SEC Filing Form Details

 

ILLUMINA INC filed this Form 10-Q on 11/08/2016

Form 10-Q

 
 
Document
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 October 2, 2016
 
¨
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 October 21, 2016, there were 146.9 million 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)
 
 
October 2,
2016
 
January 3,
2016
 
(Unaudited)
 
 
ASSETS
Current assets:
 
 
 
Cash and cash equivalents
$
794,697

 
$
768,770

Short-term investments
741,569

 
617,450

Accounts receivable, net
381,632

 
385,529

Inventory
312,242

 
270,777

Prepaid expenses and other current assets
47,696

 
54,297

Total current assets
2,277,836

 
2,096,823

Property and equipment, net
633,856

 
342,694

Goodwill
775,995

 
752,629

Intangible assets, net
255,560

 
273,621

Deferred tax assets
182,122

 
134,515

Other assets
102,458

 
87,465

Total assets
$
4,227,827

 
$
3,687,747

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
 
 
 
Accounts payable
$
134,090

 
$
139,226

Accrued liabilities
315,204

 
386,844

Build-to-suit lease liability
178,311

 
9,495

Long-term debt, current portion
1,250

 
74,929

Total current liabilities
628,855

 
610,494

Long-term debt
1,040,765

 
1,015,649

Other long-term liabilities
204,273

 
180,505

Redeemable noncontrolling interests
34,257

 
32,546

Stockholders’ equity:
 
 
 
Common stock
1,882

 
1,859

Additional paid-in capital
2,738,001

 
2,497,501

Accumulated other comprehensive income
1,314

 
36

Retained earnings
1,361,652

 
1,022,765

Treasury stock, at cost
(1,862,702
)
 
(1,673,608
)
Total Illumina stockholders’ equity
2,240,147

 
1,848,553

Noncontrolling interests
79,530

 

Total stockholders’ equity
2,319,677

 
1,848,553

Total liabilities and stockholders’ equity
$
4,227,827

 
$
3,687,747

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
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Revenue:
 
 
 
 
 
 
 
Product revenue
$
513,744

 
$
470,824

 
$
1,506,416

 
$
1,392,711

Service and other revenue
93,395

 
79,447

 
272,610

 
235,503

Total revenue
607,139

 
550,271

 
1,779,026

 
1,628,214

Cost of revenue:
 
 
 
 
 
 
 
Cost of product revenue
132,423

 
120,954

 
382,856

 
360,037

Cost of service and other revenue
37,606

 
29,590

 
117,156

 
94,289

Amortization of acquired intangible assets
10,960

 
12,188

 
32,005

 
34,957

Total cost of revenue
180,989

 
162,732

 
532,017

 
489,283

Gross profit
426,150

 
387,539

 
1,247,009

 
1,138,931

Operating expense:
 
 
 
 
 
 
 
Research and development
125,917

 
99,226

 
374,500

 
287,180

Selling, general and administrative
139,146

 
136,648

 
436,914

 
377,406

Legal contingencies

 
15,000

 
(9,490
)
 
15,000

Headquarter relocation
385

 
(5,226
)
 
1,069

 
(3,047
)
Acquisition related expense (gain), net

 
1,109

 

 
(6,449
)
Total operating expense
265,448

 
246,757

 
802,993

 
670,090

Income from operations
160,702

 
140,782

 
444,016

 
468,841

Other income (expense):
 
 
 
 
 
 
 
Interest income
2,056

 
2,767

 
6,683

 
5,804

Interest expense
(8,208
)
 
(12,821
)
 
(24,880
)
 
(35,190
)
Cost-method investment gain, net

 
2,900

 

 
15,482

Other (expense) income, net
(186
)
 
(4,711
)
 
1,116

 
(6,802
)
Total other expense, net
(6,338
)
 
(11,865
)
 
(17,081
)
 
(20,706
)
Income before income taxes
154,364

 
128,917

 
426,935

 
448,135

Provision for income taxes
37,429

 
13,296

 
106,387

 
93,609

Consolidated net income
116,935

 
115,621

 
320,548

 
354,526

Add: Net loss attributable to noncontrolling interests
11,953

 
2,556

 
18,339

 
2,556

Net income attributable to Illumina stockholders
$
128,888

 
$
118,177

 
$
338,887

 
$
357,082

Net income attributable to Illumina stockholders for earnings per share
$
128,682

 
$
118,128

 
$
335,597

 
$
357,033

Earnings per share attributable to Illumina stockholders:
 
 
 
 
 
 
 
Basic
$
0.88

 
$
0.81

 
$
2.29

 
$
2.47

Diluted
$
0.87

 
$
0.79

 
$
2.27

 
$
2.39

Shares used in computing earnings per common share:
 
 
 
 
 
 
 
Basic
146,705

 
145,349

 
146,783

 
144,447

Diluted
147,901

 
149,672

 
148,049

 
149,108

See accompanying notes to the condensed consolidated financial statements.


4


ILLUMINA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(In thousands)
 
 
Three Months Ended
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Consolidated net income
$
116,935

 
$
115,621

 
$
320,548

 
$
354,526

Unrealized (loss) gain on available-for-sale securities, net of deferred tax
(1,004
)
 
441

 
1,278

 
2,120

Total consolidated comprehensive income
115,931

 
116,062

 
321,826

 
356,646

Add: Comprehensive loss attributable to noncontrolling interests
11,953

 
2,556

 
18,339

 
2,556

Comprehensive income attributable to Illumina stockholders
$
127,884

 
$
118,618

 
$
340,165

 
$
359,202

See accompanying notes to the condensed consolidated financial statements.


