our fourth quarter results, as we exceeded virtually every financial target we had set. Our revenue growth reflects our strong market position in both arrays and sequencing. By our estimates we believe that we have more than 70% market share in the high multiplex genotyping market and more than 60% market share in the next generation sequencing market.

We were able to improve our gross margins by more than 2% relative to the third quarter, due to stable pricing in the array market and the launch of the new sequencing reagent kits. The combination of improving gross margins and our ability to manage expenses enabled us to achieve 32% non-GAAP operating margins and generate $35 million in free cash flow during the quarter. For the full year, we grew revenue by 56% over 2007 and generated $142 million in cash flow from operations.

Our fourth quarter top line performance continued to benefit from the new products we introduced this year. In our microarray business, our whole genome Infinium HD BeadChips comprised the majority of revenue and our Human610-Quad was once again our best-selling product.

This quarter, we launched a new four sample BeadChip called the 660W-Quad that was developed in collaboration with The Hospital for Sick Children and the Sanger Center. The 660W is created by adding markers to cover 5,000 regions in the human genome known to be associated with copy number variation to the existing Hap550 Plus BeadChip. Researchers are using this product, along with our 1M-Duo to analyze 90,000 samples in the Wellcome Trust Case Control Consortium 2.

The 660W highlights our ability to rapidly add new and differentiated content to our existing arrays, increasing the value to our customers. In the future, our capability to rapidly deploy new content will become increasingly important, as novel markers are discovered on our sequencing platform.

On the expression side we launched the HT12, the newest member of our expression array family, and for 2008, the value of shipments of our expression arrays increased more than 40% from 2007.

At our Analysts Day in November, we launched the cyto SNP 12 BeadChip. This new 12 sample chip targets the roughly $200 million array based cytogenetics market and is priced as low as $125 per sample. The approximate 300,000 genetic markers target all known cytogenetic abnormalities found in genes and disease pathways linked to mental retardation, autism and other common chromosome anomalies.

Our family of custom microarrays also continues to perform well. We saw a large contribution from our iSelect BeadChips as well as strong shipments of our GoldenGate Array Matrix products during the quarter. We recently announced new formats for both of these products that improved their usability and their content capability.

First, we launched the Universal-32 BeadChip, which will begin to transition customers from the Array Matrix to the BeadChip format. The Universal-32 improves per-sample scan times by a factor of four, includes content from 384 to 3,000 markers per sample and processes up to 32 samples per chip.

Secondly, we recently announced the migration of the iSelect custom products to the Infinium HD format, which will now enable customers to interrogate between 3,000 and 200,000 custom markers across 12 samples on a single chip.

Coupled with the low complexity products that run on the BeadExpress, we’ve now extended our custom content range from 1 to 200,000 markers per sample. We believe this degree of content and multi-sample flexibility will enable us to continue to push deeper into fine-mapping and target validation, as well as routine screening applications in the Ag-Bio market.

When we acquired Solexa, we outlined a vision that reflected the technical interplay between genotyping and sequencing. Today, we can highlight numerous examples of this interaction. For example, a few weeks ago we launched two new Ag-Bio BeadChips, the Porcine SNP60 and the Ovine SNP50. These products build on our existing bovine, equine and canine chips and are designed to address the potential we see in this market.

Significant portions of the content on these chips were generated using the Genome Analyzer, highlighting the coupled use of sequencing for discovery and arrays for deployment. These agricultural products are becoming a significant contributor to Illumina’s growth. In fact in 2008, we received approximately $50 million in orders from this emerging market.

In Q4, we had record shipments of our iScan system, even relative to the historical shipments of our BeadArray Reader. While we continue to be pleased with the order and shipment rates for iScan, we still expect to see somewhat fewer instrument placements due to the much improved iScan rate. In the fourth quarter, the annualized consumable pull through on the installed base of array scanners continued to exceed $700,000 per installed system.

At our Analysts Day, we previewed Harmonia, an add-on module for iScan that will enable customers to perform low to medium throughput sequencing. This module expected to be released this fall, will utilize the same sequencing chemistry as our Genome Analyzer, and offer our microarray customers a low cost way to run sequencing applications.

We’re very excited about this product, as it demonstrates the synergies between genotyping and sequencing that we envisioned when we first acquired Solexa, but also diversifies our offering of sequencing platforms to address a broader segment of the market.

During the quarter, we made significant progress with our BeadExpress platform. We shipped a record 38 systems during the quarter and continue to see the consumable pull through at the high end of our forecasted range of $50,000 to $100,000 per year.

