Illumina Inc (ILMN) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen.

Welcome to the second quarter 2010 Illumina Inc.

earnings conference call.

(Operator instructions) As a reminder, today's conference is being recorded for replay purposes.

I would now like to turn your conference over to your host for today, Mr.

Peter Fromen, Senior Director of Investor Relations.

Thanks, Regina.

Good afternoon, everyone and welcome to our second quarter, 2010 earnings call.

During the call we'll review our financial results released today and offer commentary on our commercial activity.

After which, we'll host a question-and-answer session.

If you haven't had a chance to review 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 and General Manager Life Sciences and Chief Financial Officer.

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

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

Forward-looking statements are subject to risks and uncertainties, actual events or results may differ materially from those projected or discussed.

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

To better understand the risks and uncertainties that could cause results to differ, 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 want to let you know that we participated in the Morgan Stanley Global Health Care conference in New York on September 13, and 14, and the UBS Global Life Sciences conference on September 21, and 22, also 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.

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

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

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

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

In the second quarter, we recorded $212 million in total revenue.

This represents growth of 31% over the second quarter of last year.

Product revenue was $199 million growing 30% over the prior year period, led by significant growth in our sequencing products.

Our microarray business also grew relative to Q2, 2009 and was up sequentially for the third consecutive quarter.

Consumable revenue for the quarter was $126 million compared to $97 million in Q2 of 2009.

We saw strong demand for both sequencing and microarray consumables, resulting in year-over-year growth of 30%.

Annualized consumable pull through per sequencing system was at the high end of our projected range of $150,000 to $200,000 per system.

Additionally, across our installed base of microarray scanners, annualized consumable pull through was above our targeted range of $400,000 to $500,000 per system.

Total instrument revenue for the quarter was $70 million up 30% compared to $54 million in the second quarter of last year and up 22% compared to $57 million last year.

In both cases, the growth and instrument revenue was attributable to the success of the HiSeq 2000.

HiSeq demand has vastly exceeded our initial expectations.

To meet this demand, we significantly increased our production in the second quarter, exceeding our original unit goals.

In addition, we intend to increase the number of HiSeqs produced by more than 50% in the third quarter.

The growth in sequencing instrument revenue was slightly offset by microarray instrument revenue, which declined year-over-year and sequentially from a strong Q1.

Even though revenue was down sequentially, orders for microarray instrumentation were up strongly, both sequentially and year-over-year.

Services and other revenue, which includes genotyping and sequencing services, as well as instrument maintenance contracts was $13 million compared to $8 million in Q2 of last year.

The primary driver of the year-over-year growth was the increase in maintenance contracts associated with our growing installed base of sequencing systems.

Before discussing our gross margins and operating expenses for the quarter, I'd like to note that we recorded a pre-tax amount of $17 million related to non-cash, stock-based compensation.

This impacted our EPS by a tax adjusted amount of $0.08 per pro forma diluted share for the quarter.

I want to remind you that we now include this expense in our presentation of pro forma net income and earnings per share.

However, in our discussion of gross margin, operating expenses, and operating margin, I will highlight both our GAAP expenses, which include stock compensation expense and other non-cash charges and the corresponding non-GAAP figures.

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

Total cost of revenue for the quarter was $66 million compared to $50 million in Q2 of 2009.

The Q2, 2010 cost includes stock-based comp expense of $1.4 million compared to $1.3 million in the prior year period.

Excluding this expense, and $1.6 million associated with the amortization of intangibles, non-GAAP gross margin was 70.3%.

This compares to 70.3% last quarter and 70.6% in the second quarter of 2009.

As we indicated in January, we expect gross margins to temporarily decline in the second half as we ship HiSeq systems through our Genome Analyzer training programs.

Before moving to operating expenses, I'd like to note that our financial results include two months of Helixis operating expenses

Research and development expenses were $44 million compared to $33 million in the comparable period of 2009 and includes $6 million and $5 million respectively in non-cash stock compensation expense.

Excluding stock compensation expense and $0.9 million of accrued contingent compensation in both periods, R&D expenses were $36.7 million or 17.3% of revenue compared to $27.2 million or 16.8% of revenue in the prior year period and $36.8 million or 19.2% of revenue in the first quarter of this year.

SG&A expenses were $54 million compared to $42 million in the second quarter of 2009, including stock compensation expense of $9.4 million and $8.6 million respectively.

Excluding stock compensation expense and $0.5 million of acquisition related expenses in the second quarter, SG&A was $43.8 million or 20.6% of revenue compared to $33 million or 20.6% of revenue in the prior year period.

The absolute increase in SG&A expense is primarily due to increased headcount and legal expenses.

Relative to the first quarter, non-GAAP SG&A expense increased by approximately $3 million primarily due to increased headcount.

GAAP operating profit for the second quarter was $47 million.

Excluding the expenses outlined earlier and $1.3 million of acquired IPR&D our non-GAAP operating profit for the quarter was $68.6 million or 32.4% of revenue, compared to $54 million or 33.2% of revenue in the second quarter of last year.

GAAP interest and other expense in the second quarter included approximately $5.2 million in non-cash interest expense, associated with our outstanding convertible debt, offset by a $2.9 million gain on the acquisition of Helixis.

Excluding these amounts, pro forma interest and other income was $1.3 million, which includes approximately $0.5 million of net foreign currency transaction gains due to the re-evaluation of monetary assets outside of the United States.

Our non-GAAP tax rate for the quarter was 35.3%, compared to 35.1% last quarter.

The primary reason our Q2 tax rate was higher than our expected annualized rate was the delay in passage of the US R&D tax credit, which we continue to expect to be passed and retroactively applied later this year.

Also contributing to the increase in the effective tax rate was an increase in earnings in higher tax jurisdictions, which we expect to impact us for the remainder of this year.