5


ILLUMINA, INC.
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(Unaudited)
(In thousands)
 
Illumina Stockholders
 
 
 
 
 
 
 
Additional
 
Accumulated Other
 
 
 
 
 
 
 
Total
 
Common
 
Paid-In
 
Comprehensive
 
Retained
 
Treasury
 
Noncontrolling
 
Stockholders’
 
Stock
 
Capital
 
Income
 
Earnings
 
Stock
 
Interests
 
Equity
Balance as of January 3, 2016
$
1,859

 
$
2,497,501

 
$
36

 
$
1,022,765

 
$
(1,673,608
)
 
$

 
$
1,848,553

Net income (loss)

 

 

 
338,887

 

 
(6,547
)
 
332,340

Unrealized gain on available-for-sale securities, net of deferred tax

 

 
1,278

 

 

 

 
1,278

Issuance of common stock, net of repurchases
23

 
47,115

 

 

 
(189,440
)
 

 
(142,302
)
Tax impact from the conversion of convertible notes

 
36

 

 

 

 

 
36

Share-based compensation

 
101,494

 

 

 

 

 
101,494

Net incremental tax benefit related to share-based compensation

 
109,292

 

 

 

 

 
109,292

Adjustment to the carrying value of redeemable noncontrolling interests

 
(12,023
)
 

 

 

 

 
(12,023
)
Vesting of redeemable equity awards

 
(1,481
)
 

 

 

 

 
(1,481
)
Vesting of non-redeemable equity awards

 
(28
)
 

 

 

 
28

 

Issuance of subsidiary shares in business combination

 
2,102

 

 

 

 
198

 
2,300

Issuance of treasury stock

 
3,554

 

 

 
346

 

 
3,900

Contributions from noncontrolling interest owners

 

 

 

 

 
80,000

 
80,000

Proceeds from early exercise of equity awards from a subsidiary

 

 

 

 

 
5,851

 
5,851

Tax impact of deemed dividend from GRAIL, Inc.

 
(9,561
)
 

 

 

 

 
(9,561
)
Balance as of October 2, 2016
$
1,882

 
$
2,738,001

 
$
1,314

 
$
1,361,652

 
$
(1,862,702
)
 
$
79,530

 
$
2,319,677


See accompanying notes to condensed consolidated financial statements.


6


ILLUMINA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
Cash flows from operating activities:
 
 
 
Consolidated net income
$
320,548

 
$
354,526

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation expense
65,433

 
52,774

Amortization of intangible assets
38,051

 
40,884

Share-based compensation expense
101,845

 
97,104

Accretion of debt discount
22,342

 
29,828

Incremental tax benefit related to share-based compensation
(109,934
)
 
(121,703
)
Deferred income tax expense
57,539

 
83,679

Cost-method investment gain, net

 
(15,482
)
Change in fair value of contingent consideration

 
(6,449
)
Other
5,190

 
6,178

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
4,999

 
(121,309
)
Inventory
(41,757
)
 
(43,598
)
Prepaid expenses and other current assets
3,572

 
(4,982
)
Other assets
(6,060
)
 
(428
)
Accounts payable
(7,307
)
 
49,532

Accrued liabilities
(57,325
)
 
23,884

Other long-term liabilities
9,949

 
(5,220
)
Net cash provided by operating activities
407,085

 
419,218

Cash flows from investing activities:
 
 
 
Purchases of available-for-sale securities
(679,064
)
 
(713,862
)
Sales of available-for-sale securities
406,286

 
335,351

Maturities of available-for-sale securities
148,290

 
189,929

Net cash paid for acquisitions
(17,841
)
 
(35,226
)
Net purchases of strategic investments
(9,075
)
 
(4,100
)
Purchases of property and equipment
(178,353
)
 
(107,361
)
Cash paid for intangible assets
(11,490
)
 
(275
)
Net cash used in investing activities
(341,247
)
 
(335,544
)
Cash flows from financing activities:
 
 
 
Payments on financing obligations
(70,522
)
 
(216,207
)
Payments on acquisition related contingent consideration liability
(29,200
)
 
(1,500
)
Proceeds from issuance of debt
5,000

 

Incremental tax benefit related to share-based compensation
109,934

 
121,703

Common stock repurchases
(113,075
)
 
(72,256
)
Taxes paid related to net share settlement of equity awards
(76,365
)
 
(95,157
)
Proceeds from issuance of common stock
47,156

 
65,668

Proceeds from early exercise of equity awards from a subsidiary
5,851

 

Contributions from noncontrolling interest owners
80,000

 
32,128

Net cash used in financing activities
(41,221
)
 
(165,621
)
Effect of exchange rate changes on cash and cash equivalents
1,310

 
(2,678
)
Net increase (decrease) in cash and cash equivalents
25,927

 
(84,625
)
Cash and cash equivalents at beginning of period
768,770

 
636,154

Cash and cash equivalents at end of period
$
794,697

 
$
551,529


See accompanying notes to the condensed consolidated financial statements.

7


Illumina, Inc.
Notes to Condensed 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. Basis of Presentation and 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. Interim financial results are not necessarily indicative of results anticipated for the full year. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2016, 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 expense, and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates.

The unaudited condensed consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries, majority-owned or controlled companies, and variable interest entities (VIEs) for which the Company is the primary beneficiary. 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.

The Company evaluates its ownership, contractual and other interests in entities that are not wholly-owned by the Company to determine if these entities are VIEs, and, if so, whether the Company is the primary beneficiary of the VIE. In determining whether the Company is the primary beneficiary of a VIE and is therefore required to consolidate the VIE, the Company applies a qualitative approach that determines whether it has both (1) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (2) the obligation to absorb losses of, or the rights to receive benefits from, the VIE that could potentially be significant to that VIE. The Company continuously assesses whether it is the primary beneficiary of a VIE as changes to existing relationships or future transactions may result in the consolidation or deconsolidation, as the case may be. The Company has not provided financial or other support during the periods presented to its VIEs that it was not previously contractually required to provide.

The equity method is used to account for investments in which the Company has the ability to exercise significant influence, but not control, over the investee. Such investments are recorded within other assets, and the share of net income or losses of equity investments is recognized on a one quarter lag in other (expense) income, net.

Segment Information
 
The Company is organized into three operating segments for purposes of evaluating its business operations and reporting its financial results. One operating segment consists of Illumina’s core operations and the other two relate to the Company’s consolidated VIEs. The combined results of operations of the Company’s consolidated VIEs became material for the three and nine months ended October 2, 2016. As such, the Company commenced reporting two segments in the third quarter of 2016. Financial information for all periods presented has been classified to reflect these changes to our reportable segments. For further information on the Company’s segments, refer to note “9. Segment Information”.

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 nine months ended October 2, 2016 and September 27, 2015 were both 13 and 39 weeks, respectively.


