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Affymetrix Inc. (NASDAQ:AFFX)

Q2 2009 Earnings Call

July 22, 2009 05:00 PM ET

Executives

Doug Farrell - Vice President Investor Relations and Treasury

Kevin M. King - President and Chief Executive Officer

John C. Batty - Chief Financial Officer and Executive Vice President of Finance

Analysts

Marshall Urist - Morgan Stanley

Quintin J. Lai - Robert W. Baird & Co., Inc.

William R. Quirk - Piper Jaffray

Eric Criscuolo - Thomas Weisel Partners

Isaac Ro - Leerink Swan

Ross Muken - Deutsche Bank North America

Derik De Bruin - UBS

Doug Schenkel - Cowen and Company

Operator

Good afternoon. My name is Christian and I will be your conference operator today. At this time, I would like to welcome everyone to the Affymetrix Second Quarter 2009 Earnings Conference Call. All lines have been placed on mute, to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you.

Mr. Doug Farrell, you may begin your conference.

Doug Farrell

Thank you, operator. Good afternoon, everyone, and welcome to the conference call.

At the close of the markets today, we released our operating results for the second quarter of 2009.

Joining me on the call today is our CEO, Kevin King, who will provide a commercial and operational update, as well as our CFO, John Batty, who'll provide a detailed review of our operating results for the second quarter, as well as our guidance for the third quarter.

As a reminder, today's call is being recorded and the audio from the call is being webcast over the Internet on our homepage, at affymetrix.com.

During this call, we may make various remarks about the company's future expectations, plans and prospects that constitute forward-looking statements for purposes of Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Such statements are subject to risks and uncertainties that could cause actual results to differ materially for Affymetrix from those projected.

These risk factors are discussed in Affymetrix's Form 10-K for the year ended December 31, 2008, and other SEC reports, including our quarterly reports on Form 10-Q for subsequent periods. We encourage you to review these documents carefully. Forward-looking statements are made as of today's date, and we disclaim any obligation to update this information.

With that, I'll turn the call over to Kevin King.

Kevin M. King

Good afternoon, everyone.

Our efforts to prepare the company for renewed revenue growth and profitability by focusing on three business priorities have started to pay off. We achieved revenue of $81.6 million, slightly ahead of our revenue guidance for the quarter. This represents a 4% sequential increase in revenue over Q1 2009. We also generated good improvement in gross margin and maintained tight operating expense controls.

I'll spend the next few minutes providing an update on the status of our three business priorities, and highlighting some of our accomplishments before turning the call over to John for a detailed financial discussion.

To refresh, our strategic priorities are; the expansion at the large and growing validation and routine testing markets, the reengineering of our technology platform with a lower cost basis, higher flexibility and expanded range of applications, and creating greater operating leverage to improve profitability.

Entering new markets; for several quarters, we've discussed a differentiated strategy to enter promising markets with products and applications that are downstream from genome-wide analysis, particularly, in validation and routine testing. We believe these high growth markets are less constrained by research funding, and are more likely to generate recurring revenue streams.

New product introductions, recent acquisitions and are powered by Affymetrix diagnostic partners program are now providing a more diversified revenue base for the company.

In the second quarter, approximately 15% of our revenue was derived from sales to the validation and routine test markets, up from the low single-digits a year ago.

Going forward, we'll continue to invest in these markets, and we'll leverage synergies with our whole genome analysis products.

In RNA, our RNA business was up 2% sequentially. We continue to innovate in the gene expression segment to meet customer demands for greater functional and quantitative analysis, where there are whole transcripts, microRNA, and low to mid flex QuantiGene applications. These new products are growing and contributing to a product mix shift within our stable gene expression business, augmenting our leading expression products.

In the second quarter of 2009, the mix shift in new products accounted for 35% of our total expression revenue, up from 20% in 2008 and 10% in 2007.

Our DNA business has remained steady, and was up 8% sequentially, driven by growth from new products. New products for pharmacogenomic and cytogenetic research are contributing to our growth within the DNA segment.

Our user base for these new products has grown to over a 100 industrial and academic customers. And in addition, our services business was up over 35% over the prior year, as we completed several large genotyping projects.

In terms of our second priority of reengineering our platform, we completed multiple trials at leading centers of our next-generation genotyping platform in early June. Feedback from the evaluations is quite positive and is helping to shape our final product configurations and automation refinements. We're on track to launch the product later this year as previously announced.

This new platform will provide even more comprehensive tools for genome-wide association studies and focused customizable content for targeted genotyping applications. These new products take advantage of several next-generation technology developments, including automation, flexible array formats and new assay chemistries.

In addition, our internal screening program, which has generated more than 10 billion genotypes to-date, will provide additional validated and novel content for our new products. This will also provide researchers with an evolving database of new content to further drive the study of genetic variation in the context of human disease.

Further, we expect to leverage to genetic content from releases by the 1000 Genomes Project and other efforts.

Instrumentation; we're pleased with our progress in the sales and installation of our GeneTitan system during Q2. As previously discussed, the GeneTitan is our new instrumentation platform for hands-free array processing.

Customer feedback confirms that this new system represents a revolutionary change in how researchers conduct array-based experiments. Roughly 70% of our GeneTitan sales in the quarter were weighted towards our reagent rental program and did not -- therefore, did not have a large effect on our overall instrumentation revenue.

Also during the quarter, we announced plans to introduce the gene atlas. Similar to the GeneTitan platform, the gene atlas provides hands-free array processing using our new flexible array formats. The system is designed for lower sample throughput at a lower price point, thereby opening up new users and markets for our array products.

The gene atlas system is scheduled to begin customer testing in late summer, and we plan to introduce the product in early 2010.

