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Illumina, Inc (NASDAQ:ILMN)

Q4 2009 Earnings Call

February 4, 2010 5:00 pm ET

Executives

Jay Flatley - President and CEO

Christian Henry - SVP of Corporate Development and CFO

Peter Fromen - Senior Director of IR

Analysts

Ross Muken - Deutsche Bank

Tycho Peterson - JPMorgan

Marshall Urist - Morgan Stanley

Doug Schenkel - Cowen and Company

Bill Quirk - Piper Jaffray

Jon Groberg - Macquarie

Madden - Robert W. Bair

Dan Arias - UBS

Isaac Ro - Leerink Swann

May-Kin Ho - Goldman Sachs

Dan Leonard - First Analysis

Operator

Welcome to the Fourth Quarter 2009 Illumina Incorporated, Earnings Call. My name is Chris 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 Fromen

Thank you, operator. Good afternoon everyone and welcome to our fourth 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 2010 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.

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 the risk and uncertainties that could results to results, we refer you to the document that Illumina filed with the Securities and Exchange Commission including Form 10-Q and 10-K.

Before, I turn the call to Christian, I want to let you know that we will participate in the Cowen Healthcare Conference in Boston during the week of March 8th and at the Barclay’s Healthcare Conference in Miami in the week of March 22nd.

For those of you unable to attend any of the upcoming conferences, 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 Henry

Good afternoon everyone and thank you for joining us today. During today's call, I will review our fourth quarter of 2009 financial results and discuss our financial guidance for 2010. Jay will then discuss our commercial progress and provide an update on the state of our business and markets.

In the fourth quarter we recorded $181 million of total revenue. This represents a growth of 12% over fourth quarter of last year. Product revenue was $168 million growing 10% over the prior year period led by significant growth in our sequencing products.

Our microarray business declined year-over-year, but we did recognize strong sequential growth over the third quarter led largely by growth in our whole-genome genotyping products. In January, based on management's preliminary review, we announced fourth quarter revenue of approximately $176 million.

At the time of our announcement we had excluded from revenue one multiunit sequencing instrument shipment where we had not made a final determination on revenue recognition. Subsequent to our pre-announcement, it was determined that this shipment should be recognized as revenue and was the primary factor in actual results exceeding $176 million.

Consumable revenue for the fourth quarter was $105 million compared to $99 million in Q4 of 2008. This represents year-over-year growth of 6% and was driven by very strong growth in sequencing consumables offset by a decline in microarray consumables.

Last quarter we informed you of a sequencing reagent quality issue in which we expected to have an impact on fourth quarter revenue. Originally, we indicated a potential impact on sequencing consumables of up to $15 million. Although difficult to quantify precisely, we now estimate the impact to revenue was approximately $4 million to $5 million. Nonetheless, annualized consumable pull through on the genome analyzer was still within our projected range of $150,000 to $200,000 per system.

Despite lower revenues on the year-over-year basis, microarray consumables represent more than half of our total consumables revenue. The decline relative to last year was primarily attributable to lower sales of whole-genome genotyping arrays, but was partially offset by growth in focused content arrays.

However, on a sequential basis, we did see growth in whole-genome arrays, which drove annualized consumable pull-through on iScan and the BeadArray Reader to nearly $500,000 per system. Total instrument revenue for the quarter was $61 million, compared to %51 million in the fourth quarter of last year, representing year-over-year growth of 19%.

We recognized record Genome Analyzer shipments as demand for next generation sequencing continues to grow rapidly. Although, total instrument revenue was roughly flat with the third quarter, we saw a strong growth in sequencing instrumentation, which was partially offset by lower sales of array instruments during the quarter.

Services and other revenue, which include genotyping and sequencing services as well as instrument maintenance contracts was $13 million compared to $8 million in Q4 of last year. The main driver of this growth was the increase in service maintenance contracts associated with our growing installed base of sequencing systems. The services business also grew nicely in the fourth quarter relative to 2008.

We expect services and other revenue to grow sequentially in the first quarter of 2010 as a number of large whole-genome and targeted sequencing projects are in process. Overall demand was very strong in the fourth quarter, resulting in the largest backlog in the history of the company. We exited 2009 with a backlog of approximately $228 million. A portion of this backlog is associated with the large order we received from Beijing Genomics Institute. Even excluding the BGI order, our backlog is at record levels. Typically our backlog at any given time will ship to customers within four quarters. The timing of the shipments depends on several factors including a given customer’s requested shipping schedule, which may span multiple quarters and whether the product is catalogued or custom.

Before discussing our gross margins and operating expenses for the quarter I'd like to note that we recorded a pretax amount of $16 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 includes stock compensation expense and other non-cash charges and the corresponding non-GAAP figures. I encourage you to review the GAAP reconciliation of non-GAAP measures included in today's earnings release.

Total cost of revenue for the quarter was $55 million compared to $57 million in Q4, 2008. The Q4, 2009 costs includes stock-based compensation expense of $1.3 million compared to $1.1 million in the prior year period. Excluding this expense and $1.7 million associated with the amortization of intangibles non-GAAP gross margin was 71.2%. This compares to 69.5% last quarter and 66.7% in the fourth quarter of 2008; a year-over-year improvement of over 400 basis points.

Relative to the fourth quarter of 2008, in Q4 we experienced a favorable mix of sequencing consumables improved gross margin on the Genome Analyzer and favorable absorption. From a sequential perspective gross margin increased by over a 160 basis points from the third quarter primarily due to a higher mix of microarray consumables revenue as well as a lower warranty reserve for sequencing consumables.

