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Illumina Inc. (NASDAQ:ILMN)

Q3 2009 Conference Call

October 27, 2009 05.00 PM ET

Executives

Peter J. Fromen - Senior Director of Investor Relations

Christian O. Henry - Senior Vice President

Jay T. Flatley - President and Chief Executive Officer

Analysts

Ross Muken - Deutsche Bank Securities

Doug Schenkel - Cowen & Co.

Marshall Urist - Morgan Stanley

Quintin Lai - Robert W. Baird

Bill Quirk - Piper Jaffray

Derik De Bruin - UBS

Tycho Peterson - JP Morgan

Isaac Ro - Leerink Swann & Company

Dan Leonard - First Analysis

Zarak Khurshid - Caris & Company

Davis Bu - Goldman Sachs

Jonathan Groberg - Macquarie Capital

Operator

Good day, ladies and gentlemen. Welcome to the Q3 2009 Illumina Earnings Conference Call. My name is Diana and I'll be your operator for today. At this time all participants are in a listen-only mode. Later, we will conduct a question and answer session. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today's call Mr. Peter Fromen, Senior Director, Investor Relations. Please proceed, sir.

Peter J. Fromen

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

If you have not had a chance to review the earnings release, it can be found on the Investor Relation section of our website at illumina.com.

Presenting for Illumina will be Jay Flatley, President and Chief Executive Officer and Christian Henry, Senior Vice President of Corporate Development and Chief Financial Officer.

This call is being recorded and the audio portion will be archived in the Investor Relations section of our website.

You should note that all forward-looking statements regarding financial guidance and commercial activity made during today's call to protect 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 document that Illumina filed with the Securities and Exchange Commission including Form 10-Q and 10-K.

Before, I will turn the call over to Christian, I want to let you know that we will participate in the Piper Jaffray Healthcare Conference in New York on December 2nd, the Deutsche Bank Med Tools Conference, in Boston on December 9, 10 and the JP Morgan Healthcare Conference in San Francisco on January 11 and 12.

Following the JP Morgan conference, we will host an Analyst Day in the afternoon on January 14 at our Beriya facility in Hayward, California. All information regarding this event will be available shortly. For those of you unable to attend any of the upcoming conferences or our Analyst Day, we encourage you to listen to the webcast presentation which will be available through the Investor Relations section of our website.

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

Christian O. Henry

Good afternoon everyone and thank you for joining us today. During today's call, I will review our third quarter financial results and provide guidance for the remainder 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 158 million of total revenue for the third quarter, which was approximately $4 million below the low end of our guidance for the quarter. This represented 5% growth over Q3 of last year. Product revenue was 150 million growing 7% over the prior year period led by significant growth in our sequencing products. Then over to last quarter, the strong growth we recognized in our sequencing business was insufficient to offset declines in our microarray business, specifically for products that enabled genome-wide associations studies.

Consumables revenue for the quarter was 87 million compared to 90 million in Q3 of '08 which represent a year-over-year decline of 4%. Sequencing consumables grew well over 100% on a year-over-year basis, but were essentially flat with respect to Q2. Late in the third quarter, we estimate that we lost approximately 68 million in revenue due to a sequencing reagent quality issue which prevented us from shipping certain kits at the end of the quarter.

Jay will provide more details about this matter and its resolution in his remarks. Despite this issue annualized consumable pull through on the Genome Analyzer was still within our projected range of 150 to 200 K per system.

Array consumables remain more than half of our consumable revenue but were down in the quarter on both the year-over-year and a sequential basis. The decline in array consumables continues to be directly attributed to the weakness in sales of whole-genome genotyping chips.

Consumable pull through for the array business was between 400 and 500,000 per system. We shipped another record number Genome Analyzers during the quarter as demand for the system continues to exceed our expectations.

Strong GA shipments as well as year-over-year and sequential growth in iScan revenue enabled us to recognize record instrument revenue of $61 million. This compares to 47 million in the third quarter of 2008 and represents year-over-year growth of 30%.

Services and other revenue which includes genotyping and sequencing services as well as instrument maintenance contracts was 8 million, compared to 10 million in Q3 of last year. The year-over-year decline in services was largely due to the overall decline in GWAS studies, but also to the fact that more of our genotyping service revenue has moved to our CSPro certified customers.

Before discussing our gross margins and operating expenses for the quarter, I'd like to note that we recorded a pre-tax amount of $15 million related to non-cash stock-based compensation. This impacted our EPS by our tax adjusted amount of $0.07 per pro forma diluted share for the quarter. In my discussion of operating expenses, I will highlight both our GAAP expenses, which includes stock compensation expense and other non-cash charges and these corresponding non-GAAP figures.

I encourage you to review the GAAP reconciliation of non-GAAP measures that's included in today's earnings release. Total cost of revenue for the quarter was 51 million, compared to 57 million in Q3 of '08.

The Q3 '09 cost includes stock-based comp expense of 1.3 million, compared to 1.2 million in the prior year period. Excluding the expense and 1.7 million associated with the amortization of intangibles non-GAAP gross margin was 69.5%.

This compares to 70.6% last quarter and 64.6% in the third quarter of '08, a year-over-year improvement of nearly 500 basis points. Similar to last quarter, key contributors to the year-over-year gross margin improvement were our reformulated sequencing kits, our new real time analysis software package, which allows us to reduce the hardware cost in the Genome Analyzer. And overall manufacturing and supply efficiencies that have resulted in lower material costs and favorable overhead absorption.

