UNITED STATES SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number: 000-30361

Illumina, Inc.

(Exact name of Registrant as Specified in Its Charter)

 

 

Registrant’s telephone number, including area code:

(858) 202-4500

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

 

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

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. (Check one):

 

(Do not check if a 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 o     No þ

 

As of February 2, 2009, there were 121,077,875 shares (excluding 17,927,983 shares held in treasury) of the Registrant’s Common Stock outstanding. The aggregate market value of the Common Stock held by non-affiliates of the Registrant as of June 27, 2008 (the last business day of the Registrant’s most recently completed second fiscal quarter), based on the closing price for the Common Stock on The NASDAQ Global Select Market on that date, was $4,849,118,890. This amount excludes an aggregate of 2,556,098 shares of Common Stock held by officers and directors and each person known by the Registrant to own 10% or more of the outstanding Common Stock. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, directly or indirectly, to direct or cause the direction of the management or policies of the Registrant, or that the Registrant is controlled by or under common control with such person.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s definitive proxy statement for the annual meeting of stockholders expected to be held on May 8, 2009 are incorporated by reference into Items 10 through 14 of Part III of this Report.

 

 

ILLUMINA, INC.

 

FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 28, 2008

 

TABLE OF CONTENTS

 

 

 

This Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. These statements relate to future events or our future financial performance. We have attempted to identify forward-looking statements by terminology including “anticipates,” “believes,” “can,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “should” or “will” or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks outlined under “Item 1A. Risk Factors” in this Annual Report, that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Accordingly, you should not unduly rely on these forward-looking statements, which speak only as of the date of this Annual Report. We are not under any duty to update any of the forward-looking statements after the date we file this Annual Report on Form 10-K or to conform these statements to actual results, unless required by law. You should, however, review the factors and risks we describe in the reports we file from time to time with the Securities and Exchange Commission.

 

Illumina^®, Array of Arrays^tm, BeadArray^tm, BeadXpress^®, CSPro^®, DASL^®, GoldenGate^®, Genome Studio^tm, Infinium^®, IntelliHyb^®, iSelect^®, Making Sense Out of Life^®, Oligator^®, Sentrix^®, Solexa^®, and VeraCode^® are our trademarks. This report also contains brand names, trademarks or service marks of companies other than Illumina, and these brand names, trademarks and service marks are the property of their respective holders.

 

Available Information

 

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on our website, www.illumina.com. The information on our website is not incorporated by reference into this report. Such reports are made available as soon as reasonably practicable after filing with, or furnishing to, the Securities and Exchange Commission (SEC). The SEC also maintains an Internet site at www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that electronically file with the SEC. Copies of our annual report will be made available, free of charge, upon written request.

 

Overview

 

We are a leading developer, manufacturer and marketer of integrated systems for the large scale analysis of genetic variation and biological function. We were incorporated in California in April 1998 and reincorporated in Delaware in July 2000. Our principal executive offices are located at 9885 Towne Centre Drive, San Diego, California 92121. Our telephone number is (858) 202-4500.

 

Using our proprietary technologies, we provide a comprehensive line of products and services that currently serve the sequencing, genotyping and gene expression markets. In the future, we expect to enter the market for molecular diagnostics. Our customers include leading genomic research centers, pharmaceutical companies, academic institutions, clinical research organizations and biotechnology companies. Our tools provide researchers around the world with the performance, throughput, cost effectiveness and flexibility necessary to perform the billions of genetic tests needed to extract valuable medical information from advances in genomics and proteomics. We believe this information will enable researchers to correlate genetic variation and biological function, which will enhance drug discovery and clinical research, allow diseases to be detected earlier and permit better choices of drugs for individual patients.

 

On January 26, 2007, we completed the acquisition of Solexa, Inc. (Solexa) for 26.2 million shares of our common stock. As a result of that acquisition, we develop and commercialize sequencing technologies used to

perform a range of analyses, including whole genome re-sequencing, gene expression analysis and small RNA analysis. We believe we are the only company with genome-scale technology for sequencing, genotyping and gene expression, the three cornerstones of modern genetic analysis.

 

During the first quarter of 2008, we reorganized our operating structure into two newly created business segments, Life Sciences and Diagnostics. During 2008, the Diagnostics Business Unit had limited business activity and, accordingly, operating results were reported on an aggregate basis as one operating segment. In the future, at each reporting period end, we will reassess our reportable operating segments, particularly as we enter the market for molecular diagnostics.

 

On August 1, 2008, we completed the acquisition of Avantome, Inc. (Avantome). As consideration for the acquisition, we paid $25.8 million in cash and may pay up to an additional $35.0 million in contingent cash consideration based on the achievement of certain milestones. Avantome is a development stage company working on developing low-cost, long read sequencing technology. We expect this technology, if and when available as a product, to have applicability to both the research and diagnostic markets.

 

Our Strategy

 

Our goal is to make our Genome Analyzer, BeadArray and BeadXpress platforms the industry standards for products and services addressing the genetic analysis markets. We plan to achieve this by:

 

 

Our Markets

 

Our current technologies serve three primary markets:  next-generation sequencing, mid-to-high-complexity microarrays for genotyping and gene expression, and the “applied markets,” the majority of which are comprised of agricultural research. Next-generation sequencing is the most rapidly growing of these three markets. It is fueled by private and public funding, new global initiatives to broadly characterize genetic variation, and the migration of legacy genetic applications to sequencing based technologies. We believe our DNA sequencing systems, coupled with complementary technologies from strategic investments, including the acquisition of Avantome and our collaborative alliance with Oxford Nanopore Technologies will enable us to address numerous market segments with innovative solutions.

 

In 2009, we expect to enter the market for molecular diagnostics. The molecular diagnostic market is currently estimated at nearly $3 billion with the potential to grow to over $5 billion by 2012. This market assessment covers regulated assays and reagents, and does not factor in laboratory-developed tests, which account for a significant portion of the total market. The primary growth drivers in the molecular diagnostics market are the continued discovery of genetic markers with proven clinical utility, the increasing adoption of genetic based diagnostic tests, and the expansion of reimbursement programs to include a greater number of approved diagnostic tests. We believe our Veracode technology platform is ideally suited to provide a cost-effective, high-throughput, mid- to low-multiplex solution to the molecular diagnostic market. We are planning to submit the platform for review by the Food and Drug Administration in 2009.

 

Industry Background

 

Genetic Variation and Biological Function

 

Every person inherits two copies of each gene, one from each parent. The two copies of each gene may be identical, or they may be different. These differences are referred to as genetic variation. Examples of the physical consequences of genetic variation include differences in eye and hair color. Genetic variation can also have important medical consequences. Genetic variation affects disease susceptibility, including predisposition

to cancer, diabetes, cardiovascular disease and Alzheimer’s disease. In addition, genetic variation may cause people to respond differently to the same drug treatment. Some people may respond well, others may not respond at all, and still others may experience adverse side effects. A common form of genetic variation is a single-nucleotide polymorphism, or SNP. A SNP is a variation in a single position in a DNA sequence. It is estimated that the human genome contains over ten million SNPs.

 

While in some cases a single SNP will be responsible for medically important effects, it is now believed that combinations of SNPs may contribute to the development of most common diseases. Since there are millions of SNPs, it is important to investigate many representative, well-chosen SNPs simultaneously in order to discover medically valuable information.

 

Another contributor to disease and dysfunction is the over- or under-expression of genes within an organism’s cells. A very complex network of genes interacts to maintain health in complex organisms. The challenge for scientists is to delineate the associated genes’ expression patterns and their relationship to disease. Until recently, this problem was addressed by investigating effects on a gene-by-gene basis. This is time consuming and difficulties exist when several pathways cannot be observed or “controlled” at the same time. With the advent of microarray technology, thousands of genes can now be tested at the same time.

 

There are multiple methods of studying genetic variation and biological function, including sequencing, SNP genotyping and gene expression profiling, each of which is uniquely addressed in our breadth of products and services. Our broad portfolio of current products and services supports a range of applications, from highest multiplexing (for whole-genome discovery and profiling) to mid-and low-multiplexing options (for high-throughput targeted screening).

 

Sequencing

 

DNA sequencing is the process of determining the order of bases (A, C, G or T) in a DNA sample, which can be further divided into de novo sequencing, re-sequencing and tag sequencing. In de novo sequencing, the goal is to determine the sequence of a representative sample from a species never before sequenced. Understanding the similarities and differences in DNA sequence between many species can help our understanding of the function of the protein structures encoded in the DNA.

 

In re-sequencing, the sequence of samples from a given species is determined and compared to a standard or reference sequence to identify changes that reflect genetic variation. Re-sequencing studies can be performed on a genome-wide basis, which is referred to as whole-genome re-sequencing, or on targeted areas of the genome (for example, regions identified by genome-wide association study), which is known as targeted re-sequencing. This is an extremely comprehensive form of genetic analysis, in which every base is characterized for possible mutations. We believe that these underlying discoveries will likely feed the development of new array products for broader testing and biomarker validation.

 

In tag sequencing, short sequences, often representative of a larger molecule or genomic location, are detected and counted. In these applications, the number of times that each tag is seen provides quantification of an underlying biological process. As an example, in digital gene expression, one or more tag sequences may be analyzed for each expressed gene, and the number of copies of these tags which are detected in an experiment is a measure of how actively that gene is being expressed in the tissue sample being analyzed. Similarly, a tag sequencing approach known as ChIP sequencing is used to determine the locations and extent of protein and DNA interactions throughout the genome.

 

SNP Genotyping

 

SNP genotyping is the process of determining which base (A, C, G or T) is present at a particular site in the genome within any organism. The most common use of SNP genotyping is for genome-wide association studies (GWAS) to look for an association between DNA sequence variants and a specific phenotype of interest. This is commonly done by studying the DNA of individuals that are affected by a common disease or that exhibit a specific trait against the DNA of control individuals who do not have this disease or trait. The use of SNP genotyping to obtain meaningful statistics on the effect of an individual SNP or a collection of

SNPs requires the analysis of millions of SNP genotypes and the testing of large populations for each disease. For example, a single large study could involve genotyping more than 1,000,000 SNPs per patient in more than 1,000 patients, thus requiring 1 billion assays. Using previously available technologies, this scale of SNP genotyping was both impractical and prohibitively expensive.

