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Affymetrix Corporation (NASDAQ:AFFX)

Q3 2010 Earnings Call Transcript

October 27, 2010 5:00 pm ET

Executives

Doug Farrell – VP, IR & Treasury

Kevin King – President and CEO

Tim Barabe – CFO and EVP

Analysts

Ross Muken – Deutsche Bank

Dave Clair – Piper Jaffray

Marshall Urist – Morgan Stanley

Isaac Ro – Goldman Sachs

Derik De Bruin – UBS

Julie Collins [ph] – Robert W. Baird

Brigham Hyde – Cowen and Company

Dwayne [ph] – Macquarie

Operator

Greetings and welcome to the third quarter earnings conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host Doug Farrell, Vice President of Investor Relations for Affymetrix. Thank you. Mr. Farrell, you may begin.

Doug Farrell

Thank you, operator. Good afternoon, everyone and welcome to the conference call. At the close of the markets today, we released our results for the third quarter of 2010.

Joining me on the call today is our CEO, Kevin King, who will provide a commercial and operational update. Following that, our CFO, Tim Barabe, will provide a detailed review of our financial results for the third quarter. As a reminder, today's call is being recorded and the audio from the call is being webcast over the Internet on our homepage at affymetrix.com.

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

These risk factors are discussed in Affymetrix's Form 10-K for the year ended December 31, 2009 and on other SEC reports, including our quarterly reports on Form 10-Q. We encourage you to review these documents carefully as forward-looking statements are made as of today's date and we make no obligation to update this information.

So with that introduction, let me turn the call over to Kevin.

Kevin King

Good afternoon, everyone. We continue to make steady progress in the transforming of our company through commercial, product development, and operational efforts that have resulted in significant operating gains over the prior year.

As you know, we have been executing on a strategy that diversifies our product revenues from largely academic research markets to markets that are less dependent upon government funding than the clinical validation and routine testing segments. To achieve this, we've redirected our R&D investments to address opportunities, including the development of new copy number and genotyping assays and new instruments, coupled with high throughput array formats.

On the operating side of the business, we have achieved 6 points of improvement in product gross margin and a 12% reduction in total operating expenses that have resulted in $25 million improvement in operating income for the first nine months of the year. We have also strengthened our balance sheet by repurchasing about $100 million in convertible debt.

Before turning the call over to Tim for a review of our third quarter operating results, I'd like to discuss how our year-to-date product revenues are being influenced by new product adoption, pricing, and volume trends.

We have been able to generate good end-user demand for our array products, as measured by sustained double-digit volume increases for the last three quarters. Much of this growth is the result of new products targeted at high-volume applications. During this period, the pricing of our legacy DNA and RNA products have remained relatively stable.

I'll take a few minutes to give you an update on our consumables and instrument trends. Within DNA, over the past several quarters we have significantly expanded our DNA product offerings by providing a new platform that addresses the need for validated SNP content for whole-genome and targeted genotyping applications. We have also created new clinical research assays that address the perinatal and cancer copy number analysis markets.

Within our DNA portfolio, our cytogenetic products, whole-genome custom and targeted genotyping products are the fastest growing product lines. Compared to the first nine months of last year, total DNA product volumes have increased over 20% and total revenues were up 16%.

Axiom adoption has steadily increased throughout the year and now represents 40% of our total DNA volume. In addition, roughly half of that volume is Axiom custom array designs. We believe this initial success has been driven by the unique ability of our customers to design high content arrays and attractive price per sample.

As you know, Axiom leverage is a growing database of validated content and includes the latest discoveries from the 1000 Genomes Project. As reported previously, we have expanded our Axiom custom offerings to include genotyping arrays with as few as 50,000 markers per sample to an upper range of 2.6 million markers per sample. We believe the Whole-Genome Association market has slowed in the latter part of the year, as customers are now only beginning to access newly available rare SNP contents. Looking forward, we believe the availability of this content will be a catalyst for new association studies.

In cytogenetics, we are experiencing broader adoption of our products that include our 250K, SNP 6.0, and our Cyto 2.7M. We are encouraged by the guidance that the American College of Medical Genetics issued on September 28th that recommends arrays as the first-line test over traditional karyotyping.

The ACMG's recommendation was driven by their conclusion that the increased resolution of microarray technology over conventional cytogenetic analysis allows for identification of chromosome imbalances with greater precision, accuracy, and technical sensitivity. We think this is an important milestone in establishing arrays as the gold standard for cytogenetic analysis and accelerating their adoption in this large market.

Our revolutionary new offering, the OncoScan FFPE service offering for cancer research and the development of important new cancer test is gaining broad support among leading cancer centers and key opinion leaders. We have signed agreement with several big important pharma companies, as well as academic customers that want to access this technology.

Oncologists believe the detection and measurement of copy number changes within cancer samples will be an important tool in the prognosis and treatment selection of cancer patients. The OncoScan assay has been extensively tested at leading cancer centers, including M. D. Anderson, University of California at San Francisco, and the Huntsman Cancer Institute at the University of Utah.

Customers describe the value of OncoScan as twofold. First, OncoScan has unique ability to provide a one-stop shop approach to the assessment of cancer samples by providing three genomic measurements and one whole-genome assay. Secondly, the method of choice for archiving patient biopsies and tissue samples is FFPE, a process of formalin fixation and subsequent storage in paraffin blocks.

