Illumina Inc (ILMN) 2011 Q3 法說會逐字稿

Good day, ladies and gentlemen.

Welcome to the third quarter Illumina earnings conference call.

My name is Latasha, and I'll be your coordinator for today.

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

We will facilitate a question and answer session towards the end of this conference.

(Operator Instructions)

I would like to turn the call over to Mr.

Kevin Williams.

Good morning, everyone, and welcome to our earnings call for the third quarter of 2011.

During the call we will review our financial results released today before the opening of the market, and offer commentary on our commercial activity.

After which we will host a question and answer session.

If you have not 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, our Senior Vice President and GM of the life sciences as well as our Chief Financial Officer.

The 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 we will participate in the Piper Jaffrey Healthcare Conference in New York the week of November 28.

And the Deutsche Bank Med Tools Investor Summit in Boston the week of December 5.

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 will now turn the call over to Christian.

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

During today's call I will review our third quarter financial results.

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

Total revenue for the third quarter was $235 million, representing a year over year decline of 1%.

Product revenue, which decreased 2%, was $220 million.

Consumable revenue for the quarter was $145 million compared to $133 million in Q3 of 2010 and $159 million in Q2 of this year.

On a year over year basis, consumable revenue grew approximately 9%, primarily from the expansion of our sequencing instrument install base.

On a sequential basis, consumable revenue declined by 9%, driven by declines in both array and sequencing consumables.

We believe the decline in sequencing consumables was the result of delays of sample availability and increased sequencing capacity per run.

In addition, both our sequencing and microarray consumable businesses were significantly impacted by the uncertainty over government and academic research funding in Europe and the United States.

Annualized consumable revenue per HiSeq system was approximately $270,000, which is below our historically projected range of $300,000 to $400,000 per instrument.

On the array side, annualized consumable pull through across our install base of microarray scanners was down sequentially but remained within our targeted range of $400,000 to $500,000 per system.

The sequential decline in microarray consumables resulted primarily from a slowdown in whole genome genotyping arrays.

Instrument revenue for the third quarter was $72 million, down 18% over Q3 of last year and 33% sequentially.

The year over year decline was largely a result of the genome analyzer upgrade program which drove significant instrument volume in Q3 2010.

And was not repeated in the third quarter 2011.

The sequential decline was the result of a significant decrease in upgrades of genome analyzers to HiSeq systems and what we believe to be an excess of sequencing capacity in the market resulting from the launch of our v3 sequencing chemistry.

Service and other revenue, which includes genotyping and sequencing services, as well as instrument maintenance contracts, was $15 million compared to $13 million in Q3 of last year.

The primary driver of the year over year growth was the increase in maintenance contracts for our growing install base of sequencing systems.

Before discussing our gross margins and operating expenses for the quarter, I would like to note that we recorded a pretax amount of $25 million related to non-cash stock-based compensation.

This impacted our earnings per share in Q3 by a tax adjusted amount of $0.12 per pro forma diluted share.

As a reminder, 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 non-GAAP measures which is included in today's Earnings Release.

Total cost of revenue for the quarter was $78 million compared to $80 million in Q3 of 2010.

The Q3 2011 cost includes stock-based compensation expense of $2.1 million compared to $1.5 million in the prior year period.

Excluding this expense and $3 million associated with the amortization of intangibles, non-GAAP gross margin was 68.9%.

This compares to 69% last quarter and 67.8% in the third quarter of 2010.

The year over year gross margin increase was driven by a favorable mix of consumable versus instrument revenue and higher ASPs on the HiSeq 2000.

Research and development expenses for Q3 were $50 million compared to $45 million in the comparable period of 2010.

These numbers include non-cash stock compensation expense of $8.6 million and $6.5 million, respectively.

And contingent compensation expense of $0.8 million and $0.9 million, respectively.

Excluding these costs, R&D expenses were $41 million or 17.4% of revenue compared to the prior year R&D expense of $37 million or 15.7% of revenue.

SG&A expenses were $66 million compared to $55 million in the third quarter of 2010.

Including stock-based compensation expense of $13.8 million and $9.9 million, respectively.

SG&A expenses also included contingent compensation gain of $0.3 million and amortization of intangible assets of $0.2 million in the third quarter of 2011.

Excluding these costs, SG&A was $52 million or 22.2% of revenue compared to $45 million or 19% of revenue in the prior year period.

GAAP operating profit for the quarter was $37 million.

Excluding these expenses outlined earlier and $6.5 million of expenses related to the upcoming relocation of our corporate headquarters, and acquisition related gain of $2.6 million, our non-GAAP operating profit for the quarter was $69 million or 29% of revenue compared to $79 million or 33% of revenue in the third quarter of last year.

Our non-GAAP tax rate for the quarter was 34.4% compared to 34.7% in Q2.

The sequential tax rate improvement resulted from the mix of earnings shifting to lower tax jurisdictions.

We are continuing to see the benefits from our scale up of manufacturing in Singapore.

We expecting to realize more significant tax savings beginning in 2012 and beyond.

We reported GAAP net income of $20 million or $0.15 per diluted share compared to net income of $35 million or $0.24 per diluted share in the prior year period.

Excluding the items identified in our press release and net of pro forma tax expense, non-GAAP net income was $30 million or $0.22 per pro forma diluted share compared to $41 million or $0.30 per pro forma diluted share in the third quarter of 2010.

