Illumina, Inc. — Q3 2017 Form 10-Q Summary
Business context and reporting period
Illumina develops sequencing- and array-based technologies, instruments, consumables, and genomic analysis services for research, clinical, applied, pharmaceutical, biotechnology, agricultural, diagnostic, and consumer genomics markets. The filing covers the 13-week quarter and 39-week year-to-date period ended October 1, 2017, compared with periods ended October 2, 2016.
The company reports Core Illumina and consolidated variable-interest entities. GRAIL was deconsolidated effective February 28, 2017; Helix remained consolidated.
Financial performance and position
| Metric | Q3 2017 | Q3 2016 | YTD 2017 | YTD 2016 |
|---|---|---|---|---|
| Total revenue | $714 million | $607 million | $1,975 million | $1,779 million |
| Gross profit | $482 million | $426 million | $1,284 million | $1,247 million |
| Gross margin | 67.5% | 70.2% | 65.0% | 70.1% |
| Operating income | $181 million | $161 million | $376 million | $444 million |
| Operating margin | 25.3% | 26.5% | 19.0% | 25.0% |
| Net income attributable to Illumina | $163 million | $129 million | $658 million | $339 million |
| Diluted EPS | $1.11 | $0.87 | $4.45 | $2.27 |
Q3 revenue increased 18%, led by consumables revenue of $451 million, instrument revenue of $140 million, and service and other revenue of $118 million. Year-to-date revenue increased 11%; consumables grew 9%, instruments 6%, and service and other revenue 26%.
Year-to-date net income benefited substantially from a $453 million pretax gain on GRAIL deconsolidation, including a $159 million remeasurement gain on the retained investment. The gain contributed to the increase in net income despite lower operating income. The year-to-date effective tax rate was 24.3%, including a $150 million discrete tax impact associated with the GRAIL gain; Q3 effective tax rate was 12.9%.
Cash and cash equivalents were $1.354 billion at October 1, 2017, compared with $735 million at January 1, 2017. Short-term investments were $687 million, resulting in approximately $2.0 billion of cash, cash equivalents, and short-term investments. Approximately $953 million of this total was held by foreign subsidiaries.
Year-to-date operating cash flow was $581 million, compared with $517 million in the prior-year period. Investing activities provided $101 million, reflecting securities activity and $278 million of proceeds from the GRAIL share sale, partly offset by $234 million of capital expenditures. Financing activities used $67 million, including $176 million of share repurchases.
Total debt was approximately $1.182 billion, consisting primarily of $633 million of 2019 convertible notes and $517 million of 2021 convertible notes. Neither note series was convertible at October 1, 2017. Liquidity included $2 million of current debt and $1.180 billion of long-term debt.
Material changes versus the prior comparable period
- Revenue growth accelerated, particularly in consumables, NovaSeq-related instruments, genotyping services, and instrument service contracts.
- Gross margin declined to 65.0% year to date from 70.1%, driven by an $18 million acquired-intangible impairment, lower-margin array services mix, inventory reserves related to product transitions, and lower initial NovaSeq instrument margins.
- Operating expenses increased 13% year to date to $908 million. R&D increased 9% and SG&A increased 14%, primarily due to higher headcount, facilities investment, and Helix-related marketing and compensation costs.
- Core Illumina year-to-date operating income declined to $447 million from $502 million, while consolidated VIE operating losses increased to $72 million from $50 million.
- GRAIL’s ownership declined from 52% to approximately 17% after its Series B financing and share repurchase from Illumina. Illumina received $278 million and retained a GRAIL investment recorded at $185 million in other assets.
- Property and equipment, net increased to $862 million from $713 million, reflecting facility and equipment investment. Financing lease obligations increased substantially following completion of a build-to-suit property.
- The company adopted ASU 2016-09, recording a $45 million cumulative adjustment to retained earnings and classifying excess tax benefits from share compensation in operating cash flow.
Guidance, outlook, commentary, and risks
Management expected revenue to continue increasing in 2017 and stated that current cash, investments, and operating cash flow should fund near-term operating and capital needs for at least the next 12 months. Management expects future effective tax rates to trend below the U.S. federal statutory rate because a portion of earnings is generated in lower-tax jurisdictions.
Management expects sequencing consumables demand to benefit from growth in the installed instrument base and continued adoption of next-generation sequencing. Arrays remain important in applied markets, although some research customers may migrate array studies to sequencing. Management also expects R&D and SG&A expenses to continue growing.
Key risks include commercialization and manufacturing execution for new instruments and consumables, competition and technological changes, pricing and product mix pressure, inventory obsolescence, integration of acquired technologies, international taxation, foreign exchange exposure, and unpredictable litigation outcomes. The filing states that no material changes occurred to the risk factors in the prior Form 10-K.
Helix investors may require redemption of their interests after January 1, 2021, subject to specified conditions; the recorded redeemable noncontrolling interest was $124 million. The company also had $86 million remaining under a venture capital fund commitment and approximately $175 million available under its share-repurchase authorization at quarter end.
The company had no off-balance-sheet arrangements and reported effective disclosure controls. It is implementing revenue-recognition standard ASU 2014-09 for adoption in the first quarter of 2018 using the modified retrospective method; the expected opening retained-earnings adjustment was not expected to be material.
Important facts for investors to verify
- Separate recurring operating performance from the $453 million GRAIL deconsolidation gain and related $150 million tax impact.
- Assess whether NovaSeq adoption and consumables growth can offset lower initial instrument margins and the year-to-date gross-margin decline.
- Review the sustainability of higher R&D and SG&A spending relative to revenue growth and operating leverage.
- Verify GRAIL’s retained investment valuation, ownership and voting interests, and the accounting treatment of future changes in value.
- Monitor liquidity, capital expenditures, convertible-note maturities, Helix redemption exposure, and remaining investment commitments.
- Evaluate litigation, product-transition inventory reserves, intangible-asset impairment risk, and the potential effects of new accounting standards.