In terms of creating operating leverage, in Q2 we successfully completed the havoc (ph) plan. And on budget the outstanding activities, needed to complete our planned manufacturing consolidations.

Importantly, in the quarter we began to see improved key manufacturing metrics, including increased capacity utilization, and lower reagent and wafer chip cost, while maintaining high quality standards.

We expect these improvements and contributions from new products to contribute to a steady improvement in gross margin levels looking forward.

In summary, in Q2 we delivered revenue that was above our guidance, and we continue to make solid progress towards achieving our three business priorities of reengineering our technology platforms, entering new markets and increasing operating leverage.

Our technology programs and acquisition investments are generating revenue with their new large and high growth market segments. While we believe that our core markets are attractive, we expect the challenging economic climate to continue for the remainder of the year.

For instance, the timing and the benefits of increased government funding for life science research remains uncertain. In addition, we also project that global pharmaceutical environment will continue to be constrained.

We continue to execute well against our strategic plan and have been consistently achieving our financial and operational goals. We have confidence in our business outlook and our ability to generate growth and profit over the long-term, and I look forward to updating you on our progress as the year advances.

I'll now turn the call over to John for a discussion of our financials.

John C. Batty

Thanks, Kevin, and good afternoon, and thanks everyone for joining us today.

I'll begin my comments with a detailed review of our financial results for the second quarter, followed by an update on our balance sheet before closing with our financial outlook for the third quarter.

In the second quarter of 2009, the company reported total revenue of 81.6 million, as compared to 86.9 million for the same period last year.

Total revenues were negatively impacted by foreign exchange by approximately $3 million, as compared to the second quarter of 2008.

Net income was 7.3 million or $0.11 per diluted share, versus a net loss of 3.6 million or $0.05 per diluted share in the second quarter of 2008.

Q2 2009 net income includes a pre-tax gain of 17.4 million or $0.25 per diluted share on the repurchase of $69.1 million of bonds and a restructuring charge of $200,000 as compared to the prior year quarter, which included $900,000 of restructuring charges.

Turning to the details; second quarter product revenue was 67.2 million, as compared to 75 million for the second quarter of 2008.

Consumable sales were 62.2 million, down approximately 6.7 million from the second quarter of 2008, driven predominantly by lower DNA product sales.

DNA revenue was 22.1 million, as compared to a particularly strong quarter last year at 27.9 million. And RNA revenue was 38.6 million, versus 40.6 million in the prior year. The mix of RNA and DNA revenue remained about 60, 40.

Additionally, instrument sales were 5 million as compared to 6.2 million in the prior year quarter. We shipped 27 systems and scanners in the quarter, bringing cumulative systems shipped to about 1,870. Also, included in instrument sales is the reagent rental income, used to accelerate the adoption of our GeneTitan platform.

Service revenue was 12.2 million, as compared to 9 million in the second quarter of 2008. The strong services revenue, included contributions from the Wellcome Trust Case Control Consortium, the Women's Health Initiative and several other genotyping projects.

Finally, royalties and other revenue was 2.2 million, versus 2.9 million in the second quarter of 2008.

Turning to gross margin. The second quarter total gross margin decreased to 54% from 55% in the prior year quarter, but included 4.6 million, or six margin points of expenses associated with our manufacturing consolidation.

Product gross margins were positively impacted by the early completion of our manufacturing transition activities, as well as favorable manufacturing absorption. Service revenue margins of 39% improved 13 points over the second quarter of 2008 on higher revenue in a more favorable mix of programs.

Total operating expenses for the second quarter were approximately 52.3 million, which included 200K in restructuring expenses. This compares to 50.1 million for the same period last year, which included restructuring expenses of approximately 900K.

Q2 '09 operating expenses included 1.9 million of stock compensation expenses, as compared $400,000 in Q2 '08.

Second quarter 2009 R&D expenses were 20.4 million, as compared to 19.6 million for the same period last year.

SG&A expenses in the second quarter of 2009 were 31.7, as compared to 29.6 million for the same period last year.

The company recorded net interest and other income of approximately $15.9 million in the second quarter, as compared to a net expense of 1.3 million in the prior year quarter. This included a $17.4 million gain on the repurchase of convertible debt, offset by a net expense of 1.5 million for interest income and expense in FX losses.

In the second quarter, we recognized income tax expense of $400,000. Our income tax expense for Q2 2009 is principally driven by foreign taxes and state taxes attributable to the repurchase of debt.

Net income was 7.3 million or $0.11 per diluted share, versus a net loss of 3.6 million or $0.05 per diluted share in the second quarter of 2008.

Fully diluted shares used for the second quarter of 2009 were 68.9 million shares, as compared to 68.5 million in the second quarter of 2008.

In order to facilitate the analysis of the company's core operating results, I'd like to summarize non-core adjustments for our net income for the quarter, and their impact on pre-tax earnings per share.

In aggregate, these adjustments accounted for 6.9 million or $0.10 per share, which breaks down as follows. The impact on gross margin was $5.1 million or $0.07 per share, and was comprised of 4.6 million of costs related to the closure of the Sacramento facility and $500,000 of acquisition-related intangibles amortization.

Within the operating expense line, there were 1.7 million or $0.02 per share impacts. This included $200,000 for restructuring expenses, associated with the consolidation of manufacturing capacity, 1.1 million of acquisition-related intangibles amortization, and finally $400,000 of true materials contingent consideration.

In addition to these decreases to net income, there was an offset of 17.4 million or $0.25 per diluted share from the gain on the repurchase of debt.

