Illumina Q4 2023 Earnings Call Transcript

Presentation

[Operator]

Please stand by. Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2023 Illumina Earnings Conference Call. [Operator Instructions] 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.

[Salli Schwartz, Vice President, Investor Relations at Illumina]

Hello, everyone, and welcome to our earnings call for the fourth quarter and year-end 2023.

During the call today, we will review the financial results we released after the close of market and offer commentary on our commercial and regulatory activity, after which we will host a question-and-answer session. Our earnings release can be found in the Investor Relations section of our website at illumina.com. Participating for Illumina today will be Jacob Thaysen, Chief Executive Officer; and Joydeep Goswami, Chief Financial Officer and Chief Strategy and Corporate Development Officer. Jacob 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 transitional 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 Investors 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 Jacob.

[Jacob Thaysen, Chief Executive Officer at Illumina]

Thank you, Salli. Good afternoon, everyone.

As you know, I joined Illumina as CEO, a little over 4 months ago. In this time, part of my focus has been on meeting with customers to understand their priorities, hear their feedback and develop more collaborative relationships. Our customer thinks highly of Illumina and our solutions, and they want to work in strategic partnerships with us to move the whole NTS ecosystem forward. Now that we have announced that we will divest GRAIL, it has been easier for our customers to plan what their future looks like with Illumina. These meetings have been instructive and inspiring. During my recent trip to Europe, I was able to see firsthand how we are working with our customers, governments and the broader genomics community to accelerate whole genome sequencing adoption safely and more effectively and to understand rare diseases and cancers as a part of the standard of care.

I've also learned about Germany's model project that aims to fully integrate comprehensive genomic testing into the health care system there beginning in Q2 this year. Within the hallways of our headquarters and in several global offices, I have also been connecting with our talented employees who are committed to driving innovation and continuing to build out the genomics ecosystem. I've also had an opportunity to engage with many of you at recent investor conferences. These conversations are informing my leadership agenda, and importantly, having reinforced my confidence in Illumina's core business.

2023 was a dynamic year for Illumina. NovaSeq X has been the most successful high throughput product launch in our history. We ended the year with 352 NovaSeq X shipments above the 330 to 340 we expected, amid a challenging macroeconomic backdrop that we saw many of our customers remaining constrained in their purchasing decisions. In the fourth quarter, we delivered higher-than-expected consolidated revenue of approximately $1.12 billion. Americas revenue, which is more than half of our business was flat year-on-year. Europe revenue was up 17% year-on-year on a relatively easy prior year comparable. EMEA revenue declined 1%, although that included a 10 percentage point impact from sanctions in Russia. Greater China revenue was down 13% year-on-year reflecting continued geopolitical challenges and local competition in mid throughput. As I've noted before, China and our customers there are important to Illumina. We've already taken certain pricing and other strategic actions that are beginning to yield results. We will share more specifics on our progress there over time.

Globally, we expect our customers will remain cautious. And for now, we continue to expect 2024 results to look very similar to 2023. While some macro headlines are encouraging, we haven't yet seen that translate to increased investment in our industry and therefore, have not reflected it in our guidance. Joydeep will take you through more details in our guidance in a few minutes. While we cannot control the external environment, the management team and I remain committed to accelerating value creations across the enterprise. As you are aware, I have laid out 3 key priorities that I believe will position Illumina for accelerated growth and profitability as market conditions improve.

My first priority, driving our top line is centered on continuing to grow our installed base and helping customers accelerate utilization of these instruments in new and existing applications. I discussed earlier how pleased we are with the first year of NovaSeq X shipments. But high throughput more broadly, across the NovaSeq X and NovaSeq X 6000, we placed more than 400 instruments in 2023. In 2024, we will support this growing installed base as customers launch large projects and more sequencing-intensive applications like multiomics, liquid biopsy and minimal residual disease, or MRD. We anticipate ongoing high throughput instrument orders throughout 2024, primarily coming from further conversion of NovaSeq X 6,000 customers to the X from customer fleet expansions and long term from new to high-throughput customers.

With that said, given the significant number of placements in 2023, we believe we will ultimately shift fewer high-throughput instruments in 2024. As you're aware, XLEAP-SBS chemistry has been the engine for our X platform, delivering significant improvements in quality, turnaround time and cost. This quarter, we will be making XLEAP available to our mid-throughput customers under existing NextSeq 1K/2K instruments without having to upgrade their instruments. This offering will further strengthen our leadership position around the world and drive progress in markets such as single cell, spatial and proteomics.

As we grow installed base, we will remain focused on supporting our customers as they launch new projects. This will build momentum for consumables demand this year and going forward. Already, our efforts to develop this demand is paying off. In Q4, we saw higher-than-expected growth in X consumable sales following the late October launch of our much anticipated 25B rating kit. More recently, in January, we launched a 1.5B kit, which together with the 25B and the 10B flow cells allows us to offer a full suite of products to the NovaSeq X customers. While we will continue to see customers reduce their inventories of NovaSeq X 6000 consumables as they transition to the X, building pull-through on the NovaSeq X will drive our overall high throughput consumables growth this year.

