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Illumina, Inc. (NASDAQ:ILMN)

June 12, 2013 12:20 pm ET

Executives

Jay T. Flatley - Chief Executive Officer, President and Director

Marc A. Stapley - Chief Financial Officer and Senior Vice President

Analysts

Isaac Ro - Goldman Sachs Group Inc., Research Division

David C. Clair - Piper Jaffray Companies, Research Division

Isaac Ro - Goldman Sachs Group Inc., Research Division

Okay, good morning, everybody. Isaac Ro, the Life Sciences analyst here with Goldman. I'm happy to have the team from Illumina with us again this year. Before we get started, I do have to read the disclosure, so please bear with me for a minute. We are required to make certain disclosures in public appearances about Goldman's relationships with companies that we discuss. The disclosures relate to investment banking relationships, compensation received or 1% or more ownership. I am prepared to read disclosures for any issuer now or at the end of this call if you would like me to. However, these disclosures are available to our most -- in our recent reports available to you as clients in our firm portals. So with that, Jay, thanks for being here, and Marc, great to have you.

Jay T. Flatley

Our pleasure.

Isaac Ro - Goldman Sachs Group Inc., Research Division

A lot is going on in the markets you serve and in the business in particular. So a lot of things I want to touch on, the products, as well as on sort of the use of cash and the financials. But maybe we can just start out with the most recent quarter. I think the biggest takeaway I had was that the placement of HiSeqs was probably [ph] bigger than expected. And the confidence you guys expressed around the pipeline there was pretty notable, particularly given the funding environment that we're in. So can you give us a little sense of how you feel about the visibility you have on the pipeline there and really, your expectations for the balance of the year in terms of HiSeq demand?

Jay T. Flatley

Yes, we have a reasonable visibility on what's going to happen with HiSeqs over probably 6 months or so. It gets a little hazier out 3 quarters, but we track our pipeline through a win of about 9 months overall. HiSeq demand has been quite strong for us, and I think there's a couple of key contributors to that, certainly, the rapid mode capability of the 2500 has vastly exceeded our expectations. And this is becoming more and more the standard mode that customers are operating their systems in, particularly for clinical applications for fast turnarounds important in an IPT, often in cancer sequencing. The rapid run mode becomes the default way to use the system. We're also seeing this used quite regularly in core labs, where they're trying to manage their cues effectively. So we're really pleased with that. And clearly, I think in the high end of the marketplace, the product performed vastly better than anything the competitors have. So the strength of that product line really has continued to be very surprising for us.

Isaac Ro - Goldman Sachs Group Inc., Research Division

You mentioned visibility, I think, a couple of quarters out, Can you qualitatively say what that visibility looked like maybe a year ago? Is it fair to say that the tail has gotten a little shorter just because of the sequester is there something else?

Jay T. Flatley

No, I would say that. I think where we are today, the demand is stronger than we would've forecast a year ago. But as we look out, we don't see any direct impact from the sequester, at least anything that we can determine in our numbers.

Isaac Ro - Goldman Sachs Group Inc., Research Division

One more on the HiSeq. If I look back to our last quarter comments, it sounded like, if I recalled Christian saying that you have a little bit more of an interest in pharma. And as I think the pharma end markets historically, you had a bit of a renaissance for them to take on big capital equipment and really be more directly involved, maybe they will have 1 or 2, but you don't see big pharmas or sequencers the way you did in the last generation. So what will you say is the marginal source of demand from that end market?

Jay T. Flatley

I think that characterization is accurate. In pharma, we see purchases of HiSeqs and MiSeqs for all the pharma companies in the research laboratories and particularly in the large companies that have multiple sites. They buy them for every site because it is a day-to-day research tool, that's almost an imperative now for anybody doing molecular biology. What we don't see is a fleet of large sequencers being put in place for doing large-scale discovery, which is might have happened 10 years ago. We certainly don't see that trend in pharma. Pharma is also doing some outsourcing, so our services business, we have quite a few contracts from pharma that come into the services part of our business as well.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sure. On the depths outside of the business, you've been very successful with MiSeq. It's having a great run. And I think in the last few quarters, you talked about the strength of head-to-head market share that you're seeing in the channel. Can you give us a sense, in the last couple of months, just given the news from your major competitor there and some of the disruption you might see? Has there been a tangible or notable change in your ability to convert some of those orders and win more accounts, just given that the others guys may be a little bit distracted?

