ILMN - NASDAQ

Good day, ladies and gentlemen, and welcome to the First Quarter 2023 Illumina Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Salli Schwartz, Vice President of Investor Relations.

Hello everyone, and welcome to our earnings call for the first quarter of 2023. 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 for Illumina today will be Francis deSouza, President and Chief Executive Officer; and Joydeep Goswami, Chief Financial Officer and Chief Strategy and Corporate Development Officer. Francis will provide an update on the state of Illumina's business and Joydeep will review our financial results which include GRAIL. As a reminder, GRAIL must be held and operated separately and independently from Illumina pursuant to the interim measures ordered by the European Commission, which prohibited our acquisition of GRAIL under the EU Merger Regulation. This call is being recorded and the audio portion will be archived in the Investor section of our website. It is our intent that all forward-looking statements regarding our 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 available information, 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. With that, I will now turn the call over to Francis.

Thank you, Salli. Good afternoon, everyone. Illumina delivered revenue of approximately $1.09 billion and diluted non-GAAP EPS of $0.08 in Q1, both ahead of the guidance we provided at the beginning of the year but down year-over-year, as expected. Joydeep will take you through more detail later in the call. Our focus for the rest of the year is to deliver sequential growth primarily by scaling the production and distribution of NovaSeq X, driving elasticity on the back of its increased capabilities, and improving margins. We will share more on each. We achieved key product milestones in Q1, including shipping the first NovaSeq X systems. We also launched Illumina Complete Long Read technology and Illumina Connected Insights, a cloud-based tertiary analysis tool that addresses a key barrier to adoption, and will enable more labs to perform comprehensive genomic profiling for advanced tumors. Turning to our performance across platforms, beginning with high-throughput. The NovaSeq X launch further strengthened Illumina's competitive position in high-throughput sequencing. The strong global interest for the NovaSeq X series continued in Q1 and we exited the quarter with over 200 orders received from more than 30 countries. Clinical demand continued to be stronger than expected, generating approximately 40% of orders, with some customers planning to leverage the NovaSeq X to launch new clinical offerings. About 15% of orders are from new-to-high throughput customers, like the clinical genomics lab that is leveraging NovaSeq X's ease of use and cost benefits to perform high-throughput whole genome, single cell, and RNA sequencing. Our manufacturing capabilities for NovaSeq X instruments and consumables are scaling nicely. We shipped 67 NovaSeq X instruments in Q1, above initial expectations of 40 to 50, and now expect to deliver more than 330 NovaSeq X instruments this year, up from 300. Customers' initial runs are showing robust data output and sequencing quality, with some customers reporting outputs greater than 7 terabases and more than 95% of bases above Q30, well ahead of published specifications. As customers take delivery of their NovaSeq Xs and plan their deployments, they are sharing examples about how NovaSeq X will unlock demand elasticity in the sequencing market. Customers are planning to leverage the X's greater output and lower price per sample to sequence more samples, perform more analyses per sample, and obtain more data per analysis. For example, a leading European life science research institute will use NovaSeq X to scale up its data-intensive research programs, specifically in multi-omics, spatial, and single cell, enabling them to deliver "atlas-scale" projects. Within our clinical base, customers are using the greater output and cost savings of NovaSeq X to launch new, sequencing-intensive offerings. Some customers are planning to move from targeted panels to exomes and genomes, to achieve higher diagnostic yield and healthcare efficiency. An oncology customer is planning to use the X to launch liquid biopsy testing, which requires 12 to 15 times more sequencing than solid tumor testing. Some customers are using the cost and turnaround time benefits to enter deeper sequencing applications like minimal residual disease, or MRD, to build datasets at scale. We also saw continued demand for NovaSeq 6000, primarily for fleet expansions of existing workflows, and we shipped 17 NovaSeq 6000s in Q1. More than 80% of NovaSeq 6000 shipments were to clinical customers, and approximately 25% of shipments to oncology testing. In mid-throughput, NextSeq 1k/2k unit shipments increased 6% year-over-year, as customers expand their existing fleets, or continue to shift projects from the MiSeq and NextSeq 550. More than 20% of NextSeq 1k/2k units in Q1 were placed with new-to-Illumina customers. Our win rate in the mid-throughput segment remains strong, but we are seeing some sales cycles lengthen. Our low-throughput platforms continue to provide an entry point to sequencing. Approximately 30% of these shipments in the first quarter were to new-to-Illumina customers, further increasing our installed base and enabling adoption of sequencing across a broad customer network. Looking now at our clinical markets. Q1 marked an important milestone for Illumina, with clinical sequencing consumables revenue representing 50% of our total sequencing consumables revenue for the first time. In Q1, oncology testing consumables declined 