Illumina Inc (ILMN) 2009 Q3 法說會逐字稿

Good day, ladies and gentlemen, welcome to the Q3 2009 Illumina earnings conference call.

I will be your operator for today.

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

Later, we will conduct a question-and-answer question.

(Operator Instructions) As a reminder, this is being recorded for replay purposes.

I would now like to turn the call over to Mr.

Peter Fromen, Senior Director Investor Relations.

Please proceed, sir.

Thank you, Operator.

Good afternoon, everyone, and welcome to our third quarter 2009 conference call.

During the call we will review our financial results released today after the close of the market, offer commentary on our commercial activities and provide financial guidance for the remainder of fiscal 2009 after which we will host a question and answer session.

If you have not had a chance to view the earnings release, it can be found in the investor relations section of our website at Illumina.com.

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

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

It is our intent that all forward-looking statements regarding financial guidance and commercial activity made during today's call be protected under the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are subject to risks and uncertainties.

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

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

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

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

Following the JPMorgan conference, we will have an analyst day in the afternoon on January 14 at our Bay area facility in Hayward, California.

More information regarding this event will be available shortly.

For those of you unable to attend any of the upcoming conferences or our analyst day, we encourage you to listen to webcast presentation which will be available through the investor relations section of our website.

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

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

During today's call I will review our third quarter financial results and provide guidance for the remainder of fiscal 2009.

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

We reported $158 million of total revenue for the third quarter, which was approximately $4 million below the low end of our guidance for the quarter.

This represented 5% growth over Q3 of last year.

Product revenue was $150 million, growing 7% over the prior year period led by significant growth in our sequencing products.

Similar to last quarter, the strong growth we recognized in our sequencing business was insufficient to offset declines in our Micro Array business, specifically for products that enable Genome wide association studies.

Consumables revenue for the quarter was $87 million compared to $90 million of Q3 of 2008 which represents a year-over-year decline of 4%.

Sequencing consumables grew well over 100% on year-over-year basis but were essentially flat with respect to Q2.

Late in the third quarter we estimate that we lost approximately $6 million to $8 million in revenue due to a sequencing reagent quality issue which prevented us from shipping certain kits at the end of the quarter.

Jay will provide more details about this matter and its resolution in his remarks.

Despite this issue, annualized consumable pull through on the Genome analyzer was still within our projected range of 150K to 200K per system.

Array consumables remain more than half of our consumable revenue but were down in the quarter on both the year-over-year and sequential basis.

The decline continues to be directly attributed to the weakness in sales of whole Genome genotyping chipping.

Consumable pull through for the Array business was between 400,000 and 500,000 per system.

We shipped another record number of Genome analyzers during the quarter as demand for the system continues to exceed our expectations.

Strong GA shipments as well as year-over-year and sequential growth in iScan revenue enabled us to recognize record instrument revenue of $61 million.

This compares to $47 million in the third quarter 2008 and represents year-over-year growth of 30%.

Services and other revenue, which includes Genotyping and sequencing services as as well as instrument maintenance contracts was $8 million compared to $10 million in Q3 of last year.

The year-over-year decline in services was largely due to the overall decline in GWAS studies but also to the fact that more of our genotyping service revenue has moved to our CSPro certified customers.

Before discussing our gross margins and operating expenses for the quarter, I'd like to note that we recorded a pretax amount of $15 million related to noncash stock-based compensation.

This impacted EPS $0.07 per proforma diluted share for the quarter.

In my discussion of operating expenses, I will highlight both our GAAP expenses, which includes stock compensation expense and other noncash charges and corresponding non-GAAP figures.

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

Total cost of revenue for the quarter was $51 million compared to $57 million in Q3 of 2008.

The Q3 2009 cost includes stock-based comp expense of $1.3 million compared to $1.2 million in prior year period.

Excluding the expense and $1.7 million associated with amortization of intangibles, non-GAAP gross margin was 69.5%.

This compares to 70.6% last quarter and 64.6% in the third quarter of 2008, a year-over-year improvement of nearly 500 basis points.

Similar to last quarter, key contributors to the year-over-year gross margin improvement were reformulated sequencing kits, our new real-time analysis software package which allows us to reduce the hardware cost of the Genome analyzer and overall manufacturing and supply efficiencies that have resulted in lower material costs and favorable overhead absorption.

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

As partially evidenced by our strong gross margins, pricing continued to be stable in our markets.

However, ASPs per sample declined in the overall Array market product line as due to an increase in the mix of custom and fixed content shipments which sell for lower prices per sample relative to whole Genome genotyping chips.

ASPs for whole Genome genotyping chips were essentially flat with last quarter.