Turning to my second priority. I'm focused on delivering operational excellence by applying greater rigor throughout our P&L, while sustaining innovation and growth. We have launched a multiyear effort focusing on improving our margins through greater productivity and pursuing additional areas for cost savings. In January, we took an additional action to further optimize our global workforce. Over the past year, we have made cumulative role reductions totaling approximately 12%. Our most recent actions included an adjustment that we aligned with our late 2023 portfolio optimization efforts. You'll see us continue to take steps to not only manage our near-term cost but also to build our agility to deliver more sustained growth and margins over time. Illumina is taking a highly disciplined approach to support our customers, employees and partners and to deliver shareholder returns throughout a range of macroeconomic environments.

Moving to my third priority, which is working to resolve GRAIL as quick as possible. Since joining Illumina, I've made it an imperative to move with speed on GRAIL. In December, we announced that we would divest GRAIL with a goal of finalizing the terms of the transaction by the end of the second quarter this year. We'll continue to pursue para path. The divestiture will be executed through a third-party sale or capital markets transaction, consistent with the European Commission's divestiture order. To date, we have been able to make swift progress. GRAIL Form 10 has been confidentially filed with the SEC advisers are actively moving the process forward on both sales and capital market path. The special committee of the Board that we established in Q3 continues to help ensure this process move forward efficiently. I'm encouraged by the momentum we've entered 2024 with, and I'm committed to seeing our initiative through.

For now, I will ask Joydeep to share more detail on our results for 2023 and our outlook for 2024.

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Thank you, Jacob.

I'll start by reviewing our consolidated financial results, followed by segment results for core Illumina and GRAIL and then conclude with my remarks on our current outlook for 2024. I'll be discussing non-GAAP results, which includes 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 the supplementary data available on our website.

In the fourth quarter, consolidated revenue of $1.12 billion was up 4% year-over-year, both on a reported and constant currency basis. Consolidated revenue was flat from the third quarter of 2023. Non-GAAP net income was $22 million or $0.14 per diluted share, which included dilution from GRAIL's non-GAAP operating loss of $152 million for the quarter. Non-GAAP EPS exceeded our expectations, driven by higher revenue and gross margin and lower operating expense for the quarter.

Our non-GAAP tax rate was 55.4% for the quarter and 41.8% for full year 2023 compared to 29.3% in Q4 2022 and 26% for full year 2022. Although both periods reflect the impact of R&D capitalization requirements, the impact to our effective tax rate in 2023 was more significant due to our lower earnings. In addition, our non-GAAP tax rate for both years include a meaningful impact from the consolidation of GRAIL's losses. Absent the impact of GRAIL, our full year 2023 core tax rate was in the mid-20s. Our non-GAAP weighted average diluted share count for the quarter was approximately $159 million.

Moving to segment results. Core Illumina fourth quarter revenue of $1.1 billion was up 3% year-over-year on both a reported and constant currency basis, and included an anticipated reduction of approximately 5 percentage points from 2 primary categories: one, the decrease in COVID surveillance and the effect of sanctions in Russia that together represented approximately 3 percentage points and two, the year-over-year reduction in China revenue that represented approximately 2 percentage points. Despite these impacts, core Illumina revenue exceeded expectations due to stronger-than-projected NovaSeq X placements an uptake in X consumables with strong early demand for the 25B flow cell that launched in Q4.

Core Illumina sequencing consumables revenue of $687 million was flat year-over-year. Stronger-than-expected NovaSeq X consumables purchases were largely offset by the anticipated reduction in NovaSeq 6000 consumables and the impact of pricing transitions as customers continue to adopt the NovaSeq X. Total sequencing consumables revenue was also impacted by COVID, Russia and China factors that I previously noted as well as the continued impact of macroeconomic conditions on customers' purchasing behavior. COVID surveillance contributed approximately $4 million in total revenue in Q4 2023 compared to $20 million in Q4 2022.

Turning to sequencing activity. Total activity on our connected high and mid-throughput instruments grew 46% year-over-year in the quarter following the 29% year-over-year growth we reported in Q3. Sequentially, Q4 sequencing activity grew 13% from Q3. 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 $161 million grew 10% year-over-year in Q4, driven primarily by NovaSeq X, which more than offset the decline in NovaSeq 6000 shipments. Growth in high-throughput instruments was partially offset by the expected decline in mid- and low-throughput shipments due to capital purchase and cash flow constraints that continue to impact our customers' purchasing behaviors as well as local competition in China.

For NovaSeq X, we exited Q4 with 390 orders since launch. Our shipments of 79 NovaSeq X instruments in Q4 brought our total installed base to 352 instruments. While we expect most of our NovaSeq 6000 customers to transition to the NovaSeq X over time, we are still very early in this transition. As of the end of 2023, our net installed base for NovaSeq 6000 was approximately 1,770 instruments, which reflects approximately 110 instruments that have been deactivated between 2017 and 2023. The majority of these were in 2023 due to customer transitions to NovaSeq X. We expect this to increase in 2024 as customers continue to ramp up utilization of NovaSeq X.

Additionally, going forward, we will be reporting our annual instrument installed base figures on a net basis, which accounts for instruments that have been decommissioned or inactivated since launch. The information included on this slide includes additional details to help you with your modeling. We will be posting this presentation to our Investor Relations website following our prepared remarks. Core Illumina sequencing service and other revenue of $152 million was up 16% year-over-year, driven primarily by an increase in revenue from strategic partnerships and higher instrument service contract revenue on a growing installed base.