I mean, I'll take a moment to summarize our balance sheet. We ended the second quarter of 2009 with total cash and available-for-sale securities of approximately 353.2 million, as compared to 388.3 million as of the end of the first quarter of 2009.

Notably, the company generated approximately 15.5 million cash flow from operations. Inclusive of transaction expenses, we used approximately 50.7 million of cash to repurchase 69.1 million of debt during the quarter.

Second quarter DSO was 63 days as compared to 68 days in the prior quarter. In the second quarter, capital expenditures were about $4.1 million and depreciation and amortization was approximately $13 million, including amortization of acquired intangible assets.

Net inventory for the second quarter of 2009 was 51.8 million as compared to 48 million in Q1 '09.

Now, I'd like to review our guidance for the third quarter of 2009. The company expects total third quarter revenue to increase by 4 to 8% over the prior year, and to be in the range of 78 million to $81 million.

But we expect to make progress in placing additional GeneTitan instruments in the third quarter. We believe that the growth in related plate based consumables will lag these placements, as our customers complete their validation studies for both expression and the new genotyping products scheduled for release later.

Consistent with our prior guidance, we do not expect the additional stimulus dollars will have a material impact on our results until the fourth quarter at the earliest, with the bulk of the contribution taking place in 2010.

We expect gross margin percent to improve sequentially by one to two points as a result of the contribution of new products and the reduction of the remaining redundant variable costs associated with our manufacturing consolidation.

Following the early completion of our factory transition program, we stress tested the capability of our Singapore operation with favorable results. This generated favorable absorption this quarter and higher inventory. As a consequence, Q3 will be a little lower than our steady-state fully utilized rates of margin.

The company expects total operating expenses between 52 and 53 million in Q3, including restructuring expenses of approximately 300,000.

Our overall tax rate for 2009 will depend, both on the level and geographic mix of earnings, but will be impacted predominantly by foreign taxes due to the presence of the full valuation allowance.

We expect our Q3 tax expense to be roughly inline with Q2 at around 600K, and our cash taxes for 2009 are estimated to be roughly $2.5 million.

In summary, we are pleased with a 4% sequential revenue growth that we generated and the improvements to our operating leverage.

In addition, we believe the bond repurchase in the second quarter was a sound use of cash that improved our return on invested capital, and further delevered the balance sheet.

While the outlook for our new products looks promising, we believe the guidance is prudent and reflects normal new platform validation ramps that we expects for these types of applications.

We look forward to updating you during our next call on the progress we are making with respect to these new products.

Now, we'd like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Marshall Urist with Morgan Stanley.

Marshall Urist - Morgan Stanley

Yeah, hey guys. Good afternoon.

Kevin King

Hey Marshall.

Marshall Urist - Morgan Stanley

A question on -- first question was just on the reagent rental program. Could you just take us through a little bit more? If you could quantify it, that would be great, and how you're going to recognize that going forward, just so we'll have kind of clarity on GeneTitan pull through, and then also in the impact on gross margin.

John Batty

Yeah. So, we're modeling this program after a number of diagnostics companies in this space. The structure of our program is generally speaking a two year contract term anywhere from one to two years.

And what we do is we charge our premium on the consumables that we sell. And over that period, we expect that the customer will fully pay for the instrument. So, we will recognize ratably that premium as rental income over the period.

So the impact will be to defer the recognition of instrument revenue over that contract timeframe. And also, I'll point it out that similar to what other companies do, we will recognize the cost of goods sold associated with the instrument on a linear basis over that two-year time period.

So we would expect that margins would be somewhat depressed, as we begin the ramp up of the consumables on the new platform and then would normalize as they begin to run higher volumes studies.

Marshall Urist - Morgan Stanley

Okay, great. And then, just one other follow-up which was on the -- in the RNA business, if you could just give us a better sense of maybe a little bit more detail on the specific products that we were seeing coming through, and what's driving that in your mind on the RNA side, and toward speeds of level of sustainability there that you see?

Kevin King

Sure. This is Kevin. The RNA business for us has been stable now for some time. And as I mentioned, there is a mix shift going on. The mix shift is in our whole transcript products is increasing. The mix shift is in microRNA products, which is increasing. The QuantiGene products that we acquired form Panomics is increasing. And the legacy products, the 3' IVT products are ones that are declining slightly, both in price and volume. And the net-net of that is, as we said here we're about 2% sequentially.

I think the market is looking for more functionality and quantification in gene expression, and that the new products that we have meet those needs. So I am fairly confident that the gene expression business overall can at least be stable, if not show some signs of growth in the long run.

Marshall Urist - Morgan Stanley

Okay. And then just two quick clarifications. Can you just give us the sort of percentages between the whole transcript, you know microRNA and QuantiGene versus 3' IVT as the percentage of the RNA business?

Kevin King

We haven't broken out that level of detail in the past.

Marshall Urist - Morgan Stanley

And what was the last one? What was the Panomics contribution in the quarter?

Kevin King

We haven't broken that out either.

Marshall Urist - Morgan Stanley

You guys said last quarter, I think.

John Batty

Yeah. We had said it was about $3.5 million last quarter. So I think that was to give people a baseline, but it was not intended to be an ongoing update.

Kevin King

Yeah generally speaking, we made these acquisitions really as a part of the strategy to access new markets and to add to our growth. And we believe that they're doing that.

Within our organic or legacy products, we've been investing in a new platform and have not yet begun to see the contribution from that, but would expect that to reinvigorate growth.

Having said that, we do have some products that are growing, while some are flattening and those include things like our cyto product that we've talked about and DMET.

Marshall Urist - Morgan Stanley

Okay, great. Thanks guys.

Kevin King

You bet.

Operator

Our next question comes from the line Quintin Lai with Robert W. Baird.

