Illumina Inc (ILMN) 2013 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second-quarter 2013 Illumina Incorporated earnings conference call.

My name is Aisha, and I will be your coordinator for today's call.

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

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

(Operator Instructions)

As a reminder, this call is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Miss Rebecca Chambers.

You may proceed, ma'am.

Thank you.

Good afternoon, everyone, and welcome to our earnings call for the second quarter of fiscal 2013.

During the call today, we will review the financial results released after the close 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.

Participating today will be Jay Flatley, President and Chief Executive Officer; Marc Stapley, Senior Vice President and Chief Financial Officer; and Christian Henry, Senior Vice President and General Manager of our Genomic Solutions business.

Jay will provide a brief update on the state of our business, and Marc will review our second-quarter financial results.

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

It is our intent all forward-looking statements regarding 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 statement are subject to risks and uncertainties.

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

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

To better understand the risks and uncertainties that could cause actual results to differ, we refer you to the documents that Illumina files with the Securities and Exchange Commission, including Illumina's most recent forms 10-Q and 10-K.

Before I turn the all over to Jay, I would like to let you know we will participate in the Morgan Stanley Global Healthcare Conference in New York the week of September 9. For those of you unable to attend, we encourage you to listen to the webcast presentation, which will be available through the Investor Relations section of our website.

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

Thanks, Rebecca, and good afternoon everyone.

I am pleased to report that Q2 was another exceptional quarter for the Company.

Our business demonstrated strong underlying trends in every geography in nearly all product lines.

As a result, Q2 revenue grew 23% year-over-year to $346 million, our seventh consecutive quarter of sequential revenue growth.

Total Microarray revenue increased 3% year-over-year, due primarily to the impact of BlueGnome.

Demand for arrays remains stable as the market trends toward large sample numbers with moderate content at a lower ASP per sample.

In fact, Q2 was the third quarter in a row with Infinium orders exceeding 1 million samples due to demand for our Infinium, OmniXpress exome, Core exome, and Omni2.5 products.

We will begin shipping a new custom OncoArray in the second half of this year to early-access Consortium members interested in understanding the genetic basis of cancer.

The OncoArray is the next generation of the ground-breaking iCOGS custom array that was used by the Collaborative Oncological Gene-Environment Study to identify genetic variants related to breast, ovarian, and prostate cancer.

The OncoArray contains approximately 600,000 markers for use in a meta-analysis of over 470,000 samples.

We plan to offer this array to non Consortium customers in 2014.

The consumer market continues to show significant elasticity below the $100 price point, generating strong demand for Genotyping Services and our iSelect custom arrays.

For the second quarter in a row, we received a large consumer order deliverable over several years, and we continue to project close to $50 million of consumer-related revenue in 2013.

Turning now to our Sequencing business, total Sequencing revenue grew 33% year-over-year, driven by strong demand for consumables and HiSeq instruments.

During the second quarter, Sequencing consumables grew 26% over Q2 of last year, as a result of our larger HiSeq and MiSeq install base as well as growth in our Sample Prep business.

Q2 Sample Prep shipments grew close to 50% year-over-year, with strength in both the Nextera and TruSeq product lines.

While Sample Prep is a competitive field, our broad portfolio of supported applications and sample types has allowed us to gain market share as we launch new offerings and our install base grows.

Two of our newest products, the TruSeq Targeted RNA kit and our Nextera Rapid Capture Exome are seeing significant early interest.

Our focus on Sample Prep has resulted in a portfolio of products with improved ease of use a more complete user experience.

One of our core strategies is to provide customers with the complete capability to go from biological sample to answer quickly and easily, minimizing the risk of errors and reducing hands-on time.

To that end, we recently announced collaborations with leading vendors of robotic platforms to provide automation solutions for customers requiring high throughput sample prep.

A few weeks ago, we completed the acquisition of Advanced Liquid Logic, or ALL.

This acquisition will allow us to develop an automated and integrated solution for our low to mid throughput customers.

A spinout from Duke University, the Company possesses foundational liquid handling IP, including approximately 100 issued or licensed patents and approximately 200 pending applications.

ALL has developed a proprietary digital microfluidics technology which enables the precise manipulation of small droplets within a sealed cartridge, illuminating the pumps, valves, and tubes often associated with automated liquid handling.

We believe this proven technology will enable us to deliver the simplest and most efficient sample-to-answer to workflow, particularly for customers in the clinical and applied markets where these features are especially valued.

I encourage you it visit ALL's website to see a video illustrating this exciting technology.

As you know, part of our workflow strategy includes BaseSpace, an integrated cloud ecosystem.

In Q2, we announced exiting new e-Commerce functionality, which provides software developers the infrastructure for charge of use of their applications.

Customers now have access to tools which will simplify data analysis while providing a new and largely untapped opportunity for software developers.

Several new applications are now available for purchase in the BaseSpace Apps store, and we expect more to launch in the coming quarters.

Turning now to Sequencing Instruments, Q2 Sequencing Instrument revenue grew 37% compared to the second quarter of 2012 as a result of strong demand for HiSeq instruments and 2500 upgrades.

The demands for HiSeqs was generated almost equally from existing capacity-constrained customers and customers new to the platform.

This quarter, more than 75% of HiSeq orders were for the 2500 family, reinforcing the tremendous value of rapid run mode.

The importance of rapid run technology was recently demonstrated by Stephen Kingsmore and his associates at Children's Mercy Hospital in Kansas City.

Using rapid run in a research and development configuration and a modified version of our aligner and variant calling software, they were able to prepare whole genome sequence and correctly call potential disease-causing variants from a blinded quantified DNA sample in under 24 hours.

Translational, commercial, and hospital customers are placing great value on the inherent flexibility of the 2500 platform.

Close to 45% of HiSeq orders were from customers using the technology in the clinical development or commercial setting.

This demand has also driven HiSeq 2500 upgrades.

We have now completed more than 85% of upgrades that have been ordered and expect the few remaining to be completed in the third quarter.

Customer satisfaction with HiSeq 2500 instruments and upgrades continues to be high.