Moving to the rest of core Illumina P&L. Core Illumina non-GAAP gross margin of 64.7% for the quarter decreased 260 basis points year-over-year, primarily driven by the mix of lower-margin strategic partnership revenue, lower instrument margins due to the NovaSeq X launch, which is typical with a new platform introduction and increased field services and installation costs partially offset by lower freight costs. Core Illumina non-GAAP operating expenses of $507 million were down $21 million year-over-year, primarily due to continued expense reduction initiatives and lower performance-based stock compensation expense year-over-year. As a result of these factors and higher revenue, core Illumina non-GAAP operating margin was 18.5% in Q4 2023 compared to 17.8% in Q4 2022.

Transitioning to financial results for GRAIL. GRAIL revenue of $30 million for the quarter grew 30% year-over-year, driven primarily by adoption of Galleri. GRAIL non-GAAP operating expenses totaled $167 million and increased $1 million year-over-year.

Moving to consolidated cash flow and balance sheet items for the quarter. Cash flow provided by operations was $224 million. Capital expenditures were $51 million and free cash flow was $173 million. We did not repurchase any common stock. We ended the quarter with approximately $1.05 billion in cash, cash equivalents and short-term investments.

Moving now to 2024 guidance. As Illumina continues to move as quickly as possible to resolve GRAIL, given the uncertainty around the specific timing and impact of the GRAIL divestment, the company is focusing its 2024 financial outlook on core alumina. Our guidance does not assume any impact for the potential divestment of GRAIL in 2024. Upon the completion of the divestment, we will provide non-GAAP EPS guidance for the full year 2024. As Jacob mentioned, our outlook assumes the current challenging macroeconomic environment persists in 2024 and tighter funding and budget pressures continue to impact our customers' purchasing decisions. We expect full year 2024 core revenue to be approximately flat from 2023, reflecting the following offsetting factors.

We expect core Illumina sequencing instrument revenue to decline in the high teens year-over-year driven primarily by a decrease in NovaSeq X instrument placements. The reduction reflects the expected transition in our adoption curve to early majority customers from early adopters and the lower backlog entering 2024 compared to 2023. We also expect capital and cash flow constraints to continue to impact purchasing behavior and moderate instrument placements in 2024. We expect core Illumina sequencing consumables revenue to grow in the low single digits year-over-year, driven primarily by modest growth in high throughput consumables, as increased NovaSeq X consumables purchases and sequencing volume outpaced the expected decline in NovaSeq 6000 consumables and the impact of pricing transitions.

Moving to annual pull-through. Going forward, we will be calculating and providing pull-through figures based on the instruments net installed base. As I mentioned previously, supplemental information is included in our earnings presentation to help with modeling, which will be posted to our Investor Relations website following our prepared remarks. Importantly, this does not change reported revenue in any way. We expect annual pull-through for NovaSeq 6000 of approximately $700,000 to $800,000 per system in 2024, as customers continue to transition sequencing volume to NovaSeq X. We expect annual pull-through for NextSeq 1K/2K in the range of $80,000 to $130,000 per system in 2024, which primarily reflects the impact of customers transitioning to X lead chemistry as it becomes available on NextSeq 1K/2K. We expect annual pull-through for MiSeq in the range of $30,000 to $40,000. We expect the remainder of our pull-through ranges to be in line with historical guidance.

We expect core Illumina total sequencing revenue to be approximately flat year-over-year. This includes intercompany sales to GRAIL of approximately $30 million, which are eliminated in consolidation. We expect core Illumina non-GAAP operating margin of approximately 20%. Our operating margin expectations reflect the benefit of our continued gross margin improvement and expense reduction initiatives offset by normalization of our performance-based compensation as well as the impact of inflation and market-based merit increases. For the first quarter of 2024, we expect core Illumina revenue in the range of $1.03 billion to $1.04 billion, reflecting a year-over-year decrease of 3.5% to 4.5%, driven predominantly by the following factors. We expect lower NovaSeq X instrument shipments year-over-year, given that we are entering 2024 with a more modest backlog compared to the significant pre-order book we entered 2023 following the launch of NovaSeq X.

We expect the increase in NovaSeq X consumables purchases year-over-year to be largely offset by the anticipated reduction in NovaSeq 6000 consumables and the impact of pricing transitions consistent with the trend we saw in Q4. We expect an increase in sequencing service and other revenue year-over-year driven by strategic partnership initiatives and higher instrument service contract revenue on a growing installed base. For the first quarter, we expect core Illumina non-GAAP operating margin of approximately 18%. Lastly, for the first quarter, we expect core Illumina non-GAAP net other expense of approximately $12 million with the year-over-year increase driven primarily by lower interest income on our lower cash balance following the repayment of our convertible notes in mid-2023.

I will now turn it back over to Jacob for his closing remarks. Thank you.

[Jacob Thaysen, Chief Executive Officer at Illumina]

Thanks, Joydeep.