Quintin Lai - Robert W. Baird & Co., Inc.

Hi, good afternoon.

Kevin King

Hey Quintin.

Quintin Lai - Robert W. Baird & Co., Inc.

So taking a look again at the GeneTitan, a couple of questions, first on the uses that have picked it up. Is it fair to say that some of those were some of the large FE chip users? And so, while they are in the process of validating GeneTitan, has there been a drop-off, a temporary drop-off, in terms of how many chips are using on the RNA basis now and then as those things go up they pick back up again?

Kevin King

Well, that I don't know if that's -- the second part of that statement is correct or not Quintin. As far as the users that are buying GeneTitan now or have placed orders and have got installation, they are both in our industrial accounts, as well as in academic. They tend to be medium to high throughput users. They are not just the highest throughput users.

Many of them have been doing validation studies, comparing the performance of our plate erase or pegarase (ph) as you call them to the legacy products. And they've gotten very, very excellent results there. And that does take a while for them to work through that data.

I don't know of customers actually stopping studies in anticipation of that. They still have their cartridge-based GCS3000 instruments and can continue to run experiments on those platforms.

Quintin Lai - Robert W. Baird & Co., Inc.

And then going back to Marshall's question on the reagent rental side, could you remind us again, I guess, kind of the list price of the GeneTitan on a cash basis?

And then, as you -- and then, the clients that have taken up as reagent rental, are there some minimums, quarterly purchases, and as you recognize those, via the premium priced consumables, does that run to consumables, or are you going to park some of that out and run it as revenue recognizes instruments?

John Batty

So the answer to your first question is the list price for the GeneTitan system is $300,000. And we will classify the rental income as a part of our instrument revenue line.

Quintin Lai - Robert W. Baird & Co., Inc.

Alright. Thank you very much.

Kevin King

Thanks Quintin.

Operator

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

William Quirk - Piper Jaffray

Hi there. Thank you. Good afternoon.

Kevin King

Hey Bill.

John Batty

Hey Bill.

William Quirk - Piper Jaffray

Just a couple of, not to beat a dead horse here, but just a couple of last hopefully, reagent rental questions. First is, I assume you guys maybe using your balance sheet to finance these?

John Batty

I guess, that's correct, yes. If you think about the fact that we're getting paid for the instruments over an extended period of time, yes.

William Quirk - Piper Jaffray

Okay. Then in a similar way, you're basically recognizing as CapEx and then keeping any on the balance sheet, and then depreciating that over the life of the contract?

John Batty

We'll be amortizing the cost of sales or the cost of the equipment into cost of sales on a linear basis over the contract period. So for example, if it were a two year contract period, we would divide the cost of sales by 24, and we will recognize that on a monthly basis.

William Quirk - Piper Jaffray

Okay, very good. And then, thanks for the color around the number of GeneTitans placed as reagent rental. Would that be -- would it be fair to say that we could take that for the entire instrument placements in the quarter, or was it more heavily weighted in the GeneTitan side?

John Batty

That was just for the Titan. That was not for the GCS3000 units.

William Quirk - Piper Jaffray

Okay. Can you share the overall number?

John Batty

The question was how many total instruments total number of...

William Quirk - Piper Jaffray

Correct. What percent of total instruments are placed as reagent rentals?

John Batty

I don't recall the number.

William Quirk - Piper Jaffray

Okay, understood.

John Batty

Didn't get that.

William Quirk - Piper Jaffray

Okay. And then last question from me is, thanks a lot for the color on the new businesses on pharmacogenomics and cytogenomics, and as well as obviously the wealth of contribution this year versus last year. If we were to look out a year from now guys, two years from now, where do you think this can go?

Kevin King

Well, I think the two, the pharmacogenomic and cytogenetic markets are somewhat different from one another. Pharmacogenomic market is a new market. So it is one where new products and new technologies are going to customers. This market could enter into every clinical trial at pharmaceutical industry gets involved with.

It could also play a key role in personalized medicine on the academic medical side, where people would want to know genetic variation in conjunction with drug prescribing patterns and so forth. That could possibly be a very large market.

The cytogenetics market itself is over a $1 billion for a variety of testing, cancer testing, post natal and prenatal testing. And there are well-established technologies in place for those. But the industry is moving very, very rapidly from the microscope-based approaches to microarrays. And so, in the future this could be upwards of $0.5 billion marketplace, if you will, if 50% of it converted.

William Quirk - Piper Jaffray

Understood. Thanks very much, nice quarter.

Kevin King

You bet.

John Batty

Thank you.

Operator

Our next question comes from the line of Eric Criscuolo with Thomas Weisel Partner.

Eric Criscuolo - Thomas Weisel Partners

Good afternoon. Thank you for taking my questions. I guess, first off, have you seen or heard any evidence of customers delaying array purchases until they -- more contracts coming on from the 1000 Genomes Project and other related projects?

Kevin King

I think there are two things going on right now. There is still a steady stream of DNA genotyping projects, as we saw here in the quarter. We've reported sequential growth and strong uptake in services as well. And those customers continue to round out existing studies and augment what they've done in the past. There are not too many very large scale projects similar to what we saw say, in 2007 and early parts of 2008. I think people are waiting for this new content to arrive. And that's exactly what our next-generation platform is all about in the coming months here.

Eric Criscuolo - Thomas Weisel Partners

Okay, thank you. And the services results this quarter, you said I think, were kind of helped by some of the large studies coming to an end. Could we expect that that our kind of run rate to drop back to where it was last quarter, or there are other studies going on that could keep that up to the level we saw this quarter?