 

Large-scale SNP genotyping can be used in a variety of ways, including studies designed to understand the genetic contributions to disease (disease association studies), genomics based drug development, clinical trial analysis (responders and non-responders, and adverse event profiles), disease predisposition testing, and disease diagnosis. SNP genotyping can also be used outside of healthcare, for example in the development of plants and animals with commercially desirable characteristics. These markets will require billions of SNP genotyping assays annually.

 

Gene Expression Profiling

 

Gene expression profiling is the process of determining which genes are active in a specific cell or group of cells and is accomplished by measuring mRNA, the intermediary messenger between genes (DNA) and proteins. Variation in gene expression can cause disease, or act as an important indicator of disease or predisposition to disease. By comparing gene expression patterns between cells from different environments, such as normal tissue compared to diseased tissue or in the presence or absence of a drug, specific genes or groups of genes that play a role in these processes can be identified. Studies of this type, often used in drug discovery, require monitoring thousands, and preferably tens of thousands, of mRNAs in large numbers of samples. Once a smaller set of genes of interest has been identified, researchers can then examine how these genes are expressed or suppressed across numerous samples, for example, within a clinical trial.

 

As gene expression patterns are correlated to specific diseases, gene expression profiling is becoming an increasingly important diagnostic tool. Diagnostic use of expression profiling tools is anticipated to grow rapidly with the combination of the sequencing of various genomes and the availability of more cost-effective technologies.

 

Our Technologies

 

Sequencing Technology

 

Our DNA sequencing technology, acquired as part of the Solexa merger in the first quarter of 2007, is based on the use of our sequencing-by-synthesis (SBS) biochemistry. In SBS, single stranded DNA is extended from a priming site, one base at a time, using reversible terminator nucleotides. These are DNA bases which can be added to a growing second strand, but which initially cannot be further extended. This means that at each cycle of the chemistry, only one base can be added. Each base which is added includes a fluorescent label which is specific to the particular base. Thus following incorporation, the fluorescence can be imaged, its color determined, and the base itself can be inferred. Once this is done, an additional step removes both the fluorescence and the blocking group that had prevented further extension of the second strand. This allows another base to be added, and the cycle can be repeated. Our technology is capable of generating several billion bases of DNA sequence from a single experiment with a single sample preparation. The reversible terminator bases that we use are novel synthetic molecules which we manufacture. They are not well incorporated by naturally occurring polymerases, so we have also developed proprietary polymerase enzymes for this purpose. Both the nucleotides and enzymes are the subject of significant intellectual property owned by us.

 

In our DNA sequencing systems, we apply the SBS biochemistry on microscopic islands of DNA, referred to as DNA clusters. Each cluster starts as a single DNA molecule, typically a few hundred bases long, attached to the inside surface of a flow cell. We then use a proprietary amplification biochemistry to create copies of each starting molecule. As the copies are made, they are covalently linked to the surface, so they cannot diffuse away. After a number of cycles of amplification, each cluster might have 500 to 1,000 copies of the original starting molecule, but still be only about a micron (one-millionth of a meter) in diameter. By making so many copies, the fluorescent signal from each cluster is significantly increased. Because the clusters are so small, tens of millions of clusters can be independently formed inside a single flow cell. This

large number of clusters can then be sequenced simultaneously by alternate cycles of SBS biochemistry and fluorescent imaging.

 

BeadArray Technology

 

Our BeadArray technology combines microscopic beads and a substrate in a simple proprietary manufacturing process to produce arrays that can perform many assays simultaneously, enabling large-scale analysis of genetic variation and biological function in a unique high-throughput, cost effective, and flexible manner. We achieve high-throughput with a high density of test sites per array and we are able to format arrays either in a pattern arranged to match the wells of standard microtiter plates or in various configurations in the format of standard microscope slides. We seek to maximize cost effectiveness by reducing consumption of expensive reagents and valuable samples, and through the low manufacturing costs associated with our technologies. Our ability to vary the size, shape and format of the well patterns and to create specific bead pools, or sensors, for different applications provides the flexibility to address multiple markets and market segments. We believe that these features have enabled our BeadArray technology to become a leading platform for the high-growth market of SNP genotyping and have allowed us to be a key player in the gene expression market.

 

Our proprietary BeadArray technology consists of prepared beads that self-assemble into microwells etched into an array substrate. We have deployed our BeadArray technology in two different array formats, the Array Matrix and the BeadChip. Our first bead based product was the Array Matrix which incorporates fiber optic bundles. Each bundle is comprised of approximately 50,000 individual fibers and 96 of these bundles are placed into an aluminum plate to form an Array Matrix. BeadChips are microscope slide-size silicon wafers with varying numbers of sample sites per slide. Both formats are chemically etched to create tens of thousands to tens of millions of wells for each sample site.

 

In a separate process, we create sensors by affixing a specific type of molecule to each of the billions of microscopic beads in a batch. We make different batches of beads, with the beads in a given batch coated with one particular type of molecule. The particular molecules on a bead define that bead’s function as a sensor. For example, we create a batch of SNP sensors by attaching a particular DNA sequence, or a short segment of synthetically manufactured DNA called an oligonucleotide (oligo), to each bead in the batch. We combine batches of coated beads to form a pool specific to the type of array we intend to create. A bead pool one milliliter in volume contains sufficient beads to produce thousands of arrays.

 

To form an array, a pool of coated beads is brought into contact with the array surface where they are randomly drawn into the wells, one bead per well. The beads in the wells comprise our individual arrays. Because the beads assemble randomly into the wells, we perform a final procedure called “decoding” in order to determine which bead type occupies which well in the array. We employ several proprietary methods for decoding, a process that requires only a few steps to identify all the beads in the array. One beneficial by-product of the decoding process is a functional validation of each bead in the array. This quality control test characterizes the performance of each bead and can identify and eliminate use of any empty wells. We ensure that each bead type on the array is sufficiently represented by including multiple copies of each bead type. Multiple bead type copies improve the reliability and accuracy of the resulting data by allowing statistical processing of the results of identical beads. We believe we are the only microarray company to provide this level of quality control in the industry.

 

An experiment is performed by preparing a sample, such as DNA, and introducing it to the array. The molecules in the sample bind to their matching molecules on the coated beads. The molecules in either the sample or on the bead are labeled with fluorescent dye either before or after the binding. The iScan or BeadArray Reader detects the fluorescent dye by shining a laser on the fiber optic bundle or on the BeadChip. This allows the detection of the molecules resulting in a quantitative analysis of the sample.

 

VeraCode Technology

 

Our proprietary VeraCode technology platform leverages the power of digital holographic codes to provide a robust detection method for multiplex assays requiring high precision, accuracy and speed.

Commercially launched in March of 2007 for the research market, VeraCode enables low-cost multiplexing from 1 to 384-plex in a single well. At the heart of the VeraCode technology are cylindrical glass beads measuring 240 microns in length by 28 microns in diameter. Each VeraCode bead type is inscribed with a unique digital holographic code to designate and track the specific analyte or genotype of interest throughout the multiplex reaction. We believe the up to 24 bits of information inscribed in each code allows for an unprecedented level of error checking, improves the robustness of the optical readout process and provides a level of reliability that sets a new standard in multiplex testing. Unlike traditional microarrays, the VeraCode microbeads are used in solution, which takes advantage of solution-phase kinetics for more rapid hybridization times, dramatically reducing the time to achieve results. This technology enables us to serve a number of markets including research, agriculture, forensics, pharmaceuticals and molecular diagnostics.

 

Our Products

 

Using our proprietary technologies, our products give our customers the ability to analyze the genome at any level of complexity from whole genome sequencing to low multiplex assays. This enables us to serve a number of markets, including research, agriculture, forensics, pharmaceuticals and molecular diagnostics. The majority of our product sales consist of instruments and consumables based on these various technologies. For the years ended December 28, 2008, December 30, 2007 and December 31, 2006, instrument sales comprised 32%, 33% and 23%, respectively, of total revenues and consumable sales represented 58%, 53% and 54%, respectively, of total revenues.

 

Our major products include the following:

 

Instrumentation

 

Consumables

 

 

Our Services

 

Sequencing

 

We have been offering sequencing services on our Genome Analyzers since 2007. Our services range from small sets of samples requiring as little as one run to finish, to large-scale projects, like whole-genome sequencing, necessitating multiple instruments running in parallel for extended periods of time. The breadth of applications offered includes novel custom products as well as all released products. These applications include but are not limited to re-sequencing, de novo sequencing, small RNA discovery and profiling, gene expression using tag based or using random primed RNA sampling technology, ChIP SEQ and methylome interrogation.

 

Array

 

We have been offering FastTrack Genotyping Services since 2002. Our FastTrack Genotyping Services offers all of our genotyping products, including standard and custom GoldenGate, standard Infinium and Infinium HD, as well as iSelect Infinium. Our projects range in size from a few hundred samples to over 10,000 samples. Our current capacity peak is 450 million genotypes per day. Our customer base includes academic institutions, and biotech and pharmaceutical companies.

 

Intellectual Property

 

We have an extensive patent portfolio, including, as of February 1, 2009, ownership of, or exclusive licenses to, 135 issued U.S. patents and 168 pending U.S. patent applications, including four allowed applications that have not yet issued as patents, some of which derive from a common parent application. Our issued patents, which are directed at various aspects of our arrays, assays, oligo synthesis, sequencing technology, instruments and chemical detection technologies, expire between 2010 and 2026. We are seeking

to extend the patents directed at the full range of our technologies. We have received or filed counterparts for many of these patents and applications in one or more foreign countries.

 

We also rely upon trade secrets, know-how, copyright and trademark protection, as well as continuing technological innovation and licensing opportunities to develop and maintain our competitive position. Our success will depend in part on our ability to obtain patent protection for our products and processes, to preserve our trade secrets, to enforce our patents, copyrights and trademarks, to operate without infringing the proprietary rights of third parties and to acquire licenses related to enabling technology or products.