Instrument ASPs in our sequencing businesses declined slightly from the second quarter as we closed more multisystem deals where we typically provide a larger discount.

Research and development expenses were $34 million in the quarter compared to $28 million in the comparable period of 2008 and included $4.8 million and $3.5 million respectively in noncash stock compensation expense.

Excluding stock compensation expense and $0.9 million and $0.6 million of accrued contingent compensation associated with Avantome acquisition in third quarter of 2009 and 2008 respectively, R&D expenses were $29 million or 18.1% of revenue compared to $23 million or 15.6% of revenue in the prior year period.

The increase in year-over-year R&D expense was primarily attributable to increased head count and increased project activity.

SG&A $42 million compared to $39 million in the third quarter 2008 and this includes stock compensation expense of $8.5 million and $8 million respectively.

Excluding these noncash expenses, SG&A was $34 million or 21.2% of revenue compared to $31 million or 20.9% of revenue in the prior year period.

The increase in SG&A spend on a year-over-year basis is primarily the result of increased head count.

GAAP operating profit for Q3 was $29 million, excluding noncash expenses outlined earlier and acquired in process R&D expense of $1.3 million, our non-GAAP operating profit for the quarter was $48 million or 30.2% of revenue.

This compares to $42 million or 28.1% of revenue in the third quarter of last year.

This represents year-over-year operating profit growth of 13% versus top-line growth of 5%.

This demonstrates the continued underlying leverage of the business despite a lower-than-anticipated figure.

GAAP interest and other expense in the third quarter included approximately $4.8 million in noncash interest expense associated with our outstanding convertible debt.

Excluding this amount, proforma interest and other income was $3 million which includes approximately $1.6 million or less than a penny per share of positive foreign currency due to the revaluation of monetary assets outside the US.

Our non-GAAP tax rate for the quarter was 36.4% compared to 31.2% last quarter.

The increase in our tax rate in Q3 relative to Q2 was due to the fact we're generating more income from our sequencing products than we had originally forecast.

This required us to make a year-to-date catch up adjustment that drove the tax rate higher than originally expected.

On an annualized basis, we anticipate our tax rate approximately 34%.

We reported GAAP net income of $17 million or $0.12 per diluted share compared to a loss of $10 million or $0.08 per dilute shared in the prior year period.

The GAAP loss in the prior year period was due to the noncash in process R&D expense associated with acquisition of Avantome.

Excluding the impact of noncash stock compensation expense, noncash interest expense and the other items identified in our press release and net proforma tax expense, non-GAAP net income was $32 million or $0.24 per proforma diluted share compared to $29 million or $0.22 per proforma diluted share in the third quarter 2008.

This represents 13% growth in net income year-over-year.

In the third quarter we recorded capital expenditures of approximately $20 million.

The largest component of this outlay was for the building improvement in our new UK facility.

This facility is essentially complete at this stage and we will be moving in over the next few weeks.

In the quarter, we generated $23 million in cash flow from operations and free cash flow of $3 million or approximately $0.03 per proforma fully-diluted share.

This compares to the third quarter of last year when we generated $0.09 of free cash flow per share.

Q3 cash flow compared to the second quarter was impacted by lower net income, increased inventory levels built to address the anticipated increase in demand for sequencing products, and an increase in accounts receivable.

DSO increased to 94 days up from 87 days in Q2.

Depreciation amortization expenses approximately $8 million and we ended the quarter with approximately $815 million in cash and investments.

I will now provide financial guidance for the remainder of the year.

As a reminder, we will exclude the charges associated with the adoption of the accounting guidance related to convertible debt.

Consistent with our previous calls, guidance will exclude certain noncash charges including stock compensation expense, the amortization of intangibles and acquisition-related charges.

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

Not only did sequencing reagent issue impact revenue in the third quarter, we expect it will have a negative impact up to $15 million on Q4 revenue.

As a result, for the fourth quarter we expect total revenues to be a minimum of $165 million which implies a full-year 2009 revenue at a minimum of $651 million.

This represents year-over-year growth of 3% in the fourth quarter and 14% for the full year.

We expect gross margin percentage in the fourth quarter and full year to be between 69% and 70%.

We expect non-GAAP earnings per fully-diluted proforma share in the fourth quarter to be between $0.24 and $0.25 which implies $1.05 to $1.06 for the full year.

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

The company expects full year weighted average shares for the measurement of proforma amounts to be approximately $133 million and, finally, we believe total capital expenditures approximately $52 million.

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

Jay.

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

Q3 was a disappointing quarter for Illumina with three key factors contributing to our revenue miss.