John Batty

Let me take a quick shot. Kevin can add some color. I think, by its nature, the service business tends to be lumpy. These projects can extend over multiple quarters. But typically, there are thousands of projects. There are more in the order of what you can count on both hands.

So, at least right now, what we're seeing for the third quarter is, because we've completed a couple of major studies this quarter, we expect that to decline.

Kevin King

So, it'll be back to probably just historical levels...

John Batty

Normal levels, yeah.

Eric Criscuolo - Thomas Weisel Partners

Okay, thanks. And the last question, any timeline we have as far as when we get to hear like the, sorry, the new specs for the new tech platform. Data from earlier doctors or clinical studies at major competences (ph) or anything like that?

Kevin King

Well, we presented information at our annual analysts meeting back in I guess, it was in June. We gave some overview of what that was. In October, we'll be the American Society for Human Genetics Meeting. I believe that takes place in Hawaii. So you'll certainly see the product at that point, if not sooner.

Eric Criscuolo - Thomas Weisel Partners

Okay, great. Thanks guys.

Kevin King

Yeah.

Operator

Our next comes from the line of Isaac Ro with Leerink Swann.

Isaac Ro - Leerink Swan

Hi guys. Thanks for taking the question.

Kevin King

Hi.

John Batty

Sure.

Isaac Ro - Leerink Swan

Just first up, in your prepared remarks, it sounded like you were on track to launch the new DNA arrays later this year, and I'm wondering when you expect to have arrays that will leverage some of the context in 1000 Genomes, and how important do you think that type of content would be when it comes to gaining incremental market share in DNA arrays?

Kevin King

Sure. Well, the screen that we've done, the 10 billion genotypes home types actually do contain snips or markers that are in the 1000 Genomes release.

So back in February of 2009, the 1000 Genomes project released 9.8 million variants, and part of those variants were already in the DV snip database, as many as 5.2 million of those. And so, we have validated, if you will, a portion of those.

We've screened them all and have validated those, both from a half map and a non-half map point of view. So our new arrays will have that level of content. And as new releases continue to unfold here for 1000 Genomes, we'll be able to iterate fairly quickly and produce validated content for users.

As far as is it important, I think it's in extremely important for users. I think people are finding that the likely cause of disease is probably associated with fewer or less frequency ordeals, than what they had thought. And this content's going to become increasingly important over time.

Isaac Ro - Leerink Swan

Okay. So from a timing perspective is that something we might see more product flow from later this year, or it would be more like a 2010 event?

Kevin King

The first launch of product, pardon me, will have some of that content in it, yes. That would be this year.

Isaac Ro - Leerink Swan

Right, okay. And then, just on GeneTitan, as we think about who the initial adopters have been here. Can you give us a sense, maybe geographically, where you're seeing the most traction? Is it mostly in the U.S. or is there maybe some more interest in emerging markets or in Europe, where you've traditionally had sort of less -- always a less business.

Kevin King

I think it pretty much follows our installed base. Let's say, the largest interest split pretty evenly between the U.S. and Europe, to somewhat of a lesser extent in Asia, only because our installed base is not as large as in those two areas.

Isaac Ro - Leerink Swan

Okay, okay. And then, when we think about sort of a data testing process for gene atlas, what kind of customers are you going to -- data users would you be targeting for that pipeline? Would it be existing Affy users, or you're going to try and find totally new customers that might be new to the platform all together?

Kevin King

I think its going to be a combination of both of those users in core labs that would want lower throughput instrumentation as well as new users to microarray technology.

Isaac Ro - Leerink Swan

Okay, great. And then just lastly, as I think about the cytogenetics opportunities that you just discussed, beyond new products obviously, what kinds of changes you need to see in a marketplace, to start converting that market away from conventional methods in a material way? Is there sort of a body of revenues that needs to be generated in the literature; or are there other things you can control there?

Kevin King

I think it's got a lot of momentum on its own right now. We're clearly spending a lot of time on the assay development side; the use of microarrays by cytogeneticists is new technology. These users are used to looking into a microscope and getting their diagnostic results.

So optimizing the workflow of the assay, the assay time, in addition to that -- the software tools that we have for analyzing information, have really been optimized around the user. And we think that those together are key pull through elements for adoption and differentiators for Affy.

Isaac Ro - Leerink Swan

Okay, thanks very much.

Kevin King

You bet. Thanks Isaac.

Operator

Our next question comes from the line of Ross Muken with Deutsche Bank.

Ross Muken - Deutsche Bank North America

Hi, good afternoon. Can you just talk about from a restructuring perspective, as we think about some of the new products and where they are being manufactured? Where is the sort of key focus in terms of GeneTitan and some of the new instruments in terms of where, at what location is going be focused on those instruments?

Kevin King

From a design or manufacturing?

Ross Muken - Deutsche Bank North America

Manufacturing standpoint.

Kevin King

So our instrumentation has been outsourced to third party instrument -- instrumentation manufacturers and they are located in the U.S.

Ross Muken - Deutsche Bank North America

Okay. And that's across the board now for legacy products and new products?

Kevin King

Yes, that's right.

Ross Muken - Deutsche Bank North America

Got it. Okay, that's all I had. Thank you.

Kevin King

Okay.

Operator

Our next question does come from the line of John Gilberg with McGuire Capital (ph).

Unidentified Analyst

Hi, thanks for taking the call. Congratulations on a great quarter.

Kevin King

Thanks John.

John Batty

Hey John.

Unidentified Analyst

Can you just talk about gross margins. So if I am doing the math that you kind of went through product gross margins of around 63%. Is that about right? And I know previously you had thought maybe between 2Q and 3Q is when you would get closer to that level.

