Rebecca Chambers - Vice President-Investor Relations & Treasury Francis A. deSouza - President and Chief Executive Officer Marc A. Stapley - Executive Vice President, Chief Financial Officer & Chief Administrative Officer.

Tycho W. Peterson - JPMorgan Securities LLC Doug Schenkel - Cowen & Co. LLC Daniel Arias - Citigroup Global Markets, Inc. Derik De Bruin - Bank of America Merrill Lynch Jonathan Groberg - UBS Securities LLC Ross Muken - Evercore ISI Amanda L. Murphy - William Blair & Co. LLC William R. Quirk - Piper Jaffray & Co. Isaac Ro - Goldman Sachs & Co.

Jack Meehan - Barclays Capital, Inc. Bryan Brokmeier - Cantor Fitzgerald Securities.

Good day, ladies and gentlemen, and welcome to the Illumina Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, today's conference maybe recorded.

I would like to introduce your host for today's conference, Ms. Rebecca Chambers. Ma'am, please go ahead..

Thank you, Michelle, and good afternoon, everyone. Welcome to our earnings call for the second quarter of fiscal year 2016. 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 Marc Stapley, EVP, CAO, and Chief Financial Officer.

Francis will provide a brief update on the state of our business and Marc will review our financial results. This call is being recorded and the audio portion will be archived in the Investors section of our website.

It is our intent that 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 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 on 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 filed with the Securities and Exchange Commission, including Illumina's most recent Forms 10-Q and 10-K.

Before I turn the call over to Francis, I would like to let you know that our Q2 earnings presentation is available on the Investors section of our website. With that, I will now turn the call over to Francis..

Thanks, Rebecca, and good afternoon, everyone. I am pleased to report that Q2 exceeded our financial guidance as revenue grew 11% year-over-year to $600 million. In the Americas, revenue grew 13% versus the prior year, slightly exceeding our forecast.

And Asia-Pacific revenue grew 29%, driven primarily by China, which grew 70% on the back of demand for HiSeq X, benchtop instruments from clinical customers, and array and sequencing consumables. In Europe, revenue declined 4% versus Q2 of last year, a slight miss to forecast.

We're making good progress on the action plan we enacted post the first quarter. Last quarter, we shared three areas that we're focusing on to deliver in our full year. The first area was improving our sales processes and, specifically, lessening deal complexity and ensuring the early closure of orders.

We're making progress on deal structure and saw tangible results on the timing of the deal closure. As a result, this quarter's linearity was the best we've experienced since the fourth quarter of 2014. Second, our commitment to improving the execution and outlook in EMEA.

We're pleased with the early impact of the leadership and execution changes, including the now permanent appointment of Scott Thomas as Head of Sales and Paula Dowdy as the Regional General Manager. The turnaround will take time, even a bit longer than originally projected.

We continue to believe the region's first half result and outlook is primarily reflective of execution challenges and not the result of changing demand or increasing competition. And we are confident in the ability of our EMEA leadership to achieve its full potential. Our third area of focus was expense management.

I am pleased to report that our expense re-planning efforts were completed during the quarter, slowing down our pace of hiring, discretionary travel, and other external spend without materially affecting our product development portfolio. This is partially reflected in our results for Q2 and fully reflected in our forecast for the year.

In addition to the progress made on these three areas of focus, our manufacturing and supply chain execution also improved. Specifically, the back order situation for arrays has now been resolved, and incremental capacity has been built to handle the increased demand.

More broadly, our manufacturing and supply chain teams executed flawlessly, due in part to new leadership. I'll now move on to an update on our markets. Our strategy to catalyze clinical markets is to deliver market-leading technologies and tailored solutions that enable customers to personalize patient care through genomics.

In oncology, this strategy has resulted in pharma partnerships to develop and bring to market custom panels, including TruSight Tumor 15, which has been launched as a research use-only and investigational use-only product, and TruSight Tumor 170, which will be launched as a research use-only product later this year.

We have also partnered with Amgen to develop a companion diagnostic test for Vectibix. The product development is complete, and we're preparing the final module of our pre-market approval application for the FDA.

We expect this to be the first PMA submission based on next-generation sequencing, an exciting step towards fulfilling the promise of genomics in personalized medicine. With our sample-to-answer solutions and technology leadership, we expect our oncology revenue to grow, even as reimbursement and regulation play out over time.

For example, this quarter saw a rebound in oncology testing shipments during the second quarter, which grew at more than four times the rate of total company revenue growth although from a small base. In NIPT, as expected, we continue to see customer shift to in-house testing on our sequencers.

As a result, the number of samples running through our testing facility decreased to about 25,000. And we saw an offsetting uptick in sequencing consumables from these customers. Test fee revenue paid by customers to access the NIPT IP pool grew 90% year-over-year.

We gained further traction in driving NIPT penetration in China as sample volumes accelerate and are on pace to double year-on-year. With the launch of our CE-IVD VeriSeq NIPT assay in Europe late this year, we expect to see a further acceleration in that region.

The launch of this product will be well-timed given the Dutch Health Council's recent endorsement of NIPT for all pregnancies. Focusing now on new products. Orders placed across our high-throughput instrument portfolio increased sequentially and shipments were roughly flat.

HiSeq X orders exceeded our guidance range and we added three new customers, bringing the total to 34. Again, this quarter demand came from new customers preparing to take part in the China PMI program, which has now allocated funding to more than 60 projects over the next 3 years to 5 years.

In fact, Chinese customers drove the majority of our HiSeq X shipments in the quarter. Going forward, our HiSeq X outlook remains robust at 20 instrument to 30 instrument orders per quarter and we expect to see an increase in HiSeq placements in the Americas during the latter part of this year, which is supported by a solid pipeline.

