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Illumina, Inc. (NASDAQ:ILMN)

Q2 2009 Earnings Call Transcript

July 21, 2009 5:00 pm ET

Executives

Peter Fromen – Senior Director of IR

Christian Henry – SVP and CFO

Jay Flatley – President and CEO

Analysts

Ross Muken – Deutsche Bank

Doug Schenkel – Cowen & Company

Quintin Lai – Robert W. Baird

Marshall Urist – Morgan Stanley

Tycho Peterson – J.P. Morgan

Un Kwon – Wedbush Morgan Securities

Isaac Ro – Leerink

Dan Leonard – First Analysis

Zarak Khurshid – Caris & Company

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2009 Illumina, Incorporated Earnings Conference Call. My Name is Jerry [ph] and I will be your coordinator today. (Operator instructions) I would now like to turn the call over to Mr. Peter Fromen, Senior Director of Investor Relations. Sir you may proceed.

Peter Fromen

Thank you, operator, and good afternoon everyone and welcome to our second quarter 2009 earnings call. During the call, we will review our financial results released today after the close of the market, offer commentary on our commercial activity, and provide financial guidance for the third quarter and fiscal 2009. After which, we will host a question-and-answer session.

If you have not had a chance to review the earnings release, it can be found in the Investor Relations section of our website at Illumina.com. Presenting for Illumina today, will be Jay Flatley, President and Chief Executive Officer, and Christian Henry, Senior Vice President and Chief Financial Officer. This call is being recorded, and the audio portion will be archived in the Investor Section of our website.

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

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

Before I turn the call over to Christian, I want to let you know that we will be participating in a Thomas Weisel Health Care Conference in Boston from September 7th to the 9th, The Morgan Stanley Health Care Conference in New York on September 14th to the 15th, and The UBS Global Life Sciences Conference also in New York from September 21st to the 24th.

For those of you unable to attend any of the upcoming conferences, we encourage you to listen to the web cast presentations, which will be available through the Investor Relations section of our website. With that, I’ll now turn our call over to Christian.

Christian Henry

Good afternoon everyone and thank you for joining us today. During today’s call, I will review our Q2 financial results and provide guidance for the third quarter and full-year of fiscal 2009. Jay will then discuss our commercial progress and provide an update on the state of our business and our markets.

We recorded $162 million in total revenue for the second quarter, representing 15% growth over Q2 of last year. Product revenue was $153 million growing 19% over the prior year period, and was led by significant growth in our sequencing products. However, as we disclosed in a conference call earlier this month, this growth was partially offset by a decline in the microarray business, due to a slowdown in the market for genome-wide association studies.

Consumables revenue for the quarter was $97 million, compared to $82 million in Q2 of 2008. This represented year-over-year growth of 18%, and was directly attributable to growth in sequencing consumables, partially offset by lower microarray consumables. The rapidly expanding installed base of Genome Analyzers pushed sequencing consumables revenue to record levels, growing 174% from the second quarter of last year, and 20% sequentially.

Just as in Q1, the annualized consumable pull through on the Genome Analyzer during the quarter was above our anticipated range of 152,000 to 200,000 per system. Consumable pull through for the array business remained in the range of 500,000 to 600,000 per system.

We shift the record number of Genome Analyzers during the quarter, which enabled us to recognize instrument revenue of $54 million, a new high for the Company. This compares to $43 million in the second quarter of 2008, and represents year-over-year growth of 25%.

Services and other revenues, which includes genotyping and sequencing services, as well as instrument maintenance contracts was $8 million, compared to $12 million in Q2 of last year. The year-over-year decline in services was largely due to the overall decline in genome-wide associate studies, but also due to the fact that more of our genotyping service revenue has moved to our CSPro-certified customers.

As mentioned before, services revenues are not expected to grow in line with the product business because of the shift. From a gross margin perspective, however, we are relatively indifferent to this transition, as our product gross margins are similar to our internal service business.

Before discussing our gross margins and operating expenses for the quarter, I would like to note that we recorded a pretax amount of $15 million, related to non-cash stock-based compensation. This impacted our EPS by a tax adjusted amount of $0.08 per pro forma diluted share for the quarter.

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

Total cost of revenue for the quarter was $50 million compared to $57 million in the second quarter of 2008. The Q2 ‘09 costs include stock-based compensation expense of $1.3 million, compared to $1.4 million in the prior year period. Excluding this expense and $1.7 million associated with the amortization of intangibles, non-GAAP gross margin was 70.6%.

This compares to 68.3% last quarter and 65% in the second quarter of 2008, a sequential improvement of over 200 basis points and a year-over-year improvement of over 500 basis points. Both sequential and year-over-year gross margin gains resulted from significant cost reduction and production efficiencies generated primarily within our sequencing business.

The key contributors of this gain included; first, we continued to recognize gross margin benefits from our reformulated sequencing kit that we launched in the third quarter of last year. Not only is the gross margin on these kits higher than the prior year, our sequencing reagents are becoming a larger component of overall revenue, which positively impacts the corporate gross margin.

Second, during this quarter, we launched a new software package that substantially reduces the computing power required for processing GA data. This has enabled us to eliminate significant computer hardware that previously shipped with the system. And thirdly, our supply chain and cost reduction initiatives have reduced the raw material cost of the system.

Finally, we increased volume across the sequencing business and this improved our overhead allocations. These improvements have resulted in a sequencing product line, whose profitability is now approximately equal to that of our array business. During the quarter, the gross margin benefit from our sequencing product lines was partially offset by a reduction in consumable volume from our microarray consumables.

