Illumina, Inc. Q1 FY2020 Earnings Call

Good day, ladies and gentlemen and welcome to the First Quarter 2020 Illumina Earnings Conference Call. As a reminder, this conference is being recorded. I would now like to introduce your host for today’s conference, Ms. Jacquie Ross, Illumina Investor Relations.

Good afternoon, everyone and thank you for joining us for our 2020 first quarter results. I sincerely hope that you are keeping well during this time. 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 Sam Samad, Chief Financial Officer. Francis will share an update on our business and Sam will review our financial results. Of course, we are hosting our call from a number of different locations today, so please bear with us if there are any technical challenges or pauses. 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 turn the call over to Francis.

Thank you, Jacquie. Good afternoon, everyone and thank you for joining us. I sincerely hope that you and your loved ones are healthy and safe as we collectively work our way through these challenging times. As a global citizen and a leader in genomics, Illumina is committed to doing everything we can to support efforts to combat the COVID-19 pandemic, help patients and public health efforts, and accelerate economic recovery. In earlier stages of the outbreak, Illumina’s technology was used by Dr. Fan Wu and the team at the Shanghai Public Health Center to sequence the first complete published viral genome of what was later named SARS-CoV-2. Since then, teams all over the world have been working with Illumina’s technology to identify strains and monitor mutations in support of surveillance efforts, to understand therapeutic and host response and explore sequence-based diagnostic testing as well as population screening to support return-to-work programs. In terms of surveillance, Dr. Trevor Bedford at the Fred Hutchinson Cancer Research Center in Seattle and Dr. Charles Chiu at UCSF are among those monitoring virus transmission and tracking mutations. We have donated products to the Africa CDC to expand their NGS-based surveillance capabilities for infectious diseases in the Democratic Republic of Congo, Egypt, Ethiopia, Ghana, Kenya, Mali, Nigeria, Senegal, South Africa, and Uganda, in some cases bringing sequencing capability to the country for the first time. Susceptibility to COVID-19 is almost certainly in part genetic. It’s important to understand the interactions between viral and host genetics to potentially identify those individuals most at risk and support the development of therapies and vaccines. We are supporting multiple collaborations with partners, including the New York Genome Center, Stanford, Adaptive Biotechnology, and Genomics England to better understand the evolution of the viral genome and potential genetic factors determining an immune response. Earlier this week, Genomics Medicine Ireland announced that it will sequence COVID-19 positive samples to identify risk-bearing and protective factors for COVID-19. Regarding testing, while the majority of testing will occur using PCR and serology-based tests, numerous groups are looking to multiplex testing using NGS. For example, one of our partners, IDbyDNA, offers clinically validated, NGS-based testing. Additionally, multiple groups are publishing papers describing the performance of NGS assays with plans for clinical validation. Finally, some customers are working on ultra-high throughput NGS-based screening tests for returning to work. While these efforts are early, our teams are actively working to help customers meet the testing challenges that have been highlighted as critical to enable our economies to sustainably recover without placing individuals at risk. As we support our customers’ efforts, I am always impressed, but rarely surprised, by the innovations delivered by the Illumina team. To support COVID-19 work, we have released a number of workflows and data analytics to help identify the virus and track its transmission, including a shotgun metagenomics application to enable researchers and academics to detect and characterize SARS-CoV-2 and other novel pathogens for epidemiology; the application also supports the unbiased detection of co-infections and the profiling of host response genes to study co-morbidities and the human immune response; an enrichment workflow for Public Health Labs to enable highly accurate detection of SARS-CoV-2 and viral sequence information to optimize containment strategies and identify co-infections with other respiratory viruses that may require different treatments; an amplicon workflow to support Public Health Labs studying SARS-CoV-2 epidemiology with co-infections at higher sample volumes; and a new software toolkit that makes it easier for researchers to detect and identify SARS-CoV-2 viral sequences and contribute their findings to public databases. We have made this toolkit freely available to anyone using an Illumina sequencer. Illumina’s mission to improve human health by unlocking the power of the genome has never been more relevant. I would like to thank the global Illumina team for their dedication to keeping our employees safe, ensuring supply for those customers who are performing critical work, whether COVID-19 related or not – and doing everything we can to contribute to combating this pandemic. I would also like to recognize the many Illumina customers and partners who are working directly to fight COVID-19. We are inspired by your drive, creativity, and commitment and will do whatever we can to maximize the impact of your efforts. With that, I will move to our quarterly update. Illumina reported first quarter revenue of $859 million compared to our guidance range of $850 million to $855 million. Clearly, there are a lot of moving pieces this quarter, so I will talk about our business in three ways, so that we can share many of the insights we have, by region, by customer, and by product. Starting with the regions, China was the first to be impacted by COVID-19 and was therefore the most impacted in the quarter. As the outbreak grew, our priority was to support customers as they scaled their capabilities for COVID-19 related work. This included the installation of iSeq and MiSeq systems starting in January at one of the CDCs in the hardest hit region and supporting other CDC locations and hospitals in the country. As China implemented measures to contain the COVID-19 outbreak, it became difficult for patients to maintain clinical appointments for oncology and NIPT testing. As a result, both sequencing systems and sequencing consumables were lower than expected in China in the first quarter and total China revenue was $84 million. We have started to see run volumes increase in China in March and April. It’s not back to business as usual, but we are seeing both research and clinical customers returning to their labs in China and scaling up