We reported GAAP net income of $30 million or $0.21 per diluted share, compared to net income of $25 million or $0.18 per diluted share in the prior year period.

Excluding non-cash interest expense and the other items identified in our press release, and net of pro forma tax expense, non-GAAP net income was $34 million or $0.26 per pro forma diluted share.

Compared to $29 million or $0.22 per pro forma diluted share in the second quarter of 2009.

In the second quarter we generated $75 million in cash flow from operations.

We used approximately $13 million for capital expenditures, resulting in $62 million in free cash flow.

This compares to $25 million in free cash flow in the second quarter of last year.

Q2 free cash flow benefited from strong collections during the quarter which also helped lower our DSO to 64 days, down from 74 days last quarter and 87 days in Q2 of last year.

Inventory balances increased to approximately $119 million related primarily to the scale-up of HiSeq instrument manufacturing.

Depreciation and amortization expenses for the quarter were approximately $10.2 million.

We ended the quarter with approximately $785 million in cash and investments.

As a result of our strong cash flow performance in the second quarter, and our cash flow outlook for the remainder of the year, the Board of Directors has approved a $200 million stock buy-back program.

Under the program, $100 million will be used to repurchase stock on a regular basis under a 10b5-1 trading plan.

It is expected that trading for this plan will begin in August.

The remaining $100 million will be used to repurchase stock at management's discretion during the 's open trading windows.

I'm also excited to report that early in the second quarter we acquired Helixis, a developer of high-performance, low-cost, realtime PCR technology for $70 million in cash and up to $35 million in contingent consideration payments, based on the achievement of certain revenue-based milestones through December 31, 2011.

The fair value of consideration for the acquisition at the closing date was $86.7 million including $70 million in cash, net of $2.6 million of cash acquired, and $14.1 million for the fair value of contingent consideration payments.

Under the acquisition method of accounting, the Company allocated $58 million to goodwill and $28 million to identifiable intangible assets, that will be amortized over a period of 10 years.

Jay will provide more comments on Helixis in his remarks.

Now, I'll provide updated guidance for 2010.

As you're aware, we've moved away from providing quarterly guidance and now only provide annual guidance.

As a reminder, our guidance includes non-cash stock-based comp expense in our discussion of net income and the corresponding per share amounts.

Consistent with our previous calls, guidance will exclude certain noncash charges including charges associated with non-cash interest expense on our convertible debt, the amortization of intangibles and acquisition-related charges.

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

Additionally, this guidance includes the impact of Helixis' ongoing operations on our financial statements.

We now expect total revenues for 2010 to grow by approximately 28%.

We expect to recognize the significant number of HiSeq instruments associated with trade-in programs in the third and fourth quarter, which will cause gross margins to be in the mid-60s for the second half of the year.

We expect full year gross margin percentage to be in the mid to high-60s.

We expect non-GAAP earnings per share to be between $0.93 and $1.00, which includes the dilution associated with the acquisition of Helixis.

This assumes, pro forma fully-diluted weighted average shares outstanding of approximately $136 million.

We anticipate the full-year pro forma tax rate to be approximately 35% as we generate more income in higher tax regions than previously forecasted.

We expect to incur stock compensation expense of approximately $72 million or a tax adjusted amount of $0.34 per fully diluted pro forma share.

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, Jay?

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

I'm extremely pleased with our operational and financial results for the second quarter.

On nearly every measure, our performance during the quarter was outstanding.

We grew revenue 31% year-over-year, with very strong demand for our sequencing products and a return to growth in our microarray business.

Excluding the large BGI order in Q4, orders were a record and backlog remains at an all time high growing sequentially by 20%.

The HiSeq launch has gone extremely well, as we exceeded our initial shipment targets and continue to scale manufacturing to meet demand.

Strong gross margins and prudent expense control enabled us to deliver operating margins of 32.4%, well above our long-term model.

Good balance sheet management and improved receivable collections allowed us to recognize $0.47 per share of free cash flow or growth of over 140% from Q2 of '09.

Year-to-date free cash flow per share is only $0.12 shy of what we recognized for all of last year.

From a geographic perspective, we saw strong year-over-year revenue growth in all major regions.

All territories also grew a sequential basis with the exception of Japan, which tends to be seasonally soft in Q2.

Europe delivered the largest contribution, largest dollar contribution to our Q2 growth.

As the numbers indicate, this is an exceptional quarter for the Company.

Sole Q2 revenue in our microarray business grew sequentially for the third quarter in a row and also grew over the second quarter of last year.

We're seeing encouraging uptick of our Omni family of full genome arrays, as they comprise the largest component of our microarray shipments.

Total whole genome array shipments grew sequentially from Q1, but declined year-over-year due to a single large order in the second quarter of 2009.

In June, we began shipping the Omni 2.5 quad, a four sample Vchip that contains 2.5 million markers per sample.

This Vchip is the next installment in our 2010 GWAS roadmap, that enables our customers to access the rare variant content discovered in the 1000 Genomes Project.

We saw strong initial demand and order uptick for the Omni 2.5 in addition to our new Infinium multi-use sample prep kits.

These new kits enable Omni customers to prep their samples only once and preserve them for use with supplemental arrays launched in the roadmap.

A majority of customers that have ordered the Omni 2.5 have also purchased these multi-use sample prep kits, indicating their intent to integrate future supplemental arrays and additional rare variant content into their studies.

Full array consumables grew both sequentially and on a year-over-year basis.

Growth was driven by strong demand for our focused content arrays such as the Imino and the BovineSNP Chips, including our new BovineHD chip, which we launched in the first quarter.

We also saw year-over-year and sequential growth in our custom arrays led by our standard iSelect product in addition to our VeraCode consumables that run on the BeadXpress platform.