It should be noted that ASP’s in both sequencing and microarray’s were stable in the quarter, which also favorably contributed to the strong gross margin performance. Research and development expenses were $33 million in the quarter compared to $23 million in the comparable period of 2008, and included 5 million and 3.4 million, respectively in non-cash stock compensation expense.

Excluding stock comp expense, and $0.9 million of accrued contingent compensation associated with Avantome, research and development expenses were $27 million or 16.8% of revenue, compared to $20 million or 14.3% of revenue in the prior year period, and $25 million or 15.2% of revenue in the first quarter.

The increase in sequential and year-over-year research and development spending was attributable to an increased headcount and increased project activity. SG&A expenses were $42 million compared to $36 million in the second quarter of 2008, including stock compensation expense of $8.6 million and $7.4 million, respectively.

Excluding these non-cash expenses SG&A was $33 million or 20.6% of revenue compared to $28 million or 20.1% of revenue in the prior year period, and $34 million or 20.5% of revenue last quarter. The sequential decline in SG&A expense was primarily attributable to lower legal expenses during the quarter, and the year-over-year increase was the result of added headcount.

GAAP operating profit for the second quarter was $36 million. Excluding non-cash expenses outlined above, our non-GAAP operating profit for the quarter was $54 million or 33.2% of revenue compared to $43 million or 30.6% of revenue in the second quarter of last year. This represents year-over-year operating profit growth of 25%, versus top line growth of 15%, indicative of the leverage the business generated during the second quarter.

GAAP interest and other expense in the second quarter included approximately $4.8 million in non-cash interest expense associated with FSP APB 14-1 accounting for convertible debt. Excluding this amount, pro forma interest and other income was $3.7 million, of which approximately $2 million was due to foreign currency revaluation of monetary assets held outside the United States. This resulted in approximately $0.01 of FX related gains.

As a reminder, following the end of the first quarter, we began the implementation of a hedging program to mitigate the FX impact to monetary balance sheet assets in our major functional currencies. Our non-GAAP tax rate for the quarter was 31.2% compared to 32.8% last quarter. Our effective tax rate is driven primarily by a ramping of shipments out of our Singapore facility.

As a matter of fact, this quarter, both the quality and the yields of products manufactured in Singapore were again comparable to that of our San Diego factory. We reported GAAP net income of $25 million or $0.18 per diluted share compared to $13 million or $0.09 per diluted share in the prior year period.

Excluding the impact of non-cash stock compensation expense, non-cash interest expense associated with the adoption of FSP APB 14-1, and the other items identified in our press release and net of pro forma tax expense, non-GAAP net income was $39 million or $0.30 per pro forma diluted share, compared to $27 million or $0.22 per pro forma diluted share in the second quarter of 2008. This represents 43% growth in net income on a year-over-year basis.

Moving to cash flow and the balance sheet, we generated $39 million in cash flow from operations during the quarter. We had capital expenditures of roughly $14 million, and this resulted in free cash flow of $25 million or $0.19 per pro forma fully diluted share. This compares to the second quarter of last year when we generated $0.11 of free cash flow per share.

Accounts receivable DSO were 86 days during the second quarter, which is up from last quarter, as well as the second quarter of 2008, due to a lower percentage of shipments during the first month in the quarter. Depreciation and amortization expenses for the quarter were approximately $8 million. And we ended the quarter with approximately $790 million in cash and investments.

I would like to now provide financial guidance for the third quarter and full-year of fiscal 2009. As a reminder, we will exclude the charges associated with the adoption of FSP APB 14-1, which requires us to report incremental non-cash interest expense, related to our convertible debt.

Consistent with our previous calls, guidance will exclude other certain non-cash charges, including stock compensation expense related to FAS123R, the amortization of intangibles and acquisition related charges. For additional details, please refer to the table in our earnings release that reconciled our non-GAAP guidance to the GAAP figures.

As we indicated in the preliminary announcement, we have reset our expectations for 2009 back to the initial guidance we provided at the beginning of the year. Currently, we expect total revenue for 2009 to be between $690 million and $720 million. This represents growth at the midpoint of approximately 23%. We expect gross margins for the full-year to fall in the upper 60s.

We continue to expect non-GAAP earnings per share to be between $1.13 and $1.23. This assumes pro forma fully diluted weighted average shares of approximately $133 million. We expect non-cash stock compensation expense for the year to be approximately $62 million or $0.31 per tax adjusted pro forma diluted share.

As a reminder, the pro forma diluted shares calculation, excludes the double dilution, resulting from the accounting impact of our convertible debt. The Q2 impact on shares is included in the reconciliation to GAAP figures that accompanies today's press release. We continue to expect non-GAAP annualized tax rate of approximately 33% for 2009.

Our actual tax rate will be highly dependent upon the shipments made out of our Singapore manufacturing facility to International locations. We expect capital expenditures for the full-year to be approximately $50 million. For the third quarter, we expect revenues to range between $162 million and $172 million, which represent year-over-year growth between 8% and 14%.

We expect third quarter non-GAAP earnings per share to range from $0.26 to $0.30, assuming pro forma fully diluted weighted average shares of approximately $135 million. We expect non-cash stock comp expense for the quarter to be approximately $16 million or $0.08 per tax adjusted pro forma diluted share.

At this time point, I would like to turn the call over to Jay for some remarks on our commercial activities during the quarter, before we begin the Q&A session. Jay?

Jay Flatley

Good afternoon everyone and thank you for joining us today. As I reported to you a few weeks ago, our top line performance for the second quarter was a disappointment. Having said that, we were very pleased with our overall operational and financial execution, which enabled us to achieve the high-end of our EPS guidance.

