Earnings Call Transcript - ILMN Q2 2020

Operator, Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2020 Illumina Earnings Conference. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. As a reminder, this conference call may be recorded. I would now like to introduce your host for today's conference, Ms. Jacquie Ross, Illumina, Investor Relations.

Jacquie Ross, Investor Relations

Good afternoon everyone and thanks for joining us for our 2020 second quarter results. 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've 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. Similar to last quarter, we are hosting our call from a number of different locations. 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 document that Illumina files with the Securities and Exchange Commission including Illumina's most recent Forms 10-Q and 10-K. With that, I'll turn the call over to Francis.

Francis deSouza, President and CEO

Thank you, Jacquie. Good afternoon everyone and thank you for joining us today. As expected, the second quarter was tough in the context of our original 2020 plan. But nonetheless, it was a quarter of strong execution in the current environment that further strengthens our foundation for future expansion. I've been proud to see how our employees have pivoted and flexed to support customers, how we have stepped up what was already an aggressive innovation engine, and how we have supported each other in our communities through this pandemic. As we navigate the near-term disruption, we remain focused on the long-term opportunity for Illumina and for sequencing, which, if anything, is larger today than it was six months ago. To summarize our second quarter experience and outlook. Our second quarter revenue of $633 million was down 25% from a year ago, as our customers around the world continue to be impacted by the pandemic. We are seeing indicators of gradual recovery and barring an unexpected development in the course of the pandemic, the second quarter should represent the revenue floor for the year. Further, we expect sequential revenue growth in the third and fourth quarters. Despite lower patient visits, our clinical business remains more resilient than research, which continues to be more impacted by ongoing shelter-in-place restrictions. Second, infectious disease is emerging as an additional long-term focus area for genomics. Illumina has responded quickly with three workflows, including software tools and COVIDSeq, our diagnostic test for COVID-19, which went from concept to authorization in less than 60 days. Given the timing, these contributed very modestly to revenue in the second quarter, and we're encouraged by the interest we are seeing so far in the third quarter. Finally, and most importantly, we believe that the long-term opportunity for sequencing is expanding. While COVID-19 has had a negative short-term impact on our customers' ability to operate, this shared experience is broadening awareness and appreciation of the value of genomic insights. Studies, including GEL's 35,000 patient study in the UK could ultimately accelerate the adoption of genomic tests into routine clinical use for infectious disease and surveillance. Looking to the second half of 2020 specifically, sequencing consumables, which make up most of our revenue, remain correlated with shelter-in-place activities and recovery; therefore, it depends on how quickly our customers get back into their labs. That said, we are encouraged by the momentum in the business as we move into the second half of the year. Sequencing consumable run rates are improving and some of our clinical customers are at or above their run rate from the fourth quarter of last year. Sequencing system placements increased sequentially, including higher NovaSeq shipments. Additionally, NextSeq 2000 shipments beat our second quarter expectations. Population genomics initiatives are continuing to move forward. For example, All of Us has received the necessary IDE from the FDA and we will start sequencing and genotyping later this quarter. And beyond research, COVID-19 related sequencing for both diagnosis and screening is at an earlier stage of adoption and could scale more meaningfully in the second half of the year. Sequencing continues to play a critical role in understanding the SARS-CoV-2 virus, the transmission dynamics of the pandemic, the development of effective treatments and vaccines, and the interactions between host and virus with respect to transmission and virulence. In addition, we are seeing growing interest in leveraging sequencing to help address the need for increased diagnostic and screening testing capacity. To contribute to testing capacity, Illumina urgently developed COVIDSeq, the first NGS-based diagnostic for COVID-19. We received emergency use authorization from the FDA on June 7 and shifted to a few early access customers toward the end of the second quarter. For example, they intend to launch toward the end of this quarter and scale through the end of 2020. COVIDSeq runs in our NovaSeq and, in addition to a diagnostic 'yes' or 'no', provides a full viral sequence for most positive samples. This information can be critical to understanding community transmission patterns to better control regional outbreaks. We continue to extend the utility of COVIDSeq with a series of amendments that will add saliva, improve automation, and de-risk the supply chain. In the immediate term, we have submitted an amendment to the current authorization for our existing COVIDSeq test that simplifies the workflow with an additional RNA extraction method to de-risk the supply chain and extend the test beyond our NovaSeq by adding NextSeq. This will enable lower throughput labs to offer COVID-19 diagnostic testing locally, which could supplement current PCR test providers who are experiencing turnaround times of up to 10 business days. Looking forward, and with Illumina's COVIDSeq supply scaling up, we are in discussion with dozens of customers in more than 10 countries, with a number of these actively evaluating COVIDSeq. For example, the Institute of Genomics and Integrative Biology in New Delhi just completed their first clinical validation of COVIDSeq and reported sensitivity of more than 98% and an increase in diagnostic yield of between 8% and 10% compared to PCR. The team is interested in COVIDSeq as a means to increase available frontline testing while also gaining access to the viral genome data that can be used to monitor transmission of the virus. In addition to COVIDSeq, we are pleased that Ginkgo and Helix were among the seven recipients of funding from the NIH's rapid acceleration of diagnostics initiative. This underscores the potential for sequencing-based diagnostic tests to scale and diversify testing beyond PCR, which we believe will be increasingly important as we head into the fall flu season. Moving