From a sequential perspective, gross margins declined by a 110 basis points from the second quarter, primarily due to the higher mix of instrument versus consumable revenue as well as the $2 million warranty reserves to account for the quality issues with our sequencing kits.

As partially evidenced by our strong gross margins, pricing continued to be relatively stable in our markets. However, ASPs per example declined in the overall array market product line as due to an increase in the mix of customer and fix content shipments which sell for lower prices per sample relative to whole genome, genotyping chips.

ASPs for whole genome genotyping chips were essentially flat with last quarter. Instrument ASPs and our sequencing business declined slightly from the second quarter as we closed more multi system deals, where we typically provide a larger discount.

Research and development expenses were 34 million in the quarter, compared to 28 million in the comparable period of 2008 and included 4.8 million and 3.5 million respectively in non-cash stock compensation expense. Excluding stock compensation expense and 0.9 million and 0.6 million of accrued contingent conversation associated with the Avantome acquisition in the third quarter of 2009 and 2008 respectively.

R&D expenses were 29 million or 18.1% of revenue compared to 23 million or 15.6% of revenue in the prior period. The increase in year-over-year R&D expense was primarily attributable to increased headcount and increased project activity. SG&A expenses were 42 million, compared to 39 million in the third quarter of '08 and this includes stock compensation expense of 8.5 million and $8 million respectively.

Excluding these non-cash expense, SG&A was 34 million or 21.2% of revenue, compared to 31 million or 20.9% of revenue in the prior year period. The increase in SG&A spend on a year-over-year basis is primarily the increase -- is the result of increased headcount. GAAP operating profit for Q3 was 29 million, excluding non-cash expenses outlined earlier and acquired in process R&D expense of 1.3 million.

Our non-GAAP operating profit for the quarter was 48 million or 30.2% of revenue. This compares to 42 million or 28.1% of revenue in the third quarter of last year. This represents year-over-year operating profit growth of 13%, versus top-line growth of 5%. This demonstrates the continued underlying leverage of the business, in spite of lower than anticipated revenue figure.

GAAP interest and other expenses of third quarter included approximately 4.8 million in non-cash interest expense associated with our outstanding convertible debt. Excluding this amount, pro forma interest and other income was 3 million, which includes approximately 1.6 million or less than a penny per share of positive foreign currency effect due to the revaluation of monitory assets outside the U.S.

Our non-GAAP tax rate for the quarter was 36.4%, compared to 31.2% last quarter. The increase on our tax rate in Q3 relative to Q2 was due to the fact that we are generating more income from our sequencing products than we had originally forecast. This required us to make a year-to-date catch up adjustments that drove the tax rate higher, than originally expected. On an annualized basis, we anticipate our tax rate will be approximately 34%.

We reported GAAP net income of $17 million or $0.12 per diluted share, compared to a loss of $10 million or $0.08 per diluted share in the prior year period. The GAAP loss in the prior year period was due to the non-cash in-process R&D expense associated with our acquisition of Avantome.

Excluding the impact of non-cash stock compensation expense, non-cash interest expense and the other items identified in our press release and net of pro foma tax expense, non-GAAP net income was 32 million or $0.24 per pro forma diluted share, compared to 29 million or $0.22 per pro forma diluted share in the third quarter of 2008. This represents 13% growth in net income year-over-year.

In the third quarter, we recorded capital expenditures of approximately 20 million. The largest component of this outlay was for the building improvements in our new UK facility. This facility is essentially complete at this stage and we will be moving in over the next few weeks.

In the quarter, we generated $23 million in cash flow from operations and free cash flow of $3 million or approximately $0.03 per pro forma fully diluted share. This compares to the third quarter of last year, when we generated $0.09 of free cash flow per share. Q3 cash flow compared to the second quarter this year was impacted by lower net income, increased inventory levels build to address the anticipated increase in demand for sequencing products and an increase in accounts receivable.

DSO increased to 94 days, up from 87 days in Q2. Depreciation and amortization expenses for the quarter were approximately 8 million and we ended the quarter with approximately 815 million in cash and investments.

I will now provide financial guidance for the remainder of the year. As a reminder, we will exclude the charges associated with the adoption of the accounting guidance related to convertible debt.

Consistent with our previous calls, guidance will exclude certain non-cash charges including stock compensation expense, 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 related GAAP figures.

Not only did sequencing, the sequencing regent issue impact revenue in the third quarter, we expect that we'll have a negative impact of up to 15 million on Q4 revenue. As a result, for the fourth quarter we expect total revenues to be a minimum of 165 million, which implies a full year 2009 revenue at a minimum of 651 million. This represents year-over-year growth of 3% in the fourth quarter and 14% for the full year.

We expect gross margin percentage in the fourth quarter and full year to be between 69 and 70%. We expect non-GAAP earnings per fully diluted pro forma share in the fourth quarter to be between 24 and $0.25, which implies a $1.5 to a $1.6 for the full year.

We anticipate the full year pro forma tax rate will be approximately 34% and we will incur stock compensation expense of approximately 61 million or a tax adjusted amount of $0.31 per pro forma fully diluted share.

The company expects full year weighted average shares for the measurement of pro forma amounts to be approximately a 133 million. And finally, we believe total capital expenditures will be approximately 52 million.

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

Jay T. Flatley

Good afternoon everyone. And thank you for joining us today. Q3 was a disappointing quarter for Illumina. The three key factors contributing to our revenue mix. First, the concerns that I discussed last quarter regarding stimulus related delays were realized.