Our revenue shortfall resulted from several factors. The most important of which was a faster than anticipated slowdown in our array business. Additionally, we believe the stimulus plan had a negative short-term impact on both our sequencing and microarray orders as customers wait to learn whether and to what extent they will receive stimulus funding.

And finally, we saw some impact in a few select accounts from reductions in endowment funding. Operationally, manufacturing cost reduction and significant production efficiencies enabled us to improve gross margins by over five percentage points, relative to last year. Prudent management of SG&A expenses resulted in operating margins 2.5% higher to over 33%, while maintaining a significant R&D investment to drive innovative new products, a number of which we launched in Q2.

In the microarray business, we reported lower revenue both sequentially and year-over-year. We experienced a more significant impact in the array business than we had anticipated, largely a result of some researchers taking a pause from genome-wide association studies to wait for next-generation content.

The rapid decrease in cost of sequencing is enabling discover a rare variation in the genome, which once incorporated on arrays will provide dramatically increased power from making do these associations. To put this in perspective at the Cold Spring Harbor meeting in May, The 1000 Genomes Project disclosed that it had identified over 11 million new SNPs from the sequencing data generated thus far.

It is highly probable that significantly more SNPs, structural and copy number of variants will be identified when the project nears completion later this year. This past quarter, we launched the Omni1-Quad, the first commercial microarray to include rare variant content from The 1000 Gnomes Project.

A four sample chip with over a million markers per sample, the Omni includes updated content for all major classes of genetic variation in addition to 100,000 variants from The 1000 Genome Project. The Omni-Quad began shipping at the end of the quarter, and has already become our third highest value array in shipment dollars.

We are very optimistic about the future of the array business and believe that the new generation of content will create a second round of association studies that will require increased sample numbers for statistical significance. Our models of this business expect it to be approximately flat for the next several quarters and then begin to accelerate again in 2010.

We continue to improve the capabilities of our low complexity microarray products. Following the end of the quarter, we launched multi-sample indexing or MSI for short for our GoldenGate assay, which enables researchers to run 16 times more samples per reaction, as with our standard GoldenGate assay.

For example, if a researcher were using our recently launched 32 sample Universal BeadChip, they could now screen up to 512 samples on the same chip using less reagents. MSI allowed sample polling with automation and sample tracking through our LIMS software. This enables high-value volume labs to increase their throughput, while substantially reducing per sample cost.

We believe that MSI will be ideal for high throughput customers running low complexity screening, validation, and quality control applications in commercial, agriculture, and academic markets. Our BeadExpress reagents were also a strong performer this quarter. The Q2 annualized consumables pull-through on the platform exceeded our forecasted maximum of $100,000, as we recognized record shipments in orders of VeraCode consumable kit, with particularly strong demand coming from the ag bio marker.

We once again shipped a record number of Genome Analyzers in Q2 and continue to see a ramp in consumables with the annualized rate again exceeding $200,000 per system. We continue to see broadest option of the Genome Analyzer with over 80% of systems shipped outside of the major genome centers.

Additionally, we are successfully migrating our installed base of Genome Analyzers to the GA2X configuration that we launched last quarter and have taken orders for well over 200 upgrade kits. During the quarter, we launched several new software advancements for the Genome Analyzers.

We released new version of our pipeline software, which allows us to read more clusters per lane of a flow cell and when combined with the GA2X upgrade, increases the customer throughput by 65%. This release is one of the components in our roadmap to generate 95 gigabits of throughput per run that we presented at AGBT earlier this year.

We continue to make great progress against this goal. In fact, internally we are now producing runs that exceed 55G using our established workflow and expect to achieve 95G by year-end, with that same workflow. What’s exciting is that the improvements we’re making our software and reagent related, which makes implementation in the field very straightforward.

We also launched a Windows-based interface to our sequencing pipeline software that simplifies management of the data processing for smaller, non-LINUX based labs. Additionally, we launched a new package we call RTA that enables real-time analysis of sequencing data during a run.

As Christian mentioned to you earlier, RTA also reduces the compute requirements for the platform and has allowed us to remove the iPar [ph] computing model from the Genome Analyzer. This transition has eliminated a significant component of cost improving gross margins on the platforms.

Also this quarter, we launched our personal genome sequencing service. This service will provide whole human genome sequencing at 30 times coverage to customers at a price of $48,000. This service has been enabled by the rapid reduction in cost of whole genome sequencing and our expectation that this trend will continue.

Consumers will be engaged with a physician or medical geneticist throughout the process and the data are delivered back to the physician. The consumer will have the ability to select secondary data analysis through one of our partners to understand their risk for certain diseases, the genetic ancestry and other trades of interest, all of which can be discussed with the customer’s position within the Illumina network.

While we don't see this as being a material revenue opportunity initially, as the cost of whole genome sequencing declines and the genetic understanding of disease and prevention increases, there is no question this will become a significant component of how individuals and physicians manage health care going forward.

At the same time that we announced our personal genome sequencing, we also announced that we will conduct this service in our newly certified CLIA laboratory. As many of you know CLIA certification was one of the first steps in the service component of our broader diagnostic strategy.

With respect to other components of our diagnostic strategy, we expect to submit the BeadExpress platform for 510-K approval before year-end. In our cancer sequencing program, we expect to begin data analysis on the first set of sequenced samples beginning in the third quarter.

Before I conclude, I want to update you on what we are seeing with regard to stimulus funding and related commercial activity. As we mentioned to you earlier this month, our revenue guidance now includes the potential impact of stimulus. We are seeing more than double our normal code activity, and believe that next-generation sequencing will be a material beneficiary of incremental funding, both in the genome centers and in smaller labs.