3% year-over-year, but increased 21% sequentially, driven by growing clinical testing volumes and increased product development in areas like liquid biopsy and MRD. Some customers in this segment are facing pressures to improve profitability, which may in turn slow down their ability to develop new tests and scale. Revenue from our market-leading TruSight Oncology assay, TSO 500, was greater than $25 million in the quarter, up 26% year-over-year across more than 540 accounts, driven by increased utilization and pull-through, particularly in Europe. In March, we announced the expansion of our partnership with Myriad Genetics to broaden access to homologous recombination deficiency, or HRD, testing. HRD is an important biomarker identifying tumors with a specific type of DNA damage, like those in ovarian, breast, prostate, and pancreatic cancers. Our TSO 500 HRD, a research-use-only test, is now available in the US, with early customers like Florida Cancer Specialists & Research Institute, one of the largest independent medical oncology and hematological practices in the United States. The expanded partnership also establishes a unique alliance to develop HRD as a companion diagnostic for novel agents targeting these tumors. There was significant progress for NGS-based oncology testing reimbursement this quarter in Europe, expanding the accessible market. Seven regions in Italy committed €10 million for next-generation sequencing in lung cancer. In Germany, health insurers commenced reimbursement for whole genome sequencing in pediatric cancer patients with relapse. And in the Czech Republic, funding for comprehensive genomic profiling was added to the national fee schedule, effective January 1st. Also in oncology, GRAIL saw accelerating demand in Q1 for its Galleri multi-cancer early detection blood test and delivered revenue of $20 million, exceeding plan, and representing 100% growth year-over-year. GRAIL non-GAAP operating expenses increased to $173 million, driven primarily by investments in clinical trials and scaling GRAIL's commercial organization. Since launch, GRAIL has received more than 85,000 Galleri test orders, with about 20,000 delivered in Q1 alone. The 140,000-participant NHS-Galleri trial, which completed enrollment in July 2022 in just over ten months, is progressing well, with more than half of study participants having returned for their second annual blood draw. The trial recently achieved its halfway point and is currently on track to meet retention targets. GRAIL continued to expand its partner relationships. Following a successful pilot last year, John Hancock, one of the largest life insurance companies in the US and a unit of Manulife, announced that it would expand access to Galleri to eligible life insurance customers. And Providence, a health system serving the Western US, expanded its partnership with GRAIL to offer Galleri to eligible individuals across its 52 hospitals and 900 clinics across seven states. In reproductive health, consumables shipments declined 4% year-over-year, primarily due to FX, but increased 14% sequentially due to continued coverage progress. In the US, Virginia and Michigan initiated state Medicaid coverage for NIPT in all pregnancies, adding about 4.3 million additional covered lives and more than 70,000 pregnancies per year. Genetic Disease Testing, or GDT, had a record quarter. In Q1, GDT consumables shipments grew 7% year-over-year and 6% sequentially. Coverage continues to grow for whole genome sequencing in patients with rare and undiagnosed genetic diseases. During the quarter, one of the largest US health insurance companies updated their policy to include Managed Medicaid lives in 16 states, adding another approximately 3.8 million covered lives for whole genome sequencing. Also in GDT, earlier this month we announced a partnership with Henry Ford Health, a health care organization in the Detroit metro area and a leading US academic medical center, to assess how whole-genome sequencing can improve cardiovascular disease management, with a particular interest in diverse and underserved populations. Turning to our Research and Applied markets, sequencing consumables shipments were down 19% year-over-year, primarily due to the slowdown in COVID surveillance. Looking at the whole year, we are on track to deliver on our financial commitments for 2023 as well as some important releases in the coming quarters. Specifically, we will ship the ICLR enrichment assay, an affordable, high throughput, targeted long-read solution, in Q3 and XLEAP-SBS chemistry on NextSeq 1k/2k in the first half of 2024, delivering step-change cost, speed, and sustainability benefits on that platform. Finally, as we navigate through this dynamic environment, we are focused on delivering durable success for our shareholders through a balance of investing in breakthrough innovations for future growth, while delivering operating leverage through disciplined expense management across the organization. To that end, we announced earlier today our commitment to deliver Core Illumina non-GAAP operating margins of 25% in 2024 and 27% in 2025, while maintaining investment in the key elements of our innovation roadmap. Building on the cost reduction actions announced last November, we are taking additional steps to reduce our annualized run rate expenses by more than $100 million beginning later in 2023. This will accelerate progress toward higher margins as well as free up capital to increase investment in high-growth areas. I'll now turn the call over to Joydeep to discuss additional details on our results and outlook, as well as provide more detail on the steps we are taking to deliver on the cost reduction I mentioned. Joydeep?

