10-Q 1 fy13q210-q.htm 10-Q FY13 Q2 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
 
þ
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Quarterly Period Ended June 30, 2013
 
¨
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from             to            
Commission File Number 001-35406 
Illumina, Inc.
(Exact name of registrant as specified in its charter)
 
Delaware
 
33-0804655
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
 
5200 Illumina Way,
San Diego, CA
 
92122
(Address of principal executive offices)
 
(Zip Code)
(858) 202-4500
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   þ    No   ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   þ    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.:
 
Large accelerated filer
þ
 
Accelerated filer
¨
 
 
 
 
 
Non-accelerated filer
¨
(Do not check if a smaller reporting company)
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  ¨    No   þ
As of July 10, 2013, there were 125,120,781 shares of the registrant’s Common Stock outstanding.




ILLUMINA, INC.
INDEX
 
 
Page
 
 


2


PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.

ILLUMINA, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
 
 
June 30,
2013
 
December 30,
2012
 
(Unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
783,611

 
$
433,981

Short-term investments
345,852

 
916,223

Accounts receivable, net
207,413

 
214,975

Inventory
168,070

 
158,718

Deferred tax assets, current portion
84,887

 
30,451

Prepaid expenses and other current assets
56,558

 
32,700

Total current assets
1,646,391

 
1,787,048

Property and equipment, net
187,362

 
166,167

Goodwill
596,588

 
369,327

Intangible assets, net
304,469

 
130,196

Deferred tax assets, long-term portion
9,715

 
40,183

Other assets
78,677

 
73,164

Total assets
$
2,823,202

 
$
2,566,085

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
67,648

 
$
65,727

Accrued liabilities
198,788

 
201,877

Accrued legal contingencies
122,713

 

Long-term debt, current portion
29,731

 
36,967

Total current liabilities
418,880

 
304,571

Long-term debt
822,169

 
805,406

Other long-term liabilities
192,167

 
134,369

Conversion option subject to cash settlement
1,394

 
3,158

Stockholders equity:
 
 
 
Preferred stock

 

Common stock
1,726

 
1,703

Additional paid-in capital
2,530,075

 
2,419,831

Accumulated other comprehensive income
1,163

 
2,123

Retained earnings
95,837

 
82,547

Treasury stock, at cost
(1,240,209
)
 
(1,187,623
)
Total stockholders equity
1,388,592

 
1,318,581

Total liabilities and stockholders equity
$
2,823,202

 
$
2,566,085

See accompanying notes to the condensed consolidated financial statements.


3


ILLUMINA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(In thousands, except per share amounts)
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
July 1,
2012
 
June 30,
2013
 
July 1,
2012
Revenue:
 
 
 
 
 
 
 
Product revenue
$
313,497

 
$
258,839

 
$
609,667

 
$
514,475

Service and other revenue
32,597

 
21,768

 
67,385

 
38,902

Total revenue
346,094

 
280,607

 
677,052

 
553,377

Cost of revenue:
 
 
 
 
 
 
 
Cost of product revenue
98,150

 
74,911

 
188,128

 
155,062

Cost of service and other revenue
15,951

 
9,656

 
31,089

 
18,221

Amortization of acquired intangible assets
8,584

 
3,043

 
15,134

 
6,086

Total cost of revenue
122,685

 
87,610

 
234,351

 
179,369

Gross profit
223,409

 
192,997

 
442,701

 
374,008

Operating expense:
 
 
 
 
 
 
 
Research and development
67,608

 
71,223

 
129,058

 
120,062

Selling, general and administrative
88,700

 
68,516

 
173,774

 
136,485

Legal contingencies
9,516

 

 
115,369

 

Acquisition related (gain) expense, net
(5,725
)
 
1,080

 
(1,904
)
 
2,817

Unsolicited tender offer related expense
4,811

 
6,694

 
12,295

 
14,786

Headquarter relocation
(1,507
)
 
1,830

 
(750
)
 
3,970

Restructuring

 
674

 

 
3,296

Total operating expense
163,403

 
150,017

 
427,842

 
281,416

Income from operations
60,006

 
42,980

 
14,859

 
92,592

Other income (expense):
 
 
 
 
 
 
 
Interest income
722

 
1,385

 
2,655

 
3,911

Interest expense
(10,045
)
 
(9,508
)
 
(19,792
)
 
(18,710
)
Cost-method investment related gain

 

 
6,113

 

Other expense, net
(1,323
)
 
(70
)
 
(2,037
)
 
(2,733
)
Total other expense, net
(10,646
)
 
(8,193
)
 
(13,061
)
 
(17,532
)
Income before income taxes
49,360

 
34,787

 
1,798

 
75,060

Provision for (benefit from) for income taxes
13,483

 
11,386

 
(11,492
)
 
25,457

Net income
$
35,877

 
$
23,401

 
$
13,290

 
$
49,603

Net income per basic share
$
0.29

 
$
0.19

 
$
0.11

 
$
0.40

Net income per diluted share
$
0.26

 
$
0.18

 
$
0.10

 
$
0.37

Shares used in calculating basic net income per share
124,362

 
123,214

 
124,065

 
122,928

Shares used in calculating diluted net income per share
139,377

 
133,011

 
137,645

 
133,435

See accompanying notes to the condensed consolidated financial statements.


4


ILLUMINA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(In thousands)
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
July 1,
2012
 
June 30,
2013
 
July 1,
2012
Net income
$
35,877

 
$
23,401

 
$
13,290

 
$
49,603

Unrealized (loss) gain on available-for-sale securities, net of deferred tax
(540
)
 
(59
)
 
(960
)
 
86

Total comprehensive income
$
35,337

 
$
23,342

 
$
12,330

 
$
49,689

See accompanying notes to the condensed consolidated financial statements.


5


ILLUMINA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
 
Six Months Ended
 
June 30,
2013
 
July 1,
2012
Cash flows from operating activities:
 
 
 
Net income
$
13,290

 
$
49,603

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation expense
23,718

 
23,477

Amortization of intangible assets
20,162

 
6,934

Share-based compensation expense
48,671

 
47,076

Accretion of debt discount
18,032

 
17,298

Contingent compensation expense
2,751

 
2,965

Incremental tax benefit related to share-based compensation
(14,844
)
 
(11,205
)
Deferred income taxes
(28,833
)
 
(27,752
)
Change in fair value of contingent consideration
(5,262
)
 
2,817

Impairment of in-process research and development

 
21,438

Cost-method investment related gain
(6,113
)
 

Other
2,142

 
3,348

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
11,954

 
(13,213
)
Inventory
(8,359
)
 
(4,810
)
Prepaid expenses and other current assets
(650
)
 
1,851

Other assets
(3,262
)
 
(1,987
)
Accounts payable
(1,998
)
 
13,034

Accrued liabilities
(19,374
)
 
26,295

Accrued legal contingencies
122,713

 

Other long-term liabilities
1,708

 
4,600

Net cash provided by operating activities
176,446

 
161,769

Cash flows from investing activities:
 
 
 
Purchases of available-for-sale securities
(157,499
)
 
(562,241
)
Sales of available-for-sale securities
604,031

 
359,637

Maturities of available-for-sale securities
111,331

 
100,146

Net cash paid for acquisitions
(345,161
)
 

Purchases of strategic investments
(4,429
)
 
(15,030
)
Proceeds from sale of strategic investment
10,001

 

Purchases of property and equipment
(32,975
)
 
(34,030
)
Cash paid for intangible assets
(2,843
)
 

Net cash provided by (used in) investing activities
182,456

 
(151,518
)
Cash flows from financing activities:
 
 
 
Payments on long-term financing obligations
(9,140
)
 

Payments on acquisition related contingent consideration liability
(3,985
)
 
(3,374
)
Incremental tax benefit related to share-based compensation
14,844

 
11,205

Common stock repurchases
(50,020
)
 
(32,499
)
Proceeds from issuance of common stock
41,079

 
28,020

Net cash (used in) provided by financing activities
(7,222
)
 
3,352

Effect of exchange rate changes on cash and cash equivalents
(2,050
)
 
(169
)
Net increase in cash and cash equivalents
349,630

 
13,434

Cash and cash equivalents at beginning of period
433,981

 
302,978

Cash and cash equivalents at end of period
$
783,611

 
$
316,412

See accompanying notes to the condensed consolidated financial statements.

6


Illumina, Inc.
Notes to Consolidated Financial Statements
(Unaudited)
Unless the context requires otherwise, references in this report toIllumina,” “we,” “us,” the “Company,” and “our” refer to Illumina, Inc. and its consolidated subsidiaries.

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation. In management’s opinion, the accompanying financial statements reflect all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the results for the interim periods presented.

Interim financial results are not necessarily indicative of results anticipated for the full year. These unaudited financial statements should be read in conjunction with the Company’s audited financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 30, 2012, from which the balance sheet information herein was derived.

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses, and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates.

Fiscal Year

The Company’s fiscal year consists of 52 or 53 weeks ending the Sunday closest to December 31, with quarters of 13 or 14 weeks ending the Sunday closest to March 31, June 30, September 30, and December 31. The three and six months ended June 30, 2013 and July 1, 2012 were both 13 and 26 weeks, respectively.
 
Reclassifications

Certain prior period amounts have been reclassified to conform to the current period presentation.

Reserve for Product Warranties

The Company generally provides a one-year warranty on instruments. Additionally, the Company provides a warranty on consumables through the expiration date, which generally ranges from six to 12 months after the manufacture date. At the time revenue is recognized, the Company establishes an accrual for estimated warranty expenses based on historical experience as well as anticipated product performance. The Company periodically reviews the adequacy of its warranty reserve and adjusts the warranty accrual, if necessary, based on actual experience and estimated costs to be incurred. Warranty expense is recorded as a component of cost of product revenue.

Revenue Recognition

The Company’s revenue is generated primarily from the sale of products and services. Product revenue primarily consists of sales of instrumentation and consumables used in genetic analysis. Service and other revenue primarily consists of revenue received for performing genotyping and sequencing services, instrument service contract sales, and amounts earned under research agreements with government grants, which are recognized in the period during which the related costs are incurred.
 
The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of the product or system is required, revenue is deferred until all the acceptance criteria have been met. All revenue is recorded net of any discounts.

7



 Revenue from product sales is recognized generally upon transfer of title to the customer, provided that no significant obligations remain and collection of the receivable is reasonably assured. Revenue from instrument service contracts is recognized as the services are rendered, typically evenly over the contract term. Revenue from genotyping and sequencing services is recognized when earned, which is generally at the time the genotyping or sequencing analysis data is made available to the customer or agreed upon milestones are reached.
 