We're also seeing significant stimulus activity around custom content arrays, as researchers look to conduct fine mapping and validation work on existing data from genome-wide association studies. While the aggregate revenue potential from the stimulus is challenging to quantify, the timing is even more difficult to forecast.

Consequently, we have provided a much broader range of revenue guidance for the third quarter than it is typical. Depending upon the grand approval process, it is possible that we could begin to see some stimulus benefit during the third quarter, although we are more likely to recognize material impact during Q4.

Other than the near-term slowdown we are seeing in the genome-wide association portion of our array business, our markets are healthy and growing rapidly. We continue to see significant microarray opportunities within the ag bio, fine mapping and custom content segments of our business.

Operationally, we have continued to make great strides on reducing our cost of manufacturing and improving efficiencies as our business scales. We are the market leader in both next-generation sequencing and microarrays, and believe that the overall funding environment for genetic analysis has likely never been better.

Next few quarters will reveal how the market will allocate incremental funding, as well as the interplay between next-generation sequencing and microarrays. Given that we have now achieved parity and profitability between sequencing and microarrays, we are relatively indifferent to the mix of orders between these technologies.

Our rate of innovation and product development has never been more exciting and we expect to continue to drive growth through new market and product opportunities over the next few years.

Thanks for your time and we will now open the lines for your questions.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Ross Muken with Deutsche Bank. You may proceed.

Ross Muken – Deutsche Bank

Good afternoon, gentlemen.

Jay Flatley

Hi, Ross.

Christian Henry

Hi, Ross.

Ross Muken – Deutsche Bank

Jay, I want to talk first about, sort of the sequential ramp of revenues as they are, sort of expected, it seems now as if there is a bit of stimulus assumed in the fourth quarter given the delta and the acceleration quarter-over-quarter versus 3Q, so can you kind of go through, I know you pointed to the areas and so the code activities, so the level of confidence you have in sort of that uptick, you know is it going to be a function of just the general markets accelerating or are there certain pockets, or orders, or certain grants that hit then that give you a high degree of confidence, just try to walk us through the methodology of how you, sort of, solved that initial ramp, but I realized the timing aspect is a challenging one.

Jay Flatley

Yes, it is. We are hopeful to begin to see some stimulus orders in Q3. We are not sure what that magnitude might look like, and so we have taken a cautious approach to our guidance and given a wide range. As I mentioned on the call earlier in the month, you know one particular dilemma is that the government fiscal year ends on September 30 and our quarter ends on September 27.

And there is a very significant push from the NIH and from the Federal Government to get stimulus money into the system before the end of the government fiscal year, which is September 30 date. So, the degree of our impact in Q3 will depend very significantly on the exact timing of how that money gets allocated and when the orders actually start appearing.

If they begin to appear in August and September, we will have some material revenue from those. If it all happens in the last week of September, we would very likely have little to no impact from that revenue. We are very optimistic that we will begin to see stimulus impact in Q4.

And so you will see, you know if you looked at our annual guidance and our Q3 guidance that we do have some stimulus impact built into the fourth quarter guidance that we are highly confident of and these are orders that are in our pipeline, where we're getting feedback from researchers that they are being awarded high scores, they were starting to hear of some of the research groups that are getting scores back on their grants. And so that is a very positive trend and one that we are very confident in for the fourth quarter.

Ross Muken – Deutsche Bank

So, I guess my one other sort of follow-up just on sort of the guidance, you know you talked about sort of the trajectory of the array business, sort of being flattish after being down this quarter and then reaccelerating, could you just sort of walk through the milestones and the timeline in terms of the completion of The 1000 Genome Project, the time to get sort of content on the chips? And then when you think this new study work starts, and do you think it starts, you know sort of the as you roll-out obviously with the Omni1-Quad having success, before we answered a full content from thousand genome odd chips or do you think there needs to be some sort of significant magnitude of increase rare content on the chips to really get the market going again?

Jay Flatley

As I mentioned before, our expectation is that we are going to have a full range of behavior from our customers here, we will have some customers that are going to continue using the arrays that we have had historically in the product line, the 610 and 660 and some cases the 1M-Duo. We are already seeing significant adoption of the Omni and so there will be quite some number of customers that believe there is incredible opportunities to get low hanging fruit of the Omni with the rare variant content that we have on BeadChip.

So studies will start in some customer labs based on our launch of the Omni Chip and we're seeing that already. The first (inaudible) of content has already come from The 1000 Genome program and we are partnered with a number of the very direct participants in this program to begin to shift to the SNPs that they are discovering and determine, which ones of those are the most important ones to put on the next version of a chip.

That will take a little bit of time because we want to get the content right. The researchers want to get the content right and so I suspect, you know over the next couple of quarters, there will begin to become some clarity around what that content wants to look like.

And then there will be some period of time for us to manufacture a chip and get it in the hands of those research groups. We have already seen some stimulus money put in that we think has a very high chance of being awarded to help subsidize this effort in the part of research groups, so that they would buy these chips as they come out with higher percentage of rare variant content. And so I think in the first half of 2010, you will begin to see this array opportunity reaccelerate.

Ross Muken – Deutsche Bank

Thank you, Jay. I appreciate all the comments.

Jay Flatley

My pleasure.

Operator

And your next question comes from line of Doug Schenkel with Cowen & Company. You may proceed.

Doug Schenkel – Cowen & Company

Hi, guys. Good afternoon.

Jay Flatley

Hey, Doug, how are you?

Doug Schenkel – Cowen & Company

Good. Thanks. So, I am still a bit astounded by your gross margin performance in the quarter, given that you did come up short of your earlier revenue expectations. You did provide a good amount of color on your prepared remarks on this, but I just want to see if I could dig a little bit deeper. I had always thought that consumables on iScan and BeadReader had a gross margin that with at least a few points higher than sequencing consumables. Is this no longer the case, and beyond that is there any reason to think that the COGS improvements seen in the quarter are not sustainable moving forward?