We’re seeing encouraging demand for the BeadExpress as we broaden our reach into the high throughput screening and diagnostics markets. In 2009, we expect to see significant growth in this platform, as we launch new, faster assays, achieve 510-K status with the platform and expand our consumable manufacturing capabilities.

Moving now onto sequencing; in the two years since the launch of the Genome Analyzer, there have been more than 200 scientific publications in peer review journals referencing this system across a wide variety of applications. We believe that this is a testament to the platform’s broad adoption, ease of use, and flexibility.

The fourth quarter was no exception, as we saw a robust demand, shipping a record number of Genome Analyzers. More than 75% of placements were made outside of the major genome centers. However, we did see some significant activity within the genome centers as well. For example, we shipped 11 GAs to the Wellcome Trust Sanger Center, bringing their total installed base to 37 systems and providing them with additional scale to tackle projects such as the 1000 Genomes project.

Following the close of the quarter, we announced that researchers at Duke University Medical Center will utilize the Genome Analyzer to sequence the genomes of 50 individuals who have repeat ably been exposed to the HIV virus, but remain unaffected. The goal of this project is to understand the genetic determinants of HIV resistance with the hope of improved therapies and/or vaccines.

Customers are continuing to leverage the improvements that we’ve made to the GA over the course of the year. Many high throughput customer sites are generating well over 10G per run and several sites are generating 20G or more on a single flow cell.

Two weeks ago, we were delighted to see one of our customers, The NCGR, announce that they broke the 20G barrier per run on the Genome Analyzer, as they sequenced the genome of an individual who suffers from multiple sclerosis. This achievement used paired end read lengths beyond 100 basis and maintained an average error rate below 1%.

These longer read lengths are directly attributable to the new sequencing kit that we launched last quarter, which enhanced the signal strength and preserve the quality of base calls at a longer length for use. Together with the other improvements we’ve made to the system, the throughput of the Genome Analyzer improved by a factor of approximately 15 times in 2008.

In addition to longer, higher accuracy reads, we also launched standardized kits to perform long insert reads. These multi-length inserts facilitate the detection of long and short range structural variation and are critical for the analysis of complex disease samples such as cancer, as well as for applications such as de novo sequencing. With these system enhancements, our customers now have the tools to economically tackle de novo sequencing projects that have previously been done on competing platforms.

In January, the Beijing Genome Institute announced that they have successfully generated the de novo sequence of a Giant Panda, using solely the Genome Analyzer, demonstrating the capability of the system to rapidly perform high quality de novo sequencing of a large complex mammalian genomes. In fact, the sequencing was completed in approximately one month.

We believe the demand for sequencing will grow tremendously over the next several years and will be the most exciting market in the life sciences. To take advantage of this growth, we are developing a family of sequencing products to address specific market segments. For example, I earlier referred to our preview of Harmonia as a combination product that will allow low cost access to sequencing and the ability to act as a transition product from arrays to sequencing for particular applications.

Additionally, we are developing the Avantome technology that we acquired in August of last year. This technology when launched, will enable us to address the low cost, long read segment of the market, and may be an important component of our diagnostic offering. I’m very pleased at the progress that we’re making with Avantome and look forward to sharing more with you as 2009 progresses.

In addition to Harmonia and Avantome, last month we announced our strategic alliance with Oxford Nanopore Technologies. ONT is a development stage company that uses an electrical detection method to detect single bases of DNA as they pass through a biological nanopore. This technique has key advantages in minimizing sample prep and eliminating expensive imaging components found in typical sequencing systems. We believe the simplicity of this system gives Oxford Nanopore the potential to achieve the sub-$1000 genome.

As part of this alliance, Illumina has made an $18 million equity investment and received worldwide exclusive rights to market, sell, distribute and service Oxford DNA sequencing products in the research and diagnostics markets. Upon achievement of a very significant technical milestone, Illumina will make an incremental equity investment with total ownership remaining below 20%. This technology will complement a strong portfolio of other sequencing products to address the full range of emerging market segments.

I’d like to now update you on the progress we’ve made with our organizational structure. Throughout 2008 we were in the process of integrating our array and sequencing groups into an integrated life sciences business unit. We believe that this integration is important for us to take full advantage of the similarity of the underlying array and sequencing technologies.

During the integration, I had asked Christian Henry to serve as the acting General Manager of Sequencing. Through his leadership, the Sequencing Group has made incredible progress, exceeding all their goals while working towards integration into the array business.

In January, we completed this integration, with the Life Sciences business now reporting to Joel McComb. I’d like to thank Christian for the incredible leadership that he has provided to the Sequencing Group. Going forward, Christian will continue as our Chief Financial Officer and now take on the additional responsibility of managing our Genomic Services business, which will combine our array and sequencing services operations.