8


Reclassifications

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

Significant Accounting Policies

During the three and nine months ended October 2, 2016, there have been no changes to the Company’s significant accounting policies as described in the Annual Report on Form 10-K for the fiscal year ended January 3, 2016.

Recent Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board issued Accounting Standard Update (ASU) 2016-09, Compensation - Stock Compensation (Topic 718). The new standard requires income tax effects of stock compensation awards to be recognized in the income statement when the awards vest or are settled. The new standard also allows the Company to repurchase more of an employee’s shares for tax withholding purposes without triggering liability accounting and to make a policy election to account for forfeitures as they occur. ASU 2016-09 will be effective for the Company beginning in the first quarter of 2017. The Company is currently evaluating the impact of ASU 2016-09 on its consolidated financial statements.

In February 2016, the Financial Accounting Standards Board issued ASU 2016-02, Leases (Topic 842). The new standard requires lessees to recognize most leases on their balance sheets as lease liabilities with corresponding right-of-use assets and eliminates certain real estate-specific provisions. ASU 2016-02 will be effective for the Company beginning in the first quarter of 2019. ASU 2016-02 will be adopted on a modified retrospective transition basis for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The Company is currently evaluating the impact of ASU 2016-02 on its consolidated financial statements.

In May 2014, the Financial Accounting Standards Board issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). The new standard is based on the principle that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will be effective for the Company beginning in the first quarter of 2018 and allows for a full retrospective or a modified retrospective adoption approach. The Company is currently evaluating the impact of ASU 2014-09 on its consolidated financial statements.

Earnings per Share

Basic earnings per share attributable to Illumina stockholders is computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share attributable to Illumina stockholders is computed based on the sum of the weighted average number of common shares and potentially dilutive common shares outstanding during the period. Per-share earnings of our VIEs are included in the Company’s consolidated basic and diluted earnings per share computations based on the Company’s share of the VIE’s securities.

Potentially dilutive common shares consist of shares issuable under convertible senior notes, equity awards, and warrants. Convertible senior notes have a dilutive impact when the average market price of the Company’s common stock exceeds the applicable conversion price of the respective notes. Potentially dilutive common shares from equity awards and warrants are determined using the average share price for each period under the treasury stock method. In addition, the following amounts are assumed to be used to repurchase shares: proceeds from exercise of equity awards and warrants; the average amount of unrecognized compensation expense for equity awards; and estimated tax benefits that will be recorded in additional paid-in capital when expenses related to equity awards become deductible. In loss periods, basic net loss per share and diluted net loss per share are identical because the otherwise dilutive potential common shares become anti-dilutive and are therefore excluded.


9


The following table presents the calculation of weighted average shares used to calculate basic and diluted earnings per share (in thousands):

 
Three Months Ended
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Weighted average shares outstanding
146,705

 
145,349

 
146,783

 
144,447

Effect of potentially dilutive common shares from:
 
 
 
 
 
 
 
Convertible senior notes

 
1,670

 
80

 
2,013

Equity awards
1,196

 
2,653

 
1,186

 
2,648

Weighted average shares used in calculating diluted earnings per share
147,901

 
149,672

 
148,049

 
149,108

Potentially dilutive shares excluded from calculation due to anti-dilutive effect
63

 
13

 
580

 
7




2. Balance Sheet Account Details

Short-Term Investments

The following is a summary of short-term investments (in thousands):
 
 
October 2, 2016
 
January 3, 2016
 
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
$
29,687

 
$

 
$
(30
)
 
$
29,657

 
$
14,634

 
$

 
$
(8
)
 
$
14,626

Corporate debt securities
463,484

 
282

 
(474
)
 
463,292

 
422,177

 
44

 
(1,127
)
 
421,094

U.S. Treasury securities
248,542

 
182

 
(104
)
 
248,620

 
182,144

 
3

 
(417
)
 
181,730

Total available-for-sale securities
$
741,713

 
$
464

 
$
(608
)
 
$
741,569

 
$
618,955

 
$
47

 
$
(1,552
)
 
$
617,450


Realized gains and losses are determined based on the specific identification method and are reported in interest income.

Contractual maturities of available-for-sale debt securities as of October 2, 2016 were as follows (in thousands):
 
 
Estimated
Fair Value
Due within one year
$
279,548

After one but within five years
462,021

Total
$
741,569


The Company has the ability, if necessary, to liquidate any of its cash equivalents and short-term investments in order to meet its liquidity needs in the next 12 months. Accordingly, those investments with contractual maturities greater than one year from the date of purchase nonetheless are classified as short-term on the accompanying condensed consolidated balance sheets.

Strategic Investments

As of October 2, 2016 and January 3, 2016, the aggregate carrying amounts of the Company’s cost-method investments in non-publicly traded companies included in other assets were $56.9 million and $56.6 million, respectively. Revenue recognized from transactions with such companies was $12.5 million and $42.1 million, respectively, for the three and nine

10


months ended October 2, 2016 and $16.1 million and $47.3 million, respectively, for the three and nine months ended September 27, 2015.

During the nine months ended September 27, 2015, the Company recognized a gain on a disposition of a cost-method investment of $18.0 million. The Company’s cost-method investments are assessed for impairment quarterly. The Company determines that it is not practicable to estimate the fair value of its cost-method investments on a regular basis and 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. No material impairment loss was recorded during the three and nine months ended October 2, 2016 or September 27, 2015.

On April 14, 2016, the Company announced that it has committed to invest $100.0 million in a new venture capital investment fund (the Fund). The capital commitment is callable over ten years, and up to $40.0 million can be drawn down during the first year. The Company’s investment in the Fund is accounted for as an equity method investment. During the nine months ended October 2, 2016, the Company transferred $3.2 million of its cost-method investments to the Fund and contributed $4.4 million in cash.