their operations. EMEA and AMR were resilient to COVID-19 through much of the first quarter and were tracking above our expectations in February. Momentum slowed quickly in mid-March as the wave of closure and shelter-in-place orders flooded across these regions in the closing weeks. Both EMEA and AMR still exceeded our expectations for the first quarter, but were clearly impacted by COVID-19. First, total system shipments were lower than expected in both AMR and EMEA. Systems tend to be back-end loaded in any given quarter and system purchases were not considered high priority for many customers at the end of the first quarter. Second, we saw some customers preemptively stocking up on sequencing consumables. Total EMEA revenue was $221 million and total AMR revenue was $477 million. Finally, APJ delivered revenue of $77 million, with solid sequencing consumable growth, including record shipments in Japan, despite COVID-19 related headwinds. In fact, this was a record quarter for APJ overall, with the highest total revenue ever reported for that region. We expect Q2 to be an extremely challenging quarter, with revenue declining sequentially in each region, albeit more modestly in China. On a positive note, Illumina’s operations have stayed up and running globally, and so far we have been able to overcome any COVID-19 related challenges and deliver products to our customers in a consistent and timely manner. Next, moving to a customer view, it is clear that COVID-19 is impacting different customers in different ways, and we have some insights drawn from the volume of runs associated with our connected network of sequencing systems. While not all our systems are connected, we believe this is a useful reference that shows the general activity trend across our installed base. Runs are reported regardless of volume of sequencing output and are not directly correlated to revenue. First, both research and clinical runs were ramping well throughout the quarter, peaking during the week ending March 14th. Not surprisingly, the number of research and applied runs started to slow during the week beginning March 15th, especially among academic institutions. This reflects research labs scaling back in response to shelter-in-place requirements for those not working directly on COVID-19. The decline was rapid in the second half of March, but then stabilized quite quickly, and has been roughly flat since the beginning of April. Overall, research volume is running at close to 55% of what it was in the fourth quarter of 2019. Moving to clinical, run volume was impacted by COVID-19, but was somewhat more resilient than research. Clinical runs also reached their high point for the quarter during the week ending March 14th. In the week beginning March 15th, clinical run volumes started to decline, albeit more slowly than we saw in research. Unlike some of our research customers, many of our clinical customers are considered essential healthcare services and have remained open, although sample volume is being impacted as patients avoid healthcare facilities. While more modest, the clinical declines extended for four weeks, and we started to see stabilization in the week beginning April 12th. Clinical volume is currently running at just over 80% of what it was in the fourth quarter of last year. In summary, the shape of the curve has been a little different for research and clinical customers. Research run volume dropped faster, but also stabilized more quickly, and has been roughly flat for the last four weeks. The clinical run volume drop was more gentle but the duration was longer before stabilizing in the last two weeks. Both research and clinical run volume increased modestly on a sequential basis in the week beginning April 19, although it is clearly too early to call any kind of trend. Finally, moving to the revenue view, total sequencing system revenue of $79 million was down 25% from the same quarter of last year, and substantially below our expectations driven by COVID-19 disruption. Excluding the COVID-19 impact on sequencing systems, we would have comfortably exceeded our sequencing system revenue expectation for the quarter. However, system shipments were down across all families, with the exception of NextSeq 2000 in its first quarter of launch. First customer shipments of our NextSeq 2000 were delivered right on time on March 9. Orders for the system were in-line with our internal forecast for the first quarter, but shipments were lower than expected because of the COVID-19 disruption at the end of the quarter. Early adopters of the NextSeq 2000 included both existing and new Illumina customers in research and academic institutions across all four regions. Initial NextSeq 2000 applications included food safety, genetic disease, cancer, and COVID-19 research. We did not ship any new NextSeq 2000s to HiSeq conversion customers in the first quarter. The sales funnel so far is consistent with our expectation for very modest cannibalization of NovaSeq conversions among remaining HiSeq customers in the quarters ahead. Finally, almost half of the new NextSeq 2000s shipped were to new Illumina system customers, ahead of our expectations. Sequencing consumable revenue of $553 million grew 15% from the same quarter last year and was stronger than expected. Less than half of the sequencing consumable beat was associated with COVID-19 related stocking among our clinical customers. NovaSeq pull-through per system was higher than the same quarter last year and comfortably within the previous guidance of $1.1 million to $1.2 million per NovaSeq per year. We do expect NovaSeq pull-through to step down meaningfully in the second quarter. Pull-through for both MiSeq and our NextSeq 500 and 550s was flat with last quarter, and MiniSeq was below its targeted pull-through range. Sequencing service and other revenue was $128 million, up 13% due to higher licensing revenue compared to the same quarter last year. Overall, sequencing revenue of $760 million was slightly ahead of our expectation, and represented 88% of total revenue. Moving to arrays, total array revenue was $99 million, down 33% from the same quarter last year, and in-line with our expectations for the first quarter. Our array services business grew sequentially as we expected, given the normal seasonality associated with direct-to-consumer, but declined year-over-year. Array consumables declined both sequentially and year-over-year, consistent with our expectations of the direct-to-consumer market. In summary, our business was negatively impacted overall by over $20 million in the first quarter, primarily driven by sequencing instruments, but this was partially offset by a modest contribution from COVID-19 related stocking, and broader strength across sequencing consumables and sequencing service and other. With that, I’ll hand it over to Sam to discuss the financials in more detail.