Christian Henry

No, Doug, this is Christian. We were actually, obviously quite pleased with the gross margin in the quarter. This is really just the evolution of a long list of improvement that we’ve been making to the whole sequencing platform over the last basically two years. And it really all started – it all started in last fall with the new reagent kits that we reformulated. And so that, by putting those together, we were able to take a lot of cost out and drive those gross margins up.

And then, we’ve been able to drive the instrument gross margins up through continually improving the system. And then this quarter, we had the major software release that we call RTA. It helped us eliminate a major component of hardware that we used to ship along with every system, and that dramatically reduced the COGS and gave us a big lift.

The other piece to think about is that overall ASPs in Sequencing have been pretty consistent. I know it’s a competitive market, but we’ve been able to do a very good job of keeping ASPs where they need to be and that help drive the margin as well. So at the end of the day, as Jay pointed out, the Sequencing gross margins now are basically a parity with the Array margins. And going forward, obviously price ASPs drive a lot of your gross margin from quarter-to-quarter, but we still see opportunities to take further cost out of the instrumentation, as well as the reagents.

Jay Flatley

I think in particular, Doug, the part that we've sort of over performed on here is on the instrument side. We always believe that we could take a lot of cost out of the reagents and we did that successfully, and put those reagent kits roughly in the range of our arrays, not quite perhaps. But where we did a great job is on the instrument side. And so the instrumentation, itself, is higher margin than our array instrumentation and because of such high percentage of the overall sequencing revenue, it has a very positive impact on the overall corporate margins.

Christian Henry

Yes, that's right.

Doug Schenkel – Cowen & Company

Okay, that’s really helpful. Thanks for that and then I just got one more question and get back in the queue. I think you indicated that you expect G-wide sales to be essentially stable through, I think at least the third quarter stable relative to Q2 sales levels? I just want to make sure – I just want to see if you guys can provide a little bit of color on what makes you confident that there isn’t going to be a further step down in the near-term given that you attributed a lot of the weakness that you have seen in GWASP [ph] researchers basically pulling back in advance of the release of new data and given that a lot of that new data is not coming into later this year, early next year, it will be helpful to just understand why you think this is going to stabilize in the third quarter? Thanks a lot.

Jay Flatley

The most important indicator for us, Doug, is our analysis of our pipeline of order. So we have a pretty good system that can track what the forward-looking order queue looks like, and we now have many of the potential stimulus grants in that order system and so we are going to look forward and, you know using any range of success that we've typically experienced in terms of converting prospects and opportunities into end orders. We have a pretty good visibility that we will be able to convert enough of this microarray business, so that we can keep the business flat.

Having said that, all of this, the wide range of guidance we provided, is where we have some variability on these specific timing of these orders, because there clearly are some material microarray orders that are going to result from stimulus, whether they fall in Q3 or Q4 is hard to tell.

Operator

And your next question comes from the line of Quintin Lai with Robert W. Baird. You may proceed.

Quintin Lai – Robert W. Baird

Hi, good afternoon.

Christian Henry

Hey, Quin.

Jay Flatley

Hey, Quin.

Quintin Lai – Robert W. Baird

With respect to, kind of, going back to the quarter, could you kind of go back and kind of recap to us, when did you begin to see the slowdown? And when you saw the slowdown, was it just across the board or was it just a couple of large customers that they just kind of abruptly shut down, because it looks like that your consumable sale per system is in that $500, $600 range. So, how did that all kind of blend out to go down sequentially?

Jay Flatley

I mean, the biggest impact was in our genome-wide association business, as we've talked about. We saw in Q1, our typical pattern of lower orders just on a seasonal basis that we have seen every year for many years in the company’s history, and we assumed that that was the normal seasonal pattern that we would expect to see. As we got into the second quarter, what we found was that the orders were very backend loaded more so than normal and we didn’t close as many of the Genome Wide Association study orders as we had expected. And we also were a little bit lighter of the instrumentation side in the quarter. So, in aggregate, the Array business was sequentially down from our Q1 result. Do you have any more color to add that, Christian?

Christian Henry

No, I think you have kind of covered it. I mean, I do think that since so much of our business now is instrument – is instrument-heavy in general, you know, we have had the tendency to have a little bit more back-end loading in the quarter and therefore, you don’t necessarily get total visibility until June.

Quintin Lai – Robert W. Baird

Okay. And then, kind of, as a follow-up and again just kind of echoing Doug’s question here is that, for those accounts that had that, I mean I guess is the new visibility – I guess sort of the new guidance assuming kind of that some of these machines will continue doing base level of studies and until the weight or does it take a slue of not just new products, but also custom products to get things back together. And then also just to add another question, since I only get one follow-up, so I will make it real long. On the fourth quarter, given there is a lot of sequencing instruments, should we be watching out for a gross margin on that mix in the fourth quarter?

Jay Flatley

Well, for the first part of the question, we had a couple of key accounts that we mentioned that have – that did slowdown dramatically just in the last three or four months because of endowments. So that was two or three major customers that are funded through endowments. The first time we saw that and their order patterns changed pretty significantly.

That probably was the single biggest effect from sort of the overall economic environment and then on top of that, we had some customers who decided to hold funding for just pure timing purposes to see what happened with the overall stimulus program, so that was sort of a second order effect. But I think that, as I mentioned earlier, we are going to see customers continue to do these studies, so scientists are not shutting down and going home here. What we are talking about is on the margin, particularly in some of the very large Genome Center type institutes who are involved, in many cases, in The 1000 Genomes Program, they're going to slow down doing some genome-wide associations while they wait to help develop this new round of content.