Thank you, Francis. I'll start by reviewing our consolidated financial results, followed by segment results for Core Illumina and GRAIL, and then conclude with additional remarks on our current outlook for 2023. I will be discussing non-GAAP results, which include stock-based compensation. I encourage you to review the GAAP reconciliation of these non-GAAP measures which can be found in today's release and in supplementary data available on our website. In the first quarter, consolidated revenue was $1.09 billion, up 1% from the fourth quarter of 2022, exceeding the high end of our guidance range on stronger-than-expected shipments of NovaSeq X. Consolidated revenue was down 11% year-over-year, or down 9% on a constant currency basis, net of the effects of hedging. This was primarily driven by an expected year-over-year slowdown in COVID surveillance, COVID-related disruptions in China, the transition of some of our high-throughput customers to NovaSeq X, and customers managing constrained capital markets globally. Non-GAAP net income was $13 million, or $0.08 per diluted share, which included dilution from GRAIL's non-GAAP operating loss of $164 million for the quarter. Our non-GAAP tax rate was 27.3% for the quarter, which increased from 17.8% in Q1 2022, with both quarters reflecting the impact of R&D capitalization requirements. Although the non-GAAP tax expense impact of R&D capitalization requirements in dollar terms was the same in both periods, the impact to our effective tax rate in quarter one 2023 was more significant due to our lower earnings. Our non-GAAP weighted average diluted share count for the quarter was approximately 158 million. Moving to segment results: Core Illumina revenue of $1.08 billion was down 12% year-over-year, which included an anticipated headwind from COVID surveillance of approximately 400 basis points. COVID surveillance contributed approximately $11 million in total revenue in Q1 2023 compared to $60 million in Q1 2022, reflecting a $49 million headwind. On a constant currency basis, Core Illumina revenue was down 10%, net of the effects of hedging. Core Illumina sequencing consumables revenue of $692 million was up 1% sequentially, but down 12% year-over-year, which included an approximately 500 basis point headwind from COVID surveillance. In addition to the slowdown in COVID surveillance, the year-over-year decrease was primarily attributable to lower NovaSeq 6000 consumables pull-through due to the headwinds I mentioned earlier, COVID-related disruptions in China, the transition of some of our high-throughput customers to NovaSeq X, and customers managing constrained capital markets globally. Total sequencing activity on our connected high- and mid-throughput instruments grew 6% from Q4 2022 and 3% year-over-year. Research & Applied grew 7% from Q4 2022 and declined 4% year-over-year. Clinical sequencing activity growth remained robust, up 7% from Q4 2022 and 15% year-over-year. As a reminder, we believe this data is a useful reference that shows the general activity trends across our installed base and is directionally correlated with revenue over time. Sequencing instruments revenue for Core Illumina of $154 million declined 27% year-over-year, including a 300 basis point headwind from COVID surveillance. As expected, the year-over-year decrease was primarily driven by lower NovaSeq 6000 shipments compared to a record Q1 2022, and a decrease in mid-throughput shipments due primarily to fewer NextSeq 550 placements in China. Stronger-than-expected shipments of NovaSeq X helped partially offset this impact, although we remain supply constrained in the first year of launch. We continued to see strong demand for NextSeq 1K/2K from new-to-Illumina customers. Core Illumina sequencing service and other revenue of $119 million was up 7% year-over-year, driven primarily by higher instrument service contract revenue on a growing installed base. Before moving to regional results for Core Illumina, I'd like to highlight that we've implemented a new global commercial structure to improve operating efficiencies and better align with local markets. We've integrated APJ with emerging markets across Middle East, Africa, Turkey, and CIS. Going forward, we will report regional results for the following regions: Americas, Europe, Greater China and AMEA, or Asia Pacific, Middle East, and Africa. Americas revenue of $605 million grew 5% sequentially from Q4 2022 and exceeded our expectations due to stronger-than-anticipated NovaSeq X shipments. Revenue for the region was down 6% year-over-year due to the expected decline in Research, driven by the slowdown in COVID surveillance and delayed recruitment for some large research projects. We continued to see strong demand for NextSeq 1k/2k in the Americas, with instrument shipments up over 20% year-over-year. Europe revenue of $261 million represented a 9% decrease year-over-year, or a 4% decrease on a constant currency basis, net of the effects of hedges. Growth in Clinical, led by oncology testing, was more than offset by the expected decline in COVID surveillance revenue as well as lower high-throughput instrument shipments due to supply constraints on NovaSeq X in the first quarter. Greater China revenue of $91 million represented a 28% decrease year-over-year, or a 23% decrease on a constant currency basis, net of the effect of hedges. The year-over-year decline was primarily driven by persistent COVID disruptions and liquidity and funding constraints at our customers. This resulted in lower sequencing consumables revenue and a decrease in mid-throughput instrument shipments compared to last year. We will continue to closely monitor and mitigate market headwinds in China through the rest of the year. Finally, AMEA revenue of $119 million declined 27% year-over-year, or 23% on a constant currency basis, net of the effects of hedges. As expected, the year-over-year decline was primarily caused by the completion of a large research project in Japan, lower COVID surveillance revenue and a decrease in NovaSeq 6000 instrument shipments, only partially offset by NovaSeq X shipments as demand in the region outpaced supply. AMEA revenue was also impacted by sanctions affecting our ability to conduct business in Russia. We expect the impact of sanctions to persist through 2023 and have reflected approximately $60 million in lower sequencing consumables revenue expectations for the region in our outlook for 2023. Moving to the rest of the Core Illumina P&L: Core Illumina non-GAAP gross margin of 65.2% decreased 500 basis points year-over-year, primarily driven by less fixed cost leverage on