Our benchtop instrument portfolio performed well in the quarter, driven by ramping interest in MiniSeq, NextSeq adoption for NIPT in the U.S. and China and lower than expected cannibalization of MiSeq.

Additionally, during the quarter, we received two regulatory approvals for our MiSeqDx instrument from the Ministry of Food and Drug Safety in South Korea and from the Australian Therapeutic Goods Administration.

These regulatory milestones will enable our customers to use our NGS technology in a clinical setting and are examples of how our regulatory strategy is enabling markets globally.

Microarrays were, again, a bright spot as our revenue grew 30% year-over-year driven by both consumables and services, which resulted in the highest quarter of array shipments since 2011. There were two main drivers to this result, the direct-to-consumer market, which grew more than 100%, and medical research in bio-banking customers.

Additionally, array orders grew more than 60% year-over-year due to orders for our Global Screening Array, or GSA, and Infinium XT product family, both of which will launch in the second half. Given strong orders in the last two quarters, our outlook for arrays for the year is much more optimistic.

The impact of these products, coupled with a strong first-half result is expected to lead to double-digit array growth this year, which is clearly a turnaround for this business. Before closing, I would like to thank Jay for his 17 incredible years as CEO of Illumina.

Through his vision, leadership, and determination, Jay led our company from a San Diego startup to a global market leader with over $2 billion in revenue, powering the genomics revolution.

I look forward to partnering with him in his new role as Executive Chairman to further our mission of improving human health through unlocking the power of the genome. Today, we're still at the beginning of realizing the impact genomics will have in human health.

As we march towards our mission, our top priority is to continue to deliver breakthrough products that enable the adoption of genomics in large and unpenetrated markets. Innovation has always been and will always be one of our core values, and a core part of our culture.

And as the saying goes, culture eats strategy for breakfast, and I am committed to fostering our strong culture as we scale. I'm also focused on scaling the organization, our infrastructure, process, and our people. Taking on some of the world's hardest problems requires the world's best team.

We have an incredibly talented team, and are seeing the benefit of continuing to strengthen the organization. I'm excited about the pipeline of talent being pursued across the company. From an operational perspective, I'm focused on simplifying our business and focusing our resources on activities that will have the greatest impact.

It is important that we stop doing things that don't matter. So, these are some of my early priorities in the new role. At Illumina, we are passionate about making this great company even greater. The second quarter was a positive step along this path, but we have more work to do, as we continue to execute in our mission.

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

Thanks, Francis. As Francis mentioned, total revenue grew 11% year-over-year to $600 million, slightly exceeding our quarterly guidance. This result was driven by growth in sequencing consumables, and strong demand from microarrays.

Instrument revenue declined 19% year-over-year to $126 million, primarily due to a challenging HiSeq comparison, given the 3000 and 4000 launch in the prior year. Sequentially, instruments grew 7%, primarily driven by our benchtop portfolio.

As predicted, HiSeq instruments were roughly flat sequentially, and we continue to expect to see an uptick in the second half, primarily Q4 in the Americas, as Francis mentioned.

Consumable revenue represented 63% of total revenue to equal $379 million, an increase of 25% compared to the second quarter of 2015, driven by strength in both the array and sequencing product lines.

Sequencing consumables revenue also grew 25% year-over-year to approximately $310 million, driven by our growing installed base of instruments, and particular strength in NextSeq consumables. Again, this quarter, NextSeq utilization was above our guidance range of $100,000 to $125,000 per instrument annually.

As a result of this outperformance and our increasing forecast, we are now projecting annual pull-through of $100,000 to $150,000 per NextSeq instrument. MiSeq utilization was in our projected range of $40,000 to $45,000, and HiSeq pull-through per instrument fell within the guidance range of $300,000 to $350,000.

For modeling purposes, we removed approximately 45 HiSeqs from our installed base in the second quarter, reflecting the units taken offline due to adoption of newer machines. HiSeq X utilization fell just shy of our pull-through guidance range, as a large customer continues to work down inventory as we have previously shared.

On a four-quarter rolling basis, which normalizes for the impact of shipment timing, X utilization was within our range of $650,000 to $700,000. Given customer ship schedules and the relative size of the installed base, we are widening the guidance range to $625,000 to $725,000 annually per instrument.

Services and other revenue, which includes genotyping and sequencing services as well as instrument maintenance contracts, grew approximately 18% versus Q2 2015 to $90 million.

This improvement was driven by maintenance contracts associated with a larger sequencing installed base and genotyping services, partially offset by a decline in NIPT service revenue, given customers migrating to in-house testing as expected. Turning now to gross margin and operating expenses.

I will highlight our adjusted non-GAAP results, which exclude non-cash stock compensation expense and other items. I encourage you to review the GAAP reconciliation of non-GAAP measures as well as our GAAP EPS guidance, both of which can be found in today's earnings release and presentation.

Please note that all subsequent references to net income and earnings per share refer to the results attributable to Illumina's stockholders. Our adjusted gross margin for the second quarter was 72.8%, a sequential increase of 110 basis points, driven by an improvement in sequencing consumable margin and favorable microarray pricing.

Year-over-year, adjusted gross margin expanded 40 basis points, primarily due to higher consumables mix, partially offset by lower services margin. Adjusted research and development expenses for the quarter were $114 million or 19% of revenue, including $8.6 million attributable to GRAIL and Helix.

This compares to $113 million or 19.8% of revenue in the first quarter. Adjusted SG&A expenses for the quarter were $127 million or 21.2% of revenue, including $6.5 million attributable to GRAIL and Helix. This compares to $125 million or 21.9% of revenue in Q1.