Additionally, we have expanded our executive team with two new positions. Mark Lewis was appointed as Senior Vice President of Development and is responsible for overseeing Illumina’s global product development efforts. Mark joined Illumina in December from Becton Dickinson, where he held numerous executive, business development and General Management roles.

Bill Bonnar was appointed as Senior Vice President of Operations and is responsible for overseeing Illumina’s global manufacturing and supply chain efforts. Bill joins us from KLA-Tencor, where he served in several senior operations management positions, including his most recent position as Vice President of Operations for KLA’s Retical and Photomask Inspection and Ebeam divisions. I would like to welcome Mark and Bill to the team. Both will report to Joel McComb.

These days, no overview of the business would be complete without a comment on how the global economic slowdown is impacting business. On our last call, I addressed concerns over the global economy and the potential impact to our business. Since then there have been additional concerns as market declines have affected academic endowments.

While endowments do represent 10% to 15% of the funding our customers receive, the vastly larger funding source for our products comes from government agencies such as the NIH and the European Commission. These are very large budgets that have continued to grow and the funds allocated from these sources tend to favor innovative technologies that offer new capabilities, such as what we provide in arrays and sequencing.

Financial guidance for 2009 does not reflect any potential impact from the economic stimulus package that was passed by the House and the similar draft that is currently in debate in the Senate. However, we believe that there may be a potential benefit to the overall funding environment at some point this year, should the package pass in its current form. That being said, we do not believe that it’s currently possible to quantify the timing or level of such an impact.

To conclude, we’re very pleased with the progress of the company made during 2008. We made terrific advances across our full range of products and technologies, made several important transactions, including Avantome and ONT and strengthened our management team. As we look forward into 2009, we see significant opportunities, particularly in the sequencing market. We have a rich product pipeline that will continue to enhance our technical and market position. We’ve established Illumina as a leader in both genotyping and sequencing.

We’ve made numerous investments that will allow us to continue to scale the business, operate globally, and entered new markets such as Ag-Bio. We’ve entered the implementation stages of our diagnostics strategy, and our operational and financial execution has positioned us to drive shareholder value and to take advantage of key opportunities, as they present themselves to us.

Thank you for your time, and we’ll now open the lines for your questions.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from the line of Quintin Lai with Baird. Please proceed.

Quintin Lai – Baird

Good afternoon and congratulations on a nice end to the year. So looking at the 2009 guidance of 20% to 26% overall growth, should we assume that sequencing will be above that number and that the genotyping is starting to mature a little bit and be below that number and then BeadExpress be above? Kind of help us with the different segments that you’ve got and how you rolled it into the expectations for ‘09.

Jay Flatley

Sure. Well, we’re not giving specific guidance by product line Quintin, but I think overall the Next Gen sequencing market is one that’s growing faster than the array market and so I think it’s safe to assume that there’s a probably higher growth rate expectation for the sequencing business than what we see in the array business.

Having said that, we still continue to believe that the array market will grow nicely. We do think that the Express has a lot of opportunity going forward; particularly as we push down some of the work we’re doing into these lower multiplex ag-type applications, that there could be widespread and high-volume adoption of BeadExpress over time.

Christian Henry

And Quint, the array business is still somewhat bigger than the sequencing business. So, the growth rates are different because the dollar values are different.

Quintin Lai – Baird

And then now that your install base in both areas are starting to grow and increase on the consumable trail, where do you think that you can see long term gross margins? I mean, you’re guiding to mid 60s. You posted a mid 60s in the fourth quarter. With that and with Singapore, when do you think you’ll see a little bit more leverage there?

Christian Henry

Well, we’ve continued to guide into the mid-60s. Operationally, we’re certainly very focused on continuing to push our margins up toward the high end of the 60s and certainly we’d love to hit that magical 70% mark, but we’re certainly not prepared to guide to those numbers right now.

We’re doing a lot of work on the product cost side to try to improve our margins. Bill Bonnar joining us as SVP of Operations I think is going to help a lot there as we really work to improve our supply chain, do improve local sourcing in Singapore and things of that nature. So I think we’ve got a lot of opportunity. It’s just too early to really guide to numbers higher than the mid-60s.

Operator

Your next question comes from Tycho Peterson, JP Morgan; please proceed.

Tycho Peterson - JP Morgan

Thanks for taking the call and my congrats on the quarter as well. Maybe as we think about the year ahead and your expectations for R&D spending, can you just give us a sense as to how you think about the progression there and then maybe some key milestones we should be tracking on the diagnostic front Jay, beyond the approval of BeadExpress and launch of Harmonia.