Inventory

Inventory consists of the following (in thousands):
 
October 2,
2016
 
January 3,
2016
Raw materials
$
101,646

 
$
97,740

Work in process
166,050

 
138,322

Finished goods
44,546

 
34,715

Total inventory
$
312,242

 
$
270,777


Property and Equipment

Property and equipment, net consists of the following (in thousands):
 
October 2,
2016
 
January 3,
2016
Leasehold improvements
$
197,534

 
$
178,019

Machinery and equipment
264,556

 
224,158

Computer hardware and software
153,851

 
136,550

Furniture and fixtures
20,448

 
18,539

Building
7,670

 
7,670

Construction in progress
308,825

 
44,501

Total property and equipment, gross
952,884

 
609,437

Accumulated depreciation
(319,028
)
 
(266,743
)
Total property and equipment, net
$
633,856

 
$
342,694


Property and equipment, net included accrued expenditures of $194.4 million for the nine months ended October 2, 2016, which includes $168.8 million in construction in progress recorded under build-to-suit lease accounting. Accrued capital expenditures were excluded from the condensed consolidated statements of cash flows. Accrued capital expenditures were immaterial for the nine months ended September 27, 2015.

Goodwill

The Company tests the carrying value of goodwill in accordance with accounting rules on impairment of goodwill, which require the Company to estimate the fair value of the reporting units annually, or when impairment indicators exist, and compare such amounts to their respective carrying values to determine if an impairment is required. The Company performed its annual assessment for goodwill impairment in the second quarter of 2016, noting no impairment.


11


Changes in the Company’s goodwill balance during the nine months ended October 2, 2016 are as follows (in thousands):
 
Goodwill
Balance as of January 3, 2016
$
752,629

Current period acquisitions
23,366

Balance as of October 2, 2016
$
775,995


In January 2016, the Company closed two acquisitions consisting of $17.8 million in upfront cash payments, equity instruments, and certain contingent consideration provisions.

Derivatives

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

As of October 2, 2016, the Company had foreign exchange forward contracts in place to hedge exposures in the euro, Japanese yen, and Australian dollar. As of October 2, 2016 and January 3, 2016, the total notional amounts of outstanding forward contracts in place for foreign currency purchases were $62.2 million and $61.3 million, respectively.

Accrued Liabilities

Accrued liabilities consist of the following (in thousands):
 
October 2,
2016
 
January 3,
2016
Deferred revenue, current portion
$
116,118

 
$
96,654

Accrued compensation expenses
89,527

 
120,662

Accrued taxes payable
30,855

 
44,159

Customer deposits
17,831

 
20,901

Acquisition related contingent liability, current portion
7,220

 
35,000

Other
53,653

 
69,468

Total accrued liabilities
$
315,204

 
$
386,844


Build-to-Suit Lease Liability

The Company evaluates whether it is the accounting owner during the construction period when the Company is involved in the construction of leased assets. As a result, the Company is considered the owner of three construction projects for accounting purposes only under build-to-suit lease accounting due to certain indemnification obligations related to the construction. As of October 3, 2016 and January 3, 2016, the Company has recorded $178.3 million and $9.5 million, respectively, in project construction costs incurred by the landlord as construction in progress and a corresponding build-to-suit lease liability. Once the landlord completes the construction projects, the Company will evaluate the lease in order to determine whether or not it meets the criteria for “sale-leaseback” treatment.

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 twelve 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 its warranty reserve for adequacy 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.


12


Changes in the Company’s reserve for product warranties during the three and nine months ended October 2, 2016 and September 27, 2015 are as follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Balance at beginning of period
$
15,679

 
$
16,365

 
$
16,717

 
$
15,616

Additions charged to cost of product revenue
3,878

 
6,916

 
17,200

 
20,737

Repairs and replacements
(5,180
)
 
(5,348
)
 
(19,540
)
 
(18,420
)
Balance at end of period
$
14,377

 
$
17,933

 
$
14,377

 
$
17,933


Leases

Changes in the Company’s facility exit obligation related to its former headquarters lease during the three and nine months ended October 2, 2016 and September 27, 2015 are as follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Balance at beginning of period
$
20,557

 
$
36,677

 
$
22,160

 
$
37,700

Adjustment to facility exit obligation
66

 
(5,935
)
 
87

 
(5,278
)
Accretion of interest expense
320

 
590

 
983

 
1,926

Cash payments
(1,198
)
 
(1,539
)
 
(3,485
)
 
(4,555
)
Balance at end of period
$
19,745

 
$
29,793

 
$
19,745

 
$
29,793

 
On March 18, 2016, the Company entered into an agreement to sublease its office building in San Francisco, California. The Company will receive $51.2 million in minimum lease payments during the initial term of approximately eight years.

On April 5, 2016, the Company entered into a lease agreement for certain office buildings being constructed in San Diego, California. Minimum lease payments during the initial term of ten years are estimated to be $127.4 million.

Investments in Consolidated Variable Interest Entities

GRAIL, Inc.

In January 2016, the Company obtained a majority equity ownership interest in GRAIL, Inc. (GRAIL), a company formed with unrelated third party investors to pursue the development and commercialization of a blood test for asymptomatic cancer screening. The Company determined that GRAIL is a variable interest entity as the entity lacks sufficient equity to finance its activities without additional support. Additionally, the Company determined that it has (a) control of the entity’s Board of Directors, which has unilateral power over the activities that most significantly impact the economic performance of GRAIL and (b) the obligation to absorb losses of and the right to receive benefits from GRAIL that are potentially significant to GRAIL. As a result, the Company is deemed to be the primary beneficiary of GRAIL and is required to consolidate GRAIL. On a fully diluted basis, the Company holds a 52% equity ownership interest in GRAIL as of October 2, 2016.

During the three months ended April 3, 2016, GRAIL completed its Series A convertible preferred stock financing, raising $120.0 million, of which the Company invested $40.0 million. Additionally, the Company and GRAIL executed a long-term supply agreement in which the Company contributed certain perpetual licenses, employees, and discounted supply terms in exchange for 112.5 million shares of GRAIL’s Class B Common Stock. Such contributions are recorded at their historical basis as they remain within the control of the Company. The $80.0 million received by GRAIL from unrelated third party investors upon issuance of its Series A convertible preferred stock is classified as noncontrolling interests in stockholders’ equity on the Company’s consolidated balance sheet.

During the three months ended July 3, 2016, GRAIL authorized for issuance 97.5 million shares of Series A-1 convertible preferred stock, all of which were issued to Illumina in exchange for 97.5 million shares of Illumina’s Class B Common Stock on June 23, 2016. As a result of the exchange, Illumina recorded a $9.5 million deemed dividend net of tax of $9.6 million through equity, which was eliminated in consolidation.