lower manufacturing volumes, and lower instrument margins due to the NovaSeq X launch, which is typical with a new platform introduction. We expect gross margins to improve sequentially through the year as we scale NovaSeq X manufacturing and continue to drive operating efficiencies. Core Illumina non-GAAP operating expenses of $514 million were up $9 million year-over-year, primarily due to the full year impact of our headcount growth in 2022. Non-GAAP operating expenses were lower than expected as a result of cost containment initiatives. Transitioning to the financial results for GRAIL: GRAIL revenue of $20 million for the quarter grew 100% year-over-year, driven primarily by accelerating adoption of Galleri. As expected, GRAIL revenue decreased sequentially due to a milestone payment in Q4 2022 related to MRD pharma partnerships. GRAIL non-GAAP operating expenses totaled $173 million and increased $34 million year-over-year, driven primarily by continued investments in clinical trials and to scale GRAIL's commercial organization. Moving to consolidated cash flow and balance sheet items. Cash flow provided by operations was $10 million. First quarter 2023 capital expenditures were $52 million, and free cash flow was negative $42 million. We did not repurchase any common stock in the quarter. We ended the quarter with approximately $1.5 billion in cash, cash equivalents and short-term investments. During the first quarter, we used $500 million to repay the outstanding principal of our 2023 term notes that matured in March. Moving now to 2023 guidance. We still expect full year 2023 consolidated revenue to grow 7% to 10%, including Core Illumina revenue growth of 6% to 9%. As a reminder, these ranges include an anticipated headwind from COVID surveillance of approximately 200 basis points as well as a year-over-year headwind from foreign exchange rates. GRAIL revenue is still expected to be in the range of $90 million to $110 million for 2023. Our revenue outlook for 2023 now reflects the following offsetting factors: one, lower revenue in AMEA due to the impact of sanctions affecting our ability to conduct business in Russia; two, an increase in our NovaSeq X shipment expectations to more than 330 instruments; and three, higher contributions from our strategic partnerships related to drug discovery. As we have previously stated, we expect quarterly Core Illumina revenue to ramp sequentially throughout 2023, with linearity trends similar to 2017 when we launched the NovaSeq 6000, where we delivered approximately 54% of our total revenue in the second half of the year, including approximately 26% in Q3 and the remainder in Q4. Our revenue ramp for 2023 reflects the following assumptions: one, a quarterly ramp in NovaSeq X instrument shipments as the manufacturing capacity improves each quarter; two, sequencing consumables revenue increases as NovaSeq X customers kick off projects in the second half of 2023; and three, certain macroeconomic headwinds lessen in the second half of 2023, including a recovery from COVID disruptions in China. For fiscal 2023, at the midpoint of our revenue guidance: we now expect Core Illumina sequencing instrument revenue growth of approximately 13% year-over-year, reflecting our higher NovaSeq X shipment expectations; we now expect Core Illumina sequencing consumables revenue growth of approximately 5.5% year-over-year driven predominately by our lower revenue outlook for AMEA due to the impact of sanctions affecting our ability to conduct business in Russia; we continue to expect Core Illumina sequencing revenue to grow approximately 8% year-over-year. This now includes a higher contribution from sequencing service and other revenue primarily due to higher contributions from strategic pharma partnerships. We continue to expect non-GAAP earnings per diluted share in the range of $1.25 to $1.50 for 2023, including a consolidated non-GAAP operating margin of approximately 8% and Core Illumina non-GAAP operating margin of approximately 22%. We are reaffirming all other financial guidance for fiscal 2023 that we provided on February 7, 2023. Moving to the second quarter of 2023. We expect consolidated revenue in the range of $1.15 billion to $1.17 billion for Q2 2023, reflecting a sequential increase of approximately 670 basis points from Q1 2023 at the midpoint or approximately $70 million, primarily driven by: a sequential increase in NovaSeq X instrument shipments as manufacturing capacity continues to ramp; continued sequential growth in sequencing consumables and service revenue as new instruments continue to come online; a sequential increase in GRAIL revenue driven by accelerating Galleri adoption; partially offset by a sequential decrease in microarrays revenue due to historical seasonality. For the second quarter, at the midpoint of our revenue guidance range, we expect non-GAAP diluted EPS of approximately $0.01, reflecting consolidated non-GAAP operating margin of approximately 1% and Core Illumina non-GAAP operating margin of approximately 17%. These margins reflect a sequential increase in Core Illumina operating expenses driven by an increase in compensation-related expense due to our typical annual equity grant and merit adjustment in March. We continue to expect operating margins to improve in the second half of 2023 as revenue ramps and we scale our production of NovaSeq X and leverage the fixed cost of the manufacturing base. Looking forward, we are committing to achieve Core Illumina non-GAAP operating margins of 25% in 2024 and 27% in 2025. Illumina will reduce its annualized run rate expenses by more than $100 million beginning later in 2023. These cost savings will accelerate progress toward higher margins as well as free up capital to increase investment in high-growth areas. Illumina will achieve these savings through a combination of several actions. We will leverage the recent modularization of R&D innovation created as part of the NovaSeq X development, including XLEAP-SBS and new flow cell technology, to lower the cost and accelerate time to market for future platforms. We will achieve additional savings through leveraging our global footprint enabling activities at more cost-effective hubs. We are also streamlining our organization and processes, including rationalization of the company's global real estate portfolio and third-party vendor spend, as well as accelerating IT optimization efforts. The company will continue to prioritize innovations that generate highly differentiated products that are valued by Illumina's customers. I will now invite the operator to open the line for Q&A. Thank you.