First, the concerns that I discussed last quarter regarding stimulus-related delays were realized.

Second, we saw a continued decline in the whole Genome genotyping market and, lastly, we had a rare operations issue that occurred late in the quarter.

Let me address each of these in turn.

As I describe to you last quarter, we felt the ongoing uncertainty around the magnitude and timing of stimulus funding clouded our ability to forecast revenue.

During Q3, only very limited stimulus fund were released to customers and recognized a nonmaterial amount of revenue from these funds.

We estimate around $8 million to $10 million of orders we expected to receive were delayed waiting for grants to be awarded.

Additionally, we did not see the bolus of orders at quarter end that is typical for end of NIH fiscal year.

Grant approval activity accelerated significantly at the end of September as the NIH pushed to meet its fiscal year deadline to commit awards.

While this is encouraging, there still remains significant uncertainty as to when these awards will convert to orders and ultimately be recognized as revenue.

In Q4 we have begun to receive some orders related to stimulus but cannot predict how much will hit Q4 versus sliding in to 2010.

On the positive side, we no longer expect to see stimulus related spending delays impact our business.

As we saw in the second quarter, a significant component of our revenue shortfall was due to the slowdown in Genome wide association studies, or GWAS.

GWAS Array revenue $7 million below our internal forecast for Q3.

The impact of this slowdown has been most significant in Europe where the overall funding environment has lagged the US.

The third factor contributing to our revenue shortfall was the sequencing reagent quality issue that Christian mentioned.

Late in the third quarter, we experienced an issue with our paired sequencing kit and estimate that this problem alone resulted in lower third quarter revenue of between $6 million and $8 million.

I'd like to take a moment to walk you through exactly where we are with this issue and the impact that we believe it will have on the fourth quarter.

In September, some of our customers began to see high error rates on the second read of their paired end analysis.

As a result, we elected to hold shipments temporarily on paired end cluster kits which were believed to be the cause of the failures in order to contain the problem and troubleshoot the cause.

We traced the root cause to a small group of purchased materials and have since reformulated our kits with new raw materials.

We have been testing the new kits extensively both internally and at various customer sites and believe that these new regent batches are performing to specifications.

Additionally, we have enhanced quality control procedures to assure no additional defective kits are produced or shipped.

We removed the shipping hold, we ramped manufacturing and we expect to rapidly clear our backlog.

Since we actively held shipments to contain the problem and will provide warranty replacement kits to our customers, our revenue for the fourth quarter may be negatively impacted by as much as $15 million.

With this context, let me now discuss our product groups and the latest developments in each.

Within our Micro Array products, total revenue for the quarter came in under our forecast resulting in both sequential and year over year declines.

The shortfall between our forecasted Array revenues and actuals for the quarter was primarily due to delayed orders as customers waited for funding.

We expect to recognize many orders within the next two quarters and do not believe we lost any material business to competition in Q3.

Although the overall Array products declined in the quarter, both custom and fixed content Arrays continue to show significant growth.

For example, we saw growth over 20% over last year in customer Array and over 15% in our fixed content products.

However, this growth could not offset lower revenue from our old geno Micro Arrays.

As we mentioned over the past few quarters, the GWAS segment of the Micro Array market has been negatively impacted as researchers await new and rare variant content from the thousand Genomes Project to be incorporated in to new Array products.

However, based on our discussions with customers and the number of stimulus grants awarded for GWAS subsequent to the close of the quarter, we believe the GWAS market will return to growth in 2010.

Last week at the American Society of Human Genetics Conference we announced our 2010 road map to deliver Micro Array products that will enable researchers to analyze up to 5 million variants per sample.

The content for this product will come predominantly from the 1000 Genome product data as it is released.

On the path to launch of the 5 million marker Array, we will launch an intermediate 2.5 million variant product that will build upon the Omni 1 released in the second quarter this year.

We're collaborating with a group of leading researchers to prioritize markers as they're released from the thousand Genome Project, increasing content up to the 5 million marker Array.

We plan to offer supplemental Arrays that will allow customers to build towards the 5 million Array incrementally.

This approach will enable customers to being their rich GWAS studies immediately with the Omni1 and then purchase supplemental Arrays at an overall lower total cost than if they had waited for the 5m chip.

We believe this market approach will help to relieve the pause we have seen in the market and begin to catalyze the broad emergence of rich GWAS.

Our sequencing products once again exceeded expectations this quarter as we shipped a record number of genome analyzers.

As of the end of the quarter more than 70% of systems in the field have been upgrade to the G-8 2X configuration.

This upgrade combined with improvements in our pipeline software has enabled multiple customers to now generate over 55G per run on a single flow cell.