to screening; it remains to be seen how widely screening programs are adopted, but it is clear that a number of programs will scale in the third quarter. Testing for America announced a partnership with Historically Black Colleges and Universities to develop return to campus initiatives for the academic institutions within the Thurgood Marshall College Fund and the United Negro College Fund Family. Delaware State University, for example, started its pilot screening program a few weeks ago with plans to test up to 3,000 students and educators a week. Back to the quarter, and starting with regional results. All regions were impacted by prolonged closures or reduced operations at research labs, and also, in some cases, by temporary reallocation of resources to PCR testing for COVID-19. China's revenue was down $5 million sequentially, consistent with our expectation for a relatively modest decline. COVID-19 headwinds were driven by the research market with extended closures amongst some universities and research institutes that we expect to continue into the third quarter. Clinical, however, has shown some resilience through the pandemic with growth both sequentially and year-over-year driven by reproductive health. Oncology testing is still below pre-COVID-19 levels, but improving. EMEA revenue of $168 million was largely in line with our expectations and reflected significant sequential declines in both research and clinical sequencing consumables. Research headwinds were driven by lab closures, while some other customers redirected resources to non-sequencing based COVID-19 diagnostic testing. As expected, the Americas region saw the largest sequential dollar impact from COVID-19, down $142 million from last quarter to $335 million. Compared to April, more academic and government labs are resuming operations, but most are still operating well below pre-COVID-19 levels. Clinical continues to be more resilient with some customers reporting lower clinical samples associated with shelter-in-place restrictions. Finally, the Asia-Pacific region reported revenue of $51 million compared to $57 million in the second quarter of 2019 as research labs reduced activity. Moving to the customer view; we continue to track sequencing run rates as an indicator of general activity. But remind you that this is not directly correlated to revenue. It's clear that while customers navigate this pandemic, many are maintaining a lower level of sequencing consumable inventory than before. As a result, shipments and therefore revenue are lagging the recovery we're seeing in run rates. That said, in clinical, we shared that the run volume at the end of April was about 80% of the run rate in the fourth quarter of last year. Clinical run rates for the second quarter of this year averaged 84% of the Q4 '19 run rate. The trend is one of modest recovery, but with significant variation from week to week. Within clinical, reproductive health continues to be the most resilient, followed by oncology. Moving to research, the second quarter run rate improved from about 55% at the end of April to about 65% of the Q4 '19 run rate, but clearly remains significantly impacted by the pandemic. Weekly run rates among research customers are more variable than clinical. While commercial disruption has been unavoidable, the broader Illumina team continues to execute against our strategic priorities with new product releases and acquisitions that are intended to further enhance our customers' application portfolio and ease of use and expand our market opportunity. Early feedback on NextSeq 2000 has been very positive with customers reporting that the sequencers outperform expectations with the excellent data quality they have come to expect from Illumina. Despite the shift to the virtual world, our team has done a terrific job of installing new systems and getting customers up and running, which speaks to the strength of our support organization as well as the underlying engineering and product design. Additionally, customers are showing continued interest in the P3 flow cell, which remains on track for a fourth quarter launch. As noted earlier, we obtained the first emergency use authorization for a sequencing-based COVID-19 diagnostic test in early June, highlighting our versatile R&D and regulatory capabilities. In early July, we launched the TruSight Software Suite for genetic disease that enables labs to accelerate time to potentially transformative genomic insights from weeks to hours. The TruSight Software Suite helps customers quickly sort through millions of variants to identify hard-to-find genomic conditions. We believe that this TruSight Software Suite could over time become part of a new standard of care for newborns suspected of a genetic condition. There is already broad and growing reimbursement offered for genetic disease testing. As the opportunity for clinical sequencing grows, we continue to identify and address bottlenecks to adoption, and this has resulted in innovation across the entire sequencing workflow. Most recently, we announced our new DNA PCR-free prep that reduces library prep time by as much as 75%. This accelerates time to result and improves lab efficiencies, which are both even more important in the context of clinical samples. At the other end of the workflow, we continue to find ways to help our customers store, manage, and analyze the vast amounts of data generated by our sequencers. With that in mind, we closed two technology acquisitions in June and July that, combined with our existing software solutions, improved the efficiency and scalability of processing and sharing data. BlueBee offers software solutions that enhance users' ability to extract insights from genomic data stored in Illumina's analytics platform, while Enancio brings proprietary lossless genomic data compression software that reduces storage footprint fivefold and will be integrated directly into the Dragon workflow. Outside of the sequencing workflow, but important nonetheless, we received positive feedback on our new sustainable reagent packaging, which will divert almost 250,000 cubic feet of foam packaging from landfills each year. Finally, I'm pleased to announce some enhanced features and new pricing for our NovaSeq reagent kits. The new reagent kits deliver longer shelf life and extra cycles, extending our performance lead in the high throughput market. Additionally, the new kit offers more accessible pricing for any NovaSeq user, bringing the $600 genome into reach for all our customers. These changes represent Illumina's ongoing commitment to sequencing innovation to enable deeper sequencing adoption of more data-intensive applications like whole-genome sequencing, single-cell and liquid biopsy, and larger cohorts to increase the statistical power studies. With that, I'll hand it over to Sam to discuss the financials in more detail.