Thank you. [Operator Instructions] And our first question will come from Puneet Souda with SVB Securities.

Yeah, hi, Francis, Joydeep, thanks for taking the question. So, first one on the order book. It's good to see the increase there, but just wanted to get your expectations in terms of the overall funnel you're seeing? Could that 330 number continue to increase as you go through the year? And could you just help us understand your ability to ramp the production deliver through the year? What sort of cadence should we be assuming per quarter in terms of installs? And then, if I may ask on sort of a GRAIL question, more operational and execution questions. I mean, historically, product cycle at Illumina has taken preference above everything, but there are just a number of distractions in terms of legal front with European Commission, FDC and now you have an activist campaign as well. So, wondering if any of that risks the product cycle and the execution that you have here, or how separate are these efforts? Appreciate the responses on those. And then, if I could ask also about biotech funding. There have been questions around that from a peer today. Just wondering if you're seeing impact from any of the emerging biotechs and is that contemplated into your guide? Thanks for taking the questions.

Great. Thanks, Puneet. You had a few questions there. So, let me work our way through it. So, first question was around the X and the order book of the X and the pipeline that we're seeing for the X. And your question was, well, 330, could it actually go up? And I think here the reality is that 330 is going to be more manufacturing bound than demand bound. I think it's the feeling we're getting right now that there's a huge amount of interest on -- in getting customers' hands on the X across our customer base. As you know, we always expected Research customers to be among the most aggressive early adopters and we thought Clinical would lag a little bit, but we're not seeing that this time. We're seeing strong demand from Clinical customers too as they are looking to launch new offerings on the X and expand into more sequencing intensive offerings. And you heard also that we're seeing strong demand from new-to- Illumina, new-to-high-throughput customers. And so, our expectation is that we'll continue to sort of build the demand and we'll be a little bit gated by how many Xs we can ship out the door over the course of this year. We were very encouraged by the scaling up of our manufacturing and operations teams in Q1. And as you saw, we were able to ship 67 instruments, so comfortably ahead of the guide we had of 40 to 50 instruments in Q1. So, manufacturing and scaling nicely. The teams are doing a terrific job. We are scaling that up to 80 in Q2, and so a nice little step up from Q1. And we'll take sort of gradual steps over the course of the year to get us to that 330. And so, to the extent that we're able to scale manufacturing better than that, we'll certainly update, keep you guys updated. In terms of -- there's a lot going on as you said. Obviously, all eyes are on the X for us, the story of this year is the X and this is what -- this is Illumina doing what we love to do, what we do best, launching a high-throughput instrument. And so while it seems like there's a lot going on terms of the regulatory process and so on, the reality is it's a very small part of the company that's actually involved in that. And the vast, vast, vast majority of our time and attention at Illumina is spent on getting our products out and really most of the focus is on the X right now. Oh, the other question – sorry, you had a question, one last piece. Salli just reminded you have a question about biotech funding. From our perspective, our direct exposure to small and mid-cap biotech funding companies is very small. And so, we don't expect that to have any kind of material impact on our revenue over the course of this year.

And our next question will come from Dan Brennan with TD Cowen.

Great. Thank you. Thanks for the questions guys. Congrats on the strong start to the year. Maybe on the X, could you give a little color on this idea of the [replacement ratio] (ph) just early on from the order book thus far, how is that shaping up in terms of existing NovaSeq customers in terms of ordering the X? Kind of related to that, another question we get frequently is the X dramatically expands capacity. So, just wondering early on, obviously, we're going to see what the volume looks like as we get through this year, next year. But kind of how are you viewing kind of customers as they look to buy the X and fill it? Are they having any -- is that a gating factor? It doesn't appear to be. And then, the final one just on GRAIL, Francis. How should we think -- you've got three different regulatory decisions pending and you're in the middle of those with the EU directive coming likely soon. What's the most likely outcome in your mind for GRAIL that investors should be anticipating? And kind of when will we get clarity on that? Thank you.