 

We are party to various exclusive and non-exclusive license agreements and other arrangements with third parties, which grant us rights to use key aspects of our array and sequencing technologies, assay methods, chemical detection methods, reagent kits and scanning equipment. We have exclusive licenses from Tufts University to patents that are directed at our use of BeadArray technology. These patents were filed by Dr. David Walt, a member of our board of directors, the Chairman of our Scientific Advisory Board and one of our founders. Our exclusive licenses expire with the termination of the underlying patents, which will occur between 2010 and 2020. We also have additional nonexclusive licenses from various third parties for other components of our products. In most cases, the agreements remain in effect over the term of the underlying patents, may be terminated at our request without further obligation and require that we pay customary royalties while the agreement is in effect.

 

Research and Development

 

We have made substantial investments in research and development since our inception. We have assembled a team of skilled engineers and scientists who are specialists in biology, chemistry, informatics, instrumentation, optical systems, software, manufacturing and other related areas required to complete the development of our products. Our research and development efforts have focused primarily on the tasks required to optimize our Sequencing, BeadArray, VeraCode and Oligator technologies and to support commercialization of the products and services derived from these technologies. As of December 28, 2008, we had a total of 406 employees engaged in research and development activities.

 

Our research and development expenses for 2008, 2007, and 2006 (inclusive of charges relating to stock-based compensation of $14.1 million, $10.0 million and $3.9 million, respectively) were $100.0 million, $73.9 million and $33.4 million, respectively. We expect research and development expense to increase during 2009 as we continue to expand our research and product development efforts.

 

Marketing and Distribution

 

Our current products address the genetic analysis portion of the life sciences market, in particular, experiments involving sequencing, SNP genotyping and gene expression profiling. These experiments may be involved in many areas of biologic research, including basic human disease research, pharmaceutical drug discovery and development, pharmacogenomics, toxicogenomics and agricultural research. Our potential customers include pharmaceutical, biotechnology, agrichemical, diagnostics and consumer products companies, as well as academic or private research centers. The genetic analysis market is relatively new and emerging and its size and speed of development will be ultimately driven by, among other items:

 

 

We market and distribute our products directly to customers in North America, Europe and Asia-Pacific. In each of these areas, we have dedicated sales, service and application support personnel responsible for expanding and managing their respective customer bases. In smaller markets within Europe and Asia-Pacific,

we sell our products and provide services to customers through distributors that specialize in life science products. We expect to significantly increase our sales and distribution resources during 2009 and beyond as we launch a number of new products and expand the number of customers that can use our products.

 

Manufacturing

 

We manufacture our sequencing and array platforms, reagent kits, scanning equipment and oligos. Our manufacturing capacity for consumables has grown to support our increased customer demand during 2008. In the third quarter of 2008, we began shipping BeadChips from our new Singapore facility. We are also focused on continuing to enhance the quality and manufacturing yield of our Array Matrices, BeadChips and FlowCells. To continue to increase throughput and improve the quality and manufacturing yield as we increase the complexity of our products, we are exploring ways to continue increasing the level of automation in the manufacturing process. We adhere to access and safety standards required by federal, state and local health ordinances, such as standards for the use, handling and disposal of hazardous substances.

 

Raw Materials

 

Our manufacturing operations require a wide variety of raw materials, electronic and mechanical components, chemical and biochemical materials and other supplies. While we have multiple commercial sources for many of our components and supplies, there are some raw materials we obtain from single source suppliers. If we are unable to secure a sufficient supply of those or other product components, our business could be temporarily interrupted. To mitigate this risk, we can redesign our products for alternative components or use alternative reagents. In addition, while we generally attempt to keep our inventory at minimal levels, we do purchase incremental inventory as circumstances warrant to protect our supply chain.

 

Competition

 

Although we expect that our products and services will provide significant advantages over products and services currently available from other sources, we expect to encounter intense competition from other companies that offer products and services for the sequencing, SNP genotyping and gene expression markets. These include companies such as Affymetrix, Agilent, Beckman Coulter, Complete Genomics, Fluidigm, GE Corp., Life Technologies, Luminex, Pacific Biosciences, Roche Diagnostics and Sequenom. Some of these companies have or will have substantially greater financial, technical, research, and other resources and larger, more established marketing, sales, distribution and service organizations than we do. In addition, they may have greater name recognition than we do in the markets we address and in some cases a larger installed base of systems. Each of these markets is very competitive and we expect new competitors to emerge and the intensity of competition to increase. In order to effectively compete with these companies, we will need to demonstrate that our products have superior throughput, cost and accuracy advantages over competing products. Rapid technological development may result in our products or technologies becoming obsolete. Products offered by us could be made obsolete either by less expensive or more effective products based on similar or other technologies. Although we believe that our technology and products will offer advantages that will enable us to compete effectively with these companies, we cannot assure you that we will be successful.

 

Segment and Geographic Information

 

During the first quarter of 2008, we reorganized our operating structure into a newly created Life Sciences Business Unit, which includes all products and services related to the research market, namely the Sequencing, BeadArray and BeadXpress product lines. We also created a Diagnostics Business Unit to focus on the emerging opportunity in molecular diagnostics. During 2008, we had limited activity related to the Diagnostics Business Unit and operating results were reported on an aggregate basis to our chief operating decision maker, the chief executive officer. Accordingly, we operated in one reportable segment during 2008.

 

We currently sell our products to a number of customers outside the United States, including customers in other areas of North America, Europe and Asia-Pacific. Shipments to customers outside the United States totaled $293.2 million, or 51% of our total revenue during 2008, compared to $159.1 million, or 43%, and

$81.5 million, or 44%, in 2007 and 2006, respectively. Sales to territories outside of the United States were generally denominated in U.S. dollars. In 2008, we reorganized our international structure to establish more efficient channels between product development, product manufacturing and sales. The reorganization increased our foreign subsidiaries’ anticipated dependence on the U.S. entity for management decisions, financial support, production assets and inventory thereby making the foreign subsidiaries more of a direct and integral component of the U.S. entity’s operations. As a result, we reassessed the primary economic environment of our foreign subsidiaries and determined the subsidiaries are more U.S. dollar based, resulting in a U.S. dollar functional currency determination. We expect that sales to international customers will continue to be an important and growing source of revenue. See Note 14 of the Notes to Consolidated Financial Statements for further information concerning our foreign and domestic operations.

 

Seasonality

 

Historically, customer purchasing patterns have not shown significant seasonal variation, although demand for our products is usually lowest in the first quarter of the calendar year and highest in the third quarter of the calendar year as academic customers spend unused budget allocations before the end of the government’s fiscal year.

 

Environmental Matters

 

We are committed to the protection of our employees and the environment. Our operations require the use of hazardous materials which subject us to a variety of federal, state and local environmental and safety laws and regulations. We believe we are in material compliance with current applicable laws and regulations; however, we could be held liable for damages and fines should contamination of the environment or individual exposures to hazardous substances occur. In addition, we cannot predict how changes in these laws and regulations, or the development of new laws and regulations, will affect our business operations or the cost of compliance.

 

Employees

 

As of December 28, 2008, we had a total of 1,536 employees. None of our employees are represented by a labor union. We consider our employee relations to be positive. Our success will depend in large part upon our ability to attract and retain employees. In addition, we employ a number of temporary and contract employees. We face competition in this regard from other companies, research and academic institutions, government entities and other organizations.

 

Executive Officers

 

Our executive officers and their ages as of February 1, 2009, are as follows:

 

Jay Flatley, age 56, is President and Chief Executive Officer of Illumina. Prior to his appointment in 1999, Mr. Flatley was the President and Chief Executive Officer of Molecular Dynamics, later acquired by Amersham Pharmacia Biotech in 1998 and now a part of GE Healthcare. Mr. Flatley, who was a founder and member of the board of directors for Molecular Dynamics, lead the company to its initial public offering (IPO) in 1993, in addition to helping the company develop and launch over 15 major instrumentation systems, including the world’s first capillary based DNA sequencer. Prior to joining Molecular Dynamics, Mr. Flatley was Vice President of Engineering and Strategic Planning for Plexus Computers, a manufacturer of high-performance Unix super-microcomputers. Before his career at Plexus, Mr. Flatley was Executive Vice President for Manning Technologies and held various manufacturing positions while working for the Autolab division of Spectra Physics.

 

Christian Henry, age 40, is Senior Vice President and Chief Financial Officer. Mr. Henry joined Illumina in June 2005 and is responsible for worldwide financial operations, controllership functions and facilities management. In addition, throughout 2008, Mr. Henry was Acting General Manager of Illumina’s DNA Sequencing business. Mr. Henry served previously as the Chief Financial Officer for Tickets.com, a publicly traded, online ticket provider that was acquired by Major League Baseball Advanced Media, LP. Prior to that,

Mr. Henry was Vice President, Finance and Corporate Controller of Affymetrix, Inc., a publicly traded life sciences company, where he oversaw accounting, planning, SEC and management reporting, treasury and risk management. He previously held a similar position at Nektar Therapeutics (formerly Inhale Therapeutic Systems, Inc.).

 

Christian Cabou, age 60, is Senior Vice President, General Counsel and Secretary of Illumina. Mr. Cabou joined Illumina in May 2006 and has worldwide responsibility for all legal and intellectual property matters. Mr. Cabou is also Illumina’s Code of Ethics Compliance Officer. Before joining Illumina, Mr. Cabou spent five years as General Counsel for GE Global Research and, before that, was Senior Counsel of Global Intellectual Property for GE Medical Systems. Prior to his position at GE, Mr. Cabou spent seven years with the law firm Foley & Lardner where he was a partner. He had twenty years of experience in engineering design and management prior to his career in law and intellectual property.