Adjusted operating margins were 32.6% compared to 30.1% in the first quarter, driven by an increase in revenue, gross margin expansion, and our operating expense replan. Operating margin was lower compared to the 37.4% reported in the second quarter of last year due to increased investment in head count, GRAIL, and Helix.

Core Illumina operating margin adjusted for expenses associated with GRAIL and Helix was approximately 35% in the second quarter. Stock-based compensation expense equaled $32 million. In the second half, we expect to see an increase in this expense driven by a number of key hires and the annual employee equity grants in Q4.

Our non-GAAP tax rate for the quarter was 25.7% compared to 28.9% in the second quarter of last year and non-GAAP net income was $127 million. This resulted in Q2 non-GAAP EPS of $0.86, better than expected due to higher revenue and lower expenses compared to our forecast.

This quarterly result compares to non-GAAP net income and EPS of $120 million and $0.80 in the second quarter of 2015. Non-GAAP EPS this quarter included approximately $0.06 and $0.02 of dilution in GRAIL and Helix, respectively.

We reported second quarter GAAP net income of $120 million and EPS of $0.82 per diluted share compared to net income of $102 million or $0.69 per diluted share in the prior year period.

I'm pleased to announce that late in the quarter we completed our plan to enter into a common to preferred share exchange transaction related to our shareholding in GRAIL.

As a result, our GAAP diluted EPS included $0.01 benefit from the exchange and while Q2 net income reflected approximately 90% of the GRAIL losses, going forward net income will include approximately 50% of GRAIL losses, which is more in-line with our ownership. Cash flow from operations equaled $217 million.

Q2 DSO totaled 56 days compared to 64 days last quarter. This return to pre-SAP levels was driven by continued process enhancements, focused collection efforts, and improved linearity in the quarter. Q3 linearity is expected to drive an uptick in DSO, given the summer vacation season.

Inventory rose to $311 million due to the continued build-up of consumable safety stock to enhance our supply chain performance.

This increase in inventory is expected to continue into the second half of the year, as we build safety stocks in preparation for the relocation of our San Diego reagent manufacturing to our new building on the headquarters campus.

Capital expenditures in Q2 were $68 million, and we reported an additional $75 million increase in property and equipment related to construction expenditures paid for by our landlord, and capitalized by us under build-to-suit lease accounting. Consequently, Q2 free cash flow was $149 million.

During the quarter, we repurchased $100 million of common stock under the previously announced discretionary program and ended the quarter with approximately $1.43 billion in cash and short-term investments, including the consolidated cash balances of GRAIL and Helix.

We have approximately $155 million of repurchase authorization remaining, of which $70 million is discretionary. Turning now to expectations for the remainder of 2016. We continue to project total company revenue growth of approximately 12% year-over-year.

Included in this projection is the expectation that EMEA will experience a slower pace of recovery, which will be offset by an improved outlook in Asia-Pacific. We are forecasting Q3 revenue of $625 million to $630 million and are anticipating high year-over-year growth in Q4 than in Q3.

We have increased our non-GAAP EPS guidance to $3.48 to $3.50, up from $3.35 to $3.45 given our outperformance in Q2. In conclusion, I would like to punctuate a number of key fundamental performance indicators related to the second quarter results. Firstly, we experienced robust sequencing and array consumable growth.

Secondly, we saw strong growth in oncology testing shipments, up more than 45%. Thirdly, Asia-Pacific outperformed significantly, and we saw strong Americas performance, offsetting underperformance in EMEA. We finally – we completed our expense replan and saw better than expected non-GAAP EPS.

We believe these fundamentals will enable accelerating growth through 2016. Execution continues to be a major imperative, and our teams are focused on rebuilding growth in Europe, while continuing the strong performance in the other regions. Thank you for your time. We will now move to the Q&A session.

To allow full participation, please ask one question and rejoin the queue if you have additional questions. Operator, we will now open the lines..

Thank you. Our first question comes from the line of Tycho Peterson with JPMorgan. Your line is open. Please go ahead..

Hey, thanks. Francis, can you maybe just elaborate on your comment on the European recovery being a little bit slower? I'm just wondering if that's a function of incremental steps you have to take.

And obviously, with Brexit, any thoughts on whether there is any impact to GeL (20:09) funding?.

Sure. The action plan we put in place at the beginning of Q2 is playing out. We have new leadership out in EMEA, as Scott is now the permanent Head of Sales there. Paula is the new Regional GM. And when Scott first went out there at the beginning of Q2, we asked him to look through the pipeline and validate the strength of that pipeline.

And his response and in his report back to us was that the deals in the pipeline are real. Those are real opportunities for us. And three months in, those are real. And, in fact, we've added to the pipeline. What we are finding, though, is that there are some big deals in that pipeline that are taking a little bit longer to close.

So, in Q2, we had a couple of those deals that slipped out of Q2, resulting in EMEA coming in slightly short of the forecast.

And so, what we've done looking forward is we've looked at all these big binary deals in the pipeline and we've done a probability weighting on those deals and so that's caused us to take back a little bit our forecast for the year in EMEA.

Now that's been offset by strength that we've been seeing in the Americas and APAC and so that's the commentary. The dynamics we're seeing in the market are still strong and the issues I'm talking about are primarily our own internal issues that we're working through. The demand environment seems strong.

We talked about the fact that the Dutch Health Council has approved or endorsed NIPT for all pregnancies, the research environment seems stable. The Brexit impact hasn't really shown up yet. And so it didn't really impact us for Q2.

