Earnings Call Transcript - ILMN Q4 2023

Operator, Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2023 Illumina Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. 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 of Investor Relations

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'll now turn the call over to Jacob.

Jacob Thaysen, CEO

Thank you, Salli. Good afternoon, everyone. As you know, I joined Illumina as CEO a little over four 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 customers think highly of Illumina and our solutions, and they want to work in strategic partnerships with us to move the whole MTS ecosystem forward. Now that we have announced that we will divest GRAIL, it has been easier for our customers to plan what the 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're 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 modern project that aims to fully integrate comprehensive genomic testing into the healthcare system there beginning in Q2 this year. Within the hallways of our headquarters and several global offices, I have also been connecting with our talented employees, who are committed to driving innovation and continuing to build our outer 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 have 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, we saw many of our customers remain 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-over-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 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've laid out three 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. The high throughput more broadly across the NovaSeq X and NovaSeq 6000, we placed more than 400 instruments in 2023. In 2024, we will support this growing installed base as customers launched 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 6000 customers to the X, from customer fleet expansion, and long-term from new high throughput customers. So, that said, given the significant number of placements in 2023, we believe we will ultimately ship fewer high throughput instruments in 2024. As you are aware, XLEAP-SBS chemistry has been the engine for our X platform, delivering significant improvements in quality, turnaround time and cost. This quarter, we'll be making XLEAP available to our mid-throughput customers on the 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 our installed base, we'll 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 are paying off. In Q4, we saw higher-than-expected growth in X consumables sales following the late October launch of our much-anticipated 25B reagent kit. More recently in January, we launched a 1.5B kit, which together with the 25B and 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 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, applying greater rigor throughout our P&L while sustaining innovation and growth. We've launched a multi-year effort, focusing on improving our margins through greater productivity and pursuing additional areas for cost savings. In January, we took additional action to further optimize our global workforce. Over the past year, we've made cumulative role reductions totaling approximately 12%. Our most recent actions included adjustments 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 quickly as possible. Since joining Illumina, I've made 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 transactions by the end of the second quarter this year. We'll continue to pursue parallel paths. The divestiture will be executed through a third-party sale or capital markets transaction, consistent with the European Commission divestiture order. To date, we've been able to make swift progress on GRAIL. From 10 has been confidentially filed with the SEC. Our advisors are actively moving the process forward on both the sale and capital market path. The special committee of the Board, that we established in Q3, continues to help ensure this process moves 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, CFO and Chief Strategy and Corporate Development Officer

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 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 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. 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 of 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 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 two 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 and 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're 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 Illumina. 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, the 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 outpace 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 to be 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 to be in the range of $80,000 to $130,000 per system in 2024, which primarily reflects the impact of customers transitioning to XLEAP chemistry as it becomes available on NextSeq 1K/2K. We expect annual pull-through for MiSeq to be 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 impacts from 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 with 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, CEO

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 the 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' workflows 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.

Operator, Operator

Thank you. Our first question will come from Doug Schenkel with Wolfe Research.

Doug Schenkel, Analyst

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 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, CEO

Thanks, Doug. That was one question there. 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 has performed beyond our expectations and has been very well received by our customers. So we continue to expect that this will drive X performance, but also, of course, it's completely now unleashed the full performance of the instrument. Thereby, we also expect that the availability of the 25B will have more customers jump on to the X wagon 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 big enough projects to load the closeout.

Joydeep Goswami, CFO and Chief Strategy and Corporate Development Officer

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

Operator, Operator

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

Puneet Souda, Analyst

Yes, hi Jacob, Joydeep, thank you for taking my question. I would like to follow up on that point. Can you help us understand how you arrived at the low single-digit growth rate this year? There is the 25B, along with reductions happening from the X install; the cost per database is lower, and China remains a challenge, as does the overall market environment. Could you discuss how you remain confident in the low single-digit growth rate for sequencing consumables? I would also appreciate any context and details regarding GRAIL, including its progress, levels of interest, and your planned spending for GRAIL this year. Thank you.