Thanks, Francis. And thanks to you all for joining us today. I really hope you and your families are safe and healthy. As discussed, first quarter revenue grew 2% year-over-year to $859 million, slightly with sequencing consumables and sequencing services and other, offsetting softer than expected sequencing system revenue. Moving to gross margin and operating expenses, I will highlight non-GAAP results that include 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 the supplementary data available on our website. Please note that all subsequent references to net income and earnings per share refer to the results attributable to Illumina shareholders. Non-GAAP gross margin of 73.0% was higher than our expectations, with lower sequencing system revenue and higher sequencing consumable and other revenue resulting in a more favorable mix in addition to increased fixed cost leverage as we increased safety stock volumes. Non-GAAP operating expenses of $339 million were down $33 million from the fourth quarter of 2019, and down $24 million from the first quarter of 2019. This was lower than we expected due to delayed project spending, reduced labor-related expenses and less travel. Non-GAAP operating margin was 33.6%, up from 31.0% last quarter, and better than expected. The non-GAAP tax rate of 16.1% was down from last quarter and lower than expected due to prior year return adjustments and discrete tax benefits related to the release of tax reserves. For the first quarter of 2020, GAAP net income was $173 million, or $1.17 per diluted share, and non-GAAP net income was $243 million, or $1.64 per diluted share. Additionally in the first quarter, cash flow from operations was $281 million; first quarter capital expenditures were $40 million and free cash flow was $241 million. DSO of 50 days compared to 55 days last quarter due to more favorable revenue linearity. We ended the quarter with approximately $3.3 billion in cash, cash equivalents, and short-term investments. This is down from $3.4 billion reported at the end of 2019, due to $187 million in share repurchases in the first quarter, and $132 million for the reverse termination fee and continuation advances paid to Pacific Biosciences. The expenses related to the PacBio payments are excluded from our non-GAAP results. Our weighted average diluted share count for the quarter was approximately 148 million. We have $563 million available for share repurchases under our current plan. Looking forward, we have withdrawn all our previous guidance due to the uncertainties around the severity and duration of the COVID-19 outbreak. To be very clear, this includes our revenue and EPS guidance, in addition to any other forward-looking comments we have made on NovaSeq or other system portal, NextSeq 1000 and 2000 shipments and PopGen expectations for the year. One month in, we can see that the second quarter impact will be substantially greater than the impact we experienced in the first quarter and we are planning accordingly. As mentioned before, we expect revenue to decline sequentially in every region in the second quarter with the smallest dollar decline expected in China and the largest in AMR. While we have so far been able to produce and deliver to our customers with minimal delays in the first quarter, we note a higher risk of transportation delays associated with border closures and a drop in air freight capacity linked to fewer passenger flights. Again, these are not impacting our business today, but are risks as we look forward. Given the wide range of possible outcomes, we are not offering guidance on second quarter revenue at this time. Even though we are not providing second quarter guidance, we can share some qualitative comments about factors that will impact our P&L in the second quarter. For example, it is clear that substantially lower revenue will lower our gross margin, so you should expect a lower gross margin in the second quarter on both a sequential and year-over-year basis. In terms of operating expense, we remain committed to investing strategically to ensure that we protect the strength of our business when we emerge on the other side of the COVID-19 disruption. As a result, we expect operating expenses to be roughly flat on a dollar basis compared to the second quarter of last year. Illumina is an innovation engine and while we have de-prioritized some work, we will do everything we can to retain our most important product development timelines. That said we are managing expenses very carefully. In the near-term, there are savings associated with restricted discretionary expenses, including travel, marketing events and consulting and slower hiring associated with a lengthening hiring cycle. We are also reducing spend on contract and temporary labor in certain functions. Finally, we have delayed certain non-R&D projects and delayed or canceled certain capital expenditure projects. Compared to our original budget for the year, second quarter operating expenses have been reduced by more than $40 million. We are also preparing for additional cost savings opportunities if shelter-in-place orders remain prevalent into the third quarter. While we are all hoping for loosening of restrictions in the near future, we have planned for a range of scenarios that we can activate if needed. We will monitor the situation carefully throughout the rest of the second quarter to assess whether we need to take more aggressive actions more quickly. This includes a careful reassessment of our capital investment plans and gating programs in some cases. In the meantime, we continue to hire and onboard new team members virtually, but retain the flexibility to pause or limit hiring or slow other investments if the pandemic is prolonged. With that, I will hand the call back over to Francis.