Jay Flatley

Yes. On the R&D side, we’re continuing to make significant investments. We are actually working right now on more platform technologies than we ever have by far in the history of the company and yet we’re doing that within pretty solid boundary of percentage of revenue on the R&D side, but we’re going to continue to make the investments there. So I don’t think you should expect huge incremental leverage over the kinds of numbers that we just posted on R&D and that’s really what’s going to drive the future growth of the company.

On the diagnostics side, some of the milestones would include the 510-K approval of BeadExpress; the opening of our CLIA lab, which we hope to have completed in the second half of the year. By the end of the year, we would expect to have some of our first commercial products ready to be submitted into the FDA and those would begin to generate revenue in 2010.

The other thing of course that we’re doing in the diagnostic side is our large scale sequencing program, and so by the end of the year, end of 2009 we set a target to completely sequencing 50 cancer samples and fit the matching control samples. So that would be a very important milestone and then ‘10, would begin to harvest that data set.

Tycho Peterson - JP Morgan

Okay. Can you remind us how you’re thinking about the timelines for both Oxford Nanopore and Avantome, in terms of the technology hurdles and then rolling out Avantome?

Jay Flatley

Yes. At some point we’re going to be very delighted to update you on those schedules, but it’s just too early in the development cycles to give you any specificity around the timeframes.

Operator

Your next question comes from the line of Ross Muken, Deutsche Bank.

Ross Muken - Deutsche Bank

Good afternoon gentlemen, congratulations. As we think about sort of the study size and how that’s been developing over the last several quarters for both your typical genotyping and sequencing customer, can you talk a bit about where that’s going?

I mean some of the sense that we’ve gotten in terms of likely announcements you’re going to hear over the rest of 2009, suggests that some of the types of studies being done are going to be on far more samples than we’ve ever seen before by a reasonable magnitude. Is that sort of in line with what you guys are starting to see and think about in the business and can you talk about what you’re doing with that from a product perspective to address that?

Jay Flatley

Yes, I think your observation is right Ross, particularly as the 1000 genome project begins to generate lots of content which they already are, and other sources of sequencing data come into the public domain, we’ll be able to take some of the additional discoveries that of variants, of which there is predicted to be a very large number, move those variants on to our chips and then began a whole other round of what we call rich genome-wide association studies.

The expectation is that those next phases of studies will use significantly more samples, because of the need to get statistical significance on variants that are at a lower percentage, you just need a larger sample size. So I think that’s clearly going to be the trend, particularly as we get out toward the end of this year. I think that cycle will really begin to kick in a large impact in 2010.

On the sequencing side, I think you’re going to see some of this as well, because as we now drive sequencing down in cost, we’re beginning to study, cancer becomes technologically and economically feasible; the sample sizes of complete human genomes that are going to be need to be sequenced there are pretty large. No one really knows the answer yet, but it’s expected that on a particular cancer, you’re going to need somewhere in the 100 to 250 complete human genomes to be sequenced. So that bodes very well for the development of the sequencing market.

Ross Muken - Deutsche Bank

And in terms of your business development efforts, given the difficult state of the capital markets and especially some of what we’ve seen from some of the venture companies and the venture capital investors, are you seeing a nice compression of some of the assets that you’ve looked at, whether it’s third generation technologies, IP around diagnostics; and how active would you say the pipeline is at this point, given your still pretty flush with capital, which is pretty rare in this environment?

Christian Henry

Well, I’d say we’re getting a chance to look at more technologies and opportunities than we could have ever imagined. So there is an awful lot of assets out there for sale. The challenge for us is to make sure we don’t get distracted from our core business, which is firing on all cylinders right now and so we’re really looking for where the diamonds are in the rough, if you will and it takes a lot of time and energy to find that.

So I don’t think you’ll see us go on a large acquisition binge, but you can see us work really hard to see if we can find some jewels out there. It’s likely in 2009 that we’ll do some other transactions. Our suspicion is that they’ll probably be on the smaller rather than the larger side, at least as what we know today.

Operator

Your next question comes from the line of Bill Quirk with Piper Jaffray.

Bill Quirk - Piper Jaffray

Nice quarter, guys. Jay first off, recognizing the ongoing discussion in the Senate makes it very challenging to say at least, to quantify the potential impact to you guys from the Stimulus Bill. Is it safe to say, assuming something goes through, that kind of best case is this kind of a late ‘09 impact?

Jay Flatley

I’d say second half ‘09, yes.