During the third quarter we generated cash flow from operations of $90 million.

We used approximately $22 million per capital expenditures resulting in $68 million in free cash flow.

This compares to $42 million of free cash flow in the third quarter of last year.

We ended the quarter with approximately $1.1 billion in cash and short-term investments.

Compared to Q2, our inventory balance decreased by $3 million from $142 million to $139 million.

Depreciation and amortization expenses for the quarter were approximately $18 million.

During the quarter we repurchased approximately 3.6 million shares of our common stock for $204 million under our previously announced 10b5-1 and discretionary share repurchase programs which have both been completed.

As we indicated in our press release earlier this month, we believe that fourth quarter revenue will be higher than third quarter levels primarily as the result of commercialization of the MiSeq platform.

However, given the uncertainty surrounding budgets for government funding of research and development, the Company's not providing further guidance at this time.

Given those uncertainties and in light of the current global economic environment, the Company's implementing a restructuring to better align the Company's organization and cost structure.

As a result, the Company expects to record a restructuring charge of approximately $15 million to $17 million, the majority of which will be recorded during the fourth quarter of 2011.

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 morning, everyone, and thank you for joining us today.

During the third quarter, we experienced a confluence of factors that led to our very disappointing results.

I'll describe what we know with regard to each of these factors and also try to be clear on what we do not know.

First, the global funding environment for academic research is highly uncertain as governments in the US and Europe focus on reducing fiscal deficits while at the same time, confronting slower economic growth.

In 2011, the US NIH budget was down 1% compared to 2010.

And the proposed budget for 2012 ranges from down 0.6% to up 3.3%.

And it's currently operating under a continuing resolution that is down 1.5% through November 18.

In addition, the stimulus funding that peaked about a year ago is rolling off, creating an additional headwind versus the aggregate NIH funding levels of 2010.

We have not believed that alone the stimulus roll-off would have been a significant influence on our business.

However, in conjunction with the decreasing baseline of NIH funding, it is a material factor.

To remind you, we estimate that approximately 1/3 of our total revenue is derived from NIH funding.

And while these specific budget reductions are a concern, an equivalent concern of our customers stems from the ongoing uncertainty of what the future funding scenario will provide.

In that regard, the 12-member super committee formed under the Budget Control Act is presumably working responsibly to identify $1.2 trillion of budget reductions over the next 10 years beginning in 2013.

And to have this agreed before Christmas.

Failure to agree could result in an 8% across-the-board sequestration, including the NIH.

We believe that while the potential exists for NIH to be cut by as much as 8% in 2013, this is an unlikely scenario.

Research funding is looked upon favorably by both parties and by the White House.

In addition, while the overall Health and Human Services budget, of which NIH is a part, may be cut under the BCA process, we believe HHS has the ability to reallocate within its budget to spare NIH from the full 8% impact.

We also remind investors that after 2013, discretionary spending for the next 8-year period is set to increase yearly by 2% or more.

Parts of Europe are also seeing research funding discontinuities.

While certain countries like the UK or Germany have experienced stable or even increased funding, other geographies such as southern Europe have seen cuts or funding delays.

Europe, while typically slow in the summer, came in much weaker than expected in Q3 with limited visibility to improvement.

So what we know is that in the US, the combination of the reduced 2011 NIH budget, the potential 1% reduction to NCI, and the NHGRI for 2012, the recent 20% reduction to select genome centers for 2012, the roll-off of stimulus, the 1-year no penalty extension of ARRA grants, and uncertainty regarding future budgets were in combination a major impact on our incoming order rates.

What cannot be determined at this point is the relative contribution of these factors, or how the 2012 or 2013 NIH budgets will ultimately resolve.

We have no more information on those prospects than any of you have.

Overall, we continue to believe that funding allocations globally are increasingly favoring genetic analysis tools and in particular next generation sequencing.

A second major issue during the quarter has been our customers' adjustment to the improved sequencing throughput of our v3 consumable kit, which has resulted in a 2- to 3-fold increase in capacity.

Sample delays and new sample availability to utilize this improved capacity contributed to a decrease in HiSeq placements and slower than anticipated upgrades of GAs.

We also believe these factors resulted in fewer sequencing runs as certain customers either waited for samples to consume capacity, adopted indexing work flow changes to fill the runs, or finished projects earlier than expected.

We believe this excess capacity is temporary and will be fully absorbed by the market over the next few quarters.

These 2 issues, funding and our v3 kit upgrade, were the key contributors to an unprecedented slowdown in purchasing during our historically strongest quarter.

We did not see the historical pattern of large orders at the end of September when the government fiscal year ends.

Concerns around research funding, which were felt broadly, particularly among our large volume centers, precipitated shipment delays.

All indications are that the shortfall was not due to competitive pressures.

And in fact our market share is stronger in our core markets than it's ever been.

I'd like to turn now to the specific results of the quarter.

Our total revenue in the quarter was down 1% over Q3 of last year.

However, overall business was below forecast for the aforementioned reasons.

Europe in particular experienced a greater relative decline compared to forecast than Asia Pacific or the Americas.

While both our microarray and sequencing businesses were below forecast, funding uncertainty appeared to affect our sequencing business to a greater degree.