Despite a sequential and year-over-year decline in array instrument shipments, we saw strong order growth, largely driven by demand for our new HiScan and HiScanSQ systems, which we began shipping in late Q2.

Two-thirds of the demand for the HiScanSQ is from customers new to Illumina, including university affiliated hospitals, small and mid-sized core labs and Ag-based customers.

As a reminder the HiScanSQ is what we formally called Harmonia and is the only product on the market that can scan high complexity microarrays and perform next generation sequencing on the same platform, a characteristic that we believe will be highly compelling to the market.

While demand has been robust for HiScan, the system shares many common components with HiSeq.

As such, we expect manufacturing constraints to limit our ability to ship the HiScan in volume through the end of the third quarter.

During Q2, we received 5-10-K market clearance on the BeadXpress platform for in vitro diagnostic use with a factor two and factor five assay.

These assays were perfect to support the FDA approval process but are not products that we currently plan to market.

These approvals are an important step in Illumina's diagnostic strategy, and we believe that it demonstrates our ability to meet the stringent regulatory requirements in designing and manufacturing an FDA-cleared in vitro diagnostic device.

5-10-K clearance is an important foundation for our diagnostic strategy as it paves the way for internal content development programs and also enables opportunities for our clinical and commercial partners to pursue their own diagnostic content on the platform.

I'm sure many of you have followed the events of the FDA with respect to the direct-to-consumer market for genotyping.

During the quarter, we met with the FDA to discuss the regulatory framework for GTC genotyping and we intend to fully comply with the FDA's guidance.

It should be noted however that the revenue we generate from the sale of arrays to this market is currently immaterial.

As Christian mentioned earlier, during the quarter we completed the acquisition of Helixis a Company that's developed a low-cost, real-time PCR technology, initially focused on the research market.

Today we launched the Echo system, which has been designed to deliver high performance, quantitative PCR applications with a compact footprint at a very low-cost to the individual researcher.

In fact, the US list price is $13,900, which is approximately a quarter of the price of systems in the market with comparable performance.

We believe the combination of performance features and market disruptive pricing make this system ideal for personal use in the laboratory.

The platform is complementary to the BeadXpress system as it will enable us to more effectively address the market below a complexity of 96 markers.

Initially, the Echo system will run most commercially available QPCR assays.

But, over time, we expect to leverage our assay development expertise to bring proprietary consumable kits to the markets specifically designed for the Echo system.

As these products come to market, I look forward to sharing information about them with you.

We've been working through the integration of Helixis since the beginning of May and we will begin shipping the Echo product commercially next month.

In conjunction with the acquisition, Helixis CEO, Alex Dickinson, has joined Illumina as SVP of PCR Solutions.

I'm happy to welcome Alex and the Helixis team to Illumina.

Turning now to our sequencing business, we had another outstanding quarter, total sequencing revenue grew by over 50% as we saw very strong demand for the HiSeq 2000.

This trend indicates the breadth of the market opportunity for HiSeq as more customers than anticipated are opting for HiSeq over the Genome Analyzer assuming they have the funds to support the higher purchase price.

As a result of our success in rapidly scaling manufacturing, we shipped over 100 HiSeqs per revenue since we commenced shipment in early March.

This represents the fastest instrument scale-up in the Company's history for the most complex product that we've ever built.

While we're very proud of this achievement, we're continuing to scale capacity to address the strong demand.

As I mentioned earlier we grew backlog by 20% sequentially, largely as a result of HiSeq quarters.

By simplifying the sequencing workflow, increasing data quality, and dramatically lowering the cost per genome, HiSeq is truly redefining the trajectory of sequencing and expanding the market.

Last month we announced that the Broad Institute purchased 51 HiSeqs and have already generated numerous runs in excess of 250 G.

Most recently, the Wellcome Trust Sanger Institute placed an order to purchase 20 HiSeqs as part of our trade-in program.

Excluding the major genome centers, over 40% of HiSeq quarter demand is coming from new customers, including a wide array of academic PI's core labs, service labs, diagnostic start-ups, and BioPharma.

We're adding incremental manufacturing capacity with the goal to increase Q3 production by over 50% to meet customer demand with reasonable ship schedules.

Again excluding the major genome centers, approximately 20% of Q2 HiSeq shipments were related to genome analyzer trade-ins.

We anticipate this percentage to increase in the second half of the year as more customers take advantage of our trade-in programs to gain access to HiSeq.

This is the primary reason why we expect gross margins to decline in the back half of the year as Christian outlined in our updated guidance.

In the longer run, trade-ins for HiSeq will result in a significant increase in reagent pull through per system as the theoretical capacity is more than twice that of a genome analyzer.

The reduction in cost per whole Human Genome enabled by HiSeq has also allowed us to reduce the price for our individual genome sequencing service.

In June, at the Consumer Genomics Conference in Boston we announced new pricing of $19,500 for an individual to have their genome sequenced directed by a prescription from a physician in our personal genomics network.

In addition, we've offered discounted pricing of $14,500 for a group of five individuals using the same physician and $9,500 for individuals whose physicians have determined that whole genome sequencing might provide direct clinical value in addressing their serious medical conditions.

At this price point, we believe we're moving much closer to the integration of whole genome sequence data into the management of one's health.

Nowhere is this more apparent than in the case of complex genetic disease such as cancer where through a physician's guidance, sequence data may inform the course of therapy and care.

Today we announced the formation of the Illumina Genome Network and I'd like to take a minute to give you some details around this exciting new program.

As the advances of the HiSeq system allow us to continue to drive down the costs of whole genome sequencing, we've been working on ways to leverage our existing internal sequencing services operation along with our CSPro certified customers.

Our announcement today forms a network of several leading institutions to offer rapid turn around, low-cost human whole genome sequencing services.