Bill Quirk - Piper Jaffray

Then, secondly, just as I’m sure you guys probably saw to broaden out the headcount reduction, but positively for similar reasons to Craig Venter. In other words, the Next Gen technologies are enabling them to effectively reallocate dollars without having to trim research. Can you talk a little bit about this kind of in light of tighter research budgets Jay, and does this present an opportunity for you guys?

Jay Flatley

Yes, I mean we didn’t get much chance to study that because we were preparing for this call just as the release hit, but I suspect what’s going on there is that as you’re probably aware in traditional sequencing and capillary based sequencing, it takes in fact more people to do the sample prep work than it does the management of the sequencers and in next generation sequencing technology, particularly with our platform, the sample prep requires very few people. So you can run a very large sequencing operation with a few bodies.

So I think it’s really indicative of the transition away from traditional sequencing and into Next Gen sequencing. Certainly, in all facets of what’s happening in the current sequencing market that helps us to reduce cost per base, the overall throughput people can achieve and also the reduction in labor, which is a variable cost that many centers would love to eliminate.

Bill Quirk - Piper Jaffray

Understood, and then Christian just a quick gross margin question, circling back to something that Quintin highlighted earlier. Thanks first off for the color around that, but can you help us think a little bit about the relative improvement? Was it more biased towards sequencing versus the benefits that you’re getting coming out of Singapore on the array side?

Christian Henry

Yes, if you look at the actual gross margin, you have to think about the mix and the margin, but when you look at the margin impact, i.e., the improvement in a particular product; the sequencing kits had a very significant improvement during the quarter. So that was probably the number one driver on a margin basis.

When you think about Singapore, Singapore really helps us. It’s too early to tell how much Singapore is going to help us on the array side in terms of actual gross margin improvement, but it helps us immediately on the tax side, as we saw.

Jay Flatley

We’ve never actually factored into our models any improvement in gross margin from Singapore, although we may see some and that’s driven by the fact that our arrays in general don’t have a large labor component and most of the material that we use on our arrays is sourced from unique vendors here in the United States. So they’re typically not things you can get from an Asian supply chain at lower cost. So we think we’re going to have some advantage, but we never counted on it and when we get it, there will be upside.

Christian Henry

Yes, that’s exactly right.

Operator

Your next question comes from the line of Doug Schenkel, Cowen. Please proceed.

Dough Schenkel - Cowen & Co.

Hey, good afternoon guys. Any color you can provide on where you’re placing BeadExpress instruments and what the purpose of those placements seems to be, where these instruments seem to be, being used most frequently over the last couple quarters?

Jay Flatley

Well, I guess there’s two ways they’re biased. One is toward Europe, so a very high percentage have gone into the European market and the second is into agricultural type applications. So we’re seeing a fair amount of interest in different types of agricultural companies that we’re doing research and that stands to reason, because the typical screening applications they do require small numbers of markers, some tens to hundreds of markers as opposed to thousands to millions. So it’s an ideal application area.

For us, the reason that that ag market is so exciting is because the sample numbers are huge. Many of these customers are talking about sample numbers in the many tens of thousands to millions of samples.

Dough Schenkel - Cowen & Co.

Okay, that’s actually a good segway to my next question. Can you guys provide any update on Ag-Bio revenues for the year and I apologize if you’ve already provided that, but if you haven’t, would you be willing to share that and any thoughts on what’s incorporated for Ag-Bio revenues into your 2009 guidance?

Jay Flatley

Yes, what we said was that we had $54 million in orders during 2008; we didn’t give anything specific about shipments or revenue for the year, nor did we providing any breakdown of what we expect for ‘09. Although I can’t say qualitatively that we expect it to be an important growth driver for us in the year.

Dough Schenkel - Cowen & Co.

Okay, and last question, it’s another economy question, but clearly you guys put up a really solid quarter. Did you see anything in the quarter to suggest it could have been even better if it weren’t for the current economic situation?

Jay Flatley

That’s just hard to know, Doug. I mean, the answer is probably, but the difference wasn’t significant enough for us to detect it, so just hard to know.

Operator

Your next question comes from the line of Marshall Urist with Morgan Stanley. Please proceed.

Marshall Urist - Morgan Stanley

A couple of questions, so the first one, I know that you said that 75% of GA placements were outside of the genome centers. I was wondering if you could give us a little bit more color beyond that in terms of to what extent are new placements being driven by customers adding second or multiple machines in the same location. Then can you just us a sense also if you look at the uptake within maybe the top sort of 20 research centers by total spend in the life sciences versus everyone else.

Jay Flatley

Okay. Let me deal with the first part of the question and then I need some clarification on the second part; I’m not sure I really understood the question. But on the first part, we’re probably seeing, if you’re outside the genome centers, probably roughly equivalent placements in sites that are adding an additional unit versus the ones that are putting in brand-new units; maybe 60/40, some ratio like that is probably where we’re at.