It should be noted that last quarter we took $2 million reserve to address the quality issues that arose within our Read 2 Sequencing kits. Pricing in our markets continues to be stable. We saw increased ASPs across all of our major instrument platforms during the quarter, both sequentially and year-over-year. With our overall microarray product line, slightly lower ASPs per sample were partially offset by substantially higher volumes within the focus content and whole-genome genotyping arrays as compared to the third quarter.

I will now discuss our operating expenses for the fourth quarter. It should be noted that due to our accounting calendar, the fourth quarter contained an additional week compared to the fourth quarter of 2008 as well as the third quarter of 2009. Research and development expenses were $40 million in the quarter compared to $28 million in the comparable period of 2008, and included $5.6 million and $3.8 million respectively in non-cash stock compensation expense.

Excluding stock compensation expense and $900,000 of accrued contingent compensation associated with the Avantome acquisition in both periods, research and development expenses were $34 million or 18.8% of revenue, compared to $24 million or 14.7% of revenue in the prior year period.

Relative to the third quarter of '09, non-GAAP R&D expense grew by approximately $5 million. Included in the $5 million was approximately $1.5 million in nonrecurring project expenses, the majority of which related to the HiSeq 2000 project. Additionally, expenses associated with the 14th week were approximately 900K. In Q1 we anticipate research and development expenses to be flat to slightly higher as we absorb new benefit rates and increase our investments in informatics, quality and process engineering.

SG&A expenses were $49 million compared to $39 million in the fourth quarter of 2008, including stock compensation expense of $9.6 million and $6.9 million respectively. Excluding these non-cash expenses, SG&A was $40 million or 22.1% of revenue compared to $32 million or 20.1% of revenue in the prior year period.

Relative to the third quarter non-GAAP SG&A expenses increased approximately $6 million and were driven by increased headcount, legal expenses and outside services. The sequential comparison is also affected by a reduction in the year-to-date accrual of variable compensation expense in the third quarter.

In the first quarter we expect SG&A expenses to be up slightly over Q4 levels as a result of increased headcount, benefit rates and legal expenses. In the fourth quarter we also recorded $10 million charge to in-process research and development associated with our acquisition of Avantome.

GAAP operating profit for the fourth quarter was $26 million. Excluding non-cash expenses outlined earlier and in process R&D expense of $10 million, our non-GAAP operating profit for the quarter was $55 million or 30.3% of revenue compared to $51 million or 32% of revenue in the fourth quarter of last year.

GAAP interest and other expense in the fourth quarter included approximately $5.3 million in non-cash interest expense associated with our outstanding convertible debt. Excluding this amount, pro forma interest and other income was $1.9 million, which includes approximately 700K in securities gains and about 100K of negative foreign currency effect due to the reevaluation of monetary assets outside the United States.

Our non-GAAP tax rate for the quarter was 33.4% compared to 36.4% last quarter. This decrease was due to an upward rate adjustment in Q3 to account for a higher than expected annual income from sequencing products in the first three quarters of the year. It should also be noted that our fourth quarter 2008 tax expense included a $2.2 million benefit from the retroactive extension of the U.S. R&D tax credit.

We reported GAAP net income of $12 million or $0.09 per diluted share, compared to net income of $26 million or $0.20 per diluted share in the prior year period. Excluding the impact of non-cash stock compensation expense in process R&D expense associated with our acquisition of Avantome, non-cash interest expense and the other items identified in our press release and net of pro forma tax expense, non-GAAP net income was $38 million or $0.29 per pro forma diluted share, compared to $39 million or $0.31 per pro forma diluted share in the fourth quarter of '08.

During the fourth quarter, we generated $61 million in cash flow from operations. We used approximately $6 million for capital expenditures, resulting in approximately $55 million of free cash flow. This compares to $36 million in the fourth quarter of last year. Q4 free cash flow benefited from strong collections during the quarter, which also helped lower our DSO to 80 days, down from 94 days in the third quarter.

Inventory balances increased to approximately $93 million in preparation for the launch of HiSeq. Depreciated and amortization expenses for the quarter were approximately $8 million.

During the quarter, we completed both of our outstanding share repurchase programs and bought back over six million shares of common stock for approximately 175 million. We ended the quarter with approximately 694 million in cash and investments.

I will now provide financial guidance for 2010. As a reminder, going forward, we will only provide annual guidance and we will now include non-cash stock-based compensation expense in our earnings per share guidance in addition to our discussion of net income and the corresponding per share amounts in our earnings release and conference calls.

Consistent with our previous calls, guidance will exclude certain non-cash charges including the charges associated with the adoption of accounting guidance related to convertible debt, the amortization of intangibles and acquisition-related charges. For additional details, please refer to the table in our earnings release that reconciles our non-GAAP guidance to the related GAAP figures.

As I highlighted earlier, we exit 2009 with a strong backlog which included a significant order to BGI. Before we discuss the specific guidance, I'd like to expand on the accounting treatment for this order. We expect to begin shipping HiSeq 2000 systems to BGI in the first quarter and we intend to ship systems in each of the four quarters of 2010.

We anticipate using operating lease accounting for the hardware purchase. This will require us to recognize revenue related to these instruments over a period of three years with the majority of that revenue recorded in 2011 and 2012. Additionally, consistent with operating lease accounting, the cost will be capitalized into fixed assets and depreciated over the term. At the end of the term, title to the instrumentation will be transferred to BGI.

As BGI uses the system, they will place orders for reagents, which will then be shipped and recognized as revenue under our normal terms. We expect total revenues to grow by approximately 20% for 2010. However, with the timing of manufacturing scale of the HiSeq 2000 and the other significant launch of schedule for later in the year, we expect revenue for 2010 to be backend loaded with higher growth in the second half of the year compared to the first.