Before we close and move to Q&A, I want to discuss what I believe success looks like, both this year and the years ahead. Illumina has the opportunity to truly drive the next-generation sequencing ecosystem forward. We will deepen our relationships with our customers, and seek out greater ways to collaborate and partner with them to drive greater adoption of NGS. Our goal is to make our customers heroes in their labs and to support them as they expand their work in genomics and multiomics.

In turn, this will help capitalize our market-leading innovation and continue to differentiate Illumina and maintain our industry-leading position across research and clinical markets. We will also continue to drive innovation that is focused on our customers' priorities. This includes evolving our sequencing platform and delivering greater sample-to-answer solutions. There is an opportunity to further integrate customers' workflow to build our share of wallet as we create greater value for our customers. Our comprehensive strategy work is well underway, and we will share more with you later this year. I'm excited to be part of Illumina's leadership team that is driving our unmatched core business forward. Thank you for joining.

I'll now invite the operator to open the line for Q&A.

Questions and Answers

[Operator]

Thank you. [Operator Instructions] And our first question will come from Doug Schenkel with Wolfe Research.

[Doug Schenkel, Analyst at Wolfe Research]

Hey, good afternoon, everybody, and thank you for taking the questions. I want to ask just about the 25B chip release and what you're seeing in the field entering the early part of the year. As you know, 25B reduces the cost per genome to about $200, but it also requires customers to have enough samples to run to fully use up the flow cells. So what are -- what have you seen in the first few months of availability? What's spending on X consumables? How did that trend relative to Q3? And are you seeing signs in the field that sample access is not a problem as you see folks move to the 25B? Thank you.

[Jacob Thaysen, Chief Executive Officer at Illumina]

Thanks, Doug. And that was a nice one question there. So let me start by saying that we've been very pleased with the pickup of the 25B since the launch in late November. In fact, it's kind of performed over our expectations and have been very well received by their customers. So we continue to expect that this will continue to really drive x performance, but also, of course, it's completely now unleashed the full performance of the instrument, and thereby, we also expect that the 25B, the availability of the 25B will have more customers to jump on to the X back and here. I think we are seeing customers being able to load it. Of course, many of them are still doing validation work, but we are seeing that they have a big enough projects to load the closeout.

[Doug Schenkel, Analyst at Wolfe Research]

Yes. And just maybe one quick add, right? About 40% of our X customers so far have adopted the 25B?

[Jacob Thaysen, Chief Executive Officer at Illumina]

Correct.

[Operator]

And our next question will come from Puneet Souda with Leerink Partners.

[Puneet Souda, Analyst at Leerink Partners]

Yes. Hi Jacob, Joydeep, thanks for taking the questions. So maybe just following up on that point. I mean sort of help us just understand how do you get to the low single-digit growth rate this year. There's obviously 25B, there's reductions that are happening in -- from just the X install, cost per database is lower, China continues to be challenging and then the market backdrop is challenging too. So just maybe talk to us a little bit about sort of how do you continue to have confidence in the sort of the low-single-digit sequencing consumable growth rate? And I would really appreciate if you could provide us some context around and details around GRAIL as well. What's the progress there? Any level of interest that you're finding? And what are you contemplating for spend on GRAIL this year? Thank you so much.

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

All right. Thanks for that, Puneet. And let me start by the latter part of this question about GRAIL, and then I'll have Joydeep chime in on our expectations here on consumables growth. But -- as I mentioned, we are very pleased with the announcement that we made here in December that we are now divesting GRAIL for sure. And I'm actually very pleased with the progress so far. We have our advisers really moving ahead and now in connection and in conversations with all the parties. We are continuing to run a dual track, of course, can be a capital markets initiative or it can be a transaction. And so we still expect to be on track with the time line we were previously talking about that we would have all the terms finalized by end of Q2. So we are -- at this point, we are not talking about -- since we are expecting to finish up with GRAIL this year, we're not having any guidance on the expenditure for GRAIL this year.

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes. And to address your question about the low-single digits, consumables growth, Puneet. So let me start by saying we were very encouraged by the uptake of the 25B and 10B flow cells that we saw in the fourth quarter. We're also very pleased to see the elasticity, the growth in underlying sequencing activity being driven by ex customers, right? So both of those are good. We saw that uptick on sequencing activity now for the second quarter in a row. So again, it's broad-based. It's both research and clinical customers. And it's quarter-on-quarter and year-on-year growth. So what's offsetting that expected growth in X consumables, as you rightly pointed out, is the expected price transition as customers move from the NovaSeq 6000 to the X. This is very similar to the price transition that you saw when you were moving from HiSeq to 6K. And then, of course, some of the expected again, reduction in 6K consumables as customers switch from one platform to the other. Right. So those -- that is the really big piece on the -- what's leading to the lower or the low-single-digit growth rate in consumables in 2024.

[Operator]

And our next question will come from Vijay Kumar with Evercore ISI.

[Vijay Kumar, Analyst at Evercore ISI]

Hey guys, thanks for taking my question, and I had a 2-part question on the GRAIL. I know it was a confidential S1. When will that be made public? And the reason I ask is, GRAIL's operating losses were $700 million last year. It's really hard to foresee a capital market transaction with those kind of spend levels. So I would be very curious to see what the S1 assumptions are on GRAIL? And on consumable pull-through $700,000 to $800,000 on NovaSeq 6000, Joydeep, is there like a cadence perhaps Q1 we're starting at the low end? And is the assumption we exit Q4 at the high end of that range?