The network will broaden the access of researchers worldwide to the Illumina sequencing platform and provide them with an economical high-quality sequencing services alternative for large-scale projects.

Use of the network model allows us to maximize sequence capacity utilization across multiple sites and leverage the unique technical expertise of our partner institutions.

The continued enhancement to the output of the HiSeq 2000 and advances of sample preparation and data analysis, we anticipate that the network will be able to provide researchers with the unmatched value proposition of rapid turn around time, industry standard data quality and highly competitive project costs.

In addition to the commercial progress we've made during the quarter, we've also added a number of new senior leaders to the Company.

In addition to Alex Dickinson, who I mentioned earlier, we've also appointed Nick Naclerio as Senior Vice President of Corporate Development.

Early this quarter we added Elizabeth Brady as Vice President Global Supply Chain and Emily Winn-Deen the Vice President of Diagnostics Development.

Following the close of the quarter, Melina Cimler joined the organization as Vice President of Quality and Regulatory Affairs.

In addition, we recently named Gerald Moller to our Board of Directors.

Finally, I'm happy to announce the appointment of Tristan Orpin to the newly created position of Chief Commercial Officer.

I'm very pleased with the breadth of knowledge and experience that we've been able to add to the Illumina management team this quarter In summary, Q2 was another great quarter.

We saw very strong year-over-year and sequential revenue growth.

We generated non-GAAP gross margins over 70% for the third quarter in a row.

Operating margin was above the high end of our long-term operating model and we generated $62 million or $0.47 per share in free cash flow.

We continue to believe that the whole genome array business has stabilized and that growth will accelerate in the second half.

Our new products like the Omni 2.5 and the HiScanSQ are quickly gaining momentum and the HiSeq to date has been the most successful product launch in the Company's history.

We see no slowing in the market's demand for sequence data and continue to see this reflected in record backlog levels, affording us with good visibility for the remainder of the year.

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

(Operator Instructions)

We would like to ask you to limit your questions to one question and one follow-up question.

Your first question today comes from the line of Marshall Urist with Morgan Stanley.

Marshall, you there?

Okay, we can go to the next question and get Marshall when he comes back in the queue

Your next question comes from the line of Ross Muken with Deutsche Bank.

Good afternoon, guys.

Hey, Ross.

So, obviously a lot of exciting developments into the quarter, so a lot to choose from.

In terms of the HiSeq, I mean,

obviously, as you said, it's been the best new product introduction you've had.

You've sort of had time to digest, talk to customers, obviously you've got a better idea of the demand curve and you're increasing--the manufacturing capacity, what's been sort of the most sort of surprising feedback you've had in terms of the ordering trends that you're seeing, what was kind of outside the realm of what you'd initially thought and just generally in terms of this progression, what sort of stuck out, as well?

We hadn't thought of that initially when we launched the box?

I guess the most obvious thing, Ross, is the fact that in our earlier models, we had sort of a conversion range or trade-off range between HiSeqs and the Genome Analyzers.

Probably, the most surprising outcome is the fraction of customers that have opted to go toward HiSeq as opposed to buying the GA.

And what underlies that surprise perhaps is the fact that so many customers have been able to obtain the funds to make that decision even though we have a higher purchase price, of course, for the HiSeq.

That's certainly one standout trend.

The second is the fact that we've really broadened the market with this platform.

We have lots of new customers coming into the Illumina fold if you will.

And, in the development process of the product, we worried at one point about whether it was possible that this system as the throughput continued to go up could overshoot the market, and it's very clear that that just isn't the case.

That any customer that can get the funds to buy a HiSeq, in general, will buy a HiSeq.

And even in the smallest labs we see customers migrating toward this platform if they can get the funds to buy it.

So those are probably the standout features of the launch.

Of course, we've been very pleased with the robustness of the product in the field.

When you put this many units into the field so quickly, you always are a bit concerned about how robustly they operate in the customers hands, and whether you have a support organization that can take care of any issues that crop up.

So, far that's gone extremely well for us.

And maybe turning to the acquisition that you talked about.

I think it's a business you know quite well, as you think about the QPCR market and sort of the development of some of these newer technologies, lower cost, higher throughput, et cetera, what's the entry strategy there?

I know you probably touch a lot of the same purchasers with the equipment and you already sell into most of those labs, so it's kind of a natural from a sales synergy perspective, but competitively, in terms of what this does, or what this will offer people, it's different than what's currently in market.

How do you sort of size that up?

Well, it's a very important market segment in the tool space, it's large from a dollar perspective, it's very consistent with our strategy of having tools that address the broad range of complexity that customers want all the way from full sequence down to single marker and this is a technology that reinforces that to a great extent on the very low end.

Of course, BeadXpress goes down to a single marker, but as you drop below 40 or 30 markers, it becomes less competitive and PCR of course, is more competitive in the lower complexity space.

So, certainly there's that market synergy.

We have a bit of a built-in market, because most of the customers that are using our sequencing instruments require PCR instrumentation in the front end or in the sample prep process for preparing the sequencing samples.

That's an important synergy that we get right out of the box.

We think our current sales force can sell this, we'll also obviously take advantage of Internet capabilities to sell this product at the price point of $13,900 and if you think about the strategy and how it fits with Illumina's more global approach to the market we really focus on highly disruptive technologies and we think this box in particular is that because it offers such high performance at such a competitive price point.

As we mentioned in the script, it's our intention over time to develop a reagent stream for this product as well which will create that high margin follow-on business.

Great and congratulations, everyone, for a phenomenal quarter.

Thanks, Ross

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

You there, Doug.

Hey, guys, sorry, I was having some technical challenges there.

Can you hear me?

Yes, hey, Doug, how you doing?