Large tissue banks containing millions of stored FFPE cancer samples exist all over the world and until now, have largely been inaccessible for analysis due to variability in storage methods, coupled with sample degradation that occurs with age. Importantly, these samples are generally clinically annotated with longitudinal patient outcome information that if unlocked could accelerate the medical community understanding of the progression of cancer affecting patient populations.

OncoScan has been validated on thousands of stored samples, some up to the age of 28 years old. I would like to share the experience of Dr. Joshua Schiffman, the Associate Professor of Pediatric Hematology and Oncology at the University of Utah.

The OncoScan assay enables oncologists to assess all relevant cancer measurements in one simple assay, including copy number, loss of heterozygosity and mutation information that is needed for stratification, therapy selection, and discovery of new cancer signatures. And given its outstanding performance and age FFPE samples, OncoScan has the further potential to accelerate large-scale studies of thousands or tens of thousands of patients, ultimately accelerating our understanding of an approach to cancer treatment.

Within RNA, as in DNA we have diversified our RNA portfolio with an emphasis of developing a broad range of products for use in validation and routine testing. Our portfolio of RNA products now ranges from whole-genome arrays that measure gene function, splice variance and transcripts to assays that measure single transcripts within individual cells.

We believe our RNA products are highly relevant to the scientific community and provide unparalleled pricing performance compared to competing technologies. We expect the research as only portion of this business to continue to grow in the low-single digit range in the future.

We continue to see gene expression volume increases in the double-digit range through the first nine months of the year. Key drivers include increased adoption of gene and exon products, new applications, and lower-priced IVT products to offset competitive threats at the low end of the marketplace. Average selling prices for cartridge based IVT arrays remain relatively stable.

RNA revenues for the first nine months of the year are down 4%, driven by two factors. As we reported in the second quarter, we were impacted by a slowdown in our Panomics sales as we realigned our selling channels to take advantage of increased market opportunities. I'm happy to report that our QuantiGene revenues increased over the prior quarter, indicating that our efforts to get back on track are working. Secondly, our gene expression revenues are affected by a mix shift towards new lower-price products used in validation with increased adoption of our new array plate offerings.

Last week, we filed our first 510K submission for reagents to be used in conjunction with our industry-leading Human U133 expression array. The Human U133 expression array is the most widely published array, used in studies exploring the underlying genetic mechanisms of disease and provides an industry-leading platform for the development and commercialization of unique clinical signatures.

In seeking FDA clearance for the reagents, we will enable the acceleration of developments, commercialization of FDA-cleared gene expression signature based clinical tests developed on the platform, paving the way for new growth opportunities in RNA analysis. These reagents named the gene profiling reagents are accessories to the 510K cleared Affymetrix Instrumentation System. The Human U133 Plus 2.0 array will be manufactured under cGMP and reintroduced as the gene profiling array, MDCFM which stands for medical device for further manufacture.

On the instrument side, our GeneTitan installed base has expanded globally throughout the year with adoption by existing, as well as new customers. Annualized consumable pull-through is approximately $600,000 per instrument. As we discussed previously, earlier in the year, a limited number of GeneTitan instruments were not performing at customer sites as reliably as we had expected. We elected to upgrade our installed base to achieve overall instrument reliability. We completed the majority of these upgrades in the third quarter at a cost of roughly $1 million of incremental support expense.

In addition, during the third quarter, we shipped more than half of the orders that were delayed in Q2 and we expect the remaining systems targeted for Q2 will be shipped by year-end. For the full year, we expect GeneTitan shipments to increase approximately 60% over the prior year.

In terms of our Powered by Affymetrix programs, Signature Diagnostics presented the results of their newest colorectal test, the Detector C/Plus, a whole blood-based screening tool, at the European Society for Medical Oncology in Milan last month. Using blood samples from a multi-center clinical study, Signature Diagnostics prospectively validated Detector C/Plus with high overall sensitivity and specificity. According to CEO, André Rosenthal, the test's low false positive rate of 7.5% is close to that of colonoscopy, so that large-scale use of this blood-based test can reduce the reliance on costly endoscopy procedures.

The screening population is approximately 170 million individuals. It's believed that approximately 5.1 million individuals between the ages of 50 and 79 within the U.S. and Europe have colorectal cancer. Using current approaches, only about 8% of CRC patients are diagnosed annually. The remaining 4.7 million individuals with colorectal cancer remain undetected until severe symptoms occur. As a result, Signature believes that the test is particularly well suited for population screening because of its low number of false negatives warrants its use prior to colonoscopy.

In summary, we are pleased with the progress we are making in transforming the company and recognize that there is still more work yet to do. That said, our diversified product portfolio is driving increased volume of new products in new markets and represent important growth drivers for the business. Our GeneTitan platform and array plate formats are building momentum and will help to generate improved growth in 2011 and beyond. We have also achieved important diagnostic milestones that will serve both to strengthen and diversify the business and open up significant market opportunities.

With that, I will now turn the call over to Tim for a detailed review of our third quarter operating results.

Tim Barabe

Thanks, Kevin and good afternoon. My prepared comments will include a detailed review of our financial results for the third quarter, followed by an update on our balance sheet.

For the third quarter of 2010, the company reported total revenue of $74 million compared to $78.2 million for the same period of last year. Total revenue was down 5% from the prior year, driven again by a drop in scientific services. As a reminder, much of our service business is being migrated to third-party service providers and we believe this transition is largely behind us.