Thank you, Sam. We are mindful of the balance between navigating the uncertain duration of this pandemic and ensuring that we don’t do anything that slows our pipeline of innovation or otherwise inhibits our ability to meet the needs of our customers. We are hopeful that the biggest impact will be felt in the second quarter, but ensuring that we are well prepared if it extends into the second half of the year. As challenging as the current environment is, we don’t see any change to the long-term trajectory of sequencing adoption and demand. Clinical testing has proved quite resilient even in these challenging times, highlighting the importance and medical value of genomic testing. While it’s true that some labs have paused their research operations, it’s also clear that a number of research labs are switching to COVID-19 related projects. Clearly, we have a lot of work to do to find our way out of this pandemic and then prepare for the next one. It’s reassuring to see that governments around the world are committing resources to this important work. For example, the last two relief packages from the United States government allocated over $1 billion to the CDC, with the specific goal of building out surveillance and other capabilities in the hope that we can be better prepared for the next time. We do not believe that there is a technological limitation to getting this done. It’s clear that sequencing will be at the heart of the solution. It is a challenging time to be running a business. But the Illumina community, including our employees, our suppliers, our partners, and our customers has never been more united to a cause or more convinced of the importance of our shared work. We are leaving no stone unturned as we actively look for more and more ways to contribute to the effort. With that, we can start the Q&A.

Do you have our first question at this time?

Your first question comes from Dan Brennan with UBS.

Great, thanks. Thanks for taking the question and good luck managing through this period of time. So I just had a two-parter. It relates to – first part is on the academic end market for you. Can you just give us a sense of when academic researchers start to come back to their labs? Help us think through how quickly you think they can kind of ramp back up and related to that, we’ve heard that it will be difficult to make up for lost time in the lab, vis-à-vis consumable usage but that instrument orders like we could see can still be fulfilled. So if you can just comment on that? And then the second part is related to COVID NGS testing. Obviously, there is a lot of interest in the PCR testing opportunity and you discussed some of the nascent interest or kind of impact from NGS testing? Could that turn out to be a real opportunity for Illumina, any color you can provide on that would be helpful? Thank you.

Thank you, Dan. Let's address each of your questions. First, you asked about the academic market's ramp-up after people return to work and whether they can catch up on consumables or capital purchases. I want to highlight the excellent work some of our academic research customers have accomplished recently despite very challenging conditions. For instance, Professor Bedford at Fred Hutch in Seattle and Charles Chiu at UCSF have made significant contributions. Our researchers have fully engaged in efforts to combat the pandemic and understand virus mutations, transmission vectors, and host responses. The pace at which this business can recover will depend on the lifting of shelter-in-place mandates. Once these mandates are removed, we anticipate a quick ramp-up as the critical work being done will still be relevant. Researchers will likely return to their projects in the labs soon after they can get back to the office. We expect a variety of responses; for example, some academic customers may try to catch up on their work, as seen with the UK Biobank, while others may receive extensions on their funding to complete ongoing projects. It’s difficult to find examples of work that will cease. Additionally, there is a growing realization that research is needed to study the COVID-19 pandemic, including the evolution of the viral genome. Research on single-cell interactions with the virus underscores the need for further study. We expect both our academic and commercial research customers to remain engaged in this area throughout the current and upcoming quarters. As noted in the prepared remarks, funding has been allocated to the NIH and the CDC in the UK, which supports the COVID-19 Genomics UK Consortium. Regarding your second question about NGS in COVID-19 testing, there are multiple applications being explored. Some customers are leveraging NGS-based assays for diagnostic testing, thereby increasing market capacity. NGS technologies are also becoming essential for surveillance, beginning with initiatives by the CDC in China and expanding to various CDCs globally, with recent shipments to several African countries. Furthermore, there are innovative concepts emerging from our customers regarding using ultra-high throughput screening testing to facilitate a safe return to work for healthy individuals, along with regular testing to maintain workplace safety. Additionally, NGS is becoming increasingly important for research purposes, whether it's to develop new diagnostic tests, therapies, or to understand host responses, indicating a growing demand in this area as well.

Dan, I’ll offer up one data point. In the first month of Q2, we’ve also seen stronger than expected instrument shipments actually to academic institutions. So that’s a testament to the resiliency of that part of the market, despite the fact that we’re still in shelter-in-place more than disruption. So we are confident that once we get past this pandemic, that this will rebound, both in terms of instruments and in terms of consumable utilization as well.

Your next question comes from the line of Tycho Peterson with JPMorgan.