I'm good, sorry about that.

Maybe just a couple clarifying follow-ups.

Hopefully I didn't miss this as I was trying to get my phone to work the right way, but in terms of the dynamic of HiSeq versus GA specifically in the quarter, can you just talk about GA trends and maybe the outlook for 2E and FQ from here?

And then maybe as a follow-up to that, you did mention that I think 20% of Q2 HiSeq shipments, excluding the major genome centers were trade-ins.

My understanding was in the past from previous commentary was that you guys weren't going to do many, if any trade-ins in the second quarter, so does that suggest that those shipments were made pursuant to what you expect to record for revenues in the third quarter?

Say the last part again, pursuant to what?

Basically, pursuant to Q3 revenue, versus revenue that was already recorded in the second quarter.

No.

We've got a growing backlog of trade-ins and so we wanted to begin shipments of some of those during the quarter to begin to balance out the mix between brand new instrument orders and trade-ins so we decided to ship some trade-ins in the second quarter, but the predominant part of the trade-in business will happen in Q3 and in Q4.

That's still the key driver of the gross margin change.

I think the one thing that happened, Doug, is we were able to do better on the production side, so we were able to get some of those trade-ins pushed into the second quarter.

To the first part of your question, I think the dynamic has surprised us a bit that the GA has actually, for customers who we thought might continue to order GAs, many of them have switched to HiSeqs.

So, we see a trade-off in the volumes toward HiSeq and away from the Genome Analyzers.

So, the genome analyzer volumes are shrinking as we're growing this demand curve for the HiSeqs.

The magnitude of that switch is greater than what we would have anticipated previously.

Obviously, a very positive trend for us, but something that causes us to have to continue to ramp HiSeq manufacturing pretty aggressively.

Thankfully, we've been able to do that quite well.

Okay.

The one other piece there, Doug, was you asked about the HiScan.

The demand for the HiScan system has actually been quite strong.

So, I would put that into a different category than the GA, because it's -- it really is the only instrument on the market that can -- that can run both arrays and do sequencing.

We've seen very strong demand for that product and we're scaling up shipments, we're scaling up production so we can ship more of that in the back half of the year.

Maybe if I could just slip in one real quick follow-up.

Along those lines, Christian, you did talk about microarray instrument order growth increasing sequentially year-over-year outpacing revenue.

Is this where maybe you're capturing some of the HiScan or is this maybe attributed to instances where there's building interest in rare variant chips but folks are holding off taking shipment until those are more probably available or is there some other dynamic in play?

It's more of the high scan.

There's a really nice growing list of orders for the HiScan.

The early performance on the system's been fantastic in terms of the ability to create very high levels of throughput on the system from a sequencing perspective, as well as scan arrays at comparable rates of the historical scanners, so there's a lot of demand building up for that and in our manufacturing process we've focused a little bit more on HiSeq 2000 in the quarter so we weren't able to fill all those orders.

One of the good news and bad news stories about how we did the design here, of course, is that we really wanted to make the Optix module and most of the electronics exactly the same or as similar as possible to HiSeq so that we'd have improved manufacturing capability in those platforms.

But because we're volume-constrained in our ability to make HiSeqs, it also constains our ability to make the HiScanSQ.

So, we've been able to ship, perhaps fewer of those than we might've liked to in an ideal case.

Yes.

High-class problems.

Thanks for taking the questions, I'll get back in the queue.

Your next question comes from the line of Tycho Peterson with JPMorgan.

Hi, Tycho.

Maybe just actually following up on that last line questioning, if we think about the HiScan systems that you will place going forward, once you work through the capacity constraints.

How do we think about utilization and maybe can you help us think about the customer thought process here?

Obviously, you have got the GA2E at the low-end.

You have got some customers that are presumably, already doing array work?

How do they think about the decision to go with HiScan versus adding a low-end sequencer to their existing array work.

It does depend on a lot of the individual lab circumstances.

If you're in a core lab and you have already got one or two of our array readers, adding a sequencing module, if you're occasionally going to do sequencing or you have a few of your core lab customers wanting to do sequencing, might be the way to start off or to get into the business of sequencing.

If it's very clear that you're going to be doing sequencing in some volume and you're capital constrained, then the GA2E is probably the right choice.

It depends on the individual circumstances of the customer labs in terms of which one they go to.

The truth is, it will probably take us a couple more quarters to sort out exactly what the sales dynamics look like on those two platforms.

I guess as we think about the placements, is this a decent leading indicator around array pull through?

Maybe another way to ask the question is, where do you see the array business in terms of the recovery cycle here?

Well, we're pretty optimistic about what's going to begin to happen in the second half.

We're seeing a lot of interest in the Omni 2.5.The pipeline's strong.

We think the Omni 5 will get pushed out a little bit just based on the availability of the content from the 1000 Genome Project.

So, we're probably not going to be able to get that into the market by the end of the year, solely because we don't have the content to put on it yet.

We'll probably, in the course of the next three months, make a decision on when we start actually entering the manufacturing process for the Omni 5.

But the pipeline looks real positive.

We continue to be optimistic about accelerating growth rates in the array business here through the back half and into 2011.

And, I think you're beginning to see the earliest signs of some people doing initial work on the 2.5 and beginning to discover some things that will help fuel that trend.

Okay, that's helpful.

And then just one last point, can you update us on the CFO search, where you are in that process?

Sure, we changed recruiting firms about -- I guess about eight weeks ago, something like that and we've had, what we think is very good progress since that change.

We are interviewing quite aggressively.

We have a number of very strong candidates in the pipeline.

But having said that, I do think it's going to take two to three more months before we have somebody hired and reporting for duty.

So, we're still a ways away from having somebody on board.

(Operator Instructions) Your next question comes from the line of Marshall Urist with Morgan Stanley.