Later in the second half, we will deliver additional value to customers with the launch of reagents enabling sequencing runs of up to 300g in approximately 60 hours.

Additionally, our development efforts on long-read, phasing, and ordered array technologies are progressing well and will continue to deliver dramatic performance enhancements to our SBS chemistry.

We will also introduce MiSeq functionality in the third quarter, which will enable throughput of approximately 15g per run.

Interest in this product enhancement is high as customers look forward to continually improving instrument performance.

Our competitive position in the benchtop sequencing market remains strong as evidenced by stable ASPs despite the successful conclusion of our 15- for-15 program which offered a discount on the instrument when bundled with the purchase of 15 consumable kits and competitor price concessions.

As a result, in the second quarter, we again won more than 80% of head-to-head placements.

We continue to see strong MiSeq adoption from translational and clinical customers, including customers switching from capillary systems.

Again this quarter, more than 50% of MiSeqs were ordered by non academic customers, including a multi-unit order from HistoGenetics, a leader in HLA testing services.

HistoGenetics selected the MiSeq platform, as it has the simplest workflow as well as highest quality data output for implementation into their CLIA infrastructure facility.

HLA typing is performed on more than 1 million samples annually worldwide, and we are actively engaged with the community to demonstrate the benefits next-generation sequencing to this important application.

Recently, the MiSeqDx Cystic Fibrosis System, which includes the MiSeqDx instrument, our CF carrier screening assay, and CF diagnostic assay, became the first next-gen system to have the CE Mark applied.

Our carrier screening assay detects 162 functionally-verified, clinically-relevant variants within the CFTR gene, the largest variant panel available today.

Our diagnostic assay has been shown to have superior performance in challenging regions of the gene, including homopolymers as well as large deletions and mutations.

Both of these assays run with low sample input and can be completed in less than two days.

Moving to FastTrack Services, in the second quarter, we shipped approximately 2,500 genomes, compared to 750 genomes in the prior-year period.

While genomes shipped were lower sequentially due primarily to the timing of project completions, we received more than 6,000 orders for whole genome sequencing services in the second quarter, a new record.

We expect to process these orders over the coming quarters as the samples are received.

Included in this number is the initial award for the VA Million Veteran program, where we will be working with Personalis to sequence and genotype more than 1,000 veterans, and 1,000 genomes for Inova, a not-for-profit healthcare system based in northern Virginia.

Recently, we launched our Phasing Analysis Service based on the Moleculo technology.

This is the first commercial service available for customers wanting to phase human genomes.

Early-access customers have provided positive feedback, and study designs have demonstrated the diverse range of applications supported by this service.

In the coming quarters, we will also launch kits for generating synthetic long reads and phasing of human data.

The integration of Verinata continues to progress well, and we're pleased to announce that reimbursement coverage for the verifi test has been significantly enhanced in the second quarter.

Today, coverage for the verifi prenatal test has expanded to approximately 170 million covered lives in the United States, plus, with the agreement with Teva Pharmaceuticals, 25,000 lives in Israel.

Part of this expanded coverage was a result of Verinata entering into a national agreement with BlueCross and BlueShield to offer independent plans access to competitive pricing for the verifi prenatal test.

Importantly, contracted lives, a more important metric as it reflects contract decisions for specific tests, have also grown significantly.

We recently received contracting decisions from United Healthcare and Aetna as well as multiple other payers.

Today, more than 60 million lives are contracted for the verifi test.

As you will recall, a key goal of the acquisition of Verinata was to enable the overall growth of the NIPT markets.

The two main prongs of this strategy are to license Verinata's intellectual property, and once we've completed the necessary data, to submit the verifi tests for regulatory approvals.

We believe an IVD test will significantly expand the global market and enable all test providers it to be successful in this field.

During the second quarter, we began dialogue with the FDA on the trial design necessary for an NIPT submission.

While a clinical trial to support a PMA application is a multi-year process, we are pleased with our early FDA interactions and with our progress to date.

With respect to our existing customers in the NIPT market, we are broadly engaged in discussions but have nothing specific to report to you today.

Overall, I am extremely pleased with our Q2 and first-half results.

In the second quarter, we grew revenue year-over-year and sequentially following a strong Q1.

Orders exceeded our internal plan, and we made significant progress on many of our strategies for continued technology leadership and long-term growth.

Each quarter, we are diversifying revenue base by engaging with customers who are using next-gen sequencing for new applications, making it easier, more efficient, and more economical for them to access this empowering technology.

We remain dedicated to improving human health by unlocking the power of the genome and continue to believe we are uniquely positioned to capitalize the enormous potential of the sequencing market.

I will now turn the call over to Marc who will provide a detailed overview of our second-quarter results.

Thanks, Jay.

As Jay mentioned, this was another exceptional quarter for Illumina, and I am pleased to report our operational and financial results, which include second-quarter revenue of $346 million, an increase of 23% year-over-year.

Organic revenue grew 19% year-over-year as a result of continued strength in HiSeq instruments and growth in sequencing consumables.

These results were based on strong global demand for our products.

In Q2, revenue in the Americas grew 22% year-over-year, and European revenue increased 19% over the same period.

In APAC, revenue grew 36% year-over-year, due primarily to continued strength in Japan.

Importantly, our revenue base is becoming ever more diverse, which has lessened to an extent exposure to fluctuations in funding.

Historically, approximately 80% of shipments were attributed to academic and government customers.

Last year, we saw a strong demand from non-traditional customers, which led to approximately 30% of shipments coming from clinical, agricultural, commercial, hospital, and translational customers.

We have made great progress in further diversifying our revenue stream in the first half of 2013, as approximately 40% of our shipments were to customers in these applied markets.

Instrument revenue for the second quarter was $95 million, an increase of 31% compared to the second quarter of 2012, due to upgrade revenue and significant year-over-year growth in HiSeq instruments.

MiSeq unit shipments were slightly higher than last year's elevated level, which benefited from backlog clearing associated with the first few quarters of MiSeq placements.

MiSeq orders grew sequentially as well as year-over-year, with noticeable strength in APAC.