Thank you. Francis, as we think about the growth drivers that were laid out at the beginning of the year. Obviously, PopSeq was one of them, clinical being another. I’m just wondering on PopSeq if you can bring us up to speed on all of the NHS UK Biobank, how would you think about some of those initiatives maybe restarting? There are obviously some of the most – let’s kick off in the back half of the year anyway, but I’m curious for the latest on those? And then on clinical, I appreciate the commentary that the clinical drop is more general and the duration is longer. We’ve seen some numbers that cancer testing is down 25%, 30%. Just curious about how you think about the recovery on the clinical side. And then lastly on pandemic surveillance, I’m just curious if you’re doing anything differently organizationally or in terms of R&D dollars going forward, should we think about future pandemics. Thank you.

Sure. So, let’s go through each of those questions. First, let’s start with an update on PopGen. It’s clear that the shelter-in-place requirements have actually impacted the PopGen programs. And I’ll talk about some of the major ones. As you might have heard from the NHS, we are waiting to hear revised dates for when they ramp up. They haven’t put out any new dates yet. So we’re continuing to stay engaged with them and they’re evaluating their plans around the ramp-up that was planned over the back half of this year. The UK Biobank announced in March that they were pausing their sequencing for a three-month period. Now, there is urgency around that work and so in that effort, we expect that when they start sequencing again, they will ramp up very quickly. They were running at about 10,000 genomes a month before they paused, so we expect them to be able to ramp that up quickly. They are the kind of customer that would invest to catch up in terms of the sequencing that was missed. Because there’s value to the data they are getting from a therapy perspective and there is also a finite window of exclusivity with that data, and so there is an urgency around getting back up to speed and catching up. In terms of all of us here in the U.S., they are currently working through their IDE submission, which we expect shortly to the FDA. They already have their 270,000 sample cohort. It’s watching to see how the shelter-in-place requirements come back and people can get back into their labs. But they are making progress on their IDE submission, which is what they are working on. In terms of the clinical market, as I said in the prepared remarks, the clinical markets have been somewhat more resilient than the research markets, but they are operating at below the baseline that we saw in Q4. This is primarily because you have patients around the world that are holding back from going into hospitals, and in some cases are under their own shelter-in-place requirements. The reality is though for cancer patients they do need to get that testing, and so at some point it will be important for them to get back to the clinic to do the oncology tests. Again, there is sort of a time urgency around getting that test and we saw some easing from a reimbursement perspective here in the U.S. around covering average risk from sort of large carriers here because they recognize that NIPT is an easier test to do than the alternatives. We expect NIPT to be more resilient even for the clinical markets. In terms of pandemic surveillance, we have organized an effort internally that is focused on creating workflows that our customers are asking for in each of the categories I talked about, so for diagnostic testing, for surveillance, for ultra-high throughput screening, and for research. We have already put out three workflows: the shotgun metagenomics workflow, the enrichment, the amplicon workflow, and we have put out some informatics tools for researchers free of charge we have been asking for in terms of helping them analyze the data around COVID-19 and also making it easier for them to submit the data they are getting to public databases out there so they can share it more easily. At this point, the efforts have really been around ring-fencing some of our folks who work on that – on those efforts and that’s how we are thinking on. So, it’s a little bit of a reallocation rather than sort of different R&D expense.

Your next question comes from the line of Steve Beuchaw with Wolfe Research.

Hi. Well, first of all, thanks for the time. Second, thank you for everything you guys are doing. My first question is something of a policy question for Francis, I will apologize for giving you the more difficult one. My second is just a couple of fine-tuning points for Sam, so Sam gets the easy one. Francis, as you discuss with your policy teams, you think about the guidelines that are popping up, what do you think is the pathway for reopening for academic labs? It doesn’t necessarily equate to what happens in terms of university reopenings, so there are number of questions that are operational ramp there. There is also a question as to what is deemed “essential.” I know Dan Brennan asked a good question about the timelines for those labs reopening. And for Sam, the one how do you think micro-arrays progress from here? Does the trajectory feel any different now given the environment relative to what you thought coming into the year? And then Sam, could you speak at all to the balance of stocking versus shipment delays tied to COVID and whether COVID was a net positive or negative at the end of the quarter? There is some controversy out there around stocking? Thanks so much.

So thank you Steve. Thank you for your comments as well. So let me start by talking about our expectations around when academic labs sort of come back up to capacity and you asked about how we think about universities reopening versus research labs opening and what those timelines are. I will start by saying that we have very modest expectations in terms of lab for this quarter. And so that’s what we have taken. You touched on an important point, which is we are hearing from our customers that likely to open up before universities do it. A lot of universities are thinking in a staged way and that’s the bar for opening up. It’s different than the bar from bringing all undergrad students, especially back to campus. So our belief is that you will see the academic research labs and universities open up even before you see the full universities open up. The other dynamic that’s playing is a number of the leading academic research labs are very actively involved in COVID-19 research. That’s true across the board whether you are looking at Johns Hopkins or Yale or Stanford. This means that the work they are doing is essential. A lot of them will be working ahead of the broader opening of the academic labs in universities. Well, that’s the staging. First, you will see academic labs that are now focused on COVID-19 begin to scale out, especially as the funding starts to slow. Next, you will see broader academic labs opening up and then finally you will see universities opening up to students probably.