13


For the three months ended October 2, 2016, the Company absorbed approximately 50% of GRAIL’s losses based upon its proportional ownership of GRAIL’s common stock. Prior to the exchange, for the six months ended July 3, 2016, the Company absorbed 90% of GRAIL’s losses based upon its proportional ownership of GRAIL’s common stock.

In accordance with GRAIL’s Equity Incentive Plan, the Company may be required to redeem certain vested stock awards in cash at the then approximate fair market value.  The fair value of the redeemable noncontrolling interests is considered a Level 3 instrument.  Such redemption right is exercisable at the option of the holder of the awards after February 28, 2021, provided that an initial public offering of GRAIL has not been completed. As the redemption provision is outside of the control of the Company, the redeemable noncontrolling interests in GRAIL are classified outside of stockholders’ equity on the accompanying condensed consolidated balance sheets.  The balance of the redeemable noncontrolling interests is reported at the greater of its carrying value after receiving its allocation of GRAIL’s profits and losses or its estimated redemption value at each reporting date. 

The assets and liabilities of GRAIL, other than cash and cash equivalents, are not significant to the Company’s financial position as of October 2, 2016. Additionally, GRAIL has an immaterial impact on the Company’s condensed consolidated statements of income and cash flows for the three and nine months ended October 2, 2016.

Helix Holdings I, LLC

In July 2015, the Company obtained a 50% voting equity ownership interest in Helix Holdings I, LLC (Helix), a limited liability company formed with unrelated third party investors to pursue the development and commercialization of a marketplace for consumer genomics. The Company determined that Helix is a variable interest entity as the holder of the at-risk equity investments as a group lack the power to direct the activities of Helix that most significantly impact Helix’s economic performance. Additionally, the Company determined that it has (a) unilateral power over one of the activities that most significantly impacts the economic performance of Helix through its contractual arrangements and no one individual party has unilateral power over the remaining significant activities of Helix and (b) the obligation to absorb losses of and the right to receive benefits from Helix that are potentially significant to Helix. As a result, the Company is deemed to be the primary beneficiary of Helix and is required to consolidate Helix.

As contractually committed, the Company contributed certain perpetual licenses, instruments, intangibles, initial laboratory setup, and discounted supply terms in exchange for voting equity interests in Helix. Such contributions are recorded at their historical basis as they remain within the control of the Company. Helix is financed through cash contributions made by the third party investors in exchange for voting equity interests in Helix.

Certain noncontrolling Helix investors may require the Company to redeem all noncontrolling interests in cash at the then approximate fair market value. The fair value of the redeemable noncontrolling interests is considered a Level 3 instrument. Such redemption right is exercisable at the option of certain noncontrolling interest holders after January 1, 2021, provided that a bona fide pursuit of the sale of Helix has occurred and an initial public offering of Helix has not been completed.

As the contingent redemption is outside of the control of Illumina, the redeemable noncontrolling interests in Helix are classified outside of stockholders’ equity on the accompanying condensed consolidated balance sheets. The balance of the redeemable noncontrolling interests is reported at the greater of its carrying value after receiving its allocation of Helix’s profits and losses or its estimated redemption value at each reporting date. As of October 2, 2016, the noncontrolling shareholders and Illumina each held 50% of Helix’s outstanding voting equity interests.

The assets and liabilities of Helix are not significant to the Company’s financial position as of October 2, 2016. Helix has an immaterial impact on the Company’s condensed consolidated statements of income and cash flows for the three and nine months ended October 2, 2016.

As of October 2, 2016, the accompanying condensed consolidated balance sheet includes $103.6 million of cash and cash equivalents attributable to GRAIL and Helix that will be used to settle their respective obligations and will not be available to settle obligations of the Company.


14


Redeemable Noncontrolling Interests

The activity of the redeemable noncontrolling interests during the nine months ended October 2, 2016 is as follows (in thousands):
 
Redeemable Noncontrolling Interests
Balance as of January 3, 2016
$
32,546

Vesting of redeemable equity awards
1,481

Net loss attributable to noncontrolling interests
(11,793
)
Adjustment up to the redemption value
12,023

Balance as of October 2, 2016
$
34,257


3. 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 October 2, 2016 and January 3, 2016 (in thousands):
 
 
October 2, 2016
 
January 3, 2016
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds (cash equivalents)
$
503,593

 
$

 
$

 
$
503,593

 
$
391,246

 
$

 
$

 
$
391,246

Debt securities in government-sponsored entities

 
29,657

 

 
29,657

 

 
14,626

 

 
14,626

Corporate debt securities

 
463,292

 

 
463,292

 

 
421,094

 

 
421,094

U.S. Treasury securities
248,620

 

 

 
248,620

 
181,730

 

 

 
181,730

Deferred compensation plan assets

 
29,901

 

 
29,901

 

 
26,245

 

 
26,245

Total assets measured at fair value
$
752,213

 
$
522,850

 
$

 
$
1,275,063

 
$
572,976

 
$
461,965

 
$

 
$
1,034,941

Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Acquisition related contingent consideration liabilities
$

 
$

 
$
5,300

 
$
5,300

 
$

 
$

 
$
35,000

 
$
35,000

Deferred compensation liability

 
28,447

 

 
28,447

 

 
24,925

 

 
24,925

Total liabilities measured at fair value
$

 
$
28,447

 
$
5,300

 
$
33,747

 
$

 
$
24,925

 
$
35,000

 
$
59,925


The Company holds available-for-sale securities that consist of highly liquid, investment grade debt securities. The Company considers information provided by the Company’s investment accounting and reporting service provider in the measurement of fair value of its debt securities. The investment service provider provides valuation information from an industry-recognized valuation service. Such valuations may be based on trade prices in active markets for identical assets or liabilities (Level 1 inputs) or valuation models 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 investments in life insurance contracts carried at cash surrender value, which reflects the net asset value of the underlying publicly traded mutual funds. The Company performs control procedures to corroborate the fair value of its holdings, including comparing valuations obtained from its investment service provider to valuations reported by the Company’s asset custodians, validation of pricing sources and models, and review of key model inputs if necessary.