And so I'm just -- you mentioned that you had accelerated some of the plans and so, what is the outlook for that? Is it when you say one or two points of improvement in the third quarter, is that on a product or is that on consolidated gross margins?

John Batty

Yeah. So, the objective of our manufacturing consolidation really was to align our infrastructure, to enable it to lower our costs improve our efficiency. And I think we've largely accomplished this.

During the second quarter, we stress tested or we ran the factory a little harder than we normally would. And that -- the effect of that is that in Q3, in order to bring our inventory back in line with our expected revenues, we'll run the factory at a slightly lower level than you would expect.

So, in a sense, we got to benefit in the second quarter and we reduced the benefit that we would expect to see in the third quarter.

Now, as we exit the third quarter, after truing up our demand and supply, we would expect that to return to our target of getting close to 60% as we exit the year. So the one to two point improvement was really a GAAP-to-GAAP kind of a number.

Unidentified Analyst

Okay. And then just on clear view, also I think, before you were going to have some costs that actually came out of -- that you were still holding onto with the Sacramento facility that would end at the end of the second quarter, you move into the third quarter. Is -- has that changed at all, in terms of how those are being those -- that dynamic is going to play out?

John Batty

No. That we actually realized this quarter, and that was part of my introductory comments. There was about $4.6 million of expenses, which included the accelerated depreciation for assets that had a terminal life in the second quarter, as well as some transition-related expenses.

Now, we do have some nominal expenses that -- some redundant expenses that will be eliminated in the third quarter. So we should see further improvement as we go through the remainder of the year.

Unidentified Analyst

Okay. Thanks for clarifying that. And then, if I can ask a couple of questions on the kind of revenues as we go forward. Some of your peers have much higher expectations for the stimulus, and it sounds like what you kind of are talking about.

And I'm just curious in your outreach with some of your customers and helping right grants, or maybe let me know, what are you guys doing, and what kind of benefit do you ultimately expect? Are you actively helping some of your customers with grants (ph)? Do you expect there to some big wins, so that they get you a chance to write in some of your new products into these, or are you maybe not seeing as much as some of your other peers because of the product portfolio that you have?

Kevin King

John, this is Kevin. We've done an enormous amount of work to get with our customers, make sure that they're writing the appropriate grants, not only for instrumentation, but for consumable products.

Its been our view that's the stimulus package was all about sort of shovel-ready grants. And we think from a run rate point of view, a lot of customers use our products in a shovel-ready way. So, I think while we want to be optimistic that a lot of business will flow away, I think we're being prudent and not really building anything into our plan right now, in the hopes that if things come through, it will be upside for us. But rather not build something into the plan that we really don't have control over, and at this point we just see it as uncertainty.

Unidentified Analyst

I think that makes a lot of sense. But do you I guess, the broader question is do you feel well-positioned, should some of this money start to flow and you're actively involved in helping investigators to agree?

Kevin King

Oh yeah, absolutely. Look, we're not being shy about this at all. We were out there on day one with our customers, helping them both from a sales and applications point of view, to make sure that they were aware of what the funding availability was, what the projects were like, we have tools to help them to write grants etcetera, etcetera. And we are being as aggressive as we can.

This is, in some ways new found money, and we certainly want to get our share of it. But then again, just being prudent on the planning side.

Unidentified Analyst

In a related kind of question following up, I mean, so you have this opportunity where duvas (ph) is slowing down. There is a little bit of gap, where people expect the rich duvas to begin, and also money to flow from stimulus, you're also introducing a new product right at this time.

Are you -- how do you think about this, giving you a chance to maybe recapture some of the retrench or reposition yourself to be a valuable player, maybe when you missed a little bit in the kind of in the previous years. Are you looking at it in that way at all, or not as much?

Kevin King

Well, I think there is a couple a points there. So this is on the DNA side of our business. First, we have been investing in DNA technologies that are in validation and routine testing. Pharmacogenomics, cytogenetics, the acquisition of Panomics, with their own QuantiGene copy number assays and so forth are good, good products that are in good growth markets. So we think that that is an area of opportunity for us.

Relative to the timing of our new product platform, we think its very good. The availability of new contents, the ongoing availability of new contents, with respect to the 1000 Genomes Project, as well as new instrumentation for us. So I really think that we have the opportunity to regain our share or regain growth here in the DNA side of our business most definitely.

Unidentified Analyst

And so I'd just like a follow-up on this. But one of the ideas with the new format that you're moving to, is really to lower your cost of goods quite a bit, and as you move to these rich duvas, where people want even larger sample studies.

Are you able, I am just curious, are you able to go in and help people think about -- with your new products. You could do X number of samples, given that we can provide these at a lower price, or is it too early to be having conversations with people about that yet.

Kevin King

Our sales force is aware of and trained on what the relevant price points will be, based on volume pricing for the new platform. And I guess, we're very, very much aware that to power a study sufficiently, you need large samples, and that the amount of money is somewhat fixed. So, we've been paying a lot of attention to our cost of goods, with the goal of capturing a large volumes at lower costs, lower price points.

John Batty

This is John. Just a follow-up one other comment. The GeneTitan was expressly designed to lower the lifecycle cost of our customers. And as you consider the importance of larger studies for these lower frequency alios (ph), and we think that, we're delivering incremental value to our customers, because the labor costs that's required with these automotive platform is actually lower.

So not only did I get the benefit of lower cost consumables, but they can also have push button and walk away processing for these larger studies.

Unidentified Analyst

Great. One last question, I will go with this. Just on the cytogenetics, I've talked a lot of people like your platform, is there any plans to try and make that FDA approved, or are you're going to continue to just kind of go with the research approved for research type of cytogenetics chips?