Great. Thank you, Dan, for the questions. So, let's start with the X. Yes, very strong start to the year. We're really excited about that. And we spent a lot of time modeling what to expect in terms of the number of Xs that could be absorbed by the market over the next few years. And there are a number of ways to think about it, right? One is to take the static view today and say, okay, if we just have a conversion from an upgrade cycle from the 6000 to the X, what could that mean? Now you have to add to that the number of customers that are coming into the X as new-to-Illumina and new-to-high-throughput. But let me start with that, and just again assuming -- and I'll come to elasticity in a moment. But let's put elasticity aside for a moment. And so, you may remember we went through this discussion also with the 6000 to say, well, how should you think about the upgrade cycle and how many units it would take to satisfy the upgrade cycle? And there're a couple of ways you could do it. You could start with capacity back and think about what the ratio is for each X, how many 6000 that you're replacing. But really, we think the better way to think about it is to go customer out. And what I mean by that is we have roughly maybe 1,000 customers that are high-throughput customers of ours. About 750 of them have only one 6000. And so, for those 750, you can't buy less than a single X. And so, you can think about those 750 needing to purchase an X. And so, again, even if their demand for sequencing doesn't expand beyond today, which of course it will and we'll tap into elasticity, you can see that they'll require 750 right off the bat to serve that customer base. And then the 250 that have multiple 6000s will apply their own sort of conversion ratio. And then, of course, the elasticity we're tapping into, right? And as we shared on the call, the majority of the customers that are purchasing the X are purchasing the X because they want to tap into the elasticity associated with the lower price per sequencing. And so, the clinical customers are talking about new applications that they want to get into that are fundamentally enabled by the lower price for sequencing. It's the solid tumor oncology testing customer that's now looking to get into a liquid biopsy and knowing that they can access -- it takes 12 to 15 times more sequencing, but they can access the price point of the X to enable to do that under the reimbursement limits they have. It's the customers that are looking to do the larger research experiments around single cell or spatial. And so, that will be on top of the base case of the numbers I just talked about with people just straight up upgrading. In terms of the GRAIL regulatory process, so the way we're thinking about it is that the whole process comes to a head towards the end of this year, at the beginning of next year, because we expect to get decisions around the two most important appeals in that timeframe. In Europe, we expect to get a decision around the jurisdiction appeal in that timeframe. And in the US, you might have seen that in the last week, we got granted expedited review by the US Fifth Circuit Court of Appeals for our appeal against the FTC. And so, that gives us even more confidence the decision will come even maybe a little earlier than had been initially anticipated, but certainly in the timeframe of later this year, early next year. And so, our expectation is that the whole sort of legal process winds up in that timeframe. Overall, at the same time, we got a divestiture work stream that we started a while ago, that work stream is all set to continue marching down the divestiture path. We're waiting for the divestiture order from the European Commission, which we expect to come out shortly. And so that path will be run-in parallel in the same timeframe as the appeals are happening.

Francis, I'll just add to your elasticity comment on clinical, right, so it's -- you're absolutely right, these are new applications. Typically, these are fairly complex signatures that require high levels of sequencing. And Illumina, because it's a supplier of tools and reagents, starts making money as those clinical trials kick off even before the tests are available in the public market, right? So, our elasticity actually begins even before the test reaches the market.

And our next question comes from Dan Arias with Stifel.

Good afternoon, guys. Thanks for the questions. Francis, Joydeep, can I just follow up on the comments there on elasticity? I mean, is that something you expect to materialize meaningfully in the back half of the year just in the sense that it can contribute to consumables growth for the year? I know in January, when you gave the outlook, one of the explicit drivers of the 8% consumables growth was elasticity. So, just trying to understand where things sit when it comes time to think about installation timing and ramping on usage that allows you to actually see that in the second half of the year and that you can count on it contributing to the overall target for the year?

Yes, Dan, that's exactly right. As we had stated, right, we expect the installations and the initial work that customers to bring up their workflow to happen as we get into Q2 and Q3. And in Q4, we started to see some of these projects ramp up and customers to build inventory and start earnestly moving to the Xs their [world-class] (ph) platform.

And moving on to our next -- oh, I'm sorry, go ahead.

No, that's good. I think the question was about the X, hopefully, that answers that.

Thank you. Our next question will come from Vijay Kumar with Evercore ISI.

Hey, guys. Thanks for taking my question. I had a couple on the guidance here. Joydeep, what -- I guess, can you quantify this Russia headwind, which is incremental? And then, related to guidance, gross margins were down sequentially. We're looking at sub-65%. Can you talk about what changed sequentially from the Q4 number of 66%-and-change, it's down a couple of hundred basis points. And when you look at the operating margin guidance for 2Q, with first half being at 17%, I think the back half, you need to hit 26%, 27% for Core Illumina to hit the annual guide. What drives that 17% step-up to like 27% in the back half? Thank you.

Yes. So, Vijay, thanks for the question, and good calculations, rapid calculation of the math. So, let me first hit the simple question on the Russia headwind. So, as we said in the call, it's about $60 million for the full year and approximately $18 million in headwind year-over-year in Q2. You're right, gross margins were down sequentially for us in Q1. Actually, we had signaled some of this as we gave our guide in February. There are two specific reasons. So one, of course, is the launch of the Xs. We told you, the X is just ramping up, so margins for the X tend to be low. And of course, we sold more Xs than we anticipated in Q1. The other reason, as you go from Q1 to Q -- sorry, from Q4 to Q1, you typically have lower absorption in our factories, right? So that tends to lead to a sequential decline in gross margin as you move from Q1 -- Q4 to Q1. In terms of operating margin for Q2, there are a couple of factors there, right? So, we -- as I mentioned in the call, there's -- we had our typical salary and promotional adjustments and equity adjustments. So, from -- as you move from Q1 to Q2, there is a one-time jump in overall operating expense. But of course, that then stabilizes for the rest of the year. The second factor, of course, in Q2 in terms of margins is we have -- because of the Russia issue, we have a shift again in a higher amount of instruments being sold, which has an impact on gross margin. So, those two combined offset some of the operating leverage that we are getting to keep margins at 17%. Now, you're absolutely right. We had indicated in our call that we expect margins to improve in the second half of the year. The two biggest reasons for that are really as we scale up and start to improve margins on the X, and of course, then consumables ramp up. So, we have a sequential step-up in each quarter. And because of that, absorption in our factories improves, leading to increased gross margin. And we do expect to exit the year with gross margins in the high 60%-s and operating margins close to the high 20% numbers that you indicated.