Jacob Thaysen, CEO

Thank you, Puneet. I'll address the latter part of your question regarding GRAIL, and then Joydeep will provide insights on our expectations for consumables growth. We are pleased to confirm our decision to divest GRAIL, and I am happy with the progress we’ve made thus far. Our advisors are actively engaging with potential parties and we are pursuing both a capital markets initiative and a transaction simultaneously. We remain on track with our timeline, aiming to finalize all terms by the end of June. Since we expect to conclude our dealings with GRAIL this year, we are not providing any expenditure guidance for GRAIL this year.

Joydeep Goswami, CFO and Chief Strategy and Corporate Development Officer

Yes. And to address your question about the low-single-digits consumables growth, Puneet. 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 X customers, right? So both of those are good. We saw that uptick in 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. What’s offsetting that expected growth in X consumables, as you rightly pointed out, is the expected pricing 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 NovaSeq 6000. And then, of course, some of the expected again, reduction in NovaSeq 6000 consumables as customers switch from one platform to the other. That is the really big piece on what's leading to the lower or the low-single-digit growth rate in consumables in 2024.

Operator, Operator

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

Vijay Kumar, Analyst

Hey guys, thanks for taking my question, and I had a two-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 kinds 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?

Jacob Thaysen, CEO

Yes. Yes, so let's start with the GRAIL question. 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 point. But as soon as it's available, we'll make sure you know.

Joydeep Goswami, CFO and Chief Strategy and Corporate Development Officer

Okay. And then, Vijay, I want to be sure you're asking about NovaSeq 6000 pull-through numbers and how they modulate through the year.

Vijay Kumar, Analyst

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, CFO and Chief Strategy and Corporate Development Officer

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, Operator

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

Dan Arias, Analyst

Hi guys. Thanks for the questions. Jacob or Joydeep on the 6,000 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 spins slowly, so I'm just not sure whether that's a factor for them.

Jacob Thaysen, CEO

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. They are right now validating many of the new assays or the new assays that might not have been possible in the 6000 to move to the X. So we're quite encouraged about that. We've also seen several of our specialty lab customers now order tens of NovaSeq X, so I'm encouraged that we will see a lot of volume here going forward on this.

Operator, Operator

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

Subha Nambi, Analyst

Hey, thank you guys. Thank you for taking the questions. You spent about $1 billion on R&D in 2022 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 one or two years? Can you outline where the spend is allocating?

Jacob Thaysen, CEO

Thank you. We believe there is significant innovation needed, which requires investment in R&D to advance the NGS ecosystem. I'm particularly excited about the current pipeline of innovation we have, and we expect to see many advancements from Illumina in the near future. We recognize that we are still in the early stages of opportunities in NGS and multi-omics, and we will continue to invest in these areas. It's true that R&D spending has increased, and we are looking to modify that trend over time. We maintain that a high level of investment is essential, but you will observe that the percentage of R&D expenditure relative to revenue will start to decrease in the coming years.

Joydeep Goswami, CFO and Chief Strategy and Corporate Development Officer

Just to add, Subha, we have made reductions in research and development over the last year. These changes have been very strategic, focusing on specific parts of the portfolio that were viewed as having longer payoffs or being more risky. Additionally, our overall research and development includes spending in certain areas like medical affairs that we were undertaking to support customers. As these areas have matured, we have been able to scale back on our investments there without hindering innovation.

Operator, Operator

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

Mason Carrico, Analyst

Hey, guys. Thanks for the question. 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, CEO

Yes, I think, I mean, we certainly see a lot of our high-end customers, the high-volume customers that started buying one or two NovaSeq X are now considering purchasing more instruments. They are using the first few X to validate assays on, and then they want to expand to use the additional Xs to actually run in production. But very few customers have still gone into production mode, and there is a real big opportunity in front of us. I think that 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 one or two 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, CFO and Chief Strategy and Corporate Development Officer

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 come in this year.