Sam Samad, CFO

Thanks, Francis. As discussed, second quarter revenue declined 25% year-over-year to $633 million as the pandemic impacted our research customers in particular. Total sequencing system revenue of $88 million was slightly ahead of our expectations with stronger than expected NextSeq 2000 shipments. Shipments for NovaSeq, NextSeq 2000, MiSeq, and MiniSeq all increased sequentially. We continue to see NextSeq 2000 adoption across a broad range of clinical and research applications including oncology testing, single-cell, molecular pathology, and infectious disease including COVID-19 Research. For the second quarter, most of the NextSeq 2000 shipments were legacy NextSeq conversions, and cumulatively to date, roughly a quarter of the new systems have been shipped to new-to-Illumina customers. Sequencing consumable revenue was $387 million with many customers still operating below pre-COVID levels. Interestingly, clinical sequencing consumable revenue represented close to 50% of total sequencing consumables given the greater pandemic impact we're seeing among research customers. Sequencing service and other revenue was $91 million down sequentially due to lower licensing revenue and down year-over-year due to lower sequencing service revenue. Overall, sequencing revenue was $566 million and represented 89% of total revenue. Total array revenue was $67 million, down 39% from the same quarter last year and down 32% from the first quarter of 2020, in part due to our lower expectations of the DTC market and its normal seasonality in addition to COVID-19 related headwinds. Moving through the P&L, as always, 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 68.6% was lower than expected on both a year-over-year and sequential basis due to lower revenue which generated less fixed cost leverage and higher freight costs associated with the pandemic. Non-GAAP operating expenses of $334 million were down $5 million from the first quarter of 2020 and $26 million lower than the second quarter of 2019. This was lower than expected due to an adjustment to stock-based compensation expense to account for updated EPS projections. Non-GAAP operating margin was 15.8%, down from 33.6% last quarter. The non-GAAP tax rate of 18.5% was up from last quarter and prior year due to a higher income mix in jurisdictions with a higher tax rate. For the second quarter of 2020, GAAP net income was $47 million or $0.32 per diluted share and non-GAAP net income was $92 million or $0.62 per diluted share. On a per share basis, our GAAP results include $0.61 for two discrete tax expense items. The first of these relates to a valuation allowance established against the deferred tax asset for California R&D tax credits and the second reflects the finalization of the Altera court case, which determined share-based compensation must be included in intercompany cost-sharing payments. This is partially offset by $0.38 on a per share basis from other income, which includes $69 million in unrealized gains from equity investments. Additionally, in the second quarter, cash flow from operations was $240 million, capital expenditures were $38 million, and free cash flow was $202 million. DSO of 55 days compared to 50 days last quarter in part due to less favorable revenue linearity and lower revenue. We repurchased $143 million of common stock. We therefore ended the quarter with approximately $3.3 billion in cash, cash equivalents and short-term investments. Our weighted average diluted share count for the quarter was approximately 148 million. We have $420 million available for share repurchases under our current plan. Additionally, our 2021 notes became convertible from July 1 through September 30, 2020. And as a reminder, the dilutive effects of the convertible notes have been included in our diluted average share count since the second quarter of 2018. We continue to believe that the uncertainties around the severity and duration of the COVID-19 pandemic and the impact that has on our research customers in particular makes it challenging to provide quarterly or full year outlooks at this time. Directionally, we can share that we expect sequencing run volumes for our clinical customers to modestly improve from the 84% reported in the second quarter. For research and applied, we remain cautious and expect run volumes to improve modestly over the 65% reported in the second quarter. We expect sequencing instrument revenue to grow modestly on a sequential basis, and we expect the revenue to be flat to slightly up. In terms of regional performance, we expect sequential growth in every region in the third quarter. While some regions are recovering more quickly than others, there will certainly be headwinds across all regions and when compared to the third quarter of 2019, we expect revenue in all regions to be lower with the exception of APJ, which is expected to be about flat. For the third quarter of 2020, we expect non-GAAP EPS to be modestly higher compared to the second quarter of 2020 reflecting a gradual improvement in revenue, a sequential decline in non-GAAP gross margin in part driven by the adjustment to stock-based compensation in the second quarter and increased field service activity as labs reopen and an increase in non-GAAP operating expenses primarily driven by the adjustment to performance-based compensation in the second quarter. While we expect operating expenses to grow sequentially in the third quarter, we remain thoughtful and deliberate about where we invest. This means continuing to invest in R&D projects and utilizing our balance sheet to pursue growth opportunities. As a genomic technology leader, we believe we have an obligation to invest in innovation regardless of short-term revenue headwinds. But at the same time, we will balance this in other areas by pausing or delaying certain capital expenditures and limiting other discretionary spending. With that, I'll hand the call back over to Francis.