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Yes. So let's start with the GRAIL question. And obviously, we'd like to provide as much information to all of you as possible. Right now, as you say, the filing is confidential. And I don't think it will be public available before very late in Q1 maybe dipping into Q2 here. So I think that's where we are at this. But as soon as it's available, we'll make sure you know. And then Vijay, I want to be sure, you're asking about NextSeq 6000 -- sorry, NovaSeq 6000 pull-through numbers and how they modulate through the year?

[Vijay Kumar, Analyst at Evercore ISI]

Correct, Joydeep. Is there an assumption we start at the low end and exit the year at the high end or above the high end of the range?

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

No, there isn't. I think, again, pull-through will reemphasize as a calculated number. So it's more of the total amount of consumables sold in any quarter divided by the number of now the active installed base in the quarter, right? So -- and we don't have an assumption in terms of quarterly spread on that.

[Operator]

And our next question will come from Dan Arias with Stifel.

[Dan Arias, Analyst at Stifel Nicolaus]

Hi, thanks for the questions. Jacob or Joydeep, on the 6,000 to X transition and just sort of thinking about the clinical side of things. A big part of that bucket are these commercial labs that are watching their own margins pretty tightly and trying to find ways to be just more efficient. So are you sensing that maybe you could see X adoption faster than in maybe in a normal environment in order for those folks to take advantage of the cost savings. It seems like you're incentivized to do that, but I also know that the clinical wheel has been slowly. So I'm just not sure whether that's a factor for them.

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes. Of course, it's a relevant hypothesis to come in with. What we have seen is that most of our clinical customers are using the opportunity with the lower cost of X to actually expand the depth of sequencing providing bigger panels and so on. So what we're seeing is that most of the current panels continue to run on the NovaSeq 6000 and thereby continue to also drive volume there. And then they are right now validating many of the new assays or the new assays that might not have been possible in the 6000 to trust and so on to be on the X. So we're quite encouraged about that. We've also seen several of our specialty labs customer now order tens of NovaSeq X. So I'm encouraged that we will see a lot of volume here going forward on this.

[Operator]

And our next question will come from Subbu Nambi with Guggenheim Securities.

[Subbu Nambi, Analyst at Guggenheim Securities]

Hey, thank you, guys. Thank you for taking the questions. You spent about $1 billion on R&D in 2023 relative to 2019, the revenue has grown at 6% CAGR. However, R&D has grown 12% CAGR. Why can't you reduce R&D spend in dollar terms from current levels over the next 1 or 2 years? Can you outline where the spend is allocating?

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes, thank you. You're right that we continue to believe that there's a lot of innovation that is required there by investment into R&D in order to drive the whole NGS ecosystem forward. We -- as I said, one of the things -- what I said previously, is one of the things that I was really excited about is the pipeline of innovation that we have in running right now and thereby, also there will be a lot of innovation coming out from Illumina over the next period of time here. And we continue to believe that we are in the early stages of the whole opportunities here in NDS, but even also multiomics and thereby, we continue to make investment into that. You're also right that there has been an increase in R&D, and we're certainly looking to change that trajectory over time. We still believe that a high level of investment is required, but you will see here over the next years that the percentage spending R&D versus revenue will start to come down.

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Just to add, Subbu, I think we have made reductions in R&D over the last year. It's been very strategic in terms of specific aspects of the portfolio that we had considered as longer -- much longer time of payoffs or more risky. And we have also -- our overall R&D includes spend in certain areas like medical affairs, et cetera, that we were doing to support customers. And as they have matured, right, we have been able to pull back on investment there without affecting innovation.

[Operator]

And we'll take a question from Mason Carrico with Stephens.

[Mason Carrico, Analyst at Stephens]

Hey guys, thanks for the questions. So for high-throughput customers who have already purchased the X, could you talk about the conversations you're having around the potential fleet expansion? I mean what portion of those opportunities, whether it's orders or shipments have already come through and how many remain an opportunity this year?

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes. I think, I mean, we certainly see a lot of our high-end customers, the high-volume customers that started buying 1 or 2 NovaSeq X is starting to consider purchasing more instruments. So they're using the first few X to validate assays on. And then they want to expand into to -- use the additional Xs to actually run in production, but very few customers have still gone into production mode. And thereby, there is a real big opportunity in front of us. I think that less than -- less than half of our high-volume customers have purchased X so far. So I think there's still a lot of opportunities there. But I've also mentioned some of the high-volume customers that have purchased 1 or 2 have now put orders in for 10 instruments. So I think we're still in the very early stages, and there should be a lot of opportunities here, both in '24 and '25 to drive more placements.

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Yes. I'd just add, we weren't expecting to see that before the launch of the 25B-flow cell, right? So really, you're in very early innings there, and we do expect to see those fleet expansions coming in, in this year.

[Operator]

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

[David Westenberg, Analyst at Piper Sandler Companies]

Hi, thank you for taking the questions. I'm actually going to hit on some of the competition coming in. A couple of different things we saw at AGBT, for example, a combination of spatial and sequencing on one platform. How do you see that stacking competitively? Would you pursue a strategy like that? And then on Ultima in the $100 genome, some of the specs look significantly better than it did a couple of years ago. How do you feel stacked up against the $100 price with some of your key bells and whistles? Thank you very much.