Turning to the detail, product revenue was $67.3 million during the third quarter as compared to $66.2 million during the same period in 2009. Consumable sales were $61.9 million, in line with the third quarter of 2009. DNA revenue was $20.6 million, down 1% over the same period last year and RNA revenue was $37.5 million, down 6% for the comparable period. The product mix was about 60% RNA and 40% DNA. Instrument sales for the quarter were $5.4 million compared to $4.2 million in the prior year.

As I mentioned, service revenue was down at $4.9 million compared to $9.9 million in the third quarter of 2009. For the full year, services are down by about $20 million as compared to 2009. We think that this headwind is largely behind us now. Royalties and other revenue was $1.8 million versus $2.1 million in the third quarter of 2009.

We achieved net income for the quarter of $1 million or $0.01 per diluted share, which included a pretax gain of $4.1 million or $0.06 per share on the repurchase of $71.9 million face value of convertible notes. This compares to a net loss of $8.8 million or $0.13 per diluted share in the third quarter of 2009. Fully diluted shares used for the third quarter of 2010 were 69.2 million shares compared to 68.8 million in the third quarter of 2009.

In the third quarter, total gross margin expanded to 55%, an increase of about 100 basis points over the prior year. Product gross margin for the quarter was 56%, up 200 basis points. This comprised – is comprised of higher margins for arrays and favorable absorption, partially offset by increased excess and obsolescence costs. We are currently reviewing our product portfolio and evaluating low margin and low volume products, which is likely to result in continued excess and obsolescence charges over the next couple of quarters.

Turning to operating expenses, total operating expenses for the third quarter were approximately $42.5 million, down 13% from the same period last year. This is slightly lower than we had expected, primarily the result of lower legal expenses and other one-time positive items. As I said last quarter, the range of $45 million is a more reasonable run rate going forward for the company.

Third quarter 2010 R&D expenses were $16 million as compared to $18.8 million for the same period last year, down 14%. Reduced R&D expenses were the result of lower headcount, and a net decrease in spending on products commercialized during the year.

SG&A expenses in the third quarter of 2010 were $26.3 million as compared to $30.6 million for the same period last year, down more than 14%. This was the result of decreases in facilities' expenses, driven by site consolidations, as well as lower bad debt and litigation expense.

The company recorded net interest and other income of approximately $3.3 million in the third quarter of 2010, primarily due to a gain from the repurchase of convertible notes of $4.1 million during the quarter, as well as the decrease in interest expense for the period as a result of the convertible note repurchases. This compared to a net interest and other expense of $1.7 million for the comparable period last year.

For taxes, in the third quarter, we recognized income tax expense of approximately $400,000, similar to taxes recognized last year. Our income tax expense for the third quarter consists primarily of foreign taxes.

To facilitate the analysis of the company's core operating results, I would like to summarize non-core adjustments to our net loss for the quarter and their impact on pretax earnings per share.

In the aggregate, these adjustments amounted to a net $2.1 million or a $0.03 per share decrease in GAAP net income and include within gross margin, $500,000 or $0.01 per share in the amortization of acquisition related intangibles; in operating expenses, $1 million or $0.02 per share in acquisition related intangibles amortization; in non-operating income and loss, $4.1 million or $0.06 per share in interest income and other, related to the gain from the convertible notes buyback; and $400,000 or about $0.01 per share in interest income and other, related to the impairment write-down of a non-marketable investment, again, the convertible securities.

Let me now take a moment to summarize our balance sheet. As we mentioned in last quarter's conference call, we continue to actively repurchase our convertible notes. During the third quarter, we bought back an additional $71.9 million of our 3.5% convertible notes maturing in January 2038. However, those notes are puttable to the company in January 2013.

The net impact of the buyback reduced our outstanding convertible debt to around $149 million, generating a gain of $4.1 million. In total, we have repurchased $98.6 million face value of convertible debt this year, which will save us more than $1 million in net interest expense in 2010 and over $2 million annually thereafter.

We ended the third quarter of 2010 with total cash and available-for-sale securities of approximately $269.7 million as compared to $334.2 million at the end of the second quarter of 2010. Currently, our net cash is approximately $121 million and growing. In the third quarter, the company continued to generate positive cash flow from operations in excess of $4 million. Year-to-date, we have generated more than $25 million in cash flow from operations.

Third quarter DSOs were at 64, slightly lower compared to the prior quarter; capital expenditures were about $1 million; and depreciation and amortization was approximately $8.9 million including the amortization of acquired intangible assets. Operating expenses for the third quarter included $2.5 million of stock compensation expense as compared to $3.4 million in the third quarter of 2009.

Net inventory for the third quarter of 2010 was $52.3 million compared to $55.3 million in the second quarter of 2010. This reflects our continuing emphasis on improving operational efficiencies.

Through the first three quarters of 2010, we have made steady operational improvements over the same period in 2009. Product revenues grew 4%, with instruments increasing 15% and consumables increasing 4%. Product gross margins, as mentioned before, have expanded by more than 6 points. Operating expense is reduced to 12% or roughly $20 million and improved operating income at the level of income from operations was $25 million better than the same period – year-to-date period last year.

As Kevin noted, we continue to make operational improvements, reduce our expense structure, expand our gross margin, and generate positive cash flow from operations. We remain committed to returning the company to sustained profitability and enhancing shareholder value.

That concludes our prepared remarks. At this point, we would like to open the call for questions.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, at this time we will be conducting a question-and-answer session. (Operator instructions) Our first question comes from the line of Ross Muken with Deutsche Bank. Please proceed with your question.

Kevin King

Hi, Ross. Are you there?