So, you are going to see a baseline of studies absolutely continue in the market, but in the margin $5 million or $10 million makes a difference in terms of our quarterly results.

Christian Henry

For the second part of your question, Quintin, on the gross margin, you know the guidance we provided was upper 60’s gross margin for the year at this point and it will always be depended on what the product mix is with any given quarter. Instrumentation is a little bit lower gross margins than reagents. So you would expect that you need to consider that when you are thinking about your models. But on balance now, what we're feeling, assuming the pricing environment is in reasonable shape that upper 60’s gross margins for the year is achievable.

Quintin Lai – Robert W. Baird

Great. Thank you, guys.

Christian Henry

Thanks.

Operator

And your next question comes from the line of Marshall Urist with Morgan Stanley. You may proceed. Your line is now open.

Marshall Urist – Morgan Stanley

Hello?

Christian Henry

Marshall.

Jay Flatley

Hi, Marshall.

Marshall Urist – Morgan Stanley

Hey, guys. So I want to ask you guys about guidance and kind of help us understand your confidence in your sort of insight into the channel through three quarters. Obviously there was a shortfall this quarter, and how has that changed your thinking about 3Q guidance, I know you have talked about the pipeline, but clearly there was a disconnect in 2Q, so have you sort of – have you increased the risk adjust when you think about the pipeline and how you are giving us the guidance for the third quarter? Can you just help us to understand kind of guidance and how things have changed and what you are thinking about that now?

Christian Henry

Well, I mean, the guidance we provided has a wide range and that really is a consequence of higher degree of uncertainty that we have in our revenue numbers and probably we have ever had before. We can look in our pipeline and we see a rich pipeline of orders. So this isn’t a question in Q3 about whether the orders are there to be had, it’s a question of what the timing of those orders might look like and whether we're going to see stimulus money get released early and linearly in the quarter or more of it held even then we saw last quarter. And so the operating assumption that we put into the Q3 numbers is that, we expect to see little to no stimulus upside in the third quarter and some downside risk from what our plan would have been in the third quarter, due to potential hold up of orders due to people waiting for stimulus. So that’s the backdrop of our Q3 numbers.

Now, those orders, if we miss Q3 timing wise, we expect will fall in Q4. And so the resulting number that you can obviously calculate for Q4 by doing the subtraction includes some assumptions about stimulus actually happening in Q4 and those are results we are pretty confident in, based on our pipeline.

Marshall Urist – Morgan Stanley

Okay cool. And then just one last follow-up to clarify a couple of things, the first one was that, so, when we think about the range of the Q3 guidance, should we assume that they will –.

Jay Flatley

Marshall, you cut out, there.

Marshall Urist – Morgan Stanley

Hey, am I back?

Jay Flatley

Yes, you are back.

Peter Fromen

You're back.

Marshall Urist – Morgan Stanley

Okay, sorry. So, the follow-up just on couple of other quick guidance points, so on Q3 is the low end no stimulus and it gets us to a range of about stimulus gets us to the high end? And then are you saying the entire microarray business is going to be or is it (inaudible)?

Jay Flatley

We are missing about half the question, Marshall.

Marshall Urist – Morgan Stanley

Hey, guys?

Jay Flatley

Yes.

Peter Fromen

Yes.

Marshall Urist – Morgan Stanley

Okay. Sorry. So first half just Q3, is there any stimulus in the low end of guidance. And then second, on the microarray business are you saying the whole thing is flat or just GWASP is flat?

Jay Flatley

So we wouldn’t expect, I mean if we came in at the low end of our guidance, it’s very unlikely we would have any stimulus advantage in the quarter. So the first part is that, no, we wouldn’t think we would have any stimulus if we are in the low end of that range.

And second part of the question is, will the whole array business will be flat? Is that what you are asking?

Marshall Urist – Morgan Stanley

Yes.

Jay Flatley

Yes. Well, I guess if you add up in numbers and do backward comparisons in aggregate, you could see it being flat with where we are right now. But within that, the mix will move around a little bit depending upon the timing of custom orders, the timing of ag orders, and those numbers tend to move around a bit quarter-to-quarter because some of these large orders are custom products that in many cases require us to wait for content from the customer or in some cases to sequencing to get the content and take a couple of months to manufacture to make the B pool. So, there is background noise in the custom part of the business.

We continue to feel pretty good about what’s happening in the BeadExpress part of the product line, we had really good reagent orders in the quarter and shipments during the quarter. So, we think that’s going to be a very strong component of the revenue over the next couple of quarters and continue to grow. And we remain very optimistic about what’s going on in the ag business.

Marshall Urist – Morgan Stanley

Okay. Great. Thanks guys, and sorry about the cell phone.

Jay Flatley

No, that's all right.

Operator

And your next question comes from the line of Tycho Peterson with J.P. Morgan. You may proceed.

Tycho Peterson – J.P. Morgan

Hi, thanks for taking my call. Question, I guess on the endowment issues, I mean this is something that came up a lot about six months ago and I think at that time you kind of said only 10%, 15% of revenues and you weren’t expecting a big impact. It sounds like it was fairly concentrated in terms of the number of academic labs that were impacted, but I guess, give us comfort that this doesn’t get worse going forward, I mean given that it is probably not just three universities that are cutting departments. How do we think about the next couple of quarters from the endowment perspective?