In order to assess whether the price is fixed or determinable, the Company evaluates whether refund rights exist. If there are refund rights or payment terms based on future performance, the Company defers revenue recognition until the price becomes fixed or determinable. The Company assesses collectibility based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If the Company determines that collection of a payment is not reasonably assured, revenue recognition is deferred until receipt of payment.
 
The Company regularly enters into contracts where revenue is derived from multiple deliverables including any mix of products or services. These products or services are generally delivered within a short time frame, approximately three to six months, after the contract execution date. Revenue recognition for contracts with multiple deliverables is based on the individual units of accounting determined to exist in the contract. A delivered item is considered a separate unit of accounting when the delivered item has value to the customer on a stand-alone basis. Items are considered to have stand-alone value when they are sold separately by any vendor or when the customer could resell the item on a stand-alone basis. Consideration is allocated at the inception of the contract to all deliverables based on their relative selling price. The relative selling price for each deliverable is determined using vendor specific objective evidence (VSOE) of selling price or third-party evidence of selling price if VSOE does not exist. If neither VSOE nor third-party evidence exists, the Company uses its best estimate of the selling price for the deliverable.
 
In order to establish VSOE of selling price, the Company must regularly sell the product or service on a standalone basis with a substantial majority priced within a relatively narrow range. VSOE of selling price is usually the midpoint of that range. If there are not a sufficient number of standalone sales and VSOE of selling price cannot be determined, then the Company considers whether third party evidence can be used to establish selling price. Due to the lack of similar products and services sold by other companies within the industry, the Company has rarely established selling price using third-party evidence. If neither VSOE nor third party evidence of selling price exists, the Company determines its best estimate of selling price using average selling prices over a rolling 12-month period coupled with an assessment of current market conditions. If the product or service has no history of sales or if the sales volume is not sufficient, the Company relies upon prices set by the Company’s pricing committee adjusted for applicable discounts. The Company recognizes revenue for delivered elements only when it determines there are no uncertainties regarding customer acceptance.
 
In certain markets, the Company sells products and provides services to customers through distributors that specialize in life science products. In most sales through distributors, the product is delivered directly to customers. In cases where the product is delivered to a distributor, revenue recognition is deferred until acceptance is received from the distributor, and/or the end-user, if required by the applicable sales contract. The terms of sales transactions through distributors are consistent with the terms of direct sales to customers. These transactions are accounted for in accordance with the Company’s revenue recognition policy described herein.

Fair Value Measurements

The Company determines the fair value of its assets and liabilities based on the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs. The Company uses a fair value hierarchy with three levels of inputs, of which the first two are considered observable and the last unobservable, to measure fair value:

Level 1 — Quoted prices in active markets for identical assets or liabilities.
Level 2 — Inputs, other than Level 1, that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.


8


The carrying amounts of financial instruments such as cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, accounts payable, and accrued liabilities, excluding acquisition related contingent consideration liabilities, approximate the related fair values due to the short-term maturities of these instruments.

Goodwill, Intangible Assets and Other Long-Lived Assets

Goodwill, which has an indefinite useful life, represents the excess of cost over fair value of net assets acquired. The change in the carrying value of goodwill during the six months ended June 30, 2013 was due to goodwill recorded in connection with acquisitions. Goodwill is reviewed for impairment at least annually during the second quarter, or more frequently if an event occurs indicating the potential for impairment. During its goodwill impairment review, the Company may assess qualitative factors to determine whether it is more likely than not that the fair value of its single reporting unit is less than its carrying amount, including goodwill. The qualitative factors include, but are not limited to, macroeconomic conditions, industry and market considerations, and the overall financial performance of the Company. If, after assessing the totality of these qualitative factors, the Company determines that it is not more likely than not that the fair value of its reporting unit is less than its carrying amount, then no more assessment is deemed necessary. Otherwise, the Company proceeds to perform the two-step test for goodwill impairment. The first step involves comparing the estimated fair value of the reporting unit with its carrying value, including goodwill. If the carrying amount of the reporting unit exceeds its fair value, the Company performs the second step of the goodwill impairment test to determine the amount of loss, which involves comparing the implied fair value of the goodwill to the carrying value of the goodwill. The Company may also elect to bypass the qualitative assessment in a period and elect to proceed to perform the first step of the goodwill impairment test. The Company performed its annual assessment for goodwill impairment in the second quarter of 2013, noting no impairment.

The Company's identifiable intangible assets are typically comprised of acquired core technologies, licensed technologies, customer relationships, and trade names. The cost of all identifiable intangible assets with finite lives is amortized on a straight-line basis over the assets’ respective estimated useful lives.

The Company regularly performs reviews to determine if any event has occurred that may indicate its intangible assets with finite useful lives and other long-lived assets are potentially impaired. If indicators of impairment exist, the Company performs an impairment test to assess the recoverability of the affected assets by determining whether the carrying amount of such assets exceeds the undiscounted expected future cash flows. If the affected assets are not recoverable, the Company estimates the fair value of the assets and records an impairment loss if the carrying value of the assets exceeds the fair value. Factors that would indicate potential impairment include a significant decline in the Company's stock price and market capitalization compared to its net book value, significant changes in the ability of a particular asset to generate positive cash flows, and significant changes in the Company’s strategic business objectives and utilization of a particular asset. The Company performed quarterly reviews of its intangible assets with finite useful lives and other long-lived assets and noted no significant impairments for the three and six months ended June 30, 2013.

Derivatives

The Company is exposed to foreign exchange rate risks in the normal course of business. To manage a portion of the accounting exposure resulting from changes in foreign currency exchange rates, the Company enters into foreign exchange contracts to hedge monetary assets and liabilities that are denominated in currencies other than the U.S. dollar. These foreign exchange contracts are carried at fair value and are not designated as hedging instruments. Changes in the value of the derivative are recognized in other expense, net, along with an offsetting remeasurement gain or loss on the underlying foreign currency denominated assets or liabilities.

As of June 30, 2013, the Company had foreign exchange forward contracts in place to hedge exposures in the euro, Japanese yen, and Australian dollar. As of June 30, 2013 and December 30, 2012, the total notional amounts of outstanding forward contracts in place for foreign currency purchases were approximately $42.2 million and $51.2 million, respectively. Gains related to the non-designated foreign exchange forward contracts for the six months ended June 30, 2013 were $3.2 million. Such gains or losses were immaterial for all other periods presented.

Leases

Leases are reviewed and classified as capital or operating at their inception. For leases that contain rent escalations, the Company records rent expense on a straight-line basis over the term of the lease, which includes the construction build-out period and lease extension periods, if appropriate. The difference between rent payments and straight-line rent expense is recorded as deferred rent in accrued liabilities and other long-term liabilities. Landlord allowances are amortized on a straight-

9


line basis over the lease term as a reduction to rent expense. The Company capitalizes leasehold improvements and amortizes them over the shorter of the lease term or their expected useful lives.

In 2012, the Company completed the relocation of its headquarters to another facility in San Diego, California. Headquarter relocation expenses consist of expenses such as accelerated depreciation expense, impairment of assets, additional rent expense during the transition period when both the new and former headquarter facilities are occupied, moving expenses, cease-use losses, and accretion of interest expense on lease exit liability. The Company recorded accelerated depreciation expense for leasehold improvements at its former headquarter facility based on the reassessed useful lives of less than a year. The Company recorded cease-use losses and the corresponding facility exit obligation upon vacating its former headquarters, calculated as the present value of the remaining lease obligation offset by estimated sublease rental receipts during the remaining lease period, adjusted for deferred items and estimated lease incentives. The key assumptions used in the calculation include the amount and timing of estimated sublease rental receipts, and the risk-adjusted discount rate.

During the six months ended June 30, 2013, the Company entered into an agreement to sublease sections of its former headquarters. The sublease has an initial term of approximately ten years. Minimum lease payments during the initial term of the sublease are expected to be $30.5 million in total. In conjunction with the sublease, the Company issued a letter of credit in the amount of $8.0 million, which will decrease ratably to zero over the term of the sublease.

During the three months ended June 30, 2013, the Company entered into an agreement to lease a facility in San Francisco, California for an initial term of approximately ten years. Minimum lease payments during the initial term are estimated to be $46.5 million in total.
 
Net Income per Share

Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the reporting period. Diluted net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the reporting period increased to include dilutive potential common shares calculated using the treasury stock method. Diluted net income per share reflects the potential dilution from outstanding stock options, restricted stock units, shares issuable under the employee stock purchase plan (ESPP), warrants, shares subject to forfeiture, and convertible senior notes. Under the treasury stock method, convertible senior notes will have a dilutive impact when the average market price of the Company’s common stock is above the applicable conversion price of the respective notes. In addition, the following amounts are assumed to be used to repurchase shares: the amount that must be paid to exercise stock options and warrants and purchase shares under the ESPP; the average amount of compensation expense for future services that the Company has not yet recognized for stock options, restricted stock units, ESPP shares, and shares subject to forfeiture; and the amount of tax benefits that will be recorded in additional paid-in capital when the expenses related to respective awards become deductible. In loss periods, basic net loss per share and diluted net loss per share are identical since the effect of otherwise dilutive potential common shares is anti-dilutive and therefore excluded.

The following table presents the calculation of weighted average shares used to calculate basic and diluted net income per share (in thousands):
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
July 1,
2012
 
June 30,
2013
 
July 1,
2012
Weighted average shares outstanding
124,362

 
123,214

 
124,065

 
122,928

Effect of dilutive potential common shares from:
 
 
 
 
 
 
 
Convertible senior notes
1,064

 
925

 
1,064

 
958

Equity awards
4,382

 
3,657

 
4,137

 
3,858

Warrants sold in connection with convertible senior notes
9,569

 
5,215

 
8,379

 
5,691

Weighted average shares used in calculation of diluted net income per share
139,377

 
133,011

 
137,645

 
133,435

Potentially dilutive shares excluded from calculation due to anti-dilutive effect
1,684

 
3,348

 
1,799

 
2,943



10


2. Balance Sheet Account Details

Short-Term Investments

The following is a summary of short-term investments (in thousands):
 
 
June 30, 2013
 
December 30, 2012
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
Available-for-sale securities:
 
 
 
 
 
 
 
 
Debt securities in government sponsored entities
$
56,905

 
$
14

 
$
(95
)
 
$
56,824

 
$
314,638

 
$
251

 
$
(16
)
 
$
314,873

Corporate debt securities
259,071

 
299

 
(447
)
 
258,923

 
471,989

 
1,059

 
(187
)
 
472,861

U.S. Treasury securities
30,077

 
32

 
(4
)
 
30,105

 
128,256

 
233

 

 
128,489

Total available-for-sale securities
$
346,053

 
$
345

 
$
(546
)
 
$
345,852

 
$
914,883

 
$
1,543

 
$
(203
)
 
$
916,223


As of June 30, 2013, the Company had 90 available-for-sale securities in a gross unrealized loss position, all of which had been in such position for less than 12 months. There were no impairments considered other-than-temporary as it is more likely than not the Company will hold the securities until maturity or until the cost basis is recovered.

