Affymetrix Q4 2005 Earnings Conference Call Transcript (AFFX)

Feb. 1.06 | About: Affymetrix, Inc. (AFFX)

Affymetrix (NASDAQ:AFFX)

Q4 2005 Earnings Conference Call

January 26th 2006, 5:00 PM.

Executives:

Doug Farrell, Vice President, Investor Relations

Greg Schiffman, Executive Vice President and Chief Financial Officer

Steve Fodor, Chairman and Chief Executive Officer

Analysts:

Darryl Pardi, Merrill Lynch

Tycho Peterson, JP Morgan

Russell Gilbertson, Carris & Company

Derik De Bruin, UBS

John Sullivan, Leerink Swann

Quintin Lai, Robert W. Baird

Ted Tenthoff, Piper Jaffray

Paul Knight, Thomas Weisel Partners

Ethan Lovell, Saranac Capital

Stephen Rosten, Glen Capital Management

Operator

At this time I would like to welcome everyone to the Affymetrix fourth-quarter and year-end earnings conference call. (Operator Instructions). Mr. Farrell, you may begin your conference.

Doug Farrell, Vice President, Investor Relations

Good afternoon, everyone. Welcome to the conference call. At the close of the market today, we really our financial results for the fourth quarter and fiscal year 2005. The goal of this call is to expand on the contents of our earnings release and provide financial guidance for the first quarter and fiscal year 2006.

Participating on the call with me today will be Greg Schiffman, our Chief Financial Officer, and Steve Fodor, our Chairman and Chief Executive Officer. 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 www.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 projections. These risk factors are discussed in Affymetrix's Form 10-K for the year ended December 31, 2004, and other SEC reports, including our quarterly reports on Form 10-Q for subsequent periods. We encourage you to review these documents carefully. Forward-looking statements are made as of today's date, and we expressly disclaim any object obligation to update this information.

So with that introduction, let me call turn the call over to our CFO, Greg Schiffman.

Greg Schiffman, Executive Vice President and Chief Financial Officer

Thanks, Doug. Good afternoon, everyone, and thank you for joining us for our conference call today. Before I review the details of our operating results for Q4 and fiscal 2005, I'd like to take a moment to bring you up to date on array manufacturing. Since our earnings report in October, we have made significant progress in improving our 500K yields, which exited Q4 in the mid 70% range. We will be adding additional wafer capacity in the first quarter and throughout the remainder of the year. To meet increasing customer demand for our consumables, we are well into an expansion of our manufacturing infrastructure, which will double our array manufacturing capacity by year end 2006.

In the second half of 2006, we intend to bring our first international plant online. We have acquired a state-of-the-art facility in Singapore, which had been recently outfitted by a semiconductor company and benefits us in a few ways. First of all, it allows us to bring the plant online in the second half of 2006, accelerating production from the plant by almost a year from our original expectations. Second, we will begin to realize some of the tax benefits of manufacturing in Singapore earlier. And finally, we were able to acquire the facility improvements for substantially less than outfitting a new manufacturing facility. At about 100,000 square feet, the Singapore plant is roughly double the size of our current array manufacturing plant, and provides us with significant space which we can grow into over the coming years.

I will now move on to our operating results. In summary, for fiscal year 2005, we achieved total revenue of nearly $370 million, and product and product-related revenue of more than $350 million. We laid the foundation for continued growth in each of our business areas, opening new avenues for topline revenue growth. Steve will elaborate on this later in the call. Last, but certainly not least, we generated roughly 20% growth in our consumables over the prior year, even in the face of capacity constraints. I will now give you a line-by-line summary of our operating results for the fourth quarter and full year 2005. I will then summarize our financial expectations for the first quarter and fiscal year 2006, before turning the call over to Steve Fodor for our closing comments.

During the quarter, the Company reported net income of $24.8 million, or $0.35 per diluted share, which includes acquired in-process R&D and stock-based compensation expenses which total $9.2 million, or $0.13 per diluted share. The in-process R&D is less than our previous guidance of approximately $15 million, driven primarily by refinements in planned new product introductions, established post-closing of the ParAllele acquisition.

For the full year, the Company reported a net income of $57.5 million, or $0.84 per diluted share, which includes acquired in-process R&D and stock-based compensation expenses which total $9.4 million, or $0.13 per diluted share. Product and product-related revenue in Q4, which excludes sales to Perlegen, was $105.7 million. GeneChip array revenue reached $59.7 million, as compared to $57.4 million in Q4 2004. We posted instrument sales of $19.4 million in the fourth quarter, as compared to $25.2 million in Q4 2004. Additionally, reagent sales reached an all-time high of $12.1 million during the quarter, as compared to $9.6 million in Q4 of 2004.