Despite our results we gained market share and built backlog in the quarter.

Total Q3 microarray revenue was down 9% year over year, driven in large part by the tough comparison from the very successful launch of our Omni-2.5 Quad in the year-ago quarter.

We did, however ship a record number of focused-content microarray samples during the quarter.

Microarray instrumentation, while down sequentially, grew year over year due to shipments of HiScan and HiScan SQ systems.

We recently announced several new microarrays offering novel human exome content, developed in close collaboration with leading researchers which will ship in Q4.

Infinium Human Exome, OmniXpress Exome and Omni-5 Exome BeadChips allow researchers to economically and rapidly in interrogate samples with markers for over 250,000 exome variance with the ability to add additional custom markers.

Researchers are now able to study very rare coding variance in dramatically larger number of samples, and in a more rapid fashion than would be practical by sequencing.

Orders for the exome arrays were the leading category of array orders in Q3 but were not available for shipment during that quarter.

Looking at our sequencing business, total sequencing revenue grew 5% over a year ago, largely attributable to the broad adoption of the HiSeq 2000.

As we experienced in Q2 over 90% of HiSeq orders in Q3 were to customers outside major genome centers.

We also added approximately 25 new HiSeq sequencing customers during the quarter which is consistent with our historical run rate.

Adversely affecting sequencing instrumentation revenue was a significant decrease in upgrades of genome analyzers to HiSeqs, as well as the challenging funding environment and the release of our v3 kit, as previously discussed.

Total sequencing consumable revenue grew by more than 40% compared to Q3 of last year.

As mentioned in our pre-release, however, we noted a large sequential drop in sequencing consumables on the GAs, resulting primarily from a lack of utilization of these instruments in sites that also have HiSeqs.

Sequencing is so much cheaper on a HiSeq that the GAs will not be used unless the HiSeqs are running at capacity.

We believe that HiSeq consumable pull through was also affected by sample delays, new sample availability and funding uncertainty.

Turning to our recently launched MiSeq system, there was tremendous interest from customers at the recent ASHG meeting.

Customers are excited by the breadth of applications, ease-of-use, accuracy, rapid turnaround time and throughput.

We've been very pleased with our orders for MiSeq and shipped over 45 systems in Q3.

We expect to ship in volume during Q4 and to carry a significant backlog of instruments for the next few quarters as we scale manufacturing to meet demand.

At ASHG, we announced 3 new and exciting workflow enhancements for MiSeq.

BaseSpace, a cloud initiative, removes a significant barrier for adoption of next-gen sequencing, and should accelerate the migration of sequencing from capillary electrophoresis to our next-gen platform.

Data generated by MiSeq is automatically pushed to the cloud, making it simple to use, secure, reliable and seamless for collaboration.

In addition, the new Nextera DNA sample prep kits allow for the fastest and simplest sample prep today.

These kits now support 2-by-150 base pair reads, sample indexing up to 96, improved reagents optimized for PCR, and reduced error rates.

Finally, a TruSeq custom Amplicon kit from MiSeq offers scalable multi-plexed assay for rapid, cost-effective and custom variant identification.

Researchers can now accomplish projects in several days that previously took several weeks or months.

During the quarter we announced a collaboration with the University of Oxford to sequence 500 individuals afflicted with cancer or life-threatening immunological or rare Mendelian diseases.

We believe this collaboration will demonstrate the enormous value next generation sequencing holds for clinical research as it empowers clinicians and geneticists to evaluate the genetic basis of disease with a previously unmatched level of precision.

This is the next step towards a new healthcare paradigm in which genetic information from NGS is likely to become much more widely used in routine medical practice.

Our Illumina genome network continues to gain traction as we received several large orders during the quarter, including over 500 genomes from Sanford University and 450 genomes from a large biotech company.

As a reminder, we established IGN to provide whole human genome sequencing services through Illumina and select partners using our Illumina technology.

In fact, today we're pleased to announce that the British Columbia Cancer Agency, BCCA, has become the latest IGN partner.

Although our revenue for the quarter did not meet our forecast, our operational execution was excellent.

In particular, we were able to successfully complete the development of the MiSeq system on schedule with a level of manufacturing robustness that is higher than any system we've ever launched.

During the quarter, we reduced our inventory balances as our supply chain and production groups were able to quickly react to reduced levels of demand.

We also achieved ISO13485 certification in our Hayward manufacturing facility, which will pave the way for us to achieve FDA certification for our sequencing instruments.

Finally, we qualified our Singapore operations to produce sequencing consumables, and expect to produce about 50% of those products out of our Singapore facility, driving our future tax rate down.

Given the revenue challenges we saw in Q3, we've developed a plan to restructure our business and will begin the implementation of that program shortly.

As Christian mentioned, we expect to incur a restructuring charge of approximately $15 million to $17 million, the majority of which will be recorded during the fourth quarter of 2011.

In spite of our revenue shortfall, we increased our gross margins year over year and believe this trend should continue.

We also built our backlog during the quarter.

Our tax rate decreased sequentially primarily from the mix of earnings shifting to lower tax jurisdictions and we expect to realize a more significant tax savings beginning in 2012 and beyond.

Certain end markets like ag continue to show strength as illustrated by a record number of focused content samples that were shipped last quarter.

HiSeq consumables continue to grow in the US and the recently launched Omni-2.5 Octa was our best selling array in Q3.