The following table shows the fair values and the gross unrealized losses of the Company’s available-for-sale securities that were in an unrealized loss position as of June 30, 2013 and December 30, 2012, aggregated by investment category (in thousands):
 
 
June 30, 2013
 
December 30, 2012
 
Fair Value
 
Gross
Unrealized
Losses
 
Fair Value
 
Gross
Unrealized
Losses
Debt securities in government sponsored entities
$
32,494

 
$
(95
)
 
$
28,176

 
$
(16
)
Corporate debt securities
116,149

 
(447
)
 
130,224

 
(187
)
U.S. Treasury securities
9,809

 
(4
)
 

 

Total
$
158,452

 
$
(546
)
 
$
158,400

 
$
(203
)

Realized gains and losses are determined based on the specific identification method and are reported in interest income. Gross realized gains and losses on sales of available-for-sale securities were immaterial for all periods presented.

Contractual maturities of available-for-sale debt securities as of June 30, 2013 were as follows (in thousands):
 
 
Estimated
Fair Value
Due within one year
$
117,083

After one but within five years
228,769

Total
$
345,852



11


Cost-Method Investments

As of June 30, 2013 and December 30, 2012, the aggregate carrying amounts of the Company’s cost-method investments in non-publicly traded companies were $55.4 million and $56.3 million, respectively, which were included in other assets on the consolidated balance sheets. During the three months ended March 31, 2013, the Company sold a cost-method investment and recognized a $6.1 million gain. The Company assesses all cost-method investments for impairment quarterly. No impairment loss was recorded during the three and six months ended June 30, 2013 or July 1, 2012. The Company does not reassess the fair value of cost-method investments if there are no identified events or changes in circumstances that may have a significant adverse effect on the fair value of the investments.

Headquarter Facility Exit Obligation

Changes in the Company’s facility exit obligation related to its former headquarters lease during the six months ended June 30, 2013 are as follows (in thousands):

Balance as of December 30, 2012
$
45,352

Adjustment to facility exit obligation
(1,948
)
Accretion of interest expense
1,198

Cash settlements
(5,251
)
Balance as of June 30, 2013
$
39,351


Facility exit obligation liability recorded upon vacating the Company’s former headquarters was adjusted for updates to assumptions based on terms of the facility sublease agreements entered during the six months ended June 30, 2013.

Warranties

Changes in the Company’s reserve for product warranties during the six months ended June 30, 2013 are as follows (in thousands):
 
Balance as of December 30, 2012
$
10,136

Additions charged to cost of revenue
10,298

Repairs and replacements
(9,608
)
Balance as of June 30, 2013
$
10,826


Inventory

Inventory consists of the following (in thousands):
 
 
June 30,
2013
 
December 30,
2012
Raw materials
$
60,874

 
$
61,665

Work in process
80,461

 
75,675

Finished goods
26,735

 
21,378

Total inventory
$
168,070

 
$
158,718



12


Accrued Liabilities

Accrued liabilities consist of the following (in thousands):
 
 
June 30,
2013
 
December 30,
2012
Accrued compensation expenses
$
56,278

 
$
59,864

Deferred revenue, current portion
49,918

 
55,817

Accrued taxes payable
30,072

 
23,021

Customer deposits
22,030

 
13,765

Reserve for product warranties
10,826

 
10,136

Facility exit obligation, current portion
6,993

 
8,063

Acquisition related contingent liability, current portion
6,464

 
9,490

Accrued royalties
2,960

 
2,836

Unsettled short-term investment purchase

 
9,154

Other
13,247

 
9,731

Total accrued liabilities
$
198,788

 
$
201,877


3. Acquisitions

Current Year Acquisitions

On February 21, 2013, the Company acquired all of the outstanding capital stock of Verinata Health, Inc., a leading provider of non-invasive tests for the early identification of fetal chromosomal abnormalities. With this acquisition, the Company strengthened its reproductive health product portfolio by gaining access to Verinata’s verifi® non-invasive prenatal test (NIPT) as well as what management believes to be the most comprehensive intellectual property portfolio in the NIPT industry.

The contractual price for the acquisition was $350.0 million, plus potential cash payments of up to $100.0 million based on the achievement of certain regulatory and revenue milestones. The aggregate purchase price was determined to be $396.3 million, including total cash payment of $339.3 million, $56.2 million in fair value of the contingent milestone payments, $0.3 million in fair value of converted stock options attributed to pre-combination services, and $0.5 million in loss realized on settlement of preexisting relationships. In connection with the transaction, the Company deposited into escrow $30.0 million of consideration otherwise payable to shareholders of Verinata. This amount is included in the aggregate consideration and will be held in escrow to cover indemnification claims under the acquisition agreement, if any, for a period of 1.5 years following the completion of the acquisition. During the six months ended June 30, 2013, transaction costs of $3.2 million were expensed as incurred in acquisition related (gain) expense, net.

In conjunction with the acquisition, the Company assumed the Verinata Health, Inc. 2008 Stock Plan and converted, as of the acquisition date, the unvested stock options outstanding under the plan, all of which were in the money, into 0.4 million unvested stock options to purchase Illumina’s common stock, retaining the original vesting schedules. The fair value of all converted options was $18.9 million, $0.3 million of which was attributed to the pre-combination service period and was included in the calculation of purchase price. The remaining fair value will be recognized over the awards’ remaining vesting periods subsequent to the acquisition. The weighted-average acquisition-date fair value of the converted options was determined using the Black-Scholes option pricing model with the following assumptions: (i) market price of $48.36 per share, which was the closing price of Illumina's common stock on the acquisition date; (ii) weighted average expected term of 2.3 years; (iii) weighted average risk-free interest rate of 0.32%; (iv) weighted average annualized volatility of 42%; and (v) no dividend yield. The weighted average acquisition-date fair value per share of the assumed stock options was $42.63.

An initial liability of $56.2 million was recorded for an estimate of the acquisition date fair value of the contingent consideration. Any change in the fair value of the contingent milestone consideration subsequent to the acquisition date was and will be recognized in the statements of operations. The fair value of the regulatory milestone payments was measured by the probability-weighted discounted cash flows and the fair value of the revenue milestone payments was measured using a risk-neutral option pricing model, which captures the present value of the expected payment and the probability of reaching the revenue targets. Key assumptions used in the fair value assessments included discount rates ranging from 6% to 20%, volatility of 50%, risk-free rates of 0.26%, revenue projections, and the probability of achieving regulatory milestones. This fair value

13


measurement of the contingent consideration is based on significant inputs not observed in the market and thus represents a Level 3 measurement. Level 3 instruments are valued based on unobservable inputs that are supported by little or no market activity and reflect the Company’s own assumptions in measuring fair value.

As of June 30, 2013, the preliminary allocation of the purchase price to the assets acquired and liabilities assumed on the acquisition date was as follows (in thousands):
 
Allocation of purchase price
Cash and cash equivalents
$
9,151

Accounts receivable
2,801

Inventory
1,110

Prepaid expenses and other current assets
979

Property and equipment
12,239

Other assets
978

Intangible assets
176,490

Goodwill
221,214

Accounts payable
(2,539
)
Accrued liabilities
(3,803
)
Lease financing obligation
(9,416
)
Deferred tax liability
(12,937
)
Total purchase price
$
396,267


The Company continues to obtain information to complete its valuation of assets and liabilities acquired from Verinata, including the valuation of certain deferred tax benefits during the measurement period. During the three months ended June 30, 2013, the Company recorded a net reduction to goodwill of $7.9 million, which primarily related to a $4.9 million decrease in the assessed fair value of the contingent milestone payments which was included in the purchase price, a $6.3 million increase to the assessed values of intangible assets, and the related deferred tax liability adjustments of $2.4 million.

In conjunction with the acquisition, the Company assumed Verinata’s building lease, for which Verinata was considered the accounting owner of the leased building and as such, recorded the fair value of the building as an asset as of the acquisition date. The building is depreciated over a useful life of 30 years. The Company also recorded the related lease financing obligation as a liability assumed, representing the present value of all remaining building lease payments and a balloon payment at the end of the lease for the value of the building to be transferred to the landlord. As of the acquisition date, total remaining payments under the lease was $5.7 million and the remaining lease term was 4.7 years, with two three-year renewal options.

The following table summarizes the fair value of identifiable intangible assets acquired (amounts in thousands):
 
Weighted Average Useful Lives (in years)
 
Fair Value
Developed technology
13
 
$
170,200

Customer relationships
5
 
4,690

Trade name
2
 
1,600

Total intangible assets acquired, excluding goodwill
 
 
$
176,490


The fair value of the developed technology and trade name was estimated using an income approach. Under the income approach, an intangible asset’s fair value is equal to the present value of future economic benefits to be derived from ownership of the asset. The estimated fair value was developed by discounting future net cash flows to their present value at market-based rates of return. The fair value of the customer relationships was developed using a cost approach by estimating the time and personnel effort in constructing the customer base. The useful life of the intangible assets for amortization purposes was determined by considering the period of expected cash flows used to measure the fair value of the intangible assets adjusted as appropriate for the entity-specific factors including legal, regulatory, contractual, competitive economic or other factors that may limit the useful life of intangible assets.


14


The excess of the fair value of the total consideration over the estimated fair value of the net assets was recorded as goodwill, which was primarily attributable to the synergies expected from combining the technologies of Illumina with those of Verinata, including complementary products that will enhance the Company’s overall product portfolio, and the value of the workforce that became our employees following the closing of the acquisitions. The goodwill recognized is not expected to be deductible for income tax purposes.

In addition, the Company completed another acquisition of a development-stage company during the three months ended March 31, 2013. As a result of this transaction, the Company recorded goodwill of $6.0 million and developed technology of $15.6 million with a useful life of five years.

Pro Forma Information

The following unaudited pro forma information presents the consolidated results of operations of Illumina and Verinata as if the acquisition had occurred at the beginning of each period presented, with pro forma adjustments to give effect to inter-company transactions to be eliminated, amortization of intangible assets, share-based compensation, and transaction costs directly associated with the acquisition (in thousands, except per share amounts):
 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
July 1,
2012
 
June 30,
2013
 
July 1,
2012
Net revenues
$
346,094

 
$
279,594

 
$
677,088

 
$
550,661

Net income
$
35,877

 
$
12,597

 
$
4,659

 
$
27,475

Net income per share-basic
$
0.29

 
$
0.10

 
$
0.04

 
$
0.22

Net income per share-diluted
$
0.26

 
$
0.09

 
$
0.03

 
$
0.21


These unaudited pro forma condensed consolidated financial results have been prepared for illustrative purposes only and do not purport to be indicative of the results of operations that actually would have resulted had the acquisition occurred on the first day of the earliest period presented, or of the future results of the consolidated entities. The unaudited pro forma condensed consolidated financial information does not reflect any operating efficiencies and cost savings that may be realized from the integration of the acquisition.

