Illumina Inc (ILMN) 2008 Q2 法說會逐字稿

Good day, ladies and gentlemen and welcome to the second quarter 2008 Illumina earnings conference call.

My name is Carissa and I will be your coordinator for today.

At this time all participants are in a listen-only mode.

We will be facilitating a question-and-answer session towards the end of this call.

(OPERATOR INSTRUCTIONS).

I would now like to turn the presentation over to your host for today's call, Mr.

Peter Fromen, Senior Director of Investor Relations.

Please proceed.

Good afternoon, everyone, and welcome to our second quarter 2008 earnings call.

During the call we will review our financial results released today after the close of the market, offer commentary on our commercial activity and provide financial guidance for the third quarter and fiscal 2008, after which we will host a Q&A session.

If you have not had a chance to review the earnings release, it can be accessed in the Investor Relations section of our website at Illumina.com.

Presenting for Illumina today will be Jay Flatley, our President and Chief Executive Officer; and Christian Henry, our Senior Vice President and Chief Financial Officer.

This call is being recorded, and the audio portion will be archived in the investor section of our web site.

During the call we will be discussing our financial guidance and plans for future activity.

Our intent is for these forward-looking statements to be protected under the Private Securities Litigation Reform Act of 1995.

Forward-looking statements made during this call are subject to risks and uncertainties.

Actual events or results may differ materially from those projected or discussed.

All forward-looking statements are based upon current information or available, and Illumina assumes no obligation to update these statements.

To better understand these risk factors, we refer you to the documents that Illumina files with the Securities and Exchange Commission, including Forms 10-Q and 10-K.

Before I turn the call over to Christian, I wanted to remind you of the investment conferences in which we will be participating over the next couple months.

On August 7th, in New York, we will participate in Leerink Swann's Roundtable focused on emerging products and applications and life sciences tools.

On September 4th, we will present at the Thomas Weisel Healthcare Conference in Boston, and during the week of September 22nd we plan to participate in the UBS Healthcare Conference in New York.

For those of you unable to attend any of the upcoming conferences, we encourage you to listen to the webcast presentations, which will be available through the Investor Relations section of our website.

I also wanted to announce that we be holding this year's analyst day on November 6th in our new facility in San Diego.

We will provide more details on this event as they become available.

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

Good afternoon, everyone, and thank you for joining us today.

During today's call I will review our second quarter financial results and outline our guidance for the third quarter and the remainder of the year.

Jay will then discuss our commercial progress and provide an update on the state of our business in the market.

The second quarter was our 28th consecutive quarter of revenue growth with total revenues of $140 million.

This represented 66% growth year over year and approximately 15% growth sequentially.

Product revenue was $129 million and grew 73% over Q2 of last year and 16% sequentially.

Growth compared to last year was well balanced as we saw approximately equal contributions from our sequencing and MicroArray businesses to the top-line performance.

In the second quarter consumables revenue totaled $82 million compared to $46 million in the second quarter of last year and $63 million last quarter.

This represents year-over-year growth of 78% and sequential growth of 29%.

Our growth in consumable revenue was driven principally by the rapid uptake of our new Infinium HD product line.

Not only did we ship a record number of samples during the quarter, our ASPs for the quarter were above our expectations.

Additionally, I'd like to point out that revenue from sequencing consumables grew more than 50% sequentially, which indicates that many of our customers have scaled up their sequencing programs to production levels.

Instrument revenue for the quarter was $43 million compared to $25 million in the first quarter of 2007, representing year-over-year growth of 70%.

Instrument revenue growth was driven by continued strong demand for the Genome Analyzer II.

Services and other revenue, which includes genotyping and sequencing service as well as instrument maintenance contracts, was $12 million for the quarter, compared to $10 million in Q2 of the prior year and $11 million last year.

Before discussing gross margins and our operating expenses for the quarter, I'd like to describe the effect of FAS 123R, which requires us to record the non-cash expense associated with stock options in our income statement.

The total impact of non-cash stock-based compensation for the quarter was a pretax amount of approximately $12 million or a tax-adjusted amount of approximately $0.12 per pro forma diluted share.

Stock compensation expense is allocated to each P&L line item with the amounts attributable to each expense category separately identified in the financial tables that accompany today's earnings release.

In the discussion that follows, I will highlight both our GAAP expenses, which includes the effect of 123R, and the corresponding non-GAAP figures.

I encourage you to review the GAAP reconciliation of the non-GAAP measures also included in today's release.

Total cost of revenue for the quarter was $51 million compared to $30 million in the second quarter of 2007.

The second-quarter cost includes stock-based compensation expense of $1.4 million compared to $1 million in the prior-year period.

Excluding this expense, a $4.1 million charge associated with the write-off of manufacturing equipment and a $2.7 million charge associated with amortization of intangibles, non-GAAP gross margin was 65%.

This compares to 63.3% last quarter and 65.7% in the second quarter of 2007.

The sequential increase in gross margin resulted largely from the strong demand for our new Infinium HD product line and, in particular, the rapid uptake of the 610-Quad BeadChip.

On a per-sample basis, the 610-Quad is less expensive to produce than prior generations of BeadChips.

As we indicated last quarter, as part of the launch of the Infinium HD product line, we had to develop new array manufacturing equipment to replace our existing infrastructure.

As a result of the rapid transition to the Infinium HD products, we have excess capacity in our prior generation of equipment.

Therefore, during the quarter we took a charge of $4.1 million to recognize this write-off.

The decline in gross margin compared to the prior-year quarter was primarily due to the fact that the sequencing business, which generally carries lower gross margins, has become a larger proportion of our total revenue.

Research and development expenses were $24 million in the quarter compared to $18 million in the second quarter of 2007 including $3.4 million and $2.5 million, respectively, in non-cash stock compensation expense.

The increase in R&D spend was primarily attributable to increased headcount as well as expense associated with the buildout of our Singapore facility.

Excluding stock compensation expense, R&D expenses were $20 million or 14.3% of revenue compared to $16 million or 18.6% of revenue in the prior-year period.

SG&A expenses were $36 million compared to $23 million in the second quarter of 200, including stock compensation expense of $7 million and $4 million, respectively.