Second, we saw a continued decline in our whole genome and genotyping market. And lastly, we had rear operation this year occurred late in the quarter. Let me address these internally. As I described you last quarter, we felt that the ongoing uncertainties around the magnitude and timing of stimulus funding, our ability to forecast revenue.

During Q3, only very limited stimulus funds were release to customers and we recognized a non-material amount of revenue from these funds. We estimated around 8 to $10 million of orders, we expected to receive were delayed waiting for grounds to be at work. Additionally, we did not see the bulk of orders at quarter end, it is typical for an end of NIH fiscal year. Grant approval activity accelerated significantly at the environment of September, and the NIH pushed to meet its fiscal year and deadline to commit -. While this is encouraging, it still remains significant uncertainty as to when these awards will convert to orders and ultimately be recognized as revenue.

In Q4, we begun to receive some orders related to stimulus but cannot predict how much will hit Q4 versus sliding in to 2010. On the positive side, we no longer expect to see stimulus related spending delays impact our business. As we saw in the second quarter, a significant component of our revenue shortfall was due to the slowdown in genome-wide association studies or GWAS.

GWAS revenue was $7 million below our internal forecast for Q3. The impact of this slowdown has been most significant in Europe, where the overall funding environment has lagged the U.S. The third factor contributing to our revenue shortfall was the sequencing reagent quality issue that Christian mentioned.

Late in the third quarter, we experienced an issue with our paired and sequencing kit and estimated this problem alone resulted in lower third quarter revenue of between 6 and $8 million. I'd like to take a moment to walk you through exactly where we are with this issue and the impact we believe we'll have on the fourth quarter.

In September, some of our customers began to see higher rates on the second period end analysis. As a result, we elected the whole shipment temporarily on all period end cluster kits, which we believe to be the cause of the failures in order to contain the problem and troubleshoot the cause.

We tracked the root cause was small group of purchase materials and as since we formulated our kits with new raw materials. We've been testing the new kits extensively both internally and customer sides and believe that these new reagent patches are performing specifications.

Additionally, we've enhanced quality control procedures to ensure that no additional defective kits are produced or shipped. We removed the shipping hold, we've ramped manufacturing and we expect to wrap up the clear backlog. This reactively holds shipments to contain the problem and will provide warranty replacement kits to our customers.

Our revenue for the fourth quarter maybe negatively impacted by as much as $15 million. With this context, let me now discuss our product groups in the latest developments in each. Microarray products total revenue for the quarter came in under our forecast resulting in both sequential and year-over-year decline.

The shortfall between our forecasted array revenue and the actuals for the quarter was primarily due to delayed orders as customers waited for funding. We expect to recognize many of these orders within the next two quarters and do not believe that we lost any material business to competition in Q3.

Although, the overall array products declined in the quarter, both our custom and fixed content arrays continue to show significant growth. For example, we start growth of nearly 20% over last year and customers arrays and over 15% in our fix content products. However, this growth could not offset lower revenue from our whole genome microarrays.

As we've mentioned over the past few quarters, the GWAS segment of the microarray market has been negatively impacted as researchers await new and rear end content from the project to be incorporated in to new array products. However, based on our discussions with customers and the number of stimulus grants awarded for GWAS subsequent to the close of the quarter, we believe the GWAS market will return to growth in 2010.

Last week of the American Society of Human Genetics Conference, we announced our 2010 roadmap to deliver microarray products that will enable researchers to analyze up to 5 million variants per sample. The content for this product will come predominantly from the thousand genome project data as it is released.

On the path -- the launch of the 5 million microarray, who will launch an intermediate 2.5 million variant products that were build upon the only one released in the second quarter of this year. We're collaborating with a group of leading researchers to prioritize markers as they released in the 1,000 Genomes Project, increasing content up to the 5 million microarray. Supplemental arrays that will allow customers to build towards the 5 million array incrementally.

This approach will enable customers to begin their rich GWAS studies immediately with the only one and then purchase supplemental arrays at an overall level and total cost waited for the. We believe that this market approach will help to relieve deposit, we've seen in the market and begin to catalyze to broader merchants to rich GWAS.

Our significant products start to gain expectations this quarter as we shipped a record number of Genome Analyzers. As at the end of the quarter, more than 70% of Biosystems in the field have been upgraded to the configuration. This upgraded the signs of improvements in our pipeline software has enabled multiple customers to now generate over 55 G per run on a single flow cell.

We're also on track to meet our roadmap to generate 95 G per run around the end of the year. We continue to see the GA stand as the premier next generation sequencing system on the market. In fact, we believe that we currently have well over 50% share in the next gen sequencing market. Today there have been over 450 scientific publications using the Genome Analyzer more than 18 times greater than any others short lead sequencing technology.

In addition of the hardware and software upgrades that we made in GA this year. Last week at AFHG, we announced the commercial launch and medium availability of, the next generation of our sample instrument.

CBOT replaces the cluster station and enables greatly improved automation in front of the Genome Analyzer. This system is designed from the ground depth with great improving performance and ease of use. For example, the new system requires less than 10 minutes of hands on time and four hours of total runtime representing 70% and 20% reduction respectively compared to the cluster station.

Compared to typical emulsion PCR protocols, CBOT requires 100, hands on time and 16, the runtime. Defending further, we already considerable sample prep time advantage. In addition to the improved performance, we completely redesign the user interface and the reagent cartridges.