For the full year, product and product-related revenue, which excludes sales to Perlegen, was $350.2 million. GeneChip array revenue reached $197.9 million, as compared to $168.2 million in fiscal year 2004. We posted instrument sales of $62.6 million in 2005, as compared to $77.3 million the prior year. Additionally, reagent sales for the year grew from $31.7 million in 2004 to $42.4 million in 2005, an increase of greater than 30%. As we expand into the array processing services business, the majority of the value of these deals is driven by the sales of chips and reagents. Going forward, we will include these service revenues in consumables with arrays and reagents.

During the fourth quarter we achieved strong consumables sales of roughly $72 million. The mix of consumables for the fourth quarter and for the year was about 70% from RNA analysis products and about 30% from DNA analysis products. Fiscal year 2005, our consumables revenue was approximately $240 million, an increase of more than 20% over the prior year. For the year, our RNA business grew in the mid single-digits, and our DNA analysis line grew approximately 90%. In fiscal year 2005, revenue from consumables accounted for approximately 70% of our product and product-related revenue. Instruments accounted for about 18%, and product-related revenue accounted for the remainder. Consumables continue to be the key growth driver for the Company.

The geographical breakdown of product and product-related sales for 2005 was 52% U.S., 30% Europe, 13% Japan, and 5% for the rest of the world. For the full year, academic revenue represented approximately 55% of sales, and industrial sales were approximately 45%, roughly in line with fiscal year 2004. Instrument revenue in fiscal 2005 was down roughly 20% to the prior year, largely due to reduced levels of instrument upgrades. Our instrument revenue in the fourth quarter included roughly 70 GCS3000 systems, of which a number were DX units. In fiscal year 2005 we shipped around 210 systems, consistent with the roughly 200 systems shipped in 2004. This brings our cumulative systems shipped to about 1375.

Royalties and other revenue were $3 million in the quarter. Royalties were up in Q4 as a result of signing a new license agreement. For the full year, royalties and other revenues were $8.3 million. Royalties consist primarily of the amortization of upfront license payments and minimum royalty obligations under existing license agreements. Other revenue is principally comprised of research revenue earned from government grants. Cost of product and product-related revenue, which excludes cost of products sold to Perlegen, totaled $30.7 million for the quarter. This generated a product and product-related gross margin of 71%, consistent with both our guidance and the prior quarter, as compared to a gross margin of 74.4% in Q4 of last year. For the full year, cost of product and product-related revenue was $96.3 million, generating a gross margin of 72.5%. For the fourth quarter and full fiscal year, the primary impact on our gross margin was the low initial yields on our 500K product.

Revenue from Perlegen was $2.8 million during the fourth quarter, with a cost of products sold to Perlegen of $800,000. For the full year, revenue from Perlegen was $9.1 million with a cost of products sold to Perlegen of $5.2 million. Operating expenses for the fourth quarter and full year are lower than our previous guidance, primarily due to reduced sales commissions and variable compensation. Research and development expenses for the quarter were $19.7 million, consistent with the $20.5 million in the fourth quarter of 2004. For fiscal year 2005, R&D expenses were $77.4 million, as compared to $73.4 million in 2004.

SG&A costs were $29.5 million for the quarter, as compared to $31.8 million in Q4 2004. For fiscal year 2005, SG&A expenses were $122 million, as compared to $117 million in 2004. For the quarter, the Company recorded a net interest and other income of $2.4 million. For fiscal year 2005, net interest and other income were $5.2 million, as compared to an expense of $8.8 million in 2004. For the fourth quarter 2005, we had an income tax benefit of $700,000, and for the fiscal year 2005, an expense of $5.1 million. This is due to the decrease in pre-tax income and reversal of our valuation allowance associated with prior net operating losses.

Let me take a moment to summarize our balance sheet. During the fourth quarter, our accounts receivable DSO was 78 days, consistent with Q4 2004. As we stated previously, we expect to see our DSO's in the mid-70 range. Inventory for the fourth quarter of 2005 was $36 million, with inventory turns of approximately 3.5. This is consistent with the Q3 2005 inventory balance and slightly improved in inventory turns. For the quarter, net cash provided by operations was $23.1 million. For the 12 months ended December 31, 2005, net cash from operating activities was $64.6 million. For the year, our cash and marketable securities balance grew to $285 million, after investing $40.2 million in capital expenditures.

For the quarter, capital spending was above our previous guidance by about $10 million, primarily due to an acceleration of outfitting our Singapore manufacturing plant, bringing some of fiscal year 2006 projected capital expenditures into 2005. To summarize our financial performance on a GAAP basis, the Company reported net income of $24.8 million, or $0.35 per diluted share in Q4 2005, compared to net income of approximately $27.1 million, or $0.41 per diluted share in the fourth quarter of 2004. For the year ended December 31, 2005, the Company reported net income of $57.5 million, or $0.84 per diluted share, compared to $47.6 million, or $0.74 per diluted share for the year ended December 31, 2004.