I seem to be struggling equally with the phone today.

We can hear you fine now, Marshall.

Okay, perfect thanks.

So the first question was just on the gross margin front.

As HiSeq kind of ramps ahead of your expectations, you talked about that being potentially dilutive to gross margins on an absolute basis, just because the underlying margin is lower, (inaudible- technical difficulties) has your confidence kind of increased in what kind of gross margin you're going to be able to achieve and how quickly you're going to be able to get there as some of these trade-in headwinds go away next year.

I think we have a pretty good handle on what the margins are.

We know very accurately what the cost of the system is.

You're right that as the mix has shifted more towards HiSeq, that's a bit of a drag on the overall gross margins, because it's an early product in its maturity cycle and therefore the margins are somewhat less -- considerably less than the GAs at this point in time.

But a slight offsetting effect, of course, is that as you ramp up and make more and more of these faster than you thought, you get better volume discounts on the parts that you're buying.

And we're coming down the learning curve quickly in our ability to put them through final tests and to manufacturer them efficiently.

So, there's some offsetting effect because the volume's ramping quickly.

But, I think we now have pretty good models of what those margins are going to look like into 2011.

We think we'll get through the biggest bonus of the trade-in program in the back half.

But some of the trade-ins will slop over into 2011, certainly.

As I mentioned in my prepared remarks, of course, every time we do a trade-in, we have a long-term advantage because the reagent pull through of the system is more than twice that at a theoretical level than what you have on a genome analyzer.

Okay, great, thanks.

And then just related to that on the expense side, we saw some decent expense leverage as we think about that as a percentage of revenue in the quarter, even with two months of Helixis.

So, can you give us a sense of that?

Is that going to continue as we ramp revenue in the back half?

And then, if you could quantify how much the dilution is from Helixis this year, at least that?

That'd be helpful, thanks.

Yes, we're not going to quantify the dilution for Helixis for this year.

I think what we can say is that we do expect it to be break even to somewhat accretive in 2011 is our current forecast, so we're feeling pretty good about that part of it.

We did get some leverage on the R&D line during the quarter.

Part of that was due to some one-time expenses that we had in Q1.

So, on a sequential basis, there was some leverage there, we're not guiding specifically at those expense line levels any longer, so we're not really prepared to predict that we're going to get lots more leverage from that.

I'd bring you back to our sort of ongoing guidance that our target is to hit 30% operating margins on a non-GAAP basis.

Clearly we've been running over that and we're pleased to be running over that, but we're always looking to make sure that we're making sufficient investments when we're running over 30%.

Okay, thanks, guys.

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

Hi, good afternoon.

Hi, Derek.

Hey, we've heard from a couple of people that blaming their woes on their business on the fact that stimulus money has been delayed and such.

And on funding you made the comment that people are scrambling to buy HiSeq to find funding, or buy HiSeq to find funding again, I guess you can talk about where your customers are getting funding.

Is it stimulus grants?

Is it endowment money coming back in?

Bake sales?

Any color?

I haven't seen the bake sale phenomenon yet.

That's a lot of cupcakes.

It's hard to say it's coming from one more than the other.

Certainly there's a stimulus contribution here we saw in the quarter about $26 million of orders that came from stimulus.

It's always hard to know what the alternative case would have been there, had we not had stimulus, how much of that would we have gotten anyways.

So, it's -- we just know how much of that is truly incremental to what the baseline business would've been absent the program.

So, certainly components coming there, we think there's money being pulled away from potentially other kinds of purchases, so other types of capital equipment.

Perhaps, people are seeking funding to move toward HiSeq, and certainly people applying for incremental grants going forward.

And sequencing, I think, is getting a disproportional win rate in the grant cycle because it's such an important, such a powerful technology.

And what's been the interest in your whole genome sequencing business after you drop the price?

And I guess as a follow-up question to that, it's like what do you think the inflection point is when you really would see your customers wanting to do more outsourcing versus doing it themselves?

So, the first part was about the consumer business, I presume?

The consumer business or just in general, if people want to -- yes, in general, the consumer business or just, as you look at the kind of network price, the network programs, what would kind of be an inflection point on the pricing that people would opt to do it rather than try to buy their equipment.

Well, let me give you the answer and you can let me know if I've addressed both parts of the question.

On the consumer side there's clearly a high degree of elasticity in this market.

So as we drop the price to $19,500, $14,500, and $9,500 the pipeline has grown pretty dramatically.

It's still a little early to know how many of those are going to be over the finish line and actually sign deals to move forward, but I can say we've already closed a significant number of those that are purely due to the change in the price structure.

So, I say that's gone quite well and as that price continues to come down, we're going to ride that elasticity curve quite significantly.

If you think about the second part of your question, which I think related to services versus instrument placements, we think today, services is still a very small part of this market.

But we think over time, there's the potential as the price comes down, that it will become an increasing portion.

This is the reason that we announced today, the Illumina Genome Network.

Because we clearly want to be the leader in services, as well as instruments, today most people want to own the instruments.

We think that even out a couple of years, that that will continue to be the case, and the main part of our market, most customers will want to have access to the instrumentation.

Because that's how they develop new applications and train their research associates to go out into the world and become PIs themselves.

But services will be increasing and therefore we wanted to have a really strong position in that market segment and we intend to be the leader there as well.

Great, I'll get back in the queue

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

Baird

Good afternoon, congratulations on a really nice quarter, guys.

Thanks, Quintin.

Sure, so you raise revenue guidance, originally it was 20% growth, now it's 28% growth, EPS guidance only goes up by a little bit, is the delta, the dilution from, from Helixis or is there some other expenses that are in there?

Q, it's Christian.

There's several factors actually in that.

The first, of course is the dilution from Helixis.