Orderly revenue growth during the year is subject to risks associated with our ability to meet demand and recognize revenue connected with new products. We expect gross margin percentage to be in the mid-to-high 60s and relative to 2009, is expected to be impacted by new product mix over the course of the year. We expect gross margin percentages to be higher in the first half of the year and then decline somewhat as the mix shifts to newer products and trading programs are recorded for the HiSeq system.

As a result of revenues growing faster in the second half of 2010, we expect operating expenses as a percentage of revenue to be higher in the first half of the year compared with the second half. We expect non-GAAP earnings per fully diluted pro forma share to be between $0.90 and $1.

We anticipate the full year pro forma tax rate will be approximately 34% and we will incur stock compensation expense of approximately $73 million or a tax adjusted amount of $0.36 per fully diluted pro forma share. We expect the full year weighted average diluted shares outstanding for the measurement of pro forma amounts to be approximately 132 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 the question-and-answer session. Jay?

Jay Flatley

Good afternoon, everyone, and thank you for joining us today. I'm very pleased with our fourth quarter results. Revenue grew sequentially by 14% and by 12% year-over-year. We generated strong order growth in nearly every part of our business leading to record total orders and exited the year with by far the largest backlog we've ever carried as a company.

We improved non-GAAP gross margins to over 71%, delivered non-GAAP operating margins above 30% and generated $55 million in free cash flow. During the quarter, we recovered from the quality issues with our v2 cluster kits and limited the negative impact in Q4 revenue to approximately $4 million to $5 million.

We began to see the flow of stimulus funds in the quarter as we booked about $16 million in orders directly associated with [ARS] grants. We also believe that we saw orders materialize in the fourth quarter that had previously been delayed due to the anticipation of potential stimulus funding.

From a regional perspective, Europe had the best quarter of the year and we saw an improvement in the funding environment in Japan. Perhaps most importantly, we recorded strong growth in our whole-genome genotyping products that served the [G-Vas] market. We’re very encouraged by the Q4 trend in [G-Vas] but with only one quarter of recovery we’re retaining a cautious outlook for the next several quarters.

We remain confident that the future growth will be fueled by the next generation of arrays that contain a rare variant content. Looking more broadly at the microarray business, we saw an overall rebound with strong sequential growth. The 660W-Quad BeadChip was our best selling array in Q4 and nearly outperformed the HumanOmni1-Quad whose fourth quarter revenue exceeded Q2 and Q3 combined.

In addition to strong array shipments during the quarter we generated the highest quarter level for the array business in the company's history. Order growth was strong across the portfolio with several notable highlights. Orders for microarray systems were a record with strong demand for iScan, BeadXpress and automation systems to outfit high throughput labs. We had record orders for expression arrays growing 28% over Q4 of last year driven by key account wins with our HumanHT-12 BeadChips.

We had outstanding order growth for focus content arrays with strength in Ag-Bio from our Bovine and Ovine products as well as targeted human panels. Total Infinium order, which comprise all of our BeadChip based genotyping products reached the second highest level in company history.

The number of samples represented by these Infinium orders was well over $0.5 million, by far the largest number ordered in a single quarter.

In addition to this positive order trend we also launched two new products following the quarter close. In the second week of January we launched the OmniExpress. Based on Illumina's third generation array technology the OmniExpress is a 12 sample array with over 700,000 variants per sample. The content is a subset of the Omni1-Quad and incorporates optimized markers from all three phases of the [Hatham] project.

The OmniExpress’s list price at $250 per sample and we’ll begin shipping this quarter. Just as with the Omni1-Quad, researchers can begin new genome-wide associations studies using OmniExpress and later run supplemental Omni arrays with new 1000 genomes content to increase power. This new content will be the basis for the Omni2.5 and the Omni5, which we expect to launch later this year as part of our previously announced in Infinium roadmap.

In conjunction with the Plant and Animal Genome conference held in San Diego during the second week of January, we launched our next generation High-Density Bovine BeadChip, the BovineHD. This array utilizes the same substrate and third generation array technology as OmniExpress and enables researchers to interrogate over 700,000 Bovine related markers across 12 samples on one array.

Similar to the BovineSnP50, the majority of the content utilized down the array was discovered through sequencing projects conducted on the Genome Analyzer. Resulting in collaboration with major agricultural and life stock organizations in Europe and North America, the BovineHD array contains markers from more than 20 different breeds and will enable researchers to cover the diversity in Bovine populations spread across the numerous geographies.

Turning to our sequencing business, we once again recognized record shipments of Genome Analyzers during the quarter as we continue to see very robust demand. The raging issue in Q4 requires us to allocate internal sequencing resources away from other projects, specifically the development of our 95 G-kit that we had targeted to release by year end.

Earlier this month, we released our fully commercial 50 G-kits after a successful early access program. Internally, we generated runs on the GA in excess of 95G and recently rolled out the 95G kits to early access customers with an expectation of full commercial launch in the second quarter.

The progress that we made on the Genome Analyzers since it’s launch has greatly exceeded our early expectations in the technology. We come from a platform barely capable of generating one Genome data per run at the time we acquired Solexa to the point where the Genome Analyzers in the field will soon be capable of generating nearly a 100 G of data per run all in about three years.

Researchers had demonstrated sequencing runs on the GA in peer review literature with consensus accuracy read of 99.999% and raw read accuracy critical for cancer and de novo sequencing of up to 99.5%.

This unparalleled combination of throughput and accuracy has allowed us to extend our market leading position in next generation sequencing and capture critical mind share in the scientific community as evidenced by over 560 peer review publications 18 times more than its closest competitor.