Francis deSouza, President and CEO

Thank you, Sam. While the near-term disruption is challenging as we continue to navigate the pandemic, we remain as bullish as ever on the opportunity ahead for Illumina. The long-term opportunity for sequencing is expanding as the need for more infectious disease research and surveillance capabilities comes into focus. Innovation remains our North Star and we will continue to partner with our customers as well as innovate internally to ensure that sequencing-based applications are contributing to global efforts to combat this pandemic and whatever combination of research, diagnostics, screening, and surveillance applications is the most impactful. Our competitive position is strong with the recent preliminary injunction helping protect our intellectual property here in the United States. Looking beyond the pandemic, we remain unwavering in our commitment to innovation and to investing appropriately to progress our technology pipeline and continue to deliver gold standard sequencing products to market. My thanks to our customers and to our employees who are demonstrating resilience and flexibility as we work through this pandemic together. With that, we can start the Q&A.

Operator, Operator

Your first question comes from Tycho Peterson, JPMorgan.

Tycho Peterson, Analyst

Thank you, Francis. I understand you don’t have guidance available, but can you help us by providing some insights into the COVID testing opportunity? You mentioned that this will scale more significantly in the second half of the year and that you have a dozen customers across ten countries. Could you give us any framework on how you’re approaching the scale-up and the potential impact? Additionally, regarding PopSeq, at the start of the year, you mentioned 280,000 genomes; there have been some delays, so could you update us on what percentage you expect to complete in the latter half? Lastly, concerning China, you reported a 19% decline, which was unexpected considering the recovery there. Could you discuss this and when you anticipate a return to growth? Thank you.

Francis deSouza, President and CEO

Okay. So, let's go through each of those in order, Tycho. So first let's talk about COVID and how we expect that to scale in the second half. As we said in the prepared remarks, we saw very little COVID-related revenue in Q2, and we expect that to start to build into the back half of the year. In our base modeling, we are modeling little COVID-related revenue certainty in Q3, but there are a number of areas where our customers are looking to use sequencing that we expect to start to contribute revenue in Q3, and then ramping in Q4. Those areas are research, diagnostics, screening, and surveillance. On the research side, there are a number of projects that got kicked off in Q2 that will start to scale in Q3 and into Q4. Examples include what's happening with genomic sequencing, for example, in the UK NHS GEL project where they're looking at 35,000 COVID patients, and they are sequencing them to understand what are the drivers of the severity of the infection. There's also projects like CanCOGeN in Canada or GMI. On the Diagnostics side, we have a number of customers that are starting to scale up their diagnostic capabilities and so we have customers like Ginkgo, Helix, and Garden to UCLA; they've all just started to scale up their diagnostic capabilities, and we expect them to begin to scale in Q3 and then ramp up in Q4. We also have some customers that are looking at rolling out a screening-based offering as part of Back to School or Back to Work initiatives. One example includes what's happening at Delaware State University, as I mentioned in the remarks, where they are working with one of our customers to screen about 3,000 educators and students a week as part of getting people safely back into school. It remains to be seen how those initiatives scale up over Q3 and Q4, and it's quite a range of outcomes there as you can imagine getting fairly big if it really gets adopted as a way to get people back safely to school. There are a number of surveillance initiatives that are starting that are looking at helping track the epidemiology of the pandemic, and they are also looking to put together infrastructure that will last beyond this pandemic. For example, there is work happening around the CDC in terms of setting up a surveillance infrastructure. So those are the four buckets: research, diagnostics, screening, and surveillance, again very little in terms of revenue so far, but starting to ramp in Q3 and heading towards the end of the year. That was the first question. The second question, I believe you asked about PopGen. In terms of all of us, we didn't see any sequencing revenue associated with them in Q2, but there was progress there where they received the IDE from the FDA and are looking to start ramping up in Q3, and then more meaningfully ramp up in Q4. The UK NHS has really focused — it has put on pause the project that it had, and is really now focused on the GEL-related project that I just talked about. The UK Biobank was sequencing in Q2, but significantly down in terms of run rate from where it was in Q1, and we expect that to continue to ramp over the course of the year. In terms of China, which I think was the last part of your question, it was down and what we're seeing in China is a real headwind in the research market, where although we are seeing China sort of work its way back to normal, there is still a phenomena where a lot of the academic labs are either closed or operating at lower capacity or being repurposed for COVID-related testing. The research market in China continues to be down. Having said that, we're seeing more resilience in China from the clinical market, and so we saw strength in the NIPT side of the business and in oncology, relative to the research market.

Sam Samad, CFO

Yes. And I would just add, Tycho, on the clinical side in China as well, we're seeing growth actually sequentially and year-over-year. We saw that in Q2. So definitely resilience on the clinical side of the market in China, but research heavily impacted by the closures. The Beijing resurgence as well in the closures associated with that didn't help either in the quarter.

Operator, Operator

Your next question comes from Steve Beuchaw from Wolfe Research.