 

Greg Heath, age 51, is Senior Vice President & General Manager, Diagnostics Business Unit of Illumina. Dr. Heath joined Illumina in March 2008 and is responsible for managing Illumina’s emerging diagnostics business, specifically overseeing the development of diagnostic content for the BeadXpress system, and ultimately for Illumina’s sequencing platform. Dr. Heath joined Illumina from Roche Molecular Systems where he held a number of senior executive positions, including head of clinical genomics, senior vice president of global product marketing, senior vice president of global marketing and business development, and most recently, senior vice president of global business. From 2000 — 2003, Dr. Heath was head of business development and licensing for the diagnostics division of F. Hoffman La Roche in Basel. Prior to this, Dr. Heath held numerous roles in marketing and business development with Roche Diagnostics’ U.S. affiliate.

 

Joel McComb, age 44, is Senior Vice President & General Manager, Life Sciences Business Unit of Illumina. Mr. McComb joined Illumina in March 2008 and is responsible for managing all products and services related to the research market, namely the Sequencing, BeadArray and VeraCode product lines. Mr. McComb joined Illumina from GE Healthcare where he held a number of executive positions, including president of the interventional medicine business and president of life sciences discovery systems. From 2001 — 2004, Mr. McComb was president, chief executive officer and board member of Innovadyne Technologies. Prior to Innovadyne, Mr. McComb held various positions at Beckman Coulter, including roles as general manager of the primary care diagnostic division and director of corporate business development.

 

Tristan Orpin, age 42, is Senior Vice President, Commercial Operations of Illumina. Mr. Orpin joined Illumina in December 2002 in the role of Vice President of Worldwide Sales, and in January of 2007 was promoted to the position of Senior Vice President of Commercial Operations. Before joining Illumina, Mr. Orpin was Director of Sales and Marketing for Sequenom from September 1999 to August 2001. Later, Mr. Orpin was elected Vice President of Sales and Marketing and held this position from August 2001 to November 2002. Prior to 2001, Mr. Orpin served in several senior sales and marketing positions at Bio-Rad Laboratories.

 

Mostafa Ronaghi, Ph.D., age 40, is Senior Vice President and Chief Technology Officer of Illumina. Dr. Ronaghi joined Illumina in August 2008 and is responsible for leading internal research programs and evaluating new technologies for the Company. In 2007, Dr. Ronaghi co-founded Avantome, a privately held sequencing company. Before this, he co-founded NextBio, a search engine for life science data. In 2001, Dr. Ronaghi co-founded ParAllele Bioscience, which was eventually acquired by Affymetrix, Inc., and was involved in the development and commercialization of highly multiplexed technology for genetic testing. In 1997, he co-founded Pyrosequencing AB, which was renamed Biotage in 2003. In June 2000, the company completed a successful initial public offering on the Stockholm Stock Exchange. Dr. Ronaghi was a principal investigator at Stanford University from 2002 — 2008 where he focused on the development of novel tools for molecular diagnostic applications.

 

Our business is subject to various risks, including those described below. In addition to the other information included in this Form 10-K, the following issues could adversely affect our operating results or our stock price.

 

We expect intense competition in our target markets, which could render our products obsolete, result in significant price reductions or substantially limit the volume of products that we sell. This would limit our ability to compete and maintain profitability. If we cannot continuously develop and commercialize new products, our revenue may not grow as intended.

 

We compete with life sciences companies that design, manufacture and market instruments for analysis of genetic variation and biological function and other applications using technologies, capillary electrophoresis, mass spectrometry, flow cytometry, microfluidics, nanotechnology, next-generation DNA sequencing and mechanically deposited, inkjet and photolithographic arrays. We anticipate that we will face increased competition in the future as existing companies develop new or improved products and as new companies enter the market with new technologies. The markets for our products are characterized by rapidly changing technology, evolving industry standards, changes in customer needs, emerging competition, new product introductions and strong price competition. For example, prices per data point for genotyping have fallen significantly over the last two years and we anticipate that prices will continue to fall. One or more of our competitors may render our technology obsolete or uneconomical. Some of our competitors have greater financial and personnel resources, broader product lines, a more established customer base and more experience in research and development than we do. Furthermore, life sciences and pharmaceutical companies, which are our potential customers and strategic partners, could develop competing products. For example, during the third quarter of fiscal 2007, Life Technologies (previously referred to as Applied Biosystems Group, a business segment of Applera Corporation) launched the SOLiD^tm System, its next generation sequencing technology. If we are unable to develop enhancements to our technology and rapidly deploy new product offerings, our business, financial condition and results of operations will suffer.

 

Negative conditions in global credit markets may result in delayed payments from our customers and may negatively impact our smaller suppliers.

 

The recent economic conditions and market turbulence may impact the operations of certain of our customers and suppliers. Certain of our customers may face challenges gaining timely access to sufficient credit, which could result in an impairment of their ability to make timely payments to us. If that were to occur, our allowance for doubtful accounts and our days sales outstanding could increase. Additionally, these economic conditions may cause our smaller suppliers to be unable to supply in a timely manner sufficient quantities of customized components, which would impair our ability to manufacture on schedule and at commercially reasonable costs. In addition, due to discontinuing parts, suppliers may also extend lead times, limit supplies or increase prices due to capacity constraints or other factors.

 

In addition, our business depends on the overall demand for methods of analysis of genetic variation and biological function. We rely in large part on the research and development spending of our customers, which is often discretionary, and the recent economic downturn has caused many companies to reduce their research and development budgets. If the current worldwide economic downturn continues, our customers may delay or reduce their purchases of our products and services. A reduction in demand will reduce our revenues and harm our profitability.

 

Due to our increasing foreign operations, fluctuations in foreign currency exchange rates could negatively impact our results of operations.

 

We are focused on expanding our international operations in key markets. We have sales offices located internationally throughout Europe and the Asia Pacific region, as well as manufacturing facilities in the United Kingdom and Singapore. During 2008, the majority of our sales to international customers and purchases of raw materials from international suppliers were denominated in the U.S. dollar. Changes in the value of the

relevant currencies may affect the cost of certain items required in our operations. Changes in currency exchange rates may also affect the relative prices at which we are able sell products in the same market.

 

Our revenues from international customers may be negatively impacted as increases in the U.S. dollar relative to our international customers local currency could make our products more expensive, impacting our ability to compete. Our costs of materials from international suppliers may increase if in order to continue doing business with us they may raise their prices as the value of the U.S. dollar decreases relative to their local currency.

 

Foreign policies and actions regarding currency valuation could result in actions by the United States and other countries to offset the effects of such fluctuations. The recent global financial downturn has led to a high level of volatility in foreign currency exchange rates and that level of volatility may continue and thus adversely impact our business or financial conditions.

 

If we are unable to find third-party manufacturers to manufacture components of our products, we may not be able to launch or support our products in a timely manner, or at all.

 

The nature of our products requires customized components that currently are available from a limited number of sources. For example, we currently use multiple components in our products that are single-sourced. If we are unable to secure a sufficient supply of those or other product components, we will be unable to meet demand for our products. We may need to enter into contractual relationships with manufacturers for commercial-scale production of some of our products, or develop these capabilities internally, and we cannot assure you that we will be able to do this on a timely basis, for sufficient quantities or on commercially reasonable terms. Accordingly, we may not be able to establish or maintain reliable, high-volume manufacturing at commercially reasonable costs.

 

If we lose our key personnel or are unable to attract and retain additional personnel, we may be unable to achieve our goals.

 

We are highly dependent on our management and scientific personnel, including Jay Flatley, our president and chief executive officer. The loss of their services could adversely impact our ability to achieve our business objectives. We will need to hire additional qualified personnel with expertise in molecular biology, chemistry, biological information processing, sales, marketing and technical support. We compete for qualified management and scientific personnel with other life science companies, universities and research institutions, particularly those focusing on genomics. Competition for these individuals, particularly in the San Diego and San Francisco area, is intense, and the turnover rate can be high. Failure to attract and retain management and scientific personnel would prevent us from pursuing collaborations or developing our products or technologies.

 

Our planned activities will require additional expertise in specific industries and areas applicable to the products developed through our technologies, including the life sciences and healthcare industries. Thus, we will need to add new personnel, including management, and develop the expertise of existing management. The failure to do so could impair the growth of our business.

 

We may encounter difficulties in managing our growth. These difficulties could impair our profitability.

 

We have experienced and expect to continue to experience rapid and substantial growth in order to achieve our operating plans, which will place a strain on our human and capital resources. If we are unable to manage this growth effectively, our profitability could suffer. Our ability to manage our operations and growth effectively requires us to continue to expend funds to enhance our operational, financial and management controls, reporting systems and procedures and to attract and retain sufficient numbers of talented employees. If we are unable to scale up and implement improvements to our manufacturing process and control systems in an efficient or timely manner, or if we encounter deficiencies in existing systems and controls, then we will not be able to make available the products required to successfully commercialize our technology. Failure to attract and retain sufficient numbers of talented employees will further strain our human resources and could impede our growth.

A significant portion of our sales is to international customers.

 

Shipments to customers outside the United States comprised 51%, 43% and 44% of our revenue for the years ended December 28, 2008, December 30, 2007 and December 31, 2006, respectively. We intend to continue to expand our international presence by selling to customers located outside of the U.S. and we expect the total amount of non-U.S. sales to continue to grow. Export sales entail a variety of risks, including:

 

 

In addition, we are also subject to general geopolitical risks, such as political, social and economic instability and changes in diplomatic and trade relations. One or more of these factors could have a material adverse effect on our business, financial condition and operating results.

 

We may encounter difficulties in integrating acquisitions that could adversely affect our business, specifically the effective launch and customer acceptance of new technology platforms.

 

We have made, and may in the future make, acquisitions of or significant investments in businesses with complementary products, services or technologies. Acquisitions involve numerous risks, including, but not limited to:

 

 

Acquisitions and other transactions are inherently risky and our previous or future transactions may not be successful. The inability to effectively manage the risks associated with these transactions could materially and adversely affect our business, financial condition or results of operations.

Any inability to protect effectively our proprietary technologies could harm our competitive position.