There have been some anecdotes of – a couple of instances where it showed up, for example, we've had a couple of research teams that were questioning whether they should include collaborators, PIs, in the U.K. on their collaborations.

And we expect those kinds of conversations could possibly slowdown some deals but we expect those deals to go forward anyway. We've also had one case where a customer, because of the exchange rate volatility, wanted us – wanted to pay us quarterly rather than annually.

And so, really we're seeing pretty minimal impact at this point from Brexit on our business. We're also not seeing any change in the competitive environment in EMEA..

So, Tycho, just to punctuate a point on that, the Brexit point, our current guidance and forecast, therefore, assumes business as usual in EMEA and in the U.K. And any Brexit impacts which are too premature to figure out are not included in that forecast.

GeL (22:55), specifically, we don't see any potential impact to GeL (22:58), but, again, it's a little premature to be able to tell if Brexit is going to impact that project at all, but we don't think so..

Okay.

And then maybe just a quick follow up for the China PMI placement, can you maybe just talk about how you think about the cadence maybe over the next few quarters? Are you seeing the bulk of demand in the near-term here and then it will kind of drop off a bit?.

We are, as we said already, starting to see demand flow from the China PMI initiative. We talked about the fact that in Q2 the majority of our X placements were to China based on anticipated Chinese PMI work. We have a strong pipeline looking forward so I continue to see that strength play out over the coming quarters.

And then we expect to see revenues show up from the pull-through associated with the instruments we're placing..

Okay. Thank you..

Thanks, Tycho..

Thank you..

Thank you. And our next question comes from the line of Doug Schenkel with Cowen & Co. Your line is open. Please go ahead..

Okay. Thank you and good afternoon. Sequencing instruments were up against the most difficult comparison of the year. So a pretty material decline in instrument revenue. I believe, was expected in most models. For example, we were expecting a 19% decline year-over-year.

That being said, based on the e-mails I am getting from investors, it does seem like that 21% year-over-year decline in sequencing instrument revenue is jumping out at folks. I believe you indicated that benchtops were better than expected.

HiSeq 2500 and HiSeq 4000s were about flat sequentially and that you exceeded the guidance range for HiSeq X orders in the quarter.

It would be helpful if you could just provide any additional color on how sequencing instrument revenue performance was relative to Q1, how it came in relative to your internal expectations, and maybe discuss any dynamics such as book-to-bill that will help us assess demand momentum heading into the second half..

Sure, Doug. So, overall, we are where we expected to be generally with the instruments. We knew this was going to be a tough compare. And if you look at breakdowns of our instrument line for the HiSeqs, for example, we saw stabilization in the HiSeq instrument shipments in the second quarter.

Orders were higher sequentially, and shipments were roughly flat compared to the first quarter. This was in line with what we outlined in the Q1 earnings call. And then, if you go to the X line, we continue to be happy with the strength of the X orders, which are as we expected it to be.

And as we look at the pipeline going forward, we expect that to continue. If we look at the back half of the year, we expect to see further strength, especially in the HiSeq line, as we get towards the end of the year and primarily coming out of the U.S.

We have a good line of sight into our pipeline for the HiSeq instrument sales towards the end of the year, driven by end of the year budget flush we expect to see. In terms of book-to-bill, it was sort of roughly consistent with where it's always been, which means that orders and shipments were sort of roughly in line..

Yeah. And in terms of backlog, I mean, given the commentary on X, obviously we built backlog in that particular area. But I'd say, across the rest of the instruments, it was pretty normal book-to-ship type of ratios..

Okay. That's really helpful. I guess another question, just recognizing that some have vocally argued that demand for complex genetic tools is poised to decline and that there is overcapacity in the market.

That's been out there for a little bit and the argument's become a bit more pointed subsequent to a series of recent quarters where Illumina hasn't performed up to Street expectations. This was a good quarter, albeit against a fairly low bar.

Recognizing those arguments and keeping in mind some of the progress you've made here, I want to give you an opportunity to address these concerns directly.

And specifically would you be willing to comment on how confident you are at this point that the challenges you faced over the past few quarters are a function of company-specific issues versus exogenous factors. Thank you..

Sure, Doug. Obviously that's – you've covered a lot of ground and those are areas we spend a lot of time thinking through. We have been asked about certainly in the clinical markets, people have asked about, as you pointed out, the demand environment for complex genetic testing.

And as we look through the data we have and the results we announced, we really don't see any dampening of the demand. Neither in the reproductive health markets, so, NIPT specifically, nor in oncology. In NIPT, we, overall, saw a continued growth in the number of NIPT samples.

The dynamic playing out there is as we expected and we've noted before, we are seeing more of our big customers start to take the testing in-house. And so that results in a decline in our test send out revenue for NIPT but we see a commensurate increase in the sequencing consumables that we get from those customers.

In addition, we saw really strong growth in the test fees that NIPT customers pay to access the IP associated with NIPT. So we continue to see strong demand and a growth in samples. And if you look at some of the market dynamics playing out, we expect that demand to continue to increase. We're still in the U.S.

only about 26% of covered lives that are covered for NIPT and we expect that to increase over time. And we expect to see other markets come online like we saw in the Netherlands. So we believe that there is a strong demand environment and headroom in the NIPT space.

In oncology, as we pointed out, we saw really strong growth of 45% year-on-year in oncology testing. And we know, from a market perspective, we're still at the very early stages of every tumor being sequenced for example. And so we expect to continue to see strong demand growing from both those clinical markets.

As we look at capacity and utilization, we've done a lot of work to try and understand what the impact of putting more capacity into the market has done in terms of utilization. And last quarter we put out analysis to show what happens as every quarter we put more capacity in the market, what happens to the utilization of our instruments.