Interest in MiSeq and our exome arrays is also extremely high.

Illumina's history has been marked by our ability to innovate and rapidly bring exciting new technologies to the market.

Despite the impact of the v3 kit, driving down the price of sequencing genomes will ultimately result in a significantly larger market for our products.

Our future growth will be fueled by our ability to continue the historic pattern of innovation and rapid market introduction.

Over the next few years sequencing will become widely adopted in clinical applications, as evidenced by Sequenom's recent launch of their Materni T21 test.

Our development pipeline remains strong on the heals of some exciting product launches, including MiSeq, our exome arrays, Bovine LD, TruSeq custom Amplicon, and BaseSpace.

The fundamentals of our business and our markets remain intact.

We believe our market share is as strong as ever, as is our order win rate.

Next generation sequencing influences healthcare delivery as genetic information becomes more widely used in routine medical practice.

While we were very disappointed by our revenue performance in Q3, we generated cash flow from operations of $90 million and are taking steps to optimize our cost structure to maintain strong profitability.

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

(Operator Instructions) Tycho Peterson with JPMorgan.

I'm just wondering, for starters, if you can walk us through a little bit of the time line during the quarter in which you picked up on some of these issues.

It seems like from a lot of the discussions you were having in mid September there's a lot more focus on 2012 and '13.

NIH dynamics, rather than about the excess capacity issues and some of the kit issues.

So could you just talk about when you picked up on some of these things in the field?

And also what you can do to address the v2 to v3 overcapacity and work with customers on that dynamic?

Q3 is historically our strongest quarter, Tycho and it's also, interestingly, the one that is the least linear.

The reason for that is that in the summertime Europe is largely shut down and it's also a relatively slow couple of months in the US.

So, September winds up being very radically back-end loaded.

That's a historic pattern in our business overall.

On top of that, you have the end of the government fiscal year in September, so it tends to be an extremely back-end loaded quarter.

In the middle of September, we still had prospects of getting near or to our number, we just didn't see any rush of orders at the end of the quarter.

So, it was late notice but that's not a surprise given the typical dynamics that we see in Q3.

With regard to the v2 to v3 conversion, I think one of the interesting things we've realized is that not only do we need to consider the absolute factor increases that we make in sequencing, in terms of percentage increase, but also think about that in terms of the absolute G level of increase.

And the importance of that is the following.

If you think about a sequencing system that was running at perhaps 10G, and you triple the capacity to 30G, many of the existing customers would simply sequence their samples to greater depth or they would look at more genes in a targeted application or they might look more broadly across a set of collective samples.

But when you go from 200G to 600G, because you're now dealing in increments of complete genomes, complete mammalian genomes, you have to have the ability to access in virtually every case more samples to fill up a run, That was a dynamic that we probably under-appreciated a little bit when we made this very large jump in absolute sequencing capacity.

So, what we're doing with our customers, of course, is working hard for them to get access to these samples.

We can't help so much in defining the projects, but we certainly can help them in terms of getting samples through the sample prep process and on to the actual running of the sequencers.

And of course, the easier we make the front-end sample prep, as we've continued to do, makes that front-end processing much more easy for those customers.

One thing we might say that I think has been a concern on the part of some, is that we continue to believe fundamentally that there is an insatiable demand of things to get sequenced.

So the samples are out there.

It's a question of how rapidly can the projects be defined, can the IRBs be set in place, and the samples acquired in the process.

And on the capacity there's been a lot of discussion that some of the genome centers are shifting their emphasis from data generation to analysis.

So can you talk to how you think about that transition?

And what's the risk that this is a longer-term shift that would diminish the amount of sequencing that actually gets done?

Certainly, analysis is very important part of what the genome centers are doing, in fact, all customers are doing.

We're working hard to reduce the overhead of data transmission and the actual size of the data sets that these customers have to deal with.

But we don't, in almost any case, see a tradeoff of actually sequencing versus informatics.

If you did that, you'd do analysis for a year and then you'd have to go back and turn on the sequencers and bounce back and forth.

We're certainly not seeing that effect at all in our customer base.

And then a couple other quick ones.

You talked about some of the rollover effect, the 1-year no penalty extension for the ARRA grants.

And it seems like the NIH was allowing more customers to rollover grants, as well.

Can you talk whether that was a dynamic that you didn't expect through September?

We were a little worried about that.

We certainly didn't know that it was going to happen, but we did have some concerns about it.

And it's the effect that normally requires customers to spend money at the end of the fiscal year, and why we have such a large order rate in the last several weeks of September.

We just didn't see it this year because of the no-penalty extensions that the NIH granted.

And then last one, can you just talk about the trajectory for HiSeq going forward?

Obviously moving down the genome enters, talk about maybe where you're seeing interest -- you mentioned Sequenom.

Are you seeing pretty significant uptick by some of the diagnostic customers?

And then how about porting over some of the capabilities you've introduced on MiSeq, like BaseSpace, over to HiSeq?

Is that a near-term trend or how do we think about that?

We certainly are seeing much broader adoption of HiSeq in clinical applications.

The clinical market will have 2 distinct segments, part of it on MiSeq for doing targeted applications.

But in many applications, including cancer, applications like trisomy testing where you need extremely deep sequencing, HiSeq is the perfect instrument for that.