As a result of an acquisition completed in January 2016, the Company recorded $5.3 million in contingent consideration liabilities, the majority of which are payable within 12 months after the acquisition date. The Company reassesses the fair value of any contingent consideration liabilities on a quarterly basis using the income approach. Assumptions used to estimate the acquisition date fair value of the contingent consideration include discount rates ranging from 4% to 6% and the probability of achieving certain milestones. This fair value measurement of the contingent consideration is based on significant inputs not

15


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.
Changes in estimated fair value of contingent consideration liabilities during the nine months ended October 2, 2016 are as follows (in thousands):
 
Contingent
Consideration
Liability
(Level 3 
Measurement)
Balance as of January 3, 2016
$
35,000

Additional liability recorded as a result of a current period acquisition
5,300

Cash payments
(35,000
)
Balance as of October 2, 2016
$
5,300


4. Debt

Convertible Senior Notes

As of October 2, 2016, the Company had outstanding $632.5 million in principal amount of 0% convertible senior notes due June 15, 2019 (2019 Notes) and $517.5 million in principal amount of 0.5% convertible senior notes due June 15, 2021 (2021 Notes).

0% Convertible Senior Notes due 2019 and 0.5% Convertible Senior Notes due 2021

In June 2014, the Company issued $632.5 million aggregate principal amount of 2019 Notes and $517.5 million aggregate principal amount of 2021 Notes. The Company used the net proceeds plus cash on hand to repurchase a portion of the outstanding 2016 Notes in privately negotiated transactions concurrently with the issuance of the 2019 and 2021 Notes. The 2019 and 2021 Notes’ mature on June 15, 2019 and June 15, 2021, respectively, and the implied estimated effective rates of the liability components of the Notes were 2.9% and 3.5%, respectively, assuming no conversion.

Both the 2019 and 2021 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 3.9318 shares per $1,000 principal amount of the notes (which represents an initial conversion price of approximately $254.34 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 2019 and 2021 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 September 30, 2014, 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 2019 and 2021 Notes; and (4) at any time on or after March 15, 2019 for the 2019 Notes, or March 15, 2021 for the 2021 Notes, through the second scheduled trading day immediately preceding the maturity date.

Neither the 2019 nor the 2021 Notes were convertible as of October 2, 2016 and had no dilutive impact during the three and nine months ended October 2, 2016. If the 2019 and 2021 Notes were converted as of October 2, 2016, the if-converted value would not exceed the principal amount.

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) with a maturity date of March 15, 2016. The effective rate of the liability component was estimated to be 4.5%. Based upon meeting the stock trading price conversion requirement during the three months ended March 30, 2014, the 2016 Notes became convertible on April 1, 2014 through, and including, March 11, 2016. All notes were converted by March 11, 2016.


16


During the nine months ended October 2, 2016, the Company recorded a loss 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 date. To measure the fair value of the converted notes as of the settlement date, the applicable interest rate was estimated using Level 2 observable inputs and applied to the converted notes using the same methodology as in the issuance date valuation. The loss recorded on extinguishment of debt for the nine months ended October 2, 2016 was immaterial.

The following table summarizes information about the conversion of the 2016 Notes during the nine months ended October 2, 2016 (in thousands):
 
2016 Notes
Cash paid for principal of notes converted
$
75,543

Conversion value over principal amount paid in shares of common stock
$
63,753

Number of shares of common stock issued upon conversion
409


Summary of Convertible Senior Notes

The following table summarizes information about the equity and liability components of all convertible senior notes outstanding as of the period reported (dollars in thousands). The fair values of the respective notes outstanding were measured based on quoted market prices, and is a Level 2 measurement.
 
 
October 2,
2016
 
January 3,
2016
Principal amount of convertible notes outstanding
$
1,150,000

 
$
1,225,547

Unamortized discount of liability component
(112,716
)
 
(134,969
)
Net carrying amount of liability component
1,037,284

 
1,090,578

Less: current portion

 
(74,929
)
Long-term debt
$
1,037,284

 
$
1,015,649

Carrying value of equity component, net of debt issuance cost
$
161,237

 
$
213,811

Fair value of outstanding notes
$
1,224,169

 
$
1,456,451

Weighted-average remaining amortization period of discount on the liability component
3.9 years

 
4.6 years


Other

As of October 2, 2016, the accompanying condensed consolidated balance sheets include $1.3 million and $3.4 million in current and long-term debt, respectively, related to an outstanding line of credit held by Helix.

5. Share-based Compensation Expense

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

 
Three Months Ended
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Cost of product revenue
$
1,799

 
$
2,567

 
$
5,949

 
$
7,012

Cost of service and other revenue
1,261

 
498

 
2,114

 
1,243

Research and development
11,515

 
9,098

 
32,889

 
31,152

Selling, general and administrative
20,008

 
20,066

 
60,893

 
57,697

Share-based compensation expense before taxes
34,583

 
32,229

 
101,845

 
97,104

Related income tax benefits
(7,604
)
 
(9,876
)
 
(23,082
)
 
(28,304
)
Share-based compensation expense, net of taxes
$
26,979

 
$
22,353

 
$
78,763

 
$
68,800



17


The assumptions used for the specified reporting periods and the resulting estimates of weighted-average fair value per share for stock purchased under the Employee Stock Purchase Plan (ESPP) during the nine months ended October 2, 2016 are as follows:
 
 
Employee Stock Purchase Rights
Risk-free interest rate
0.40% - 0.50%

Expected volatility
40% - 44%

Expected term
0.5 - 1.0 year

Expected dividends
0
%
Weighted-average fair value per share
$
47.88


As of October 2, 2016, approximately $203.2 million of unrecognized compensation cost related to stock options, restricted stock, and ESPP shares granted to date is expected to be recognized over a weighted-average period of approximately 2.4 years.

6. Stockholders’ Equity

As of October 2, 2016, approximately 7.5 million shares remained available for future grants under the 2015 Stock Plan and the 2005 Solexa Equity Plan.

Restricted Stock

The Company’s restricted stock activity and related information for the nine months ended October 2, 2016 is as follows (units in thousands):
 
Restricted
Stock Awards
(RSA)
 
Restricted
Stock Units
(RSU)
 
Performance
Stock Units
(PSU)(1)
 
Weighted-Average
Grant-Date Fair Value per Share
 
 
 
 
RSA
 
RSU
 
PSU
Outstanding at January 3, 2016
21

 
2,206

 
583

 
$
47.93

 
$
131.80

 
$
169.41

Awarded
22

 
174

 
30

 
$
179.00

 
$
156.32

 
$
156.75

Vested

 
(383
)
 

 
$

 
$
85.57

 

Cancelled

 
(197
)
 
(99
)
 
$

 
$
136.40

 
$
163.51

Outstanding at October 2, 2016
43

 
1,800

 
514

 
$
114.59

 
$
143.46

 
$
169.81

______________________________________
(1)
The number of units reflect the estimated number of shares to be issued at the end of the performance period.