We've optimized the user experience by adding a touch screen interface to the instrument. Wireless users can now simple graphic icons to quickly get the samples processed and in addition, the system has integrated barcode reader for efficient tracking and logging of reagents.

In conjunction with CBOT, we also launched our version 4 of cluster generation kits, which is a higher fidelity enzyme to deliver greater accuracy during amplification. These kits now come pretax and sealed for single step plug and play loading indices CBOT to help eliminate reagent prep areas and sources of contamination.

Once the regents are loaded, the technician can walk away remotely monitor the run and receive diagnostic updates on any web enabled device including an iPhone. In the third quarter, we achieved record order levels. We built our backlog and maintained our strong gross margins.

In manufacturing, we've continued to generate cost reductions and production efficiencies, which have resulted in gross margin improvement of almost 5% point last year. Prudent management of SG&A expenses resulted in operating margins over 30% more than 2% points higher than last year, while maintaining significant R&D investments to drive our product development portfolio.

Overall, while we are disappointed with our total revenue performance in the third quarter, we are seeing many encouraging signs in our markets. Although, we have some remaining uncertainty about GWAS in Q4, we continue to gain confidence that growth will return in 2010.

During the quarter, we saw significant increase in grants activity for GWAS, as well as custom content studies from both stimulus and related funding in the 2009 NIHB's budget. Next generation sequencing remains robust and continues to be the most exciting opportunity in the life sciences research area and we have maintained if not extended our market leading share during the quarter.

Finally, our R&D programs are richer than they have ever been supporting our core goal of delivering innovative products to our customers and our markets Thank you for your time and we'll now open the lines for your questions.

Question-and-Answer Session

Operator

(Operator Instructions). We have a question from the line of Ross Muken, Deutsche Bank. Please proceed. Your line is open. Please unmute your phone, if you've muted your phone.

Ross Muken - Deutsche Bank Securities

No, I am here. Hey guys.

Jay Flatley

Hey, Ross.

So it seems like a confluence of things happened this quarter that were some were some were unexpected. I guess, the one that sort of stands out is obviously the sort of execution this Q on the manufacturing side. I mean when in the quarter did you realize that and when you saw that you were going to come up short relative to the guidance that you had set and what was the decision making process, particularly given it's impact not just for 3Q, but also for 4Q in terms of alerting the street versus sort of coming and doing it now in this forum?

Jay Flatley

Yeah. The earliest indicators we have Ross, were sort of in the early part of September, when we got one or two customers, who showed some aero weights (ph) and their second read, we'll began to investigate that. And sort of late in the September timeframe where we realized that we may have a reagent problem and we put a bunch of people on investigation of that problem to understand what was causing the problem. What was sort of the root cause of that issue and that's when we put a shipment hold on all of those paradigm kits.

And so we spend sort of the next three to four weeks investigating that and building new kits from scratch with new raw materials. Which has proven to solve problems, we are very confident the reagents we're now shipping. But until we understood that we had the problem solved, it was very difficult for us to get a handle on our Q3 revenue, level on our Q4 revenue impact. And that's because we have some transactions, some business arrangements out in the field that has to do with the way that revenue gets allocated based on allocation to various kinds of shipments.

We didn't exactly know what the warranty reserve is going to need to be. And so what is it really until last week that we had a handle on what the revenue number for Q3 would be and what the earnings would be for the quarter?

Ross Muken - Deutsche Bank Securities

Okay. And as we look to the fourth quarter and to next year, I want to try to understand sort of the Firefox number, the guidance is extremely open ended relative to sort of setting a minimal level and obviously one can see what kind of the potential 50 million headwind what it is. If we sort of take that that sort of manufacturing issue which hopefully is now solved and kind of put that aside. I mean what is the sort of general backdrop look like for the performance of the business, once we sort of normalize for that in terms of what you are expecting in the fourth quarter relative to the stimulus. I mean you sort of earring on the side of caution there assuming most of those orders or clothes turn into revenues eventually in the first quarter, I mean I am just trying to get a sense for kind of the process there and then in turns what access kind of one-time issue and now that we should be a passed the point where the stimulus is freezing you out on the sequencing business, what's the sort of big picture look like?

Jay Flatley

Yeah. Well, a couple of factors; one is that for Q4 we pulled out roughly in a range of $10 million of GWAS from what we had guided to where we thought we were a quarter ago. And that was because of the continued decline that we saw in the third quarter. So fourth quarter, we're seeing some stabilization. We're not quite prepared to say that we're at a bottom of the decline in GWAS, we don't know. But we think we're sort of in that range now, but we took $10 million additional out for GWAS in the Q4.

We've also because of delays in the flow of stimulus pushed $10 million of stimulus out of Q4 into next year from what we originally had estimated. We just don't know what the timing is going to look like of when these orders come in, when we then shift the product and we ultimately recognize revenue. And because of that uncertainty, we wanted to make sure that we didn't overestimate or pull in the stimulus more than it was really going to happen. So we are being cautious on stimulus. So far this year, it's been a negative for the company, we want to make sure that it wasn't a negative again in Q4.

Operator

We have a question from the line of Doug Schenkel from Cowen. Please proceed.

Doug Schenkel - Cowen & Co.

Hey, good afternoon. So let me start with a follow-up to one of Ross' questions. Just to be clear on this, based on how you described it, is it fair to assume or is my understanding correct that you shift 6 to $8 million of debt where you didn't record revenues, given the reagent issue is that, is that how you came up with that estimate in terms of what the impact was in the quarter?