 

Our success will depend in part on our ability to obtain patents and maintain adequate protection of our intellectual property in the United States and other countries. If we do not protect our intellectual property adequately, competitors may be able to use our technologies and thereby erode our competitive advantage. The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and many companies have encountered significant challenges in protecting their proprietary rights abroad. These challenges can be caused by the absence of rules and methods for the establishment and enforcement of intellectual property rights abroad.

 

The patent positions of companies developing tools for the life sciences and pharmaceutical industries, including our patent position, generally are uncertain and involve complex legal and factual questions. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary technologies are covered by valid and enforceable patents or are effectively maintained as trade secrets. We intend to apply for patents covering our technologies and products as we deem appropriate. However, our patent applications may be challenged and may not result in issued patents or may be invalidated or narrowed in scope after they are issued. Questions as to inventorship may also arise. Any finding that our patents and applications are unenforceable could harm our ability to prevent others from practicing the related technology, and a finding that others have inventorship rights to our patents and applications could require us to obtain certain rights to practice related technologies, which may not be available on favorable terms, if at all.

 

In addition, our existing patents and any future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products. There also is risk that others may independently develop similar or alternative technologies or design around our patented technologies. Also, our patents may fail to provide us with any competitive advantage. We may need to initiate lawsuits to protect or enforce our patents, or litigate against third party claims, which would be expensive and, if we lose, may cause us to lose some of our intellectual property rights and reduce our ability to compete in the marketplace. Furthermore, these lawsuits may divert the attention of our management and technical personnel.

 

We also rely upon trade secret protection for our confidential and proprietary information and have taken security measures to protect this information. These measures, however, may not provide adequate protection for our trade secrets or other confidential information. Among other things, we seek to protect our trade secrets and confidential information by entering into confidentiality agreements with employees, collaborators and consultants. Nevertheless, employees, collaborators or consultants may still disclose our confidential information, and we may not otherwise be able to protect effectively our trade secrets. Accordingly, others may gain access to our confidential information, or may independently develop substantially equivalent information or techniques.

 

Litigation or other proceedings or third party claims of intellectual property infringement could require us to spend significant time and money and could prevent us from selling our products or services or impact our stock price.

 

Our commercial success depends, in part, on our non-infringement of the patents or proprietary rights of third parties and on our ability to protect our own intellectual property. Third parties have asserted and may in the future assert that we are employing their proprietary technology without authorization. As we enter new markets, we expect that competitors will likely claim that our products infringe their intellectual property rights as part of a business strategy to impede our successful entry into those markets. In addition, third parties may have obtained and may in the future obtain patents allowing them to claim that the use of our technologies infringes these patents. We could incur substantial costs and divert the attention of our management and technical personnel in defending ourselves against any of these claims. Any adverse ruling or perception of an adverse ruling in defending ourselves against these claims could have a material adverse impact on our stock price, which may be disproportionate to the actual import of the ruling itself. Furthermore, parties making claims against us may be able to obtain injunctive or other relief, which effectively could block our ability to develop further, commercialize and sell products, and could result in the

award of substantial damages against us. In the event of a successful claim of infringement against us, we may be required to pay damages and obtain one or more licenses from third parties, or be prohibited from selling certain products. In addition, we may be unable to obtain these licenses at a reasonable cost, if at all. We could therefore incur substantial costs related to royalty payments for licenses obtained from third parties, which could negatively affect our gross margins. In addition, we could encounter delays in product introductions while we attempt to develop alternative methods or products. Defense of any lawsuit or failure to obtain any of these licenses on favorable terms could prevent us from commercializing products, and the prohibition of sale of any of our products could materially affect our ability to grow and maintain profitability.

 

Changes in our effective income tax rate could impact our profitability.

 

We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgments based on interpretations of existing tax laws or regulations are required in determining the provision for income taxes. Our effective income tax rate could be adversely affected by various factors including, but not limited to, changes in the mix of earnings in tax jurisdictions with different statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in existing tax laws or tax rates, changes in the level of non-deductible expenses including share-based compensation, changes in our future levels of research and development spending, mergers and acquisitions, and the result of examinations by various tax authorities.

 

If we are unable to increase our manufacturing capacity and develop and maintain operation of our manufacturing capability, we may not be able to launch or support our products in a timely manner, or at all.

 

We continue to ramp up our capacity to meet the anticipated demand for our products. Although we have significantly increased our manufacturing capacity and we believe we have plans in place sufficient to ensure we have adequate capacity to meet our business plan for 2009, there are uncertainties inherent in expanding our manufacturing capabilities and we may not be able to increase our capacity in a timely manner. For example, manufacturing and product quality issues may arise as we increase production rates at our manufacturing facilities and launch new products. As a result, we may experience difficulties in meeting customer, collaborator and internal demand, in which case we could lose customers or be required to delay new product introductions, and demand for our products could decline. Additionally, in the past, we have experienced variations in manufacturing conditions that have temporarily reduced production yields. Due to the intricate nature of manufacturing products that contain DNA, we may encounter similar or previously unknown manufacturing difficulties in the future that could significantly reduce production yields, impact our ability to launch or sell these products, or to produce them economically, prevent us from achieving expected performance levels or cause us to set prices that hinder wide adoption by customers.

 

Additionally, we currently manufacture in a limited number of locations. Our manufacturing facilities are located in San Diego and Hayward, California; Singapore; and Little Chesterford, United Kingdom. These areas are subject to natural disasters such as earthquakes or floods. If a natural disaster were to significantly damage one of our facilities or if other events were to cause our operations to fail, we may be unable to manufacture our products, provide our services or develop new products.

 

Also, many of our manufacturing processes are automated and are controlled by our custom-designed Laboratory Information Management System (LIMS). Additionally, the decoding process in our array manufacturing requires significant network and storage infrastructure. If either our LIMS system, or our networks or storage infrastructure were to fail for an extended period of time, it may adversely impact our ability to manufacture our products on a timely basis and would prevent us from achieving our expected shipments in any given period.

We expect that our results of operations will fluctuate. This fluctuation could cause our stock price to decline.

 

Our revenue is subject to fluctuations due to the timing of sales of high-value products and services projects, the impact of seasonal spending patterns, the timing and size of research projects our customers perform, changes in overall spending levels in the life sciences industry, and other unpredictable factors that may affect customer ordering patterns. Given the difficulty in predicting the timing and magnitude of sales for our products and services, we may experience quarter-to-quarter fluctuations in revenue resulting in the potential for a sequential decline in quarterly revenue. A large portion of our expenses is relatively fixed, including expenses for facilities, equipment and personnel. In addition, we expect operating expenses to continue to increase significantly in absolute dollars. Accordingly, if revenue does not grow as anticipated, we may not be able to maintain annual profitability. Any significant delays in the commercial launch of our products, unfavorable sales trends in our existing product lines, or impacts from the other factors mentioned above, could adversely affect our future revenue growth or cause a sequential decline in quarterly revenue. Due to the possibility of fluctuations in our revenue and expenses, we believe that quarterly comparisons of our operating results are not a good indication of our future performance. If our operating results fluctuate or do not meet the expectations of stock market analysts and investors, our stock price could decline.

 

Our success depends upon the continued emergence and growth of markets for analysis of genetic variation and biological function.

 

We design our products primarily for applications in the life sciences and pharmaceutical industries. The usefulness of our technology depends in part upon the availability of genetic data and its usefulness in identifying or treating disease. We are focusing on markets for analysis of genetic variation and biological function, namely sequencing, SNP genotyping and gene expression profiling. These markets are new and emerging, and they may not develop as quickly as we anticipate, or reach their full potential. Other methods of analysis of genetic variation and biological function may emerge and displace the methods we are developing. Also, researchers may not seek or be able to convert raw genetic data into medically valuable information through the analysis of genetic variation and biological function. In addition, factors affecting research and development spending generally, such as changes in the regulatory environment affecting life sciences and pharmaceutical companies, and changes in government programs that provide funding to companies and research institutions, could harm our business. If useful genetic data is not available or if our target markets do not develop in a timely manner, demand for our products may grow at a slower rate than we expect, and we may not be able to sustain profitability.

 

Loss of the tax deduction on our outstanding convertible notes.

 

We could lose some or all of the tax deduction for interest expense associated with our $400.0 million aggregate principal amount of convertible notes due in 2014 if the foregoing notes are not subject to the special Treasury Regulations governing integration of certain debt instruments, the notes are converted, or we invest in non-taxable investments.

 

We may not be able to sustain operating profitability.

 

Prior to 2006, we had incurred net losses each year since our inception, and in 2007 we reported a net loss of $278.4 million, reflecting significant charges associated with our acquisition of Solexa in January 2007 and the settlement of our litigation with Affymetrix. As of December 28, 2008, our accumulated deficit was $332.5 million. Our ability to sustain profitability will depend, in part, on the rate of growth, if any, of our revenue and on the level of our expenses. Non-cash stock-based compensation expense and expenses related to prior and future acquisitions are also likely to continue to adversely affect our future profitability. We expect to continue incurring significant expenses related to research and development, sales and marketing efforts to commercialize our products and the continued development of our manufacturing capabilities. In addition, we expect that our research and development and selling and marketing expenses will increase at a higher rate in the future as a result of the development and launch of new products. Although we have regained profitability, we may not be able to sustain profitability on a quarterly basis.

Negative conditions in the global credit markets may impair the liquidity of a portion of our investment portfolio.

 

Our investment securities consist of marketable debt securities, including treasury bills and commercial paper with strong credit ratings, corporate bonds and short maturity mutual funds providing similar financial returns. Additionally, as of December 28, 2008, we had $55.9 million of auction rate securities issued primarily by municipalities and universities. These securities are debt instruments with a long-term maturity and with an interest rate that is reset in short intervals through auctions. Our entire auction rate portfolio is held in a brokerage account with UBS Financial Services, Inc., a subsidiary of UBS AG (UBS) and is currently rated AAA or AA by a rating agency. Beginning in February 2008, these auction rate securities became illiquid because their scheduled auctions failed to settle. An auction failure occurs when the parties wishing to sell securities at auction cannot. As of December 28, 2008, the securities continued to fail auction and remained illiquid.