Operator, Operator

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

David Westenberg, Analyst

Hi, thank you for taking the question. 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, CEO

Thank you, Dave. We're closely monitoring market developments and take our competition seriously. As I've mentioned before, we're interested in the multiomics space and have plans to engage there. Currently, our focus is on proteomics through our partnership with Stemologic, but we recognize the potential for additional modalities to be integrated into our instrument. Once we're prepared to launch something new, we'll provide insights about it. Additionally, with the NovaSeq X, we've introduced an appealing price point suitable for various applications, not just a select few. It's important to consider the total cost of the workflow, including manual steps and instrument expenses, rather than just the cost per sequencing. A detailed examination will show that Illumina offers a differentiated and attractive platform.

Operator, Operator

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

Conor McNamara, Analyst

Hey, guys and thanks for taking the questions. 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, CEO

The tax rate is expected to remain relatively stable as we move into 2024 for core Illumina. We are not providing guidance on the consolidated number at this time. Regarding the operating margin, it typically increases as gross margins rise with higher volumes throughout the year. However, you may see a decrease in Q2 due to merit increases and other inflation-related factors. Following that, a quarter-on-quarter increase is anticipated as we progress through the year. Additionally, while there has been some activity concerning the R&D capitalization, which we are closely monitoring, it has passed the House but still requires Senate approval and the President's signature. If this is approved, we can expect an improvement in the tax rate, but we are not incorporating that into our current assumptions.

Operator, Operator

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

Sung Ji Nam, Analyst

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 there might be potential for that to be developed into an IBD assay in the future for clinical applications? Thank you.

Jacob Thaysen, CEO

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 behind it, to at some point, move into a tumor-naive approach. In terms of being capable of being IBD, of course, as you know, we have invested very heavily in platforms, technologies and infrastructure that allow us to move assays to IBD when the time is right. Right now, the agreement we have with pharma has been mainly to explore this in various forms. But we can move into IBD when the time is right.

Joydeep Goswami, CFO and Chief Strategy and Corporate Development Officer

Let me also add that we have no intention of providing that through a commercial clear lab. We do have our clear lab, which is running very few samples, but we're not looking to commercialize it this way. In fact, we're very interested in collaborating with customers and partners to continue its development.

Operator, Operator

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

Patrick Donnelly, Analyst

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 the 4Q step down a little bit? It 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 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, CFO and Chief Strategy and Corporate Development Officer

Yes. So Patrick, in terms of the sequential decrease in the 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 on 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, CEO

Yes. As I evaluate pricing strategies for the company, I want to emphasize that Illumina offers a premium product, which allows us to set premium pricing in the industry. However, focusing solely on cost per gigabase doesn't capture what our customers care about most. They are more concerned with the overall cost from sample to insight across the entire workflow, which includes sample automation and crucially, informatics, a significant cost factor for them. With the Dragon platform and our extensive informatics offerings, we can provide customers with a very cost-effective solution. We are optimistic about our current position. Additionally, in the mid-throughput segment, we will be introducing more competitive pricing, better quality, and increased capacity on our 1K and 2K instruments. This is exciting, as it will enhance elasticity based on the new price point, allowing us to address more factors than just one pricing element.

Operator, Operator

And our next question comes from Eve Burstein with Bernstein Research.

Eve Burstein, Analyst

Hi, there. Thanks a lot for taking the questions. I want to ask about next seat 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 two 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, CFO and Chief Strategy and Corporate Development Officer

Yes. I see two or maybe three major factors, along with a sub-factor. As you mentioned, following COVID in 2021 and 2022, there was a significant increase in sales of mid-throughput and low-throughput instruments. However, this has somewhat normalized as the COVID threat has diminished. Additionally, in 2023, we observed certain macroeconomic conditions that caused our customers to be more conservative and resulted in a convergence in capital purchases. Another important factor for mid-throughput instruments was China. We did face impacts in China due to competition and macroeconomic conditions, as we've noted in our 2023 earnings calls. While competition was a factor in China, it doesn't seem to be a major issue elsewhere in the world. We closely monitor our competitive win rates, and we observed a stabilization in the third and fourth quarters.

Operator, Operator

And moving on to Dan Brennan with TD Cowen.