As many of you are already aware, at the recent J.P. Morgan conference, we unveiled the HiSeq 2000, the next generation of Illumina sequencing technology. This system has the potential to radically transform the way sequencing experiments are conceived and performed. At launch, HiSeq is capable of generating 200G of quality culture data in a single run, enabling researchers to sequence two human Genome simultaneously at 30x coverage. This capability is ideal for cancer research as it enables the ability to pair a cancer tumor sample and to match normal on a single run.

HiSeq is an entirely new platform engineered from the ground up and delivers on the original vision of combining Illumina and Solexa’s strength in SBS chemistry with state-of-the-art optical and systems design.

HiSeq is a dual flow cell system that images both surfaces in each flow cells using four cameras at simultaneously gathered data from all four bases of DNA. By integrating line scanning technology and maximizing the camera duty cycles, HiSeq is capable of generating unprecedented throughput of over 25G per day, all with a quality of SBS chemistry, and which the next gen sequencing community has standardized.

At this level of throughput, customers can now sequence whole human genomes for less than $10,000. HiSeq also incorporated a broad development initiative to improve the user experience across our systems, and was first launched on the cBot, our next generation cluster system.

We have greatly simplified the way user float our flow cells and reagents for using hands-on-time to start a run to about two minutes. Similar to cBot, HiSeq utilizes an easy to use touch screen interface and enables remote monitoring of the run. In total, sample prep on the cBot and the run set up on HiSeq require less than 20 minutes of total hands-on-time.

We’ve also made tremendous efficiency enhancements to the data flow and processing. A real-time processing project has dramatically improved our ability to process images that come off the sequencer. In 2008, the Genome Analyzer generated 14 terabytes of data per run that had to be written to a disk drive. Through RTA, we have now reduced that to 100 gigabytes per run. So the system requires now only a desktop computer.

Similarly, we’ve reduced the alignment and mapping protocols for single genome from three terabytes down to 600 gigabytes, and once summarized the genome is reduced to about 50 gigabytes. Enormous amount of data that HiSeq generates made these improvements critical and essential for large scale analysis of genomes. At the same time we announced HiSeq 2000, we also announced that BGI had ordered 128 systems, which we believe is the largest single order ever for next generation sequencing systems.

Installation is expected to begin in the first quarter and will be completed by the fourth quarter of this year. Once all systems are installed BGI will be the largest genome center in the world with a capacity to generate data equivalent to that of 11,000 genomes per year. So we see back on HiSeq from our customers have been positive. We are in the process of running initial customer samples now and expect to share some of that data at the upcoming AGBT meeting.

At our R&D Day following the JPMorgan conference, we announced another product new sequencing product Genome Analyzer IIe. The IIe is based on the architecture of the GA and capable of generating up to 40G of data per run with a list price of $250,000 the GA IIe will target labs with lower capital equipment budgets that want access to next generation sequencing. Ultimately we believe there's a very large opportunity to continue to segment the sequencing market and address the broad set of requirements in molecular biology labs around the world.

In summary we had a great fourth quarter and saw strength broadly across our business. We generated record operating cash flow of $175 million in 2009 and returned that same amount to our shareholders by repurchasing six million shares of our stock. The market for next generation sequencing continues to show unprecedented strength and the array market is improving as we’ve gained better visibility in the funding in the U.S. We exited 2009 with a largest backlog in the company’s history and entered 2010 with what we believe to be the most exciting and innovative product portfolio in genetic analysis.

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

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Ross Muken of Deutsche Bank.

Ross Muken - Deutsche Bank

Good afternoon. So, Jay, you made the comment that sort of the early feedback on the HiSeq was positive, not surprising given the tremendous sort of innovation there. In terms of the type of customer that is initially seeming most interested in some of that feedback that you got, is it the sort of large genome center, or is it that the [core] labs, how small of a lab can you see that eventually making its way into.

Then also on the back of that, in terms of the BGI announcement, what was the response from some of the other genome centers, who typically historically were kind of in the lead from a kind of ability to generate data perspective now with BGI sort of having a fairly significant advantage, what was the thought process there from the customers?

Jay Flatley

Yes. As I mentioned Ross, we think that the acceptance of HiSeq is going to be pretty broad. Customers across the spectrum of lab sizes have all reacted very positively to the technology. They recognized the degree of innovation in the system. Certainly those customers that are in the large genome centers are looking at ways of potentially doing trade in programs to migrate their install base over the HiSeq over some period of time and we are discussing those types of programs with the larger centers. So I would say that the interest in the system is really quite broad across the entire range of the customer base.

With respect to the BGI order, I think it was a shock to lots of people in terms of the magnitude of that order, and we anticipate that many of the large centers around the world are going to go back and look for ways to try to up their investment if possible to attempt to maintain competitiveness in terms of the total overall output that they are capable of generating. That's obviously going to take some time to do, and we're anxious to see what the result of that is here over next couple of quarters.

Ross Muken - Deutsche Bank

On the array business, you saw some encouraging signs in [GWatt] in the quarter after or two, relatively weak ones. As you looked at sort of what was driving that recovery and you sort of had some time to reflect, what was sort of the key-types of projects people were focused on? Was it a certain type of customer that was coming back there? Then in terms of the early feedback on the 2.5 and the 5 and the OmniExpress, broadly, what did you hear as well from the customer base?

Jay Flatley

Well, say, if you look at the microarray business broadly, we saw strength across the full spectrum. So we did see significant demand for our focused chips. We saw a number of our brand new targeted chips. We saw a very interesting demand for, we had great response in the Bovine side of the business as well. We did see Omni-1 Quad begins very rapid sort of ascension in the hierarchy of our chips and was just behind the 660W.

I believe we actually exceeded the 660W kind of order basis, but not on a revenue basis for the quarter. So, clearly, that means customers are moving towards higher content Omni arrays, which is certain procedures what expect them to do as we move into this next round of Whole-Genome Gene loss.