And our next question will come from Tejas Savant with Morgan Stanley.

Hey, guys, good evening, and thanks for the time here. So, Francis and Joydeep, maybe a couple on the Core and then a couple on GRAIL. So, on the Core business here, nice upside on the X shipments obviously versus what you indicated earlier in the year. But instrument revenues were essentially in line with our forecast. So, Joydeep, just the math there, was the offset essentially the EMEA weakness with the NextSeq 550 shipments in China? Or was there some sort of like greater-than-expected discounting or some such elsewhere in the portfolio? Second, for you, Francis, on the NextSeq, any updated thoughts on where you need to land on the per GB price point once you bring XLEAP to that platform next year? The competition is roughly at $2.00 a gig. So, do you think $4.00 to $5.00 is sort of a fair assumption? Or could it even be higher than that given the inertia to switching here? And then, on GRAIL really, the question that we get a lot is how committed are you to divesting the asset? Should you win that jurisdictional appeal and claw back the European Commission fine? So, put another way, I mean, what color could you share on the scenarios under which you could decide to keep GRAIL instead? I mean, is it essentially premised on what you'd get for the asset via an IPO or a sale or some such? Or just walk us through that thought process. Thank you.

Yes. So, let me answer the instrument question first. So, yes, we were happy with our increased supply of NovaSeq X. And as we mentioned on the call, the primary offset was in terms of instruments, the offset in the mid-throughput instrument cycle. And that was again mostly due to the reduced 550 shipments, and that was primarily in China. In terms of pricing, I want to be very clear, we track pricing pretty carefully. We're not seeing any differential with the expected prices nor a decrease in the prices that we track, both for instruments and our consumables. So, they are exactly at where we had expected them to be. And I think the next question was, was it out to GRAIL or...

The next question was about -- maybe I'll jump in, to talk about NextSeq and the -- what the impact of XLEAP-SBS could be on NextSeq? And so, Tejas, as you know, when we put XLEAP-SBS on NextSeq, you'll see a number of pretty dramatic improvements. One, you'll see an improvement in the price points associated with NextSeq, and I'll come back to that because that's where your question was. But you'll also see improvements in other capabilities, right? So the actual performance of the chemistry in terms of quality and so on. And then, you'll obviously see the sustainability benefits, and that's a big draw for our customers, because with XLEAP-SBS chemistry, you don't need a cold chain when you are shipping the consumables. And that's a really big savings for our customers in terms of the sustainability value proposition of the product. Now in terms of how we think about the price, our perspective is -- and we're not enhancing the price right now, but our perspective is we want to price it such that we can maximize the market opportunity. And so clearly, we're going to bring prices down. But our products also have, uniquely in the market, additional capabilities, not only the sustainability features that I just talked about, but we have the onboard compute associated with having the FPGAs built into the NextSeq. We also have the onboard storage optimization, which is also unique to Illumina's NextSeq compared to any other mid-throughput instrument in the market. And so, we're going to bring the prices down, but we're also going to recognize the additional value we provide in our instruments. And that will be part of the calculus that determines what the ultimate pricing is, and it will be around what opens up the market the most in the mid-throughput segment. In terms of GRAIL, so the pass-through divestiture is -- to answer your question around what's about the divestiture and then in what scenario do you keep GRAIL. So, the pass-through divestiture is, obviously, the divestiture order will come out shortly, that will lay out the process and the structure of the divestiture. We have a divestiture team, that's already engaged with the team in the European Commission, and we'll move forward with that process. In parallel, we have the two appeals going. If we lose either of the appeals, we'll divest promptly in the best interest of our shareholders. And we expect that to play out again in the late this year, early next year kind of timeframe in parallel with the appeals that are happening. Under what scenario would we keep it? If we win both the appeals and, at that time, we have a chance to sort of look at the asset and sort of make sure that the assumptions in the business case that we did hold in terms of us keeping it compared towards divesting it. And so that would be the scenario under which we would keep the asset and integrate.

And shortly, I'll be turning the call back over to Francis for closing remarks. [Operator Instructions] The next question comes from Julia Qin with J.P. Morgan.

Hi, good afternoon. Thanks for taking the question. First off, regarding your operating margin targets, can you help us think about the upside/downside scenario? And in those numbers, do you assume that your in-house NovaSeq X manufacturing reaches full efficiency by the end of '24 or by the end of '25? And for the R&D efficiency, I wondering if you could elaborate on how to think about the magnitude of improvement in new product [indiscernible] before and after you implement that new R&D structure? And then, lastly, I wonder if you can comment more on China. Are you seeing any offset from the government stimulus? And are you seeing any signs of [indiscernible] recovery here? Thank you.