 

Various regulatory agencies initiated investigations into the sales and marketing practices of several banks and broker-dealers, including UBS, which sold auction rate securities, alleging violations of federal and state laws. Along with several other broker-dealers, UBS subsequently reached a settlement with the federal and state regulators that required them to repurchase auction rate securities from certain investors at par at some future date. In November 2008, we signed a settlement agreement to sell our auction rate securities at par value to UBS during the period of June 30, 2010 through July 2, 2012.

 

The settlement agreement with UBS and the associated put option mitigates the risk of loss on our auction rate security portfolio. However, given the negative conditions in the global credit markets there is still risk that UBS may not be able to fulfill its obligation.

 

 

None.

 

 

The following chart indicates the facilities we lease as of December 28, 2008, the location and size of each such facility and their designated use. During 2008, we expanded our facilities and leased additional space to accommodate growth in our business. We anticipate continuing to expand our facilities over the next several years as we continue to expand our worldwide commercial operations and our manufacturing capabilities.

 

In February 2008, we agreed to lease an additional facility in Little Chesterford, United Kingdom that is in the process of being constructed for research and development, manufacturing and administrative purposes. This facility covers approximately 41,500 square feet. We expect to occupy this new building by the end of 2009.

 

In the recent past, we incurred substantial costs in defending ourselves against patent infringement and patent ownership claims and expect, going forward, to devote substantial financial and managerial resources to protect our intellectual property and to defend against any future claims asserted against us. From time to time, we may also be parties to other litigation in the ordinary course of business. While the results of any litigation are uncertain, management does not believe the ultimate resolution of its legal matters will result in a material adverse impact to us.

 

Applied Biosystems Litigation

 

On December 26, 2006, the Applied Biosystems Group of Applera Corporation (Applied Biosystems) filed suit in California Superior Court, Santa Clara County against Solexa (which we acquired on January 26, 2007). This State Court action related to the ownership of several patents assigned in 1995 to Solexa’s predecessor company (Lynx Therapeutics) by a former employee (Dr. Stephen Macevicz), who is the inventor of these patents and is named as a co-defendant in the suit. The Macevicz patents are directed to methods for sequencing DNA (US Pat. Nos. 5,750,341 and 6,306,597) using successive rounds of oligonucleotide probe ligation (sequencing-by-ligation), and to a probe (5,969,119) used in connection with these sequencing methods. Lynx was originally a unit of Applied Biosystems but was spun out in 1992. On May 31, 2007, Applied Biosystems filed a second suit, this time against us, in the U.S. District Court for the Northern District of California. This second suit sought a declaratory judgment of non-infringement of the Macevicz patents that were the subject of the State Court action mentioned above. Both suits were later consolidated in the U.S. District Court for the Northern District of California, San Francisco Division. By these consolidated actions, Applied Biosytems was seeking ownership of the three Macevicz patents, unspecified costs and damages, and a declaration of non-infringement and invalidity of these patents. Applied Biosystems was not asserting any claim for patent infringement against us.

 

On January 5, 2009, the case went to trial in two phases. The first phase addressed the determination of ownership of the patents-in-suit, and the second phase addressed whether these patents were valid and infringed by Applied Biosystems. On January 14, 2009, at the end of the first phase, a federal jury determined that Solexa was the rightful owner of all three Macevicz patents. On January 27, 2009, the same jury found that Applied Biosystems did not infringe the ’119 probe patent and that the ’119 patent was valid. In August 2008, the court had ruled that Applied Biosystems’ two-base system did not infringe the ’341 and ’597 patents. Prior to the jury finding of non-infringement of the ’119 patent, Applied Biosystems conceded its one-base system infringed claim 1 of the ’597 patent and Solexa conceded invalidity of that same claim under the court’s construction of that claim. Both parties reserved the right to appeal the court’s construction of claim 1 of the ’597 patent, among other things.

 

Our Genome Analyzer products use a different technology, called Sequencing-by-Synthesis (SBS), which is not covered by any of the Macevicz patents. In addition, we have no plans to use any of the Sequencing-by-Ligation technologies covered by these patents.

 

 

No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2008.

 

 

Market Information

 

Our common stock has been quoted on The NASDAQ Global Select Market under the symbol “ILMN” since July 28, 2000. Prior to that time, there was no public market for our common stock. The following table sets forth, for the periods indicated, the quarterly high and low sales prices per share of our common stock as reported on The NASDAQ Global Select Market and has been adjusted to reflect the two-for-one split of our common stock that was effected in the form of a 100% stock dividend on September 22, 2008.

 

 

Stock Performance Graph

 

The graph below compares the cumulative total stockholder returns on our common stock for the last five fiscal years with the cumulative total stockholder returns on the NASDAQ Composite Index and the NASDAQ Biotechnology Index for the same period. The graph assumes that $100 was invested on December 26, 2003 in our common stock and in each index and that all dividends were reinvested. No cash dividends have been declared on our common stock. Stockholder returns over the indicated period should not be considered indicative of future stockholder returns.

 

 

Holders

 

As of February 2, 2009 we had 476 record holders and 56,709 beneficial holders of our common stock.

 

Dividends

 

Our present policy is to retain earnings, if any, to finance future growth. We have never paid cash dividends and have no present intention to pay cash dividends in the foreseeable future. In addition, the

indenture for our convertible senior notes due 2014, which are convertible into cash and, in certain circumstances, shares of our common stock, requires us to increase the conversion rate applicable to the notes if we pay any cash dividends.

 

Purchases of Equity Securities by the Issuer

 

On October 23, 2008, our board of directors authorized a $120.0 million stock repurchase program, which was announced October 24, 2008. The following table summarizes shares repurchased pursuant to this program during the quarter ended December 28, 2008:

 

 

 

 

Sales of Unregistered Securities

 

None during the fourth quarter of fiscal 2008.

 

 

The following table sets forth selected historical consolidated financial data for each of our last five fiscal years during the period ended December 28, 2008.

 

Statement of Operations Data

 

Balance Sheet Data

 

 

In addition to the following notes, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, “Financial Statements and Supplementary Data” for further information regarding our consolidated results of operations and financial position for periods reported therein and for known factors that will impact comparability of future results.

 

 

 

 

The purpose of the following discussion and analysis is to provide an overview of the business to help facilitate an understanding of significant factors influencing our historical operating results, financial condition and cash flows and also to convey our expectations of the potential impact of known trends, events, or uncertainties that may impact our future results. The following discussion and analysis should be read in conjunction with “Item 6. Selected Financial Data” and our consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K. The discussion and analysis in this Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, strategies, objectives, expectations, intentions and adequacy of resources. Words such as “anticipate,” “believe,” “continue,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project” or similar words or phrases, or the negatives of these words, may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward looking. Examples of forward-looking statements include, among others, statements regarding the integration of our acquired technologies with our existing technology, the commercial launch of new products and the duration which our existing cash and other resources is expected to fund our operating activities.

 

Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward looking statements. Factors that could cause or contribute to these differences include those discussed in “Item 1A. Risk Factors” as well as those discussed elsewhere. The risk factors and other cautionary statements made in this Annual Report on Form 10-K should be read as applying to all related forward-looking statements wherever they appear in this Annual Report on Form 10-K.

 

Overview

 

We are a leading developer, manufacturer and marketer of integrated systems for the large scale analysis of genetic variation and biological function. Using our proprietary technologies, we provide a comprehensive line of products and services that currently serve the sequencing, genotyping and gene expression markets. In the future, we expect to enter the market for molecular diagnostics. Our customers include leading genomic research centers, pharmaceutical companies, academic institutions, clinical research organizations and biotechnology companies. Our tools provide researchers around the world with the performance, throughput, cost effectiveness and flexibility necessary to perform the billions of genetic tests needed to extract valuable medical information from advances in genomics and proteomics. We believe this information will enable researchers to correlate genetic variation and biological function, which will enhance drug discovery and clinical research, allow diseases to be detected earlier and permit better choices of drugs for individual patients.

 

On January 26, 2007, we completed the acquisition of Solexa for 26.2 million shares of our common stock. As a result of that acquisition, we develop and commercialize genetic analysis technologies used to perform a range of analyses, including whole genome re-sequencing, gene expression analysis and small RNA analysis. We believe we are the only company with genome-scale technology for sequencing, genotyping and gene expression, the three cornerstones of modern genetic analysis.

 

During the first quarter of 2008, we reorganized our operating structure into two newly created business segments, Life Sciences and Diagnostics. During 2008, the Diagnostics Business Unit had limited business activity and, accordingly, operating results were reported on an aggregate basis as one operating segment. In the future, at each reporting period end, we will reassess our reportable operating segments, particularly as we enter the market for molecular diagnostics.

 

On August 1, 2008, we completed the acquisition of Avantome. As consideration for the acquisition, we paid $25.8 million in cash and may pay up to an additional $35.0 million in contingent cash consideration based on the achievement of certain milestones. Avantome is a development stage company working on developing low-cost, long read sequencing technology. We expect this technology, if and when available as a product, to have applicability to both the research and diagnostic markets.

Our revenue is subject to fluctuations due to the timing of sales of high-value products and service projects, the impact of seasonal spending patterns, the timing and size of research projects our customers perform, changes in overall spending levels in the life science industry and other unpredictable factors that may affect our customer ordering patterns. Any significant delays in the commercial launch or any lack or delay of commercial acceptance of new products, unfavorable sales trends in our existing product lines, or impacts from the other factors mentioned above, could adversely affect our revenue growth or cause a sequential decline in quarterly revenue. Due to the possibility of fluctuations in our revenue and net income or loss, we believe quarterly comparisons of our operating results are not a good indication of our future performance.