With respect to the 2.5 and the 5.0, those products are not shipping yet. Customers, I'd say are eagerly awaiting their availability. We continue to work with the consortium in the 1,000 genome project to get that content solidify. We do have the content in hand now for the 2.5 and we're beginning the development process of that chip. We don't have all the content yet for the five million marker chip. Then that we'll be coming here over the next quarter or a two where we'll have all the content for the 5m chip.

So I think customers have responded positively to the roadmap as we've mentioned the economics are starting now are pretty compelling for customers.

Operator

(Operator Instructions). Our next question comes from the line of Tycho Peterson of JPMorgan.

Tycho Peterson - JPMorgan

Jay, can you talk a little bit about the go-to-market strategy for both GAIIE and then iScan HQ later this year?

Jay Flatley

I'm sorry. There was a jet going over here. What was the second part of the question?

Tycho Peterson - JPMorgan

Did you see the go-to-market strategy for both the new iScan and then GAIIE in terms of kind of going after some of those lower volume customers and how you approach them?

Jay Flatley

By the way, iScan, are you referring to what we call Harmonia the new.

Tycho Peterson - JPMorgan

Yeah. Exactly.

Jay Flatley

Yeah. Yeah. Okay. Well, we started versus sequencing, our plan all along in that marketplace has been to have different systems address different portions of the marketplace and the market divides along a couple of different axis certainly price and capital availability being one part of that throughput being another application potentially being the third and where the 2E fits is the labs where perhaps they are little more capital constraint and they don't need the phenomenal throughput that we provide on a product like HiSeq.

So the 2E fits, underway the GAIIX has been, it will be very accessible to a broader range of labs and 40G even looking back to where we were a couple months ago is still pretty high throughput. So they are going to be able to do lots of great science very economically with that product.

If you look at what we used to call Harmonia, that product which we will begin to ship in the second quarter is positioned with customers who want to begin to transfer applications over to sequencing but are significant array users.

So this will be a sequencing module that can add on to the iScan and allow customers, perhaps who do a whole-genome genotyping studies and then want to do sequencing in local regions of the genome or customers who are perhaps today using our expression arrays and want to begin to migrate their expression use over to sequencing. So we're really looking at that product as one that will target customers that are principally array users today, but want to overtime to migrate towards sequencing.

Tycho Peterson - JPMorgan

In your commentary, Jay, you talked about the strength you saw in Europe and then funding in Japan. Can you talk little bit about your visibility into those two markets? The news out of Europe this morning wasn't so encouraging. If you could just talk little bit about how you are viewing those markets over the coming years that’d be helpful.

Jay Flatley

I'm not sure I saw the news from your perspective.

Tycho Peterson - JPMorgan

It's just a macro on that kind of the default.

Jay Flatley

Yeah. Europe was very strong in the fourth quarter. We think that there were some sign of sort of funds being released from what was sort of economic paralysis for a while during the earlier part of the year. I think we did really well across the number of very important tenders, the sequencing products in Europe.

Overall, we feel really good about our European organization in terms of their ability to address the market needs there. So I guess cautiously optimistic about how Europe will perform in 2010. We did have a particularly weak European business in Q2 and Q3. If you contrast that, our business in the U.S. was more steady I'd say during 2009, and actually met the original plan this year in the US. So the US performed consistently. Europe had a dip in the middle and a very strong [structure].

Operator

Our next question comes from the line of Marshall Urist of Morgan Stanley.

Marshall Urist - Morgan Stanley

First one, I was hoping you can give us little bit more insight into the HiSeq manufacturing scale up and kind of when you think you will be at full capacity? How we should think about how that’s going to impact revenue progression over the year?

Then to follow-up on another question, I was wondering if you would be able to hazard a more specific estimate as to what percentage of the install base do you think is could potentially upgrade to HiSeq?

Jay Flatley

We are ramping pretty aggressively on the production side of this. So, we had actually put the HiSeq into production in the fourth quarter. So we have a number of units, quite a number of units in the final test process in our Hayward facility right now. We continue to believe we will begin shipping those units over the next month or two.

So we are feeling pretty good about meeting the original ramp-up plan that we had in Q1. I’d say we will reach full volume production in the second quarter of that system and feel pretty good about the supply chain and all the pieces that need to come together to get our Q2 numbers achieved.

I’d say we probably be absent some unbelievably unanticipated demand in the third quarter and probably be able to begin to supply most of the orders that come in a timely way. Then that’s also for the quarter where we will begin to actually perform the trade-ins that we are in some discussions with our customers now.

In terms of what percentage of the install base will trade up ultimately to HiSeq, it’s pretty early to tell on that. So there is a fair amount of interest on people's part to talk about what would be required to do that trade in but of course it requires access to additional capital, opens a lot then rather than trading in and we’ll just buy a new HiSeq and put it along side the GA. So there would be a full mix over the next couple of quarters and how people actually place orders there and in another quarter we'll probably know little more definitively how we expect it to roll out.

Marshall Urist - Morgan Stanley

Okay, great. Then just one more, on the backlog with respect to the micro-array business and particularly around the Genome like arrays. Is there similar strength in that part of the backlog as well and how does that so that we would be more optimistic kind of thinking about the sustainability of the gains that you saw or is that part of the reason why you are taking a more cautious view over the next couple of quarters? Thanks.

Jay Flatley

We are not going to be too granular on the backlog but you can deduce from some of the that we made, that the order rates were quite strong across the array business, and in most cases in our array market we don't ship all of the order right after we get it because often there is a delivery schedule for the array that go out over several quarters. Some of them are customer arrays that take up to a quarter to actually manufacture the first chip. So you could expect whatever backlog we developed there to be shippable over some number of quarters. So that's how we expect that to roll out.