On the second part of your question, could you maybe try again there?

Marshall Urist - Morgan Stanley

Well sure, sorry. So, I’m just trying to get a sense of if you look at, if you take universities and medical centers across the US, sort of in the top quartile in terms of NIH funding or the top half versus the bottom half, how much of the demand is in the top-end centers versus maybe smaller places?

Jay Flatley

I don’t have any statistics on that, but one metric that I’ve used often is that when I review our order received list every single day and I look at who we get orders from and it’s always surprised me when I look at the sequencing orders, how many names on the list I don’t even recognize. So that gives you some sense of the breadth of the market and the kind of customers who are buying the units.

Christian Henry

And the global diversity. I mean, I’m looking at the list of instruments we shipped this quarter, and it really is all around the globe, all different sizes of institutions. We don’t really keep statistics kind of like you outlined there, Marshall; we kind of look at it on an account-by-account basis.

Marshall Urist - Morgan Stanley

Okay, got you. And the next question on sequencing consumables. I was wondering if you could talk a little bit about where you think that can go. As read length goes up and cycle time continues to go down, I mean should we be thinking that there’s plenty of runway in terms of where consumable pull through could go? You guys are already at the top end of where you had originally guided.

Jay Flatley

Yes, I don’t think so. We’re not going to guide above that $200,000 number, because there are competing forces on the sequencing pull through. Certainly cycle time improves the capacity on the one hand; read lengths actually decrease the consumables, because it takes longer with the same reagent kit, you just continue running longer. So that works a bit in the opposite direction.

Also over time, we continue to believe there’s huge elasticity in the sequencing market and so we along with everybody else in this space is working hard to push the cost of sequencing down, because we think the aggregate revenue in the market will go up as we do that. So I wouldn’t model in numbers higher than $200,000, at least for now.

Operator

Your next question comes from Derik De Bruin with UBS. Please proceed.

Derik De Bruin – UBS

A couple of questions on just some market stuff. So, last year Jay, you’ve made a comment that 4Q was a milestone that you shipped over 200 GAs. Say you have 70% market share in this. I’m wondering, can you tell us if the number you shipped in 2008 was above that 200? I’m basically just trying to get a number for the overall installed base of next generation sequencing in the market, because I get a lot of questions basically on just that from clients.

Jay Flatley

Yes and we haven’t given any more numbers on the units and the market share, just for clarity we talked about 60% in sequencing, 70% in raise and genotyping is 60%. So, I don’t think we’re prepared to give any more specifics around placement. At some point in the future, we’ll pick the right day and give some updates on unit placements, but today is not the day.

Derik De Bruin – UBS

Okay, fair enough. When you look at some of the spending that went on this quarter, as opposed to Doug’s question asking about weakness looking at 1Q, did you get any sense that some of the spending that you saw in 4Q was people rushing to get stuff because they were worried their budgets weren’t going to come next year? Was it just basically people just trying to get whatever they can now because they were less certain about the future?

Jay Flatley

We didn’t see anything unusual there. Always at the end of the year there’s a bit of a rush as people try to use up unallocated funds, but nothing that we noticed was out on the ordinary. So I don’t think there was some massive pull through thing that’s going to make Q1 inherently weaker.

I mean Q1 is always in our industry and for Illumina generally the weakest order quarter of the year, just seasonally and that’s partly because of the fact that people spend their year end budgets and budgets are refreshed in Q1, but I think based on everything we’ve seen, it’s about what it has been for us historically.

Derik De Bruin – UBS

Okay, that’s great. Also on the market environment, have any of your customers had problems getting IT upgrades or infrastructure build outs to support the new DNA sequencing and solve?

Jay Flatley

It’s certainly an area of challenge, because they do need to build out their IT infrastructure, but at least so far we haven’t heard of any material orders that we’ve lost because they’ve been able to get money for sequencing but not the IT side. They tend to bundle it all together and so no, we haven’t seen that either.

Operator

Your next question comes from Un Kwon-Casado with Pacific Growth Equities. Please proceed.

Un Kwon-Casado - Pacific Growth Equity

Hi, good afternoon. I was wondering as we look into 2009, this past quarter your operating margins were very strong. Could we get a little bit more color on how you anticipate SG&A expenses to ramp this year?

Jay Flatley

Well, I mean I think Un what you’re going to see over the years, you’re going to see continued expansion in infrastructure, particularly internationally as we continue to hire folks to service the instruments and sales people. We have very large quotas that we carry for our sales force and so as we get bigger, it makes sense to shrink territories down and give more customer attention, so you’re seeing growth there on the SG&A side.