Prior Year Acquisitions

On September 19, 2012, the Company announced the acquisition of BlueGnome Ltd., a provider of cytogenetics and in vitro fertilization screening products. Total consideration for the acquisition was $95.5 million, which included $88.0 million in initial cash payments and $7.5 million in fair value of contingent cash consideration of up to $20.0 million based on the achievement of certain revenue based milestones by December 28, 2014.
 
The Company estimated the fair value of contingent cash consideration using a probability weighted discounted cash flow approach, a Level 3 measurement based on unobservable inputs that are supported by little or no market activity and reflect the Company’s own assumptions in measuring fair value. The Company used a discount rate of 30% in the assessment of the acquisition date fair value for the contingent cash consideration. Future changes in significant inputs such as the discount rate and estimated probabilities of milestone achievements could have a significant effect on the fair value of the contingent consideration.

In conjunction with the purchase transaction, the Company also agreed to pay up to $20.0 million to BlueGnome shareholders contingent upon the retention of certain key employees and certain other criteria. Such contingent payments will be recognized as contingent compensation expense over the retention period through December 28, 2014.

The Company allocated approximately $11.2 million of the total consideration to tangible assets, net of liabilities, and $48.9 million to identified intangible assets, including additional developed technologies of $25.0 million, customer relationships of $16.8 million, and a trade name of $7.1 million with average useful lives of seven, five, and ten years, respectively. The Company also recorded a $12.1 million deferred tax liability to reflect the tax impact of certain identified intangible assets, the amortization expenses for which are not tax deductible. The Company recorded the excess consideration of approximately $47.5 million as goodwill.

On January 10, 2011, the Company acquired Epicentre Technologies Corporation, a provider of nucleic acid sample preparation reagents and specialty enzymes used in sequencing and microarray applications. Total consideration for the

15


acquisition was $71.4 million, which included $59.4 million in net cash payments made at closing, $4.6 million in the fair value of contingent consideration settled in stock that is subject to forfeiture if certain non-revenue based milestones are not met, and $7.4 million in the fair value of contingent cash consideration of up to $15.0 million based on the achievement of certain revenue based milestones by January 10, 2013.
 
The Company estimated the fair value of contingent stock consideration based on the closing price of its common stock as of the acquisition date. Approximately 0.2 million shares of common stock were issued to Epicentre shareholders in connection with the acquisition, which shares are subject to forfeiture if certain non-revenue-based milestones are not met. One third of these shares issued with an assessed fair value of $4.6 million were determined to be part of the purchase price. The remaining shares with an assessed fair value of $10.1 million were determined to be compensation for post-acquisition service, the cost of which was recognized as contingent compensation expense over a period of two years in research and development expense or selling, general and administrative expense.
 
The Company estimated the fair value of contingent cash consideration using a probability weighted discounted cash flow approach, a Level 3 measurement based on unobservable inputs that are supported by little or no market activity and reflect the Company’s own assumptions in measuring fair value. The Company used a discount rate of 21% in the assessment of the acquisition date fair value for the contingent cash consideration.
 
The Company allocated $0.9 million of the total consideration to tangible assets, net of liabilities, and $26.9 million to identified intangible assets, including additional developed technologies of $23.3 million, a trade name of $2.5 million, and customer relationships of $1.1 million, with weighted average useful lives of approximately nine, ten, and three years, respectively. The Company recorded the excess consideration of $43.6 million as goodwill.

Summary of Contingent Compensation Expenses

Contingent compensation expense recorded as a result of all acquisitions consists of the following (in thousands):
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
July 1,
2012
 
June 30,
2013
 
July 1,
2012
Contingent compensation, included in research and development expense
$
(163
)
 
$
732

 
$
326

 
$
1,464

Contingent compensation, included in selling, general and administrative expense
2,425

 
(516
)
 
5,354

 
1,844

Total contingent compensation expense
$
2,262

 
$
216

 
$
5,680

 
$
3,308



16


4. Fair Value Measurements

The following table presents the Company’s hierarchy for assets and liabilities measured at fair value on a recurring basis as of June 30, 2013 and December 30, 2012 (in thousands):
 
 
June 30, 2013
 
December 30, 2012
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds (cash equivalents)
$
594,536

 
$

 
$

 
$
594,536

 
$
252,126

 
$

 
$

 
$
252,126

Debt securities in government-sponsored entities

 
56,824

 

 
56,824

 

 
314,873

 

 
314,873

Corporate debt securities

 
258,923

 

 
258,923

 

 
472,861

 

 
472,861

U.S. Treasury securities
30,105

 

 

 
30,105

 
128,489

 

 

 
128,489

Deferred compensation plan assets

 
15,926

 

 
15,926

 

 
13,626

 

 
13,626

Total assets measured at fair value
$
624,641

 
$
331,673

 
$

 
$
956,314

 
$
380,615

 
$
801,360

 
$

 
$
1,181,975

Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Acquisition related contingent consideration liabilities
$

 
$

 
$
60,102

 
$
60,102

 
$

 
$

 
$
12,519

 
$
12,519

Deferred compensation liability

 
13,834

 

 
13,834

 

 
12,071

 

 
12,071

Total liabilities measured at fair value
$

 
$
13,834

 
$
60,102

 
$
73,936

 
$

 
$
12,071

 
$
12,519

 
$
24,590


The Company holds available-for-sale securities that consist of highly liquid, investment grade debt securities. The Company determines the fair value of its debt security holdings based on pricing from a service provider. The service provider values the securities based on “consensus pricing,” using market prices from a variety of industry-standard independent data providers. Such market prices may be quoted prices in active markets for identical assets or liabilities (Level 1 inputs) or pricing determined using inputs that are observable either directly or indirectly (Level 2 inputs), such as quoted prices for similar assets or liabilities, yield curve, volatility factors, credit spreads, default rates, loss severity, current market and contractual prices for the underlying instruments or debt, broker and dealer quotes, as well as other relevant economic measures. The Company’s deferred compensation plan assets consist primarily of mutual funds. The Company performs certain procedures to corroborate the fair value of its holdings, including comparing prices obtained from service providers to prices obtained from other reliable sources.

The Company reassesses the fair value of contingent consideration to be settled in cash related to acquisitions on a quarterly basis using the income approach. This is a Level 3 measurement. Significant assumptions used in the measurement include probabilities of achieving the remaining milestones and the discount rates, which depend on the milestone risk profiles. The changes in the fair value of the contingent considerations during the three and six months ended June 30, 2013 were due to changes in the estimated payments and a shorter discounting period.

17


Changes in estimated fair value of contingent consideration liabilities during the six months ended June 30, 2013 are as follows (in thousands):
 
 
Contingent
Consideration
Liability
(Level 3 Measurement)
Balance as of December 30, 2012
$
12,519

Additional liability recorded as a result of current period acquisitions
57,284

Change in estimated fair value, recorded in acquisition related (gain) expense, net
(5,262
)
Cash settlements
(4,439
)
Balance as of June 30, 2013
$
60,102


5. Convertible Senior Notes

0.25% Convertible Senior Notes due 2016

In 2011, the Company issued $920.0 million aggregate principal amount of 0.25% convertible senior notes due 2016 (2016 Notes) in an offering conducted in accordance with Rule 144A under the Securities Act of 1933, as amended. The 2016 Notes were issued at 98.25% of par value. Debt issuance costs of approximately $0.4 million were primarily comprised of legal, accounting, and other professional fees, the majority of which were recorded in other noncurrent assets and are being amortized to interest expense over the five-year term of the 2016 Notes.

The 2016 Notes will be convertible into cash, shares of common stock, or a combination of cash and shares of common stock, at the Company’s election, based on an initial conversion rate, subject to adjustment, of 11.9687 shares per $1,000 principal amount of the 2016 Notes (which represents an initial conversion price of approximately $83.55 per share), only in the following circumstances and to the following extent: (1) during the five business-day period after any 10 consecutive trading day period (the “measurement period”) in which the trading price per 2016 Note for each day of such measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock and the conversion rate on each such day; (2) during any calendar quarter (and only during that quarter) after the calendar quarter ending March 31, 2011, if the last reported sale price of the Company’s common stock for 20 or more trading days in the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; (3) upon the occurrence of specified events described in the indenture for the 2016 Notes; and (4) at any time on or after December 15, 2015 through the second scheduled trading day immediately preceding the maturity date.

As noted in the indenture for the 2016 Notes, it is the Company’s intent and policy to settle conversions through combination settlement, which essentially involves repayment of an amount of cash equal to the “principal portion” and delivery of the “share amount” in excess of the conversion value over the principal portion in shares of common stock. In general, for each $1,000 in principal, the “principal portion” of cash upon settlement is defined as the lesser of $1,000, and the conversion value during the 20-day observation period as described in the indenture for the 2016 Notes. The conversion value is the sum of the daily conversion value which is the product of the effective conversion rate divided by 20 days and the daily volume weighted average price (VWAP) of the Company’s common stock. The “share amount” is the cumulative “daily share amount” during the observation period, which is calculated by dividing the daily VWAP into the difference between the daily conversion value (i.e., conversion rate x daily VWAP) and $1,000.

The Company pays 0.25% interest per annum on the principal amount of the 2016 Notes semiannually in arrears in cash on March 15 and September 15 of each year. The 2016 Notes mature on March 15, 2016. If a designated event, as defined in the indenture for the 2016 Notes, such as an acquisition, merger, or liquidation, occurs prior to the maturity date, subject to certain limitations, holders of the 2016 Notes may require the Company to repurchase all or a portion of their 2016 Notes for cash at a repurchase price equal to 100% of the principal amount of the 2016 Notes to be repurchased, plus any accrued and unpaid interest to, but excluding, the repurchase date.

The Company accounts separately for the liability and equity components of the 2016 Notes in accordance with authoritative guidance for convertible debt instruments that may be settled in cash upon conversion. The guidance requires the carrying amount of the liability component to be estimated by measuring the fair value of a similar liability that does not have an associated conversion feature. Because the Company has no outstanding non-convertible public debt, the Company determined that senior, unsecured corporate bonds traded on the market represent a similar liability to the convertible senior

18


notes without the conversion option. Based on market data available for publicly traded, senior, unsecured corporate bonds issued by companies in the same industry and with similar maturity, the Company estimated the implied interest rate of its 2016 Notes to be 4.5%, assuming no conversion option. Assumptions used in the estimate represent what market participants would use in pricing the liability component, including market interest rates, credit standing, and yield curves, all of which are defined as Level 2 observable inputs. The estimated implied interest rate was applied to the 2016 Notes, which resulted in a fair value of the liability component of $748.5 million upon issuance, calculated as the present value of implied future payments based on the $920.0 million aggregate principal amount. The $155.4 million difference between the cash proceeds of $903.9 million and the estimated fair value of the liability component was recorded in additional paid-in capital as the 2016 Notes are not considered currently redeemable at the balance sheet date.