Excluding these non-cash expenses, SG&A was $28 million or 20% of revenue compared to $19 million or 23% of revenue in the prior-year period.

Sequentially, SG&A declined to 20% of revenues compared to 23%.

This decrease is largely attributable to the increase in top line revenue.

Our non-GAAP operating profit for the quarter was $43 million or 31% of revenue compared to $21 million or 25% of revenue in the second quarter of last year.

This represents year-over-year operating profit growth of 106% or 1.6 times our revenue growth rate.

Before I comment on net income, I wanted to note the sequential decline in net interest and other income.

Interest and other income declined by $2.8 million in the quarter to $0.8 million.

The decline was due to a $1.1 million sequential swing related to our intercompany foreign exchange translation.

The remainder of the decline was associated with both lower interest rates earned on our investment portfolio coupled with a lower cash balance due to the $90 million litigation settlement which we paid in the first quarter.

We reported GAAP net income of $15 million for the second quarter or $0.23 per diluted share compared to $9 million or $0.16 per diluted share in the prior-year period.

Excluding the impact of non-cash stock compensation expense, the charges associated with the write-off of our manufacturing equipment, the amortization of intangibles and net of certain tax benefits, we're pleased to report non-GAAP net income of $28 million or $0.44 per diluted share compared to $17 million or $0.29 per diluted share in the second quarter of 2007.

This represents year-over-year net income growth of 63%.

Turning to the cash flow statement and balance sheet, we generated $37 million in cash flow from operations during the quarter compared to $25 million in the comparable quarter of the prior year and $28 million in the first quarter.

However, during the second quarter, we used approximately $23 million in cash for capital expenditures.

The capital expenditures were primarily facilities-related as we opened our new building on our campus in San Diego.

We completed a 50,000 square foot new reagent manufacturing and services facility also based in San Diego, and we completed the facilities improvements associated with our Singapore manufacturing plant.

Finally, we continued to add Infinium HD array capacity to our San Diego manufacturing facility.

Depreciation and amortization expenses for the quarter were approximately $6.6 million and on a free cash flow basis we generated $14 million or $0.23 per diluted share compared to $18 million or $0.31 per diluted share in the second quarter of last year.

We ended the second quarter with $356 million in cash and investments.

Before I update you on our guidance, I wanted to mention our announcement today to effect a 2-for-1 split of our common stock.

The split is subject to stockholder approval of a proposed amendment to our certificate of incorporation to increase the number of authorized shares of our common stock from 120 million to 500 million.

We expect that the record date for the stock split will be September 15th, 2008, and that the payment date for the split will be September 26th, 2008.

We believe that the stock split, if affected, may place the market price of our common stock in a range that is more attractive to investors, particularly individuals, which may result in a broader market for our stock.

I will now update our financial guidance for the third quarter and fiscal 2008.

Consistent with our previous call, the following guidance excludes the impact of certain non-cash charges, including the amortization of intangibles, the write-off of manufacturing equipment, legal settlement payments and the impact of stock-based compensation related to FAS 123R.

For additional details, please refer to the table in our earnings release that reconciles our non-GAAP guidance to the related GAAP figures.

We expect fiscal 2008 revenues to be between $550 million and $560 million, representing growth between 50% and 53% over the 2007 figures.

This is an increase of $30 million over the mid range of our 2008 guidance that we provided last quarter.

We continue to expect gross margins for the year to range in the mid 60s, and we expect non-GAAP earnings per share between $1.65 and $1.75, which represents an increase of $0.08 over the midpoint of our previous guidance.

This assumes a pro forma fully diluted weighted average shares outstanding of approximately 63 million.

As a reminder, going forward, we provide a pro forma fully diluted share number that will exclude the double dilution associated with the accounting treatment of our convertible debt outstanding and the corresponding call option overlay.

The call option that Illumina owns offsets all dilution associated with the net share settlement of the note over its conversion price of $43.66.

We will include the ongoing economic impact associated with the net share settlement of the warrants issued in conjunction with the call option overlay which have a strike price of $62.87.

The Q2 number is included in the reconciliation to the GAAP figures that accompanies today's press release.

As I mentioned last quarter, please feel free to follow-up with Peter after today's call, and he can walk you through the details of the calculation.

For the third quarter, we expect revenues to range between $142 million and $147 million, which represents year-over-year growth of 46% to 51%.

Excluding the impact of stock compensation expense and the amortization of intangibles, we expect third-quarter non-GAAP earnings to range from $0.42 to $0.45, assuming pro forma fully diluted shares of 64 million.

We anticipate a non-GAAP annualized tax rate of approximately 36% for the year.

We expect the tax rate to be lower in the fourth quarter, as we recognize profit from product manufactured and shipped out of our Singapore site.

Over the next few years, as we generate more international income and continue to build out the Singapore facility, we expect a further decline in our consolidated corporate tax rate.

We expect pre-tax annual stock compensation expense to be approximately $49 million or $0.50 per tax-adjusted pro forma fully diluted share.

As we've emphasized in the past, this expense is highly dependent on our underlying stock price.

It should be noted that earnings per share guidance does not account for our proposed 2-for-1 stock split but does include the impact of Avantome's operations on our business.

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

Good afternoon, everyone.

By almost any measure, our quarter just completed was the best in the Company's history.

We have now recorded seven consecutive years of quarterly sequential revenue growth.

Our new products, many of which were transitioned only last quarter, drove both revenue growth and gross margin expansion.

This combination, coupled with the effective growth management in R&D and SG&A spending, enabled us to achieve over 30% operating margins for the quarter.

In addition, our markets continue to be very healthy, resulting in an incoming order rate which exceeded our prior record by a wide margin.

That success resulted in a very strong backlog exiting Q2.

This backlog, coupled with our successful scale-up of manufacturing capacity, gives us the visibility to significantly raise our revenue guidance for the second half of the year.

I'd now like to spend some time focusing on each of our business areas.

As Christian mentioned, second-quarter revenue growth was 66% over last year.

The strength in our array business was a key factor in revenues exceeding our expectations.