It's extremely cost-effective and very fast.

So we are seeing significant uptake in those segments.

I think if you stand back from the specifics, probably the single biggest factor that will determine the go forward trajectory of the system is what happens in the funding environment, which is uncertain as we look forward.

I will say that the platform we think has a very strong continued life.

We're really just reaching mid life for that overall technology.

And we continue to enhance virtually all aspects of that system.

And getting to the second part of your question, 1 additional enhancement that we will make is the ability of data to stream from HiSeq up into the cloud.

It's more challenging on HiSeq, because the data rates are much faster, the overall data size is larger.

So, it takes today -- would take today, several days to transmit a human genome up to the cloud given the size of most of the pipes that come out of our major customer sites.

We're working very hard, and have figured out, we think, some key technologies to do an increased level of pre-processing on board HiSeq which will allow us, we think over the next 12 months, to directly connect HiSeq to the cloud.

And that will imply that customers need a zero footprint compute infrastructure in their facility to run these systems.

Which, for many of our customers, would be an enormous advantage.

Doug Schenkel with Cowen.

Over the next several quarters you face some very difficult comparisons, as you've been talking about for several quarters.

You're facing some industry wide and a series of Company-specific headwinds.

As you acknowledged, it seems hard to say with certainty exactly when these headwinds are going to subside.

Yet you guys are still seen as the most innovative company in the industry.

You haven't signaled that there's any reduction or slowdown in the level of confidence you have regarding the multi-year potential for Illumina in the industries you address.

With all this in mind, is it fair to say that we should expect that you're going to continue to invest in building out the necessary support infrastructure, and continue to invest in new products along the same lines as you have in the past?

And how does this jive with your restructuring plan?

Yes, Doug, I think there's no basic change in our strategy whatsoever.

We're going to continue to invest in R&D, we're going to continue to invest in building our distribution channel, particularly as it relates to what we're doing in the emerging clinical markets.

We are, as we mentioned in the script, taking a very hard look at our cost structure.

We think it's appropriate to more closely align our cost structure to our current and near-term expected levels of revenue.

We have defined a plan there that we'll begin to execute very shortly.

Part of that restructuring will include the creation of a new business unit that will be focused specifically on the clinical markets.

We have, today, the business unit that Christian runs in Life Sciences Tools.

We have a pure diagnostics business unit that's focused on bringing Illumina-based diagnostics that we build and sell into the market.

But we think that we really need to create a much stronger focus on customers that are using our technologies in clinical applications.

They have slightly different requirements; they need slightly different software, different shelf life for reagents.

They need greater professional services and help in building reference applications.

We're going to create an organization that will be dedicated and focused on those emerging clinical markets and we think that will help us really take advantage of the impending growth of that market segment.

And then in terms of a very specific follow-up, any related changes in cost structures, or is that something we'll have to wait a quarter or two to learn more about?

In the script we said we're going to begin implementing this shortly and so I would expect to hear news of that soon.

And one more follow-up.

Regarding the capacity issues, how important is it, in your opinion, Jay, that researchers start to shift from really focusing on exomes, as we've seen over the last year, year-and-a-half, at least, to do more whole human genome analysis in addressing some of these capacity issues?

Is that an important component of addressing some of the drop in utilization?

I wouldn't consider it to be a strategic factor in utilizing all the capacity but it's certainly a trend that would help us.

One that we are working hard to encourage customers to move towards, sequencing complete human genomes.

In particular customers like that direction because it reduces the up-front sample prep and the indexing that has to occur.

It is the case that exome sequencing continues to be cheaper, but as we close the gap between the cost of sequencing an exome and sequencing a whole human genome, that more and more customers will convert over and that will be a positive trend for us.

Ross Muken with Deutsche Bank.

I thought you did a good job talking about some of the parts in your control and some out of your control.

Taking the budgetary concerns aside and just thinking about the competitive landscape, and some of the challenges you face just dealing with the market, which seems to be in a bit of oversupply, how do you gauge, and how are you thinking about the right steps?

Whether it's from a new product introduction, market positioning, product stratification standpoint, both on arrays and sequencing, to think about some of the tradeoffs and pricing that your competitors have done on both the boxes and services and sequencing.

And then relative to some of the tradeoffs between applications that have moved from arrays to NGS.

A very broad question, Ross.

Let me see if I can try to address that.

Certainly, we're beginning to diversify our business.

That's one element.

The push very strongly into ag which we've done for several years.

We think the emerging diagnostic and clinical applications of sequencing are important sectors that we need to make sure we take advantage of.

In those sectors we have the potential to get higher pricing, because we add more value to both the instrumentation as it gets approved and to the consumables as they become GMP manufactured and more closely controlled in terms of their shelf life and revision control.

I think from a gross margin perspective, we have some upside potential as we begin to push into those markets.

From an application perspective, we're working very hard across the breadth of different applications that we have to see whether there are opportunities for growing particular segments.

Also for either increasing the price or reducing the price at a slower rate for those particular applications, as we develop the ability to create less generic reagents.

By that, I mean reagents that are more specifically composed, if you will, for a particular type of application that runs on our machine.

In terms of the tradeoff between micro arrays and sequencing, because we're the leader in both those markets, we're to a first order largely indifferent to how the technologies transfer back and forth.