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes. Thanks, Dave. And of course, we're tracking, of course, everything that is happening out in the market and we take our competition very seriously. But I think you've also heard me on the multiomics place. I think you've heard me speak multiple times about multiomics. So we have an intention also to be in that space. I think we were not talking about moving forward as a starting point with proteomics here with our relationships with Stemologic. But I think you can see that -- actually, we believe there is many more modalities that can be available on the instrument. So I think the -- where we -- where Illumina is doing is that we will go out and provide that insight when we're ready to put something in the market and speak less about it when it's more in the future.

Secondly, we feel with the NovaSeq X where we come out with a very attractive price point for a lot of different applications and not only a very few ones. So I think we feel that we have a very attractive solution. But I also remind you that it's not only the cost per sequencing -- that anymore, that is relevant, but also you need to look at the whole cost of the whole workflow, how many manual steps you have, how much waste you are, instrument spending and so on. So I think if you dig into the details, you will actually realize that Illumina has a very attractive and very differentiated platform.

[Operator]

We'll take a question from Conor McNamara with RBC.

[Conor McNamara, Analyst at RBC]

Hey guys, thanks for taking the questions. I appreciate it. Just a financial question on margins. You're guiding to 18% in Q1 and 20% for the whole year. So how do we think about the cadence of the margin progression? And I guess, same on tax rate, just you talked about a mid-20s for the core Illumina tax rate, how should we think about that in '24?

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes. So the tax rate, again, is something that should be -- you should expect to be relatively constant as you go into -- and again, for core Illumina into 2024. And this is, again, core Illumina, right? We are not giving guidance this year yet on the consolidated number. In terms of the operating margin cadence, again, that is typically that does go up as the gross margins tend to go up as we move into greater volume through the year. In terms of operating margin, you will see a decrease in potentially in Q2 as the merit and the other inflation-related aspects come into play. But then you will see after that, a quarter-on-quarter increase as we move into the rest of the year. And then, of course, I think on the -- sorry, just one other thing, right? I know there's been some movement in terms of the R&D capitalization piece, but that is something we're monitoring very carefully. It is past the house, but it still needs to get through the Senate and the President signing. If we get that, you can expect a further improvement in the tax rate, right? But we are not building that into our assumptions at this point.

[Operator]

And our next question will come from Sung Ji Nam with Scotiabank.

[Sung Ji Nam, Analyst at Scotiabank]

Hi, thanks for taking the question. Just on the MRD assay under development with Janssen, I was wondering if you might be able to comment whether that's a tumor-informed or a tumor naive approach or something different altogether? And whether that might have -- whether there might be potential for that to be developed into an IBD assay in the future for clinical applications? Thank you.

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes. Thanks for the question. So again, to remind everyone, the approach that Illumina has is quite unique. It's a whole genome-based MRD assay. It is initially a tumor-informed assay, but it does have the potential with more data and behind it to at some point, move into a tumor naive, right? In terms of being capable of being IBD, of course, as you know, we have invested very heavily in platforms and technologies and infrastructure that allow us to move assays to BIBD when the time is right, right? So right now, the agreement we have with pharma has been mainly to explore this in various forms. But we can go move into IBD when the time is right.

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Let me also add that we have no intention of providing that through a clear lab -- commercial clear lab. We do have our clear lab that, of course, is running very few samples, but we're not going out and commercialize it through our clear lab. In fact, we're very interested to work with customers and partners to continue to develop this.

[Operator]

And we'll take our next question from Patrick Donnelly with Citi.

[Patrick Donnelly, Analyst at Smith Barney Citigroup]

Hey guys, thanks for taking the questions. Joydeep, maybe a quick one for you and the follow-up would be probably more for Jacob. But just on the gross margin piece, can you talk about 4Q step down a little bit, came in a little light of where we were. Can you just talk about anything that impacted that in 4Q, the right way to think about the progression there throughout '24? And then on the gross margin kind of pricing initiatives, Jacob, how are you thinking about just the price side? Again, I know someone mentioned AGBT competitors are making noise, kind of saying they're seeing discounting in the market, particularly on kind of the mid throughput side. So just curious as you've taken a look here, what you're thinking about on the pricing side? Thanks, guys.

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Yes. So Patrick, in terms of sequential decrease in fourth quarter on gross margin, there are several factors there, right? One, revenue was lower. So that has an impact, obviously, in terms of just absorption of fixed costs. We also did have a higher-than-expected X contribution. And that, coupled with more of the partnership revenue, which tends to be lower margin driven, all affected our gross margin numbers. And then lastly, I will say there was a mix shift from 6K consumables to X consumables, and that also had an impact in our overall gross margin number for Q4. I will say, and I think it leads into your question to Jacob. We have made a lot of progress in 2023 in terms of COGS productivity and we started seeing the benefits of that as we rolled out of 2023 and into 2024 as well and beyond.