Consumable revenue in the quarter was $215 million, an increase of 17% compared to the second quarter of 2012, primarily due to our growing install base, higher demand for sample prep and sequencing consumables, and BlueGnome.

Consumable revenue represented 62% of total revenue, flat compared to Q1, and a decrease from 65% in the prior-year period, primarily due to the strength seen this quarter in HiSeq instruments.

In Q2, annual HiSeq pull-through for instruments was in our projected range of $300,000 to $350,000, and up sequentially due to the increased customer utilization of core sequencing consumables and sample preparations.

We do expect HiSeq utilization to decline modestly in the third quarter while staying well within your guided range as a result of typical seasonality associated with the vacation season.

With more than 60% of MiSeq placements going to new customers in the first half of 2013, MiSeq utilization per instrument was immaterially below our annual projected pull-through range of $45,000 to $50,000.

Services and other revenue, which includes genotyping and sequencing services, instrument maintenance contracts, and revenue from Verinata, grew 50% versus Q2 2012 to equal $33 million.

This improvement was driven by an increase in genomes processed year-over-year, the ongoing growth in our extended maintenance contracts associated with an increasing sequencing install base and revenue from Verinata.

Turning now to gross margin and operating expenses, I will highlight our adjusted non-GAAP results, which exclude legal contingency, non-cash stock compensation expense, expenses related to Roche's unsolicited tender offer, and other items.

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

Our adjusted gross margin for the second quarter was 69.5%, as compared to 70.9% in the second quarter of 2012.

The year-over-year decline in margin was attributable to the impact of acquisitions and a lower mix of consumables.

Gross margins expanded 30 basis points sequentially due to sales of higher margin instruments and operational efficiencies.

Adjusted research and development expenses for the quarter were $59 million, or 17% of revenue, compared to $53 million, or 16% of revenue, in the first quarter.

The sequential increase in R&D expense was primarily due to the full-quarter impact of Verinata as well as headcount additions and outside services to support our robust pipeline of products and development.

Adjusted SG&A expenses for the quarter was $70 million, or 20.3% of revenue, compared to $66 million, or 19.9% of revenue, in the previous quarter.

The sequential increase was primarily due to a full quarter of Verinata, additional headcount to support our planned commercial growth, and our project focused on improving global business processes.

Adjusted operating margins were 32.3%, compared to 33.3% in the first quarter, primarily due to the impact of a full quarter of Verinata and increased headcount.

Compared to the 36.7% we reported in the second quarter of last year, adjusted operating margins were lower due to the impact of acquisitions and lower gross margins as well as increased investment in both R&D and SG&A to support our long-term growth.

In the second quarter, we recognized approximately $1 million of adjusted other expense due to volatility of foreign exchange rates and lower interest income.

Going forward, assuming no material fluctuation in foreign exchange rates, we expect the other expense line to be close to zero as result of a lower cash balance post the warrant retirement and ALL acquisition.

Our non-GAAP tax rate for the quarter was 30.7%, compared to 33.8% in the second quarter of last year.

Non-GAAP net income was $60 million for the quarter, and non-GAAP EPS was $0.43.

This compares to non-GAAP net income and EPS of $53 million and $0.40 respectively in the second quarter of 2012.

We reported GAAP net income of $36 million, or $0.26 per diluted share, in the second quarter, compared to $23 million, or $0.18 per diluted share, in the prior-year period.

Current period results include a charge of $16 million for the litigation associated with the Syntrix verdict, $7 million of which was reported in cost of goods to reflect the ongoing royalty associated with BeadChip sales plus associated interest, and $9 million of which was recorded in operating expenses to reflect the updated judgment, which was primarily related to interest.

Our post-trial motions are proceeding in this case, and we expect an update later this year.

Ongoing expenses related to Roche's unsolicited tender offer were $5 million, and such charges are expected to end in the third quarter.

We generated cash flow from operations of $89 million during the second quarter, capital expenditures were approximately $12 million, resulting in $77 million of free cash flow.

We ended the quarter with $1.13 billion in cash and short-term investments, and post the close of the quarter, we completed the purchase of ALL for up to $96 million, which will be reflected in our ending third-quarter cash balance.

Q2 inventory was $168 million, which is flat a compared to the first quarter despite sequential revenue growth.

DSO decreased to 55 days, compared to 58 days last quarter, as a result of improved linearity and gains from process improvements made over the last few quarters.

During the quarter, approximately 397,000 shares were repurchased for $25 million, which completed our 10b5-1 buyback authorization.

We continue to have $118 million remaining under our previously announced discretionary repurchase program, and following the close of the quarter, we retired approximately 3 million warrants associate the with the 2014 convertible debt call spread for $125 million in an effort to offset ongoing regular dilution from our employee stock plans.

Approximately 15 million warrants remain outstanding, which expire ratably between May and July of next year.

The impacts of these warrants has been included in our diluted share count at an amount related to our stock price since the issuance of the 2014 convertible bond.

As I mentioned earlier, we are very pleased with our operational and financial performance for the first half of 2013.

Given our strong results, we are raising both our revenue and earnings per share guidance.

For 2013, we are now projecting total Company revenue growth of approximately 20%, an increase from the previous guidance of 15% growth, and full-year non-GAAP EPS at $1.68 to $1.72, higher than our prior guidance of $1.55 to $1.62.

These projections include the impact of both the Verinata and the ALL acquisitions as well as ongoing investments to support our long-term growth.

Assumptions embedded in this guidance include-full year gross margin of 69.5%, stock compensation expense of $105 million, and the full-year pro forma tax rate of 30%.

Lastly, at the current stock price, full-year weighted diluted shares outstanding are expected to be 138 million.

This projection includes the impact of the retired warrants.

In summary, we are very pleased with the rhythm of our business and our strong first-half results.

We continue to be diligently focused on exemplary execution of our business strategies.

Thank you for your time.

We will now move to the Q&A session.

To allow full participation, please ask one question plus a related follow-up as necessary.

Operator, we will now open the line for questions.

(Operator Instructions)

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

You may proceed.

First, just on the ALL deal, can you talk about -- they obviously had a number of collaborations with GenMark and Luminex and others.