Steve Beuchaw, Analyst

Hi, good afternoon and thanks for the time here. Two things I wanted to touch on. One is academic and two is sort of lead indicators, I guess I'd call it. In academic, I think we all have a pretty good understanding as to why it's a challenging environment, right? It has nothing to do with Illumina; it's just the way the world is right now. But what I wonder is, how do you think about, to what extent this is demand destruction versus demand deferral. I mean, I'll elaborate on that a little bit. So, the funding in a lot of cases, it's there, but it's hard for people to get into the lab; does that mean that these projects are simply being deferred into some point out in the future? To what extent are you concerned about the funding itself, given the challenges that universities are facing though I don't know that they are the entirety of your academic funding set, if you will? And then, the second thing I want to talk about or ask about is Francis, early on in your prepared remarks you made a comment that suggested that at some point out in the future as a function of everything that's going on right now, you think the TAM is larger. So I wonder if you could just elaborate on that and I'm sure you've already touched on a lot of the points, but how do you track that? What is it you're seeing day to day or is it mostly intuition? Are there project metrics or quoting activity that you're looking at that give you a view as to what is likely to emerge in terms of sequencing activity, some number of weeks or months or quarters out into the future that you would be willing to talk to us about a little bit? Thank you.

Francis deSouza, President and CEO

Sure, Steve. Thank you for the question. So there are two parts to it. The first part is around what do we expect will happen in the academic markets around research dollars and whether we expect the projects to be deferred or canceled and how are we thinking about it. The feedback we're getting from our customers Steve, is that the projects are being deferred; they aren't being canceled, they're being deferred because either people are working at home as part of shelter-in-place initiatives and are unable to do the research that they need to do right now, or they are in the lab, but they're being directed to non-sequencing COVID-related work. They are being told that it is their intent to get back to those research projects and even in cases where there is a deadline associated with funding for those projects, in many cases, the deadlines are being pushed out to allow them to come back and pick up on the work. The clear feedback we're getting from our customers is that those projects are on pause and they expect to pick them back up. In addition, what we are hearing from our customers in the research community is that there is additional funding coming into the mix as a result of the pandemic. What they are seeing is money being allocated to genomics research associated with the pandemic, whether it's to do with the host response, for example, or understand why some people are impacted more severely by the disease or a whole host of other things that's driving more dollars into the research market. So they are thinking about how to plan those projects right now. Additionally, they are telling us that the early signals around NIH budgets for example in the US are very positive, that early proposals are around an increase of about $5.5 billion to the NIH budget on a base of about $47 billion; so pretty substantial increase as the first proposal. That includes things like COVID-related work, but it also proposes an increase into the funding of NHGRI, which is directly related to genomics initiatives. So, the academic research signals about the comeback in academic research seem very positive to us right now. That's part of the reason why we introduced the $600 dollar genome because we want people, as they are thinking about the projects that they will take on and will come back in, to be able to cope them appropriately and go broader with their mission because now they can plan larger projects with deeper sequencing or larger cohorts. There is definitely a lot of thinking about what they do when they come back. So that was the first part of your question. The second part of your question was around how does this impact the addressable market for Illumina, what's been the impact of the pandemic? It's becoming clear to us that the overall TAM for Illumina has expanded over the last few months; if you had talked to us, even in January or certainly by December or before, we really would have talked about the opportunity in clinical oncology and reproductive health, but not a lot about infectious disease. Clearly that's really changed over the last few months. What is becoming very clear is that there is a role for genomics in a number of areas in infectious disease. There is an existing role for genomics that is scaling up in research, so there was always some genomics-related research in infectious disease that's really starting to scale up as we look to the coming months and quarters around some of the things I talked about — like understanding the virus, understanding the interaction of the virus and the host. There is also a real need for genomic testing in diagnostics, and that's fairly new right? If we talked a few months ago, we would have said that the infectious disease diagnostics market is primarily a PCR market and that's changing as we look forward. There's going to be sequencing-based diagnostic capability that comes to market because of customers of ours like Ginkgo or Helix, and that's going to be an important part of the diagnostic testing market going forward. It is new and it's real. We're also seeing customers explore a much larger opportunity about screening, and we're early in that. You've heard about what's happening in Delaware State University. But that represents an entirely new opportunity around thinking about how you create safe environments in schools and work, and that's a new part of the market that's becoming accessible to genomics. Finally, there is a surveillance opportunity, and this is something that I think is durable because it's becoming very clear that we need a global pathogen surveillance network that's genomics-based, we need a much better early warning system to understand if there is a viral outbreak happening and that could be for things like the Coronavirus today. But looking forward, it's needed for antimicrobial resistance, for bio-terrorist attacks, for example, and there is a need for an early warning system. There is a need for a network system that understands the transmission and virulence of the pathogen as it makes its way through our population and is able to track the epidemiology of it, and so that's also new. This is starting to be put into place and it's something that we will need from now on. That's a whole new part of the market that's being introduced to genomics.

Operator, Operator

Your next question comes from Doug Schenkel from Cowen.