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes. If I -- when I'm coming into the company here, Patrick, and looking into pricing and how we are thinking about pricing going forward. First, I will say that Illumina is presenting a premium product and thereby, I think also our customers are seeing that we can command premium pricing in the industry. But I think more importantly is that only talking about cost per gigabase is probably too simplistic for most of our customers. They are more interested in the cost for the whole for sample to insight for the whole workflows. And that is, of course, including sample automation, but probably even more importantly, informatics, which is also a key cost driver for our customers.

So really with the Dragon platform and what we have in our comprehensive informatics offering, we actually can provide the customer be a very cost-attractive solution. So therefore, the thing about just talking cost per gigabase is kind of the -- maybe the old way of looking at it in the future way we look at a little more comprehensive. So I feel really good about that. Where we are. And that said, we will now with -- in the mid throughput with the XLEAP-SBS chemistry be available. We are we are coming out with a more attractive pricing, quality and more capacity on our 1K and 2K instrument. So I'm really excited about that and again, driving elasticity based on that new price point. So you will see us really move the nuts on many more elements than just one pricing element.

[Operator]

Our next question comes from Eve Burstein with Bernstein Research.

[Eve Burstein, Analyst at Bernstein Research]

Hi there, thanks a lot for taking the question. I want to ask about NextSeq placement. So there, you ended the year with 885 placements, and that's comfortably above where you were pre pandemic, but it's also below where you've been for the last 2 years. So how much of this do you attribute to just changing needs, obviously, post-pandemic, how much do you attribute to the capital purchase and cash flow constraints that you talked about? And how much do you attribute to competitive dynamics, which you also talked about? And then how should we think about what normalized demand here looks like going forward?

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Yes. So I think the major factors I would put 2, maybe 3, right? And then there's a sub factor. So -- the major factors, as you rightly pointed out, coming out of COVID in '21 and '22, we had a real uptick in the amount of mid-throughput instruments and low-throughput instrument sales, right? And that has normalized a little bit as the COVID threat frankly has reduced. We also, at the same time, did see in 2023 some of the macroeconomic conditions that led to more conservatism at our customers and more convergence in the purchases on capital come through. The third factor in mid throughput especially was also China, right? So if you're looking at an overall number, we did get impacted in China for competition and for macroeconomic reasons as we have repeatedly stated in our 2023 earnings calls. As far as competition goes, I mean, clearly, that was a factor in China, but that does not seem to be a huge factor in the rest of the world, right? And we did see our -- we track our competitive win rates fairly closely, and we did see that stabilize in Q3 and in Q4.

[Operator]

And moving on to Dan Brennan with TD Cowen.

[Dan Brennan, Analyst at TD Cowen]

Great. Thanks for the questions, guys. On X pull-through, we were coming up around $1 million in the fourth quarter and some quick math. We arrived at something like maybe $850,000 in 2024. So any comment on those numbers that they seem reasonable? And if so, could you just speak to like what would drive the assumption for that kind of sequential step down? Thank you.

[Jacob Thaysen, Chief Executive Officer at Illumina]

So thanks, Dan. And I think you've done more math than that than we have at this point since it's still way too early in -- way early innings here to start to look at pull-through from the X. So we haven't really done that math as of yet. And we will provide that math when we think we are more in a stable situation where it makes sense.

Any other comments on that, Joydeep?

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

No. I think I'll reiterate, look, it is early. I think Jacob stated earlier that many customers are just going through validation, especially on the 25B. So I will disagree with them that we haven't done the math, but the math is not relevant, and we don't want to confuse you. When this stabilizes, right, we will absolutely come out with a number. But so far, what we have seen has been encouraging to us.

[Operator]

And we have a question from Dan Leonard with UBS.

[Dan Leonard, Analyst at UBS Group]

Thank you. Jacob, I'm curious if you could elaborate further on the health of your diagnostics markets following your customer listening tour. And with looming FDA regulation of LDTs, how does that impact demand for your products or not?

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes. No, I think that's a good question, something also. I really was eager to understand better coming into Illumina. As you know, I have a background in IBD and I have a lot of passion for cancer diagnostic, but really fighting cancer. And I think how we think about it, of course, that we serve a lot of clinical customers out there that is using the Illumina ecosystem and build companies on top of that, primarily into the LDT space. And then we have our own offerings in other LDT, but in all places also IBD on especially the TSO 500 and the NIPT and other places where -- and if you look into our TSO 500 business, it's been growing really fast over the last period of time. And it's more than $100 million now, and we expect to have a high double-digit growth also into this year, and we don't see any end to that right now. So I'm really bullish around where we can bring that. And we are, of course, looking into a strategic review right now on how does that fit into the overall core business strategy. But clearly, we would also like to play in that space going forward.

It wasn't another -- was there a second part of that question?

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Regulation impact?

[Jacob Thaysen, Chief Executive Officer at Illumina]

Yes. Okay. So I think the second part was the impact of the regulation. I mean, of course, we're monitoring that very, very deeply right now. And there's, of course, again, a conversation with our customers and be helping some customers make sure they are ready for that. Our -- the larger customers can, of course, go through a single-site PMA which help them. But there's also a change maybe in the leveling of the different -- so some of the Class III products are considered being brought down to Class II products right now. It's still kind of on the table for consideration. But if that happens, that will certainly also reduce the requirement for getting through clinical trials and so on. So I think there's still a lot of moving elements. But what I can tell you is that I think Illumina is very well positioned to support the markets going forward, almost independent on where FDA is landing on this one.