Okay. So, let me -- Julia, let me take the operating margin target question. So, I think there are probably two steps there. For 2022, I want to reaffirm that we are still at our operating margin guidance of 22% for the year for Core. We see a couple of offsets there. So, of course, we are seeing more instruments in the number for the year, again, due to some of the offset from Russia about $60 million for the year. So for that, we do expect a slight gross margin hit, which will be offset by further productivity efforts on our manufacturing, and of course, some of the impact from the further cost reductions that we have introduced. In terms of your instrument or X manufacturing efficiencies, we do expect that by the end of the year, we will have achieved the efficiencies that we had initially outlined. We don't think the efficiencies will stop there. As we have done with all of our instruments, we continue to have further efficiencies as we go into subsequent years. So, you will see that those efficiencies continue to progress as we get into year two, three of manufacture. In terms of the R&D efficiencies that we talked about, so this is really coming from a couple of areas, and it's R&D and beyond, right? So, from the R&D side, we have spent a lot of effort in modularizing our innovations as part of the X and of course, even part of the NextSeq 1k/2k. And innovations like the new flow cell technology and XLEAP-SBS really allow us to radically reduce the spend per platform and for subsequent platforms and accelerate their time to market. So, you won't see this in 2023, but you'll see this in '24 and beyond. And then, we're also streamlining where we are doing some of our R&D, so leveraging our global footprint in more cost-effective hubs. So, this is for R&D, but also for other functions. And then that -- those kinds of activities also lead to further streamlining our organization and our processes allow us to rationalize our global real estate portfolio, spend and our IT infrastructure as well. So, again, you'll see that coming through starting towards the end of this year, but really kicking into place as we go into 2024 and beyond. And finally, in China, we are not seeing the benefits of any stimulus in China, at least for our business. We are monitoring China closely in terms of looking at some of the funding challenges our customers are facing and taking steps to mitigate some of these challenges.

And we have a question from David Westenberg with Piper Sandler.

Hi. Thank you for taking the questions, and congrats on the big NovaSeq X placement. So, I want to stick on those 67 placements. Have any of those customers started decommissioning any of their 6000s? Traditionally, you had customers kind of can finish their old projects before starting on the X. Now you have really good consistency between platforms. Has any of that behavior might have changed? Have you seen any maybe subsequent orders on 6000 even though they've already switched to X? Just trying to really get a sense on kind of this dynamic. Thank you very much.

Yeah. So, Dave, on -- thanks for the question. I think on the NovaSeq Xs, right, so you're right, a majority of our customers, they are -- they will transition their projects over time, and they are not intending, especially on the clinical side, not intending to decommission their NovaSeq 6000s. For the initial set of customers that we are tracking into from Q1 into Q2, we expect just about 10 to 12 decommissions as those Xs come online. But again, decommissions and replacements will be a smaller fraction. And as we get into the year, we'll provide more updates in terms of how the 6000 inventory -- or, 6000, not inventory, but set of installed base continues to evolve.

And we will take our next question from Kyle Mikson with Canaccord.

Great. Thanks guys. Thanks for taking the questions and congrats on the launch of the X here. Just one question for me. Historically, the company's revenue growth has been kind of elevated in the year or two following one of the meaningful signature launches. '17, '18 those were strong with 6000. '19 was a setback, and '14, '15 were solid with the HiSeq X. But in '16, growth was single digit. So, is there anything about the NovaSeq X launch that would lead to a different outcome? Or could Illumina be stuck in this kind of perennial cycle and dependence on new products driving near-term growth? Because now you have kind of more headwinds than you had in the past. I think it would be helpful to understand. Thanks.

Yes. Thanks for that question, Kyle. I'll say -- maybe a couple of points I'll make. One, product cycles are important in our market from a couple of perspectives. One, obviously, there's an upgrade cycle that they catalyze and that's typically more quick in the research market. And so historically, it's been very important in terms of driving near-term revenue growth because our market was primarily a research market. But now as we pointed out last quarter, 50% of our consumables are coming from the clinical market. I'd say that's one of the drivers of growth, but a big driver of growth is just going to be the growth in the clinical use cases. And so, we talked about the fact that we're seeing in the clinical markets from our proactive runs that we monitor continued strong growth of our clinical customers just because we're seeing more uptake of tests like the genetic disease testing segment that's continuing to grow or more coverage associated with oncology therapy selection or increased NIPT coverage. And so, as you look forward, a significant driver of growth is going to come more from adoption of sequencing in the clinical market more so necessary than just a straight upgrade cycle.

I think just one more thing to add, right? Kyle, you will see a little bit of what we traditionally see as customers cut over from one system to the other, right? There will be a little bit of a transition from consumables from one system to the other. So, I don't think that can totally be avoided. But Francis is right. You see that much more with research customers than clinical customers, right? So that will tend to mitigate.

Thank you. And that concludes our Q&A session. I will now hand the call back over to Francis deSouza.

Thank you for joining us. As we close the call, today is DNA Day, celebrating the 70th anniversary of the discovery of the double helix structure of DNA. This month is also Illumina's 25th anniversary. Over our history, our team has played an important role in the genomic revolution by delivering breakthrough innovations that dramatically reduce sequencing costs and broaden access to genomics, unlocking new frontiers in biology and healthcare. And yet today, with only 4 million genomes ever sequenced, representing only 0.07% of the population, we are still at the beginning of the genome era. That concludes our call today. We look forward to seeing you at upcoming conferences and other events.