Jay Flatley

No, no Doug when we actually shut shipments off, we would have shipped 6 to 8 million more than the amount we're actually shipping out the door.

Doug Schenkel - Cowen & Co.

Okay.

Jay Flatley

And then there is also other orders that we would have -- there is other orders that we would have received that we know we would have received had we not had the issue in shift.

Doug Schenkel - Cowen & Co.

Okay. And so, I guess as a follow-up to that, there was no impact on instrument placements related to that. This is purely your estimate based on the reagent issue.

Jay Flatley

That's right.

Doug Schenkel - Cowen & Co.

Okay. And then moving forward is there any risk that this issue would impact negatively either new from a competitive standpoint of placing instruments or the time lines associated with placing instruments?

Jay Flatley

We don't think so. Most of our customers have continued to run, this was a problem that didn't occur on every run, occurred on a fraction of the run that customers were doing, putting our large production sites. We consider that to be an unacceptable situation. So that's where we begin working directly with those customers and have them stop running so that we could solve the problem.

So we don't think that there has been an impact in the majority of customers, nor do we think there has been an impact on the order received rate for instruments. And we should say we're confident that we believe that we're over the problem.

Operator

Okay. In the interest of time, please limit your questions to one question and one follow-up question. We do have a question from the line Marshall Urist, Morgan Stanley. Please proceed.

Marshall Urist - Morgan Stanley

Yeah. Hey, guys, good afternoon. So, I had a question on the other, kind of the other point you guys made about order delays. I think you said there were 8 to $10 million and I wasn't clear what you're saying there, was that orders that were delayed because of stimulus or those were stimulus orders that didn't come through because they didn't hear back from NIH in time?

Jay Flatley

It's really a combination of those things, and so when we put together our guidance for the quarter, we build up our sales pipeline from what we expected to close in the quarter and there was some mix of a little bit stimulus in there and there was some regular orders that we think were delayed because people might get stimulus money, so it's a combination of those two effects.

Marshall Urist - Morgan Stanley

Okay. Great, thanks.

Operator

We have question from the line of Quintin Lai, Robert W. Baird. Please proceed.

Quintin Lai - Robert W. Baird

Hi, good afternoon. Going back to kind of the GWAS discussion, you said that European sales also impacted you. They are not going to be impacted by NIH stimulus, so could you explain the little bit about how you expect that to come back to growth. And is there a source of funding for them that's going to get them back for next year?

Christian Henry

We think, as in the U.S., Quintin the reduction that we saw in Europe, across the world there is sort of slower economic environment, coupled with a specific impact in GWAS.

In Europe, there is no stimulus, you're right? So that won't be a positive affect bringing that back. But we do think as GWAS recovers that the funding mechanisms that are replacing Europe will fund next generation of GWAS studies.

So we don't have much concern about that. We do have as we mentioned in the past quarter or two, some key foundations funding NAVs in Europe that has gone down considerably in their array business as those endowments have suffered over the past few quarters.

Quintin Lai - Robert W. Baird

Okay, as a follow-up to that, the preliminary discussions that maybe some of your customers have shared with you on the future of GWAS, could you talk a little bit about what kind of population sizes that they are looking at, are they are going to be comparable or bigger than the previous ones and then with respect to price per sample, I mean do you anticipate it being a little higher now that you are going to go to 2.5 or 5 million snips per sample?

Jay Flatley

Yeah, we think the population sizes will be larger and that's driven by the statistics of the fact that we are dealing with low frequency variants that to get statistical significance you need larger populations and so, a study that might have historically been around 2,000 samples may now require 5 to 6,000 samples.

In terms of pricing, we do think that 2.5 m and the 5 m prices will be higher on a sample basis than say we are charging for the OMNI today, so that will definitely be an increase in per sample prices. Obviously, we can command that because the content will we much rich.

Quintin Lai - Robert W. Baird

Thanks.

Operator

And we have a question from the line of Bill Quirk, Piper Jaffray. Please proceed.

Bill Quirk - Piper Jaffray

Thanks, good afternoon. Jay, not be there for sure but, just I guess one last question if you could just some reagent issue. The correction sounded a lot like it was just requiring new raw materials and then maybe some improved quality control internally. But in terms of the overall manufacturing process, there is no meaningful changes above and beyond that correct?

Jay Flatley

Yeah. This wasn't a process problem it is the raw material problem. And so, what've done is we've isolated it down to one of three raw materials. We now have very expensive incoming quality control checks on those over and above that we have already.

And we are testing every lab that we produce. And so we don't think that the problem will recur. But, this really was a not a failure in how we were making new reagents. It was a failure of incoming material.

Bill Quirk - Piper Jaffray

Okay. Now, it's very clear. And then also just thinking about a stimulus, now we've got a pretty good handle on a lot of the awards and some of the actual funding timelines here. How should we thinking about the initial stuff and 10 expectations?

Jay Flatley

Well, we are still trying to figure out what that timing is going to look like but we think we have a better handle now on the scope of the opportunity and we think that initial committed funds which about half of the 10 billion that NAH was going to receive in stimulus that the alumina opportunity set there is somewhere a $100 million or 100 million plus, we might not give all of that, because obviously there is some competition for those funds.