Toward the end of Q1 we began shipping the 610-Quad, and it has now become our largest volume product in its first full quarter of shipment.

We also saw a significant uptake of the [CNC 370-Quad], and toward the end of the quarter we began shipping the Human1M-Duo, our most complex BeadChip to date.

The rapid adoption of these Infinium HD products resulted in a $4.1 million non-cash write-off to retire manufacturing equipment not capable of producing the Infinium HD chips.

Over the next several quarters we'll continue to launch more products using the HD format, which may help us achieve higher gross margins.

iScan, which is our new BeadChip scanner, increases scan times by a factor of six and has already been a significant impact in accelerating customer projects.

Incorporating iScan into customer workflows will remarkably reduce the time to complete projects or increase the total number of samples that can be run in a given period.

We're pleased with customer reception to the new system and have already seen initial iScan customers place repeat orders.

Given the higher throughput of iScan, we expect somewhat fewer instrument placements versus where we might have been with the BeadStation but with higher consumables per installed system.

This quarter we received orders for Infinium HD BeadChips from researchers funded by the second phase of the Wellcome Trust Case Control Consortium to study over 90,000 samples in what collectively will be the world's largest genetic research initiative conducted to date.

In addition to the performance of the Infinium HD assay, the availability of iScan makes the economics of our complete system ideal for large-scale complex genotyping studies.

As more of our chip catalog migrates to the HD technology, both we and our customers will enjoy improved performance and economics.

Looking forward, we remain optimistic about the demands in our traditional array markets.

Over the next few years we expect major growth to come from the emergence of applied and consumer markets.

As a leading indicator, in Q2 we generated over $6 million in orders for our bovine SNP 50 product, our first fixed content product focused on the ag market using our 12-sample iSelect format.

Moving onto the sequencing business, our momentum continues to build as next generation sequencing has truly become now generation.

In the quarter we saw the GA II gain momentum as we continued to demonstrate increased throughput, improved robustness and a wider diversity of applications.

It's amazing to note that just a year ago we were focused on achieving 1 G of high-quality information, and now internally we are routinely achieving throughput levels greater than 10 G per run.

Our customers have responded overwhelmingly and we now have received upgrade orders from the majority of our installed base and believe that most of the original Genome Analyzers will be upgraded to GA IIs by the end of this year.

Another key driver in the sequencing business was our ability to scale up shipments of our paired end model.

As a reminder, the paired end module enables protocols that insert specific lengths of DNA into a sample and effectively reads the sample from both ends.

This protocol is especially useful in whole genome resequencing applications and structural analysis of the genome.

During the quarter we shipped more than 150 paired end modules and expect that virtually every Genome Analyzer in the field will ultimately include one.

During the quarter we commercialized our short insert protocol, which enables 200 based pair inserts, and at the end of this summer we expect to commercialize our long insert protocol, which will enable insert sizes from 2 to 4 KB.

Operationally, we're focused on improving the gross margins of our sequencing business.

During the quarter we completed the development of our new sequencing reagent kit that greatly simplifies customer workflow by reducing the number of tubes in the kit from 27 to nine and significantly improves manufacturability.

In the third quarter we'll fully commercialize this kit and we expect to see improvements to the sequencing gross margins as a result.

Improving consumable gross margins is going to be a critical success factor going forward as we're beginning to see the ramp in our consumables revenue in sequencing.

In the second quarter we saw sequential growth of more than 50% in sequencing consumable revenue.

We now have a large enough installed base and sufficient data to feel confident in our range of 150,000 to 200,000 of annual consumables per installed system.

The technology advantages of the GA II continue to drive broad adoption of the sequencing platform.

In the quarter, two-thirds of our shipments were to non-genome centers.

We're also seeing an increase in digital counting applications that continue to expand the market potential beyond traditional sequencing applications.

As we've mentioned previously, we believe that next-generation sequencing will become increasingly cost-effective with traditional array-based methods for gene expression.

Recently, we've seen a number of customer publications in peer-reviewed journals using the genome analyzer for RNA seek, a method of full transcriptome sequencing.

RNA seek has enabled customers to discover novel gene expression markers not present on existing microarrays at costs that are rapidly becoming competitive with arrays.

During the quarter our R&D team made significant progress with our internal sequencing initiatives by completing the sequencing of a Human African Trio.

By leveraging the improvements we have made to the GA II in a matter of weeks our scientists generated 14 times sequencing coverage from the mother and the son of the African male that we sequenced last year.

Subsequent sequencing of the trio has generated coverage to over thirty-fold.

Sequencing runs during this project routinely generated 7.5 G of data and yielded up to 10 G of data on a single flow cell using 50 based pair read links.

Through additional development of our chemistry and software programs during the quarter, we're now able to internally generate 15 G of sequence data per run and have clearly defined a roadmap to reach 20 G or beyond by the end of this year.

We continue to believe that demand for sequencing over the next few years will be very robust.

Last month we announced our participation in the 1000 Genome Project, where we will work with a consortium of sequencing centers to generate the most detailed map of human genetic variation to date.

The project will build on the international HapMap project, which cataloged human genetic variance at a frequency of 5% or greater.

The 1000 Genome Project will identify variance at a frequency of 1% across the genome and down to 0.5% within genes, opening an exciting new view into the association of rare variation with disease.

In addition, the project will generate a comprehensive understanding of structural variation and epigenetic factors in the genome.

This project and other sequencing projects like the Cancer Genome Atlas will illustrate the application of next-generation sequencing as a high-powered discovery tool.

Over the next few years we expect sequencing to become increasingly important as a diagnostics tool.

Today we announced the acquisition of a privately held company called Avantome, Inc.

for $25 million in cash and up to $35 million in contingent consideration.

Avantome is a development stage company working on a low-cost, long-read sequencing technology.

We expect this technology, when available as a product, to have applicability to both research and diagnostic markets and be complementary to our existing technology.

As part of this transaction, Dr.

Mostafa Ronaghi will join the Company as our Senior Vice President and Chief Technology Officer.

Next, I would to update you on some of the operational initiatives and facilities projects that we have underway.

First, we've completed the capacity expansion of our array manufacturing in San Diego.