Stock Options

The Company’s stock option activity under all stock option plans during the nine months ended October 2, 2016 is as follows:
 
Options
(in thousands)
 
Weighted-Average
Exercise Price
Outstanding at January 3, 2016
1,599

 
$
41.95

Exercised
(532
)
 
$
29.65

Cancelled
(2
)
 
$
46.35

Outstanding at October 2, 2016
1,065

 
$
48.08


At October 2, 2016, outstanding options to purchase 1.1 million shares were exercisable with a weighted-average exercise price per share of $48.08.


18


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 day of the offering period or purchase date, whichever is lower. During the nine months ended October 2, 2016, approximately 0.2 million shares were issued under the ESPP. As of October 2, 2016, there were approximately 14.3 million shares available for issuance under the ESPP.
 
Share Repurchases

On July 28, 2016, the Company’s Board of Directors authorized a new share repurchase program, which supersedes all prior and available repurchase authorizations, to repurchase $250.0 million of outstanding common stock. During the three months ended October 2, 2016, 0.1 million shares for $13.1 million were repurchased. During the nine months ended October 2, 2016, the Company repurchased approximately 0.8 million shares for $113.1 million in aggregate. Authorizations to repurchase up to an additional $236.9 million of the Company’s common stock remained available as of October 2, 2016.

7. Income Taxes

The Company’s effective tax rate may vary from the U.S. federal 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 nine months ended October 2, 2016 were 24.2% and 24.9%, respectively. For the three and nine months ended October 2, 2016, the variance from the U.S. federal statutory tax rate of 35% was primarily attributable to the mix of earnings in jurisdictions with lower statutory tax rates than the U.S. federal statutory tax rate, such as in Singapore and the United Kingdom; offset slightly by the tax impact associated with the investments in our consolidated variable interest entities.

8. 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 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 July 1, 2016, the Company entered into a Settlement and License Agreement with Enzo Life Sciences, Inc. (Enzo) that settled all claims in the litigation. Pursuant to the terms of the Settlement and License Agreement, the Company paid Enzo a one-time payment of $21.0 million for release of past damages claimed and a fully paid-up non-exclusive license to U.S. Patent No. 7,064,197. None of the parties made any admission of liability in entering into the Settlement and License Agreement. The Company allocated the $21.0 million settlement on a relative fair value basis, resulting in $11.5 million capitalized as an intangible asset and a corresponding gain recorded in legal contingencies for the value of the license, which will be amortized over a period of 7 years on a straight-line basis, and the remaining $9.5 million related to past damages claimed. The fair value of the license and past damages was estimated using a discounted cash flow model, and is considered to be a Level 3 measurement.


19


9. Segment Information

The Company has two reportable segments: Core Illumina and one segment related to the combined activities of the Company’s consolidated VIEs, GRAIL and Helix. The Company reports segment information based on the management approach. This approach designates the internal reporting used by the Chief Operating Decision Maker (“CODM”) for making decisions and assessing performance as the source of the Company’s reportable segments. The CODM allocates resources and assesses the performance of each operating segment using information about its revenues and income (losses) from operations. Based on the information used by the CODM, the Company has determined its reportable segments as follows:

Core Illumina:

Core Illumina’s products and services serve customers in the research, clinical and applied markets, and enable the adoption of a variety of genomic solutions. Core Illumina includes all operations of the Company, excluding the results of its two consolidated VIEs.

Consolidated VIEs:

GRAIL: GRAIL was created to enable the early detection of cancer in asymptomatic individuals through a simple blood screen based on the concentration of circulating tumor nucleic acids. GRAIL is currently in the early stages of developing this test and as such, has no revenues to date.

Helix: Helix was established to enable individuals to explore their genetic information by providing affordable sequencing and database services for consumers through third party partners, driving the creation of an ecosystem of consumer applications.

Management evaluates the performance of the Company’s operating segments based upon income (loss) from operations. The Company does not allocate expenses between segments. Core Illumina sells products and provides services to GRAIL and Helix in accordance with contractual agreements between the entities.

The following table presents the operating performance of each reportable segment (in thousands):

 
Three Months Ended
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Segment revenues:
 
 
 
 
 
 
 
Core Illumina
$
615,135

 
$
550,271

 
$
1,792,150

 
$
1,628,214

Consolidated VIEs

 

 

 

Elimination of intersegment revenues
(7,996
)
 

 
(13,124
)
 

Consolidated revenues
$
607,139

 
$
550,271

 
$
1,779,026

 
$
1,628,214

 
 
 
 
 
 
 
 
Segment operating income (loss):
 
 
 
 
 
 
 
Core Illumina
$
190,742

 
$
145,893

 
$
501,411

 
$
473,952

Consolidated VIEs
(25,136
)
 
(5,111
)
 
(49,700
)
 
(5,111
)
Elimination of intersegment earnings
(4,904
)
 

 
(7,695
)
 

Consolidated operating income
$
160,702

 
$
140,782

 
$
444,016

 
$
468,841


20



The following table presents the total assets of each reportable segment (in thousands):

 
October 2,
2016
 
January 3,
2016
Segment assets:
 
 
 
Core Illumina
$
4,095,182

 
$
3,657,953

Consolidated VIEs
190,904

 
30,447

Elimination of intersegment assets
(58,259
)
 
(653
)
Consolidated total assets
$
4,227,827

 
$
3,687,747



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) will help readers understand our results of operations, financial condition, and cash flow. It is provided in addition to the accompanying condensed consolidated financial statements and notes. 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 off-balance sheet arrangements.

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

Recent Accounting Pronouncements. Summary of recent accounting pronouncements applicable to our condensed consolidated 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 January 3, 2016. 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

Our Company is organized into three operating segments for purposes of evaluating its business operations and reporting its financial results. One segment consists of Illumina’s core operations. The other two relate to the activities of our consolidated VIEs, GRAIL and Helix, which are combined into one reportable segment. For information on GRAIL and Helix, refer to Note 9 of the Notes to the Condensed Consolidated Financial Statements provided in this Quarterly Report on Form 10-Q.