And we saw that the capacity utilization has remained roughly flat and slightly gone up. And as we've updated that data for this quarter, we saw that play out again. We saw both an increase in capacity in the market, as we put out more instruments, and we saw the utilization slightly tick up as well.

And so, we feel confident that even as we put out more capacity into the market, there is demand for that capacity..

Great. Thank you..

Thank you. And our next question comes from the line of Dan Arias with Citigroup. Your line is open. Please go ahead..

Yeah. Good afternoon. Thank you. Marc, what are you seeing at the tail end of the HiSeq X customer segment in terms of pull-through? I mean, are you starting to see some of the folks there take their utilization up? And then, I guess, along those lines, Francis mentioned consumables pull-through on the China placements.

So I guess, how quickly would you expect those instruments to ramp in terms of utilization?.

Yeah. So, Dan, we continue to see the entire – it's why we have this nice analysis we do of every customer because there is not a huge number and their pull-through. And it's not quite a straight line but you've got every single potential level of pull-through there from those that are very low to those that are very high.

Notwithstanding the one kind of customer inventory situation that has impacted us for the last three quarters, I'd say, it's pretty good. And as new customers come onboard, they drag the number down, but existing customers increase their utilization and takes it back up. And so, it's working out pretty well.

On the China situation, specifically, I would expect that to normally be a headwind as to the utilization rate, as the number of instruments gets placed and the projects come at a slower pace than you might normally expect. But on the other hand, we're still seeing those high-end customers increase.

So I would expect them to offset that and so stay within this new range that we provided..

Okay. And then maybe just a question on oncology, specifically, on the consumables pull-through for the systems that you've placed.

Is the usage or the order consistency there any different than you find for the rest of the business, if we're just trying to understand how visibility tracks once the placement itself has been made?.

Yeah. I think I can take that, if you like. Again, it varies a lot by customer and by application and what they're doing. We see – we do have some that are running very, very high and some in the lower end. So I think it's hard to put any kind of specific pattern on it, Dan.

I think it follows the same kind of pattern we see across the high throughput instruments in general..

Yeah, and it follows the same pattern as we see in other domains. So that distribution, as Marc said, of the high-end customers that have high utilization all the way down to much smaller occasionally-used instruments..

Okay. Thanks very much..

Thanks, Dan..

Thank you. And our next question comes from the line of Derik De Bruin with Bank of America Merrill Lynch. Your line is open. Please go ahead..

Hi. Good afternoon..

Hi, Derik..

Hi, Derik..

So I've got a couple of questions, a multi-parter on the oncology market. So, I guess, the first question is, could you talk a little about the 45% growth. Was that – what was boxes versus test and was that all consumables, I guess is the first question.

The second question is, obviously, the reimbursement landscape is very complicated for next-generation sequencing-based test. What are you hearing in the market about trying to drive higher reimbursement rates for NGS test? What are your customers doing along those lines? And then I've got a follow-up on that..

Sure. So what we are seeing in the oncology market is that a lot of the growth in oncology is driven by a number of the higher end customers and they are both consuming more consumables and buying more instruments.

And so, while the overall sort of distribution in the oncology market maps the other markets, we definitely do have a set of very large customers that are running at high utilization and are driving a disproportionate percentage of the growth in revenue in that space.

And, sorry, what was the other part of our question?.

A question on the reimbursement landscape.

I guess what are your customers doing in terms of trying to get a higher reimbursement rate from CMS and just trying to get paid for what they're doing?.

Sure. A lot of the growth we're seeing today is not driven by any reimbursement, as you know. So it's either a self-pay market or it's a large cancer centers that are offering these genomics tests as part of their strategy of differentiating from other cancer centers.

We are seeing some panels sort of go through reimbursement, but we're still at the very early stages of that process. We're still in the stage of the market where we're seeing a proliferation of panels, I think at last count there were over 1,000 panels out there.

And so, as we look forward, I think, the next step in the process is to start to see some consolidation in the number of panels, which we think will accelerate the reimbursement in oncology.

We've also – we're also in the stage now where we're starting to submit our PMA for our test for Vectibix, and that will be covered under a reimbursement schedule. But we're still at the early stages of reimbursement in oncology..

Great. Thank you..

Thank you. And our next question comes from the line of Jonathan Groberg with UBS. Your line is open. Please go ahead..

Thanks. Congratulations on a solid quarter. Francis, can you – notwithstanding your own new role and Marc's new role, you've highlighted new leadership in Europe. I think you mentioned new leadership in supply chain that you thought was paying off.

Could you maybe just give us a sense as to how you're feeling about the current leadership at Illumina or the other changes that you think or certain areas that you like to strengthen or just maybe give us your overall thought on where you stand there?.

Sure. I'll start by saying that we are incredibly fortunate, here at Illumina, to have an incredibly talented leadership team and incredibly talented team as a whole.

We have – I think most of you know Marc, and over time you'll get to know the rest of the leadership team, but we have a team that's deeply experienced in this space and incredibly talented. So we're starting with a very strong base of leaders.

As we grow, though, both in scale and as we grow in geographies and in new areas, we have needed to expand our leadership team. In some areas, we've needed to add specific expertise. So for example, we did the acquisition of Myraqa, brought on Mya and expanded – and are still expanding our regulatory team, for example, globally.

The scale of our business over the last few years has grown significantly.

And so, in the last couple of years, we've had to strengthen our supply chain team, bringing in a new leader, our consumables manufacturing team bringing in another new leader, and so, strengthening both the team and then the infrastructure associated with the operations there.

There are a number of roles that we are looking to hire across the company but then, especially, on the leadership team. So we're looking for roles like the Head of Oncology, the Chief Medical Officer, and we're looking to expand our team that helps our customers with market access and reimbursement, for example.