But there are opportunity -- is of that magnitude and we suspect in the second phase of committed grants that there will be some additional upside to that number, sometime through 2010, 2011. What we are still uncertain about, is exactly how fast those moneys will flow? What the allocation between instruments and the agents will look like and therefore we are not at a point where we can assign them with those opportunities on a quarterly basis yet.

But clearly, we do expect a positive affect on 2010.

Bill Quirk - Piper Jaffray

Very good. If I can take one last one and here for Christian, in terms of the rising DSO anything we should worry about here Christian or is this is a function of timing?

Christian Henry

No, it's a function of timing actually. If you look at the actual ageing buckets in terms of the delinquent accounts. The ageing relative to last quarter is actually looking better. So it's really due to the timing of when you do the emblazing and things like that.

So from my perspective, we are watching it carefully of course. But our cash have been good and our write-offs are non existent. We don't really have any write-offs and I font think it's -- I think about it but I am not that worried about at this point.

Operator

We have question from the line of Derik De Bruin, UBS. Please proceed.

Derik Bruin - UBS

Hi. So, I guess when you kind of look at some of the new content, GWAS chips that are going to be out there and then as people kind of gear up to do the studies. I guess, given that given disappointed and some of the results from the first round of studies.

I mean when do they think the content is going to be rich enough in order that we again the next round of studies, I mean are they going to. I mean do you see that something happening by middle of 2010, do they think or how we find enough data from the projects and then start going, or they going to wanted to be more and more stuff coming out from that.

I guess at what point do you think some of your big labs are going make that go, no go decisions I think big projects.

Christian Henry

I don't think the decisions, our customers will be binary and universal. I think there'll be, we make the decisions about what their best strategies will be? Now of been on what their research program looks like and where they are in their phase of study?

One of the reasons we put forward our roadmap is because, it's very clear that even if you had say the first chip of 25 million mark impact or even the if you ran those chips, you have some probability of discovering some very important markers in the low hanging fruit because the initial markers that we will put on, the 2.5 million chip will be the best set of markers out of the 20 million that have come out of the 1000 genome program.

And so they will have the highest opportunity in making the next set of discoveries. The way we've set out the program then allows someone to begin using the then run the series of supplement chips, two supplemental chips in that case to get up to the and our hope is that, some customers will begin to start even now in the or when we launch the 2.5 and then we'll run the supplemental chips to get up to the five.

With the that they have an opportunity of making some very important discoveries early on, as opposed to waiting until the 5 m was fully available. And we priced those supplemental chips to inset customers to take that path.

So that's part of the marketing approach that we've taken on this program.

Derik Bruin - UBS

Okay. I guess is there concern of this, the researchers won't have enough raw sample to go back and do to repeat studies, I mean just given the, have difficulty as foundation sample in ?

Jay Flatley

No, they are in pretty good shape in most of the populations and most of the diseases and many of the projects that we saw even in the last phase were came together around the world to do the programs and so we don't think there will be a limitation on samples and since stated the last round many of these groups have continued to collect samples on an ongoing basis and get some R&D.

Derik Bruin - UBS

Good. One minute a quick one, we heard a lot of chatter about some large awards, some of the genomes, some of the large genome. Could you give any color on sort of happened to date about some of the large systems orders, can you but its what's out there so far?

Jay Flatley

Well, we haven't given any information out about that. And as we've said before if we get an order that we think is substantial and material we'll press release that at the appropriate time.

Operator

We have a question from line of Tycho Peterson, JP Morgan Please proceed.

Tycho Peterson - JP Morgan

Hey, good afternoon. The 10 million I think you talked pointing out GWAS for the fourth quarter, does that include a service component. And if not, what take as to prevent service from having a third quarter and the fourth quarter?

Christian Henry

Well the service is impact is too fold. One is the overall reduction in GWAS studies and secondarily, I think we've mentioned now three or four quarters running the fact that more and more that business is going off to our CS core customers.

And that's the trend that we think is okay. Our sales team has enabled our customers to run these service projects. And we've encouraged them in fact to develop by automatic analysis on the backend that we don't offer.

And so that migration is one we're fine with. And so from a GWAS growth opportunity in our own services business, that's not something we're measuring as strategic to Illumina's progress.

Tycho Peterson - JP Morgan

Okay. That's helpful. And then can you talk a little bit about capital deployment, you've got a new buyback. How we think about balancing that with some of the investments you've made in new technology versus infrastructure?

Jay Flatley

I think we're generating sufficient cash. So we're looking -- we're putting into the business, you see the R&D, we're still spending quite an R&D. We have a very extensive project set. And you're right; we do have the buyback in place, out certain place largely that recovers the dilution from the stock option programs.

And basically a carry forward from the buyback that we announced, I believe it was last year and so then on the capital spend side, we are just wrapping up our building in the UK, which is a very significant expense in the quarter, it was a little bit -- a little more than $10 million of the 20 million was spent that area alone. And at that point, most of our scale is complete and for at least the foreseeable future.

So, I think from a CapEx perspective, you'll see the CapEx moderate in 2010.

Christian Henry

We have no other material building programs underway, you were taking some small incremental space first or San Diego but that's routine, so resold improvements nothing significant in the next year to 18 months.

Jay Flatley

And then our strategic investments Tycho, that's probably better, we don't really kind of signaled those until we make them, but of course we're always looking a technology opportunities, with me moving into my new role, it's going to give us an opportunity to focus a little more deeply in that area, so stay tuned.

Operator

A question from a line of Isaac Ro, Leerink Swann. Please proceed. And your line is open, if you've muted your line, please unmute your line.

