Illumina, Inc. — Q1 2017 Form 10-Q Summary
Business Context and Reporting Period
Illumina develops sequencing- and array-based genomic technologies, including instruments, consumables, software, and related services for research, clinical, applied, pharmaceutical, biotechnology, agricultural, and consumer genomics markets. The report covers the 13 weeks ended April 2, 2017, compared with the 13 weeks ended April 3, 2016.
Effective February 28, 2017, Illumina deconsolidated GRAIL after GRAIL’s Series B financing reduced Illumina’s ownership from 52% to approximately 19% and voting interest to 13%.
Financial and Operating Metrics
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Total revenue | $598 million | $572 million | Up 5% |
| Product revenue | $491 million | $483 million | Up 2% |
| Service and other revenue | $107 million | $89 million | Up 20% |
| Gross profit | $368 million | $397 million | Down 7% |
| Gross margin | 61.5% | 69.4% | Down 7.9 percentage points |
| Income from operations | $52 million | $121 million | Down 57% |
| Operating margin | 8.7% | 21.2% | Down 12.5 percentage points |
| Net income attributable to Illumina | $367 million | $90 million | Up 308% |
| Diluted EPS | $2.48 | $0.60 | Up 313% |
| Net cash from operating activities | $168 million | $99 million | Up $69 million |
Reported net income and EPS were significantly affected by a $453 million pretax gain from the deconsolidation of GRAIL. Excluding the unusual gain, operating performance was weaker year over year.
- Consumables revenue increased 7% to $387 million, supported by growth in the sequencing installed base.
- Instrument revenue declined 15% to $100 million, primarily due to lower HiSeq shipments, partially offset by initial NovaSeq shipments.
- Research and development expense increased 17% to $145 million, and selling, general and administrative expense increased 9% to $163 million.
- Legal contingency expense increased to $8 million from $2 million, primarily related to patent litigation.
- The effective tax rate was 30.8%, compared with 24.5% in the prior-year quarter.
Balance Sheet, Debt, Liquidity, and Cash Flow
- Cash and cash equivalents were $981 million at April 2, 2017, compared with $735 million at January 1, 2017.
- Short-term investments were $797 million, bringing cash, cash equivalents, and short-term investments to approximately $1.8 billion. Approximately $679 million was held by foreign subsidiaries.
- Total assets were $4.6 billion and total debt was approximately $1.1 billion, consisting primarily of $633 million of 0% convertible notes due 2019 and $517 million of 0.5% convertible notes due 2021.
- The convertible notes were not convertible as of April 2, 2017.
- Operating cash flow was $168 million. Investing cash flow was $163 million, including $278 million received from the GRAIL interest sale and $83 million of capital expenditures. Financing cash flow was negative $86 million, including $101 million of share repurchases.
- Management stated that existing cash, investments, and expected operating cash flow should fund near-term operating and capital needs for at least the next 12 months.
Material Changes Versus the Prior Comparable Period
- Revenue grew modestly, driven by consumables and services, while instrument revenue declined during the transition from HiSeq to NovaSeq.
- Gross margin contracted materially because of an $18 million acquired-intangible impairment, product-transition effects related to NovaSeq, higher array services revenue, and product mix.
- Operating income declined despite revenue growth because of lower gross profit and increased R&D, SG&A, and legal contingency expenses.
- Net income increased sharply because of the $453 million GRAIL deconsolidation gain, including a $159 million remeasurement gain on Illumina’s retained GRAIL interest.
- GRAIL raised more than $900 million in Series B financing, repurchased $278 million of Illumina’s interest, and became an equity-method or cost-method investment rather than a consolidated entity. Illumina recorded a $171 million GRAIL investment at April 2, 2017.
- Illumina completed its prior $250 million share repurchase authorization by repurchasing approximately 0.6 million shares for $101 million. On May 4, 2017, the board authorized an additional $250 million repurchase program.
- The company adopted ASU 2016-09, recording a $45 million cumulative adjustment to retained earnings and reflecting $8 million of excess tax benefits in the income tax provision.
Guidance, Outlook, Commentary, and Risks
- Management expects revenue to continue increasing in 2017, but the filing does not provide a specific numerical revenue or earnings forecast.
- Management expects R&D and SG&A expenses to continue growing.
- Future gross margins may be affected by pricing, sales and product mix, new-product launches, excess and obsolete inventory, royalties, manufacturing costs, and product-support obligations.
- Management expects the effective tax rate to trend below the U.S. federal statutory rate because some earnings are generated in lower-tax jurisdictions.
- Key risks include successful development and commercialization of new products, manufacturing execution, product transitions, competition, technology and market changes, acquisitions and integration, international tax exposure, foreign exchange, and intellectual-property litigation.
- Legal proceedings remain unresolved; the company states that it cannot reasonably predict the ultimate outcomes or potential losses for matters where no liability has been accrued. A $8 million legal contingency charge was recorded in Q1 2017.
- Illumina has a $14 million obligation to purchase additional GRAIL Series B shares and an $89 million remaining commitment to a venture capital investment fund.
- Certain Helix investors may require a cash redemption of their interests after January 1, 2021, subject to specified conditions; the recorded redeemable noncontrolling interest was $59 million.
- The filing states that there were no material changes to previously disclosed risk factors and no off-balance-sheet arrangements.
Important Facts for Investors to Verify
- Separate recurring operating results from the nonrecurring $453 million GRAIL deconsolidation gain when assessing earnings quality.
- Monitor NovaSeq adoption, HiSeq replacement trends, instrument revenue, consumables growth, and the resulting gross-margin trajectory.
- Review the effect of GRAIL’s deconsolidation on future revenue, expenses, cash flow, ownership accounting, and supply arrangements.
- Assess the maturity, conversion terms, and potential dilution associated with the $1.15 billion principal amount of convertible notes due in 2019 and 2021.
- Evaluate the sustainability of cash generation after capital expenditures, share repurchases, strategic investments, and GRAIL-related obligations.
- Review pending patent litigation, the legal contingency accrual, Helix redemption terms, and other contractual commitments.
- Confirm the eventual impact of revenue-recognition, financial-instrument, and lease accounting standards not yet adopted at the reporting date.