Before moving on to our guidance, I would like to highlight a few changes that you should be aware of for 2006. The first is the impact of expensing stock options under FAS 123R. Consistent with the majority of companies, we will not be restating prior years to reflect the historical cost of stock option expensing. Therefore, in order to make year-over-year comparisons more meaningful, we will be reporting pro forma earnings this year, which exclude the cost of equity-based compensation. For the full year, we estimate the after-tax cost of equity-based compensation will be about $11 million, or $0.15 per share.

The second factor is the year-over-year impact of acquiring ParAllele. ParAllele incurred approximately $19 million in operating expenses in 2005, of which only 3 million was reflected in our financial statements. At the exit of the year, ParAllele was on a $15 million run rate for operating expenses in fiscal year 2006. We remain committed to growing our operating expenses at roughly half the rate of revenue growth in 2006, adjusting for the growth associated with the ParAllele acquisition.

The third factor is the shift to a fully-burdened tax rate for GAAP reporting purposes. While the reported GAAP tax rate for 2006 will be approximately 35%, we expect to continue to see a cash tax rate of approximately 10%, consistent with last year. Given the material impact the new reported tax rate has on EPS growth in 2006, we believe it is important to focus on pre-tax operating profit as the more meaningful metric in measuring our operational performance. Over the next four to five years, we expect to see our tax rate decline to the low-30% range as our international operations continue to expand.

From a macro perspective, there are a couple of trends you should expect to see in 2006. Our overall revenue growth will be driven by consumables, as a result of expanding our product lines, applications, and adding new customers. We expect to see our RNA business return to a high single to low double-digit growth range, and D&A to continue to grow well above our overall growth rate.

We expect to see instrument revenue of around $50 million as we approach the end of the instrument upgrade cycle. Additionally, this year we will essentially complete the transition of our remaining subscription fee customers to volume-based pricing, resulting in about a $7 million reduction of product-related revenue. This is the last year we expect to this transition will have a material impact on our financial statements.

I will conclude my comments with our financial guidance for the first quarter and full year 2006. For fiscal 2006, we expect to see our product and product-related revenue increase by around 15% to roughly $400 million. We anticipate total revenue for the year of around $420 million, which includes Perlegen, royalties, and other revenue. We expect that revenues will be distributed consistently with prior years, with roughly 55% of our revenue generated in the second half of the year. However, we expect to see a more gradual ramp between Q3 and Q4 than we have experienced historically.

We expect to see consumable growth of roughly 30% for the year. For the first quarter, we expect 15% consumable growth, which includes the effect of having shipped roughly $2 million in upgraded 500K arrays in Q4, most of which will be processed in Q1. In addition, instrument revenues will be down by about $5 million from the prior year, which had both strong system sales and upgrades.

In total for Q1, we expect approximately $87 million in product and product-related revenue and $91 million in total revenue. Additionally, for fiscal 2006, we expect to see royalties and other revenue of around $2 million per quarter, for a total of around $8 million for the year; Perlegen revenues of $2.5 million in the first quarter and $10 million for the full year, contributing gross profit of approximately $5 million; SG&A expenses of around $33 million in the first quarter and $136 million for the full-year; R&D expenses of about $23 million in the first quarter and $90 million for the full year.

For the full year, we expect to see gross product and product-related margin of around 69%. We expect that the first half of the year will average approximately 66%, primarily due to start-up investments in our Singapore plant. By year end, we expect to see margins return to the 71 to 72% range, as our production volumes ramp in Singapore. For Q1, we are forecasting gross margin of about 68%; interest income net of around $2 million per quarter, for a total of $8 million for the full year; capital expenditures of around $65 million for the full year.

Our assumptions are based on a share count of about 75 million shares and a tax rate of 35%. Based on these assumptions, and as indicated in our press release, we expect to see a pro forma first-quarter net profit of around $6.5 million, or $0.09 per diluted share. For the full year, we expect to see pro forma operating profit of roughly $64 million, and pro forma net profit of $47 million, or about $0.65 per diluted share.

I will now turn the call over to Steve Fodor for our closing comments.

Steve Fodor, Chairman and Chief Executive Officer

Thanks, Greg, and good afternoon, everyone. Three years ago, Affymetrix was essentially a gene expression company with a leading share in the life sciences marketplace. Our attention was focused on developing new markets for future company growth. In January of 2003, we forged a strategic alliance with Roche Diagnostics that positioned us to become a key player in the high-potential market for molecular diagnostics. In June of 2004, we launched our 10K mapping array, starting a new product line, which now includes the 100K and 500K products, and created an entirely new industry in which researchers examine hundreds of thousands of SNPs simultaneously.

In just two years, this business has grown to a $90 million-a-year opportunity. Without question, each of these initiatives has created new markets and opened new revenue sources for Affymetrix. While we have made tremendous progress in expanding our markets, it has come with challenges. This was particularly clear in 2005, when manufacturing constraints and product delays prevented us from achieving some of our commercial and financial goals. In retrospect, it was a challenging year, but has highlighted areas of the organization that need strengthening, particularly in manufacturing and new product introductions.