Kevin King

We haven't talked publicly about anything beyond the cytogenetics research marketplace, and that's where we're centered right now.

Unidentified Analyst

Thanks. Congratulations again.

Kevin King

Thanks John.

John Batty

Thank you, John.

Operator

Our next quarter comes from the line of Derik De Bruin with UBS.

Derik De Bruin - UBS

Hi, good afternoon.

Kevin King

Hey Derik.

John Batty

Hey Derik, how are you?

Derik De Bruin - UBS

Good. Hey, just a little bit more on just trying to flush out the stimulus. I mean, can you give us some idea on how many academic scientists have actually submitted grants that specify the use of the GeneTitan, or if not the GeneTitan grants that incorporate some of your validation technologies?

John Batty

Derik, I don't have that. Well, we have it. I don't have it sitting at this table. We use a tool called salesforce.com for tracking all of our sales related activities both in the quarter and looking forward. And those accounts that have stimulus dollars associated with them, we have demarcated in the database. So we could probably get you a rough number, but I don't have it handy right here.

Derik De Bruin - UBS

No I guess, I'm just basically going for is that there are specific grants for my gene (ph) hasn't approximately with that, that has specifically written in the GeneTitan and some of your ends in the Panomics and some of your products.

Kevin King

Absolutely, yeah absolutely.

Derik De Bruin - UBS

No that's just why we kind of getting for. As you kind of look at the model going into 2010, you kind of think about leverage of the business. I mean, is the kind of run rate we're seeing for total operating expenses, which has been kind of basically similar for the last two quarters. Is that -- how much more -- how much variability is going stay that?

Do you see RNA or R&D ramping up more, do you see SG&A coming down seasonally more. I guess, can you just give us some I guess, some way to kind of bracket where you potentially see the cost savings?

Kevin King

Sure, may be I can put this in the context of what we've set our long term goal is to be roughly about 49%, 50% of sales would be OpEx. We're obviously higher than that now.

Now, when you look at what we've done in the last say, three to four quarters, we've had major investments in technology. We've had major changes in operations with factories moving about and so forth. And it really wasn't a very good time for us, for also be taking our OpEx down, given that those are big investment points.

Now that those are behind us, we really want to turn our attention to controlling more of our OpEx and getting down to those numbers. And I think it will be probably be across the board. I think that both R&D as well as SG&A are good targets for us to continue to optimize on, as we go forward, not only into 2010, but beyond.

Derik De Bruin - UBS

Thank you.

Kevin King

You bet.

John Batty

Thanks Derik.

Operator

Our next question comes from the line of Tycho Peterson with JPMorgan.

Unidentified Analyst

Hi, this is actually Abby Dywecing (ph) in for Tycho today. Could you just comment on what kind of trends you're seeing on ASPs for the ginger (ph) breeze.

I guess, so far in 2009, both on the gene expression side and on the DNA analysis side. And then I guess, maybe specifically in those comments, comment on any competitive dynamics you might be seeing playing out there.

And then as you look ahead for the rest of the year, some of the new content coming out on the DNA analysis side with the 1000 Genomes package, is that -- what kind of impact that might have on ASPs there as well.

Kevin King

Sure I would say Abby in total DNA prices are stable. They have been for quite some time. And that's largely for the whole genome association studies. The new products that we have for pharmacogenomics and cytogenetics, those products were recently launched and those have different price points. But they too are stable.

We see a lot of price pressure in RNA. And as such, we have a wider family of products now at various price points. The product that comes under the most price pressure is our legacy product. That's the U133 product. And those price trends are anywhere from a couple of points a quarter to maybe a couple of low single-digits to maybe even higher than that in a particular quarter, overall. And I think that, that trend is likely to continue for that particular product line.

As far as new contents and new products, we haven't talked specifically about pricing. Although, I just made a few comments about, we have the flexibility to provide lower price points at high margin, with a new platform and the new products.

Unidentified Analyst

Great, thank you very much.

Kevin King

You bet.

Operator

Our next question comes from the line of Ann Quann (ph) with Wedbush Morgan Securities.

Unidentified Analyst

Hi, thanks for taking my call.

Kevin King

Hi Ann.

Unidentified Analyst

I was wondering, and I understand that this is going to be volume dependant, but what is the rough pricing differential for the genotyping consumables, for example, for reagent rental versus the non-reagent rental customer.

So I'm just trying to understand sort of how much customer has to pay on the consumables side to be able to amortize the cost of the instrument over a couple of years.

John Batty

Well, I think in your introduction you kind of got to the number which is, we take a look at what their expected and committed volume commitment is for the contract period. For the large genome centers, they may have sufficient volume to enter into a single year contract.

And because of their volume requirements, the premium may be small. For some of the smaller players, if they have a two year contract, and their volume commitment is relatively small, the premium maybe more expensive. So we sort of pre-screen the appropriate candidates. If the two year volume requirements would the cause the consumable premium to be unrealistically large, then we would guide them to another solution.

Unidentified Analyst

Okay, great. That's helpful. And then a follow-up question, are you able to provide a rough breakdown between RNA and DNA specifically, within your USP sales?

I know in the past you had given rough ranges like 50-50, 30, so I'm just wondering, when we sort of break out our revenues, how we should allocate that between the two segments.

Kevin King

I think whatever we had given you in the past is probably still a decent ratio, I don't have the top of my head here.

Unidentified Analyst

Okay, great. Thanks. And one quick clarification, on this 35% of your gene expression revenue, that's coming from new products, those new products, are those entirely the geneable (ph) arrays or does that also include the Panomics products?

Kevin King

So that is the WT product line, the microRNA product line and the Panomics line.