We're also on track to meet our road map to generate 95G per run around the end of the year.

We continue to see the GA stand out as the premier next generation sequencing system on the market.

In fact, we believe we currently have well over 50% share of the next gen sequencing market.

To date there have been over 450 scientific publications using the Genome analyzing, more than 18 times greater than other sequencing technology.

In addition to hardware and software upgrades that we made to the GA this year, last week at AFHG we announced the commercial launch and immediate availability of cBOT, the next generation of our sample (inaudible).

cBOT replaces the cluster station and enables greatly-improved automation in front of the Genome analyzer.

This system was designed from the ground up with the goals of greatly improving performance and ease of use.

For example, the new system requires less than ten minutes of hands on time and four hours of total run time representing 70% and 20% reduction respectively compared to the cluster station.

Compared to typical emulsion PCR protocols, cBOT requires one-hundredth the hands on time and one-sixth the run time, extending further the already considerable sample prep time advantage.

In addition to improved performance, we completely redesigned the user interface and the reagent cartridges, we've optimized the user experience by adding a touch screen interface to the instrument.

Novice users can now follow simple graphic icons to quickly get their samples processed and, in addition, the system has an integrated bar code reader for efficient tracking and logging of reagents.

In conjunction with cBOT we also launched our version 4 cluster generation kit which uses a higher fidelity enzyme to deliver greater accuracy during amplification.

These kits now come prepacked and sealed for single step plug-and-play loading in to cBOT to help eliminate reagent prep errors and sources of contamination.

Once the reagents are loaded, the technician can walk away, remotely monitor the run and receive diagnostic updates on any web enabled device, including an iPhone.

In the third quarter we achieved record order levels, we built our backlog and we maintained our strong gross margins.

In manufacturing we continue to generate cost reduction and production efficiencies which resulted in gross margin improvement of almost 5 percentage points from last year.

Prudent management of SG&A expenses resulted in operating margins over 30%, more than 2 percentage points higher than last year, while maintaining significant R&D investments to drive our product development portfolio.

Overall, while we're disappointed with our total revenue performance in the third quarter, we're seeing many encouraging signs in our markets.

Although we have some remaining uncertainly about GWAS in Q4, we continue to gain confidence that growth will return in 2010.

During the quarter, we saw significant increase in grant activity for GWAS as well as custom content studies from both stimulus and related funding in the 2009 NIH based budget.

Next generation sequencing remains robust and continues to be the most exciting opportunity in the life sciences research area and we have maintained if not extended our market leading share during the quarter.

Finally, our R&D programs are richer than they've ever been, supporting core goal of innovative products to customers and our markets.

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

(Operator Instructions) We have a question from the line of Ross Muken, Deutsche Bank.

Please proceed.

Are you there?

Your line is open.

Please unmute your phone if you muted your phone.

No, I'm here.

Hey, guys.

Hey, Ross.

It seems like a confluence of things happen this quarter which were somewhat unexpected.

The one that sort of stands out is obviously the sort of execution miscue on the manufacturing side.

When in the quarter did you realize this and when you saw that you were going to come up short relative to the guidance that you had set -- what was the decision-make process, particularly given its impact not just for 3Q but also for 4Q in terms of alerting the street versus sort of coming and doing it now in this forum?

Yes.

The earliest indicators we had, Ross, were in the early part of September when we had one or two customer who showed some error rates in their second read and we began to investigate that and it was sort of late in the September time frame where we realized that we may have a reagent problem and we put a bunch of people on investigation of that problem to understand what was causing the problem, what was the root cause of that issue, and that's when we put a shipment hold on all of those kits.

So we spent sort of the next three to four weeks investigating that and building new kits from scratch with new raw materials, which has proven to solve the problem so we're very confident in the reagents we are now shipping.

But until we understood we had the problem solved, it was very difficult for us to get a handle on our Q3 revenue let alone our Q4 revenue impact and that's because we have some transactions, some business arrangements out in the field that have to do with the way revenue gets allocated based on allocation to various kinds of shipments.

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

Okay.

And as we look through the fourth quarter and to next year, I want to try to understand sort of the thought process.

The guidance is extremely open-ended relative so setting a minimal level and obviously one can see with kind of the potential $15 million why that is.

If you take that sort of manufacturing issue, which hopefully is now solved and put that aside, what does the sort of general backdrop look like for the business once we sort of normalize for that?

In terms of what you're expecting in the fourth quarter relative to the stimulus, are you sort of erring on the side of caution there assuming most of those orders or quotes turn into revenues eventually in the first quarter?