In terms of our caution, we are just being careful to not drop too many global conclusions from one data point where we had a strong Q4 and Q4 is historically a pretty strong order quarter for us. Q1 is typically a less strong order quarter. In fact its generally the weakest order quarter of any fiscal year for us. So we are just remaining cautious about it until we see a couple of quarters of positive results.

Operator

Our next question comes from the line of Doug Schenkel of Cowen and Company.

Doug Schenkel - Cowen and Company

Let me start with one on, well I guess a couple on sequencing. Any early indicators that the segmentation approach is working? Then maybe it’s just a little too early, but I'd be interested to hear if you’ve seen anything in terms of just new customer flows or if it’s more interest from certain customers, more international interest, just any signals that suggest that this strategy is going to work?

Jay Flatley

It’s just too early to tell Doug. It's only been a couple of weeks since we announced these products, and so it will take at least a full quarter until we could draw any conclusions we think from how the strategy will roll out.

Doug Schenkel - Cowen and Company

Is that kind of what you would expect over the next couple of months, couple of quarters that if this is working you are going to see interest in sequencing from labs that may not have otherwise reached out to you?

Jay Flatley

That's certainly the hope. Labs that didn't think they can get into sequencing at all before, or were very anxious to do it and just didn't get the money, because if you recall, particularly in programs like stimulus, there were such an enormous number of grants that the actual percentage of grants that were awarded was pretty small compared to the ones that were submitted. So there may be a fallout from that where customers could now afford $250,000 where they couldn't afford $500,000 before.

Doug Schenkel - Cowen and Company

Maybe just another follow-up along those lines. You guys talked about the robust backlog you had coming out of the end of last year. Has there been any abnormal rate of converting the backlog and the early going into new orders just because maybe customers want to slow down and evaluate all the different options you guys have out there at this point?

Jay Flatley

By converting the backlog you mean, hold up shipment? Is that what you meant?

Doug Schenkel - Cowen and Company

Yes or maybe put differently, if there's somebody who was pretty close to actually placing an order for a shipment, have you seen any signs that it's taking them a little bit longer to actually move forward with the order or they are delaying a an order because now they are looking at not just one sequencing option but they are looking at multiple sequencing options?

Jay Flatley

Yes I do think there definitely some of that going on in the field right now and we expected that. We just surprised all of our customers and so they've all taken the time or taking the time to evaluate their plans and decide whether to go ahead with the G order that they would have ordered anyway or whether they are going to go buy HiSeq instead. So yeah we do expect that, it was built into our plan.

Christian Henry

Doug this is Christian. Just to clarify. The actual backlog that we quoted, our actual non-cancelable orders that we have in-house on the books that we ship every day again. So it's just to make that distinction there.

Doug Schenkel - Cowen and Company

The backlogs have got to go. It's just a matter of when it's going to happen and what we are talking about is new orders and there may be some effects on the pacing of new orders just by the fact that you have a bunch of new instruments out there, but ultimately that is something that you would expect to work through over the next quarter or so?

Christian Henry

For the most part that is right. We do have obviously customers who had orders in backlog who are now engaged in discussing with us whether they would do a trade in or not and so in some cases that is something we may decide to do and some cases not. As I've said before, that's all been taken into account in our plans Doug.

Operator

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

Bill Quirk - Piper Jaffray

Couple of questions for Christian. If we think about the gross margin guidance for 2010 and I guess I'm thinking about why it should decline in light of the last couple of strong quarters. Is this simply just the expectation guys, about the mix of products in other words heavier on the instrumentation side?

Christian Henry

So Bill, it's a couple of things, obviously instrumentation, the product mix in any given quarter is going to have a big impact, but now it's compounded by the fact that we have new products that are getting launched like the HiSeq 2000, which typically have lower gross margins when they are initially launched and then margins get better over time as we get better at manufacturing, get better at getting purchase price variances, et cetera, et cetera. So that's probably a big element that's driving the margin.

The other piece here is we are trying to factor the trade-in programs and see as these trade-in programs roll themselves out, it's difficult to predict exactly who’s going to take advantage of those programs and consequently we've taken some pretty conservative assumptions that many customers will take advantage of those, which will have some negative impact on gross margin.

So if you look at the first part of the year we are expecting gross margins to be higher than the second part, because of the timing of win, for example HiSeq’s will actually start shipping in quantity, and as Jay pointed out we won't be fully ramped in manufacturing, till at least the second quarter. So those are the factors that we have. Then of course it’s a mix between instruments and arrays as it always has been for us.

Bill Quirk - Piper Jaffray

Okay understood and then just a second accounting question. In terms of the operating lease structure for BGI, I assume that you guys aren't out actively promoting operating leases in terms of instrument deals. Having said that do you have any hurdle rate? I assume if there is other large deals potentially from the other genome centers out there that this may come into the mix again?

Jay Flatley

Yeah, I think we are not actively pursuing operating leases, I would agree with you there. I think what the way we think about it is, is that we are always evaluating each deal on its own merit, and so we'll take a look at large deals and depending on the nuance of the situation, we'll figure out what's the best alternative is for that situation.

At the end of the day, the deal has to be accretive for us and we are very focused on that and the BGI is going to be accretive to our operating margins and so it was one of those deals that made a lot of sense for us to do.

Operator

Our next question comes from the line of Jon Groberg of Macquarie.

Jon Groberg - Macquarie

Jay, I guess two questions around some new products and all these initiatives that have come out. One is, as you've gone out now and talked to your customers specifically and this might be just a little bit different way of asking questions has been asked, but as you go and talk to go your customers specifically, how do you think or what are they saying in terms of how they may go about adopting the new product, the HiSeq, kind of timing, what does that do to kind of potential GA cells in the meantime, just maybe talk about how do you think that plays out through the year?