First and foremost, we are in the process of expanding our manufacturing operations. As Greg indicated earlier, with our expansion in Sacramento and Singapore, we will have doubled our installed wafer capacity by the end of 2006. In addition, the new Sacramento facility will support next-generation high-resolution chip manufacturing, enabling us to reduce the cost of genetic information by a factor of 50 to 100. The investment we are making in manufacturing infrastructure will enable us to continue the migration of our product lines to higher density, and thus lower costs, through 2006 and beyond.

The increase in information density allows us to continue our industry-leading position by adding powerful new products such as our Human Exon and tiling arrays, which enable unprecedented research into how the human genome functions. These products would not have been possible without the ever-increasing information density we achieved through our investments in photolithographic manufacturing. In 2006, we will be expanding these product lines to include other organisms, and expect to see growth in our gene expression business as a result of these product launches. In addition, we will continue to support automation that will allow our customers to expand the scope of their research, particularly in downstream pharmaceutical applications, including toxicology and clinical trials.

Our ambition in DNA analysis is high. In 2005, we firmly established Affymetrix as the industry leader, generating more than $70 million in consumable sales alone. We set the standard for whole genome association studies with the launch of our 500K mapping array, and now offer the broadest product portfolio in the industry. We also completed our acquisition of ParAllele BioScience, opening new avenues for revenue growth, driven by their highly-complementary assay technology. We launched a half-dozen new ParAllele-based products over the last month, and in 2006 will significantly expand the product offerings of this innovative technology. We expect that these innovations will continue to drive strong growth in the expanding genotyping market for years to come.

In molecular diagnostics, we have added several new companies to our growing list of Powered by Affymetrix partners. Additionally, we have now sold 85 diagnostic systems, and continue to build critical mass in this important market. We look forward to helping our partners, including Roche, Veridex and bioMerieux, to commercialize the ever-increasing portfolio of gene-based diagnostic products. Recently, we announced the formation of Affymetrix Clinical Labs, which will drive adoption of GeneChip technology into the clinical and diagnostic markets. While we don't expect significant revenues from Affymetrix Clinical Labs in 2006, we do expect to stimulate additional growth in consumables, as researchers work to validate biomarker signatures for broad diagnostic applications.

In summary, for 2006 we will focus our efforts on growing the markets for the product portfolios launched in 2005. These include new state-of-the-art products such as ParAllele-based products, 500K, all Exon arrays, and whole genome tiling arrays. We will work with customers to make certain they are successful as they ramp up their high-volume studies using our technology. We are also expanding our customer base through application development and geographic expansion, including increased sales support in China. We believe these new products and initiatives position us well for growth in 2006 and beyond.

At this point, we would like to open the call for questions.

Questions & Answers

Operator

(Operator Instructions). Our first question comes from the line of Darryl Pardi with Merrill Lynch.

Q - Darryl Pardi

Do you guys pay commissions to salespeople at the time an order is received or the time the revenue is recognized?

A - Greg Schiffman

We pay it based upon bookings of the orders.

Q - Darryl Pardi

Can you help me understand what, how exactly you were able to reduce the absolute dollar amount of SG&A and R&D, both sequentially and year-over-year, in light of having ParAllele in this year?

A - Greg Schiffman

So ParAllele had a minor impact in the fourth quarter. I think the total was $3 million in terms of OpEx. What we did have was, given the final results for Q4, that is based on compensation and bonus structures were different than what we had been accruing to for the year. And you had your reversals there that drove the expense structures that you saw.

Q - Darryl Pardi

Okay. And can you give us a sense for what the initial order activity has been for the new tiling arrays?

A - Greg Schiffman

Actually, I don't think that that's one we've put out. The arrays have been in the market for a short period. The initial uptake and the interest has been high, but I think the absolute dollar amount hasn't been anything that, and I don't even have it, to be honest, at my fingertips. I will say the interest level for both the Exon and the tiling, though, has been strong. Steve?

A - Steve Fodor

I think we just announced the launching of the tiling arrays, the whole commercial launching, so we probably couldn't even give you that number yet. But if you looked in the news release that we had, there were a couple of customers that had early access to some of these. And in fact, they've already got some scientific publications out on them. So there is a lot of interest in these, but again, it's premature to give you any numbers.

Q - Darryl Pardi

I wasn't asking for a number, per se. I just wanted to get kind of a qualitative…..

A - Steve Fodor

It's one of these things that it's definitely at the early adopter phase of scientists that take this on. The all-Exon arrays are being, there's a lot of excitement about using them in marker discovery and in general genome analysis. In terms of looking broadly across the genome, the whole genome tiling arrays are a bigger set of arrays that are really going out to a smaller set of customers that want to use them for high-end scientific studies. So again, we expect that this evolution, as we go from a multiple chipset down to smaller chipsets, will occur with the whole genome arrays as we just make the whole genome more and more accessible to a broader base of customers.