I'm just trying to get a sense for kind of the thought process there and in turn what one-time issue and now that we should be past the point where the stimulus is freezing you out on the sequencing business, what does the sort of big picture look like?

A couple factors.

for Q4 we pulled $10 million from GWAS because of the continued decline that we saw in the third quarter so fourth quarter we're seeing some stabilization.

We're not quite prepared to say we're at the bottom of the decline in GWAS.

We don't know but think we're sort of in that range now but took $10 million additional out for GWAS in Q4.

We also, because of delays in the flow of stimulus, pushed $10 million of stimulus out of Q4 into next year from what we originally had estimated.

We just don't know what the timing is going to look like of when these orders come in, when we ship the product and when recognize revenue and because of that uncertainty, we wanted to make sure that we didn't over estimate or pull in the stimulus more than it was really going to happen so we are being cautious on stimulus so far this year.

It's been a negative for the company.

We want to make sure it wasn't a negative again in Q4.

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

Please proceed.

Hey, good afternoon.

Let me start with a follow up to one of Ross' questions.

Just to be clear on this, based on how you described it, is it fair to assume or is my understanding correct that you shipped $6 million to $8 million of kits where you didn't record revenues due to the reagent issue?

Is that how you came up with that estimate in terms of impact was in the quarter?

No.

No Doug, when we shut shipments off, we should have shipped $6 million to $8 million more than we wound up actually shipping out the door.

There's other orders we would have received that we know we would have received had we not had the issue and shipped.

Okay.

And I guess as a follow up to that, there was no impact on instrument placements related to this.

This is purely your estimate based on the reagent issue?

That's right.

And moving forward, is there any risk that this issue would impact negatively either you from a competitive standpoint in placing instruments or the time lines associated with placing instruments?

We don't think so.

Most of our customers have continued to run -- this was a problem that didn't occur on every run but on a fraction of the runs that customers were doing.

But in our large production sites, we consider that to be an unacceptable situation so that's where we began working directly with those customers and had them stop running so we could solve the problem.

So we don't think there's been an impact in the majority of customers nor do we think there's been an impact on order receipt rate for instruments and we should say with confidence that we believe we're over the problem.

Okay, in the interest of time, please limit your questions to one question and one follow-up question.

We do have a question from the line of Marshall Urist, Morgan Stanley.

Please proceed.

Hi, guys, good afternoon.

So I had a question on the other point you guys made about order delays.

I think you said there are $8 million to $10 million and I wasn't clear what you were saying there.

Was that orders that were delayed because of stimulus or those were stimulus orders that didn't come through because they didn't hear back from NIH in time?

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

Okay, great, thanks.

We have a question from the line of Quintin Lai, Robert W.

Baird.

Please proceed.

Hi, good afternoon.

Going back to kind of the GWAS discussion, you said that European sales also impacted you.

They're not going to be impacted by the NIH stimulus, so could you explain a little bit about how you expect that to come back to growth and is there a source of funding for them that's going to get them back for next year?

Well, we think as in the US, Quintin, the reduction that we saw in Europe, across the world there's sort of a slower economic environment coupled with a specific impact in GWAS.

In Europe, there's no stimulus.

You're right.

So that won't be a positive effect bringing that back but we do think as GWAS recovers that the funding mechanisms in place in Europe will fund the next generation of GWAS studies so we don't have much concern about that.

We do have, as we mentioned in the past quarter or two, some key foundation funding entities in Europe that have slowed down considerably in their Array business as those endowments have suffered over the past few quarters.

Jay, as a follow-up to that, the preliminary discussions maybe some of your customer have shared with you on the future of GWAS, could you talk a little bit about what kind of population sizes they're looking at?

Are they going to be comparable or bigger than the previous ones and then with respect to price per sample, do you anticipate it being a little higher now that you're going to go to 2.5 or 5 million per sample?

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

In terms of pricing, we do think the 2.5 M and 5 M prices will be higher on a sample basis than say the Omni today, so that will definitely be an increase in per sample price.

Obviously we can command that because the content will be much richer.

Thanks.

We have a question from the line of Bill Quirk, Piper Jaffray.

Please proceed.

Thanks, good afternoon.

Jay, not to beat a dead horse here, but one last question on the sequencing reagent issue.

The correction sounded a lot like it was just requiring new raw materials and maybe some improved quality control internally, but in terms of the overall manufacturing process, there's no meaningful changes above and bond that, correct?

Yes, this was not a process problem, it was a raw material problem.

So what we've done is we have isolated it down to one of three raw materials.

We now have very extensive incoming quality control checks over and above what we had on those already and we are testing every lot that we produce and so we don't think the problem will recure.