Then the second question was just going to be on the R&D line, you guys have had a phenomenal, a long time I guess, the last two months specifically introducing new products. Is there any kind of taking off the pedal off the gas on the R&D, or is that just to continue to invest kind of at the levels you've been investing in?

Jay Flatley

As I mentioned earlier, it's a little early to draw global conclusions about the actual way HiSeq will be adopted, but we have certainly customers that have GAs now that are thinking about what does it take to convert their entire installed base over to HiSeq. So in the larger centers, they are contemplating transactions with us that may result in converting fully over. That might take six to 12 months for it to actually be implemented.

We have other customers that are hopefully just going to buy HiSeq to augment what they have in GAs and they may not buy that HiSeq this quarter they may buy it next quarter and we have some single unit customers that that may just stick with what they are doing and continue to buy GAs because they are going to be cheaper.

So exactly how that sorts out is not clear yet and we've got models that look at potential variations around our set of assumptions in each of those specific cases and I think it will take us a quarter or two to really understand how its going to roll out.

In terms of R&D, we are not taking our foot off the gas in terms of new products. As I mentioned in my script, we do have a lot of very innovative new things in the pipeline. We are continuing to work very hard on that. Having said that, in the last couple of quarters of this year R&D as a percentage of revenue has been higher than what we generally would have anticipated. Most of that has been a denominator problem in the equation because our revenue has been less than we might have otherwise hoped. So we are going to be a little bit cautious in how rapidly we add R&D particularly in the first couple of quarters in 2010.

We are making some investments in the quality organization in bioinformatics and in process engineering to make sure that we have an adequate support structure around the actual teams that are developing the products to make sure that we minimize the chances of any problems coming up in either our internal processes or quality of our products or reagents.

Jon Groberg - Macquarie

If I may just follow up quickly on the first part and as you've had these conversations and as you are modeling has, obviously it's early on into January, but since you made the announcement, has it created any kind of positive effect of customers saying, well we need to sit back and evaluate kind of what we are going to do or has it not impacted really the GA side that much at all?

Jay Flatley

Yes, I definitely think there is some positive effect and we anticipated a little bit of a pause because it was a surprise to every customer and so there make sure they take time to make the right conclusion. Perhaps you think you get more money. So there will be a little bit of slowdown on GA orders we think and we’ve planned for that. We think that may lend a little bit of volatility into the Q1, little bit into Q2 in terms of exactly when orders come in, but we are very confident in the year overall and as I said we made our plans to support that kind of anticipated small period of uncertainty. We don't think customers are going to sit around for quarters, you know they are going to probably take weeks to maybe a month or six to at least to figure out.

Operator

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

Madden - Robert W. Bair

Hey good afternoon it’s actually [Madden] for Quintin. Just a quick question going back to the long term operating model you guys showed last month at the Analyst Day. The Op margin kind of guidance range of 24 to 30 is that inclusive of stock-based comp or would I have to back that out as well?

Christian Henry

You have to back that out. That's basically on a pro forma basis.

Operator

Our next question comes from the line of Derik De Bruin of UBS Securities.

Dan Arias - UBS

This is actually Dan for Derrick. Thanks for taking the questions. On the HiSeq, just curious about whether the majority of the orders or the potential orders thus far have been for multiple units. Then for those orders that are multisystem whether the pricing discounts that you've been able to offer thus far have been in line with the early days of the GA.

Jay Flatley

Well, the initial orders that we're taking are all multiple unit orders. So the early sales we’ve constrained to customers who want to order a couple of units and that’s because we think we’ll have limited supply and as we ramp-up this brand new system in the marketplace, we want to minimize the number of the sites we have to support the new technology. So most of the orders will get here in this quarter will be multiple unit orders. The second part of the question was?

Dan Arias - UBS

Pricing?

Jay Flatley

Pricing, yeah, and the discounting on these systems is I’d call it little to none in the way of discounts and it’s a brand new technology. It’s a technology customers want to get access to. So we're not finding the need to discount the technology.

Dan Arias - UBS

Then quickly on manufacturing, apologies if I miss this, but, have you begun manufacturing the sequencing product in Singapore?

Jay Flatley

Not in Singapore. So we don’t today make any of our instrumentation in Singapore. We will begin in 2010 moving a few self assemblies over to Singapore, but we don’t have any plan right now to move full system manufacturing to Singapore in 2010.

Operator

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

Isaac Ro - Leerink Swann

First of, just, I want to make sure, I caught you guys right saying that new 95G chemistry for GAII might be available in early access during second quarter and if that’s right, just, can I presume that that is chemistry that’s only really going to be available for GAIIx? So just wondering how that would compare on a per genome cost for reagents versus GAIIe?

Jay Flatley

The 95 kits are going in the early access right now, and so, that program is rolling out. We expect full commercial availability assuming the early access [close] the way we expect full access of those kits in the second quarter of the year. So we'll call it that quarter and a half behind, two quarters behind where we had hoped to be because of the reagent problem that we had in the allocation of internal systems to solving that problem rather than working on 95G.

With respect to where those kits will operate, that chemistry and the protocols will also work on the IIe. In fact, that's what takes the IIe performance up to the 40G range. That 40G number is equivalent chemistry to the 95G number on the IIx.

Isaac Ro - Leerink Swann

Then just maybe secondly, if you adjust attrition for the arrays, if you just put extra week in the quarter, could you maybe give us a sense of what the growth in arrays was?

Jay Flatley

Yeah, I don't think the extra week really had that significant impact on our revenue, probably no impact actually given the fact that we had the holiday period. So, I don't really think we should break it out. Actually, the other thing I think is we were shut down in the last week of the year.