We'd obviously like to see both those markets continue in a healthy way, which is why you saw us introduce the exome version of several of our micro arrays.

Which makes it very cost effective for customers that were beginning to do exome sequencing to now, instead of doing 50 or 100 samples using exome sequencing, they can do 5,000 samples using our exome arrays.

So, we're going to continue to announce products in both areas that are complementary to each other.

That, in fact, was part of the original strategy of why we got into sequencing, because we saw that synergy between how customers use arrays and how they use sequencing.

Obviously we're going to continue to push in other emerging new markets for us such as the PCR market and the Eco product.

We're now approaching an installed base coming up on about 1,000 units for Eco.

You're going to see us continue to push that technology.

We're working very hard on the reagent side of that because all of the revenue thus far has been just from the instrument placements.

There's even a bigger market opportunity for reagents as we begin to bring those to market in 2012.

I think the one other thing, Ross, to think about is we're really excited about how BaseSpace creates a marketplace basically for us, in a way that creates and really get a network effect out of the installed base.

Really moving us along a path of the socialization of genomics in the sense that -- really giving everyone the opportunity to participate in the market, share data, and then create app stores and other types of opportunity opportunities for us to generate growth, as well.

Great.

Maybe can you just talk a bit about cash utilization?

You had another good cash flow quarter despite the top line delta.

Obviously we saw you bought back some stock.

You used up the repurchase.

What's the thought going forward?

You obviously have a big cash balance there even though you do have the converts outstanding.

What's the thought on one; not re-uping the share repo today, and two; priority of what you're going to do with the cash?

I think, Ross, the objective for us is to use the cash to continue growing the business.

As we've talked about in the last several quarters, we continue to be more and more engaged and more and more interested in various M&A types of opportunities that can either increase our footprint, or get us further deeper into diagnostics, or bring new technologies to bear.

At any given time we're always assessing a number of different opportunities.

So, having that capital gives us a lot more flexibility.

With respect to share repurchases, today we're not announcing anything but the reality is that periodically we've done share buybacks over the last several years, and I wouldn't be surprised if we continue to do that at some aperiodic rate.

I would expect more of the same from us in terms of really focusing on generating strong cash flow for the business and using that capital to really create future growth opportunities for us.

Amanda Murphy with William Blair.

I just had a follow-up to Tycho's question on the consumable point that you had mentioned.

I'm just curious, obviously there's the sample access issue, and then whatever there is in terms of data storage and informatics bottlenecks.

So, how are you thinking about the pull through side of things at this point?

In other words, have most people upgraded to Version 3, so we're at the low point, potentially getting better going forward?

And do we have any visibility at all into how this could progress over the next few quarters in terms of the market actually addressing some of the bottlenecks that you talked about?

I'd say the majority of customers have upgraded to v3.

Probably the vast majority upgraded to v3 at this point, so I think that is a good baseline assumption.

As we look forward in terms of overall reagent consumption, the equation gets a bit more challenging, because we have more factors involved.

Clearly funding is probably the dominant one that will influence the rate of consumable usage.

But we also have, probably beginning next quarter, the beginnings of uptake of reagents on MiSeq and so that will become convolved into the HiSeq and genome analyzer install base number.

So, there will be at least that one additional factor in the system and I think decomposing that is going to be challenging unless we decide to break it out, which I think is probably unlikely.

And then any comments on timing?

You mentioned that you expect it to improve over the next few quarters.

Do you have any visibility at all into how that might look over the next 12 months or so?

In terms of absorption of capacity?

Yes.

Yes.

I mean, we are optimistic that the fundamental assumptions we have about our marketplace are unchanged.

It is a challenging macro period for us, no doubt about that.

So, we have to take any comments and any assumptions we make about the business with that in mind.

Having said that, we think that customers are beginning to consume the capacity already.

We think there will be increased certainty around funding.

They may not like the number, we don't know what it's going to be, but at least they will know what they're going to have.

That will begin to become pretty clear either by the end of this year or into Q1 as the super committee completes their work.

So, I think that will begin to break free some of the funding that is installed just because people are uncertain.

Once that starts to happen, I think the capacity will be consumed, the projects will get started and we'll start seeing the samples fill up with sequencers.

Thanks, that's helpful.

Then, just a question on the MiSeq.

Now that you've been shipping that instrument, and obviously there's another competitive platform on the market at this point.

I'm curious what the customer reaction has been and how you see the competitive dynamics evolving in that particular market over time.

We've been very pleased with customer reaction to the system.

It's, I think, a market-leading technology in almost any respect.

It is extremely easy to use.

The sample prep is getting better all the time and is now down to a matter of a few hours.

The throughput exceeds any other system in the market in that price range.

The overall accuracy of the data is outstanding, as good as, or better than HiSeq.

So, we are quite pleased with the performance of the system.

We will continue to scale the performance of that system and make it better over time.

Like any other technology that we have brought to market, it's not a dead end once we begin to sell it; it will continue to get better.

I think, from a customer's perspective, having the same chemistry, having the cloud enabled, all the other features and performance metrics that I talked about, make an extremely attractive purchase.

So, we're very optimistic about how that product's going to sell.

I think one other thing, Amanda, is the fact that when we put MiSeq on the market we launched it with a whole suite of capabilities.

You'll see us continue to develop, for example custom targeted applications for the system.