We currently have no further plans to add capacity in San Diego other than from general process improvements.

Our Singapore facility is on track to meet our fourth-quarter projections with approximately 40% additional array capacity online by year end.

The majority of work on our new San Diego site has been completed, and we began moving into this building last week.

Also in San Diego, we completed the buildout of our Carroll Park reagent manufacturing facility, where we will also co-locate our services business.

Leasehold improvements and assorted capital improvement to outfit these new facilities led to the significant increase in capital expenditures during the quarter, as Christian outlined earlier.

We've also made significant progress in the quarter in building out our senior management talent.

We recently added Fredrick Clerie as Vice President of Quality Assurance and Regulatory Affairs.

Fredrick comes to us most recently from the diagnostics division of Bayer Healthcare, now Siemens Diagnostics.

Fredrick will report to Joel McComb and be responsible for Illumina's quality system strategy supporting both research and diagnostics products.

Earlier this week, Dr.

Steve Pentoney joined Illumina as Vice President of Assay and Reagent Development.

Most recently, Steve was director of technology and management for the Molecular Diagnostics business at Beckman-Coulter.

He will report to Joel as well and brings extensive experience in automated DNA sequencing, multiplexed assays and clinical diagnostic systems.

Finally, we have promoted Dr.

Steven Barnhard to Vice President of Array Development.

Steve is the fourth employee of Illumina and worked with David [Wald] at Tufts on the initial invention of Illumina's core technology.

To conclude, we're very pleased with our operational and financial results for the second quarter.

We've seen encouraging uptake of the new products that we launched in the first half and received equally encouraging customer feedback.

We've scaled our infrastructure to support our continued growth and we've made significant progress in crystallizing our molecular diagnostics strategy, which we expect to update you on at our analyst meeting in November.

Most importantly, our markets continue to grow rapidly, and we feel that we are very well-positioned to capture that opportunity.

Thank you for your time, and we'll now open the lines for your questions.

(OPERATOR INSTRUCTIONS) Ross Muken.

Congratulations, wonderful quarter.

There was a bit of concern coming into the quarter, I think, in general about a slowdown on the array side of the business.

Obviously, that is the antithesis of what we saw.

Can you talk a bit about, aside from the obvious in terms of some of these new studies that are coming along and the size increases, what we're seeing in some of the nontraditional markets for array, and then compare and contrast what you're seeing in terms of incremental demand?

Is it from existing customers, new customers?

Just help us think about the dynamics there and what's continuing that pretty attractive growth trajectory.

Sure.

As I mentioned in the script, Ross, I think, as we look forward in the array market, we continue to feel really good about what's happening in whole genome association studies in that as these very large projects come through we're going to continue to see greater adoption of new versions of our chip, particularly as we begin to sequence these very large numbers of samples.

We'll start identifying rare variants, and that has the potential to create wholly new versions of our chip that have much richer content.

So we expect that whole path through the genotyping market to continue.

We do expect very strong growth in what we call the emerging segments, in the applied markets and in the consumer markets.

In the applied side, we now have three different chips we're shipping -- a bovine chip, an equine chip and a K-9 chip.

We're working very broadly with a large number of collaborators in other potential organisms.

In fact, we have a very large company in the office today talking about a particular crop that they want to sequence and ultimately put onto chips.

So it's a very exciting, I think, long-range and high-growth opportunity.

We also continue to be very bullish about what's going to happen in the consumer space, despite the fact that there's been a lot of regulatory noise in this space.

We are confident that those issues are going to get resolved over the next six to 18 months or so, and that there's going to be a very clear path where consumers can get access to their genetic information.

And over time, as those prices come down, we think the market is very elastic and it will grow significantly.

Turning to the sequencing business, your competitor introduced not too long ago the second generation of their system.

Can you comment a bit on what we're seeing real-time in the market, in terms of incremental demand?

Do you still feel like the metrics on your box and some of the advantages that you've enjoyed over the last six to 12 months continue?

And as we see this market grow in such exponential fashion, how you think the combination of today with Invitrogen affects anything in the landscape?

Well, I think you can tell from our numbers that we continue to see a very robust market, and we expect that to continue.

Clearly, it's going to be a competitive space, and we think that our competitor in this market is going to be very formidable, and we are prepared for that.

We think that some of the performance advantages that we've got on our system continue despite the launch of the second version of their system, and those include ease-of-use, ease in sample preparation, much smaller upfront sample requirements, much easier back-end data processing and much faster run times.

So all those advantages, we think, stay with us in the marketplace.

In terms of throughput, I think there's going to be a back-and-forth battle on throughput.

And as the throughput numbers continue to increase, you get to 20 G and it goes beyond 20 G, whether somebody is 2 G or 4 G ahead of the other player in any given month is probably not going to be the determining factor for who wins in this marketplace.

In terms of the merger that was announced, I guess our feeling is that that combination probably makes some sense in the long run, and we are assuming that they put those companies together well and that they will continue to be very competitive with us.

And Christian, just in terms of the housekeeping, I think I missed it in all of the numbers up front.

What was the instrument versus consumable breakdown?

Consumables were about, what, 58% of revenue for the quarter.

And I will give you the consumable number, give me a second here to pull it up.

Consumables revenue was $82 million, and instrument revenue was $43 million.

Tycho Peterson, JP Morgan.

Jay, I'm just wondering if you can elaborate a little bit on the sequencing technology that you acquired, and how you see this fitting in and what you see the competitive advantages of the technology longer-term.

Avantome is a development stage company, so we're not going to disclose a lot about the underlying technology.

What we will say is that we do think it's highly complementary to the very high-end sequencing we have now on the GA II and that this system is targeted for a different part of the market that really will be optimized for much lower-cost, long-read sequencing that happens very quickly.

So that will be a different sector of this market, and we think it hits most squarely at the traditional Sanger sequencing space.

We are very excited about the technology and how we can apply that technology, get a product to market and attack a different segment, perhaps, than the high-end GA does.

Is this the old pyrosequencing technology?

I know there's a link there somewhere.

Well, they have used pyrosequencing technology in their lab, but what we wind up launching as an ultimate product may or may not include pyrosequencing technology.