Isaac Ro - Leerink Swann

So as I, fair enough.

Jay Flatley

That shutdown is something we do every year by the way.

Isaac Ro - Leerink Swann

Yeah.

Jay Flatley

Yet, not something we did this year uniquely.

Operator

Our next question comes from the line of May-Kin Ho of Goldman Sachs.

May-Kin Ho - Goldman Sachs

In the last couple of weeks one of the competitors introduced something that could compete again HiSeq 2000. Can you comment on that?

Jay Flatley

Well, we don't comment a lot about competitors systems making, but I think that what we've done with HiSeq is really a step function change in the sequencing curve. We focused across the broad spectrum of performance characteristics of this system and obviously from the throughput to the inherent quality of the data to usability, user interface and price performance. So we feel really good about our competitive position in the marketplace.

May-Kin Ho - Goldman Sachs

On the stimulus, you mentioned it was above $60 million in the fourth quarter, but some of that has benefited from prior delays. So how should we think about that going forward?

Jay Flatley

Well, as we mentioned before, the total pot of money from the first half of the funds that have been released through NIH is somewhere in the range of about $100 billion that's accessible to the kind of technologies that we supply. We anticipate that we're going to have only a limited ability to know exactly which orders came from stimulus and which didn't going forward.

So I think it's going to be hard for us to have precision around what a stimulus order was say, brought into the second quarter, what was from stimulus and what wasn't. So I would say at this point that we think that total pot for us is about $100 million. That will be over mostly over 2010 and 2011. Then we expect and hope that in the second tranche of funds that comes at the NIH, that there is some additional opportunity for us.

May-Kin Ho - Goldman Sachs

I guess in the new budget proposal, there’s extra money for NIH.

Jay Flatley

Extra money for…?

May-Kin Ho - Goldman Sachs

NIH. I think that's clear.

Jay Flatley

Yeah, then the baseline budget in recommendation was positive. I think it probably wasn't as positive as people might have hoped, but it was overall more positive than it’s historically been in the past five or six years.

Operator

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

Tycho Peterson - JPMorgan

A quick question on BeadXpress, can you talk as to whether you've incorporated the Origen chemistry at this point? Then how are you looking at porting over the rest of the Origen menu, respiratory viral and some of the other products? Then, also, maybe your appetite for acquiring additional content for BeadXpress?

Jay Flatley

Sure. The Origen assays, the key advantage of that is it’s a single tube assay and very, very fast. So much faster even than our improved GoldenGate assay for BeadXpress. So over time, we will migrate most, if not all of the tests that are going to be running on BeadXpress over to use the Origen technology.

They are actually doing a lot of the work reporting their existing products over to BeadXpress, and so we're not directly in control of that part of it. All of the new products that Illumina is developing most of the new products that we're developing will be based on the Origen assay. So the panel that we talked about, for example, at R&D day will largely use the Origen assay as the platform.

Tycho Peterson - JPMorgan

I mean are you looking to partner and bring on additional content to expand that menu?

Jay Flatley

Yeah we are and we're working on a couple of fronts there. Clearly, we can supply that assay to third parties who want to build applications on top of the platform and in some cases we remarket it. So that’s one way that it will get out to the market and then we continue to look for partnerships to bring content into Illumina in areas that are consistent with our strategy and products that we might want to market.

Tycho Peterson - JPMorgan

Then just one follow-up on sequencing. With the introduction of the GAIIe, are you starting to see interest from the Ag markets and some of the other non-traditional markets for sequencing as you move down the cost spectrum?

Jay Flatley

Well, we had a fair amount of interest from the Ag markets already on the high-end and, in fact, some of the biggest players in the Ag market are very focused on the ultra high throughput, because in their sequencing very challenging genomes and they have a tremendous number of species that they want to sequence.

So, high throughput and cost is actually critically important for the large players in the Ag market. Probably what you'll begin to see, I think, perhaps, what you're alluding to is in maybe some of the smaller research labs doing work on perhaps less, some of the less important crops or animals if you get down to some species that a customer might be working on the IIe could be a very important product for that market, particularly as it gets into screening and targeting sequencing that IIe could become a very important product.

Operator

Our next question comes from the line of Dan Leonard of First Analysis.

Dan Leonard - First Analysis

Jay, has the second data release from the 1000 genomes project occurred yet and if it hasn't does that impact your thinking on 2010 array growth?

Jay Flatley

I have lost track exactly of how many they have been in total, but there's one major one yet to go that we don't have and that will be the one that will fill in the remainder of the markers that we need to the 5M. We expect that to happen sometime in the next quarter, and if that happens, I think we'll be on track. If it gets delayed beyond a quarter from now, then it probably would begin to impact the 5M part of the product line a little bit in terms of how fast it would ramp.

In terms of the overall market, we are hoping that many customers get started with either the OmniExpress or the Omni-Quad. Certainly lots of customers we hope will get started with the 2.5 even if the follow-on five million chip [slit] a couple of months that they might start with the 2.5 and then run the supplemental. So we don't think that’s going to have a huge impact on our business in the back half of 2010, but might have a little bit.

Dan Leonard - First Analysis

Then Christian, did you quantify how much of the operating expense jump in the quarter was due to that extra week?

Christian Henry

No, not specifically. I mean, we said roughly about 900K of the R&D growth was but we didn't quantify it for the SG&A.

Peter Fromen

That's all the time we have for questions today. 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 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 April following the close of the first quarter.

Operator

Thank you for your participation in today's call. This concludes the presentation. You may now disconnect. Have a good day.

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Source: Illumina, Inc Q4 2009 Earnings Call Transcript
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