Ross Muken – Deutsche Bank

Yes, I'm here, sorry. So, you've done a lot to evolve the portfolio and we have always seemed to diversifying and pursuing new end market segments. I mean, when do you feel like we will be at a point with the business where the mix is sort of optimized or at least we are back to a point where from a revenue growth perspective we can start to see the fruit of some of the labor in terms of some of the new product introductions?

Kevin King

Ross, this is Kevin. I think we are getting pretty close to that. We have gone from a company that was a price point company. We had a single product in RNA, IVT, and we had largely a single product in DNA as well with the 6.0 product. And now, we have got a very broad, diversified base. And almost all of those products, with the exception of the GWAS related market, seem to be growing nicely for us with the new markets, cyto, the OncoScan product, and the targeted products for Axiom growing very nicely.

And so, I think we are going to be getting closer to that revenue point in the near future here – revenue growth point in the near future. I would remind you that in Q4 and Q1 – Q4 of last year, Q1 of this year, earlier we had posted up 10% product growth in those products and – overall from a product revenue standpoint and I don't think it takes that much more to get back up there. Those are fairly achievable goals for us, given the broadness of the portfolio now.

Ross Muken – Deutsche Bank

And just from a new product perspective, if you look at some of the recent launches, is there anything sort of specifically where it's gone meaningfully different than you first anticipated, either better or worse?

Kevin King

Yes, I would say Axiom comprising a larger percentage of our DNA volume is better than we had expected. As I mentioned, it's about 40% of our DNA volume now and about half of that are custom products. I don't think that we were thinking that half of our business would be custom so quickly. And these are products that are – some of them are GWAS, but most of them are non-GWAS, some of them are population projects, the China custom chip for example is a custom array that will yield large volumes. So I would say that's a big part.

Cytogenetics is tracking very nicely to our expectations and that ACMG announcement that I mentioned, I think is going to continue to promote the use of arrays in cytogenetics research. I think that's a big one.

Early days right now for OncoScan. It's a program that was just launched, but the interest on that is really, really very strong, given the millions and millions of samples that are locked up in storage that oncologist and pathologists want to get a hold of.

Probably the largest surprise we've had year-over-year is the decline in services, the scientific services segment.

Ross Muken – Deutsche Bank

Sure.

Kevin King

And that is, I think in aggregate, probably $20 million. That goes in hand in hand with the large GWAS studies and it also goes hand in hand with a lot of capacity in the industry for customers to do these on their own. I think that was one that took us more by a surprise than anything.

Ross Muken – Deutsche Bank

Great. Thank you, guys.

Kevin King

You bet.

Operator

Bill Quirk with Piper Jaffray. Please proceed with your question.

Dave Clair – Piper Jaffray

Hi, good afternoon, everybody. It's actually Dave Clair here for Bill.

Kevin King

Hi, Dave.

Dave Clair – Piper Jaffray

Hi. I was hoping, first of all, we can talk a little bit about Europe. Have we seen a recovery there?

Kevin King

I wouldn't quite say a recovery. Europe did sequentially better than they did last quarter. FX was not as bad as it was the previous quarter. We did pull in about half of the instruments, slightly more than half of the instruments that were part of the delay that we had described in Q2. We don't believe we have lost any of the remainders and we think we are going to close those by year-end.

So from that standpoint, I think they did well sequentially. I still think the European market is still a fairly difficult market overall. I don't know if other companies on this around the quarterly calls are sharing that. I know we brought that out last time and perhaps we were one of the few companies to say that. But I think we continue to see that market to be somewhat of a challenge.

Dave Clair – Piper Jaffray

Okay. And I was hoping you could give us an update on the cytogenetics pipeline. Should we expect any of these tests to be submitted FDA in the near term?

Kevin King

We will be providing more information on our regulatory strategy in the New Year as 2011 unfolds. We've been very actively involved in this space with the FDA, but we have not yet described specifically the path that we are on and that will be coming in the beginning of the year.

Dave Clair – Piper Jaffray

Okay. And then just on the Powered by Affy program, where are we in terms of the number of partners and assays under development? And then do you expect the potential FDA regulation of lab-developed tests to have much of an impact on this business?

Kevin King

Sure. So the number of assays exceeds 60. I think we spoke about this in our Q2 call. I think it's about 64, somewhere around there. More than 15 partners that have multiple tests under development. There are five or six tests that are on the market today in either Europe or the U.S. The Signature one that I described here for colorectal cancer, Pathwork has a test for tumor of unknown origin, there is the Ipsogen test for breast cancer, and a few others.

As far as the FDA's role with – or view with respect to lab-developed tests, many of our partners are preparing for 510K submissions and are actively engaged with the FDA in order to kit and sell their products. So I think in the long term if the FDA were to change their position on lab-developed tests, these folks would be well covered, because they are planning for submissions and a vast majority of them right now that have lab-developed tests, we have to talk to them about their concerns, but I don't think I could comment on what their view is. I can only say that they are preparing for FDA-related tests.

Dave Clair – Piper Jaffray

Okay. And then just a quick one here for Tim. I might have missed this, but what was the obsolescence and excess charge in the gross margin in the quarter?

Tim Barabe

Yes, we didn't say what it was specifically, although Kevin hinted at part of it just in the GeneTitan revamping. That was part of what went in there. But our margins were slightly lower than we would have expected and that was partly because we have stopped manufacturing some low volume products and obviously, there have been some charges. But we haven’t been specific. We would expect our margins to remain lower than our goal for a couple of quarters while we clean up the rest of that and because the rest of the business has very, very healthy margins, our main product lines have very healthy margins.