And so, I'll say, look, we are starting with an incredibly strong team. But we are also scaling the business. And so, we're looking to strengthen that team..

Okay. That's helpful. And then my follow-up just has to do a little bit with guidance.

I think you mentioned – maybe it's kind of two parts here, but I think you mentioned, one, a little bit of a shift in how you were thinking of forecasting Europe, which is now more probability adjusted, is that unique to Europe, or is that something you do across geographies? And then the second part of it is, I think you also highlighted the growth in the consumer segment and the arrays in particular and I am just – as Helix gets going, I'm just curious how you're thinking about managing the potential for channel conflict in an area like your consumer initiative.

Thanks..

Sure. So let's talk about both.

In terms of our guidance for the year, the reason we feel confident with 12%, even though I said that, look, we're looking at the big deals in Europe and applying sort of a probability-based view on them, is that we are seeing slightly stronger than expected pipelines coming out of both, the Americas and – forecast coming out both the Americas and Asia.

We, in general, do apply some probability weighting to deals across the globe but we have leaders that have been in place longer in EMEA and in APAC, and so we feel like we have a much better handle on where those deals are and what their likelihood of closing is.

We applied a little bit of a heavier weighting – probability weighting in Europe than we do right now in the Americas and in APAC until we have the team on the ground and have some track record behind us in terms of the forecasting there.

But the strength in EMEA – and the strength in Asia and Americas, sort of more than compensate for that from our perspective. In terms of Helix and the consumer business, so the way we set Helix up is that Helix goes out and recruits direct-to-consumer businesses to build on the Helix platform.

The intent is that anybody who is looking to set up a direct-to-consumer genomics business will go talk to Helix. And there are incredibly compelling reasons about why you would want to go to Helix and get set up with Helix, rather than set up your own sequencing lab environment, your own informatics pipeline, your own operations.

If, however, a customer feels like Helix is not the right fit for them, then they can certainly buy from us equipment and consumables. We do have customers that are outside Helix that are direct-to-consumer. They are terrific customers and we're going to continue to support them going forward..

And, Jon, I don't think there's really any direct channel conflict because of the segmentation. Customers that have an array-based genotyping panel that they want to continue with, clearly, we can service that.

But if any customer who wants to take advantage of not just the infrastructure point that Francis made but also the opportunity to do exome plus would clearly be directed to Helix. So it's segmented based on the actual product..

Thanks..

Thank you. And our next question comes from the line of Ross Muken with Evercore ISI. Your line is open. Please go ahead..

Good afternoon, everyone. So it seems like, obviously, the momentum in China has been quite good. It's a market, obviously, you've been in for quite a while, and they've been a dominant sequencing power for some time.

Can you give us a bit of color on some of the emerging players that are obviously incremental X customers? I mean, these are not household names for us, and it's hard to sort of judge where they are playing, what types of businesses they are, are they all government-funded or some private, how much of it is coming and fueled by sort of the PMI money that has been talked about? Just put some color around sort of the emergence there, given it seems like an important sort of part of your business..

Yeah. Good question because China is emerging as one of our top country markets already and is driving strong growth for us. If we look at the dynamics play out in that market, the market in China is primarily a clinical market. And so, we look at where the demand is coming from.

There is a lot of demand from customers looking to set up NIPT operations in China. We expected that to continue to be a growing segment for us. We're also seeing some of those customers also enter the oncology space, but we're also seeing pure-play oncology providers that are emerging as customers of ours. By and large, these are private companies.

They're not necessarily government entities that are being formed to go after those market opportunities. In the last – sort of in the recent past, we have now seen the emergence of organizations that, in some cases, are primarily targeting work coming out of the Chinese PMI.

And those are the customers that are driving some of the X demand that we are seeing. The oncology and NIPT customers are more likely to be buying the NextSeq from us, for example. And so we're seeing sort of this new segment emerge around customers that are targeting projects from the Chinese PMI..

Great. And just as we think about product development and tiering and the like, over the last number of years, the demand from the client base has kind of been obvious and you've obviously segmented the business quite sensibly and you have instruments in most ends of the market.

When you have discussions now on sort of future launches and/or areas for expansion or for areas where the customer demands product development, how have those conversations changed? And is it more on the application side? Is it more still on footprint? Is it on speed? Is it on cost? Where do you still get the biggest push in terms of what the customer base, where they really want you to take the technology from a roadmap perspective?.

That question is a great one, because right now we are seeing, as our business sort of expands, we're getting requests across the board.

There are still segments of the market that want to continue to see us drive the costs of sequencing down, drive the throughput up, shortened turnaround time, and so there is still an elasticity in the market that customers want us to enable them to access.

And so, clearly, a part of our portfolio is always going to be around delivering the world's best sequencing offering. We're getting, though, requests from customers that are saying that that's not the whole problem for them.

Increasingly, we're seeing some of our clinical customers ask us to focus on helping them, for example, on the clinical reporting side.

And so, as we look to how we want to evolve our portfolio over time, there are segments of the market where we're looking to provide the complete sort of sample-to-answer solution all the way down to potentially a validated clinical report. And so, for some segments, that's going to be the key enabling component of that segment.

And then in a bunch of cases, the enablers are things that we can influence indirectly.

And so working with the regulators, working with the payers on reimbursement, driving the data needed to demonstrate analytical clinical validity and clinical utility, so those are things that are enabling to the market that are not maybe directly driving our business today but an area where we feel we can be productively involved to help catalyze certain markets.

So, as our business has gotten bigger, there are a number of strategic levers that we're focused on to drive the adoption of genomics in the various markets we're in..