There's also the tax rate's a little bit higher than we were originally forecasting when we started the year and then of course, the share count's a little bit higher also as well since the stock is a little bit higher today than it was at the beginning of the year.

There's more, the dilutive effect of those -- of those shares is in there as well.

So, on the tax side, the reason why the tax is really higher, is because we're generating more profit in foreign jurisdictions, where we were stuck with some double taxation, until we continue--until we really complete our IT migration to Singapore, which we're in the process of working on right now.

It's the combination of those factors that affect the EPS line.

That's a historical artifact of the Solexa transaction where the IP for sequencing resides largely in the UK and results in some double taxation and we're working on--.

We couldn't move it, because we had lots of NOLs, the value of the NOLs was too great.

Now we're -- we're eating up those NOLs more quickly because of the profitability of sequencing and now we're in the process of moving it all to Singapore.

Thank you for the clarification.

And then going back to the Genome Network.

It seems that a lot of the centers or the, maybe the larger customers would -- are still running at max capacity.

So, how, I mean, is there a lot of capacity that you forecast that you could off-shoot the small one-off projects into that?

Would you augment it with your own services and you would be part of that network as well.

We're definitely -- our part of the network, in fact, we're the hub of the network if you want to think about it that way, Quintin.

We'll do a lot of the marketing and the sales transactions around these large human genome sequencing orders, and then we'll distribute and subcontract the actual sequencing to the collection of partners.

And one of the advantages of using this network is that we get to load-level the capacity.

So, it could be that one institute at one particular time has more capacity than someone else.

So, they may be the ones that receive the sub-contracting work.

In the case that none of them have enough capacity, we'll do it in-house at Illumina.

So, it takes advantage of this broader network and can sort of leverage the natural ups and downs of big projects coming in and out across a broader number of institutions.

Good, thank you.

Your next question comes from the line of John Groberg with Macquarie Capital.

Hi.

Thanks for taking the question, can you hear me?

Yes, hi, John.

Sorry, I'm at the airport.

I'm just going to ask my two questions and then hop so you guys don't get bombarded with announcements of flights going and coming, but the first question, Jay, you mentioned that you had recently met with the FDA and you talked a little bit more about your consumer sequencing offering just now.

Can you maybe just talk about what it was that you discussed, and what it was that they wanted you to do to be fully compliant with what they were after.

And then the second question, Christian, can you -- on the free cash flow, can you, are these sustainable kind of improvements that you've made?

Obviously that was probably the most impressive thing in the quarter.

Can you maybe just talk about how sustainable the DSOs and some of the others are on the cash flow?

Thanks.

We did meet with the FDA and we've now met with them a couple of times.

The basic premise that the FDA has -- the position they have taken is that the DTC genotyping companies are supplying information that represents a diagnostic device.

Given that those devices fall under the regulatory purview of the FDA.

The challenge here, of course, is that because these arrays are highly complex in terms of the amount of information they provide, and the ability to interpret hundreds to thousands of pieces of information from those arrays, that the traditional model of how you conduct a clinical trial for demonstrating clinical validity is somewhat challenged.

So, what we're working through with the FDA is how do you come up with some new paradigm that really takes into account the fact that these arrays are totally different from the traditional single analide test where you run one clinical trial, get one result, and either approve it or not.

it's a different way of thinking here.

And the truth is that I don't think the FDA knows exactly how to go about this and the entire industry is working through this regulatory gray zone to try to figure out how it is we can bring these arrays into some degree of compliance, and yet, at the same time, deal with the overall complexity and so that's an unknown that everyone 's working through right now.

And will take some time to figure out.

And John, on the free cash flow, we did have a -- I was really proud of the free cash flow this quarter because really, if you look at the DSO, we were able to pull ten days out of the DSO relative to last year.

We've been working really hard since third and fourth quarter of last year, when DSOs got a little bit higher than what we'd like.

I think a range of DSOs that make sense for this type of business is mid-60s to 70, 72 or so.

And, so, I think that that's, we've kind of gotten there.

I think that that's a sustainable level for us.

If you looked at the balance sheet, one of the items we probably weren't as happy with was our inventory level at $119 million, now that's really because we're scaling up manufacturing at a feverish pace all across the Company and not only just in instruments, but also in sequencing reagents and quite frankly, we're continuing to scale the array throughput as well.

Our next opportunity, or my next challenge, is to kind of start generating more cash flow or more acceleration of throughput so to speak to improve the cash flow there.

But if you look at the business, if we can continue to generate operating margins where they are, then you can create cash flow from operations, where we were this quarter.

If you look at the level of CapEx, we had a pretty modest level of CapEx, so it's, it's -- there might be a little bit, because that's going to fluctuate from quarter-to-quarter a bit, but these kinds of levels of free cash flow are achievable when you have the business performing the way it is.

I think the announcement today, of the approval of a $200 million stock buy-back is reflective of the confidence that management and the Board have in our ability to continue to generate free cash flow.

That's right.

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

Hi, thank you.

My first question, on the HiSeq, are the mix of applications being performed on the HiSeq, any different than those applications conducted on the Genome Analyzer, either in the early instruments you have in the field or in your order backlog?

We haven't seen any indication that the application mix is any different.

Okay.

And could you remind me what you're doing with the Genome Analyzer trade-ins.

Are these being refurbished and put back out into the field or what?

Yes, they are.

We're just at the beginning of the cycle of getting those back from customers, but, yes, they'll be refurbished and resold as used.

Okay, thank you.

Your next question comes from the line of Tony Butler with Barclays Capital.

Yes, thanks very much.

On the Genome Network, what was the main driver, was it external demand from customers or did, was this an internal creation?

It was a market creation, I guess is the way to think about it.

We do see that there are some large projects forming that -- where customers want to sequence, 50 to a couple hundred genomes in a single project.