But this really was not a failure in how we were making the reagent, it was a failure in incoming material.

Okay.

Now that's very clear.

Also just thinking about stimulus now, we have a pretty good handle on a lot of the awards and some of the actual funding timelines here.

How should we be thinking about the initial stuff and expectations?

Well, we're still trying to figure out what that timing is going to look like but we think we have a better handle now on the scope of the opportunity and we think that of the initial committed funds, which is about half of $10 billion NIH would receive in stimulus, the Illumina opportunity set there is somewhere $100 million, $100 million plus.

We might not get all that because obviously there's some competition for those funds, but our opportunity is of that magnitude.

We suspect in the second phase of committed grants that there will be some additional upside to that number some time through 2010, 2011.

What we're still uncertain about is exactly how fast those monies will flow, what the allocation between instruments and reagents will look and, therefore, we're not at a point where we can assign those opportunities on a quarterly basis yet, but clearly we do expect a positive effect on 2010.

Very good.

If I can sneak one last one in here for Christian.

In term of the rising DSO, anything we should worry about here, Christian, or is this a function of timing?

It's a function of timing, actually.

If you look at the actual aging buckets in terms of delinquent accounts, the aging relative to last quarter is looking better so it's really due to the timing of when you do the invoicing and things like that.

So, from my perspective we're watching it carefully, of course, but our cash has been good and our write offs are nonexistent.

We don't really have any write offs.

So I don't think it's -- I think about it but I'm not that worried about it at this point.

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

Please proceed.

Hi.

So I guess when you kind of look at some of the new content GWAS chips that are going to be out there and as people kind of gear up to do new studies, given the scientists are kind of disappointed in some of the results of the first round of studies, when do they think the content is going to be rich enough in order to begin the next round of studies?

I mean, are they going to want -- do you see this happening by the middle of 2010?

Do they think they have enough data for the thousand Genome product so we can start going or are they going to want to see more and more stuff coming out from that.

At what point do you think some of these big labs are going to make that go no-go decisions on these projects?

I don't think the decisions on customers will be binary and universal.

I think they will make different decisions about what their best strategies will be and will depend on what their research program looks like and where they are in their phase of study.

One of the reasons we put forward our road map is because it's very clear that even if you had, say, the first chip, the $2.5 million marker or in fact even the Omni, if you ran the chips you have some opportunity of discovering very important markers of some low hanging fruit because the initial markers that we will put on the 2.5 million chip will be the best set of markers out of the 20 million that have come out of the thousand genome program so they will have the highest opportunity of making the next set of discoveries.

The way we set up the program, then, allows someone to begin using the Omni, then run the a series of supplemental chips, two supplemental chips in that case, to get up to the 5 M and our hope is some customers will begin to start either now on the Omni or when we launch the 2.5 and then we will run the supplemental chips to get up to the 5 with the thought that they have an opportunity of making some very important discoveries early on as opposed to waiting until the 5M was fully available.

We priced those supplemental chips to incent customers to take that path.

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

Okay.

Okay.

That's -- I guess is there concern the researchers won't have enough raw sample to go back and do the repeat studies, given how difficulty it is to find sample in the first place?

No, they're in pretty good shape in most of the populations in most of the diseases.

Many of the projects we saw in the last phase were consortium and came together around the world to do the program and so we don't think there will be a limitation on samples.

Since they did the last round, many of these group have continued to collect samples on an ongoing basis.

Okay.

One other quick one.

We heard a lot of chatter about some large awards, some of the Genome -- can you give any color on the stuff that has been awarded to date, about some of the large orders?

Can you let us know what is out there so far?

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

We have a question from the line of Tycho Peterson, JPMorgan.

Please proceed.

Hey, good afternoon.

The $10 million you pulled out of GWAS for the fourth quarter, does that include a service component and if not, what to prevent service from having another tough quarter in the fourth quarter?

The service's impact is two-fold.

One is the overall production in studies and secondarily I think we mentioned three or four quarters running the fact more of that business is going to our CSPro customers and that is a trend that we think is okay and our sales team has enabled our customers to run these service projects and encouraged them, in fact, to develop [monoframatic] analysis on the back end that we don't offer and so that migration is one we're fine with.

So from a GWAS growth opportunity in our own services business, that's not something we're measuring as strategic to Illumina's progress.

Okay.

That's helpful.

Can you talk a little bit about capital deployment?

You have a new buy back.

How do we think of balancing that with the investments you made in new technology versus infrastructure?

Well, I think, Tycho, we're at a point where we're generating sufficient cash.

We're looking -- we're putting in to the business.

You see the R&D.

We're still spending quite a bit on R&D.