Jay T. Flatley

I don't think we've detected that yet. But what I would say is that it's very clear that our competitors there are being very aggressive in trying to keep their placements up. And so we are seeing systems go into the market with try-it-to-like-it sorts of programs, place it for 6 months and buy it at the end if you like what you see and also some price reductions on the systems. So I think that's indicative of the strength of the MiSeq platform in head-to-head competition.

Isaac Ro - Goldman Sachs Group Inc., Research Division

And you guys have been pretty consistent in saying you haven't responded in a kind and a meaningful way, is that a fair characterization? How are you guys dealing from a pricing and sort of purchasing term standpoint?

Jay T. Flatley

We've held our ASPs very firmly on MiSeq. So the system was launched at a list price and our ASPs have been stable over the past couple of quarters.

Isaac Ro - Goldman Sachs Group Inc., Research Division

I wanted to spend a moment on arrays before we come back to the sequencing business and some of the other things we're doing there. Because the array business has been, I think, an area where people have spent all the time of focusing, but again, there's been a nice little renaissance there. And if you could sort of give us an updated view on the growth trajectory of that franchise and some of the puts and takes within that specific product?

Jay T. Flatley

Yes, I think of the array market as having several subsegments. So clearly, the large growth segments 5 to 6 years ago in GWAS is now a shrinking market in the array business. And much of that work has been transferred over to using our sequencers to do large-scale discovery. Offsetting that to some extent is the growth in the business we see in ag and certainly, in consumer. And the consumer markets have grown up very dramatically over the past year. I think their pricing, you raised, is now at sort of a magical price point of around $100. And that's caused a real explosion in demand in the consumer markets. So overall, if you put out all that together, we think the array business is growing at sort of low-single digits, but the different segments at different rates.

Isaac Ro - Goldman Sachs Group Inc., Research Division

And as I think about the margins and the profitability of that business, it's a very profitable business for you guys. The incremental investment is not necessarily that high. With price points that you're talking about in the $100 range, what's the impact to margins? Can you still get an attractive margin given the volume?

Jay T. Flatley

Yes, I think the margins on the arrays remain great. They will go down a little bit over the next year or 2, we think, as volumes probably -- overall pricing probably comes down, volumes of -- unit volumes will go up and pricing will continue to probably come down in the array market. So we think there may be a little bit of degradation in the gross margins of the arrays, but they still are dramatically above our corporate gross margins.

Isaac Ro - Goldman Sachs Group Inc., Research Division

And if you think about 2 and 3 years out, on product design, how did the arrays need to evolve to continue serving the growth parts of that business for ag in the applied setting?

Jay T. Flatley

I think we need to continue to drive the density on the arrays and put more samples on the chip. That's the way that we get better economics in our factory, and we can basically produce the chip for almost a fixed cost, not quite. But if we can double the number of samples that we put on the chip, we can get out on a per sample basis. From a cost perspective, it drops nearly in half. So that's really the core direction we're moving. Certainly, content discovery fuels what's happening in the array business. So as more sequencing occurs in the world, we learn more about what variants or what structural changes in the genome are meaningful. That creates the demand to put those specific markers on arrays, and that's largely what the consumer companies are doing now.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sure. And if we look at some of the more clinical uses, cytogenetics have an interesting area, you guys got into that last year for BlueGnome. Tell us a little bit about your long-term goals for that marketplace. Is BlueGnome the centerpiece of that whole strategy, and where would you say you are in developing that opportunity?

