ILLUMINA, INC. quarterly report, Q3 FY2018

Illumina, Inc. — Q3 2018 Form 10-Q Summary

Business context and reporting period

Illumina is a global provider of DNA sequencing and array-based technologies serving research, clinical, pharmaceutical, biotechnology, agricultural, and other applied markets. The filing covers the 13-week quarter ended September 30, 2018, and the 39-week period ended September 30, 2018, compared with the corresponding periods ended October 1, 2017.

The company reports Core Illumina and consolidated variable-interest entities, principally Helix. GRAIL was deconsolidated in February 2017 and is no longer consolidated.

Financial performance and key metrics

Metric	Q3 2018	Q3 2017	YTD 2018	YTD 2017
Total revenue	$853 million	$714 million	$2.466 billion	$1.975 billion
Gross profit	$597 million	$482 million	$1.710 billion	$1.284 billion
Gross margin	70.0%	67.5%	69.4%	65.0%
Income from operations	$241 million	$181 million	$686 million	$376 million
Operating margin	28.2%	25.3%	27.8%	19.0%
Net income attributable to Illumina stockholders	$199 million	$163 million	$616 million	$658 million
Diluted EPS	$1.33	$1.11	$4.15	$4.45

Q3 revenue increased 20%, led by product revenue growth of 19% and service and other revenue growth of 21%.
YTD revenue increased 25%, primarily due to sequencing consumables, services, and instruments. YTD consumables revenue rose 29% to $1.595 billion, while service and other revenue rose 32% to $455 million.
Sequencing revenue represented the majority of reported revenue. Q3 sequencing revenue was $719 million versus $593 million in the prior-year quarter.
YTD gross margin improved by 4.4 percentage points, primarily because consumables represented a larger portion of revenue and because prior-year results included an acquired-intangible impairment and inventory reserves related to product transitions.
YTD operating expenses increased 13% to $1.024 billion, including higher research and development, headcount, facilities, and performance-based compensation costs.
YTD net income attributable to Illumina stockholders declined 6% because the prior-year period included a $453 million pretax gain from GRAIL deconsolidation.
Q3 and YTD effective tax rates were 19.0% and 14.6%, respectively, compared with 12.9% and 24.3% in the comparable 2017 periods.

Cash flow, liquidity, debt, and capital resources

Cash and cash equivalents were $1.346 billion at September 30, 2018, compared with $1.225 billion at December 31, 2017.
Short-term investments increased to $2.043 billion from $920 million. Cash, cash equivalents, and short-term investments totaled approximately $3.4 billion, including approximately $817 million held by foreign subsidiaries.
YTD operating cash flow was $842 million, compared with $581 million in 2017.
YTD investing cash flow was negative $1.465 billion, reflecting $2.352 billion of purchases of available-for-sale securities, $100 million of acquisition spending, and $231 million of capital expenditures.
YTD financing cash flow was positive $748 million, primarily due to net proceeds of $735 million from the issuance of 0% convertible senior notes due 2023.
Total debt had a net carrying amount of $1.710 billion for convertible-note liabilities, plus $254 million of financing-lease obligations and other debt. The 2019 and 2021 notes, with aggregate principal of $1.150 billion, were classified as current because they became convertible within twelve months of the balance-sheet date.
The 2019 and 2021 notes became convertible at the holders’ option beginning October 1, 2018. Management expects combination settlement, involving cash repayment of principal and potential share delivery for conversion value above principal.
Illumina repurchased $103 million of common stock concurrently with the 2023 note issuance. Approximately $147 million remained available under the repurchase authorization at September 30, 2018.
Management stated that existing cash, investments, and expected operating cash flow should fund near-term operating and capital needs for at least the next twelve months.

Material changes versus the prior comparable period

Revenue growth accelerated across consumables, instruments, and services, with sequencing consumables benefiting from growth in the installed instrument base and increased NovaSeq shipments.
Profitability improved materially through higher gross and operating margins, despite increased investment in research and development and selling, general and administrative activities.
Operating cash flow increased by $261 million year over year, while investing cash flow shifted from positive $101 million to negative $1.465 billion because of substantially higher purchases of short-term investments and the Edico Genome acquisition.
Debt increased following the issuance of $750 million principal amount of 2023 convertible notes. The 2019 and 2021 notes were reclassified to current liabilities and became convertible after quarter-end.
Illumina acquired Edico Genome on May 14, 2018, for $100 million net of cash acquired, recording $56 million of goodwill and $46 million of identifiable intangible assets.
Helix received $100 million of additional Illumina investment during the first nine months of 2018. Its redeemable noncontrolling interest was $218 million at quarter-end.
Comparability of year-to-date earnings is significantly affected by the $453 million GRAIL deconsolidation gain recorded in 2017.

Guidance, outlook, commentary, risks, and unusual items

Management expected 2018 revenue to continue increasing versus 2017 and stated that operating expenses would continue to grow in absolute dollars.
Future margins will depend on pricing, product and sales mix, new-product transitions, inventory reserves, royalties, manufacturing scale, and product-support obligations.
Management expects future effective tax rates to trend below the 21% U.S. federal statutory rate because of earnings in lower-tax jurisdictions, although tax estimates remain subject to U.S. Tax Reform interpretation and additional changes.
The company recorded an $11 million discrete tax expense in Q3 related to updating prior estimates for U.S. Tax Reform. A potential additional tax detriment of less than $30 million was discussed in connection with an uncertain stock-compensation cost-sharing matter.
Illumina identified risks involving new-product development and manufacturing, supply-chain dependence, customer order timing and mix, competition, commercialization, acquisitions, global economic conditions, taxation, and litigation.
Pending legal proceedings include intellectual-property, employment, and contractual matters. The filing states that ultimate outcomes and reasonably possible losses cannot currently be predicted meaningfully where no liability has been accrued.
The company expects adoption of the new lease standard in the first quarter of 2019 to materially increase reported assets and liabilities, primarily through recognition of operating lease right-of-use assets and lease liabilities.
The filing reports no off-balance-sheet arrangements and no material changes to previously disclosed risk factors or market risks.

Important facts for investors to verify

Whether sequencing consumables growth and NovaSeq placements continue to support revenue and margin expansion.
The conversion, refinancing, or cash-settlement implications of the 2019 and 2021 convertible notes, including potential share dilution.
The sustainability of the 2018 tax rate, including the effects of U.S. Tax Reform, GILTI, Helix-related tax benefits, and the unresolved tax matter.
Capital spending, facility expansion, acquisition activity, and the use of the company’s substantial short-term investment portfolio.
Helix’s operating losses, additional funding requirements, and the potential cash redemption of noncontrolling interests after January 1, 2021.
The effect of 2019 lease-accounting adoption on reported assets, liabilities, leverage, and key performance ratios.
Potential legal, intellectual-property, supply-chain, competitive, and product-transition exposures that could affect future results.