As a policy election under applicable guidance related to the calculation of diluted net income per share, the Company elected the combination settlement method as its stated settlement policy and applied the treasury stock method in the calculation of dilutive impact of the 2016 Notes. During the three and six months ended June 30, 2013 and July 1, 2012, the 2016 Notes were not convertible and therefore not included in the calculation of weighted average shares outstanding. If the 2016 Notes were converted as of June 30, 2013, the if-converted value would not exceed the principal amount.

0.625% Convertible Senior Notes due 2014

In 2007, the Company issued $400.0 million principal amount of 0.625% convertible senior notes due 2014 (2014 Notes). The Company pays 0.625% interest per annum on the principal amount of the 2014 Notes semi-annually in arrears in cash on February 15 and August 15 of each year. The 2014 Notes mature on February 15, 2014. The effective interest rate of the liability component was estimated to be 8.3%.

The Company entered into hedge transactions concurrently with the issuance of the 2014 Notes under which the Company is entitled to purchase up to approximately 18.3 million shares of the Company’s common stock at a strike price of approximately $21.83 per share, subject to adjustment. The convertible note hedge transactions had the effect of reducing dilution to the Company’s stockholders upon conversion of the 2014 Notes. Also concurrently with the issuance of the 2014 Notes, the Company sold to the hedge counterparties warrants exercisable, on a cashless basis, for up to approximately 18.3 million shares of the Company’s common stock at a strike price of $31.435 per share, subject to adjustment. The proceeds from these warrants partially offset the cost to the Company of the convertible note hedge transactions.

The 2014 Notes became convertible into cash and shares of the Company’s common stock in various prior periods and became convertible again from April 1, 2012 through, and including, September 30, 2013. In all cases of conversions of the 2014 Notes, the principal amount converted was repaid with cash and the excess of the conversion value over the principal amount was paid in shares of common stock. The equity dilution resulting from the issuance of common stock related to the conversion of the 2014 Notes was offset by repurchase of the same amount of shares under the convertible note hedge transactions, which were automatically exercised in accordance with their terms at the time of each conversion. As of June 30, 2013, there remained in place the balance of the convertible note hedge transactions with respect to approximately $31.1 million principal amount of the 2014 Notes, which are convertible for up to approximately 1.4 million shares of the Company’s common stock. The warrants were not affected by the early conversions of the 2014 Notes and, as a result, warrants covering up to approximately 18.3 million shares of common stock remained outstanding as of June 30, 2013. If the remaining 2014 Notes were converted as of June 30, 2013, the if-converted value would exceed the principal amount by $73.7 million.

As a result of conversions during the three months ended June 30, 2013, the Company recorded losses on extinguishment of debt calculated as the difference between the estimated fair value of the debt and the carrying value of the notes as of the settlement dates. To measure the fair value of the converted notes as of the settlement dates, the applicable interest rates were estimated using Level 2 observable inputs and applied to the converted notes using the same methodology utilized for the issuance date valuation.

The following table summarizes information about the conversions of the 2014 Notes during the three months ended June 30, 2013 (in thousands, except percentages):

Cash paid for principal of notes converted
$
9,000

Conversion value over principal amount paid in shares of common stock
$
16,982

Number of shares of common stock issued upon conversion
265

Loss on extinguishment of debt
$
511

Effective interest rates used to measure fair value of converted notes upon conversion
0.7% - 0.8%


19



The following table summarizes information about the equity and liability components of the 2014 Notes and 2016 Notes (dollars in thousands). The fair values of the respective notes outstanding were measured based on quoted market prices.
 
 
June 30, 2013
 
December 30, 2012
 
2016 Notes
 
2014 Notes
 
2016 Notes
 
2014 Notes
Principal amount of convertible notes outstanding
$
920,000

 
$
31,125

 
$
920,000

 
$
40,125

Unamortized discount of liability component
(97,831
)
 
(1,394
)
 
(114,594
)
 
(3,158
)
Net carrying amount of liability component
822,169

 
29,731

 
805,406

 
36,967

Less: current portion

 
(29,731
)
 

 
(36,967
)
Long-term debt
$
822,169

 
$

 
$
805,406

 
$

Conversion option subject to cash settlement

 
$
1,394

 

 
$
3,158

Carrying value of equity component, net of debt issuance cost
$
155,366

 
$
118,364

 
$
155,366

 
$
116,600

Fair value of outstanding notes (Level 2 measurement)
$
1,003,122

 
$
108,122

 
$
892,446

 
$
101,470

Remaining amortization period of discount on the liability component
2.7 years

 
0.6 years

 
3.2 years

 
1.1 years


Contractual coupon interest expense and accretion of discount on the liability component recorded for the convertible senior notes during the three and six months ended June 30, 2013 and July 1, 2012, respectively, were as follows (in thousands):

 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
July 1,
2012
 
June 30,
2013
 
July 1,
2012
Contractual coupon interest expense
$
611

 
$
637

 
$
1,247

 
$
1,197

Accretion of discount on the liability component
$
9,023

 
$
8,699

 
$
18,032

 
$
17,298


6. Share-based Compensation Expense

Share-based compensation expense for all stock awards consists of the following (in thousands):

 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
July 1,
2012
 
June 30,
2013
 
July 1,
2012
Cost of product revenue
$
1,444

 
$
1,844

 
$
2,886

 
$
3,656

Cost of service and other revenue
157

 
168

 
311

 
185

Research and development
8,954

 
7,687

 
16,960

 
15,114

Selling, general and administrative
13,897

 
14,348

 
28,514

 
28,121

Share-based compensation expense before taxes
24,452

 
24,047

 
48,671

 
47,076

Related income tax benefits
(7,499
)
 
(8,135
)
 
(15,064
)
 
(15,959
)
Share-based compensation expense, net of taxes
$
16,953

 
$
15,912

 
$
33,607

 
$
31,117



20


The assumptions used for the specified reporting periods and the resulting estimates of weighted average fair value per share of options granted and for stock purchase rights granted under the ESPP for the six months ended June 30, 2013 are as follows:
 
 
Stock Options
 
Employee Stock Purchase Rights
Risk-free interest rate
0.14 - 1.86%

 
0.11 - 0.15%

Expected volatility
30 - 44%

 
31
%
Expected term
0.8 - 9.4 years

 
0.5 - 1.0 year

Expected dividends

 

Weighted average fair value per share
$
40.66

 
$
13.11


As of June 30, 2013, approximately $188.4 million of unrecognized compensation cost related to stock options, restricted stock, performance stock, and ESPP shares is expected to be recognized over a weighted average period of approximately 2.2 years.

7. Stockholders’ Equity

The Company's 2005 Stock and Incentive Plan (the 2005 Stock Plan), 2005 Solexa Equity Incentive Plan (the 2005 Solexa Equity Plan), the Verinata Health, Inc. 2008 Stock Plan (the 2008 Verinata Stock Plan) and the New Hire Stock and Incentive Plan allow for the issuance of stock options, restricted stock units and awards, and performance stock units. During the three months ended June 30, 2013, the stockholders ratified an amendment to increase the maximum number of shares of common stock authorized for issuance under the 2005 Stock Plan by 5.0 million shares. As of June 30, 2013, approximately 7.8 million shares remained available for future grants under the 2005 Stock Plan, the 2005 Solexa Equity Plan, and the 2008 Verinata Health Stock Plan. There is no set number of shares reserved for issuance under the New Hire Stock and Incentive Plan.

Stock Options

The Company’s stock option activity under all stock option plans during the six months ended June 30, 2013 is as follows: 
 
Options
(in thousands)
 
Weighted
Average
Exercise Price
per Share
Outstanding as of December 30, 2012
8,351

 
$
32.10

Granted
512

 
14.74

Exercised
(1,413
)
 
26.23

Cancelled
(113
)
 
47.79

Outstanding as of June 30, 2013
7,337

 
$
31.78


At June 30, 2013, outstanding options to purchase approximately 5.9 million shares were exercisable with a weighted average exercise price per share of $30.41. Grant activity during the current year includes the conversion of options to purchase Verinata common stock into options to purchase Illumina’s common stock in connection with the acquisition of Verinata.


21


Restricted Stock

A summary of the Company’s restricted stock activity and related information for the six months ended June 30, 2013 is as follows:

 
Restricted
Stock
(in thousands)
 
Weighted Average
Grant-Date Fair
Value per Share
Outstanding at December 30, 2012
4,125

 
$
46.43

Awarded
575

 
54.86

Vested
(549
)
 
47.81

Cancelled
(183
)
 
48.41

Outstanding as of June 30, 2013
3,968

 
$
47.37

 
Performance Stock Units

The Company issues performance stock units for which the number of shares issuable will range from 50% and 150% of the shares approved in the award, based on the Company’s performance relative to specified earnings per share targets at the end of a three-year performance period. A summary of the Company’s performance stock unit activity and related information for the six months ended June 30, 2013 is as follows:
 
Performance
Stock
(in thousands)
 
Weighted Average
Grant-Date Fair
Value per Share
Outstanding at December 30, 2012
587

 
$
49.64

Awarded
471

 
50.67

Cancelled
(70
)
 
50.42

Outstanding as of June 30, 2013
988

 
$
50.08


Employee Stock Purchase Plan

The price at which common stock is purchased under the ESPP is equal to 85% of the fair market value of the common stock on the first or last day of the offering period, whichever is lower. During the six months ended June 30, 2013, approximately 0.2 million shares were issued under the ESPP. As of June 30, 2013, there were approximately 15.2 million shares available for issuance under the ESPP.

Warrants

As of June 30, 2013, warrants exercisable, on a cashless basis, for up to approximately 18.3 million shares of common stock were outstanding with an exercise price of $31.435. These warrants were sold to counterparties to the Company’s convertible note hedge transactions in connection with the offering of the 2014 Notes, with the proceeds of such warrants used by the Company to partially offset the cost of such hedging transactions. All outstanding warrants expire in equal installments during the 40 consecutive scheduled trading days beginning on May 16, 2014.

On July 18, 2013, the Company settled with a hedging counterparty outstanding warrants to purchase approximately 3.0 million shares of the Company’s common stock for $125.0 million in cash.

Share Repurchases

On April 18, 2012, the Company’s Board of Directors authorized a $250 million stock repurchase program to be effected via a combination of Rule 10b5-1 and discretionary share repurchase programs. During the three and six months ended June 30, 2013, the Company repurchased approximately 0.4 million and 0.9 million shares for $25.0 million and $50.0 million, respectively.