 

As of December 28, 2008, our accumulated deficit was $332.5 million and total stockholders’ equity was $848.6 million. Our losses have principally occurred as a result of acquired in-process research and development (IPR&D) charges of $24.7 million related to our acquisition of Avantome in 2008 and $303.4 million related to our acquisition of Solexa in 2007, the substantial resources required for the research, development and manufacturing scale-up effort required to commercialize our products and services and a charge of $54.5 million in 2007 primarily related to settlement of our litigation with Affymetrix. We expect to continue to incur substantial costs for research and development over the next several years. We will also need to increase our selling, general and administrative costs as we build up our sales and marketing infrastructure to expand and support the sale of systems, other products and services.

 

Critical Accounting Policies and Estimates

 

General

 

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. Management bases its estimates on historical experience and various other assumptions it believes to be reasonable. Although these estimates are based on management’s best knowledge of current events and actions that may impact us in the future, actual results may be different from the estimates. Our critical accounting policies are those that affect our financial statements materially and involve difficult, subjective or complex judgments by management. Management has discussed the development and selection of these critical accounting policies with the audit committee of our board of directors, and the audit committee has reviewed the disclosure. Our accounting policies are more fully described in Note 1 of the Consolidated Financial Statements.

 

Revenue Recognition

 

Our revenue is generated primarily from the sale of products and services. Product revenue consists of sales of arrays, reagents, flow cells, instrumentation, oligonucleotides (oligos) and associated freight charges. Service and other revenue consists of revenue received for performing genotyping and sequencing services, extended warranty sales and amounts earned under research agreements with government grants, which are recognized in the period during which the related costs are incurred.

 

We recognize revenue in accordance with the guidelines established by SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. Under SAB No. 104, revenue cannot be recorded until all of the following criteria have been met: 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. All revenue is recorded net of any applicable allowances for returns or discounts.

 

Revenue for product sales is recognized generally upon shipment and transfer of title to the customer, provided no significant obligations remain and collection of the receivables is reasonably assured. Revenue from the sale of instrumentation is recognized when earned, which is generally upon shipment. Revenue for genotyping and sequencing services is recognized when earned, which is generally at the time the genotyping or sequencing analysis data is delivered to the customer.

In order to assess whether the price is fixed and determinable, we ensure there are no refund rights. If payment terms are based on future performance or a right of return exists, we defer revenue recognition until the price becomes fixed and determinable. We assess collectibility based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection of a payment is not reasonably assured, revenue recognition is deferred until the time collection becomes reasonably assured, which is generally upon receipt of payment. Changes in judgments and estimates regarding application of SAB No. 104 might result in a change in the timing or amount of revenue recognized.

 

Sales of instrumentation generally include a standard one-year warranty. We also sell separately priced maintenance (extended warranty) contracts, which are generally for one or two years, upon the expiration of the initial warranty. Revenue for extended warranty sales is recognized ratably over the term of the extended warranty period. Reserves are provided for estimated product warranty expenses at the time the associated revenue is recognized. If we were to experience an increase in warranty claims or if costs of servicing our warrantied products were greater than our estimates, gross margins could be adversely affected.

 

While the majority of our sales agreements contain standard terms and conditions, we do enter into agreements that contain multiple elements or non-standard terms and conditions. Emerging Issues Task Force (EITF) No. 00-21, Revenue Arrangements with Multiple Deliverables, provides guidance on accounting for arrangements that involve the delivery or performance of multiple products, services, or rights to use assets within contractually binding arrangements. Significant contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables specified in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, how the price should be allocated among the deliverable elements, when to recognize revenue for each element, and the period over which revenue should be recognized. We recognize revenue for delivered elements only when we determine that the fair values of undelivered elements are known and there are no uncertainties regarding customer acceptance.

 

Investments

 

Effective January 1, 2008, we adopted Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurement. In February 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) No. SFAS 157-2, Effective Date of FASB Statement No. 157, which provides a one-year deferral of the effective date of SFAS No. 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. In October 2008, the FASB issued FASB FSP SFAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. The FSP clarifies the application of FASB Statement No. 157, Fair Value Measurements, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active.

 

We determine fair value of our financial assets and liabilities in accordance with SFAS No. 157 and 157-3. Fair value is defined under SFAS No. 157 as 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 under SFAS No. 157 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value:

 

 

In using this fair value hierarchy and the framework established by SFAS No. 157, management may be required to make assumptions of pricing by market participants and assumptions about risk, specifically when using unobservable inputs to determine fair value. These assumptions are judgmental in nature and may significantly affect our results of operations.

 

Allowance for Doubtful Accounts

 

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We evaluate the collectibility of our accounts receivable based on a combination of factors. We regularly analyze customer accounts, review the length of time receivables are outstanding, review historical loss rates and assess current economic trends that may impact the level of credit losses in the future. Our allowance for doubtful accounts has generally been adequate to cover our actual credit losses. However, since we cannot reliably predict future changes in the financial stability of our customers, we cannot guarantee that our reserves will continue to be adequate.

 

Inventory Valuation

 

We record adjustments to inventory for potentially excess, obsolete or impaired goods in order to state inventory at net realizable value. We must make assumptions about future demand, market conditions and the release of new products that will supersede old ones. We regularly review inventory for excess and obsolete products and components, taking into account product life cycle and development plans, product expiration and quality issues, historical experience and our current inventory levels. If actual market conditions are less favorable than anticipated, additional inventory adjustments could be required.

 

Contingencies

 

We are subject to legal proceedings primarily related to intellectual property matters. Based on the information available at the balance sheet dates and through consultation with our legal counsel, we assess the likelihood of any adverse judgments or outcomes of these matters, as well as the potential ranges of probable losses. If losses are probable and reasonably estimable, we will record a liability and an expense for the estimated loss.

 

Goodwill and Intangible Asset Valuation

 

We make significant judgments in relation to the valuation of goodwill and intangible assets resulting from acquisitions and litigation settlements.

 

In determining the carrying amounts of our goodwill and intangible assets arising from acquisitions, we use the purchase method of accounting. The purchase method of accounting requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair value of the net tangible and intangible assets acquired, including IPR&D. Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to at least annual impairment tests. The amounts and useful lives assigned to other acquired intangible assets impact future amortization, and the amount assigned to IPR&D is expensed immediately.

 

Determining the fair values and useful lives of intangible assets acquired as part of litigation settlements also requires the exercise of judgment. While there are a number of different generally accepted valuation methods to estimate the value of intangible assets, one method used by management is the discounted cash flow method. This method requires significant management judgment to forecast the future operating results used in this type of analysis. In addition, other significant estimates are required such as residual growth rates and discount factors. The estimates we use to value and amortize intangible assets are consistent with the plans and estimates that we use to manage our business and are based on available historical information and industry estimates and averages. These judgments can significantly affect our net operating results. Our judgments can also change with respect to the estimated life of intangible assets which could increase or decrease related amortization expense.

SFAS No. 142, Goodwill and Other Intangible Assets, requires that goodwill and certain intangible assets be assessed for impairment using fair value measurement techniques. If the carrying amount of a reporting unit exceeds its fair value, then a goodwill impairment test is performed to measure the amount of the impairment loss, if any. The goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined in the same manner as in a business combination. Determining the fair value of the implied goodwill is judgmental in nature and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the magnitude of any such charge. Estimates of fair value are primarily determined using discounted cash flows and market comparisons. These approaches use significant estimates and assumptions, including projection and timing of future cash flows, discount rates reflecting the risk inherent in future cash flows, perpetual growth rates, determination of appropriate market comparables, and determination of whether a premium or discount should be applied to comparables. It is reasonably possible that the plans and estimates used to value these assets may be incorrect. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur additional impairment charges. We have performed our annual test of goodwill as of May 30, 2008 noting no impairment. No indicators have arisen since management’s assessment on May 30, 2008 that would require further assessment.

 

Impairment of Long-Lived Assets

 

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, if indicators of impairment exist, we assess the recoverability of the affected long-lived assets by determining whether the carrying value of such assets can be recovered through undiscounted future operating cash flows. If impairment is indicated, we measure the future discounted cash flows associated with the use of the asset and adjust the value of the asset accordingly. Certain estimates and assumptions are used in determining the fair value of long-lived assets. These estimates and assumptions are judgmental in nature and could have a significant impact on the determination of the recognition of an impairment charge and the magnitude of any such change. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur additional impairment charges.

 

Stock-Based Compensation

 

We account for stock-based compensation in accordance with SFAS No. 123R, Share-Based Payment. Under the provisions of SFAS No. 123R, stock-based compensation cost is estimated at the grant date based on the award’s fair-value as calculated by the Black-Scholes-Merton (BSM) option-pricing model and is recognized as expense over the requisite service period. The BSM model requires various highly judgmental assumptions including volatility, forfeiture rates, and expected option life. If any of these assumptions used in the BSM model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

 

Income Taxes

 

In accordance with SFAS No. 109, Accounting for Income Taxes, the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for the expected future tax benefit to be derived from tax loss and credit carryforwards. Deferred tax assets and liabilities are determined using the enacted tax rates in effect for the years in which those tax assets are expected to be realized. A valuation allowance is established when it is more likely than not the future realization of all or some of the deferred tax assets will not be achieved. The evaluation of the need for a valuation allowance is performed on a jurisdiction-by-jurisdiction basis, and includes a review of all available positive and negative evidence. Factors reviewed include projections of pre-tax book income over the foreseeable future, determination of cumulative pre-tax book income after

permanent differences, history of earnings, and reliability of forecasting. As of December 28, 2008, we have maintained a valuation allowance only against certain U.S. and foreign deferred tax assets that we concluded have not met the “more likely than not” threshold required under SFAS No. 109.

 

Due to the adoption of SFAS No. 123R, we recognize excess tax benefits associated with share-based compensation to stockholders’ equity only when realized. When assessing whether excess tax benefits relating to share-based compensation have been realized, we follow the with-and-without approach, excluding any indirect effects of the excess tax deductions. Under this approach, excess tax benefits related to share-based compensation are not deemed to be realized until after the utilization of all other tax benefits available to us.

 

Effective January 1, 2007, we adopted FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109, which clarifies the accounting for uncertainty in tax positions. FIN No. 48 requires that we recognize the impact of a tax position in our financial statements only if that position is more likely than not of being sustained upon examination by taxing authorities, based on the technical merits of the position. Any interest and penalties related to uncertain tax positions will be reflected in income tax expense.