Jay T. Flatley

BlueGnome is certainly a key component of the strategy, but we think about it quite broadly and really, now discuss it in terms of an overall strategy for reproductive health. And that strategy goes all the way from carrier screening on the front end when there's the potential of conception all the way through the NIPT market space, where we're monitoring with the Verinata technology and through other partners, T21, T18 and T13 and then cytogenetics, which is used for developmental delay studies. So we see them as a continuum in our reproductive health strategy. Sequencing addresses most of that, but in the cyto markets and the PGD, we use array technology because it's very effective and the content is known. So this will continue to be a very important emphasis for us, and I think it's a market that we're going to see continue to grow very, very rapidly over the next few years.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sure. You touched on NIPT, it's been a obviously a really interesting market to watch in the aggregate, probably going faster than most people would have expected. And the simple math people have done is sort, I think, 3 million births a year in the U.S. 750,000 of which are higher risk. But as I look at sort of the annualized run rates that the combined companies are running at, it would suggest a pretty impressive level of penetration. And to me, it would suggest that maybe the adjustable market that we started out looking at was maybe -- it's bigger than that. And so what are your thoughts on that? Do you think that the total opportunity is materially larger and why?

Jay T. Flatley

We do think it's going to be an enormous opportunity, particularly as we get this technology into an IVD form as we get to that point over some period of the next few years, we think it becomes $1 billion market opportunity. The challenge today isn't so much a U.S.-based one, but the geographical challenge in terms of how you penetrate more fragmented market opportunities in Europe and in Asia. And I think to do that very effectively will require an IVD that we can apply on a less expensive system and in a more automated fashion. And when that happens, I think the market is going to be absolutely enormous. In the meantime, the uptake has been dramatically faster, I think, than anybody thought. It's clearly a test that has terrific analytical performance, as well as the avoidance of the traditional risks associated within [indiscernible].

Isaac Ro - Goldman Sachs Group Inc., Research Division

You guys have historically, that I would say, relatively secretive about new products, but you did spark my interest with that comment. Can you talk qualitatively about what a product like that needs to look like, whether it be performance, footprint, price tag.

Jay T. Flatley

The IVD product?

David C. Clair - Piper Jaffray Companies, Research Division

Yes.

Jay T. Flatley

Well, it certainly needs to be very easy to use. It needs to be deployable, probably on multiple platforms so that you can address both the centralized lab requirements in some geographies but also the more fragmented labs in other geographies. And therefore, you will probably want a lower throughput system, for example, than HiSeq. It needs to be a product that has very automated software associated with it and ultimately, one that could be sold into the hospital setting. For example, in China, there's about 3,000 hospitals in the long run that we think all would want to do NIPT testing if they could do that with a technology that's sufficiently easy to use and clinically proven to be accurate. So that's the path we're on with this IVD technology that we're working on in-house and one of the key reasons we're a part of Verinata.

Isaac Ro - Goldman Sachs Group Inc., Research Division

The China point is interesting here, we actually had, I think, PerkinElmer yesterday, talking a little bit about where they are and their footprint with what they have, which is very basic [indiscernible] test, right, low price. So when you talk about 3,000 hospitals, do you really think that there's going to be that many birth a year in China that can realistically be tapped into that or pregnancies that can be tapped into economically speaking, where you could have actually, if you had an answer, do something about it?

Jay T. Flatley

Well, I certainly -- I mean, having this test certainly isn't going to change the birthrate in any way. But I think that the hospital sort of infrastructure in China is quite different. They tend to be extraordinarily large. They tend to be profit centers rather than cost centers. And therefore, the hospitals would like to run this test themselves rather than contract it out. And as a result, whether the system gets used everyday or not is a secondary consideration, but I think all of those hospitals would have the desire to have the technology in house and have the ability to run it if they could.

Isaac Ro - Goldman Sachs Group Inc., Research Division

That's interesting. Are you guys going to do an analyst meeting in China. I will be on the plane.

Jay T. Flatley

That will be great.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sorry, so just getting back to technology. As we think about the growing installed base here from MiSeq, the position of leadership you have in HiSeq, one of the things that I've been very interested in personally is the role of software across tieing all this data together. You guys have recently shown the uptake in the pace of data that you're getting in. Now you have a lot of these realtime analytics, can you talk about how important this BaseSpace is now that's sort of driving competitive advantage, not just sort of for your own purposes but just against other potential competitors?