Doug Farrell

So Dave, this is Doug. It might be worth noting that within expression, there is almost 400 different products that we sell. So as opposed to some platforms where there is a limited number of expression offerings, we have actually a huge portfolio that covers the full range of custom products and model organisms as well. And you can imagine some of those running cycles.

Dave Clair – Piper Jaffray

Okay. So, we should kind of expect charges to continue for a couple of quarters then?

Tim Barabe

Yes. There will be some margin pressure over the next couple of quarters.

Dave Clair – Piper Jaffray

Okay. Thanks a lot, guys.

Operator

Our next question comes from the line of Marshall Urist with Morgan Stanley. Please proceed with your question.

Marshall Urist – Morgan Stanley

Hi guys, good afternoon. Thanks for taking the question. I am jumping on a little bit late, but just wondering if you could comment on what you are seeing on the GWAS side and you have had your competitor make a significant new product launch and have you seen any impact from that in terms of your own business so far?

Kevin King

Sure, Marshall. As we said in the call here, our DNA volumes are up 20% through the first nine months of the year and revenue is up 16%. A lot of that is driven by new products like cyto, targeted genotyping, and it's our view that the GWAS market has kind of slowed down here in the back half of the year, the little slowdown in the second quarter and a little more slowdown here in the third quarter. And the reason for that I think is that customers are now just gaining access to the real variant content that's been made available by Affy, by the 1000 Genomes organization and so forth. And people are starting to gear up to study designs, design customer arrays and try to get funding.

I don't think we would say that we've been impacted competitively because of new products. We have products of equal capability or better in terms of contents, in terms of novel content and workflow and so forth. I don't – I wouldn't say that there has been share loss or anything like that. I think overall, the market has fewer opportunities right now for GWAS. We are very optimistic that that will come back as these discoveries from 1000 Genomes and other types of discovery projects need to be validated.

Marshall Urist – Morgan Stanley

Okay, great. Thanks. That's helpful. And then I was just trying to understand – I realize there is a lot of moving parts in gross margin. But have we seen a benefit of Axiom mix in gross margin at this point? I think if you could tease out how that's been relative to the – relative to all these other drivers, that would be great, and when we might see that start to come through more clearly.

Kevin King

Well, sure. Gross margins are up 5% for the total year. A lot of that is driven by the new products that we have. The peg array products are lower cost for us. We have also vertically integrated reagents on the DNA side for Axiom. And so I think those margins on a percentage basis are certainly higher than what they were for our legacy 6.0 product.

That said, we are seeing a much broader range of prices with Axiom, because we have the ability to go from 50,000 markers to 2.5 million markers per sample and there is a whole variety of price points there. So I would say on a percentage basis, margins are better. I would say on an absolute basis, it really depends upon which product you look at.

Marshall Urist – Morgan Stanley

Okay, great. Thanks. And then, again, I apologize if this was asked, but on the – you added some recent positive news on the cytogenetic side in terms of incorporating arrays into cytogenetics. And so I was – just wanted to get your thoughts on how you are kind of planning to go after that and how – are you investing or sort of repositioning in terms of being able to take advantage of that as the impact of those guidelines starts to come through.

Kevin King

Yes, very much it's a major go-to-market effort for us on the commercial side of our business. We have been at this now on the cytogenetic research side for both perinatal and cancer for the better part of a year and a half to two years. And our portfolio has grown in numbers of products. We anticipate having even further products as we go forward and the deployment of our sales team is the big issue here for us to make sure that we have call points with the appropriate people around the world, because these products are used globally. And so, the go-to-market efforts are really in full gear as we move forward here with the news from ACMG and other types of organizations.

Marshall Urist – Morgan Stanley

Perfect. And one last quick one from me. Can you give us a sense of what the average size of custom projects with Axiom have been so far?

Kevin King

Well, it really spans a very, very broad continuum. You often see customers wanting to do early proof-of-principle or POP studies and those could range from a couple of thousand samples initially and then the subsequent follow-on study could be anywhere from 5,000 to 25,000 samples. The largest study that we have right now for Axiom is Kaiser, that's 100,000 samples.

Marshall Urist – Morgan Stanley

Sure.

Kevin King

And then everything ranges in between. We talked briefly about the Chinese Han array; that is a custom product that's in the tens of thousands of samples. And so it covers the spectrum, but that's kind of the range that we are seeing.

Marshall Urist – Morgan Stanley

And I'm sorry. My – I wasn't clear. In terms of the number of markers that the custom projects are looking for, is there like an average number that you guys have seen so far?

Kevin King

I think by and large, people are pretty much filling up one peg, so anywhere from 350,000 to 700,000 is probably the sweet spot. Only recently with the introduction of the 2.5 million, 2.6 million markers are we seeing the multi-peg interest come. But of course that has a price tag associated with it.

Marshall Urist – Morgan Stanley

Right.

Kevin King

And people are generally more interested in powering a study, which means that they need more samples than they – and they are trading off content for it. So the sweet spot is probably between the 3.5 to – 350,000 and 700,000.

Marshall Urist – Morgan Stanley

Perfect. Thanks for taking all the questions.

Kevin King

You bet.

Operator

Our next question comes from the line of Isaac Ro with Goldman Sachs. Please proceed with your question.