Yes, Steve, on your questions around the tweaks that you mentioned, so first of all, for micro-arrays, the micro-arrays are going to be challenged obviously significantly in Q2 just like the rest of our business to our prepared remarks and for the year, but specifically around DTC, I would say, first of all, that has continued to become a smaller portion of our business, but DTC will definitely be significantly impacted, maybe even disproportionately because, as we saw in China for instance in Q1, even though that’s a small part of the business, but saliva shipments were essentially banned. You couldn’t even perform testing on DTC. You have some marketing that usually revolves around sporting events, the Olympics, etcetera, all of those now are pushed out. I think DTC will be disproportionately impacted as well albeit that’s a very small part of our business now. In terms of the stocking, the net impact that we mentioned of $20 million represented a negative $24 million impact on instruments. In the last two weeks, we definitely saw customers pausing on capital purchases and that represented a negative $24 million impact and there was a plus $4 million impact, a positive impact in terms of stocking on consumables. So, a small impact overall on consumables. So, the net impact was $20 million negative. As you can see all of this was instruments offset by a very modest amount of consumable stocking.

Your next question comes from the line of Doug Schenkel with Cowen.

Hey, good afternoon and thank you for taking my questions. Based on what you described in your prepared remarks, it seems like you are describing continued recovery in China, albeit not to levels where we were earlier last year. Then it sounds like outside of China, you are describing a situation where at least at the end of April, including all end markets you were seeing stabilization. I just want to make sure that’s right and building off of that, are there any areas worth noting either geographically or by end markets that are still deteriorating? On the other side of that, are there areas that are notably improving outside of China? Thank you.

Got it. Well, thank you Doug for your question. You have got it exactly right. What we are seeing is China-size business impacted first, but it has definitely started changing the trajectory and continuing to build. Likewise, if you look at the rest of the world, starting in the last couple of weeks of March, we did see a deterioration. It was sharper in the research market and more gradual in the clinical market, but they seem to have stabilized and certainly if we look at the data points for the last week, you can start to see them at least – seem to point towards the gradual building back. In terms of areas where we expect it to be above average in terms of recovery or below average, the areas that have seen resilience are the clinical areas, most specifically NIPT, but then oncology testing as well. Those are the ones that did slow down but slowed down more slowly and the stabilization is at a higher level than the rest of the other segments that we have seen. We talked a lot about the research markets that the shelter-in-place requirements are going to inhibit the academic labs from reopening and we expect to play out the majority of them this quarter, although some of those labs are now repurposed for COVID-19 research. I believe one of the slower markets to recover would be the direct-to-consumer market, primarily because of the things that Sam talked about earlier.

Hey, Brandy. Since you are sitting on the next question I will just add. Just a reminder, something we said in the script was that we did see a sequential increase in the run volume data for both research and clinical at the most recent week we have actually did show a sequential increase from the prior week. So that is a positive sign there. Just one data point. We will look for more data points to support that trend, but something that gives us a good amount of optimism.

Your next question comes from the line of Derik De Bruin with Bank of America.

Hi, good afternoon, everyone.

Hi, Derik.

So I am going to do a multi-parter if I can. First one is easy just quantify the size of the licensing agreements that benefited services, because that number is a little bit higher than we thought. Second one is, can you talk a little bit about instrument ordering patterns are they still coming in? Have you seen things slow down, just some sort of general trends on your order pipeline right now obviously since you’re not – you don’t have people out there selling right now. The other one is how much inventory and consumables are your customers normally hold? The reason I bring this up is because, obviously you’re going to have lab shutdown and keep on going to be using things. So it’s a question of when do we sort of see consumables ramp as things come back and what’s the shelf life there? I’m just sort of curious about the dynamics and how we think about people bringing because of using inventories before they start – before they start reordering. Do we get an air pocket? So I am just sort of trying to think about the play going through on that? Thank you.

Yes. So with regards to the licensing revenues, Derik, we are not disclosing exactly what the amount of the licensing revenues were. But all I can tell you is we had some licensing revenues built into our guidance that was realized in Q1. As you saw, we had growth in that line, came in slightly better than expectations. That’s the dynamic there. In terms of the licensing revenues too, this relates to some deals that we had from last year and usually those are not necessarily all recognized at the time that you design them. There are some that you recognize afterwards based on different milestones and certain revenue recognition principles. What was the second question? With regards to shelf life of consumables, so I’ll jump to that. The shelf life is usually around six to nine months effectively. So that’s usually what customers have in terms of what our consumable shelf life is. What was the third question that Derik had?

The third question is on consumable inventory. So, how much do customers typically hold and how long to reorder. I’ll just take that to say typically customers hold about eight months of inventory on hand, and just as a reminder for a lot of our reagents, the shelf life is around six months. If I just add a little more color on the system ordering. Certainly for the first couple of months of the quarter, we were seeing very strong ordering for systems. In fact, we were seeing stronger-than-normal linearity. We were heading for a strong quarter in terms of system orders so that even there and so with the numbers. It was a strong quarter setting of to the last couple of weeks of March from a systems orders perspective.