We are not really talking about what the ultimate product might look like.

With regard to your comments before on the applied markets, as we think about development in ag, in particular, are you starting to see demand for sequencing in those markets?

I know you talked a little bit about the array demand.

And how do we think, I guess, about where your array portfolio could go there as well?

Very often, it actually starts with sequencing technology, because some of these organisms have only rough-draft sequences, if any sequence.

And if they have some, it's only been done on a couple of copies.

There's very little known about the genetic variations in these crops or organisms.

And so, very often, it starts with a sequencing project to do discovery and then it translates into implementation of those genetic variations onto a chip.

Typically, that would be deployed in our 12-by-1 format, which allows high throughput and very low-cost.

Typically, you're not looking at millions of SNPs in these applications, you are looking at some numbers of tens of thousands.

And then the goal ultimately is to continue to reduce that down to the smaller number that really matter and whatever the screening application is that the Company is targeting.

Would you be able to give some color internationally as to where you may have seen some strength during the quarter, beyond Beijing and some of these other markets?

Europe continues to be really strong for us, Tycho.

We've built out a lot of infrastructure in Europe in the last year, and we're really starting to see the benefit of that.

Asia continues to be growing as well, and then the US was strong as well during the quarter.

So we really are seeing -- Europe is probably leading the pack a little bit.

But the reality is, we're seeing strength across the entire set of markets, and I think it's due to the fact that we've a launched bunch of new products and there's pretty significant competitive advantages to those products, so the customers are adopting them pretty quickly.

On the paired end modules, in terms of what is required from the customer side, can you give us a sense of what the cost is and how quickly the customers are up and running, once they get the module attached?

Yes.

When we initially launched the paired end module, we actually offered it with a bundle of consumables.

But the pricing on the paired end modules is in the $40,000 range, give or take.

What they need to get up and running, quite frankly, is we go out and install it, and they are up and running essentially the same day.

So there's not a dramatic difference.

There's a different kind of kit that you use, so you have a different reagent kit that we call it, the paired end kit.

We're very creative with that name.

And then you buy that kit and you're up and running.

So the great part about it -- it all happens in front of the sequencing.

Once a flow cell is prepared, it goes straight onto the sequencer, and you sequence just as if you were doing any other sequencing experiment.

Bill Quirk, Piper Jaffray.

Good afternoon and I'll add my congratulations on the quarter as well.

A couple of questions on Avantome.

Can you help us flush out the expected increase or increase in expenses related to this?

Obviously, it's in the guidance.

But could you tease that out a little bit for us?

Well, we put it in the guidance so that we wouldn't -- we don't want to really identify the cost of any one particular program that we have ongoing.

So it's baked into the guidance that we provided today.

And understanding that it's still a development stage company, willing to take a stab at when we could expect some type of complementary product coming out of that group?

Bill, we are not far enough along yet to be able to predict with any confidence the date of a product launch.

But as appropriate, we'll update you on that and give more color as we get further into the development and we begin to position this product into the marketplace.

Obviously, you are still working through numbers on this side.

But just qualitatively, in terms of installs for GAs, were they flat, up, down, in terms of the quarter sequentially?

Bill, we don't give that kind of granularity on a quarterly basis.

Well, I have to give it a shot, right?

Good effort.

Lastly, guys, as you think about the portfolio from a longer term management standpoint, should we still think that Illumina is going to be looking at deals advantageously in terms of complementary technology to tuck in and perhaps expand some of the existing applications, or do you feel quite comfortable where we are sitting right now?

I think the kind of things we would be looking at, Bill, would include technologies that are highly complementary to what we're already doing.

It would be unlikely that we would be doing any kind of add-on acquisition that, say, adds a separate business to what we currently do.

That's always theoretically possible but, I don't think, very likely.

We have a pretty good set of technologies right now in what we are looking for.

And as they come across our desks, we study our opportunities that really bolster the core capabilities we already have, leverage the distribution.

And that's a critically important factor in the Avantome transaction is that it's the same distribution channel, so you don't need a different sales force, and it's not going to be a different customer base.

So those are other types of factors that we evaluate.

So they tend to be smaller and more technology focused.

Doug Schenkel, Cowen & Company.

I have, as you can imagine, a few Genome Analyzer questions.

But before I go there, I was wondering if you could give us an update on BeadExpress.

I don't think you said really anything about that on the call.

If you did, I apologize for missing it.

But could you give us some update on how that's progressing?

Yes, you are right; we didn't give an update on that.

And the reason was that it's a smaller part of our revenue than the other two businesses.

So, because of time limits, we decided to not put it into the script.

But we're seeing very strong demand for BeadExpress.

It's going to be a -- and it is a critical part of our emerging diagnostics strategy.

The product is performing well.

As we mentioned on prior calls, we did have some startup challenges, and really getting our manufacturing ramped up and getting it relocated to San Diego.

We believe we are beyond all those issues now, and so we are real optimistic about how it's going to continue to roll out into the field.

On Genome Analyzer, I know you were not willing to answer the question in terms of sequential growth or lack thereof in terms of placements.

But maybe taking this from a different direction, in terms of the longer term outlook, you've talked about freeing up capacity for genotyping production.

If demand for GAs was to increase by, say, 10 to 20 per quarter over the balance of the year, are there any capacity concerns that you have that would hinder you from meeting that demand?

None whatsoever.

We make it in a separate factory up in the Bay Area, and given just a few months of lead time, we can scale capacity pretty significantly there.

We've got the space to do it, and really the only constraint would be how rapidly we could bring in the materials.

We tend to plan the long lead items with a little bit of safety stock so we have the ability to ramp up quickly inside the lead time of the longest part, and that just takes a little bit of inventory investment that you might see on our balance sheet to do that.

I think the other piece there is we've been getting more efficient at manufacturing the GA II.

As you know, we launched the GA II in the first quarter, pretty early in the quarter.

Now we've had some experience under our belts of manufacturing it.

So not only do we have capacity, but we're getting more efficient at making the product.

So I think that looking out of many different demand scenarios, we would be able to accommodate them.

The other thing I might add to that is that one of the really important factors in our ability to meet customer demand is on the reagent side of the equation.