Jay Flatley

Well, you are right. It was very narrow in a couple of customers, so we haven't seen it in general and in these couple of customers, the first time we really saw it was probably three months ago where they began to talk about their funding getting squeezed to some extent. We have not heard that from most of other academic customers. In fact, they are just sort of on the flip side because they are so wildly bullish about stimulus, and so we certainly need to control the balance of their enthusiasm on the other side of the equation. But, you know I mean endowments could get cut a little more, but on the back drop of the market is probably slightly positive toward endowment funding over the last couple of months and who knows what’s going to happen over the next three to six, but I think the overall trends are probably towards endowment starting to come back a bit.

Tycho Peterson – J.P. Morgan

Okay. That’s helpful. With regards to GWASP, is there some risk I guess its not risk given where your margins are on arrays and sequencing, but is there some chance that some of that rich variant work may migrate over the sequences as customers are reluctant to wait until some of the product cycles next year are – I understand there are different projects in nature, but is there a risk that some of those projects may be kind of redesigned to migrate over to sequences in the interim.

Jay Flatley

No, the kind of distribution of the variants across the genome are so broad that – unless you sequence the entire human genome you're not going to get the same data and the cost points of sequence of whole genome versus running an array are so dramatically different that there is no possibility of the substitution effect there. You could see some institutes say, okay, we are going to sequence five or ten samples under stimulus may be a few hundred, but for most of these disease associations you need sample collections in the thousands and with rare variants probably more like three, four, five thousand samples. And so that’s not a practical sequencing experiment.

Tycho Peterson – J.P. Morgan

Okay. Yes, that makes sense. And then just lastly on the ASPs, does the quote, the number you provided include the upgrade kits? I mean I guess how do we think about ASPs going forward once you kind of finish the upgrade cycle?

Christian Henry

The holding of ASPs was independent of the upgrade. So, on the base systems, the ASPs have been holding nicely and on the arrays, the ASP per chip has been continuing to inch up some.

Jay Flatley

That’s right.

Tycho Peterson – J.P. Morgan

Okay. Thank you.

Jay Flatley

Thanks, Tyco.

Operator

And the next question comes from the line of Un Kwon with Wedbush Morgan Securities. You may proceed.

Un Kwon – Wedbush Morgan Securities

Hi, thanks for taking my question.

Jay Flatley

Hi, Un.

Christian Henry

Hi, Un.

Un Kwon – Wedbush Morgan Securities

I was wondering, is it possible at all to give us a rough breakdown in your genotyping business between the GWAS microarrays versus your custom flash ag bio products?

Jay Flatley

No, we’ve never given that breakdown and we don’t plan to change that today.

Un Kwon – Wedbush Morgan Securities

Okay. Fair enough.

Jay Flatley

Okay.

Un Kwon – Wedbush Morgan Securities

And then my second question then, you had indicated that your sequencing and array business are on parity with respect to gross margin, can you talk a little about the operating margin differences between the two businesses?

Christian Henry

You know what, there is really not a lot of difference there, because we use the same sales force. The R&D is completely integrated between arrays and sequencing, and the G&A I guess, Jay and I, still are working on both businesses. So, the reality is, the operating margin line is roughly the same. Obviously, we may have R&D projects going on in sequencing at some give time versus arrays or vice versa that would make differences, but fundamentally it’s the same R&D organization. It’s actually one of the key reasons why this acquisition made so much sense is that, we can create incredible synergy across not only the commercial organization, but also the R&D organization.

Un Kwon – Wedbush Morgan Securities

Great. Thanks.

Operator

And your next question comes from the line of Isaac Ro with Leerink Swann. You may proceed.

Isaac Ro – Leerink

Hi, guys. Thanks for taking the question.

Jay Flatley

Sure, Isaac.

Isaac Ro – Leerink

First off, on the new array content that we are looking at potentially down the road for the – out of The 1000 Genomes, is it fair to say that the overall Array market will benefit from the availability of new content and so that would sort of be perceived as a key driver of renewing the growth rate, and if that's the case could you give us historical precedence on product development cycles?

Jay Flatley

Well, I think if I'm seeing your question correctly, yes, there is going to be enormous theoretical value in this content, because what has happened is that we have completed many, many whole Genome Association studies with the common variants that were discovered in sequencing four, five years ago. And that’s the business that evolved to be quite a large array business here in the last few years. And what was discovered there were many disease associations, over 400 of those, but the effects of those markers were moderate in terms of explaining the heritability of the disease.

We know that these diseases have generic components to them, and so the speculation and in fact the high degree of confidence, is that the actual remaining heritability, which is a significant amount of the heritability is buried other places in the genome in rare variance and structural variation, and that is what the next-gen Sequencing Technology is enabling us to discover and one of the major goals of The 1000 Genome Program. And so there is a high degree of confidence that buried in the variation that’s going to be discovered in The 1000 Genome Program are the secrets to explaining much of the remaining heritability of diseases. So, we will go through a cycle of putting that content on the chips and the product cycles are typically three to six months, including design and validation and selection of content and manufacturing of the chips. And the historical precedent you saw is what happened three or four years ago, when the first whole genome arrays came into the market and the rapid adoption you saw genome-wide association.

Our view is that you are going to see that again here in the rich genome-wide association studies and in fact, there is the probability that it could be much more dramatic because number one, you need more samples because the variation is more rare, so statistically you have to have bigger sample sets. And secondly, I think that all it will take is a discovery of a few very key disease associations that explain significant portions of heritability and you will see tremendous amounts of money pour into the whole genome – genotyping market, if and when that happens.

Isaac Ro – Leerink

Okay. Great. That’s exactly what I was looking for. And then, just secondly, just to check here on Harmonia, since it hasn't been asked. Are you guys, I guess number one, still on track for year-end launch. And number two, is it fair to say may be from a marketing standpoint that this product is being positioned as sort of coincide with the availability of funding and perhaps a lot of smaller centers who previously couldn’t access the technology?