Jay T. Flatley

I think BaseSpace is strategically very important for us, not only the ability to create this initial killer app in data sharing but in the long run, the whole idea of the App Store and the ability to sort of capture the customer imagination and have one single place where customers can go to run a broad suite of different applications, whether they come from us or from other software suppliers. And that will create a level of convenience for our customers, I think, that will be unprecedented. So we think about BaseSpace as sort of a unifying overall architecture. Today, it serves largely the role of being at the tailwind of sequencing. But over time, I think BaseSpace has the ability, strategically, to grow to embrace a greater part of the overall workflow in what we're doing. So it is a very important strategic advantage for us. Today, it's probably not something that drives a huge difference in market share. But over time, I think it will have that effect for sure and also create stickiness in our customer base.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sure. It makes a lot of sense. I don't think most of us have had the opportunity to use a sequencer and think about what types of applications would help. But are you able to sort of bucket in a couple of large areas the types of applications BaseSpace will bring out to the users?

Jay T. Flatley

Well, our goal is to have all types of applications in there. But one way we started this is that if our customers stream their data up to BaseSpace, we will run our base color and our variant analyzer and aligner all automatically for them for free. And so the data just streams up there, it goes through our processes, if that's the one they choose. And essentially, they get a finished genome just by streaming the data through BaseSpace. So that's part of the normal workflow that in any individual laboratory, they'd have to have this software. They'll maintain it, upgrade it when it comes available, have somebody that can be a Linux computer manager to keep all the infrastructure running and will eliminate all of that for customers. So that's just a very elementary way to use it. But certainly, as we get into cancer genomes, for example, the ability to compare across large numbers of cancer genomes will be enabled by BaseSpace because customers can share a large collection. And otherwise, you have to have all those locally and you have to probably develop your own software to do that or buy FIT licenses to do it. And basically, it eliminates that. So that's sort of on the other end of complexity, where someone might want to do a comparison across 500 cancer genomes. And we don't quite have that capability yet, but that's where it's headed.

Isaac Ro - Goldman Sachs Group Inc., Research Division

So we saw the 2 buckets. There's the finishing sort of the actual workflow piece that you're making sort of like footprint, if you will, and then the other piece is sort of once you have it all, how do you look at it and manipulate the analytics of the data and sort of extracting biological relevance out of the data.

Isaac Ro - Goldman Sachs Group Inc., Research Division

And can you get paid for one or both of those buckets? Is that a revenue stream for you potentially?

Jay T. Flatley

Well, certainly, the secondary one is. The front end one, we don't think so. So that's a software that we typically supply with our systems. And it's a convenience that we offer our customers as a way to encourage them to push their data up into BaseSpace. Because one of the goals of BaseSpace is to get as much data up there as possible, and so this is an incentive for customers to do that.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Now it's interesting, on the one hand, whenever I talk to labs, you typically get this whole pushback of "I don't want to pay for a software." Flip side is if you actually ask them, they're already spending a lot of money on software. So how do you get that philosophical gap to be closed, such that they get used to sort of instead of building it their own, writing you guys a check once a month or whatever the business model is, subscription wise, they pay for that?

Jay T. Flatley

Well, I do think it helps to have software that's paid by use because it's a smaller bite. I think one of the challenges for the software companies who have these large packages today is that they try to sell it via FIT licenses in multi-year commitments. And that's very difficult for any institute to step up to and to get through the approval process because it's a very dynamic environment in the software world. If we can get those software applications into BaseSpace, and customers have to pay just for a single analysis, and they can use a different package the next week, if there's some better package, I think that both levels of the playing field across these helps all the software companies with distribution. And I think it makes the adoption of the software much easier for any institution.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Got it. I wanted to switch to the clinical opportunity, which and I think all of us are excited about. The idea of sequencing for everyday clinical use is clearly a long-term opportunity, and in many ways that actually takes shape. And one thing I've noticed in speaking with a lot of companies in the space is there's a bit of a divide on the philosophy of how sequencing will be used. And specifically, it's sort of in the short term, there's this big move towards gene panels, right, where you have sort of a very small subset of genes that if you pick the right ones, you're highly predictive if your risk for cancer or for the ability to diagnose. And at the same time, there's a longer-term view that if you can get more data and really look at the genome holistically, you'd want it. If you could, you would. And it's a question of price. Do you think this is sort of just a transition period where we're looking gene panels because we can and we'll just move to whole genome, or do you think there's sort of a parallel market for both?