Great. Thank you so much..

Thank you. And our next question comes from the line of Amanda Murphy with William Blair. Your line is open. Please go ahead..

Hi. Good afternoon. I just had a couple of questions on the HiSeq X franchise, specifically longer-term. So, first, you made the comment around the 20 to 30 orders, which has been pretty consistent.

But if you take the puts and takes between sort of the limitations on whole genome sequencing versus obviously some positive funding dynamics there, do you think that there is enough demand to carry that cadence of orders through or just beyond 2016?.

Yeah. If we look at what's driving that business, with all the puts and takes but some of the dynamics like the Chinese PMI that we said really drove a significant chunk of the X demand. We expect, net-net, those dynamics to be positive exiting 2016 and to continue to sort of drive that level of orders, as we exit the year..

Okay. Got it. And then just a same kind of question on the consumables side. So, obviously, you talked quite a bit about the utilization and you have the installed base sort of aging issue.

But thinking about, again, sort of in the next 12 months to 24 months and the cadence of per box usage increases excluding some of the inventory dynamics you talked about and whatnot, is there anything that you can point to that might accelerate that line, thinking again about funding or anything else on the table there?.

As we look forward, I think that we feel that the pull-throughs will remain in the ranges that we talked about. As we look at the instruments we've placed, so we have new instruments that are coming online and those obviously will take a little while to ramp-up depending on which instrument you're buying.

But we're also seeing instruments that are moving towards the high-end of the utilization across our portfolio. And so, I expect that range to be fairly stable going forward.

I guess the only caveat that we talked about is that there is some volatility associated with the X pull-through depending on how a single order coming in a quarter can move that number one way or another. And so we expanded the range a little bit, but other than that we expect those ranges to stay stable..

Amanda, you specifically expressed a couple of year timeframe. I think if you think out beyond that, the only potential dynamic that could move in the positive direction would be population sequencing projects layering on top of each other. But that's not in the timeframe you specified..

Okay. Got it. Thanks..

Thank you. And our next question comes from the line of Bill Quirk with Piper Jaffray. Your line is open. Please go ahead..

Great. Thanks. Good afternoon, everybody..

Good afternoon, Bill..

First question is, just on the raised expectations for the Asia-Pacific region, this is certainly consistent with our diligence around China. I was hoping maybe you could spend a few minutes addressing Japan. It's obviously been a bit of a challenging geography here for several quarters..

Yeah. During the quarter, we actually did see the revenue from Japan increase slightly compared to the prior year, but we still think that – I'll start with saying Japan is not a big part of our revenue today. I think it's about 3% of our revenue today. So it's a small part of our revenue and it's unlikely to really move the needle one way or another.

We see a gradual strengthening of the environment there but it is gradual..

Understood. And then just looking at the segment results here, and I guess, specifically a comment at the end of your prepared remarks about double-digit array guidance, but we kept the overall revenue guidance the same. And so, how should we think about the offset here? It's obviously in sequencing.

Is it specific to Europe? A little color would be great. Thank you..

Yeah, Bill, so, obviously, we've don't guide to specific levels generally – specific segments generally, but we feel that given the trend that we're seeing now in arrays, we would give that perspective to you, that double-digit. We've been seeing that start to form. We mentioned it last quarter.

We said it was an emerging bright spot, but we needed to see a little bit more of a trend. With the orders that we saw last quarter and the quarter before and the products this year, we had already been contemplating this potential array growth. We just didn't want to provide a number until we felt more comfortable.

So it doesn't really change our guidance. And it doesn't offset necessarily on the sequencing side, it's been contemplated for... (51:31)..

Got it. Okay. I appreciate the color there. Thanks, Marc..

Okay..

Thank you. And our next question comes from the line of Isaac Ro with Goldman Sachs. Your line is open. Please go ahead..

Good afternoon, guys. Thank you. I want to ask a first question on the instrument business and then a follow-up on GRAIL.

On the instrument business, just putting together some of the comments here on the call, and I was looking back for history, a little bit of context, you've had a couple of huge product cycles the last five years or six years with the HiSeq family.

And just wondering how you think about the high-end of the instrument market being a growth driver if we take a long-term view.

Is it really about driving new innovation at the high-end or should we assume that as we think about where this market is going from a clinical standpoint that it's going to be really more about driving lower-end instruments, maybe a lower ASP that reaches out to the clinical market.

Just trying to think about how you look at driving growth in sequencing instruments?.

Sure. I think there are a few parts to how we think growth is going to come out of the instrument market. One is – and we've seen this before – one of the big drivers of growth there is the upgrade cycle. And if you look at our entire portfolio, over time, each of those instruments needs to be upgraded.

And whenever we can drive a big upgrade cycle, that contributes to growth. Now, in previous years where we've had one instrument, you would have a single big upgrade cycle that would drive a lot of growth.

Clearly now, we have a much bigger portfolio, and so while any one upgrade cycle will drive growth, that will play out over multiple instruments rather than a single big upgrade cycle. There is, we believe, opportunity – further opportunity in placing clinical boxes.

And so, you'll see us continue to look to get clearance in the various markets around the world. We are very optimistic on the clinical market being a driver of purchases of – new purchase of our instruments. And then, in the longer-term, we do expect to see the low-end of the market to drive instrument growth.

And so we talked about Firefly and the instrument we are launching at the end of next year. We believe that there are a number of segments that will be new to sequencing that will be opened up by Firefly.

So there are tens of thousands of labs, for example, around the world that the vast, vast majority of which don't use sequencing at all, and they are capital constrained and, in some cases, they are sample constrained so that a purchase of even a MiniSeq or a MiSeq really doesn't make sense for them today.