Q - Darryl Pardi

Lastly, Greg, do you have a sense for what the Singapore operations, what the impact will be on the tax rate looking out to '07?

A - Greg Schiffman

As we've guided on the tax rate, we will be at 35% for '06. We expect to see it move down towards the low 30s. And it's probably reasonably linear movement. We will be able to give better input as things go forward, but I, sort of you could assume a sort of dropping; maybe a point a year over the next several years would be an original, a reasonable assumption upfront.

Operator

(Operator Instructions). Our next question comes from the line of Tycho Peterson with JP Morgan.

Q - Tycho Peterson

Following up on the question about the Singapore plant, I was wondering if you can just kind of spell out how that transition is going to happen, or how you're going to build that out over the coming year, and how we can get comfortable, I guess, with the fact that yields will be where you expect them to be. This was presumably a semiconductor facility that you're taking over?

A - Greg Schiffman

Let me start and then we can see if Steve wants to provide any additional comments. So first, it's a semiconductor plant that we're taking over. The clean room is probably a stronger clean room we've ever operated in. We're in the process of actually, we've sent over the first aligners, it's in the process of being installed, and we would hope at some point early next month we're getting feedback or inputs with regards to validation of sort of how the first wafers are coming off. What we're doing that really minimizes the impact of the plant is we are transferring over machines that have operated in our Sacramento facility up front, and we're having operators from Sacramento that have been processing the chips for quite a while going over as part of the start-up.

So the only new variable you're really dealing with is the plant being in Singapore. We will certainly, come Q2, at the end of Q1 be able to give you some indications of the successes that we've had, and how it's going with regards to qualification of the plant. And if things are going well, we would start shipping over a fair number of aligners liners in Q2 to have real commercial volumes in Q3. So I think from the standpoint of how we're managing and the risks, we do see them as relatively low. This certainly isn't the first time we're doing an offshore plant. And I think with that, the individual who is heading our manufacturing group, he's done this before, and the plant manager that we've got there has operated certainly very sizable plants in the past. So I think across the board we've minimized what we could see as operational challenges.

Q - Tycho Peterson

That's helpful. A quick second question. On the CLIA laboratory business, can you just give us some details on what sort of expenses you expect to incur, and how that is going to be built out as well?

A - Greg Schiffman

The CLIA lab is one that upfront the expense structure for the year, assuming that we're processing some, probably looking at about $1 million. It's factored into the numbers that we have provided here. It is one that certainly as things ramp up, in terms of production volumes and demand, you will see the costs sort of ramping reasonably with the volumes there. I think the plant itself, we are in the phase right now of outfitting a building that we have acquired. It's in process at this stage. I think in the second half of the year we're looking to hopefully have it qualified and capable of running diagnostic tests in a clean environment for our key customers.

Operator

Our next question comes from the line of Russell Gilbertson with Carris & Company.

Q - Russell Gilbertson

Regarding the yields on the 500K mapping set, I think I heard you say that there was 70% at the end of the year. How does that compare to other product lines, and how much improvement can you get from there?

A - Greg Schiffman

So right now, actually we exited the end of the year in the mid-70s. If you look at traditional products, we tend to run sort of 90-plus%. So it's certainly a bit below where we traditionally run. Our expectations and beliefs at this point in time are it is a product that we would expect to see get up into the mid-90s, and there aren't anything that we are aware of that would cause it long-term to be different than other products. When we introduce a new product, we traditionally see it come out somewhere around sort of 70, 75, and it slowly moves up over the next six to nine months. In the case of the 500K, it started a little below that. And at this point in time, I think we're at a healthy yield level.

Q - Russell Gilbertson

Just one follow-up question on the in-process R&D expense; obviously, lower than you had guided. And I think you said that it was due to refinement in planned product introductions. Could you just give us a little more color on that?

A - Greg Schiffman

Sure. I think as the two entities got together, and really were able to understand the cost structure and nature of the chips, and the cost structure and the nature of the ParAllele technology, we were able to modify and simplify the assay structure for products that we intend to release this year. And doing that, it's removed products that really were in process, and has sort of put it into a new technology, a new product. So it moved from IPR&D into goodwill.

Operator

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

Q - Derik De Bruin

Why was the formal gross margin guidance for '06 lower than your previous estimate?

A - Greg Schiffman

The previous estimates for '06, Derik, I think what we had talked to is the fact that we would see about a 2 point erosion associated with implementation of the capacity. And I think we're pretty consistent with that. There's a little bit of mix change associated with it, and I will say the acceleration of the start-up of Singapore is having probably a little more impact. If you pulled out the start-up for Singapore itself in the first half, we're actually running at about a 70% gross margin.