Isaac Ro – Goldman Sachs

Thanks for taking the question, guys. Just first off on the R&D spend this quarter, Tim, I was just looking at the numbers here and it's obviously trended down throughout the year and hope you guys get closer to profitability on the P&L. I was just wondering, as we think about the FDA requirements for the diagnostic side of your business as you build that out, doesn't the R&D spending sort of comeback eventually or are you at a run rate here that you think is sustainable relative to your investments in diagnostics?

Tim Barabe

Well, I think there will be product line tradeoffs. So, we had a major R&D effort behind GeneAtlas and GeneTitan and some of the other products that have been – Axiom products that have been launched recently. And clearly, we will be investing significant R&D resources into cyto. But I wouldn't expect the overall number to trend dramatically up from where we are now. I think that we can make things work, given the way we shift our portfolio.

Isaac Ro – Goldman Sachs

Got it. Okay.

Kevin King

Yes, I would also maybe just add to that, Isaac, that the company has a very robust quality system and we've made FDA submissions in the past for instruments, for chips, and now for reagents. So, a lot of that workflow, if you will, for getting FDA registration is there. There is incremental cost associated with various study designs that you might want to do to support a clinical claim. And I think that's largely where Tim's reference about the tradeoff would take place.

But from an infrastructure standpoint, we have got a robust system here of work processes, documentations, ability to have traceability and so forth. That exists, the incremental investment isn't supporting the clinical claim.

Isaac Ro – Goldman Sachs

Got it, thanks. And then just secondly on the gross margin piece, I know you guys have recently talked a little bit about sort of your long-term goals for gross margin. Can you maybe talk about how the dynamic you are seeing right now might move some of the timelines for getting to those mid-60 gross margins over the next couple of years?

Tim Barabe

Well, I think we are still committed to getting above 60% over the short term. But we will have some charges, excess and obsolescence over the next couple of quarters as we really prune and bring efficiency to our manufacturing process. But we think it's imminently achievable to be in the mid-60s longer term

Isaac Ro – Goldman Sachs

And in the short term, like 60% for this year, is that still feasible?

Tim Barabe

Excuse me, what percent?

Isaac Ro – Goldman Sachs

60%.

Tim Barabe

Yes. I think at this point in time, we said 56% was the third quarter number and we think that it's not going to be dramatically above that for the next quarter of two. But then we expect to get back on track.

Isaac Ro – Goldman Sachs

Got it. Okay, great. Thank you very much.

Operator

Our next question comes from the line of Derik De Bruin with UBS. Please proceed with your question.

Derik De Bruin – UBS

Hi, good afternoon.

Kevin King

Hi, Derik. How are you?

Derik De Bruin – UBS

Good. I guess, can you just – how much of your DNA and RNA products are still what you would consider legacy products? What percentage of the overall business is still legacy?

Tim Barabe

So, legacy in terms of the product itself?

Derik De Bruin – UBS

Yes, like 6.0. I mean, things that are not – that haven’t gone through your RNA upgrade cycle, your DNA upgrade cycle. I'm just curious what is still being used in your older product offerings that are out there.

Tim Barabe

Yes. So let's see what we can try to piece together here. So, on the DNA side, we said DNA – we said 40% of our business was Axiom. And so, the remainder would be legacy products, less the cyto volume which we haven’t broken out.

Derik De Bruin – UBS

Right, okay.

Tim Barabe

So, somewhere between zero and 60% and you just got to make a swag for the cyto volume.

Derik De Bruin – UBS

Got you.

Tim Barabe

On the RNA side, legacy being defined as 3-prime IVT cartridge where the portfolio now ranges from a low-cost U219 product and a peg format WT in a peg and IVT in a peg. I think that that one is probably – I'd have to swag that one, I don't know that one off the top of my head. I'd have to check that one, Derik, for you. I'm concerned that I'm going to call a number that's going to be wrong.

Kevin King

Yes, we can circle back with you on that, Derik.

Derik De Bruin – UBS

And that kind of goes to the – kind of circles back to kind of Ross' question. I mean, you are making – your top line stabilizing, your – so you believe you are getting near growth and you obviously managing expenses quite well. So I guess, at what point do you see yourself reaching sustainable profitability again? I mean – and what was the – what was like the quarterly run rate in revenue need to be?

Tim Barabe

I think that $80 million in revenue will get us breakeven. I think we can get to breakeven at $80 million, maybe a little bit less, but right around there. There is no reason why we can't be making money above $80 million.

Derik De Bruin – UBS

Okay. And I guess – I know you are not giving guidance, but in Q4, historically your strongest quarter, are you expecting similar seasonal trends to emerge this quarter?

Kevin King

Well, the – yes, it depends upon how far back you go on the season and I'm not trying to be cute with it, but I think the Q4 trend for us that we saw maybe three plus years ago where there was a big pharma bolus, we haven’t seen in the last two years.

Derik De Bruin – UBS

Right.

Kevin King

So if you sort of you look at what's happened last year and maybe the year before that, I'd have to go back and think about those numbers. Q4 tends to be a –seasonally be higher spend overall for customers. So – yes, I think so. But I wouldn't say that there is going to be a big bolus of industrial spend by pharma.

Derik De Bruin – UBS

Okay.

Kevin King

And you know that as well as I.

Derik De Bruin – UBS

Right. Yes, I just was making sure I wasn't going to miss anything on that. Okay, thank you very much.

Kevin King

Okay. You bet, thanks.

Operator

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

Julie Collins – Robert W. Baird

Good afternoon. This is actually Julie Collins [ph] in for Quintin.

Kevin King

Hi.

Tim Barabe

Hello.