And I think as Sam mentioned earlier, we’ve actually seen that continue into Q2. Right? So the orders it doesn’t actually shipped so far this quarter are little bit ahead of sort of normal linearity. We’re seeing orders from both clinical and research customers, but at this point actually, the strength we’ve been seeing so far has been driven by research. Of course, that could change with one month of data, but it’s what we’re looking at.

Your next question comes from the line of Puneet Souda with SVB Leerink.

Yes. Hi, Francis. Thanks and thanks for the important work that you are doing in the pandemic. So first on – if I could just go back to instruments again, I was hoping if you could elaborate what you had seen or what the team has seen in the past downturns here? What do you think is the appetite for instrument purchases in situations and academic customers and some of those cases where they are getting furlough in the current timeframe and when they return back to the lab? What’s the expectation there? Among the diagnostic customers, what’s the expectation sort of in the second half when potentially when we are expecting things to return back to normal and we’re hearing about some pent-up demand? Obviously, significant trial shutdowns anywhere from 50% to 70% new enrollment is down. So when we think about biopsy getting to the sequencer how do we think about instrument purchases in that framework? If I could also – if I could ask the second one just briefly on run versus revenue clarification, I just wanted to understand the run numbers that you have provided, how should – what sort of arrow bar should we think on that? Are these run counts or are these runs already a reflective or inclusive of the duration of the runs and thus inclusive of the sequencing volumes that you have? Thank you.

Sure. Thank you, Puneet. Let me work my way through those questions. In terms of the appetite for instrument purchases, as Jacquie pointed out, they were running strong through the majority of Q1 and we were on track for a very strong systems quarter in Q1. They are starting to run strong again in Q2 in the first month of Q2. The disruption we saw was not in orders, but primarily in shipments because in the last two weeks of Q1, the number of labs had shelter-in-place requirements and frankly weren’t just physically there to be able to take the instruments of their orders. The disruption was not really in ordering activity; it was much more in shipments activity. As we talk to our customers what they are telling us is the appetite for instruments is completely driven by the demand that they are seeing. If you talk to our NIPT customers or oncology testing customers, they are ordering based on the demand that they’re getting from driven by a number of pregnancies that are covered and oncology testing and that they expect to recover. They are saying we saw a tick down, but this is a central testing and so this shouldn’t change. It’s completely driven by demand. The same thing is happening on the academic side. It’s driven by the bonus of work that they have. They have to come back into the labs to take those shipments, and there will be a gating factor around when the shipments actually happen and that shows up in revenue. Our expectation is that they will be sheltered in majority of Q2. But going out beyond that, they have budgets, they need to spend it, they still have the work that they’re doing, there is now incremental work associated with COVID research that will require new instruments as well. In terms of the run count. Sorry, let me just finish up the last part of the question, Puneet had which was around run counts. The numbers we’re sharing with you are truly just number of runs. They are not related to the type of run or the outset data for each run or certainly the cost per run. So there is no direct correlation to revenue, but it does give you a sense for the level of activity in our business.

And Puneet, it reflects the fact that not every single instrument that we have is connected but it reflects the fact that we have a portion of our instruments. The highest connectivity is in AMR. The next highest is in Europe and then APJ and very little connectivity in China. So it’s a proxy, but it’s a good indicator in terms of the direction that we’re seeing in terms of the rebound of the business.

Your next question comes from the line of Dan Arias with Stifel.

Good afternoon, guys. Thanks. Francis, maybe just to follow-up on PopSeq, less related to the active projects and more those that were sort of sitting out there in the planning and design stage, can you comment on those? I mean are those so complex that you kind of have to expect a pause if you were talking about large health networks or maybe conversely? I mean is it pandemic just kind of serving as an advertisement for aggregating genomic health data. I am just wondering about the next wave of those initiatives?

Yes. Let me talk about what we are seeing Dan in terms of what’s playing out in those initiatives. If an initiative is in the planning stage then a lot of the work for that planning can happen while the people are sheltered at home. The work that can happen remotely continues to move forward. We’re seeing that even here in the U.S. around the IDE submission for all of us. If that initiative is really in the planning stage, a lot of the work continues to happen even over this period. Some parts of a PopSeq ramp-up could be impacted by the pandemic. If you are in the midst of collecting samples for example, that would be a part of the project that would be slowed down until people start getting back into the labs or out into the fields. Another dynamic that’s playing out is we are seeing the emergence of obviously the importance of COVID-19 element to some of these population sequencing efforts. For example, the work that Trevor Bedford did at the Fred Hutch in Seattle, started out as a flu population research project that then got repurposed in December, January, February timeframe to look for COVID-19 incidents. We are starting to realize the importance of these population efforts in terms of helping combat this existing pandemic and giving us the surveillance capability into future pandemics. We are seeing that emerge as part of the thinking for the population sequencing efforts that are playing out.