We have a very extensive project set.

You're right.

We do have the buy back in place.

That was put in place largely to cover the dilution from the stock option program and basically a carry forward from the buy back we announced I believe it was last year.

And so on the capital spend side we are just wrapping up Gonville building in the UK which is a very significant expense in the quarter.

It was a little more than $10 million of the $20 million was spent in that area alone.

And at that point most of our scale-up is complete for at least the foreseeable future.

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

We have no building material programs underway.

We're taking some small incremental space in San Diego but that is routine for lease hold improvements, nothing significant in the next year to 18 months.

And strategic investments, Tycho, that's probably better we don't kind of signal those until we make them but, of course, we're always looking at technology opportunities with me moving into my new role.

It's going to give us a new opportunity to focus a little more deeply in that area so stay tuned.

We have a question from the line of Isaac Ro, Leerink Swann.

Please proceed.

Your line is open.

If you muted your line, please unmute your line.

Thanks for taking the question.

Looking at fourth quarter guidance of $165 million in revs, I just want to make sure it's fair to say that number excludes any impact from the -- some of the larger orders we talked about last quarter.

I think you mentioned that you had a couple potentially $40 million sized orders as well as multitude of call it $5 million to $10 million-sized orders potentially out there related to stimulus.

I want to make sure the extent to which you pulled all those potential orders out of expectations at this point and then maybe the extent to which they might provide optionality for the up side should they materialize this quarter.

To be clear, I believe we said grants as large as $40 million and clearly if somebody would get a grant, all that money wouldn't necessarily go to us.

There was some large grants in the Q as we've seen reported since the end of the third quarter.

What we've done is factored in some expectation of what might happen statistically across that set of grants for the fourth quarter but, in general, what we've seen is a little slower process than I think many anticipated six months ago with the commitments really coming around the end of the third quarter and some dribbles of money hitting researchers now and so it's hard for us to predict any specific grant for fourth quarter revenue so we have not included anything specific but taken some statistical expected value across the whole opportunity set.

We have a question from the line of Dan Leonard, First Analysis.

Please proceed.

Hi, good afternoon.

Hi.

So I guess my question is why at this point didn't you have visibility on which you'll capture from the stimulus given that a lot of grants have already been awarded and in instances where somebody is requesting an instrument, my understanding is often times will name the instrument in the request.

Well, we have clear visibility at that level so we've been through every single grant award and analyzed and read every abstract and categorized them, we know which are Arrays and which are sequencing, which ones have Illumina's name in them and which ones don't.

That's ambiguous for the first half of the committed grants.

What is ambiguous is the timing so we don't know when those grants will transfer into orders for Illumina.

All of them or many of them have to go through administrative processes at their institutions.

There's negotiation periods to get the orders closed and in some cases there is revenue recognition issues.

Whether they fall into Q4 or into 2010 is where the largest uncertainty is.

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

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

More time and more customers.

The other factor, of course, is that for some of the customers that were affected we're now supplying them with replacement kits for the ones they had issues with and so for the next weeks they will be running factor-free kits.

We have a question from the line of Zarak Khyrshid from Caris and Company.

Please proceed.

Good afternoon, thank you for taking the questions.

I'm curious about the Array road maps.

To get to the 5 million variance engineering-wise, what do you actually have to do differently to the Omni chip?

It's straightforward.

There's no technical risk there.

It's a factor of content timing.

We already have the omni quad chip which, in effect, has that number of markers on it, and so we simply have to change the gasketting to make that into a 5 million variant Array so there's no change required on the chip formats, simply a change in the gaskets.

What we do of course is decide on the content and synthesize the oligos and make the (inaudible) so there's some sequential timing until you can actually get the Array manufactured.

That's helpful.

As a followup just for fun, I'll ask about the reagent issue again.

Does this mis-step change anything with respect to the planned GA throughput improvements for this year or next year?

Thank you.

We don't think it will have a material impact.

We were slowed down a little bit in our testing and R&D but we think that is going to be measured in weeks, not months.

So it could have been delayed by some number of weeks but it's not material.

We have a question from the line of Davis Bu with Goldman Sachs.

Please proceed.

Hi, thanks.

My question a follow-up kind of related to the mix of businesses.

The first is on the tax side.

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

Yes, you're right.

Most of our sequencing products, actually all of our sequencing products are manufactured either in California or some components are manufactured in the UK and consequently as the sequencing business has become a greater proportion of our total income relative to our expectations, the tax rate has gone up accordingly because we're not getting the benefit of Singapore.