The other element of SG&A that will be growing in 2009 will be focused on some of the core infrastructure around our systems. So our Business Applications Group, folks that really help us run the business day-to-day, understand how we move inventory around the world, basically tracking systems, things like that, that allow us to run an effective and very efficient operation. So those are where the dollars are going to go, in terms of growth in ‘09.

Christian Henry

One other way to think about that Un is that if you look at the percentage of revenue we’re earning in SG&A, at 20.1%, we continue to look for ways to get leverage out of that number and we do everything we can, but we think it’s a best-in-class number and we just don’t see any companies being able to maintain that kind of performance over the long run. So I think we’re feeling awfully good about where we are right now and if we can keep near those kinds of numbers, we’ll do real well.

Un Kwon-Casado - Pacific Growth Equity

Okay great and I missed the amortization of intangibles expense that impacted your gross margin, what was the dollar amount of that and what was that related to?

Christian Henry

That was related to the Affymetrix settlement and the dollar amount; I don’t have it right now. $2.7 million Peter tells me. That’s GAAP Un.

Operator

Your next question comes from Isaac Ro with Leerink Swann. Please proceed.

Isaac Ro - Leerink Swann

Thanks for taking the question. You know, my first question is really more on the technical side. I know there’s been a lot of lip service given over the last few months regarding read lengths, and from an application standpoint the ability to improve de novo sequencing works when the read lengths are longer.

I’m wondering, when you guys work with your product engineers on developing GA technology for the clinical setting, do you guys work on the technology with a mind towards maybe optimizing it in a totally different fashion for the clinical diagnostics down the road? So, in other words, is there potentially two totally different systems out there in the research versus clinical setting?

Jay Flatley

I’m not sure they’d be totally different, but I do think in some diagnostics applications, read length is greater than what we will achieve on the GA and probably going to be requiring that was one of the reasons we made the Avantome acquisition.

So, Avantome is a system that’s targeting read lengths in the Sanger range and so certainly much longer than we will get to on the GA. I think for that reason, it will be a very good system for diagnostics and additionally, it’s really being designed for fast turnaround sequencing. So I think that will be the system that’s used in pure diagnostic applications.

Isaac Ro - Leerink Swann

Then obviously you and your biggest competitor in the space have been pretty active in recent months when it comes to gaining access, either through acquisition or partnership, to some of these privately held technologies. Do you still see a reasonable number of technologies out there that are available and maybe worth taking a look at or do you feel like most of the IP has been snapped up here?

Jay Flatley

Well, I guess there’s not that many novel ways to sequence DNA that we run across on a regular basis. I mean there are small companies that are trying to put particular nuances on how you do imaging or other components of the overall technology.

Certainly, we’re, as I mentioned, very excited about the potential of nanopore sequencing as an important way to do sequencing in the long run, so hence our investment in the Oxford transaction, but I guess I’d say that in terms of other new small companies, most of them are not brand new novel ways to do sequencing that we haven’t heard of.

Operator

Your next question comes from Zarak Khurshid with Caris & Company. Please proceed.

Zarak Kurshid - Caris & Co.

Hi guys, solid quarter. Most of my questions have been answered. I was curious what’s going on with Children’s Hospital of Philly these days and generally how should we be thinking about the potential adopters in the hospital community as the technology evolves?

Jay Flatley

They’re continuing to be a substantial customer for us. They’re in the top few customers that we have.

Christian Henry

Yes, they’re definitely in the top 10 every quarter.

Jay Flatley

We take trips on a regular basis and I think their model is playing out nicely for them.

Christian Henry

I saw them in November actually, and they were very enthusiastic about what they’re doing and they’ve had broad acceptance of this model of genotyping children that come into the hospital and in the outer community and they just keep building out their database.

Zarak Kurshid - Caris & Co.

Then Christian, I was just curious about the interest expense. It looked a little bit lighter than we had expected. What was going on there?

Christian Henry

It’s just due currency. I mean, there’s a whole bunch of things that go in that line, so it’s not just the interest, there’s a lot of little things this quarter, not really anything major.

Operator

(Operator Instructions) Your next question comes from Tony Butler with Barclays Capital. Please proceed.

Tony Butler - Barclays Capital

Well, 2008 drove a 15 fold increase in throughput for GA. Do you have target for 2009?

Jay Flatley

Well, we certainly have internal targets. Probably not ones we’re ready to talk about publicly at this point. It’s probably safe to say it’s not 15x in 2009. Obviously, we’re on a much higher base now, but we see a lot of headroom for the technology and it’s moving very quickly.