Doug Schenkel, Analyst

Hey, good afternoon. I want to start with the question on COVID and then ask a higher-level question on the capital equipment outlook. So starting on COVID. Yes, while there's little to debate that your efforts to help develop COVID solutions broadly should be commended and widely appreciated, I think it's fair to say there is a ton of debate in both the clinical as well as the investor community about how big a role Illumina next-generation sequencing approaches such as SwabSeq can play as a true clinical testing solution given the associated complexity and logistical challenges. We've all read about exciting initiatives such as those perceived by Ginkgo, but we've also read about places like the Broad Institute, which have a ton of sequencers setting there, are really sophisticated, maybe the most sophisticated in the world, and yet while they're doing the most COVID testing volume in Massachusetts, we have no plans to use Illumina NGS for clinical sequencing. With that in mind, how many labs do you think are going to try to do what Ginkgo is doing? And for market sizing purposes, is it fair to conclude that the revenue per test opportunity for that approach is likely somewhere between $1 to $3 per test? The second thing I want to talk about capital. It's great to hear that clinical volumes are picking up and that folks are getting back in the lab, and obviously those are good signs when it comes to the outlook for consumable demand. But instruments — year-over-year you did better than I think a lot of us expected in the quarter. But as you look ahead, what do you think is going to happen, like how are you thinking about the second half? Are you thinking that labs, even if they get back and pick up activity, are going to tend to hold back a little while on capital spending when possible, just given the uncertainty of the environment? Thank you.

Francis deSouza, President and CEO

Thank you, Doug. So let's work through parts of your question. The first part was around the real role of NGS in COVID testing and what kind of role will NGS play given that the majority of testing is being done on PCR and has been. So let's start there and then I'll talk about capital equipment. In terms of COVID, again, if I look at research, diagnostics, screening, and surveillance, there's no question that there are research projects that are coming online that are uniquely suited to NGS compared to PCR. So all the projects that I talked about really, they are new, they are incremental, and they need NGS. So whether it's GMI in Ireland or any one of the projects that I talked about, that will be done on NGS and those will ramp over the course of the year. In diagnostics, there's no question that the first wave of testing was already done on PCR. So, as the world needed to scale quickly its testing, it absolutely made sense for all of that scale up in the first wave to happen on PCR. The reason NGS is being pulled in now is due to a few reasons. One is, we are running into capacity constraints, right? When we talk to labs in certainly you read that — even here in the US, the turnaround times associated with the testing in the US right now can be 10-plus days, and when you ask the labs why that is, they will tell you there are supply chain constraints that all the PCR testing services are competing for the same elements in the supply chain. Labs are talking to us about needing a testing modality that doesn't compete for the same supply chain resources. That's where NGS comes in and that's why they expect a significant need for testing. We were talking to one lab and they said look on a given day, they will turn down 20,000 people for tests just because there is no capacity, so there is clearly need for a sizable system that doesn't compete for the same supply chain. That's one reason we're being pulled into diagnostic testing. Another reason we're getting pulled into diagnostic testing is in some cases, people want more information. They don't just want the diagnostic 'yes' or 'no,' they want more information. They want to do a confirmatory for example if somebody is positive on PCR. In some cases, they want to run a certain percentage of the negatives just to make sure that there isn't a false negative problem happening. And so for that reason too, they're looking to scale up their NGS capacity. So, those are some of the reasons we're being pulled into diagnostic testing and you asked about SwabSeq versus COVIDSeq and frankly, obviously, we support them all. SwabSeq has been developed to provide a quick diagnostic 'yes' or 'no' answer, right? So it's a cheaper test and it does give you that yes-no answer, and there are various flavors of SwabSeq that are being implemented by different customers of ours. You asked about the economics; you can think about depending on the flavor, it's sort of in the low to mid-single digits per test that comes to Illumina. If the customer is using COVIDSeq, you should think about it as a $20 test for example that comes to Illumina. So, that is sort of the drivers of why NGS is being pulled into diagnostics. Now to help with that obviously, we developed COVIDSeq and sort of launched it at the end of Q2. We've just filed for the EUA amendment to make the workflow simpler and to enable COVIDSeq to be run on NextSeq, which allows smaller labs to do the COVID testing. The next question you had about capital; I'm going to turn it over to Sam.

Sam Samad, CFO

Yes. So if I can jump in real quick, Doug, on capital, I mean first of all, really encouraged by the results and the performance that we saw in NextSeq 2000 in Q2. It came in better than expected and really — the feedback that we're hearing from customers is great. What we're also hearing from customers is absolutely no outright cancellations of capital equipment or, you know, basically no need for capacity. They are delaying certain purchases and that's to be expected given the uncertainty. I mean they have been facing some pretty significant closures and we saw that also on consumables where they drew down inventories in Q2. So we're seeing delays, but we're not seeing cancellations. They are still interested in terms of our expectations for the second half. We're expecting definitely a sequential increase in terms of the revenue that we expect from instruments and obviously the placements as well.

Operator, Operator

Your next question comes from Dan Brennan from UBS.

Dan Brennan, Analyst

Great, thank you. Thanks for taking the questions. Quite a couple, which I'll wrap into one. First one would be just on the clinical market; I know the improvement that you're expecting in Q2 is fairly modest. I mean I believe when you look at a lot of data being reported out of hospitals, the improvement has been sharper through the quarter and the outlook I think is better. So I'm just wondering why you think you're not seeing a faster improvement for clinical NGS. Number two, just on pricing, do you expect, could you maybe elaborate a bit on this to just really open up maybe the lower end of the market you're offering a $600 price down to the smaller labs and do you think that could galvanize maybe NovaSeq upgrade cycle as things get a little better with funding? Then, kind of number three, back to COVID; I'm just wondering on screening. I would think kind of the time is now in terms of as schools are looking to open up in the next couple of weeks. The fact that you're pointing maybe to Q4 is when this could kind of become more real for you, what is it that kind of is taking more time to get to this point for screening for you guys? Maybe could you elaborate a little bit on your funnel? I know Francis, you talked about Delaware and you said there's a lot of interest, but any color in terms of the screening opportunity and what you're seeing from customers? Thank you.