Can you maybe just talk about how you foresee those playing out going forward?

And then also, the up to $96 million, what does that assume for milestones and other things going forward?

Yes, we are intending, clearly, Tycho, to honor the obligations we have under the existing ALL agreements and those -- give to those third parties particular rights to the technology in specific market segments.

None of those agreements we think preclude Illumina from doing exactly what is our goal with respect to the technology, which is very directly focusing into sequencing marketplace over all.

In terms of the purchase price, it's a combination of an upfront and milestones.

We are not at this point disclosing what those milestones are, what the amounts are.

Okay.

And then just as a quick follow-up on diagnostic pricing, can you talk about whether, as your customers are commercializing tests, whether you are able to extract better pricing?

We've heard a little bit from the field about putting on supplementary pricing for some of the customers, commercializing diagnostic tests.

I am just wondering if you --

We are.

And largely, that comes through what we call our TCG reagents channel.

As we began so get into the diagnostics market a few years ago, what we heard very clearly from those customers was that they required more in our reagent kits than we typically provided.

That has to do with more extensive lot tracking, longer shelf life, the ability for us to continue to manufacture what would otherwise be obsolete projects in the RUO space.

And as we layered these obligations that are appropriately demanded from us by those diagnostic customers, it clearly increases our costs of producing and holding those reagents.

As a result of that, anybody who is using the TCG reagents pays a premium price to access those reagent sets, and they get essentially premium capability and services associated with those kits.

Great.

Thank you very much.

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

You may proceed.

Hi, good afternoon, guys.

Hi, Doug.

First question is, during the quarter, you announced the CE Mark for a CF platform, a partnership with Histogenics in HLA testing and also plans to launch an HAI kit with Pathogenica, three areas where multiplex tools have had a prominent role.

Can you just walk us through why these areas -- are there more to come, and do you have plans to work through the FDA process in some of these areas, especially CF where you did pursued the CE Mark in Europe?

We are looking to partner very broadly, Doug, across lots of areas of diagnostics.

HLA is a very large market opportunity, and we are engaged with multiple customers who want to use next-gen sequencing into that market.

Histogenics was the first of potentially several that we might work with in that marketplace.

You will see us continue to attempt to do this in many other areas including infectious disease and cancer, where we have lots and lots of different customers using the technology platform.

So I think the partnering strategy there is working very well.

What we will put through the FDA will be highly selective, and those are particular applications where we think having an IBD kit makes sense to be able to sell very broadly into labs around the globe.

There may be cases where there is intellectual property in the partner we're working with that prevents us from doing that unless we specifically partner with that entity to put the product through the FDA jointly.

In the case specifically of CF, we were able to do that on our own, and we're now selling it in Europe under CE Mark broadly, and once we get it approved through the FDA in the US, we will sell it to all the labs broadly as an FDA-approved product here.

That's great.

And then, really, an expense question.

Q2 was your first full quarter with Verinata as part of the Company.

R&D spend increased, I believe it was $4.6 million sequentially.

Is most of that Verinata, and is this a good R&D run rate as we think about how to model the second half?

And more broadly, 2013 was positioned as a year where you were going to aggressively expand your commercial footprint.

How is that effort progressing, and how should we think about spend accordingly as we move into a second half?

Thank you.

Yes, I would say, a material part of the increase in expenses was due to the incremental remaining part of the quarter of Verinata expenses.

But you should expect through Q3 and Q4 a continued increase in R&D and SG&A spending.

Obviously, those spending increases will be, should I say, modulated appropriately, and so they are not going to be huge increases, but we are adding headcount in both areas.

In R&D particularly because we have a rich portfolio of products that we continue to work across and lots of demand for resources there.

In the commercial side of the business, we're making great progress in adding salespeople into the Team as well as new additions in marketing.

Most of the impact of that on the revenue side will be seen toward the end of the year because as we add new salespeople, it typically takes three to six months for them to fully come up to speed.

But we are progressing well on the headcount additions in SG&A.

And Doug, it's Marc.

Just to be clear, the increase in expenses that Jay is referencing is implied in the updated guidance that we provided.

Okay.

That's really helpful, guys.

Thanks again.

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

You may proceed.

Hi.

Good afternoon.

How you doing, Derik?

On the new 15g run for MiSeq, could you talk about a little bit the technology that you've got there?

What's the cycle time improve to and where you are in the read links?

The improvements are largely due to new versions of chemistry.

So we call it v3 chemistry.

It increases the number of reads as well as the overall read length.

The read length, 2 by 300 --

2 by 300, that's right.

So we have great performance across read lengths.

We also are increasing the number of tags to allow us to do more exome sequencing on that platform as we get the v3 kits into the marketplace.

So it's still running the same five-minute cycle time?

So a 15g run, then, is how long to take?

Cycle times I believe are going to speed up some.

And I don't have that number right off the top of my head, Derik, but we have shrunk the cycle time down.

Every time we try to extend read length, we try to shrink cycle time at the same time.

And we were successful; I just don't know the exact number.

I can follow up with you after.

But the full -- a full run on a MiSeq with paired 300s will be approximately 60 hours.

Okay.

Great.

Then I just wanted to switch on another one.

Could you talk about just the whole genome sequencing market and where ASPs are on that and some commentary on volume?

And also, just to follow through on that, where are you with your BGI contract?

Yes.

The whole genome sequencing, I'd say we continue to see migration of customers toward whole-genome sequencing, away from exome and targeting to some extent.

Although, exomes continuing.

HiSeq is a clearly a fantastic for running exomes because you can multiplex them to highly and do it so inexpensively.

As I said in the script, we had a record order receipt number for whole genomes in services.

So we're continuing to see good progress there, although that service ordering tends to be irregular in terms of both the pattern of orders, because they are large, and also in terms of delivery, because we record the revenue when we complete the project, and in some cases, when the actually accepts the data under some contracts.

So great continued trends in whole-genome sequencing.

And as we continue to make improvements in technology, we are going to continue to make progress in the ability to do that ever more cheaply for our customers.