22


Stockholder Rights Plan

On January 25, 2012, the Company's Board of Directors declared a dividend of one preferred share purchase right (Right) for each outstanding share of the Company's common stock. During the six months ended June 30, 2013, the expiration date was amended to be March 27, 2013 and the Rights expired accordingly.

8. Income Taxes

The Company’s effective tax rate may vary from the U.S. statutory tax rate due to the change in the mix of earnings in tax jurisdictions with different statutory rates, benefits related to tax credits, and the tax impact of non-deductible expenses and other permanent differences between income before income taxes and taxable income. The effective tax rates for the three and six months ended June 30, 2013 were 27.3% and (639.2)%, respectively. For the three and six months ended June 30, 2013, the variance from the U.S. federal statutory rate of 35% was primarily attributable to the tax treatment of the Syntrix legal contingency, which was recorded as a discrete item and is nondeductible for tax purposes until paid. The retroactive reinstatement of the 2012 federal research and development credit as part of the American Taxpayer Relief Act of 2012 that was enacted on January 2, 2013 increased the benefit from income taxes in Q1 2013 by approximately $2.0 million.

In the second quarter of 2013 the Internal Revenue Service began an audit of the Company’s corporate income tax return filed for fiscal year 2011. At this time the audit is in the initial information gathering stage.

9. Legal Proceedings

The Company is involved in various lawsuits and claims arising in the ordinary course of business, including actions with respect to intellectual property, employment, and contractual matters. In connection with these matters, the Company assesses, on a regular basis, the probability and range of possible loss based on the developments in these matters. A liability is recorded in the financial statements if it is believed to be probable that a loss has been incurred and the amount of the loss can be reasonably estimated. Because litigation is inherently unpredictable and unfavorable results could occur, assessing contingencies is highly subjective and requires judgments about future events. The Company regularly reviews outstanding legal matters to determine the adequacy of the liabilities accrued and related disclosures. The amount of ultimate loss may differ from these estimates. Each matter presents its own unique circumstances, and prior litigation does not necessarily provide a reliable basis on which to predict the outcome, or range of outcomes, in any individual proceeding. Because of the uncertainties related to the occurrence, amount, and range of loss on any pending litigation or claim, the Company is currently unable to predict their ultimate outcome, and, with respect to any pending litigation or claim where no liability has been accrued, to make a meaningful estimate of the reasonably possible loss or range of loss that could result from an unfavorable outcome. In the event that opposing litigants in outstanding litigations or claims ultimately succeed at trial and any subsequent appeals on their claims, any potential loss or charges in excess of any established accruals, individually or in the aggregate, could have a material adverse effect on the Company’s business, financial condition, results of operations, and/or cash flows in the period in which the unfavorable outcome occurs or becomes probable, and potentially in future periods.

On November 24, 2010, Syntrix Biosystems, Inc. filed suit against the Company in the United States District Court for the Western District of Washington at Tacoma (Case No. C10-5870-BHS) alleging that the Company willfully infringed U.S. Patent No. 6,951,682 by selling its BeadChip array products, and that the Company misappropriated Syntrix’s trade secrets. In November and December 2012, the Company filed motions for summary judgment that the patent is not infringed and is invalid, and that Syntrix’s trade secrets claims are barred by various statutes of limitation. Syntrix filed a motion for summary judgment that the patent is valid. On January 30, 2013, the court granted the Company’s motion for summary judgment on Syntrix's trade secret claims, and dismissed those claims from the case. The court denied Syntrix's motion for summary judgment on validity, and denied the Company’s motion for summary judgment for non-infringement and invalidity. On March 14, 2013, a jury reached a verdict in favor of Syntrix, finding that Illumina's BeadChip kits infringe the Syntrix patent. During trial, the court dismissed Syntrix’s claim that the alleged infringement was willful. On July 1, 2013, the Court entered a final amended judgment for $115.1M, in accordance with the jury verdict, including supplemental damages and prejudgment interest. In addition, the court awarded Syntrix an ongoing royalty of 8% for accused sales from March 15, 2013 until the patent expires on September 16, 2019.

The Company believes strongly that it did not infringe the Syntrix patent and that the patent is invalid. The Company, therefore, disagrees with the jury verdict and contends that the verdict is not supported by the law or facts. Accordingly, the Company filed on July 17, 2013, its post-trial motion asking the District Court to vacate the amended judgment and to enter judgment in the Company's favor or, alternatively, grant a new trial. In addition, if the Company’s post-trial motion is unsuccessful, the Company plans to file an appeal to the Court of Appeals for the Federal Circuit challenging the adverse verdict.

23



As a result of the amended judgment, the Company has recorded a legal contingency accrual of $122.7 million as of June 30, 2013, which includes the damages and prejudgment interest awarded to Syntrix, estimated additional damages through June 30, 2013, and an estimate of interest accrued on the damages subsequent to June 19, 2013. This resulted in legal contingency charges of $15.8 million recorded in the three months ended June 30, 2013, $8.7 million of which was related to damages through the jury verdict date, and was recorded within operating expenses as a separate line item. The remainder was related to the royalty amount subsequent to the verdict date, and was recorded to cost of sales. For the six months ended June 30, 2013, such charges totaled $122.7 million, $114.6 million of which was recorded within operating expenses, and the remainder was recorded to cost of sales. In addition, the Company will continue to accrue ongoing royalties on future sales at the royalty rate stated in the Amended Judgment. The Company may be required to secure the amount of the judgment during the appeals process.

10. Subsequent Event

On July 1, 2013, the Company acquired Advanced Liquid Logic Inc., a leading provider of liquid handling solutions, for up to $96.0 million in cash.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is provided in addition to the accompanying condensed consolidated financial statements and notes to assist readers in understanding our results of operations, financial condition, and cash flows. This MD&A is organized as follows:

Business Overview and Outlook. High level discussion of our operating results and significant known trends that affect our business.

Results of Operations. Detailed discussion of our revenues and expenses.

Liquidity and Capital Resources. Discussion of key aspects of our statements of cash flows, changes in our financial position, and our financial commitments.

Off-Balance Sheet Arrangements. We have no significant off-balance sheet arrangements.

Critical Accounting Policies and Estimates. Discussion of significant changes since our most recent Annual Report on Form 10-K that we believe are important to understanding the assumptions and judgments underlying our financial statements.

This MD&A discussion contains forward-looking statements that involve risks and uncertainties. Please see “Consideration Regarding Forward-Looking Statements” at the end of this MD&A section for additional factors relating to such statements. This MD&A should be read in conjunction with our condensed consolidated financial statements and accompanying notes included in this report and our Annual Report on Form 10-K for the fiscal year ended December 30, 2012. Operating results are not necessarily indicative of results that may occur in future periods.

Business Overview and Outlook

This overview and outlook provides a high level discussion of our operating results and significant known trends that affect our business. We believe that an understanding of these trends is important to understanding our financial results for the periods being reported herein as well as our future financial performance. This summary is not intended to be exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided elsewhere in this Quarterly Report on Form 10-Q.

About Illumina

We are a leading developer, manufacturer, and marketer of life science tools and integrated systems for the analysis of genetic variation and function. Using our proprietary technologies, we provide a comprehensive line of genetic analysis solutions, with products and services that address a broad range of highly interconnected markets, including sequencing, genotyping, gene expression, and genomic-based diagnostics. Our customers include leading genomic research centers, academic institutions, government laboratories, clinical research organizations, and in vitro fertilization clinics, as well as pharmaceutical, biotechnology, agrigenomics, and consumer genomics companies.

Our broad portfolio of instruments, consumables, and analysis tools are designed to simplify and accelerate genetic analysis. This portfolio addresses the full range of genomic complexity, throughput, and price points, enabling researchers to select the best solution for their scientific challenge. These systems can be used to efficiently perform a range of nucleic acid (DNA, RNA) analyses on large numbers of samples. For more focused studies, our array-based solutions provide ideal tools to perform genome-wide association studies (GWAS) involving single-nucleotide polymorphism (SNP) genotyping and copy number variation (CNV) analyses, as well as gene expression profiling and other DNA, RNA, and protein studies.

In 2012 and early 2013, we took steps to support our goal of becoming a leader in the reproductive health market by acquiring Verinata Health, Inc. in February 2013 and BlueGnome Ltd. in September 2012. With the Verinata acquisition, we further strengthened our reproductive health product portfolio by gaining access to Verinata’s verifi® non-invasive prenatal test (NIPT), as well as what we believe to be the most comprehensive intellectual property portfolio in the NIPT industry. BlueGnome is a leading provider of solutions for the screening of genetic abnormalities associated with developmental delay, cancer, and infertility, and BlueGnome’s offerings enhance our ability to establish integrated solutions in reproductive health and cancer. To further enhance our genetic analysis workflows, in 2011 we acquired Epicentre Technologies Corporation, a leading provider of nucleic acid sample preparation reagents and specialty enzymes for sequencing and microarray applications.

Our financial results have been, and will continue to be, impacted by several significant trends, which are described below. While these trends are important to understanding and evaluating our financial results, this discussion should be read in conjunction with our condensed consolidated financial statements and the notes thereto in Item 1, Part I of this report, and the other transactions, events, and trends discussed in “Risk Factors” in Item 1A, Part II of this report and Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 30, 2012.

Funding Environment
 
While many of our customers receive funding from government agencies to purchase our products or services, we are lessening our dependency on government funding. In Q2 2013, approximately 40% of our total revenue came from applied market customers including customers in the clinical, consumer, translational, and agriculture segments who are not reliant on government agencies for funding, and it is our strategy to diversify our customer base to increase further the portion of our revenue from applied market customers over time. We estimate that less than 30% of our total revenue is derived, directly or indirectly, from funding provided by the U.S. National Institute of Health (NIH). NIH funding from October 1, 2012 to March 31, 2013 was subject to a continuing resolution while funding for the second half of the 2013 U.S. fiscal year is subject to sequester provisions of the Budget Control Act of 2011, which includes a 5% reduction to the NIH budget. The 2014 NIH budget is currently under discussion. We believe that allocations within the NIH budget will continue to favor genetic analysis tools generally and, in particular, research programs that utilize next-generation sequencing.

Next-Generation Sequencing

Next-generation sequencing has become a core technology for modern life science research and is increasingly being used in the applied, molecular diagnostics, and translational markets. Over the next several years, expansion of the sequencing market, including an increase in the number of samples available and enhancements in our product portfolio will continue to drive demand for our next-generation sequencing technologies. Our sequencing instrument installed base continued to expand in Q2 2013. As a result, we believe that our sequencing consumable revenue will continue to grow in future periods.