Jay Flatley

Yes, certainly it’s targeted for those smaller centers and one that we want to help transition over sequencing for accounts to materially or principally array work, but do occasional sequencing and will be positioned in a way that customers can do follow-up targeted studies from initial genome-wide associations. That’s exactly the target market can also be used for converting customers who are using array based expression towards sequencing based expression, which we think is fundamentally more powerful way to do that. We will be launching that product somewhere around the end of the year. We haven’t given specific dates to that. We will probably update that at our Analyst day in December.

Isaac Ro – Leerink

Okay. Great. Thank you.

Operator

And your next question comes from the line of Dan Leonard with First Analysis. You may proceed.

Dan Leonard – First Analysis

Hi, good afternoon.

Jay Flatley

Hi, Dan.

Christian Henry

Hi, Dan.

Dan Leonard – First Analysis

This is a bit redundant, but I am trying to hit some comfort here. So your revenue forecast for the full-year, if I just take the midpoint of your third quarter and midpoint of your full-year, it looks like you are implying a greater than $40 million sequential growth in the fourth quarter from the third quarter. And I understand you have a pipeline tracking system, but just given the expectation at the pay line on some of these grant buckets is going to be very, very low. How do you come up with that number?

Christian Henry

Well, I mean I am not giving you the exact formula of how we did it, but there are several individual orders, individual grants that were submitted that are in the magnitude of that entire delta. And so if anyone of those grants come about, it could make up the entire difference in Q4 assuming we're able to ship those products for revenue. So, the grant opportunity here is large. We don’t know with certainty, how many of those will get granted exactly when they will hit and so I think we’ve been very upfront with investors about that degree of uncertainty, but we certainly expect some of them too and there is many, many grants that are in the $5 million to $10 million range.

Dan Leonard – First Analysis

Okay. And there are some individual grants that could be up to 40 by themselves?

Christian Henry

Yes, that’s right.

Dan Leonard – First Analysis

Okay. And then my follow-up, on that sequential revenue growth you are looking for, it looks like with only five additional cents of EPS, again using the midpoints of the guidance, it looks like you are expecting the incremental margins on that revenue to be rather low. Is that the right analysis and if so, why would be expect those incremental margins to be low?

Christian Henry

Well, I think what we are doing is, we are just looking at the whole business in totality. We do expect, we are continuing to invest in R&Ds, if so there is some R&D element to it. It depends on where you think ASPs will land on those particular deals. As deals get larger, they typically have some discounting associated with them and you may have some ASP impact as an implication of that.

And so, we took a pretty just our best view of where we think ASPs might end-up. As we talked about a few minutes ago, we think gross margins are going to end up in the upper 60’s for the year. So if you take up – if you look at the upper 60’s for the year combined with some investments in R&D and a little bit of SG&A. That’s how you can kind of come up with those kinds of EPS numbers.

Dan Leonard – First Analysis

Okay. Thank you.

Operator

And your next question comes from the line of May-Kin Ho with Goldman Sachs, you may proceed. Your line is open.

Peter Fromen

Hello?

Jay Flatley

May-Kin? Can we move to the next question, operator?

Operator

Okay. We will go to the next question. And your next question comes from the line of Zarak Khurshid with Caris & Company. Please proceed.

Zarak Khurshid – Caris & Company

Hi, guys. Thanks for taking my question. Sorry to the background noise here. Thanks again for the color today. Obviously, Sequencing business continues to take off or just tracking incredibly well. How should we think qualitatively about the relative impact of NIH on your genotyping business, versus the sequencing business? It sounds like lot of the big grants may be on the genotyping side, but is there potentially a backlog building on the sequencing side too that could lead to an inflection or an acceleration in that business, as well as the NHI monies come through?

Jay Flatley

Well, we certainly think that, next generation sequencing is going to be more than likely the biggest beneficiary of stimulus funding. However, we have seen lots and lots of grounds put in for microarrays as well. So we think that that there will be substantial microarray projects that get awarded as a part of stimulus. The one difference you see is that, in sequencing, there are many sort of moon-shot project, very bold things that customers may try to do and these are these challenge grants that were put in for very large amounts of money where they are contemplating sequencing, potentially thousands of samples of particular type.

And so you have large dollars that potentially go with those grants and these are for scientific endeavors that have never been possible before us. So, we think there is a reasonable chance that some of those are going to get awarded. In the microarray business, not to say that isn’t exciting, because it is, but it’s more of the same in the way. So, it’s more disease association studies and you may see $2 million grants and $5 million grants in microarrays, but you are not going to see many $20 million to $40 million grants in microarrays and that’s the reason that the dollar distribution will not be as heavy in microarrays as it is in sequencing.

Additionally, we think that the underlying NIH budget. Stimulus a side, we will begin to increase in a very favorable way both because of the disposition of the Obama Administration and clearly with the kind of talent that they are bringing in now to run the NIH with Francis Collins' nomination to lead the NIH, bodes very well for both sequencing and arrays, and genetic analysis in general.

Zarak Khurshid – Caris & Company

Sounds good, thanks.

Operator

And this does conclude the Q&A portion of the conference. I would now like to turn it back over to Mr. Peter Fromen for closing remarks. Sir, you may proceed.

Peter Fromen

Thank you, operator. As a reminder, a replay of this call will be available in webcast format in the Investor Section of our website, as well as through the dial-in instructions contained in today’s earnings release.

Thanks for joining us today. This concludes our call and we look forward to our next update in October following the close of the third quarter.

Operator

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

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