But Firefly would be perfect for that market. So we see a number of markets that we think a low-end sequencer would be very attractive for. And that would all be incremental instrument revenue..

It's helpful. And just to follow up on GRAIL, just looking for any update you could give us in terms of key milestones for that program over the balance of 2016 or next 12 months? Just sort of looking at the next 6 month and 12 month timeframe in terms of what we should expect in terms of progress from that program? Thank you..

Yeah. The GRAIL team is making really good progress. They continue to build out their team. So, as you remember, a nucleus of people moved over from Illumina to GRAIL. And that team has done a really good job adding really world-class talent in addition to that team.

They've made really good progress and are continuing to make good progress in developing the assay and are on track to have that done by the end of this year. And the team is hard at work on designing their clinical trial. We don't have any new updates to provide right now and we'll make sure to get it out as we do..

Got it. Thanks very much..

Thank you. And our next question comes from the line of Jack Meehan with Barclays. Your line is open. Please go ahead..

Hi. Good afternoon. Thanks. I wanted to start and ask about NIPT.

Could you walk us through some of the moving parts with the insourcing from customers and how that – plus the IP pool impacted both revenue and maybe gross margin in the quarter?.

Yeah. So the way that market is playing out is, in a number of cases what we do is when we signup a new customer, we allow them to market their services even before they have their lab set up and we will process the samples for them in our CLIA lab. And for that, we charge them a test send-out fee and that drives test send-out revenue for us.

That's good revenue but it really sort of on-ramp for them to have their own lab. And so, while we are processing their samples, a lot of these customers are actively building out their own lab and, over time, the intent is to move the samples from being processed by us to being run by the customers themselves in their own labs.

To do that, they obviously have to buy instruments as well as consumables from us and so that's what you see playing out in that market. In addition to instrument purchases and consumable purchases, they pay us a test fee associated with getting access to the intellectual property we have around NIPT.

And so the way you see that market working then is, we'll signup a customer, you'll see a test send-out, revenue stream show up to us and, over time, that gets replaced by instrument consumable and test fees..

And the way, Jack, that plays out in gross margin is, it generally only have an impact when we have underutilization in our services lab, which we did see a little bit of a headwind for that this quarter, as customers migrated the test to in-house and we have overcapacity for a while which takes us a little while to fill and, therefore, under-observation of overhead.

And that's where you see a little gross margin headwind but it's not that significant this quarter..

Okay. Understood. That's helpful. And then just one more, Francis, I appreciate some of the commentary you made around the cost initiatives this quarter. We can back into what core Illumina is doing on both SG&A and R&D.

I'm just curious, could you give us a little bit more granularity on how both the GRAIL, Helix portion you expect that to ramp through year-end and then what a sustainable rate looks like for that and then maybe even what the implied core Illumina looks like? That would be very helpful. Thank you..

Yeah. I'll happily take that one as well. I mean, they're both growing businesses. So they're both going to ramp during the rest of this year. That's partially offset by a higher non-controlling interest charge on GRAIL because of the recent restructuring of the shares.

So no change there in terms of our forward-looking perspective on the dilution from Helix and GRAIL together.

Trying to think, was there another part of the question?.

There was a part for this year and on a go-forward basis..

Yeah. And so, on a going forward basis, we haven't provided any official guidance on that yet. Directionally, we've talked about a couple of options and we'll come back when we've completed our budgeting with more detail on that.

The GRAIL and Helix are both tied into the overall Illumina budgeting cycle, and so we're starting to get into the thick of that right now..

Okay. Thanks, guys..

Thank you. And our next question comes from the line of Bryan Brokmeier with Cantor Fitzgerald. Your line is open. Please go ahead..

Hi. Thanks for taking the questions. You said that you're expecting strong HiSeq orders in the fourth quarter and you cited that the pipeline is why you believe that you can achieve that.

Where in the sales cycle do you see a lot of opportunities that give you the confidence in your pipeline? In other words, have customers made the decision to purchase HiSeqs but are waiting for funding applications to be accepted or where are customers or, I guess, are they dragging their feet on committing to making an order?.

Yeah. So a little bit of all of the above. Now, typically, the people buying HiSeqs are not new to Illumina customers. And so, typically, we've been working with a lot of these customers already. We understand sort of their business and the demands on their business.

And that's what allows us to project when we think they'll be needing instruments and work with them on when they will need instruments. So, in some cases, it's grant applications that are in. In some cases, it's people that are looking at their budgets for the year and using their end-of-year budgets to buy HiSeqs.

In some cases, it's they're just ramping up their business, and that's when they'll need the new instruments. But in the majority of cases, these are customers that are already customers of ours and that we have been working with for a while..

Okay. And on a similar topic, you've removed, I think, 270 HiSeqs from your installed base over the last year and a half.

Do you expect the rate of instruments that are decommissioned to slow down later this year when you're expecting that pickup in the HiSeq placements?.

I mean it doesn't – actually it doesn't really matter as long as they are replacing those older HiSeqs with newer instruments. And so, as Francis mentioned earlier, with respect to the utilization analysis we do, that we've seen an uptick in the available capacity and so that net of those reductions in older instruments.

So even with that, we're seeing the capacity going up as customers buy the new higher throughput instruments. So it's probably not fruitful to try and predict where that's going because – that's my point, (1:01:12) it doesn't matter as long as it's replacement, which is generally is..

Okay. Thanks a lot..

Thank you. And I am showing no further questions at this time. And I would like to turn the conference back over to Ms. Rebecca Chambers for any closing remarks..

Thank you, operator. 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..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a great day..