With respect to BGI, we've completed an RUO agreement with BGI, and so that's been in place for some time, one month or two.

We are still working on a clinical agreement with them that's incomplete at the moment.

Thank you very much.

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

You may proceed.

Good afternoon, guys.

Hi, Ross.

Could you give us maybe on Verinata a little bit of color on what the volume ramp has looked like?

Obviously, we have seen what the key player in that market has done.

Just to get a sense for -- obviously, it's been exponential growth as an industry overall.

Give a sense for how you feel like you are faring from a share perspective and how you are expecting that to accelerate in the second half with the efforts of your partner.

Yes.

We are going to be cautious about disclosing volumes on Verinata, particularly because, as you know, we play broadly in this market, and we supply to all of the major companies that are providing technology into this space.

We are doing well, as I mentioned.

We think both our covered lives and contracted lives numbers are progressing quite nicely, so we are doing very, very well there.

We've continued to improve the technology that's being used by Verinata.

We've put more sequencers in.

They're automating the sample prep around the technology to be able to handle higher sample volumes.

I think the reimbursement rates have exceeded our expectation probably in terms of where those numbers are coming in.

So really pretty positive trends across the board there.

Great.

And maybe talk a bit about what Christian has been doing on the BD side.

ALL, really interesting little asset.

It seems like you guys are being a lot more active, trying to fill in all the various areas around the existing portfolio with exciting new technologies.

Maybe talk a bit about what the pipeline looks like, what areas, maybe not giving away specific targets, but just generally big picture areas that get you the most excited, and where you see the best emerging technologies maybe developing on the forefront.

Yes, we have been quite active in M&A, and I think you'll continue so us do some of these tuck-in type of acquisitions, fewer of the moderate to large ones and some continued rate of these relatively small ones.

We are looking at technology pieces that accelerate the development of our future platforms.

Obviously, our platform plans go out three to five years, and we have really great expectations about where the technology is going to head and how we will be able to improve overall system integration, reducing hands-on time, making this more foolproof so that sequencing can become ever more prevalent in the clinic and used by less and less sophisticated users.

So you can imagine, if you think about the entire workflow of sequencing from the earliest parts of the sample prep all the way through informatics, we are looking to fill in any bits and pieces along that pipeline that we don't currently have.

Some of that, clearly, is being done internally through our own research and development efforts, but if we have the opportunity to go get it quickly outside at a reasonable price, we will do that.

Yes, and I also think, Jay, we should recognize our Corp-Dev Group, Nick Naclerio.

Yes.

The ALL transaction was complicated in the sense that there were a lot of different relationships to work through, and they stuck is with it, and it's going to be a real fantastic asset for us.

I am really excited about it.

Great.

And congrats, Christian.

Thanks.

Thanks.

Your next question comes from the line of Amanda Murphy with William Blair.

You may proceed.

Hi.

Thanks.

I had a question on the ordered arrays.

I am curious, from our discussions, it seems like your customers are pretty excited about that in terms of what it might do for throughput.

So curious if you can provide a perspective on timing and how to think about what throughput improvements there might be relative to overall demand for capacity at this point in the sequencing phase.

I think we're on track, Amanda, to hit the targets that we set out earlier in the year, and that's to have the first ordered arrays in the hands of our customers before year end in an early-access mode.

We think they will probably become commercial in the very earliest part of 2014.

We will deploy ordered arrays selectively in particular kits where those applications demand high throughput, so not every one of our kits is going to get ordered arrays.

Maybe ultimately, they'll all move in that direction, but in the near term, we are picking off the most important application areas, and applications in general, in terms of read length and reads, both, that need the ordered array technology.

The performance improvements you will get from order arrays will depend on the architecture you deploy it on.

In almost all cases, we will get the advantage of more reads.

But in our lower resolution optical systems, the density you will be able to put down -- lay down in terms of order arrays will be more limited than in the higher resolution systems, which obviously is the HiSeq at the very high end.

So HiSeq will get the greatest advantage; MiSeq will get a lesser advantage.

And then I don't know if you talked about pricing for ordered arrays yet, or maybe you could provide something there if you are giving that data?

And then also just generally how you are thinking about price for HiSeq consumables -- generally sequencing consumables going forward.

We have not disclosed any pricing on ordered arrays yet.

In fact, we haven't even had our pricing committee meeting, so we don't actually know what the prices are.

And we are waiting to see what the final performance looks like off these arrays before we go into the pricing phase, which will happen here in the back half of 2013.

I am sorry.

The second part of your question was what?

I was thinking about, you have had a few price increases on the consumables for sequencing.

Is that something you plan on continuing?

I think in general, our intention is to have moderate price increases in consumable kits on an annualized basis, and then we will deliver significant changes in value to customers when we have technology shifts either in major changes in the kits or modifications in the platforms.

And so if you think about what the pricing curve looks like, it will probably be one that will have some plateaus in it, and then there will be some significant drops, and then another plateau, and then additional drops.

And so it may not be monotonically decreasing.

It may be more digital, the way you may think about it.

Got it.

Thanks very much.

Your next question comes from the line of Dan Arias with UBS.

Please proceed.

Yes, hi.

Thank you.

Jay, you mentioned the work that the Mercy General folks are doing in pediatrics, which when they talked about it, sounded like a pretty excellent application.

But it also seemed fairly cutting edge.

So how quickly do you think we see an acceleration of that type of quick turnaround work in the hospital setting?

I think the 2500 is a great example of how important these rapid turnaround capabilities are.

And what we talked about in the script is really exemplary of what customers think about the ability to both manage their cues on the one hand, but also, in clinical applications, get data back to the treating physician.

We are working with lots and lots of groups now where they really want to get answers quite quickly.

It's very important in areas like infectious disease, transplants in HLA, less important perhaps in cancers, at least in the bulk of the cancer market where treatment decisions usually take a couple weeks and you have a little bit more leeway.

But in almost every case, the patient wants to know as quickly as possible.

And so whether you are doing an NIPT test, or even in the cancer example, turnaround time matters.

So I think the technology we use with Stephen Kingsmore is largely technology we have today.