I talked briefly in my script about a project we've just completed where we reformulated the sequencing kit.

Part of the reason for that was not only to improve workflow and reduce the number of components in the kit, but to make it amenable to our automated systems here in San Diego.

So that's now being manufactured in our new San Diego reagent facility.

As part of that facility we have very high-throughput robotics systems to make the kits, and that improves the overall quality because you don't have human intervention in making the tubes, and it also allows us to scale very, very rapidly if we need to.

So the reagent side is just as important as the hardware side.

Jumping around a bit, let me go to the third business, genotyping.

Clearly, you guys are enthused about the growth potential associated with ag-bio and the consumer end markets.

It's been a little while since I think you provided an update on what you think the growth rate is for the market as a whole when it comes to whole genotyping arrays.

Could you help us understand where you think that is right now for traditional applications and how these new end markets affect overall growth in genotyping?

We've given broad ranges of 25% to 40% in genotyping growth, and we are feeling good about that.

Obviously, the growth rates in some of the newer markets could be way higher than that because they are coming off a small base.

So it depends on whether you are looking at growth rates just within a small segment like a slide or whether you're averaging that into the overall genotyping market.

But I think, if you think about growth rates in that 25%, 30% to 40%, you're in the right range.

Any color you can provide on what you are doing with BeadReaders when you swap them out for iScans?

Yes.

So, as customers d upgrades, we will bring back the older system, we'll retrofit them, and then we'll resell them.

And so we think they'll be particular markets where they are more price sensitive and less throughput sensitive.

That will be great markets for refurbished BeadStations.

Quintin Lai, Robert W.

Baird.

Congratulations also on a nice quarter.

In this quarter it sounded like that you've got an extra push on the microarray side.

You raised the full-year guidance.

So should be extrapolating that that delta for the increased revenue guidance is also more weighted toward the microarray side, or is it split between both genotyping and sequencing?

We didn't really break it out that way.

Basically, we do an evaluation of each business on its own and build up a forecast.

Based on the strong backlog we had exiting the quarter and the visibility we see on both sides of the business, quite frankly, that's how we came up with the annual guidance of $550 million to $560 million.

I think you heard pretty clearly in the prepared remarks that we see both markets, both sequencing and the array markets, as being very robust right now.

It's up to us to continue focusing on execution and delivering a great customer experience.

It sounded like that the ASPs for especially the multi-sample formats are quite favorable, good gross margin, consumable trail for sequencing increasing.

You've got, in fact, an improved set that you said -- you talked about launching for consumables for sequencing in the third quarter.

So should we be thinking that gross margins have an upward bias from where we are here today?

If not, why just reiterate, I guess, mid-60s for gross margins?

Quintin, we are working real hard on gross margins, as you might expect us to do.

You are right; we have a lot of factors that we are hoping give us an upward bias on the gross margins.

We do, however, have some offsetting factors there, and one of those clearly is our refurbishment programs or our exchange programs.

So, as we upgrade GAs to GA IIs, the shipment of those upgrade kits are not high-margin shipments.

Similarly, we've offered special programs for customers to upgrade from BeadStations to iScans, and those are low margin as well.

So we have some offsetting factors that have caused us to continue to guide into the mid 60s.

What was the impact of FX on your top line?

And right now what are you running as a percent US/ex-US sales?

On the top line, FX doesn't really have a big impact because, even in the second quarter, we still bill most of our customers in US dollars.

So we haven't really been able to enjoy any of that benefit as many of our competitors have over the last couple of years or year or so.

Although, we did have an FX hit this quarter from a foreign translation.

Basically, we have subsidiary balance sheets that get translated, and we did have an exposure there.

We took about a $200,000 hit on the other income line, and that was -- last quarter, we actually had a favorable, $900,000 favorable variance there.

So it's a million swing $1.1 million swing that I referred to in my remarks.

If you look at the split of revenue for the quarter, Americas represents about 70% of the business, Europe is about 25%, and Japan is about 5%, give or take, for the quarter.

In terms of the geographic split, though, Quintin, it was distorted a little bit by revenue recognition.

So we look at three different numbers there, and one is what does the order receipt rate look like.

From an orders basis, the Asian market was much stronger.

We just didn't ship all those systems.

From a shipment basis, it was pretty strong in Asia as well, but not many of those got across the finish line in terms of revenue recognition.

And (multiple speakers) often, there's FOB terms that mean they have to be received by the customer before we count them in revenue.

So there's three different ways to look at that geographic mix.

The one Christian gave you was the revenue recognition view.

Yes.

John Sullivan, Leerink Swann.

Congratulations on working toward 20 gigs per sequencing run by the end of the year, but I think sample multiplexing is what would be incrementally valuable to many of your customers.

What sort of progress are you making or are you seeing made by maybe your partners in improving biochemistry that allows researchers or diagnostics labs to place a large number of samples on a single flow cell?

Can you talk about that all?

Yes, sure.

Our customers are doing that relatively routinely now, John.

We actually don't have a formalized kit on the market yet to do that, but we're working hard on it, and we expect to have that, certainly, before the end of the year.

So you are right; that's an important thrust in the market and tag-based applications is an area we're working hard on and customers are already running sort of with the homebrew version.

What sort of feedback are you getting from the market, specifically with respect to your sequencing platform replacing microarray-based gene expression?

Can you just speak about maybe the economic hurdles that have to be overcome in order for sequencing to be a credible replacement for microarray-based gene expression?

There's two parts to that market as you think about, John.

One is the direct replacement for arrays where you're looking at a subset of the genome and what you typically have on the arrays are what we best think of as all the genes.

And today, if you did that on a sequencer with some enrichment method, the cost would be about the same range as it would be on a microarray, and you get better quality data because you're doing digital counting.

The real killer app here, we think, is full transcriptome sequencing, where you look without any sort of assumption or hypothesis about what might be expressed in the genome across anything that's transcribed.

So that's the more powerful application, where you catch things that arrays would never catch, because you don't have the specific content.

That, today, is still more expensive than using an array, but we think, over the next 12 to 24 months, because of the improving throughput, the ability to do tagged applications and a general reduction in sequencing costs, that it's going to be approximating array prices for much richer data.