Our sequencing instrument portfolio primarily includes the HiSeq and MiSeq product families. We began full commercial shipments of our HiSeq 2500 sequencing system in the fourth quarter of 2012. The HiSeq 2500 allows customers to sequence an entire human genome in approximately a day. Our MiSeq sequencing system is a low-cost personal sequencing system that provides individual researchers a desktop-sized platform with rapid turnaround time, high accuracy, and streamlined workflow. We believe our MiSeq systems will continue to be a competitive offering in the lower throughput sequencing market and help us expand our presence in this emerging market segment.

MicroArrays

As a complement to next-generation sequencing, we believe microarrays offer a less expensive, faster, and highly accurate technology for use when genetic content is already known. The information content of microarrays is fixed and reproducible. As such, microarrays provide repeatable, standardized assays for certain subsets of nucleotide bases within the overall genome. As the cost of sequencing continues to decrease, we believe that life science researchers will migrate certain whole genome array studies to sequencing; however, we expect this decline to be offset by demand from customers in applied, consumer, and translational markets.

Financial Overview

Financial highlights for the first half of 2013 include the following:

Net revenue increased by 22.3% during the first half of 2013 compared to the same period in 2012. Our sales increased across our portfolio of sequencing products, including consumables, instruments, and services. We believe our revenue will continue to grow in 2013.

Gross profit as a percentage of revenue (gross margin) was 65.4% for the first half of 2013, a decrease from 67.6% for the same period in the prior year. Gross margin decreased in the first half of 2013 due in large part to higher amortization of acquired intangible assets and legal contingencies associated with the Syntrix litigation matter. See note “9. Legal Proceedings” in Part I, Item 1 of this form 10-Q. We believe our gross margin in future periods will depend on several factors, including market conditions that may impact our pricing power, sales mix changes among consumable, instrument, and services, product mix changes between established products and new products in new markets, our cost structure for manufacturing operations, royalties, and our ability to create innovative and high premium products that meet or stimulate customer demand.

Income from operations in the first half of 2013 was $14.9 million compared to $92.6 million during the same period in 2012. This was a result of higher operating expenses offsetting the increase in gross profit. During the current period, we recorded a $115.4 million legal contingency expense in operating expenses associated primarily with the Syntrix patent litigation matter. Additionally, our research and development expenses and selling, general and administrative expenses increased by $9.0 million and $37.3 million, respectively, from the same period in the prior year as we continue to invest in the growth of our business. We expect operating expenses to continue to grow.

Our effective tax rate was negative for the first half of 2013, which was primarily attributable to the tax treatment of the Syntrix legal contingency charges, which was recorded as a discrete item and is nondeductible for tax purposes until paid. Our future effective tax rate may vary from the U.S. statutory tax rate due to the mix of earnings in tax jurisdictions with different statutory tax rates and the other factors discussed in the risk factor “We are subject to risks related to taxation in multiple jurisdictions” in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 30, 2012. For the remainder of 2013 and beyond, we anticipate that our effective tax rate will trend lower than the U.S. federal statutory rate as the portion of our earnings subject to lower statutory tax rates increases.

In the second quarter of 2013 the Internal Revenue Service began an audit of the corporate income tax return filed for fiscal year 2011. At this time the audit is in the initial information gathering stage.
 
We ended Q2 2013 with cash, cash equivalents, and short-term investments totaling $1.13 billion.


24


Results of Operations

To enhance comparability, the following table sets forth our unaudited condensed consolidated statements of income for the specified reporting periods stated as a percentage of total revenue.
 
 
Q2 2013
 
Q2 2012
 
YTD 2013
 
YTD 2012
Revenue:
 
 
 
 
 
 
 
Product revenue
90.6
 %
 
92.2
 %
 
90.0
 %
 
93.0
 %
Service and other revenue
9.4

 
7.8

 
10.0

 
7.0

Total revenue
100.0

 
100.0

 
100.0

 
100.0

Cost of revenue:
 
 
 
 
 
 
 
Cost of product revenue
28.4

 
26.7

 
27.8

 
28.0

Cost of service and other revenue
4.6

 
3.4

 
4.6

 
3.3

Amortization of acquired intangible assets
2.4

 
1.1

 
2.2

 
1.1

Total cost of revenue
35.4

 
31.2

 
34.6

 
32.4

Gross profit
64.6

 
68.8

 
65.4

 
67.6

Operating expense:
 
 
 
 
 
 
 
Research and development
19.5

 
25.4

 
19.1

 
21.7

Selling, general and administrative
25.6

 
24.4

 
25.7

 
24.7

Legal contingencies
2.7

 

 
17.0

 

Acquisition related (gain) expense, net
(1.7
)
 
0.4

 
(0.3
)
 
0.5

Unsolicited tender offer related expense
1.4

 
2.4

 
1.8

 
2.7

Headquarter relocation expense
(0.4
)
 
0.7

 
(0.1
)
 
0.7

Restructuring charges

 
0.2

 

 
0.6

Total operating expense
47.1

 
53.5

 
63.2

 
50.9

Income from operations
17.5

 
15.3

 
2.2

 
16.7

Other income (expense):
 
 
 
 
 
 
 
Interest income
0.2

 
0.5

 
0.4

 
0.7

Interest expense
(2.9
)
 
(3.4
)
 
(2.9
)
 
(3.4
)
Cost-method investment gain

 

 
0.9

 

Other expense, net
(0.4
)
 

 
(0.3
)
 
(0.4
)
Total other expense, net
(3.1
)
 
(2.9
)
 
(1.9
)
 
(3.1
)
Income before income taxes
14.4

 
12.4

 
0.3

 
13.6

Provision for (benefit from) income taxes
4.0

 
4.1

 
(1.7
)
 
4.6

Net income
10.4
 %
 
8.3
 %
 
2.0
 %
 
9.0
 %

Our fiscal year consists of 52 or 53 weeks ending the Sunday closest to December 31, with quarters of 13 or 14 weeks ending the Sunday closest to March 31, June 30, September 30, and December 31. The three and six month periods ended June 30, 2013 and July 1, 2012 were both 13 and 26 weeks, respectively.
Revenue
 
(Dollars in thousands)
Q2 2013
 
Q2 2012
 
Change
 
Percentage
Change
 
YTD 2013
 
YTD 2012
 
Change
 
Percentage
Change
Product revenue
$
313,497

 
$
258,839

 
$
54,658

 
21
%
 
$
609,667

 
$
514,475

 
$
95,192

 
19
%
Service and other revenue
32,597

 
21,768

 
10,829

 
50

 
67,385

 
38,902

 
28,483

 
73

Total revenue
$
346,094

 
$
280,607

 
$
65,487

 
23
%
 
$
677,052

 
$
553,377

 
$
123,675

 
22
%


25


Product revenue consists primarily of revenue from the sale of consumables and instruments. Service and other revenue consists primarily of instrument service contract revenue as well as sequencing and genotyping service revenue.

QTD 2013 vs. QTD 2012

Consumables revenue increased $31.7 million, or 17%, to $215.4 million in Q2 2013 compared to $183.7 million in the prior year period. The increase was primarily attributable to increased sales of sequencing consumables, driven by the growth in the installed base for both HiSeq and MiSeq systems.

Instrument revenue increased $22.6 million, or 31%, to $94.8 million in Q2 2013 compared to $72.2 million in the prior year period, driven primarily by an increase in HiSeq shipments.

The increase in service and other revenue in Q2 2013 compared to the prior year period was driven by an increase in both sequencing service revenue, as a result of an increased volume in sequencing services, and instrument service contract revenue as a result of our growing installed base.

YTD 2013 vs. YTD 2012

Consumables revenue increased $63.7 million, or 18%, to $420.3 million in first half of 2013 compared to $356.6 million in the prior year period. The increase was primarily attributable to increased sales of sequencing consumables, driven by the growth in the installed base for both HiSeq and MiSeq systems.

Instrument revenue increased $31.1 million, or 20%, to $182.9 million in first half of 2013 compared to $151.8 million in the prior year period, driven primarily by an increase in HiSeq shipments.

The increase in service and other revenue in the first half of 2013 compared to the prior year period was driven by an increase in both sequencing service revenue, as a result of an increased volume in sequencing services, and instrument service contract revenue as a result of our growing installed base.

Gross Margin
 
(Dollars in thousands)
Q2 2013
 
Q2 2012
 
Change
 
Percentage
Change
 
YTD 2013
 
YTD 2012
 
Change
 
Percentage
Change
Gross profit
$
223,409

 
$
192,997

 
$
30,412

 
16
%
 
$
442,701

 
$
374,008

 
$
68,693

 
18
%
Gross margin
64.6
%
 
68.8
%
 
 
 
 
 
65.4
%
 
67.6
%
 
 
 
 

QTD 2013 vs. QTD 2012

Gross profit in Q2 2013 increased in comparison to the prior year period, primarily due to the increase in revenue. Gross margin decreased in Q2 2013 primarily due to an increase in amortization of acquired intangible assets and legal contingencies. In addition, the recent acquisitions and a lower percentage of consumable sales, to a lesser degree, also contributed to the decline in gross margins, while the impact was partially offset by higher margin realized on instrument sales and operational efficiencies.  Legal contingencies recorded in cost of sales during Q2 2013 represent royalties awarded to Syntrix on BeadChip sales subsequent to the verdict date. See details regarding the Syntrix matter in note “9. Legal Proceedings” in Part I, Item 1 of this form 10-Q. To a lesser degree, a shift in our sales mix from higher margin consumables to lower margin service and instrument revenues contributed to the decrease in gross margin during Q2 2013.

YTD 2013 vs. YTD 2012

Gross profit in the first half of 2013 increased in comparison to the prior year period, primarily due to the increase in revenue. Gross margin decreased in the first half of 2013 primarily due to an increase in amortization of acquired intangible assets and legal contingencies, partially offset by higher margin realized on instrument sales and operational efficiencies.   Legal contingencies recorded in cost of sales during the first half of 2013 represent royalties awarded to Syntrix on BeadChip sales subsequent to the verdict date. See details regarding the Syntrix matter as discussed in note “9. Legal Proceedings” in Part I, Item 1 of this form 10-Q.