Jay T. Flatley

Well, we think there's going to be a market for both for some time, but we think the world will move to full genome sequencing as prices continue to come down. There's really 2 reasons why people might not do that today and certainly, price is one of them. The second certainly has to do with sort of discoveries that are unintended, so unreportable results. And what you do is discoveries that happen that were not in parts of the genes that you cared about. And that's a big concern for people in the ethical side about what you do with those pieces of data. So that's the second reason perhaps that people might not go directly to whole-genome sequencing. But in the long run, it's all what we've done with whole genome, we think, and probably also include RNA analysis and perhaps, methylation.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Can you maybe indulge the audience a little bit and talk a little bit about the scientific or medical reasons why that will be the case, whole genome? I mean, again, it seems if you look at the current marketplace, there are a lot of tests that have been very successful, just telling you a little bit about a couple of genes, and that's changed clinical decision-making. But why is that not good enough?

Jay T. Flatley

Well we're discovering more and more relevant information that lies outside the genes. And certainly, if you're looking at only a few genes, you have to believe that you understand everything about the biology of that disease. And I think realistically, that's just not the case today. And there are genes that moderate the effects of other genes that we just don't understand now. There are activities that happen or parts of the genome outside the genes that matter in terms of regulation and transcription. And it's looking across the entire genome that really gives you the ability to analyze the disease without a prior set of assumptions. So we think in the long run, that's the way this will all go. The challenge, of course, is that's a much more difficult analytical problem. And for the software limitations today, it's the third reason why it pushes people to do analysis of just a few genes.

Isaac Ro - Goldman Sachs Group Inc., Research Division

And as we tackle all these issues, you think we'll need to look at all those in a snapshot. So I go in, I've got something that doesn't feel so good, and doctor runs a whole genome, scanned and look at everything the snapshot to diagnose whether I have chest pains or a lung tumor to make that diagnosis?

Jay T. Flatley

Well, I think what will happen in the long run is people wanting to get sequence when they're born, and so they'll have that as part of their medical record. And then if you're dealing with cancer, as an example, then you would sequence the cancer tumor itself, but you'd already have the baseline reference from when you were previously sequenced. And in the case of cancer, of course, we think that the tumors will be sequenced in multiple events. So initially, at the time of diagnosis, to understand at the molecular level what's going on with the cancer, but then it certainly is, has a monitoring process afterwards. And hopefully, we'll get to the point where we will be doing sequencing as a screening test. And there's more and more evidence about cancer cells being shed into the blood from various types of cancers and to the extent that we can get sequencing sensitive enough to pick this up in the blood, we have massive opportunities here to be able to start sequencing from blood draws to do early detection of cancer. That's still several years away, but that's where the whole field is going to be headed.

Isaac Ro - Goldman Sachs Group Inc., Research Division

One last one for me on the cancer initiative is you are seeing a number of other companies out there with pain cancer tests, large panels, et cetera. You guys have been focused more recently on the NIPT opportunity, but can you give us an update on when you think you need to be in the market with a broader cancer offering?

Jay T. Flatley

Us directly?

Isaac Ro - Goldman Sachs Group Inc., Research Division

Yes.

Jay T. Flatley

Well, our strategy in cancer is to build panels that our customers can use as starter sets. And we think of it as doing a heavy lifting across a set of genes that everybody's going to want. So today, we have a couple of cancer panels into the market. We've designed those so that customers can add their own genes on top of the panel. And that's really the way we intend to go into the market. So we don't think we're going to, be anytime soon, running lab-based cancer diagnostic panels. We're really trying to enable the broad market. It's a complex market with hundreds of subsegments. If you look at the progression of disease and the stages of cancer, all the different molecular types of cancer, the different treatments, it is not an area where we think we should be directly involved.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Let me ask one more on technology, and this is sort of a bigger question. But the concept of third generation, post-light single molecule a long read, all of these metrics that we read about. The reason I asked about this topic specifically is a little bit of a development last week with your relationship with Oxford Nanopore. Can you talk a little bit about the thought process there and sort of where you think the field is going in terms of real third generation products?