We thought we needed an infrastructure that allowed us to take on that business very directly through Illumina, but to take advantage of the CSPro certified network we have out there.

Because many of our customers want to participate in these -- in doing these large scale services as well.

And it's always a challenge and there's some natural tension between Illumina bidding on these projects and our customers bidding on the same project.

So, part of the idea behind the network here was that we have the ability to either do this independently or Illumina can bid on them and then subcontract them to these third party institutions and our partners, so that they wind up taking advantage of the scale-up of this service as well in terms of running these through their shop.

The other factor, I think, that's going to be important is that many of these institutes have specific expertise that they bring to the party.

Bio informatic capability in certain areas, advanced sample prep techniques, and having this network in place allows the customers who want the sequencing done to direct their projects toward a particular services operation that might have expertise that they uniquely might want or, in fact, be willing to pay for additional to the actual sequence.

That's very helpful, thank you.

And then back to manufacturing, while there was robustness for HiScan.

Obviously, there has been robustness for HiSeq.

You think about manufacturing build-up and constraints that exist today.

If you have got constraints on both ends, who actually gets the majority of the money and/or the time and if you will, the footprint for manufacturing?

Is it -- is it actually HiSeq or can you do both simultaneously to fuel and absorb the existing backlog?

We can certainly do both.

It's a question of what the mix is and the HiSeq -- as strong as the demand is for the HiScan SQ.

The HiSeq demand is much stronger.

It's a much bigger number in absolute terms.

So, HiSeq will continue to get the predominant focus, but at the same time, we are able to fill orders for HiScanSQ, it's just that the delivery times are out probably three or four months.

And we'd like to have them be two months or less.

Very fair.

Last question again around cash flow.

As the inventory is likely to continue to build in the second half, you may have really hit a nadir or the high end of your $0.47 per share free cash flow, and the real question becomes, would you expect, as you, as one thinks about inventory would you expect that to actually become more normalized than in 2011 or does that actually happen later this year?

For example, in Q4?

Well, let me comment on that and maybe Christian can elaborate.

I think inventory as the business grows will continue to grow in absolute terms.

What we're trying to work on of course is the velocity of products through manufacturing so that the turn rate goes up and therefore, on a proportional basis, inventory is less of a factor and we essentially pull cash out of where inventory would have been if the turn rate was less.

That's really what we're focused on.

We think, we had a couple more quarters here of ramping very fast and of accelerating the velocity of products through manufacturing, and I do think we'll definitely get better at that.

It's an area that Christian and his team is really focused on as we go into 2011, and I think we have some opportunities there.

Yes, Jay's given me some very specific guidance on focusing on inventory and so that's what we're doing.

If you looked at second quarter turns, I think they're kind of in the 2, 2.2 range.

For a business like ours, we should probably be striving to get to 3 to 4 turns per year.

And you'll see as we continue to move up the ramp of HiSeq and the learning curve, that will improve the velocity there.

We're continuing to really focus on the velocity of reagents through our system, particularly through our QC processes to make sure -- to make sure we send out high quality product in timelines that make sense for customers.

And so, that's really front and center, where our mission is right now.

Thanks, guys, very helpful.

Your next question today comes from the line of Paul Knight with CLCA.

Congratulations.

Thanks, Paul.

Thank you, Paul.

Can you talk about the $27 million of stimulus orders?

Does that get delivered over a quarter?

How do you think that rolls out?

I haven't looked at those exact orders as a separate bucket, Paul.

So I don't know exactly what the delivery schedules are, but I would say typically those would probably be delivered over a three to four month timeframe with our HiSeq backlogs, it may stretch out to be somewhat longer than that.

And then lastly, talks for Nanopore, you have that investment, any color on what that technology is up to and what your vision is there?

Yes, we're not getting any specific technical update there, I guess what we can say is that we continue to be very excited about the prospects of that technology.

We're not yet to the point where we're ready to talk about specifically where it is or when it could become a product, but we believe that at the time it does become a product that it will be potentially disruptive to the marketplace in pricing and throughput.

Okay, great, thanks.

Your next question comes from the line of Amit Bala with Citi.

Hi.

Good afternoon.

I had a question on the production manufacturing.

You did say that you can have 50% increase in prediction in 3Q and I'm assuming demand is going to be continuing to be strong throughout the rest of the year.

So, maybe you could just walk through the plans of manufacturing expansion beyond 3Q.

Anything you can give us there.

Thanks.

You were dropping out a little bit.

Let me see if I can take a stab at this.

So, in the third quarter, you're right.

We're going to increase our -- we're going to set a goal to increase HiSeq production at 50% more than what we did in the second quarter.

At that point, we think we will have really a critical mass or a capability to handle not only whittling through the backlog but ongoing demand.

I don't see us necessarily having to scale too much beyond that, but we'll see, obviously as things shake themselves out.

We're prepared, facility-wise and capability-wise to keep that scale and going if necessary.

But I think by the time we get to the end of the third quarter we'll be in a position to really start working through the remaining backlog, and trying to create the reasonable shift times or lead times for customers that they expect.

Okay, thanks.

And just, one quick follow up on backlog conversion, you mentioned HiScan.

You want to get that down to about two to three months in terms of delivery time?

What is HiSeq right now?

What's the delivery time there?

We don't quote exact delivery times in the backlog, but we'd like HiSeq delivery times to be in the range of six to eight weeks and it's considerably longer right now.

Okay, great, thanks

Ladies and gentlemen, this concludes the question-and-answer portion of the call.

I'd like to turn the call back over to Peter Fromen for closing remarks.

Thanks, Regina.

As a reminder, a replay of this call will be available in webcast format on the investor section of our website as well as 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 in October following the close of the third quarter.