Q - Derik De Bruin

Okay, but on prior calls we have had the conversation regarding the, we were talking the impact on the, the 2% impact on the gross margin relative to the numbers at the beginning of 2005 or toward the end of 2005. So I think there was a little, certainly a little confusion in terms of where the impact would fall. I guess, the next question is, does the service business, how does that impact the overall gross margin as you start looking at a ramp of that in '07? I guess what I'm trying to ascertain is when or if you get back to that, the higher 73 to 74% range.

A - Greg Schiffman

Year-end exit right now, given the mix of products, which include the service and other businesses, we are expecting to exit the year at sort of 71 to 72%. You've still got an awful lot of capacity in the plants that you've put in place that you have not moved into, and so I think we expect to continue to see substantial leverage moving forward there. I think the service business itself, the chips and components that we're selling, which is the majority of the value of the deals, is in line with the margins that we traditionally receive. Certainly, the component on the services is going to be a lower margin. I think that you're seeing a little bit of that in just the mix this year, the combination of service, along with, and probably more importantly, OEM-based instrumentation that we are expecting to sell a little more that does impact the mix and our overall margins. So I think as we look at '07 right now, and it's tough to give absolute facts on where the business is going to be, but we're at a 71 to 72, and probably staying in that type of a range. And I think we've always guided sort of low-70s is where we were at, and they may erode slightly over time as we looked at shifts in mix of products.

Q - Derik De Bruin

I'll get back in the queue.

Operator

Our next question comes from the line of John Sullivan with Leerink Swann.

Q - John Sullivan

A couple of quick questions here regarding revenues. Did you say that your expected instrument revenues for 2006 were in the $50 million area?

A - Greg Schiffman

Yes. We expect about $50 million in instruments for 2006.

Q - John Sullivan

And that includes the incremental revenues from Automated Target Prep and from the HCS system?

A - Greg Schiffman

It's looking at the total instrument picture. The biggest piece that you've got is between '05 to '06, there's a reduction of a little over $10 million in upgrades that we are going to experience. And that is really a predominate driver for the change. What we are seeing is, in many of the very large accounts where we've placed systems, the automation, I think, is what we will be placing, because they don't need a lot more systems to process the chips. And so we expect fairly consistent placements of systems, some growth in automation, and declines in the upgrades.

Q - John Sullivan

And regarding Q1 '06 revenue guidance in the $91 million area, is there some benefit in that number associated with some of the pent-up demand for the 500K from Q4 that you're going to be able to satisfy in Q1 with the continued yield improvements in the manufacturing process?

A - Greg Schiffman

There is certainly sales of 500K in Q1, and we're certainly expecting to ship out the products that was pent-up demand in the fourth quarter. The one piece that we do have, and I think we talked to is we did an upgrade of a lot of the early access chips. And those upgrades went out in the fourth quarter. And we are expecting an awful lot of the customers to be processing those upgrades in Q1 and Q2. And given the life of the chips, we think that that is going to cause a little bit of a slow in order rates in Q1 that picks back up in Q2 as those chips are processed.

Q - John Sullivan

Right, but you had a big backlog at that end of the fourth quarter. Was the big backlog not substantially in 500K arrays?

A - Greg Schiffman

We had backlog in chips; it was 500 K as well as other expression products.

Operator

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

Q - Quintin Lai

With respect to the customer response as you've been going through these manufacturing issues, have there been any cases where some, some of these customers have maybe switched to competitors, or are they just patiently waiting as you ramp capacity?

A - Steve Fodor

We're not aware of big switching issues at this point. Most of the things when, most of the customers, as we have proceeded in projects with the 500K, has really been, the projects tend to be relatively large projects. So for example, there's over 30 customers that are looking at running sample sets for genetic studies of greater than, say, 1000 samples each. And so in fact, there's a couple of customers that are in the range, in fact, I think three or four of them that are in the range of 10,000 to 15,000 samples. So what typically happens is a period of start-up here, where we actually go in and get the customers trained up on the technology. And they at the same time, it's just not a chip issue, it's also an infrastructure issue of getting geared up to be able to run that many genetic samples. So there's a lot of pieces to this, not just the chip. So we continued to work on all of that.

At this point now, though, the chip constraint has been relaxed quite a bit. And during Q1 of this year, we are making the commitments right now to put the infrastructure in, the customer support in, to get all of these customers up and running at full production values. We, about probably 30% of them now or so are in full production. And part of our goal is to get each and every one of these customers that are now running these new, large paradigm genetic studies up into full production range. So it's a little more complex than just shipping them the chips and getting them going. These really are new paradigm-breaking experiments, and we actually have to participate with the customers in the learning curve of getting them up and running at full speed. And we feel like we're on a pretty good path for that right now.

Q - Quintin Lai

With the follow-up, with respect to the build-out of the Singapore plant, it sounds like that you're shutting down some of the machines that already are making chips in Sacramento, and you're going to have them shipped over there, along with a couple of, or some of the personnel there, which means that that's going to be capacity that was running at 75% yield, and now being moved over there. How long of a time lag do you expect those machines to be off-line?