So it's really just a packaging up.

There is no brand-new invention required to get to that sub24-hour turn around.

It really has do with packaging a sample to answer complete workflow and deploying that fully commercially to get it.

There is really no breakthroughs required, no.

Got it.

Okay.

And then maybe just a follow-up on the whole genome question.

Can you talk about the IGN genomes that you are shipping?

What kind of customers are those going to, and what kind of an appetite is there from the clinically-focused crowd?

Well, it continues to be a relatively diverse customer base, some from pharma companies, a couple of these big projects like the VA project.

I think you are going to see more and more from population-based sequencing programs.

If I were to turn the clock forward one year or 18 months, I would think you will have more and more from these large programs.

Some of those will wind up with local installations of HiSeqs.

But some of them may, particularly in the earlier phases, use outsource services to get that work done.

So I think the trend there is a good one.

I still think that, as I said probably two years ago, that the outsource part of whole human genome sequencing is going to be an important but not significant part of the overall dollars in the marketplace, in the 5% to 10% range ultimately.

Okay.

Thanks.

Your next question comes from the line of Bill Quirk with Piper Jaffray.

You may proceed.

Thanks.

Good afternoon, everybody.

A couple questions from me.

First off, thanks for the disclosure around the ALL transaction.

Last housekeeping question here.

What is that going to add in terms of revenue to 2013?

The revenue is insignificant, Bill, so it's not measurable.

Okay.

Got it.

Just in terms of our overall revenue at least.

Willing to take a shot at what we expect in 2014?

We certainly recognize, Jay, that due to some of their collaborations, that obviously will ramp up once some of those products get commercial.

But how should we think about the pacing over the next couple of years?

Yes, I wouldn't think about the ALL revenue being standalone revenue.

It's going to be so tightly integrated into what we are delivering as part of our product mix that it will be indistinguishable into 2014.

Yes, there will be some revenue from the partnership projects, but those are, frankly, at this point, still speculative, and we don't control the distribution channel there, so we can't really count on that revenue.

Got it.

And then as a follow-up and maybe a little bit bigger picture question here, but we haven't seen any material expansions of HiSeq in terms of throughputs since the v3 launch two years ago.

So how should we be thinking about the future evolution here, perhaps just HiSeq as one category versus some of your pipeline technologies?

Thanks, Jay.

Thanks, Bill.

Well, we have, as we've said many times before, lots of degrees of freedom in terms of where we move the platforms and the SBS chemistry.

The important thing we did over the past 18 months with HiSeq was to accelerate the time of the runs.

And that's really what customers wanted was the most important new feature and new capability.

It was frankly less important that we moved the total output up.

In fact, HiSeq now, if you are doing anything other than whole human genomes, you need to multiplex lots and lots of samples.

Other than that segment of the market, it doesn't make sense to continue to push it too far too fast.

As the market continues to go more and more toward whole human genome sequencing, clearly, we will have the capability to put higher-output technologies into the market and continue to drive down that cost per whole human genome.

So we're working across all those fronts, but we've prioritized speed of the runs, and that's why you saw the 2500, and that's what we're really going to focus on here in the next kit that's coming out on HiSeq before the end of the year.

Got it.

Thank you.

Your next question comes from the line of Amit Bhalla with CitiGroup.

You may proceed.

Thanks.

Jay, I just wanted to know if you could talk a little bit about reagent consumption between the 2500 into 2000 now that the 2500 seems to have been gaining some good traction?

And also, can you give us a sense of utilization rates amongst your clinical customers versus your traditional academic customers from the reagent side?

Amit, I don't have the breakdown by system type in front of me of reagents.

They are not radically different.

So it's not something where we're seeing, a 2X or even a 50% difference whether a customer has a 2500 or not.

And even if they have a 2500, they probably run it half the time on average in standard mode.

So I don't think that distinction is one that we spend a lot of time trying to focus on.

Right.

I am sorry.

The second part of your question was on?

It was on the clinical customers because now that your customer base is also diversifying.

And I had one quick follow-up after that.

I think in the clinical markets, what we see is a bimodal distribution of reagent usage.

You will have customers initially buy the systems, whether it's a HiSeq or MiSeq, and use it in a development mode to begin to put their assay together.

During that mode, the consumption often isn't very high, and they are trying to sort out exactly what genes to include in a panel, for example.

Very often, they are working on the informatics to improve the data analysis, so they don't even need to run the system during that phase.

Then you have the other customers who have gotten over that initial hurdle and are beginning to actually deploy the technology.

And when you look at that customer base, the utilization rates are extraordinarily high, and that applies to both MiSeqs and to HiSeqs.

So you find them in both camps.

And then the net of that effect, of course, is that it tends to average out in the middle somewhere.

I would say another factor that plays into that is the amount of sample prep and the complexity of sample preparation that goes into that as well.

That could also create some bimodal distribution in that type population.

Okay, thank.

And then just a quick follow-up on Moleculo as a kit-able product.

I think you said in the prepared comments that you plan to roll that out in the coming quarters.

It sounds like there is a couple of [gaming] factors there.

I thought it was more of an end-of-2013 rollout.

Can you maybe just talk about Moleculo as a kit-able solution?

Yes, that remains our goal.

We expect to have it, at least in early access, before the end of the year.

It may slip a little bit into 2014 depending upon how the product development goes here over the next quarter or two.

The challenges here are around areas like informatics, so we have to really work on optimizing both the ease of use of the front-end sample prep part of this, but also the compute time on the back end is important.

And what we don't want do is put a commercial product our there where the customers get overwhelmed by the computing requirements necessary to phase a genome or to get the synthetic long reads.

And so there is a significant amount of work we are doing on that part of it as well, which is unrelated to the actual chemistry.

And of course, Amit, by running it in our services lab, customers are getting experience with the data and what it can do, and they have different kinds of applications, but we are also getting experience on how to optimize the workflows.

Jay said, the workflow -- making it a very simple workflow is a key ingredient to making it successful in the market.

As Jay said, early access, around the end of the year is what we're shooting for right now.