So, the researcher really has a complete offering where some of the other platforms maybe aren't as robust nor as complete.

Derik De Bruin with Bank of America.

Good morning, this is actually Raphael in for Derik.

I just had a few questions, and pardon me if this has been asked already.

Just trying to get a better sense of your definition of temporary.

What factors are you looking for in order to get -- call it, a recovery of the market?

And is temporary a matter of a few quarters or could it be potentially a little longer than that?

What we said, Raphael, is that we think that the capacity will be absorbed over the next few quarters, so that's how we've characterized temporary.

I did mention that all of that is within the backdrop of these challenging macro factors that we are facing.

In terms of what metrics we'll be watching, we have pretty good ways to evaluate this.

We're in constant contact with the genome centers so we have people actually in their sites so we can watch the utilization of their instruments and how fast the projects are progressing and how fast new projects get started.

Clearly the overall incoming consumable order rate is a first order metric for us as we divide it by the installed base to see if the overall utilization of the systems is going up.

So, we have a pretty good handle on those metrics going forward.

And as a follow-up just on consumable pull through, are you seeing a notable difference either by the size of a genome center, by the application, are any of these factors notably different?

You mean a shifting from one application to another one?

Yes.

One that's been quite prominent over the last few quarters is whole exome sequencing.

So, we see in some of our large centers very large volumes of whole exome sequencing being done and we do think that will continue.

We had a discussion a few minutes ago about the fact that as the price gap between an exome and a whole genome gets smaller, we'll begin to convert more of that toward whole genome.

But right now, I'd say that's probably the single emerging application area that's growing the fastest.

Bill Quirk with Piper Jaffrey.

First question, Jay, on MiSeq, have we seen a fairly even pacing of orders?

Or do we see any ebb and flow here given the overall funding concerns?

And just to tack on here, I realize that obviously it's only been a week, but any comments post ASHG in terms of order flow, et cetera, would be helpful.

Thanks.

Since we only started taking orders in April, I think there's not enough time behind this, Bill, for us to make any conclusions about ebbs and flows of order rates on MiSeq.

So, I don't think we have any conclusions about that.

We would suspect, post ASHG, even at $125,000, most of the ordering comes from grants and from things from funding sources that take some time to develop or were in process.

It's not so much the case as it would be in an extremely low-priced instrument that someone would go to a trade show and just place an order the Monday they get back.

It generally doesn't happen that way.

We wouldn't have expected a large in-rush of orders the week after the trade show.

And then just a longer-range question is, if we think about the impact, however short or long term it is, from the v2 to v3 transition on sample processing, revenue flow, et cetera.

Does that change at all, Jay, how you guys think about R&D, or for that matter how you prioritize some of your projects longer term?

Thanks.

Yes, I think it does.

The one clear factor now is that, because we're in less of a race at the high end to launch every capability we have as quickly as possible, we have the ability to bundle together enhancements in larger collections of releases.

So, we tend to bundle software releases with a reagent release, and perhaps with a small hardware change.

We don't have to roll those out to the field in small increments that cause customers some disruption, we can deploy those in a more rational collected way.

So, certainly that's one change.

I think what you're getting at there, as well, is what about the next increment in throughput.

And certainly, we've learned some lessons from the v3 launch and we're thinking long and hard about how we would do subsequent launches.

Clearly, we have head room in the technology and we will have higher throughput in other capabilities on this system.

What it does do is it causes us to reflect on exactly what the next best feature the customer needs.

And this technology can be pushed in many dimensions including faster run times, higher output, higher quality, and other metrics as well, breadth of applications.

So, it may shift the priorities a bit in timing in terms of what we put our R&D resources on, say, in the next 12 months.

Last question for me.

Just any quick update on the cytogenetics program?

The program is proceeding toward FDA submission.

I would say at this point we are on track and should have a submission probably by Q1.

Quintin Lai with Robert W.

Baird.

This is actually Julie in for Quintin.

I'm trying to understand the dynamic of the installed GAs.

Can you give us a bit more color on what proportion of the original installed base remains in the lab?

What proportion of those are in labs that are also running HiSeqs?

And how you expect consumable pull through on the MiSeq to compare to the currently installed GAs?

I can do that qualitatively for you.

I don't have exact numbers in front of me on that.

But we have, first of all, we've traded out a fair number of the genome analyzers, to begin with.

Of the remaining set of genome analyzers, it's probably the case that at least half of those and maybe more are in what I would call a hybrid site that have both HiSeqs and genome analyzers.

As we said in the script, it's very likely that if it is in a hybrid site that it would not be used unless the HiSeqs were running at full capacity.

So, the trend we've seen is some of those GAs are not producing any reagent flow at all because if the institute is running at 60% capacity they may be doing it all on HiSeqs and not on the genome analyzers.

Then, the remainder of the installed because are the GAs that operate independently.

Obviously we continue to get consumables from them but they are impacted to the same extent by the overall funding questions and equation that we talked about a bit earlier.

I'm sorry, there was a second part to your question, which was?

How you might expect consumable pull through in MiSeq to compare to those GAs that are running?

Yes, we haven't got any empirical data on that yet.

So, we're waiting to get our first quarter or two of actuals to be able to speak more definitively about this.

Internally we have a pretty wide range of estimates.