Isaac Ro - Leerink Swann & Company

Sorry. Thanks, for taking the questions, just looking at the fourth quarter guidance of 155 million in reps. I just want to make sure that where do you see that number excludes any impact from the larger orders we talked about last quarter. I think you mentioned that you had coupled potentially $40 million size orders, it was a multitude caused by the $10 million size orders, potentially out there, was a stimulus.

And I want to make sure the extent to which you pulled all those types of potential orders out of the expectations at this point. And then maybe the extent to what say might provide optionally the upside should they materialize this quarter?

Jay Flatley

Yeah. We clearly think what we said that there were some grants as large as $40 million. And clearly, somebody got to grant all that money, wouldn't necessary go to us. But there was some large grants in the queue, as we seen reported, since the end of the third quarter. And what we've done is we've factored in some expectations of what might happen statistically across that set of grants for the fourth quarter.

But in general, what we've seen is a little slower processes than I think many people anticipated six months ago with the commitments really coming around the end of the third quarter. And some dribbles of money hitting researchers now. And so, it's hard for us to predict any specific grants for fourth quarter revenue and so we haven't included any specific, but rather taken some statistical expected value across the whole opportunity set.

Operator

And we have a question from the line of Dan Leonard, First Analysis. Please proceed.

Dan Leonard - First Analysis

Hi, good afternoon.

Jay Flatley

Hi.

Dan Leonard - First Analysis

So, I guess my question is why this point didn't you more visibility and which you will capture from the stimulus, given that a lot of grants -- have been awarded and since there was somebody's requesting an instrument, my understanding is often times on the instrument on plus.

Jay Flatley

We have very creditability at that level. So we have been through every single grant that's been awarded. We have analyzed, we've read every abstract, we've categorized them, we know which are arrays, which are sequencing, which ones have Illumina's name in them, which ones don't. So that parts on ambiguous now, at least for the first half of the committed grants. What is ambiguous is the timing and so we don't know when those grants will transfer into orders for Illumina.

And all of them or many of them have to go through administrative processes, there is institutions, there is negotiation periods to get the orders closed and in some cases there is revenue recognition issues. So whether they fall into Q4 or into 2010, this is where the largest uncertainty is.

Dan Leonard - First Analysis

Okay. And then from my follow-up question on the sequencing consumables issue again, how is the fourth quarter revenue impact twice the third quarter level?

Jay Flatley

Because we start shipment of reagent kits probably around the third week of September, somewhere in there. And into fourth quarter, we started shipping last week and so we had more aggregate weeks of hold on those reagent kits in the fourth quarter and the greater number of customers affected as the problem went forward.

More time, and more customers. The other factor of course is that for some of the customers that were affected we're now supplying them with replacement kits, the ones they had issues with. And so for the next weeks, they'll be running one in the factor three kits.

Operator

And we have question from the line of Zarak Khurshid, Caris & Company. Please go ahead.

Zarak Khurshid - Caris & Company

Yes, Zarak Khurshid, Caris & Company. Good afternoon guys. Thanks for taking my questions.

Jay Flatley

Hey, Zarak.

Zarak Khurshid - Caris & Company

I'm curious about the array roadmap, so to get to the 5 million variants engineering wise, what do you actually have to do differently to the OMNI chip?

Jay Flatley

It's straightforward, so there is no technical risk there. It's a factor of content timing. We already have the OMNI-Quad chip which in affect has that number of markers on it and so we simply have to change the gasket into make that into a 5 million variant arrays. So there is no change required on the ship format, simply changing the gaskets. What we do, of course have to do is decide on the content. And then simplify the algos and make that equal. So there is some timing, sequential timing until we can actually get the array manufacture.

Zarak Khurshid - Caris & Company

Okay. That's helpful. And then as a follow-up just for fun I'll ask about the reagent issue again. So, does this miss that change anything with respect to the plan GA throughput improvements for this year or next year? Thank you.

Christian Henry

We don't think it will have a material impact, we were slowed down a little bit in our testing, in our R&D, but we think that is going to be measured in weeks not months. So it could been delay by some number of weeks, but this s not material.

Operator

We have a question from the line of Davis Bu, Goldman Sachs. Please proceed.

Davis Bu - Goldman Sachs

Hi, thanks. I had a question and then follow-up. Kind of related to the mix of businesses. The first is on the tax side, so if I understand that the reason that the

tax rate was a little bit, was that because of the manufacturing outside the United States and the Singapore plant, and if so longer term, do you have plans to ship sequencing products -- manufacture sequencing products outside United States?

Christian Henry

Yes, you are right. Most of our sequencing products, actually all of our sequencing products are manufactured either in California or some components are manufactured in the UK and consequently as the sequencing business has become a greater proportion of our total income relative to our expectations, the tax rate's gone up accordingly, because we're not getting the benefit of Singapore. It is our intention to move more and more products to Singapore and we're doing that in a step wise fashion, basically looking at the highest value products to keep moving to Singapore, so in 2010, you'll start to see some of our sequencing products be manufactured out of Singapore.

And also remember that the tax rate this particular quarter was a little bit higher because we had to make a catch up adjustment, basically a year-to-date adjustment given where we're forecasting the sequencing business, or the income from sequencing to come out relative to the array income at this point.