Our focus on innovation has established us as the global leader in DNA sequencing and array-based technologies, serving customers in the research, clinical, and applied markets. Our products are used for applications in the life sciences, oncology, reproductive health, agriculture, and other emerging market segments.

Our portfolio of integrated systems, consumables, and analysis tools is designed to accelerate and simplify genetic analysis. This portfolio addresses a range of genomic complexity, price points, and throughput, enabling customers to select the best solution for their research or clinical challenge.

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 January 3, 2016.

Next-Generation Sequencing

Next-generation sequencing has become an essential technology in our markets, and our portfolio of sequencing platforms represents a family of systems that are designed to meet the workflow, output, and accuracy demands of a full range of sequencing applications. We believe that the expanding sequencing market, along with an increase in the number of samples available and enhancements in our sequencing portfolio, will continue to drive demand for our next-generation sequencing technologies. As a result, we believe that our sequencing consumables revenue will continue to grow in future periods.

Arrays

As a complement to next-generation sequencing, we believe arrays offer a less expensive, faster, and highly accurate technology for use when genetic content is already known. The information content of arrays is fixed and reproducible, providing a repeatable, standardized technology to read out subsets of nucleotide bases within the overall genome. We believe that our customers will migrate certain array studies to sequencing. However, we expect that demand from customers in reproductive health, agriculture, and applied markets will partially mitigate this decline. Demand in the array market has trended toward lower complexity arrays that can be used on larger numbers of samples, resulting in a lower selling price per sample. We believe that our innovation in array products supports the lower selling price.

Financial Overview

Consolidated financial results for the first three quarters of 2016 include the following:

Net revenue increased 9.3% during the first three quarters of 2016 to $1,779.0 million compared to the first three quarters of 2015 due to the growth in sales of our sequencing consumables and services, partially offset by lower shipments of our high-throughput platforms.

Gross profit as a percentage of revenue (gross margin) was 70.1% in the first three quarters of 2016 compared to 69.9% in the first three quarters of 2015. Gross margins increased primarily due to a greater mix of sequencing consumables, partially offset by a decline in service margin. Our gross margin in future periods will depend on several factors, including: market conditions that may impact our pricing power; sales mix changes among consumables, instruments, and services; product mix changes between established products and new products in new markets; royalties; our cost structure for manufacturing operations; and product support obligations.

Income from operations decreased $24.8 million in the first three quarters of 2016 compared to the first three quarters of 2015 primarily due to the increase in research and development and selling, general and administrative expenses, which we expect will continue to grow. The increase in operating expenses was partially offset by higher gross profit.

Our effective tax rate was 24.9% in the first three quarters of 2016, compared to 20.9% in the first three quarters of 2015. The variance from the U.S. federal statutory tax rate of 35% was primarily attributable to the mix of earnings in jurisdictions with lower statutory tax rates than the U.S. federal statutory tax rate, such as in Singapore and the United Kingdom, partially offset by the tax impact associated with the investments in our consolidated variable interest entities. Our future effective tax rate may vary from the U.S. federal 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 Part I Item 1A of our Annual Report on Form 10-K for the fiscal year ended January 3, 2016. We anticipate that our effective tax rate will trend lower than the U.S. federal statutory tax rate in the future due to the portion of our earnings that will be subject to lower statutory tax rates.
 
Cash, cash equivalents, and short-term investments were $1.5 billion as of October 2, 2016.

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.
 
 
Q3 2016
 
Q3 2015
 
YTD 2016
 
YTD 2015
Revenue:
 
 
 
 
 
 
 
Product revenue
84.6
 %
 
85.6
 %
 
84.7
 %
 
85.5
 %
Service and other revenue
15.4

 
14.4

 
15.3

 
14.5

Total revenue
100.0

 
100.0

 
100.0

 
100.0

Cost of revenue:
 
 
 
 
 
 
 
Cost of product revenue
21.8

 
22.0

 
21.5

 
22.1

Cost of service and other revenue
6.2

 
5.4

 
6.6

 
5.8

Amortization of acquired intangible assets
1.8

 
2.2

 
1.8

 
2.2

Total cost of revenue
29.8

 
29.6

 
29.9

 
30.1

Gross profit
70.2

 
70.4

 
70.1

 
69.9

Operating expense:
 
 
 
 
 
 
 
Research and development
20.7

 
18.0

 
21.0

 
17.6

Selling, general and administrative
22.9

 
24.8

 
24.5

 
23.2

Legal contingencies

 
2.7

 
(0.5
)
 
0.9

Headquarter relocation
0.1

 
(0.9
)
 
0.1

 
(0.2
)
Acquisition related expense (gain), net

 
0.2

 

 
(0.4
)
Total operating expense
43.7

 
44.8

 
45.1

 
41.1

Income from operations
26.5

 
25.6

 
25.0

 
28.8

Other income (expense):
 
 
 
 
 
 
 
Interest income
0.3

 
0.5

 
0.4

 
0.4

Interest expense
(1.3
)
 
(2.3
)
 
(1.5
)
 
(2.2
)
Cost-method investment gain, net

 
0.5

 

 
1.0

Other (expense) income, net

 
(0.9
)
 
0.1

 
(0.5
)
Total other expense, net
(1.0
)
 
(2.2
)
 
(1.0
)
 
(1.3
)
Income before income taxes
25.5

 
23.4

 
24.0

 
27.5

Provision for income taxes
6.2

 
2.4

 
6.0

 
5.7

Consolidated net income
19.3

 
21.0

 
18.0

 
21.8

Add: Net loss attributable to noncontrolling interests
1.9

 
0.5

 
1.0

 
0.1

Net income attributable to Illumina stockholders
21.2
 %
 
21.5
 %
 
19.0
 %
 
21.9
 %

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 nine month periods ended October 2, 2016 and September 27, 2015 were both 13 and 39 weeks, respectively.

21


Revenue 
(Dollars in thousands)
Q3 2016
 
Q3 2015
 
Change
 
% Change
 
YTD 2016
 
YTD 2015