A - Greg Schiffman

Actually, on that one, so what we are doing is we've got one machine that's over in Singapore, and they're working to qualify and verify the plant and everything works. We've got new instrumentation coming in, and we are installing it. So in Q1 we will be up, sort of that 30% kind of capacity. I think as we indicated, throughout the remainder of the year we're going to be installing additional capacity. We have a series of aligners arriving, so that come end of the year, we have twice the level of capacity installed that we exited at 2005 with. And so what you've got is you've got machines coming into Sacramento that will be installed and put in place, and the machines that are pulling out and moving over to Singapore installed. Come Q3, they should all be up and online. So we don't ever see it decreasing from where it's at, but actually it's more of a rolling transfer from Sacramento over, as we put new ones in place then.

Operator

(Operator Instructions). Our next question comes from the line of Ted Tenthoff with Piper Jaffray.

Q - Ted Tenthoff

Two quick questions that I missed in the text. What was the SG&A guidance for 2006? And the 210 GeneChip scanners that were instruments that you mentioned, are they all GeneChip scanners, or what was sent out in the automated products?

A - Greg Schiffman

Of the 210, those were all GeneChip scanners. So that is not sort of talking about the level of automation in the automated products. We can give you some kind of indication. We can give you some kind of indication of what took place in automation itself. Let's step in first with regards to the SG&A growth. And the SG&A, we expect to see about $136 million for the full year. The 210 system is actually a mix of diagnostic machines, as well as the research versions of the 3000. That was not automation. And actually, in the automation itself, we have not specifically broken it out. It was probably $2 million worth of the GCAS system. And I think as we indicated at year end, given the fact that the plates had not fully launched, we were not placing a lot of the HT scanners at that point. So several million dollars of the GCAS is what sort of moved through in 2005.

Q - Ted Tenthoff

And when will you be launching those plates then?

A - Greg Schiffman

We will be updating specifically, we've launched the plates at an 8 micron feature size, but key is actually shrinking it down into a smaller size. And we will be giving an update on that one probably on the next call, but we're not expecting it this quarter.

Operator

Our next question comes from the line of Paul Knight with Thomas Weisel Partners.

Q - Paul Knight

Greg, you mentioned 70 million of genotyping revenue. What again was that in the prior year?

A - Greg Schiffman

Genotyping revenue had gone from, it's up about 90% over the prior year. I think it was around 35, $38 million, and it was about 10 million the year before that.

Q - Paul Knight

And what do you expect your operating margins are in the future, kind of forgetting '06?

A - Greg Schiffman

If you look at '06, you've got a Q1 Q2 impact that's associated with just starting up a plant in Singapore with no production moving through it. So that's about $5.5 million. And then you start growing into the volume in the second half of the year. As we look at it going forward, in the business that we are in today, I think we expect it to move back into the margins that we had been seeing prior to that. And I think you'll start seeing that happening as we move into the '07 time period. I think one that's an important one, though, that we've talked to, and this is where I think as some of the emerging and evolving businesses come about, and I think as Steve indicated at JP Morgan, we have had some discussions specifically in some of the areas we're looking at in pathogen detection. But you get some of the emerging markets there in diagnostics. We do expect to see the gross margins of those businesses down relative to what we traditionally see. We expect to see a similar operating structure is going to be a little bit lower in that they're direct sales going from company to company; there's less of an infrastructure in the support. And the bottom-line operating margins may be very, very similar. And I think as those businesses start to evolve, we will give better input or guidance. But I think it's very important to recognize we will end up with almost two different channels, two different businesses as we evolve sort of the, at the inside strategy, as well as the life science business that we've traditionally been in.

Operator

(Operator Instructions). Our next question comes from the line of Ethan Lovell with Saranac Capital.

Q - Ethan Lovell

The call is late, so forgive me if this has been asked. I was just curious about the AR at Perlegen, which looks a little bit higher sequentially. And you can calculate your DSO a little bit different ways, but I come up to like 160 days for a company that I thought was pretty well capitalized. So I'm just wondering what might account for that.

A - Greg Schiffman

Actually it's just timing. I think that those were collected on the fifth or sixth of this year. And so I think it's just timing of when things moved through there with Perlegen.

Q - Ethan Lovell

So just a late shipment?

A - Greg Schiffman

A check that arrived just right after the, right after the start of the year.

Operator

Our next question comes from the line of Stephen Rosten with Glen Capital Management.

Q - Stephen Rosten

Just a quick follow-up on the financial models longer-term. Can you just review where you are from an operating margin perspective going forward, and when you think, how you think that will evolve over time?