Francis deSouza, President and CEO

Sure. Thank you, Dan. So let's start with the clinical market. It’s the story of two markets; if you look at what's happening in NIPT, it has actually been fairly resilient. In the Americas, we actually saw quarter-on-quarter growth in the NIPT market. From Q1 to Q2, even though overall revenues went down you did see growth in NIPT. On one part of the clinical market, that's been fairly resilient on the NIPT part and that's fairly consistent. If you look at oncology, what's happening is, even though the oncology segment is more resilient than the research market, it is less resilient than NIPT. What's happening, and this is a dynamic that's playing out more broadly, is that people aren't going in to get screened for cancer, and fewer people are being diagnosed with cancer. It’s not that they're not getting cancer just as much as they were before; they're just not going in. That's a human tragedy and it's showing up for us to where the oncology market has slowed down. Now, the cancer isn't going away and so at some point, we do expect people will go into get screened and will want to get tested so they can get matched for the appropriate therapy. So, in the oncology market, there is likely to be some catch-up that needs to happen now. Unfortunately, it won't help everybody, but there will be some catch-up that needs to happen. So that's dynamics playing out in the clinical market; on the NIPT side some more resilience and oncology some resilience but certainly not as much as on the NIPT side. In terms of the new NovaSeq pricing, the $600 genome, the intent is to make this more accessible for our Illumina customers with this kit. What we think that does is allow our customers to plan for larger projects themselves. They think about writing grants, and it's primarily targeted in the research market to whether it's single-cell applications or deeper sequencing or larger cohorts. We want them to be aware of the price point as they are planning the projects when they come back into the labs. I think this will be an incremental positive in terms of the economics for the maybe some smaller core labs that haven't yet upgraded from their HiSeqs to NovaSeq. I think this makes the economics even more compelling. In terms of screening, unfortunately the screening need isn't going to go away in the next couple of weeks as people go to school. I was talking to an individual who runs public health in America, and he and I sort of agree that we will meet this for at least a year or maybe somewhere between a year to two years. Because the reality is, even in an optimistic scenario, we're talking about a vaccine towards the end of this year becoming available; and then between being available and being broadly deployed, there's going to be some time. In that time, there's going to be a real need to make sure that we have safe schools and safe work environments, and that's where the need for screening is. I think that need for screening is going to play out even going into sort of the middle of next year. Now, we've talked about one case being rolled out; we have a number of customers that are working on their screening initiatives, and we’ll leave it up to them to be public about what they are doing.

Operator, Operator

Your next question comes from Puneet Souda from SVB Leerink.

Puneet Souda, Analyst

Yes, hi, Francis. Thank you for taking my question. I understand this topic has been briefly discussed, but I want to address a key point. Historically, we have seen Illumina achieve growth through demand elasticity, which has allowed you to enter multiple markets. This demand elasticity has led to the expansion of various markets, and you were pioneers in integrating into some of them, with whole-genome sequencing being a significant example that spurred market growth. As we look ahead to the next couple of years, do you think that research, testing, and surveillance related to COVID—recognizing the role of sequencing in these areas—can genuinely enhance that demand elasticity for Illumina? Moreover, considering the $20 per test price point, and the expectation that other solutions like TCR antigen and point-of-care technologies will emerge in these markets within the next year, I’m interested in your perspective on how you foresee the demand elasticity developing for Illumina. Thank you.

Francis deSouza, President and CEO

Yes, thank you, Puneet. I think that different parts of the COVID market need different price points and sort of what we want to do is make sure that we have the right offering at the right price point to activate the different parts of the market. So let me be more specific. If we look at the diagnostic part of the market, there you do need price points where labs are able to offer a test at $75 to $100, which is where reimbursement is and have a viable business. For this, something like COVIDSeq where the cost to their Illumina reagents is $20 or SwabSeq where it is in the single-digit dollars is exactly the right fit. So that's the price point that unlocks — that opens up that market for NGS. Now that market was never an NGS market; this was a PCR market. So, all of this is new dollars now that are available to NGS and to open up that market you need a test at the $75 to $100 price point. For Illumina, that's either low to mid-single digits or a $20 test but that's a large test. Similar with screening; that requires the same price point, and you may even with pooling be able to get to lower price points in that market, and that's the price point that you need to activate those markets. Screening could be a very large market and it needs that kind of price point. Now, research and surveillance can sustain a higher price point and so there, the $600 genome I think is the right sort of price point where if you're doing cohorts not measured in the millions, but measured in the thousands or tens of thousands, that $600 price point makes sense and activates that market. Surveillance, it could be even a little bit higher because you're not talking about again millions of samples. That's how we are thinking about the different markets and having different offerings with different price points to activate those markets.