And that's why we were able to deploy in a services environment first is because is simplicity of the workflow is less important, and we can obviously train our internal Team, and they know how to run this quite well.

It's different if you start offering it broadly to any customer who wants to buy it.

Got it.

Thanks a lot.

Your next question comes from the line of Dan Brennan with Morgan Stanley.

You may proceed.

Hi.

Thanks for taking the question.

First question is just on the competitive environment.

Jay, I know you mentioned it in the prepared remarks.

But just wondering, given the slower pace of improvement in product introductions from your key competitor, just wondering if you could maybe give a little bit more color about what type of impact you have seen on your business from maybe a demand and/or pricing perspective?

We break our market really into the two segments, the higher throughput segment and desktop segment.

And clearly, while maybe a year or two ago, there was some marketing of the competitive technology as potential replacement for HiSeq, I think that has tended to diminish quite significantly over that period of time.

So I think we're competitively in great shape with respect to HiSeq, and particularly with the 2500 there.

The desktop market remains competitive.

They're a very capable and aggressive competitor, and so we fight for all those orders.

But I think we're continuing to win the vast majority of those where we're present.

And again, in the script, we said that that number is at least 80%.

And we are working on the coverage to make sure that we get into these other markets and geographies and application areas where we're not historically as strong.

Okay.

Great.

And then maybe to follow up on a separate topic.

While your non-academic mix is growing rapidly, still be interested in just give an update of what type of growth you saw this quarter from the US economic and maybe the European economic customer base and how we should think of that growth maybe as the NAH budget flattens out as the new fiscal year approaches?

We are continuing to see growth in the academic markets.

It's obviously largely driven by expansion of applications coming on to sequencing and growth from more dollars being allocated towards sequencing, and it's burdened by the fact that there is less total dollars to go around.

And so while there is continued angst about the reduction in the NAH budget, and we would love to see it increase as much as anybody else would, academically, we continue to do well.

So I think that it remains a positive for us.

If all of a sudden, the NAH budget went up 3% instead of down 5%, we'd do better in those academic segments, but I think we are more than holding our own there.

Okay.

Great.

Thank you.

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

You may proceed.

Good afternoon.

So just a couple of questions on sequencing.

I think you said in the script that instruments were up 37%.

I am just curious.

I think you also said that 85% of the installed base had now upgraded to the 2500, so I'm just thinking about the second half of the year, how you're thinking about HiSeq demands relative to the first half of the year and MiSeq demand relative to the first half the year.

Sounded like maybe MiSeq was picking up again a little bit.

Just to clarify, John, what we said was that of the people who ordered upgrades of the 2000 and 2500, 85% of those orders have been installed.

Okay.

Okay.

So that's quite different.

And the instrument revenue was up 31%.

31%.

Sorry.

I was trying to write the notes down.

The question is still the same.

Big picture how -- I think there had been some effort to maybe try and do a little bit better job of pacing HiSeq so you didn't have the end of '11 event like it happened before.

Just how you are thinking about HiSeq in the second half versus what you've seen here in the first half of the year.

As we look forward in our pipeline, which is pretty firm six months out and reasonably good visibility nine months out, we continue to see a rich demand for HiSeqs coming from emergence of lots of new types of applications running on the platform.

Clearly, we're seeing an increase fraction of the HiSeqs markets going into clinical kinds of applications and non-traditional applications.

We think that's going to continue.

In terms of the desktop market, that continues to do well in addition.

So I don't think we're here predicting that we're going to fall off any kind of cliff that we see on the horizon.

Things feel pretty good to us at this point.

I think our guidance reflects the appropriate balance between upside opportunities and downside risk.

Okay.

Let me just clarify.

When I say instruments are up 31%, that was total instruments.

Your note on sequencing instruments being up 37% was correct.

Okay.

And then another sequencing follow-up.

It's a little surprise sequentially that services would be down just because that includes Verinata, if I'm not mistaken, and that would have been the first full quarter there of Verinata.

So was there any meaningful downshift in the other services that we should be aware of?

Is that just the lumpiness that you were talking about?

Just any insight there.

Thanks.

Yes.

There is certainly some lumpiness in the services number.

We had one significant services contract that slipped out of the quarter into Q3 that was pretty large in terms of revenue all together, and it will be recorded in Q3.

It was simply a customer acceptance question.

Had to go through a third party on the way to customer acceptance.

And so I think that was the single biggest factor in the services line.

But we did have really strong contract revenue in the third quarter, so that was very positive, and then we had the full addition of Verinata on top of it.

Thanks.

Your next question comes from the line of Isaac Ro with Goldman Sachs.

You may proceed.

Thanks, guys, for taking the question.

Just a follow-up on sequester.

Appreciate the comments you made earlier.

Wondering if you could maybe touch on what's making your guidance for the balance of this year in the areas of the business where you have exposure?

And the reason I ask is, we are obviously still in the early months of settling in on the run rate here.

So I'm just trying to figure out how you guys are trying to handicap the spending behavior for your academic customers.

Thanks.

Yes.

Isaac, it's clearly an uncertain time there, and there is a wide range of potential outcomes.

We are clearly watching what is happening with respect to the budget debates that are starting to kick into gear here in the third quarter.

Nobody has a clue really what's going to happen with that, and I think the chances of us avoiding a continuing resolution are nearly zero.

So I think by the time we get it Q4, we are going to be under some new continuing resolution.

So what we've done is we have modeled a broad range of down-sign funding scenarios, and then we've modeled what we think are a set of upside opportunities that the Company has in terms of large deals and strength across the product line, funding, stimulus in Japan, solid performance in Europe with the new budget structure going into place in Europe.

And we've done our best to balance that out in our overall guidance.

And so I think it is a number that we feel relatively confident we can deliver with that set of uncertainties.

Great.

And then just a follow-up for Marc on the financials.

With regard to the step up in SG&A the last couple of quarters, could you maybe delineate a little bit between what there is core to the business for some of the distribution initiatives that Jay mentioned, and then maybe what is incremental with regards to acquisitions?

And then just lastly, on tax rate, you guys have done a great job there.

Any material opportunities left to continue lowering the tax rate?