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

I'd just add, Jacob, that we are about the only company that has -- even in our REO products, ISO 13485 classification on all our instruments and most of our consumables, and we have, obviously, the path to IBD should our customers want it, right? So we're well positioned to serve whichever direction they want to go in.

[Operator]

And our next question will come from Kyle Mikson with Canaccord.

[Kyle Mikson, Analyst at Canaccord Genuity Group]

Hey guys, thanks for the question. Just following guidance. So it seems like you probably had the opportunity to kind of establish an outlook that was softer than what you said in November. Could set a low bar, you kept the range, though, risks clearly remain. How much like visibility or comments do you have enhancements over this are you kind of baking in compared to prior years? And you listed some of what are the most material swing factors and kind of risks that we should consider in 1Q and then first half versus second half? And if I could just ask one for you, Joydeep, on 6000 pull-through. The $700,000, $800,000 seems like possibly aggressive compared to how HiSeq kind of decline in its years, post the 2000 launch. So just kind of walk through what you're thinking about in terms of the decline, I guess, or deterioration in 6000 pull-through? Thanks.

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

So let me address the 6000 piece first, maybe an easier one, right? So remember when HiSeq was -- well, NovaSeq 6000 was introduced. We didn't have as many clinical customers, right? So now we have clinical about 50% of our cons revenues coming from clinical customers who have these validated assays, right, where you're not going to change platforms in the short term. So the overall reduction in pull-through will be more mitigated compared to what you saw with HiSeq.

Jacob, do you want to comment on the overall guidance or you want me to?

[Jacob Thaysen, Chief Executive Officer at Illumina]

You can continue.

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Okay. So I think overall, look, we have repeatedly said, right, we see this as a prudent approach to the overall forecast, right? And while there have been some signs in some markets that the macroeconomic conditions might be turning, we have not assumed this in our forecast. And the only place we have been pessimistic and of course, has been in China, right, where the recent news also seems to corroborate that piece. As far as the puts and takes, look, it's a lot about adoption of the X, right. So we're spending an ordinate amount of time making sure that our X customers can transition quickly, can adopt and get on with their assays as quickly as possible. And we will continue to do that. And of course, if the if the markets pick up, we are very well positioned then to benefit from any of the upside. On the flip side, it's further macroeconomic headwinds that further reduce our customers' ability to bring on the X or to spend on consumables will affect us as well.

Jacob, I don't know if there's anything else you want to add?

[Jacob Thaysen, Chief Executive Officer at Illumina]

I think we are good.

[Operator]

And our next question will come from Rachel Vatnsdal with JPMorgan.

[Rachel Vatnsdal, Analyst at JPMorgan Chase & Co.]

Hey, good afternoon. Thanks for taking the questions. I just want to follow up to your answer on Patrick's question earlier. You mentioned that the gross margin line in 4Q was lighter due to that consumables mix shift from 6000 to X. So can you just walk us through that dynamic a little bit more? Is this just a function of the Xs ramping, so there's less volume leverage at this point? Or is there something where as consumables are structurally lower margins? And then how should we think about that consumables mix impacting gross margin throughout '24 as well?

[Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer at Illumina]

Yes. So first, easy part is, no, we have said right all through, right, that we had designed the X and X consumables that at scale, right, they would -- we would expect the margins to be comparable to X consumables at scale. What you're seeing is, of course, early on in the adoption, you're going to see the consumables margins to be lower. We haven't fully scaled up. And as we move through '24, you will see that more or less normalized. Now as you go into '24, overall gross margins will be -- have several factors, right? So one, -- we will have a little bit of a benefit from the lower placement of instruments as you -- we've said right that we do expect that to declines a little bit more consumables that will lead to an increase in gross margin. We also will benefit from some uptick in terms of all the actions we have taken to improve COGS productivity. So those are the 2 largest things that will serve to improve our gross margins as we get into 2024.

[Operator]

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

[Salli Schwartz, Vice President, Investor Relations at Illumina]

Thank you for joining us today. As a reminder, a replay of this call will be available in the Investors section of our website. This concludes our call, and we look forward to seeing you at upcoming conferences and other events.

[Operator]

[Operator Closing Remarks]

Participants

Corporate Executives

• Salli Schwartz, Vice President, Investor Relations
• Jacob Thaysen, Chief Executive Officer
• Joydeep Goswami, Chief Financial Officer, Chief Strategy & Corporate Development Officer

Analysts

• Doug Schenkel, Wolfe Research
• Puneet Souda, Leerink Partners
• Vijay Kumar, Evercore ISI
• Dan Arias, Stifel Nicolaus
• Subbu Nambi, Guggenheim Securities
• Mason Carrico, Stephens
• David Westenberg, Piper Sandler Companies
• Conor McNamara, RBC
• Sung Ji Nam, Scotiabank
• Patrick Donnelly, Smith Barney Citigroup
• Eve Burstein, Bernstein Research
• Dan Brennan, TD Cowen
• Dan Leonard, UBS Group AG
• Kyle Mikson, Canaccord Genuity Group Inc.
• Rachel Vatnsdal, JPMorgan Chase & Co.