It is our intention to move more and more products to Singapore and we are doing that in a step-wise fashion, basically looking at the highest value products to keep moving to Singapore so in 2010 you'll start to see some of our sequencing products manufactured out of Singapore.

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

Thanks.

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

Yes.

We don't typically break out each of the different product areas.

One thing I did say in my remarks is that Array consumables are still higher than sequencing consumers but on a year-over-year basis sequencing consumables grew over 100%.

The sequencing business is definitely gaining on the Array business right now, but we don't break out the specifics.

We have a question from the line of John Groberg, Macquarie Capital.

Please proceed.

Hi, good afternoon.

So Jay, can I understand this migration again?

So if somebody buys an Omni chip, do they then have to buy the two supplemental Arrays that come behind it or how does this work from a pricing standpoint?

They don't have to buy them but have the opportunity to buy them.

For every chip -- every Omni chip that a customer buys, they can then buy the follow-on supplemental chips.

Those supplemental chips are not the 2.5 and 5, they are the incremental piece.

Right.

To get you to 5.

They essentially have the right to buy those incremental chips at a total aggregate cost all the way through the process that's slightly less than if they bought the 5M.

Okay so the all-in cost of doing that to them is something that would be less than if they waited for the 5M.

Yes.

That's right.

We've done that explicitly to try to catalyze the market to get going and to not wait because there are great discoveries waiting to be made on every increment of content from the thousand Genome program and what we didn't want to happen, as an earlier question alluded to, for everybody to wait until you have the 5 million variant chip to get started and so that is what this marketing program is intended to address.

We have a foul loll-up question from the line of Derik De Bruin, UBS.

Please proceed.

Did I miss it or did you give a specific breakout for instruments and consumables in the other in terms of specific revenue?

I heard $61 million for the instruments but I didn't get the other two.

Yes.

Consumables revenue I believe was $87 million.

Okay.

And the other about $2.7 million like it normally is?

Yes, give or take.

Yes, okay.

Did you know -- I got a couple question from clients wanting to know where the source of the raw materials were.

We're not going to disclose that.

Okay, thanks.

Thanks.

And we have another follow-up question from the line of Doug Schenkel from Cowen.

Please proceed.

I guess I have three what I think -- well, two quick follow ups and a third which may take a little longer.

Can you just talk about -- and I apologize if I missed this -- what's the expected negative gross margin impact in the fourth quarter specific to reagent issue?

Doug, we have taken a warranty accrual for it.

So from a warranty perspective we have already taken that accrual.

From -- if we achieve -- I guess what you need to look at is guidance we gave was 69% to 70% for the quarter and for the year.

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

Okay.

And then when do you expect the GA annuity stream to rebound and what directionally are you assuming for Q4 in terms of what's incorporated into your guidance?

I'm trying to get at whether we should be thinking about the annuity dropping a little bit sequentially before it comes back.

Well, it will drop a little bit because we had a couple weeks with zero shipments to many large customers and they're sort of gradually getting back into this and they will be running some warranty reagents in the meantime so there will be some impact, but if you were to, say, start your math around the middle of November, I think then will be back up to a run rate that we would expect.

And Q1 we're back to normal, 200 plus?

Well, we have been saying 150 to 200 and you're right.

In the second quarter we were much closer at that high end and have been trending at that high end.

Okay.

And last one -- not to rub salt in the wound here, but this is the second quarter in a row where you missed and this time based on the e-mails I'm getting, there's a lot of frustration about the lack of visibility and questions about whether you should have preannounced or not.

Given this -- I'm sure this is not a surprise to you -- can you talk about how comfortable with the target you are relative to the last two quarters?

Yes, I can understand why people are frustrate and we're frankly frustrated as well.

Clearly not happy with our results or our ability to forecast.

We've done everything we know how to do to get clarity around the impact of stimulus and the reduction in GWAS.

We have done everything to get a handle on that and it just didn't turn out as we hoped or assumed.

I think the guidance that we gave is the most responsible guidance we could come up with as a minimum number.

We think that there are ways to have upside to that number but our visibility on the degree to that upside is limited and that's why we chose interestingly to not give a high-end of the range as we typically do.

We didn't want to bound it very narrowly because we thought that might indicate we have more precision in the forecast than, in fact, we do.

We think the 165 minimum number is the most responsible number that we could arrive at.

Okay, ladies and gentlemen, this concludes the question and answer session.

I would like to turn the phone call baubling to Peter Fromen for closing remarks.

Thank you, Operator.

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

Thank you for joining us today.

This concludes our call and we look forward to our next update in February following the close of the fourth quarter.

Ladies and gentlemen, this concludes today's conference.

Thank you for your participation.

You may now disconnect and have a good day.