Jay T. Flatley

Specifically, with respect with Oxford Nanopore, most of you are aware that we've had a development agreement within commercialization agreement, we've been in arbitration, and we completed that arbitration recently and they did their financial reporting, which disclosed the results of that arbitration. And what happened there is that we agreed together to extend the agreement and have it last through 2016. And that -- what that requires them to do is to commercialize their strand technology themselves rather than do it through a third party. So our objective is to make sure that they couldn't -- if successful in developing that, distribute it through some large competitor of Illumina. The agreement and an extension of that makes that the case that they can't do that all the way through 2016. We continue to have rights, some rights under change in control in the agreements, so I think it came out to be exactly what we had hoped to get out of the settlement with them. They don't have any obligation to continue to work on the excellent technology. But as a result of where this is all headed, we now have internally our own nanopore development. In terms of where third-generation technologies are, sort of in totality, we think they're still ways away from the market. It's a very difficult -- particularly nanopore is a very difficult technology to get to work robustly. And I think that's been shown by how long it's taken Oxford to get their products into the marketplace. And certainly, we're making great progress in our labs, but we think it's some years away from being commercially available.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sure. That's so much of technology questions. Let me stop for a second. If there are questions in the audience, please raise your hand. If not, I'll keep going. I can't imagine, there are no questions for Illumina. Okay, so actually, one more on the technology. I mean, as I look back at other markets, not even -- you don't even have to go outside of life sciences, you can see, for example, in the Sanger market, these technologies can, in many cases, have extremely long lifespan. Even when you know the next technology is effectively around the corner, these products get used for quite a long time. So as you think about your business model, product development on the current SBS chemistry, what does that imply? I mean logically, the first GAs and HiSeqs, they've all been out there 5, years, 6 years at most. What do you need to do from a product line extension standpoint to kind of ensure that, that installed base is as sticky as you want it to be and that when the time comes for a third-gen product, whether it's yours or somebody else's, that you can manage the transition?

Jay T. Flatley

Well, I'd say, one of the first things around that question is the robustness of the SBS chemistry. So a great advantage we have is the fact that we're using essentially the same chemistry that we launched in 2007. Our customers are used to this. We've had many, many years of investment in perfecting this chemistry, which I think, for any new technology that comes into the market, that's a very high bar for them in terms of accuracy, performance and robustness of the technology. We're continuing to push forward on in the SBS technology, and we're looking at how to deploy that in emerging market segments. And you can imagine, for example, in the NIPT market, there are particular ways where we might develop follow-on technologies that are more optimized for doing this specific kind of work that you do in the NIPT market. There are emerging segments certainly at the low end of the market, we think ultimately from where integrated system is ample to answer, certainly continued demand for higher throughput and therefore, lower cost per genome. So we look at all of those segments of the market, and we try to address most of them. We won't necessarily address all of them. But our internal development programs are very actively targeting the big and emerging market segments there.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sure. I want to ask a question on the financial side of things and switch gears to that, maybe if Marc, you want to touch on it. But pricing, that's going to be a huge tailwind for you guys. You have extraordinarily healthy pricing power in the overall marketplace where pricing has become marginally tougher. And at the same time, your customers are fighting for budget dollars. So how do you look at -- what's your philosophy on pricing going forward from here, given some of the comments on competition and where the technology is going?

Marc A. Stapley

I think it's really very closely related to the technology. I mean, if you look back a couple of years ago, in the late kind of Q3 '11 timeframe, we were able to effectively triple capacity for many customers overnight. And I think as we think about that going forward, and you've seen this with the rapid mode that we've had on HiSeq, we tried to -- we'll try to price that in such a way that it gives our customers a kind of a cost per base benefit, but it also gives us a benefit from the standpoint of gross margins and so on. We're continually investing in technology to help keep gross margins where they are. And so as you think about pricing going forward, we're all about trying to help keep the pricing levels down and maintain our gross margins at the same time. And as you mentioned, we've been very pleased with the way our ASPs have held up, and I think maybe going back to the comments Jay made about HiSeq and how that's been doing, I think that's one of the reasons. And the competitive landscape, of course, plays into that.