Julie Collins – Robert W. Baird

Most of my questions have already been answered. But I have a couple product questions. So very, very recently results of the 1000 Genomes pilot data just came out of Nature [ph]. Can you provide a timeline for how long it would take for – to incorporate some of this new data into population-specific arrays or making it available on the database for custom arrays?

Kevin King

Yes. Actually, we have been doing this now for the better part of the year with the prior releases of the 1000 Genomes data. It's not a lengthy process, it's probably measured in a few months, certainly under a quarter to – for us to get the data, design an array or a plate if you will, run the samples and analyze the information bioinformatically and that's all done in-house. So a couple of months is probably the turnaround time for us to validate what are thought to be polymorphisms to validating those polymorphisms that are real, as well as work well with our assay.

Julie Collins – Robert W. Baird

Okay. And then can you provide an update on timing for the release of the 5 million arrays?

Kevin King

We haven’t done that. We actually have a 5 million plus product offering right now, a service level offering that we allow customers to access. So in some cases, customers have study designs or ideas and they don't know which steps to use. We allow them to take any combination of about 5.2 million or 5.4 million SNPs, we put them on a series of plates and run them for them to create subsequent targeted custom panels. And we've got a couple of examples of people using that now. We have not formalized, however, any $5 million product program announcements at this time or given any timing on that.

Julie Collins – Robert W. Baird

Okay. And can you give any really color on how the QuantiGene launch is going?

Kevin King

Yes, QuantiGene, the former Panomics company product line, has done extremely well for us this quarter relative to last quarter. In the second quarter, we had a disruption with respect to our distribution channel. We took a series of actions to get ourselves back on track. We did see subsequent growth. We didn't spell out specifically what it was, but that product offering grew quarter to quarter from second quarter to third quarter.

The adoption of that product is very widespread in the industrial segments, as well as increasingly in the academic area and it's a long – three product lines, there is a Procarta product for measuring cytokines is doing quite well; the QuantiGene Plex product is growing very nicely, particularly in the industrial side; and increasingly the QuantiGene View product, this ability to look at single transcripts and single cells is getting – taken up by the cancer community and academic medical centers, regenerative medicine marketplace in a big way. So we are hopeful that this product is going to continue to grow nicely into the future.

Julie Collins – Robert W. Baird

Okay, thanks a lot. Great, thanks for taking my question.

Kevin King

Okay, Julie.

Doug Farrell

Thank you.

Operator

Our next question comes from the line of Brigham Hyde with Cowen and Company. Please proceed with your question.

Brigham Hyde – Cowen and Company

Hi guys. Thanks for taking the question.

Kevin King

Sure.

Brigham Hyde – Cowen and Company

In Q2, you guys came up a little bit light of your instrument expectations that was part of the miss. And then you pointed now to the lengthening of the purchase cycle rather than a deterioration in demand relative to kind of the expectations for the year. So if the Q2 miss is simply a function of extended cycle, when we think about this Q3 result in terms of instruments, what part of that was this catch-up? And I guess trying to overlay that one, thinking about Q4, what's underlying demand and what's this kind of backlog, if you will, from Q2?

Kevin King

Yes. So Brigham, in the prepared remarks we talked about the success we had in closing slightly more than half of the orders that we had identified in Q2. We closed those orders in Q3. Now, not all of those orders turned out to be capital purchases. Some of them ended up being converted into reagent rental where customers were having difficulty getting capital dollars, but they could afford the operating side, so they converted to a reagent rental program. So a little bit more than half are converted.

Looking at our pipe – and we have studied this very carefully, we don't believe we have lost any business, that is that customers have decided to do something else. It's been protracted, we think we are going to close the Q2 orders by the end of the year that were remaining and plus our usual pipeline of instruments continues to grow going into the fourth quarter and into – up until the middle of next year where we have good visibility.

Brigham Hyde – Cowen and Company

Okay, great. So I mean, is it fair to say that if we take what was the instrument miss in Q2 and kind of spread that over the second half of the catch-up and then again meet some kind of underlying demand there?

Kevin King

Yes, that plus, I think the second half demand is growing as well. I don't think it's just taking the second half and spreading it. It's spreading it, plus the growing demand. As the product gains more traction in the marketplace, as the menus expand, new products get added and so forth, but more and more customers are interested in the product line.

Brigham Hyde – Cowen and Company

Great, that's really helpful. And one last one. Julie touched on kind of Panomics and also I mentioned USB acquisition last year. Given that there is a number of competitors in the space that are ramping up in this area towards kind of PCR or other types of quantitative assays in that realm, maybe what's the niche for these products and how do you see you guys kind of winning a piece of the pie there? Is it with current customers, is it specific assays – I know you mentioned the cytokine assay, just maybe how you are thinking about that going forward?

Kevin King

Sure. There is – where the QuantiGene assay performs extremely well are in a couple of areas. One is in the formalin-fixed paraffin-embedded samples. So anything to do with a degraded sample or something that's been stored, QuantiGene has been shown to work remarkably well, which is better than a lot on the cases in PCR. When customers need to multiplex beyond just a few genes up to 30 or 50 genes, the QuantiGene products have a unique capability there.

From a workflow standpoint, the QuantiGene assays required no amplification or purification. So the results are both more precise and the workflow was easier and so, customers that are doing high throughput samples find that this workflow is ideal for them.

And so, what are the areas? siRNA, so these RNAi knockdown studies that are used drug development is a big application for us. High throughput screening of drug compounds in the pharmaceutical industry is a big application. As people are looking at single-cell detection in both regenerative medicine as in – and in cancer where they are trying to sort out single cells from sort of a mixture of cells, we have unique advantages.