Thanks much.

Yes, Isaac.

So on the SG&A spending, I wouldn't want to be convoluted into individual pieces, but there are really a couple of things driving that, and you listed them.

We've got the whole quarter now of Verinata in SG&A, obviously, which includes things like legal expenses, the sales force that Verinata has, and so on, and then the regular G&A.

We've got some of our own process improvement projects taking place that we've talked about previously on these calls, and so we've had a step up in spending in those projects in the quarter.

Those are really the key elements.

I am trying to think if there is anything else worth calling out.

And then you are going to see more of that as we go into -- as Jay mentioned earlier, as we go into the second half.

We will do more of that process spending as well as adding more to our commercial infrastructures or our commercial sales force and so on.

On the tax rate, thanks for pointing that out.

Yes, I think both the Operational Team that is involved in moving our manufacturing to the appropriate locations plus our Finance Team have done a really good job in managing our exposure from that standpoint.

We are now halfway through a year, so we've got two quarters behind us, which is why we have been able to take our guidance to about 30% for the year.

And we've done that through a combination of moving more of our manufacturing to our plant in St.

Paul and other operational factors as well, and we'll continue to do more of that.

There might be some more headroom.

We think there will be.

We have been targeting to try and get that tax rate on an aggregate basis for a year down to the high 20%s.

Just remember, Isaac, next year we won't have the benefit of the double R&D tax credit.

That's correct.

Yes, got that one.

Okay.

Thank you.

Your next question comes from the line of Dan Leonard with Leerink Swann.

You may proceed.

Thanks.

First off, the number you gave, that 45% of your HiSeq shipments were into commercial and clinical applications, how does that compare to prior periods, if you have been tracking that?

It's higher.

The trend line there is very strong because overall, the HiSeq business is doing better than we expected if we were to look back a few quarters, and I think the incremental improvement is coming from non-academic markets.

Yes, that's right.

Okay.

Thank you.

And then for my follow-up, Jay, have you seen any impact on your order funnel from the Supreme Court Gene Patent ruling, presumably any impact of diagnostic labs wanting to get into businesses they were previously precluded from?

Not yet.

There's a number of them have announced diagnostic tests, but I don't think any of them are actually at the point where they've deployed them.

They've announced they are going to deploy them.

And clearly, there is new litigation on top of those announcements that I think will be ruled on relatively quickly in terms of whether there is potential injunctive relief here.

But no one to my knowledge has ordered new platforms, for example, to host those new tests.

Great.

Thank you.

Your next question comes from the line of Zarak Khurshid with Wedbush Securities.

You may proceed.

Good afternoon.

Thanks for taking the questions.

With respect to ALL, can you give us a flavor for how the technology might be commercialized?

Is it something that would be integrated directly into a MiSeq or HiSeq or future platform?

I can generally answer that.

Obviously, we don't talk specifically about our developments until we are ready to nearly launch them, if not launch them.

But you can imagine that the ALL technology could be used extensively in the sample prep process, and the ability to use smaller amounts of reagents impacts the cost.

In particular, it influences ease of use because the customer gets rid of lots of (inaudible) steps and multiple operations that are needed in the existing sample prep environment.

For our high-throughput customers, they are doing that on robotic platforms of various sorts.

But for low-throughput customers, it's more of a manual operation, and we have the potential with this technology to really make that go away largely.

If you fast-forward some number of years, then clearly, this gives us an interesting technology to begin to increasingly integrate with the sequencing itself.

And over time, you have seen us pull more operations onto the sequencer, beginning with things like cluster generation, and you will see us to continue to move in that direction.

Not all customers will want that because in some cases you want sample prep to be more decoupled; in some cases, in some applications and markets, you may want it to be increasingly coupled.

This gives us a great core technology to begin to work on that problem.

Interesting.

Thank you for that.

And then just a high-level question about the diagnostics business.

How would you compare the relative sizes in growth rates of the various areas, like cancer versus total prenatal versus consumer or other growing segments of that business?

Thanks.

If you look back a couple years, consumer was clearly at the head of the pack in terms of speed of growth in actual revenue.

The last two years, it's clearly been eclipsed by what's happened in NIPT.

That market has evolved faster than I think anyone could ever have imagined.

I'm hearing just stories all the time.

We were out on a road show talking it to investors, and we ran into multiple people who had actually had firsthand experience with the test itself.

Not, sorry, the Verinata version, but of the general NIPT testing.

So the awareness level is spreading at rates that are unprecedented here.

So that market is large and growing quite fast.

I think if you look forward, three years, four years, it will probably be overwhelmed by what's going to happen in the cancer market, and that's because the number of opportunities you have to sequence cancer patients is large.

There will be screening applications in cancer as well as monitoring applications, and globally, it's going to be a vastly bigger market.

Great.

Thank you.

Your next question comes from the line of Peter Lawson with Mizuho.

You may proceed.

Jay, just around the ALL acquisition, are you going to be expanding upon their diagnostic as assays?

Well, we don't have any specific plans to announce around that now.

What I can say in general is that in most of the areas of the diagnostics market, our plan is to partner and to work with third parties who have intellectual property in particular areas or have know-how or distribution in particular markets.

You will not see us broadly take as many diagnostic tests directly to the end users or to the physician.

That's not generally our business model.

Yes.

And of course, ALL has already got some pretty solid collaborations that we will continue to support and fulfill all of our obligations there to enable them to be successful.

Got you.

And then on the Encore array, just as you commented around the cancer market, is that going for FDA approval, and does that cannibalize the sequencing panels you're generating?

We don't have any current plan to put that through the FDA.

We will put it into the market broadly in '14 after selling it on a proprietary basis to this Consortium group in '13.

We'll clearly monitor its usage and how customers -- how they apply it and in what kinds of clinical environments it gets used, so we may change our minds about that at some point, but I'd say the probability of putting that through the FDA is relatively low.

Okay.

Thanks so much.

There are no further questions in the queue at this time.

I would now like to turn the call over to Rebecca Chambers for closing remarks.

Thank you.

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

Thank you for joining us today.

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

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Have a great day.