Isaac Ro - Goldman Sachs Group Inc., Research Division

As you look at sort of getting the technology fully penetrated into the smaller markets, whether it's our friends in [indiscernible] or companies in the U.K. trying to develop with different pricing models from the equipment to make it easier to acquire the technology, is that something you guys need to do as well?

Marc A. Stapley

At this point, not really. I mean there are some things that we can do and have been able to do. But in terms of discounting the products, significantly offering major promotions, reagent rentals, that kind of thing, we haven't had to do too much about. It's held up pretty stable with our current pricing models, and we haven't had really pushed the envelope.

Isaac Ro - Goldman Sachs Group Inc., Research Division

All right. On the operational front, a couple of things. One is Verinata again, sort of ramping that business up quickly. It's a new asset for you, it's a fast-growing market. Can you talk a little bit about what your production capacity looks like today? Is there an element that's right limiting on that front if the market really takes off faster than you think it would?

Jay T. Flatley

No, I think one of the advantages, of course, of Verinata being part of Illumina is that we have the ability to put as many sequencers there as we need. They are scaling up the front-end sample, prep process and putting more automation around that. And that's nearly complete now. So I don't think there's any limitation in the number of samples, if they want to [indiscernible], we could address it.

Isaac Ro - Goldman Sachs Group Inc., Research Division

And would you need to invest in incremental infrastructure to meet that type of magnitude?

Jay T. Flatley

By incremental, if you mean more sequencers, yes, that would expand linearly with the sample volume, but no big step function changes in facilities or anything like that.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sure. Speaking of which, I was saying earlier, you guys have moved into a new facility. Can you talk a little bit about operationally what's going on there, if we want to take kick the tires around building, what's the -- how's is it going? Is it plumbing off that up, are you guys up and running?

Marc A. Stapley

Yes, it's -- I mean, we've been moving into the new headquarters and building it out now for the last couple of years. And the move in went extremely well from our previous location. And the build-out of our expanding facilities in San Diego has gone extremely well. We're now occupying a couple of new buildings, and we have other amenities that we've implemented for our employees and we've created a really welcoming campus.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Okay, great. I want to spend a few more moments at the end here on guidance. You guys, again, had a great first quarter. At the same time, we all read the same newspapers, and the impacts of sequester from a cash flow perspective, probably figures impacts your customers the most this quarter next quarter. And then hopefully, we'll get an abatement thereafter, but can you talk a little bit about what's baked into your guidance at this point, specifically with regards to the end markets you serve where sequester is an issue?

Jay T. Flatley

Well, we said very openly that we've built in sort of a minus 3% to minus 4% negative impact on NAH budgets into the guidance for this year. I think we're wound up as certainly within the arrow bars of our ability to estimate the numbers. So we don't think that we're going to see any major implications from sequestration. Clearly, if there had been no budget cut, our business would be stronger, no doubt about that. But I think the overall growth of the sequencing market for us is the working impacts of sequestration, and that's why we felt comfortable at the beginning of the year giving 15% growth guidance for revenues.

Isaac Ro - Goldman Sachs Group Inc., Research Division

If I could maybe press on that on 2 angles: one is, if I look at sort of how the sequester actually works on a dollar basis, you have this minus 5% for the year, but really we are under a CR until the end of March, right? So you're really playing catch-up for this quarter and next. So to me, it's going to feel like a minus 7% or 8% cut this quarter and next, is that how you guys are looking at it? I just want to make sure I understand that 3% to 4% comment.

Jay T. Flatley

Well, not really, because the -- I mean the NAH was billing out actual funds at 90%, and now they have an extra 5% to put out into the marketplace. So in some ways, you might have a bit of the opposite effect.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Right. Okay, that's helpful. Either the same but hard to know, the math, the numbers, it really can vary. But I've heard that 90% is your strength. When you actually go to the customer, they were kind of getting paid out at 90% on a grant.