And collectively, all of those capabilities are unique to QuantiGene that we really don't think that the PCR market or technologies really play a role in coming close to that level of performance.

Brigham Hyde – Cowen and Company

Great. Thanks a lot.

Kevin King

You bet.

Operator

Our next question comes from the line of Jon Groberg with Macquarie. Please proceed with your question.

Dwayne – Macquarie

Hi, good afternoon, gentlemen. This is actually Dwayne [ph] filling in for Jon.

Kevin King

Hi, Dwayne.

Tim Barabe

Hi, Dwayne.

Dwayne – Macquarie

Congrats on the quarter. I guess I'm dying cleanup here, so I'll make it fast. Just looking at kind of the consumable revenues for the quarter in RNA and DNA, there is a nice sequential increase, but on an absolute basis, it still seems a little bit below the first quarter. And just looking at DNA first, you kind of made up some shipments in the GeneTitan. When do we kind of see the consumable stream come on for some of these additional shipments and is this something that's going to steadily increase through the end of the year or where some of the shipments kind of later this quarter so there should be some sort of step function 4Q?

Kevin King

Yes. So related to – specifically related to GeneTitan volumes on DNA?

Dwayne – Macquarie

Yes.

Kevin King

Yes. So, our GeneTitan DNA volumes have been increasing 30% to 35% on a compound growth rate per quarter. And so that's steadily increasing and the outlook for that is it will continue to do that. So we are starting to see more and more utilization of those systems. And as I said right now, the annualized consumable pull-through was about $600,000. So you can kind of do the math on what you think of sample costs and get an idea of that volume, as people ramp up. People don't get those systems installed and hit 100% capacity right away.

Dwayne – Macquarie

And then what's kind of the timeline from getting – in their hands and set up and when they start running them?

Kevin King

We found it really varies anywhere from a quarter to – in some cases, it's two or three quarters. And it really depends upon if they have a new study ready to go, if they are finishing a study they have to transfer their work protocols and so forth. Sometimes it's taken a lot longer than we thought, particularly when they are an Affy legacy customer using cartridges. So it – anywhere from three to nine months has been our transition for us and it varies from site to site.

Dwayne – Macquarie

Okay, thanks. That's helpful. And just on the RNA side, with regards to kind of the sales force rejiggering in the second quarter there, is –was that kind of complete this quarter or was – that's still going on a little bit in the first part of the quarter and should be markedly different in the fourth quarter?

Kevin King

Well, it's a continuum and this is a part of our business that is growing. And so, it's not about getting the sales force back to where it was. It's about getting the sales force to a new endpoint or to a point that will be off from [ph] a distance.

And the rejiggering that we had to do was largely around structure. We had turned the Panomics products on to our general to [ph] sales force and that was not working as well as we wanted to and we have kind of rejiggered and gone back to a dedicated channel and now, we are adding more people in that channel to sell. So the progress is steady and the progress will continue I think for the coming quarters as we continue to try to grow this business at high growth rates.

Dwayne – Macquarie

Great. So I guess you had – was the disruption that you kind of pointed out last quarter finished in the 2Q or did some of that spill over into this quarter?

Tim Barabe

We've seen recovery.

Kevin King

No, we've seen recovery. We saw sequential growth from Q2 to Q3 and I think we are getting ourselves back on track and we are going to continue to push it even further.

Dwayne – Macquarie

Okay, great. Thank you.

Kevin King

Okay.

Operator

Our next question comes from the line of Tycho Peterson with JPMorgan Chase. Please proceed with your question.

Unidentified Analyst

Hi, guys. This is (inaudible) in for Tycho Peterson. Thanks for taking the question.

Kevin King

No problem.

Unidentified Analyst

I was just – yes, I think it's been covered already on GeneTitan, but I was just trying to understand what – if you guys have any forecast for 2011 that you would want to share. You said 60% for the full year, but what's the expectation for actual instruments for 2011?

Tim Barabe

Yes, we haven’t really spelt that out yet and we are still in the stages of doing lots of planning for 2011 and so forth. So it's a little bit early for us to talk about that.

Unidentified Analyst

Okay. Thanks.

Operator

Our last question is a follow-up question from the line of Bill Quirk from Piper Jaffray. Please proceed with your question.

Dave Clair – Piper Jaffray

Hi guys, it's Dave Clair again here for Bill. I just want to make sure I have a number right. Did you say consumables were $61.9 million?

Tim Barabe

That's correct.

Dave Clair – Piper Jaffray

Okay. And then DNA was $20.6 million and RNA was $37.5 million? What am I missing there?

Tim Barabe

You are going to find that there is a gap of $3 million and change there, some protein products that we haven’t broken out specifically in the past, because they have been small enough. So there – that is – the plug to get there is like $3.8 million or something.

Dave Clair – Piper Jaffray

Okay. Thanks a lot, guys.

Operator

I would like to turn the call back over to management for closing comments.

Doug Farrell

Well, thank you very much for taking the time to join us for today's call. If you did miss any portion of the call, a phone replay will be available for the next seven days, beginning at around 5 o’clock Pacific Time. To access replay, domestic callers please dial 877-660-6853. We ask international callers to dial 201-612-7415. Now, the passcode for both is the same, 359017. Alternatively, you can listen to an audio replay under the Investors Relations section of our website. So, thank you again for joining us. Have a great day.

Operator

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.

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