Davis Bu - Goldman Sachs

Thanks. And on a related matter, I was wondering if you could give us some color on what the mix looks like this past quarter and what it can look like in 2010. And is there are any other downstream affects other than tax, for instance on margins or anything else that we should be thinking about in terms of the mix of businesses?

Jay Flatley

Yeah. We don't typically break out the each of the different product areas. One thing we didn't say in my remarks was that array consumables are still higher than sequencing consumables, but of course on the year-over-year basis, sequencing consumables grew over a 100%. So the sequencing business is definitely in a gaining on the array business right now, but we don't breakout the specifics.

Operator

And we have a question from the line of John Groberg, Macquarie Capital. Please proceed.

Jonathan Groberg - Macquarie Capital

Hi. Good afternoon. Jay, can I just understand this migration again and so someone buys an OMNI chip, do they then have to buy the two supplemental arrays and may come behind it or how is the price, how does this work from like a pricing standpoint?

Jay Flatley

They don't have to buy them, but they have the opportunity to buy them. So, some who really chip, every only chip that a customer buys, they can then buy the follow-on supplemental chips. And those supplemental chips are not the 2.5 and the 5. They are the incremental piece, to get you to 5.

So, they essentially have the right to buy those incremental chips. And a total aggregate cost all the way through the process and slightly less than it got the 5 amp.

Jonathan Groberg - Macquarie Capital

Okay. So, it's all end of cost of doing that to them is something it would less than if they waited for the just for the 5 amp?

Jay Flatley

Yeah. That's right and we've done explicitly to try to capitalize the market to get going here and to not to wait. Because there are great discoveries waiting to be made on every incremental content that becomes available from thousand genome program and we didn't want to happen as earlier question alluded to for 5 million variant chip to get started. And so that's marketing program is intended to address.

Operator

There we have a follow up question from the line of Derik De Bruin, UBS. Please proceed.

Derik Bruin - UBS

Did I message or did you give us the brief breakout for instruments and consumalres in the other in terms of specific by 61 million for the instruments, I didn't get the change for the other.

Jay Flatley

Yeah consumables revenue, I believe was 87 million.

Derik Bruin - UBS

Okay. And the other about 2.7 million.

Christian Henry

Yes, give or take.

Derik Bruin - UBS

Okay, did you know whether I got a couple of question from clients out wanting to know where the source of the raw materials were?

Christian Henry

We're not going to disclose that.

Derik Bruin - UBS

Okay. Thanks.

Operator

We have another follow up question, this is from the line of Doug Schenkel. Please proceed.

Doug Schenkel - Cowen & Co.

I have a -- I guess three, what I think, well two quick follow ups and I guess the third one which may take a little bit longer. Can you guys just talk about and I apologize if I missed it. What's the expected negative gross margin impact in the fourth quarter specific to reagent issue?

Jay Flatley

Dough, we've already taken a warranty for it. So from a warranty perspective, we've already taken that accrual. From -- if we achieve, I guess what you need to look at is the guidance we actually gave was 69 to 70% for the quarter and for the year.

So I don't expect it to have a big impact on the quarter.

Doug Schenkel - Cowen & Co.

Okay. And then when do you expect the GA annuity string to rebound and what direction are you assuming for Q4 and I guess in terms of what's incorporated into guidance. I am just trying to get out, whether we should be thinking about the annuity string dropping a little bit sequentially and bounce back?

Jay Flatley

A little bit because we had a couple of weeks here with actually we shipments to some many large customers and there sort of and gradually get back into this and there will be running some warranty reagents, and so there will be some impact. But if you were to say start to map around in the middle of November, I think then will be back up to a run rate, we would expect.

Doug Schenkel - Cowen & Co.

And then Q1 were back to normal 200 plus.

Jay Flatley

We have been saying 150 to 200. You are right, in the second quarter we were closer to that, at that high end and we didn't at that high end.

Doug Schenkel - Cowen & Co.

Okay. And last one, not to rub -- in the room here but this the second quarter in a row where you have missed and this time based on the emails I am getting there is lot of frustration about, the lack of visibility and questions about whether you should have preannounce or not; given this and I am sure this doesn't come as a surprise to you, can you please talk about how comfortable with the target you are relative to the past two quarters?

Jay Flatley

Yeah and I can understand why people are frustrated and we're frankly frustrated as well. I am clearly not happy with our results and our ability to forecast. We've done everything, we know how to do to get clarity around the impact of stimulus and the reduction in GWAS.

We've done, I think everything we could have done to get a handle on that and it just didn't turnout exactly as we had hoped here as we had assumed. I think the guidance that we gave is the most responsible guidance that we could come up with, as a minimum number we think that there are ways to have upside to that number but our visibility under degree to that upside is limited and that's why we choose interestingly to not give a high end of the range as we typically do.

And we didn't want to bound it very narrowly, because we thought that might indicate that, more procession in the forecast and in fact we do. So what we think the 165, minimum numbers, the most responsible number that we could arrive at.

Operator

Okay. Ladies and gentlemen, this concludes the question and answer session. I would now like to turn call back to Peter Fromen for closing remarks.

Peter Fromen

Thank you, operator. As a reminder, a replay of this call will be available in the web cast format in Investor Relations section of our website as well to be dial on instructions contained in today's earnings release.

Thank you for joining us today. This concludes our call and we look forward to our next update in February, close of the fourth quarter.

Operator

Ladies and gentlemen, this concludes today's conference. Thank you for your participation. You may now disconnect. And have a good day.

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Source: Illumina Q3 2009 Earnings Call Transcript
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