Jay T. Flatley

That's right.

Isaac Ro - Goldman Sachs Group Inc., Research Division

How about pay lines? I mean, pay line has clearly gone down. You have a bit of a narrower range of scientists getting funded for their experiments. Do you have a sense of how sequencing these strands are getting awarded against the lower pay lines?

Jay T. Flatley

In terms of percentage of which types of grants are, getting cut, I don't think we have that resolution yet. At least I haven't seen any analysis of that. I guess, what we do have is more of the macro view what's going on in the market, and there continues to be very strong demand for sequencing. And we just completed a series of our scientific summit that we do around the world. So we do this in -- one in Asia, one in Europe and one in the U.S. And the excitement around sequencing and the clinical applications of sequencing is really just unprecedented right now.

Isaac Ro - Goldman Sachs Group Inc., Research Division

On the regional piece, Japan has been an area, where FX is working against you, but at the same time, there's some help for stimulus to effect for the positive in the back half. Is that consistent with your view in Japan? Do you have an opinion on that market?

Jay T. Flatley

Yes. The Japanese market has been quite strong for us, particularly in Q1, which we normally expect because of the end of the Japanese fiscal year. So Q1 will be our strongest quarter for the year in Japan, but the business there, overall, continues to be recovering. For a long time, Japan was running sort of at the 5% of revenue level or historically, if you look back 15 years ago, Japan would typically be 20% of our research company's revenue. We're certainly moving up from that 5% number, closer maybe into the 7% to 10% range. And so we think that's going to be the more likely contribution from Japan over the next few years, absent any dramatic meltdown.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Right. china, you have a large customer in China, they have made some interesting strategic changes to their approach to sequencing. Do you have an update for us on how you think you can manage through the customer concentration there, and what you think the most likely outcome will be?

Jay T. Flatley

Well, our business in China is actually quite broad now, so I know we do have a large customer there, a very important customer to us. And we're working very hard to make sure that even given their strategic changes, they will remain a very strong Illumina customer. They have a lot of our systems and they need feed those systems with reagents. And I think for the most part, the markets that they address require the use of HiSeqs. And so it's very likely that they'll continue to use those for the bulk of the business that they do.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sure. Coming up on about 2 minutes. So if you have a question, now is the time. Okay, 1 or 2 on the technology, I mean, you guys are a technology company, you're always pushing the envelope. Earlier this year, there was a little bit more of a renewed conversation around the impact of semi-ordered arrays and the potential that has to improve the performance and the technology in general. What's the latest view on semi-ordered arrays? Are you still on track to have that technology, that capability available in the back half of the year?

Jay T. Flatley

We are, we've made great progress on these arrays. We actually call them ordered as opposed to semi-ordered. So they're fully ordered in the way we think about them. And we are working on flow cells that have ordered clustering on them for several different kits. And so you'll see this come into the market in particular segments, where we think that level of throughput performance is required. And you'll begin to see that roll out sort of in back half of the year.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Sure. How about the efforts you're making on sample prep at the front end, you guys have done a lot of work there to make it easier to use technology. At the same time, you've sort vertically integrated the work flow to capture more of the economics. How much more is left do there? Can you still capture a little bit more?

Jay T. Flatley

There's a lot left to do. So we think our market share, while increasing dramatically in Sample Preps, still has a lot of headroom. We think there's a tremendous amount of additional work we can do to improve the technology in Sample Prep to make it simpler for our customers, more automated, more LIMS enabled. And I'd say we're just really getting started in the Sample Prep around, if you fast-forward 3 to 5 years, you're going to see sequencing be much more integrated operationally than what you see today.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Okay. I think we're about out of time. So I want to keep everyone on schedule. So thanks so much for you guys being here. I appreciate it.

Jay T. Flatley

Our pleasure.

Isaac Ro - Goldman Sachs Group Inc., Research Division

And thank you, guys, for being here as well.

Jay T. Flatley

And thank you, all, for coming.

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Source: Illumina Inc. Presents at Goldman Sachs 34th Annual Global Healthcare Conference, Jun-12-2013 09:20 AM
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