Your next question comes from the line of Patrick Donnelly with Citi.

Great, thanks. Maybe one for you Sam on the expense control, I certainly appreciate that you guys want to keep expenses controlled in the near term, but also positioned to capture the growth in the other side of this. To your point about being nimble, if things do kind of linger here, you do have initiatives to pull the cost back further. I guess what would it take for you to do that as a certain timeframe that things stay shutdown that you would kind of push a little harder on the cost side? Maybe just talk through the scenarios on that front? Thank you.

Yes, thanks, Patrick. We have looked at a number of scenarios both to understand what potentially the revenue impact might be for the year and the impact on expenses. First, let me say, even in the first half of the year given where we are today and what we know today, we are taking significant cost out of the business. In Q1, as you heard, we were roughly $50 million below our expectations in terms of spend. In Q2, we are expecting to be somewhere around $40 million below our expectations in terms of spend. We are taking quite a bit of cost out of the business and that reflects some actions around discretionary expenses; some of it’s driven by travel reductions, conference, lack of attendance, etcetera. If this disruption persists and I don’t want to give you a certain number of months or a very specific timeframe, but if this – if we believe that these shelter-in-place work-from-home restrictions continue for definitely Q3 and beyond, then we have got contingency plans that we have put in place that require us to cut expenses in a significant way. This would involve things like pausing hiring altogether, looking at our contract sales force and temporary workers, looking at significant reductions in our capital expenses, and significant reductions in our non-R&D projects. So, broad-based in terms of things that we would cut based on, that involves having a view to the fact that we are going to have a more prolonged disruption that goes definitely beyond Q3. So that’s the way we are approaching it.

Brandy, the next question?

Thanks for taking the question. Francis, I think you mentioned that most of the COVID-19 testing will be through PCR-based or serology testing. I was curious as to what do you think is the biggest hurdle given that we probably need unprecedented levels of diagnostics over the next year or two? What’s the biggest hurdle in terms of getting sequencing to take a bigger share in providing diagnostic testing? Is it the cost, the installed base, the accuracy, if you could talk about that? Thank you.

Yes, thank you for that. Certainly today, the majority of testing is being done on PCR. But looking forward, I think you can expect to see more NGS testing happen in the market. You can expect to see it happen in several buckets. First, you will see more diagnostic testing of symptomatic individuals happen on NGS technology. We are starting to see a number of clear lots stand up diagnostic testing using NGS capability and you should expect to see more of that happen going forward. The second thing that will happen is you will start to see the emergence of ultra-high throughput capabilities we believe for screening of healthy individuals to get them back to work. There are a number of very exciting concepts being worked on by a number of customers around how you can screen very large numbers of healthy individuals to give employers confidence to bring their employees back into the workforce, to give schools confidence to bring their students back into schools. There is work that needs to be done to put together those workflows and that’s what is being done right now. But a lot of work is happening in that arena because the capacity you could get from NGS and the cost per sample you could get from NGS could make that very, very compelling. Likewise, you should expect to see NGS used in surveillance capabilities driven in some cases by CDCs around the world. But there are other organizations too that are putting together NGS capability to monitor how this outbreak is progressing. For that, you need NGS to understand how the virus is mutating. You need NGS to track the geographic transmission of this virus and you’re seeing that capability starting to come online. If I look at diagnostic testing, screening, and surveillance, you should expect to see NGS to be a bigger part of the testing paradigm going forward than it is today.

Your next question is – we do have time for one further question. Your last question comes from the line of Vijay Kumar with Evercore ISI.

Hey, guys. Thanks for taking my question. Just one quick follow-up. I think Francis you mentioned the run-rate on the research side was down 45, clinical perhaps down in high-teens. I’m just – like what is your revenue mix between clinical and research and where are we on capacity utilization on the systems? The reason I am asking is when we look at the economy reopening, is there capacity utilization and these systems are running at 100% and there is a catch up in the back half? Thank you.

Sure. If you look at the breakdown of our business on the sequencing consumable side, it’s about 60% research and 40% clinical. If we think about how the market recovers, there are some areas where we expect to see some catch-up. For example, the UK Biobank initiative that was moving at a full front model going into March with lease of catch-up we expect around that initiative. Similarly, patients, cancer patients that were holding back from going into the clinic to get tested, we expect to see some catch-up happen there as well. And maybe a little bit on the NIPT side as well. There are definitely parts of our business where you can expect to see some catch-up. But there are many parts of our business we expect people to go back and finish the work that they were working on. So, it’s very unlikely that the work goes away. The majority of our business will pick back up and in some cases there will be some catch-up as well.

I would now like to turn the call back over to the speakers for closing remarks. Thank you, Brandy. As a reminder, a replay of this call will be available as a webcast in the Investors section of our website as well as 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 second quarter.

This concludes today’s conference call. You may now disconnect. Thank you for your participation.