Tony Butler - Barclays Capital

Thanks a lot.

Operator

Your next question comes from Davis Bu - Goldman Sachs.

Davis Bu - Goldman Sachs

I guess I have two questions. The first is regarding the Oxford Nanopore Technologies. So how far away is that from reaching sort of a commercial product? Like, when might we see something there?

Jay Flatley

We haven’t given a timeframe for that and given that we’re just an equity investor there, it would probably be inappropriate for us to do that outside of their company, but the way to characterize it is that it’s a company still in the late research/early development phases of this product. So it’s not something where you’re going to see an announcement in the next six months, but we think as the fundamentals to be very promising in the long run.

Davis Bu - Goldman Sachs

Great and going back to some of the economic conditions questions and so forth, if I could just take a different spin on that. A lot of your customers are academic customers and so forth. I was just wondering are any of their budgets dependent on sort of endowments or have the financial markets and endowments impact your customer base?

Jay Flatley

Well, certainly there is some dependence on endowments. So we think of our total funding for our products somewhere in the range of 10% to 15% is related to endowment funding. Certainly those portfolios have been hit hard, but most of these foundations are still giving away money. They haven’t shut down because of the financial crisis; they’ve just maybe reeled back in particular areas.

So it continues to be important for us to have the most important technology that people want and I think that’s where we find ourselves, fortunately. I guess the other thing I’d say there is that we actually haven’t had enough of an impact to be able to detect it in our order rate. So if it’s there, it’s not something that’s large enough for us to detect.

Operator

Your next question comes from Isaac Ro with Leerink Swann. Please proceed.

Isaac Ro - Leerink Swann

Thanks for taking the follow-up. Real quick on the NIH situation, I know you said that you’re not really planning for any increase, but I’m wondering have you had conversations with customers at the university setting who’ve said, “if I get this grant funded or if I get a little more money, I would be a buyer.” Can you maybe give us some color on what you’re hearing from your sales force with those kinds of conversations?

Jay Flatley

Yes. I mean, absolutely there’s a lot of upside. There’s a lot of grants that people either want to put in or have put in that haven’t crossed the finish line that given a supplemental package like the stimulus would certainly bode very well for us. So I think we’d feel very positive if that stimulus package would pass in its current form, at least until they start business.

Isaac Ro - Leerink Swann

Okay and then just lastly, I think you might have mentioned some point along the road that your headcount probably doubled in 2008 and with your plans for growth this year; do you have a rough plan for headcount expansion this year?

Jay Flatley

It didn’t really double in ‘08. It went up about 50% or so in ‘08. We expect to add somewhere in the range of 400 to 500 people to the company in 2009.

Operator

Your next question comes from Matthew Scalo - Canaccord Adams. Please proceed.

Matthew Scalo - Canaccord Adams

Hi guys, just two real quick questions. It seems like you were pleasantly surprised with the iScan shipments for the quarter. Is that coming all from new customers? Is that coming from upgrades from existing customers that are on the BeadStation side?

Jay Flatley

We’ve had a mix of both, but I’d say many of the customers, the large group of customers that wanted to change out multiple BeadStations, a lot of that happened in Q3. So I’d say the predominant force in Q4 was new customers as opposed to either change outs of BeadStations or additional systems to existing customers.

Matthew Scalo - Canaccord Adams

Okay and we shouldn’t model that going into 2009?

Jay Flatley

Model the kind of rate we had in Q4?

Matthew Scalo - Canaccord Adams

Exactly.

Jay Flatley

I’d say that’s correct. We continue to believe that the instrument numbers for iScans should trend less than what we were doing for the BeadStation and that’s just because the throughput is so much higher. So even in fact, when customers do trade-ins, they might trade in four BeadStations for iScan.

Matthew Scalo - Canaccord Adams

Okay great and then just the follow-up question here on next generation sequencing of the 75% or so that are in the smaller institutions. Are you noticing their business model change where rather than using the Genome Analyzer to do kind of proprietary discovery work, they’re now becoming more a service provider to other academic centers that may not want to have the capital outlay?

Jay Flatley

I guess we’re seeing a bit of that. There’s a large number of academic centers that sort of aspire to be a service provider in one way or another, but I don’t think that’s a material fraction of the market right now.

Peter Fromen

That’s all the time we have for questions today. Thank you everyone. As a reminder, a replay of this call will be available in webcast format in the Investor section of our website, as well as through the dial-in instructions contained in today’s earnings release.

Thank you for joining us today. This concludes our call and we look forward to the next update in April following the close of the first quarter.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect and have a wonderful day.

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Source: Illumina Inc. Q4 2008 Earnings Call Transcript
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