Operator, Operator

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

Derik De Bruin, Analyst

Hi, good afternoon. So, a question on your comments about inventories being drawn down in the third quarter I guess. Where are they? And do you expect additional drawdowns in the third quarter, or could be some potential for some catch-up spending has come back? I just want to go back on the sort of the academic and government market. I mean, we've had some conversations with people talking about pressures on philanthropy and endowments, and we've seen a number of organizations, just the ACS, these are the ones cutting back on their spending. I know that's a big chunk of money that goes into supporting some of the sequencing centers and biomedical research centers. So, I'm just sort of wondering what you're hearing about potential personnel cutbacks and things in the academic markets. This sort of goes into another question about, are you expecting any sort of pick up or budget flush in the fourth quarter? Thanks.

Sam Samad, CFO

Yes. So let me talk about inventories, Derik. Thank you for the question. I'll hand over to Francis to talk about the academic dynamics that you referred to. With regards to inventories, Q2 really played out as expected for us in a number of ways, I would say on the instrument side was favorable, driven by NextSeq 2000. On the sequencing consumable side, really where I would say we had lower than expected performance was on the research side, driven by what we think is inventory drawdown in that market. As we talk to our customers, driven by a couple of things: first of all, the uncertainty, the fact that there are still closures, the fact that there is still uncertainty as they look forward, the fact that also supply chains have become less uncertain so they have more visibility to the fact that supply chains are not disrupted so they can actually get inventories when they need them. They don't need to stock up. When you look at the activity levels that we saw in Q2, it was really where we were expecting activity levels to be, but there was definitely a gap on the research side driven by research customers drawing down inventories. Your question is around what do we — what are we seeing in terms of the number of months of inventory with customers and what do we expect the dynamic — how we expect the dynamics to play out over the next few quarters; that's hard to project, Derik, in terms of whether we see starting back up, whether we see a different dynamic in Q3 or Q4. Really, we don't have that visibility. What we are expecting is that activity levels will be a proxy to how we see sequencing consumables sequentially grow in the next few quarters. As we said in the prepared remarks, we are expecting activity levels to improve modestly for both clinical and research in Q3. But in terms of predicting inventory and predicting customer behavior in terms of how they're going to stock or de-stock, that's really difficult to answer at this stage; it's easier to just explain the Q2 dynamic as we did.

Francis deSouza, President and CEO

Yes. And then in terms of academic and government funding, what we are seeing is that in some cases, researchers are getting more time to spend academic funding. So, that could certainly sort of prolong a little bit how long the project takes as people are sheltered in place and they have longer to actually use the money. So, we definitely are seeing that. We are, however, seeing that more money is coming into genomics-related COVID research, not less, and that's coming from some of the usual sources. So, for example, I talked about the proposal to increase NIH funding next year by $5.5 million, including an increase of just over $650 million to NHGRI. That's the proposal for NCRI. We're also seeing funding come into COVID-related research, surveillance from, for example, philanthropies. When we did the donation to the 10 countries in Africa for the African CDC, we were working with one of the largest philanthropies here in the US as well as one out of Asia to try and help deploy this global surveillance network. So, we are also seeing people who aren't usually funders of genomics work; for example, there’s an interesting cooperation between the expansion of the relationship between Microsoft and Adaptive for example around understanding the immune response to COVID. So overall, we are still seeing interest in government funding, academic funding, and philanthropy funding associated with that COVID genomic research.

Operator, Operator

And our last question comes from Jack Meehan from Nephron Research.

Jack Meehan, Analyst

Thank you. I have a few additional follow-ups. First, regarding the NGS consumables, what is your outlook on how long it will take for research labs to return to full capacity? Some customers have indicated they believe they can recover by the end of the year from the recent closures. Do you think that's a realistic expectation? Additionally, on the clinical side, as you implement COVIDSeq from the NextSeq box, can you provide an update on the expected turnaround time for testing and how it might address the needs for COVID-19? Thank you.

Sam Samad, CFO

Yes. Maybe I'll talk very quickly about the sort of research ramp that you talked about, Jack, and thank you for the question. Francis can talk about COVIDSeq and the NextSeq turnaround. Again, this is all assumption-based at this stage and it all depends on many factors around what we see with regards to the virus and the potential shelter-in-place restrictions. As we saw in Q2, we were going in the right direction and then things went in the wrong direction, I'm referring to the US here in terms of the response to the virus. But our expectations, Jack, is that as we mentioned earlier, we expect to see an improvement, we were at 65% average in terms of run rates in Q2. That's a proxy; that's essentially activity levels on the sequencers that are connected to our proactive network and the base space. We expect that to improve in Q3 and also sequentially improve in Q4. To get back to 100%, I can't answer that; that really is not something that we have visibility to at this stage. But I think the way you should be thinking about it is a gradual, modest improvement in terms of activity levels as we go forward, and that applies to clinical as well, but that's in response to your question on Research.

Francis deSouza, President and CEO

Yes, and then, Jack, in terms of your question on the turnaround time in NextSeq, obviously it depends on the workflow at our customers' sites that are implementing COVIDSeq and NextSeq in-house. The intent of course is to be able to have a test that allows turnaround in that 24-hour time frame, but it really depends on the customer.

Jacquie Ross, Investor Relations

Thanks, Mike. 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 press release. Thank you for joining us today. This concludes our call and we look forward to our next update following the close of the third fiscal quarter.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.