Dan Brennan, Analyst

Great, thanks for the question, guys. On the 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, CEO

Thank you, Dan. It seems you've done more calculations than we have at this stage as it's still quite early to assess the pull-through from the X. We haven't actually performed that analysis yet. We will share that information when we believe the situation is more stable and it makes more sense to do so. Joydeep, do you have any additional comments on that?

Joydeep Goswami, CFO and Chief Strategy and Corporate Development Officer

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, Operator

And we have a question from Dan Leonard with UBS.

Dan Leonard, Analyst

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, CEO

Yes, I think that's a great question, and I was eager to understand it better when I joined Illumina. I have a background in IBD and a strong passion for cancer diagnostics. Our focus is on serving many clinical customers who are utilizing the Illumina ecosystem and building companies, particularly in the LDT space. While we offer our own products in LDTs, we also focus on IBD, especially with TSO 500, NIPT, and other areas. Our TSO 500 business has been growing rapidly and has surpassed $100 million, with expectations of high double-digit growth this year as well. I remain optimistic about its potential. We are currently conducting a strategic review to see how this aligns with our overall business strategy, and we intend to continue our involvement in that area. Was there a second part to your question?

Joydeep Goswami, CFO and Chief Strategy and Corporate Development Officer

Regulation impact?

Jacob Thaysen, CEO

Yes. We are closely monitoring the impact of regulation. We are having discussions with our customers to ensure they are prepared. Larger customers can pursue a single-site PMA, which is beneficial for them. Additionally, there may be changes regarding the classification of certain products, with some Class III products potentially being reclassified as Class II. If that occurs, it would likely lessen the requirements for clinical trials. There are many factors still in play, but I believe Illumina is well positioned to support the markets moving forward, regardless of where the FDA lands on this issue.

Joydeep Goswami, CFO and Chief Strategy and Corporate Development Officer

I would like to add, Jacob, that we are one of the few companies with ISO 13485 classification for all our instruments and most of our consumables in our REO products. We also have a pathway to IBD if our customers choose that option. Therefore, we are well positioned to support any direction they wish to pursue.

Operator, Operator

And we'll take our next question from Kyle Mikson with Canaccord.

Kyle Mikson, Analyst

Hey, guys. Thanks for the questions. 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 visibility or confidence do you have? Enhance conservatism are you kind of baking in compared to prior years? And you listed some of the most material swing factors and kind of risks that we should consider in Q1 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, CFO and Chief Strategy and Corporate Development Officer

Let me start with the NovaSeq 6000. When it was first launched, we didn't have as many clinical customers. Now, around 50% of our revenue from the Conn’s segment comes from clinical customers who utilize these validated assays. Because of this, the overall reduction in pull-through will be less severe than what we experienced with HiSeq. Jacob, would you like to share your thoughts on the overall guidance, or should I take that?

Jacob Thaysen, CEO

You can continue.

Joydeep Goswami, CFO and Chief Strategy and Corporate Development Officer

So I think overall, look, we have repeatedly said, right, we see this as a prudent approach to the overall forecast. While there have been some signs in some markets that the macroeconomic conditions might be turning, we have not assumed this in our forecast. The only place we have been pessimistic, 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. We will continue to do that. Of course, if the markets pick up, we are very well positioned 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.

Operator, Operator

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

Rachel Vatnsda, Analyst

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 Q4 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 X's 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, CFO and Chief Strategy and Corporate Development Officer

Yes. First, it's clear that we designed the X and X consumables with the expectation that, at scale, their margins would be similar to those of X consumables. In the early stages of adoption, it's normal to see lower margins from the consumables since we haven't fully scaled up. As we progress through 2024, you can expect those margins to normalize. Overall gross margins in 2024 will be influenced by several factors. One, we anticipate some benefit from a slight reduction in instrument placements, which we believe will result in higher consumables, leading to an increase in gross margin. Additionally, improvements we've implemented to enhance cost of goods sold productivity will also contribute to better gross margins as we move into 2024.

Salli Schwartz, Vice President of Investor Relations

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

Thank you. That does conclude today's conference. We do thank you for your participation. Have an excellent day.