Thanks very much and congrats again.

Derik De Bruin, UBS.

So when you are building out some of your reagent manufacturing and kit manufacturing, I guess are you going to start taking over more of your own sequencing reagent manufacturing?

I know that Invitrogen OEM'ed some of that for you.

We do most of the kit manufacturing ourselves.

What we do get from Invitrogen are some components that go into the kits.

But most of the kit work is done by Illumina and it has been done even previously by Solexa.

Does the ABI/Invitrogen merger potentially change that interaction?

We don't think so.

You said that about two-thirds of your Genome Analyzer placements were outside the genome centers.

What are you seeing from the pharma and biotech labs?

Have they started to step up their purchases of (inaudible) equipment, or are they still on the sidelines?

No, we are starting to see that.

In the quarter we had about 10% of our business in sequencing on a revenue basis went to corporate customers.

So that's interesting, and I think we continue to believe that you're not going to see pharma ramp up to operate like a genome center having 10 or 20 systems.

But anybody now that's doing genomic research almost has to have a system in next-gen technology.

So our view is that every research center for a pharma company is going to have one or a couple of next-gen sequencers.

So that market will be there; it just won't be a scaled market like it might have been in early '90s, where those sites were buying 10 or 20 or 30 systems.

What type of applications are they buying them for?

Are they buying them for gene expression applications?

Are they buying them for -- how are they incorporating that in the research?

On the pharma side, we don't get a lot of data about what they're doing inside their programs.

But in general, I can say that a pretty large percentage of our overall customers are either doing expression or have tried expression.

That number is probably in the range of 50% that have run some expression applications on the sequencer.

And there's lots of other applications besides just expression.

So doing things like methylation is now becoming increasingly important, and so whole genome methylation looking at CNV analysis, using sequencing, there's lots of emerging opportunities that we think pharma labs and other labs as well will be doing.

So when you look at -- you're doing 10 G now in your labs, you are talking about getting to 20 G by year end.

When does the 10 G become the standard for what you are shipping out on the GA?

We're working with our customers now on getting some improved chemistry into their hands, and so we'd like to get the installed base consistently running up to 10 G before year end and moving on beyond that shortly thereafter.

I think one of the things that's interesting, Derik, is that the Genome Analyzer has such a diverse set of applications and a diverse customer base relative to any sequencer that has come before.

So you'll have some high-end customers, genome centers, doing greater than 10 G early this summer.

And you'll have some of the lower-end customers that, quite frankly, don't need 10 G because they're doing expression or other tag-based applications, probably later in the fall or in the winter, achieving those levels.

The key for us is really simplifying the workflow, improving the data analysis capabilities and making the system as robust as we can.

I think, if you look at the last nine months, that's really what our focus has been and we're starting to see the dividends pay off.

You have had quarter after quarter success, and the numbers have gone up.

Really, what keeps you up at night in terms of what do you think -- what do you worry about in terms of the most potential thing that could derail the plans you've got going?

Well, I think the focus we have is to continue to innovate at a very fast rate.

So we are continuing to look at our technology, the technology of the competitors.

We need to make sure we are on very steep curves to continue to reduce our cost.

What has contributed largely to our success as we look backward has been our ability to grow the markets because the prices have fallen for customers.

And we are fortunate to be in these spaces where it's highly elastic, and we think products like what we are doing with Avantome and that acquisition fit right into that strategy where we now have the ability to address the lower-cost part of this market and take sequencing to yet another level beyond this high-end segment that we're concentrating on now.

So I'm not sure that keeps me up at night, but it's certainly a very intense focus that we have in the Company to make sure that we continue to innovate rapidly.

I think another thing that we constantly grapple with internally is, as we get bigger, we become increasingly complex.

Keeping the corporate culture and the spirit around the world 24 hours a day, seven days a week is something that we've spent a lot of time thinking about.

I think, so far, we have done a pretty good job of keeping that.

But that's something that keeps me up.

May-Kin Ho, Goldman Sachs.

This is Davis Bu, actually.

May-Kin apologizes, she had another appointment (inaudible).

So a couple of things.

One, I know it's a small part of your business, but the services revenue, because I know that you had certified another couple of companies in Japan and Germany this past quarter.

Can you give us some color on what the growth opportunities there are and how that fits in your business?

Yes.

If you look at our service business over the past four or five quarters, I guess it's probably best described as sort of flat.

But I think that's not necessarily reflective of what has happened in the market because we have certified now quite a large number of what we call CSPros, and these are customers who go through a qualification process with us and receive our certification to run services.

So, compared to where we were, say, two years ago, there are many, many of these entities out there that are providing third-party services and we encourage that.

So, while our own service business has been on the flat side, we think the overall service business has continued to grow.

We are going to become more and more active in the sequencing services, just as we did in genotyping.

So I think you'll see over the next year the beginnings of add-ons of other applications in our services business, which could kick-start the growth that you see from us as well.

The second question, I just want to make sure I heard you right.

For your iScan, because of the higher ASPs, did I hear you right in terms of the effect -- or, if you could just provide a little bit more color on what affect that has on the installed base or the installations.

And maybe, is it having an effect on their customer mix, or any additional color there?

I don't think it necessarily impacts customer mix, but the point I was trying to get across there was that, because the throughput is so much higher on an iScan, if a customer might have bought three BeadStations previously over the course of six months, now they might be able to get by with one.

So there may be on the margin a somewhat lower number of systems required to meet the market demand.

But on average, the consumables -- [consumables] per system are going to be higher because the throughput is so much greater on the system.

This also excludes the fact that, when we get returns of BeadStations, we're going to resell those as well.

And so I think that was the trend that I was indicating.

I don't think it's going to be a measurable difference in our overall number of systems placements, but it might slow down the growth of our array scanner placements compared to what we would have had, had we still been selling BeadStations.

Thanks for the clarification.

The next is, for your upgrade kits and trade-ins, I was wondering, is that having a measurable impact on your top line?

I don't know if you could quantify what impact that's having.