Unidentified Analyst

Great. Thanks very much.

Operator

Our final question comes from the line of Doug Schenkel with Cowen.

Doug Schenkel - Cowen and Company

Hey, good afternoon, guys.

Kevin King

Hey Doug, how are you?

Doug Schenkel - Cowen and Company

Good, thanks. So Kevin, way back in the beginning of your prepared remarks, you talked about some positive GeneTitan user feedback. I was hoping that you might be willing to just provide a little bit more detail on specifically we could be able talk about things like how much of this feedback is focused on genotyping versus gene expression. And specific to genotyping, how much of the feedback is based on the research of generated data, versus company generated data at this point?

Kevin King

So, as far as GeneTitan installations we're only running the RNA platform right now. So the feedback we have from customers that are using commercial products are related to RNA products.

There customers have been most impressed with the hands-free automation, the overall ease of using the array plates, the data compatibility from cartridges to pegs are probably the three largest areas.

On the DNA side, where we've done early research, well not research, but early evaluation work on our next-generation genotyping platform, there customers have commented both against our 6.0 legacy product, as well as competing products.

And there the results are very similar to RNA. They've said that the hands-free automation is real breakthrough in terms of genotyping, both relative to our competitors as well as the 6.0 that the sheer number of arrays that you can run in a given week is a big, big contribution over the same categories that I mentioned.

And customers have run our samples for the genotyping product. I'm not sure if they ran their own or not. I'd have to check for you. If they ran their own, we probably did the data evaluation for them. That I could check.

Doug Schenkel - Cowen and Company

Okay, but we should be moving more. You guys probably are pretty close to the point where they'd be doing most of this on their own instruments on data tests or instruments that are also for data testing purposes pretty soon right.

Kevin King

Yeah, well what you try to do in these big system releases, where you got multiple components instrumentation, assays, new chips, new workflow and so forth, you want to try to divide up the effort that the customer has to do to answer specific questions. So, for example in the early phases, we were testing the workflow of the assay. Did the assay perform as we thought in the hands-free operation way.

That was largely independent of whether it's a sample from us or sample from someone else. As far as getting genotyping calls on the actual data that you get, then you'd want to use customer samples as well our own, and so you sort of do this overtime.

Doug Schenkel - Cowen and Company

Got it, okay. That's helpful and then John, I thought you had previously talked about getting gross margin into the low to mid-60s over the next year. And I may not be remembering correctly, but I thought that's what you guys have talked about earlier this year.

It sounds like you are targeting something at least from the high 50s by year-end, based on the answer that you provided to I think one of John Gilberg's questions. Are you still expecting to get into low to mid-60s at some point, I guess, in 2010. And if not, is this just largely a function of the fact that this reagent rental strategy?

John Batty

No, I was really focused on the third quarter.

Doug Schenkel - Cowen and Company

Okay.

John Batty

Our goal for 2010 remains to get into the low to mid-60s. And I think a key component of that is the contribution from new products.

And so, to the extent that in Q3 and Q4, that the contribution for new products is not likely to be significant in the grand scheme of things, then we won't see that benefit. We'll certainly get the benefit from the consolidation of our manufacturing operations. And so, as we exit the year, I think our gross margins will really be a function of the overall revenue levels and loading levels of the factory.

Doug Schenkel - Cowen and Company

Okay, that's helpful. And then just one last one. Could you talk about where you are in scaling, or I guess, where your partner is in scaling GeneTitan manufacturing? I guess, what I'm getting at is that, if demand for GeneTitan was to approximate, say, the total number of instruments you've been placed in the last few quarter say, about 25. Are you in a position to meet that demand. And I guess, the need the details?

In what facility were the instruments being produced and advanced of your move to outsourcing? And sorry, last one, do you still expect to get 35 GeneTitans out there this year?

Kevin King

So the GeneTitan was built with the idea that it would outsourced manufacturing. So this was the product was not moved from one location to another.

Doug Schenkel - Cowen and Company

Okay.

Kevin King

The company that's doing the work for us was doing it during the development process.

Doug Schenkel - Cowen and Company

Okay. Where was you -- in your traditional, your legacy instrument manufacturing was that in California?

Kevin King

That was the GCS3000 line was manufactured in Sacramento in our facility and that was transferred to another third party manufacturer. Its not the through the company.

Doug Schenkel - Cowen and Company

Okay.

Kevin King

Okay. The scalability of both third party manufacturers is very good. So we're not concerned at all about if volume goes up by a factor of two or three, can we handle it. We believe we can.

And this was part of our effort to variabilize our cost, and we made sure that our suppliers could ramp up and ramp down as need being. So, we're not worried about that. And the last question was the 35 GeneTitan systems, the goal that we set. Yeah, I think that that's still a good goal and hopefully, we'll overshoot that one.

Doug Schenkel - Cowen and Company

Okay, that's great. Good quarter.

Kevin King

Thank you.

John Batty

Thank you, Doug.

Operator

There are no further questions at this time. Are there any closing remarks.

Doug Farrell

Yes. Thank you for all for taking the time to join us on the call today.

If you did miss any portion of the call, a phone replay will be available for the next seven days beginning at about 5:00 Pacific Time today. To access that replay, domestic callers should dial 800-642-1687. International callers please dial 706-645-9291. The pass code for both will be the same that is 19153613. Alternatively, you can listen to the audio replay under the Investors Section of our website at affymetrix.com. So thanks again for joining us and have a great day.

Operator

Ladies and gentlemen, this does conclude the Affymetrix second quarter and 2009 earnings conference call. You may now disconnect.

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Source: Affymetrix Q2 2009 Earnings Transcript
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