26


Operating Expense
 
(Dollars in thousands)
Q2 2013
 
Q2 2012
 
Change
 
Percentage
Change
 
YTD 2013
 
YTD 2012
 
Change
 
Percentage
Change
Research and development
$
67,608

 
$
71,223

 
$
(3,615
)
 
(5
)%
 
$
129,058

 
$
120,062

 
$
8,996

 
7
 %
Selling, general and administrative
88,700

 
68,516

 
20,184

 
29

 
173,774

 
136,485

 
37,289

 
27

Legal contingencies
9,516

 

 
9,516

 
100

 
115,369

 

 
115,369

 
100

Acquisition related (gain) expense, net
(5,725
)
 
1,080

 
(6,805
)
 
(630
)
 
(1,904
)
 
2,817

 
(4,721
)
 
(168
)
Unsolicited tender offer related expense
4,811

 
6,694

 
(1,883
)
 
(28
)
 
12,295

 
14,786

 
(2,491
)
 
(17
)
Headquarter relocation
(1,507
)
 
1,830

 
(3,337
)
 
(182
)
 
(750
)
 
3,970

 
(4,720
)
 
(119
)
Restructuring

 
674

 
(674
)
 
(100
)
 

 
3,296

 
(3,296
)
 
(100
)
Total operating expense
$
163,403

 
$
150,017

 
$
13,386

 
9
 %
 
$
427,842

 
$
281,416

 
$
146,426

 
52
 %

QTD 2013 vs. QTD 2012

Research and development expense decreased by $3.6 million, or 5%, in Q2 2013 from the same period in 2012, primarily due to a $21.4 million impairment charge for in-process research and development recorded in the prior year, partially offset by higher expenses driven by increased headcount and consulting services as we continue to increase our investment in the development of new products as well as enhancements to existing products.

Selling, general and administrative expense increased $20.2 million, or 29%, in Q2 2013 from the same period in the prior year. The increase is primarily driven by increased headcount and consulting services to support the growth of our Company.

Recently completed acquisitions also contributed to the increases in research and development expense and selling, general and administrative expense.

During Q2 2013, we recorded $9.5 million in legal contingency charges within operating expenses primarily as a result of the Syntrix litigation matter, reflecting an adjustment in the damages and prejudgment interest awarded to Syntrix through March 14, 2013, the jury verdict date. See additional discussions on this matter in note “9. Legal Proceedings” in Part I, Item 1 of this form 10-Q.

Acquisition related (gain) expense, net, in Q2 2013 and the same period in 2012 consisted of changes in fair value of contingent considerations.

During Q2 2013, we recorded $4.8 million of expenses incurred in relation to an unsolicited tender offer in Q1 2012. The expenses consisted primarily of advisory and legal fees. The advisory related expenses decreased from the prior year period as the advisory service arrangements near completion.

We completed the relocation of our headquarters in 2012. During Q2 2013, we recorded a gain in the headquarter relocation line item to reflect a reduction in accrued facility exit obligation as a result of entering into subleases for sections of our former headquarters at a more favorable rate than previously estimated. This gain was partially offset by accretion of interest expense related to the facility exit obligation recorded upon vacating our former headquarters. Headquarter relocation charges recorded in Q2 2012 consisted of the accretion expense related to the facility exit obligation, double rent expense during the transition to our new facility, and moving expenses.


27


YTD 2013 vs. YTD 2012

Research and development expense increased by $9.0 million, or 7%, in the first half of 2013 from the same period in 2012, primarily due to increased headcount and consulting services as we continue to increase our investment in the development of new products as well as enhancements to existing products, partially offset by a $21.4 million impairment charge for in-process research and development recorded in the prior year.

Selling, general and administrative expense increased $37.3 million, or 27%, in the first half of 2013 from the same period in 2012. The increase is primarily driven by increased headcount and consulting services to support the growth of our Company.

Recently completed acquisitions also contributed to the increases in research and development expense and selling, general and administrative expense.

During the first half of 2013, we recorded $115.4 million in legal contingency charges within operating expenses primarily related to the Syntrix litigation matter. The amount recorded in operating expenses included the damages and prejudgment interest awarded to Syntrix through March 14, 2013, the jury verdict date. See additional discussions on this matter in note “9. Legal Proceedings” in Part I, Item 1 of this form 10-Q.

Acquisition related (gain) expense, net, in the first half of 2013 consisted of acquisition transaction costs of $3.4 million and changes in fair value of contingent considerations. Acquisition related (gain) expense, net in the prior year period consisted of changes in fair value of contingent considerations.

During first half of 2013, we recorded $12.3 million of expenses incurred in relation to an unsolicited tender offer in Q1 2012. The expenses consisted primarily of advisory and legal fees. The advisory related expenses decreased from the prior year period as the advisory service arrangements near completion.

We completed the relocation of our headquarters in 2012. During Q2 2013, we recorded a gain in the headquarter relocation line item to reflect a reduction in accrued facility exit obligation as a result of entering into subleases for sections of our former headquarters at a more favorable rate than previously estimated. This gain was partially offset by accretion of interest expense related to the facility exit obligation recorded upon vacating our former headquarters. Headquarter relocation expense recorded in the same period in 2012 consisted of the accretion expense related to the facility exit obligation, double rent expense during the transition to our new facility, and moving expenses.

In late 2011, we announced restructuring plans to reduce our global workforce and to consolidate certain facilities. As a result of the restructuring effort, we recorded restructuring charges of $3.3 million during the first half of 2012, comprised primarily of severance pay and other employee separation costs.

Other Expense, Net
 
(Dollars in thousands)
Q2 2013
 
Q2 2012
 
Change
 
Percentage
Change
 
YTD 2013
 
YTD 2012
 
Change
 
Percentage
Change
Interest income
$
722

 
$
1,385

 
$
(663
)
 
(48
)%
 
$
2,655

 
$
3,911

 
$
(1,256
)
 
(32
)%
Interest expense
(10,045
)
 
(9,508
)
 
(537
)
 
6

 
(19,792
)
 
(18,710
)
 
(1,082
)
 
6

Other expense, net
(1,323
)
 
(70
)
 
(1,253
)
 
1,790

 
(2,037
)
 
(2,733
)
 
696

 
(25
)
Cost-method investment related gain

 

 

 

 
6,113

 

 
6,113

 
100

Total other expense, net
$
(10,646
)
 
$
(8,193
)
 
$
(2,453
)
 
30
 %
 
$
(13,061
)
 
$
(17,532
)
 
$
4,471

 
(26
)%

QTD 2013 vs. QTD 2012

Interest income primarily consists of realized gains from our investment portfolio. Interest income decreased in Q2 2013 from the same period in 2012 as a result of a decrease in our investment portfolio balance as well as a decline in average market interest rates during the quarter. Interest expense in Q2 2013 remained relatively consistent as compared to the same period in 2012 and consisted primarily of accretion of discount on our convertible senior notes.


28


Other expense, net, in Q2 2013 and Q2 2012 primarily consisted of net foreign exchange losses and losses on the extinguishment of debt recorded on conversions of our 0.625% convertible senior notes due 2014.

YTD 2013 vs. YTD 2012

Interest income primarily consists of realized gains from our investment portfolio. Interest income decreased in the first half of 2013 from the same period in 2012 as a result of a decrease in our investment portfolio balance as well as a decline in average market interest rates during the period. Interest expense in the first half of 2013 remained relatively consistent as compared to the same period in 2012 and consisted primarily of accretion of discount on our convertible senior notes.

Other expense, net, in the first half of 2013 and the same period in 2012 primarily consisted of net foreign exchange losses and losses on the extinguishment of debt recorded on conversions of our 0.625% convertible senior notes due 2014.

During the first half of 2013, we recognized a $6.1 million gain as a result of the sale of a cost-method investment.

Provision for (Benefit from) Income Taxes
 
(Dollars in thousands)
Q2 2013
 
Q2 2012
 
Change
 
Percentage
Change
 
YTD 2013
 
YTD 2012
 
Change
 
Percentage
Change
Income before income taxes
$
49,360

 
$
34,787

 
$
14,573

 
42
%
 
$
1,798

 
$
75,060

 
$
(73,262
)
 
(98
)%
Provision for (benefit from) income taxes
$
13,483

 
$
11,386

 
2,097

 
18
%
 
$
(11,492
)
 
$
25,457

 
$
(36,949
)
 
(145
)%
Effective tax rate
27.3
%
 
32.7
%
 
 
 
 
 
(639.2
)%
 
33.9
%
 
 
 
 

QTD 2013 vs. QTD 2012

Our effective tax rate was 27.3% for Q2 2013. The variance from the U.S. statutory rate of 35% was primarily attributable to the tax treatment of the Syntrix legal contingency, which was recorded as a discrete item and is nondeductible for tax purposes until paid. Our future effective tax rate may vary from the U.S. statutory tax rate due to the mix of earnings in tax jurisdictions with different statutory tax rates and the other factors discussed in the risk factor “We are subject to risks related to taxation in multiple jurisdictions in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 30, 2012. The effective tax rate was 32.7% for Q2 2012, and the variance from the U.S. statutory rate of 35% was primarily attributable to the tax treatment of the $21.4 million impairment charge for IPR&D, which was recorded as a discrete item in the quarter.

YTD 2013 vs. YTD 2012

Our effective tax rate was negative for the first half of 2013, which was primarily attributable to the tax treatment of the Syntrix legal contingency, which was recorded as a discrete item and is nondeductible for tax purposes until paid. The effective tax rate was 33.9% for the same period in 2012, and the variance from the U.S. statutory rate of 35% was primarily attributable to the tax treatment of the $21.4 million impairment charge for IPR&D, which was recorded as a discrete item in Q2 2012.

The American Taxpayer Relief Act of 2012, which was signed into law on January 2, 2013, included the retroactive reinstatement of the federal research and development credit, from January 1, 2012 through December 31, 2013. Our provision for income taxes for the year ended December 30, 2012 did not include the impact of the federal research credit generated in 2012 since the law was enacted subsequent to our 2012 reporting period. Instead, the retroactive reinstatement of the federal research credit generated in 2012 increased our benefit from income taxes for the first half of 2013 by approximately $2.0 million.


Liquidity and Capital Resources

At June 30, 2013, we had approximately $783.6 million in cash and cash equivalents, a $349.6 million increase from last year, due to the factors described in the “Cash Flow Summary” below. Our primary source of liquidity, other than our holdings of cash, cash equivalents and investments, has been cash flows from operations. Our ability to generate cash from operations provides us with the financial flexibility we need to meet operating, investing, and financing needs. Cash and cash equivalents held by our foreign subsidiaries at June 30, 2013 were approximately $367.0 million. It is our intention to indefinitely reinvest all current and future foreign earnings in foreign subsidiaries.

29



Historically, we have liquidated our short-term investments and/or issued debt and equity securities to finance our business needs as a supplement to cash provided by operating activities. As of June 30, 2013, we had $345.9 million in short-term investments. Our short-term investments include marketable securities consisting of debt securities in government-sponsored entities, corporate debt securities, and U.S. Treasury notes.

Our primary short-term needs for capital, which are subject to change, include expenditures related to:
support of commercialization efforts related to our current and future products, including expansion of our direct sales force and field support resources both in the United States and abroad;
acquisitions of equipment and other fixed assets for use in our current and future manufacturing and research and development facilities;
repurchases of our outstanding common stock;
the continued advancement of research and development efforts;