I can say, qualitatively, we are seeing, as I think we mentioned in our remarks, a very high percentage of quick conversions from the GA I to the GA II.

So in the sequencing side, we think everybody is going to upgrade because it's a relatively inexpensive upgrade for a huge jump in capability.

It's somewhat different on the array scanner side, and there we think the upgrades will be over a much longer period of time.

The reason is that, if somebody is operating already with a BeadStation and they are at the right throughput, unless the equipment is becoming either obsolete or unrepairable for some reason, there's not a big incentive in the short-term to spend a little bit more money to get the higher performance system.

So I think the upgrades you will see in the scanning side of this will take some number of years.

How much are the upgrade kits?

Well, we don't give the pricing specifically, but the way to think about it -- in the array business, we offered upgrades that vary somewhat in price, depending upon how recently you bought your scanner.

So if someone had just recently taken and installed a BeadStation, they have the opportunity to get the upgrade much less expensively than someone who had a three-year-old unit.

Jonathan Groberg, Merrill Lynch.

Maybe you can talk about your SG&A spend.

I know that's one area where you've thought that you -- every quarter, you say you are below your long-term model, but as a percentage of sales it seems to keep getting lower.

So maybe you can describe your plans for that line, say, over the next year or so.

We're continuing to invest pretty heavily in SG&A, and not so much on the G&A part, but on the sales and marketing and support side.

We now have almost 90 salespeople.

We have about 175 customer support people on the team, and so we're having to grow that organization not quite at the pace of revenue, but not too far off the pace of revenue.

I think why we continue to be lower on the percentage of revenue is mostly a top line factor.

I think we are pretty much doing what we expected to do in terms of the growth and the expense line, but we have continued to exceed the revenue plan.

Part of that is that our teams are doing a great job.

Our sales teams are bringing in big orders and they continue to carry very large quotas and be very successful.

And so that's why the percentages have been under our long-term guidance.

But as you were saying in some of your remarks that you're shipping more outside of core genome centers and to potentially smaller labs and even, as things move out on the applied markets on the array side.

Has your view changed as to what the right rate is for, again, just the sales, I guess, the sales part of the equation in terms as a percentage of sales, what you're going to need to spend?

Are you learning anything as you get bigger here?

Certainly, one effect is that we are becoming more efficient, and that has to do both with -- the quality of the system we're producing is much higher than it was a year ago, and the systems are much more robust.

We have sequencing sites that had bought their first sequencer, and it takes almost as much energy of a field support person to support one in a side as it does to support two.

As they reorder the second one, the incremental support isn't that high.

So, to be honest, we're still fine-tuning those models, and we do every quarter to understand what we need to do going forward.

But I guess the bottom line of that is that we do believe we need to continue to invest in building that infrastructure.

We've just been successful in keeping it slower than revenue growth.

Okay.

Then going back to the notion of where you're at in terms of pricing on some of the sequencing applications and then some of the array applications, can you just talk about how your own expression array business grew, or how it's growing, or not growing?

Yes.

We did pretty well again in expression, particularly on the order side.

We had a very strong quarter in orders in gene expression.

So we continue to be a small part of the overall market, but we did introduce a new chip.

Our HD 12 is a very exciting new product in expression that brings the price per sample down under $100.

So I think that we're starting to get significant traction with that new product.

So, while we think overall the market over time is going to shift to sequencing, we're still doing okay in the array business.

So, as a customer comes to you to maybe look for a solution and they could either do sequencing or an array and you explain to them the costs as kind of comparisons, do you have a preference internally in terms of which one they do from either a margin or a business standpoint, internally?

It probably would depend.

If they had one of our systems already, we would probably want them to buy the other one.

But in general, I think we depended a little bit on what their profile was.

If they wanted to do broad sets of applications and they wanted to look across the whole transcriptome, then the sequencing is the right answer.

If what they wanted to do was a very focused study and they were doing only 100 chips at a time or 100 samples at a time, say in a five or six-month period, then it might make more sense for them to use chips to do it.

And if they only cared about the genes, then that's the perfect solution.

So you can sort of segment these customers depending upon their profile.

But in terms of having an instrument in place there and whether or not they use the chips consumable or the reagent consumable on the sequencing instrument, is one better for you from like a margin standpoint?

It's a complicated answer because it depends on -- if it's in a core lab and there's other people using the same instrument and what the utilization rate is.

So that's not an easy question to answer.

There's too many factors that go into it.

If you keep it really simple, right, we have historically said that the gross margins of the array side of the world are higher than the sequencing side of the world, right now.

So if you just want to use that metric.

But as Jay said, the truth of the matter is it's really what the customer -- it's really that we have the opportunity to help answer the question the customer is asking.

And I think that's the way we have to approach this.

Christian, can you just clarify -- I think in your prepared remarks you said something to the effect that the growth -- or both sequencing and the microarray business were equal contributors in terms of growth.

Were you talking about growth rates, absolute dollar?

I'm just trying to understand what you were saying.

That was kind of on a relative basis compared to last year.

But from a growth (multiple speakers) standpoint?

So, basically, in terms of dollar.

Dollars year over year.

Yes, in terms of dollars year over year.

Okay, got it.

So, if I take some of those statements and then take some of the statements around instrument revenues and some of the other ones you gave, and if I triangulate it in, was there anything happening with sequencing this quarter in terms of push-back at upgrading to the GA II, or problems with shipping the GA II, or anything happening in the quarter with shipping some of the sequencing instruments?

No.

We had a great quarter shipping the instruments.

I think we were right on target with what we are trying to get done internally.

As a matter of fact, we were a little bit above those targets.

And then the outperform -- and then, you had a big component of the outperformance out of the stronger than expected array part of the business.

So in terms of how we thought about what the sequencing business would do for the quarter, we were very pleased.

I think that's all the time we have for questions.

Yes, sir.

There are no further questions in queue.

As a reminder, a replay of this call will be available in webcast format in the investor section of our website as well as through the dial-in instructions contained in today's earnings release.

Thanks for joining us today.

This concludes our call, and we look forward to our next update following the close of the third quarter.

Thank you for your participation in today's conference.

This concludes your presentation.

You may now disconnect.

Good day.