A - Greg Schiffman

I think the model that we've talked about for the past several years, and it's still the model that we're focused on and moving towards, was looking at SG&A ending up somewhere around 28% of revenue. You may see leverage after that. But if you look at the industry, we tend to see somewhere sort of 28 to 30% in this space, or maybe 32. And R&D, probably around 14%, 15%. And the driver there is we really do benchmark that against companies who have margins sort of 70, 70-plus% that are manufacturing entities. And one of the drivers of those margins is the R&D, and those are the benchmarks that we do keep looking at and keep working towards. And the commitment that we've made and, I think, the commitment that we still hold is we're looking to grow the operating expenses at about half the rate we're growing our revenue as we move towards those objectives. And I think we're living through that in 2006 as we look at, we are picking up an acquisition of ParAllele that's incrementally adding about $15 million of operating expenses, which we'll grow and leverage into. And the other costs we are growing very nominally as we look at next year.

Q - Stephen Rosten

There are a couple of more moving pieces given the gross margin change because of Singapore and also due to ParAllele. So in some ways there's been sort of a step back. And then as you go forward after 2006, will you see operating expenses grow because there was a step back at slightly less than half the growth rate of revenue from then on, or will you see that, are you going to sort of target half the revenue growth rate?

A - Greg Schiffman

I think the target of half is sort of the commitment and the goal we've set. In terms of any individual year, you might have slightly less or slightly more, and I think that's really tied to the business needs, because we're going to do the right things there. But the margin itself, this year, given the start-up of the additional plant that, I think, as we look at long-term, provides a tremendous amount of leverage and ability to grow, we are outfitting. We've got sort of Sacramento moving forward, we've got the CLIA lab, and we've got Singapore. It does bring things down a little bit.

I think when you look at the potential that we think it's getting us, one, long-term cost structure, and two, in terms of opportunities to grow revenue, we do feel that this is a very worthwhile investment and the right thing to be doing as a company. The margins and the guidance, we have never guided margins to continue to expand. And I think this is a very important one that, long-term, topline revenue growth and absolute margin is the focus of the Company. And I think we will continue to stay focused on that. To the extent that we are able to use price and we can increase the absolute margins, operating profits and EPS to shareholders with dropping a couple of points in margin, that is something that we would see as the right thing to do as a company and, I think, we've actively discussed over the last four to five years. So I think as we look at long-term margins, we were hovering at 74; we ended the year at about 72; we look to be at 72 at the end of this year. We feel 72 margin with the operating costs we've just talked about generates an incredibly strong operating profit and is a pretty healthy business.

Operator

Our next question comes from the line of John Sullivan with Leerink Swann.

Q - John Sullivan

Just chatting briefly about the 65%, $0.65 EPS guidance for '06, it looks like the ParAllele effect of that is, what, in the $0.13 area, something like that? Is that fair or not?

A - Greg Schiffman

For FY '06, if you look, there's 15 million of expenses coming in with ParAllele.

Q - John Sullivan

Is that 15 million above the 3 million, just kind of apples-to-apples versus 2005? You did, you layered in 3 million in Q4 of '05, right?

A - Greg Schiffman

It's 12 million incremental above last year. It's 15 million absolute. So you're correct. It's 12 million incremental year-on-year that's coming in associated with the business. Now, we are certainly growing revenues, and ParAllele is integrating in with our business. And long-term, a large amount of the products that we're selling, we believe, are going to be based upon the strengths and the value that MIP assay is bringing. So as you look at this year, we are growing revenues, we are expecting to see ParAllele on its own, essentially neutral to earnings, fairly consistent with what we guided last time, with good growth in sort of the targeted genotyping space that we are introducing products in. We introduced it the end of last year, and some others will be coming out this year.

Q - John Sullivan

So when we think about your traditional long-term guidance of operating expense growth at around half of the rate of sales growth, for 2006 we're really talking about that sort of a metric, and then layering this 12 to $15 million on top of that. Is that true?

A - Greg Schiffman

Absolutely. If you take the 3 million out last year, you grow it at half the revenue, and you add the 15 million in, that essentially gets you the OpEx we're looking at this year.

Q - John Sullivan

Okay. Was there, as you reviewed ParAllele upon closing the acquisition, were there operating expenses that were redundant to what was going on at Affymetrix that you were able to remove?

A - Greg Schiffman

I think as we indicated, ParAllele ran operating expenses last year of about $19 million. We are bringing in about 15 million between the combined entity, so there were certainly some efficiencies as we moved through.

Operator

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. Mr. Farrell, are there any closing remarks?

Doug Farrell, Vice President, Investor Relations

Yes, thank you. Thanks for taking the time to join us on the call today, everybody. If you did miss any portion of the call, a phone replay will be available for the next seven days, beginning at about 5 PM Pacific Time tonight. To access the replay, domestic callers should dial 800-642-1687; international callers should use the number 706-645-9291. The passcode is the same for both; that is 3859939. Alternatively, you can listen to an audio replay on the investor section of our website at www.Affymetrix.com. So thanks again for joining us.

Operator

This concludes today's Affymetrix fourth quarter and year end '05 earnings conference call. You may now disconnect.

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