We've said the best place to put your pencil down probably initially is to use, as a proxy, the $50,000 per year that a typical capillary sequencing customer would consume.

For now we're going to start there and see which direction it moves as we get actual data.

And could you also give us the contribution from Epicentre during the quarter?

We did not.

Isaac Ro with Goldman Sachs.

First off on the restructuring plans, I'm wondering if you guys could maybe go into a little more detail there regarding how that might be focused between sales and marketing, or perhaps focusing the resources in R&D.

And then secondarily how does that balance against your needs to invest in the commercial support for MiSeq, just given your competition there has a pretty sizeable channel?

The first thing I'd say is that the restructuring we're going to do here will not effect either our core development programs nor our market channels.

We think that all that will remain intact and not in any way diminish our ability to compete effectively in the market, either technologically or commercially.

We are going to do some changes in the way we are actually organized internally.

I mentioned that we will create a greater focus on the clinical markets, so there will be more specifics about that, and how we expect to implement that and why it's important.

I think the other area that we need increased focus is in our low-plex business.

One of the challenges we've had in the lower-plex products with BeadXpress and Eco is getting sufficient organizational attention on those products given the very high-end and high-priced sequencers and micro array products.

We'll probably, from this organizational change, get some improved focus in those areas, as well.

The second question I had would be on BaseSpace.

I understand that you guys are shouldering some of the expenses there, or all of the expenses there, as it launches.

At what point would you say it makes sense to charge for that service?

Or maybe what, if any, is the economic model behind that technology?

With respect to MiSeq, the data sets are small enough and we compress them well enough that the actual cost to Illumina are pretty insignificant.

So, we've announced it as a free service for now.

We will make a decision in the future whether we think charging for it makes sense.

Probably the way we would charge that is after data has been there for some period of time, so if data stored perhaps for longer than 6 months or longer than a year.

Or if the customer exceeds a particular overall amount of storage.

So, if they're greater than xG of data, then we would begin to charge for the increment.

We do think from a marketing perspective, having free and easy access to basic MiSeq runs, particularly in the startup phase of a new customer, is the right way to sell this.

The costs for us are not large enough that it matters, to be honest.

One of the great opportunities it gives our customers is the ability to create collaboration models that are otherwise quite difficult.

Particularly as we begin to implement this on HiSeq, where you're dealing with complete human genomes.

You can imagine if you have 3 customers in different parts of the world who want to collaborate on some cancer genome project, they today have to ship disk drives around to be able to do that.

The cloud technology will allow them to transparently collaborate and we're very excited about bringing that capability to the market.

Of course, Isaac, in terms of the ability to build an Eco system and build out other applications and other services that actually generate more direct revenue, the BaseSpace is really the beginning of giving us that capability.

So, what's really interesting, or what we're really excited about, is the fact that BaseSpace is connected automatically into every MiSeq system today that ships.

Over time, BaseSpace -- the opportunity, will be incorporated into the HiSeq system.

So, that will give us a fantastic opportunity to create new applications, new analysis tools that we could create revenue streams from.

Dan Leonard with Leerink Swann.

Just two questions.

One, can you quantify the annual benefits of your planned restructuring efforts?

Not yet, but I think over certainly the relatively near future, we'll be able to talk more about that.

Thank you.

My follow-up question, do you plan to expand your research sales channel at all to sell to MiSeq in a more disseminated setting?

Or are you thinking that you're going to redeploy resources maybe that were previously focused purely on HiSeq to shoulder some of the MiSeq burden, as well?

The first thing I'd say is that the customer characteristics are not that different from MiSeq versus HiSeq.

They're generally, the vast majority of the customers are in the same types of labs that we already call on.

Clearly, over some time, we get to more and more distributed customers that may require some different focus on the part of the sales force.

From a technology perspective, and application perspective, the way the samples are prepared, the exact same salesperson and application specialist can handle the sale of MiSeq.

It is important that we increase the focus on MiSeq and so we are adding salespeople that are specifically going to lead the charge on MiSeq.

But in general, the overall sales force will be capable of selling it into the market.

Dan Arias.

Just curious whether you're seeing any pushback at this point on pricing for sequencing kits, just given everything going on.

We're not.

We actually increased the price of the v3 kits over the v2.

Any time you raise prices, customers always gripe a little bit, but they realize that we brought them massive new performance capabilities with that kit and reduced the overall price per genome pretty radically.

So, the pushback was not extensive.

And then when you think about HiSeq placements going forward, Jay, what role do competitive displacements play as your primary competitor transitions to a new platform?

It's certainly a target market for us.

There's not a huge install base of competitive systems but it's one that we're going after.

I think it will be a factor in HiSeq placements going forward.

Particularly, there's a couple of larger accounts that have decided to convert over to HiSeqs, and so that will be a significant couple of orders for us.

And then just one more on the GA trade-in program.

Would you say that the issues in the quarter were more related to fewer customers deciding to upgrade or fewer just taking shipments of machines and having them come on line?

No, it's the former.

It's really the incoming order rate.

I'd now like to turn the call over for any closing remarks.

Great, thank you.

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

Thanks for joining us today.

This concludes our call.

We look forward to our next update in January following the close of the fourth quarter.

Thank you.

This concludes the presentation.

Thank you for your participation and you may all now disconnect.

Good day.