 

Results of Operations

 

To enhance comparability, the following table sets forth audited consolidated statement of operations data for the years ended December 28, 2008, December 30, 2007 and December 31, 2006 stated as a percentage of total revenue.

 

Comparison of Years Ended December 28, 2008 and December 30, 2007

 

Our fiscal year is the 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, and September 30. The years ended December 28, 2008 and December 30, 2007 were both 52 weeks.

 

Revenue

 

 

Product revenue consists of revenue from the sale of consumables, instruments, oligos and associated freight charges. The increase in product revenue was driven primarily by sales of our Infinium BeadChips, sequencing systems and sequencing consumables. Consumables and instruments constituted 63% and 35% of product revenue for the year ended December 28, 2008, respectively, compared to 59% and 37% for the year ended December 30, 2007, respectively.

 

Consumable revenue increased by $140.2 million over prior year. Growth in consumable revenue was primarily attributable to strong demand for our Infinium and sequencing products, which led to increased sales of $104.8 million and $35.4 million, respectively. The increase in revenue associated with our Infinium products can be mainly attributed to the strong demand for our Infinium High-Density BeadChips, particularly the Human610-Quad, which we began shipping during the first quarter of 2008. Of the overall increase in Infinium BeadChip sales, approximately 79% is due to new product introductions with higher average selling prices, while the remaining 21% can be attributed to increased volume. The increase in sequencing consumables is primarily attributable to the growth in our installed base of instruments and the progression of customer labs ramping to production scale.

 

Instrument revenue increased by $64.8 million over prior year, of which $63.0 million was due to increased sales of our sequencing systems. This increase in revenue can be primarily attributed to shipments of our second generation Genome Analyzer, the Genome Analyzer II (GAII). Additionally, during the second quarter of 2008, we launched the iScan System, our next-generation BeadChip scanner to replace the BeadArray Reader. Any increase in revenue resulting from shipments of this new system was offset by a reduction in sales of our BeadArray Reader as we stopped manufacturing this product upon the launch of our iScan System.

 

We expect to see continued growth in product revenue, which can be mainly attributed to the anticipated launch of several new products, sales of existing products and the growth of our installed base of instruments.

 

Service and other revenue includes revenue generated from genotyping and sequencing service contracts, extended warranty contracts, and research revenue. The increase in service and other revenue is primarily due to an increase of $3.1 million in extended warranty sales coupled with an increase of $2.0 million in sequencing service contracts. This increase was substantially offset by a decline of $4.7 million in our Fast Track genotyping service contracts as we shift more towards CSPro certified customers. CSPro is a collaborative program through which we certify third party service partners using our products to ensure delivery of performance and data quality equivalent to that available from our internal service offering. The decline in service revenue as a result of the shift to CSPro certified customers has been offset by the resulting increase in our consumable sales to these third party service providers. If product sales increase, we expect to see continued increases in the sale of our extended warranty contracts. We also expect sales from SNP genotyping and sequencing service contracts to fluctuate on a yearly and quarterly basis, depending on the mix, the number of contracts completed and the success of our certified service providers. The timing of

completion of SNP genotyping and sequencing service contracts is highly dependent on the customers’ schedules for delivering the SNPs and samples to us.

 

Cost of Product and Service and Other Revenue

 

 

Cost of revenue, which excludes impairment of manufacturing equipment and amortization of intangible assets, represents manufacturing costs incurred in the production process, including component materials, assembly labor and overhead, installation, warranty, packaging and delivery costs, as well as costs associated with performing genotyping and sequencing services on behalf of our customers.

 

The increase in cost of product revenue was primarily driven by higher instrument and consumable sales. Cost of product revenue as a percentage of related revenue was 36% for the year ended December 28, 2008 compared to 37% for the year ended December 30, 2007. The decrease is primarily due to favorable product mix driven by increased sales of our new High-Density Infinium Beadchips, with higher average selling prices as compared to the Infinium Beadchips sold in the prior year. This was partially offset by increased provisions for inventory obsolescence of $7.2 million for the year ended December 28, 2008 compared to $1.9 million for the year ended December 30, 2007. The increase in the inventory reserve is primarily associated with product transitions. During the year, we recorded reserves for product obsolescence associated with the launch of our new Infinium Beadchips and the launch of a new sequencing kit. Instrument cost of sales as a percentage of related revenue increased slightly over the prior year due to lower average selling prices mainly associated with promotional campaigns as we launched our next generation Beadarray Reader, the iScan in the first half of 2008.

 

Cost of service and other revenue increased over the prior year primarily due to higher extended warranty contract revenue. Cost of service and other revenue as a percentage of related revenue stayed consistent at 31%.

 

Research and Development Expenses

 

 

Our research and development expenses consist primarily of salaries and other personnel-related expenses, laboratory supplies and other expenses related to the design, development, testing and enhancement of our products. We expense our research and development expenses as they are incurred.

 

Research and development expenses as a percentage of revenue decreased to 17% for the year ended December 28, 2008 compared to 20% for the year ended December 30, 2007. However, there was an overall increase in research and development expenditures compared to the prior year. Costs to support our BeadArray technology research activities increased $10.4 million for the year ended December 28, 2008 compared to the year ended December 30, 2007, primarily due to an overall increase in personnel-related expenses, increased lab and material expenses associated with the establishment of our manufacturing facility in Singapore and the development of new products. The continued development of our Sequencing technology resulted in increased research and development expenditures of $9.1 million for the year ended December 28, 2008 compared to the year ended December 30, 2007. In addition, non-cash stock-based compensation expense increased by $4.1 million compared to the year ended December 30, 2007. Accrued compensation expense of $1.5 million

associated with contingent consideration for the Avantome acquisition completed on August 1, 2008 and expenses related to the development of our newly created Diagnostics Business Unit of $0.9 million also contributed to the increase in research and development expense for the year ended December 28, 2008.

 

We believe a substantial investment in research and development is essential to remaining competitive and expanding into additional markets. Accordingly, we expect our research and development expenses to increase in absolute dollars as we expand our product base.

 

Selling, General and Administrative Expenses

 

 

Our selling, general and administrative expenses consist primarily of personnel costs for sales and marketing, finance, human resources, business development, legal and general management, as well as professional fees, such as expenses for legal and accounting services. Selling, general and administrative expenses as a percentage of revenue were 26% for the year ended December 28, 2008 compared to 28% for the year ended December 30, 2007. Selling, general and administrative expenses for the year ended December 28, 2008 and December 30, 2007 included stock-based compensation expenses totaling $28.5 million and $19.4 million, respectively.

 

Sales and marketing expenses increased $34.1 million for the year ended December 28, 2008 compared to the year ended December 30, 2007. The increase is primarily due to increases of $29.3 million attributable to personnel-related expenses, including salaries, benefits and commissions, to support the growth of our business. Included as part of these personnel- related expenses is an increase in employee travel expenses of $4.5 million due to increased headcount and continued international expansion. The remaining $4.8 million variance is comprised of increases to non-personnel-related costs of $2.9 million, consisting mainly of sales and marketing activities for our existing and new products and an increase of $1.9 million of non-cash stock-based compensation expense.

 

General and administrative expense increased $12.7 million during the year ended December 28, 2008 compared to the year ended December 30, 2007 due to increases of $10.4 million in personnel-related expenses associated with the growth of our business, $7.2 million of non-cash stock-based compensation expense and $0.9 million in outside consulting services offset by a decrease of $5.8 million in legal costs primarily related to the settlement of the Affymetrix litigation during the first quarter of 2008.

 

We expect our selling, general and administrative expenses to increase in absolute dollars as we expand our staff, add sales and marketing infrastructure and incur additional costs to support the expected growth in our business.

 

Impairment of Manufacturing Equipment

 

 

The impairment of manufacturing equipment resulted from our assessment of recoverability on a portion of our imaging and decoding systems that were no longer being utilized due to the development of our next-generation system and our transition to the Infinium HD product line.

Amortization of Intangible Assets

 

 

Amortization of intangible assets as a percentage of revenue was 2% and 1%, respectively, for the year ended December 28, 2008 and year ended December 30, 2007. The increase in amortization expense is primarily due to the settlement of our lawsuit with Affymetrix on January 9, 2008, resulting in the recording of an intangible asset of $36.0 million. See Note 5 of Notes to Consolidated Financial Statements for further information regarding this settlement.

 

We began amortizing this asset during the first quarter of 2008, causing an increase in amortization of intangible assets of $7.8 million for the year ended December 28, 2008. The additional increase of $0.2 million during the year ended December 28, 2008 as compared to the year ended December 30, 2007 represents an additional month of amortization associated with the assets acquired from Solexa that we began amortizing in February 2007.

 

Acquired In-Process Research and Development

 

 

As a result of the Avantome acquisition in August 2008 and the Solexa acquisition in January 2007, we recorded acquired IPR&D charges of $24.7 million and $303.4 million, respectively. See Note 2 of Notes to Consolidated Financial Statements for further information regarding these acquisitions.

 

Litigation Settlements

 

 

During the year ended December 30, 2007, we recorded a charge of $54.5 million associated with two settlement agreements. The total charge is comprised primarily of $54.0 million related to a $90.0 million settlement with Affymetrix entered into on January 9, 2008 for certain patent litigation between the parties. See Note 5 of Notes to Consolidated Financial Statements for further information regarding the Affymetrix settlement.

 

Interest Income

 

 

Interest income on our cash and cash equivalents and investments decreased $3.5 million during the year ended December 28, 2008 compared to the year ended December 30, 2007. The decrease was primarily driven by the overall decline in interest rates due to current market conditions coupled with a change in our cash and investment portfolio to a mix of shorter duration maturities and an increased number of agency-rated investments.

Interest and Other Expense, Net

 

 

Interest and other expense, net, consists of interest expense and other income and expenses primarily related to net foreign currency exchange transaction gains and losses. Interest and other expense, net, increased $1.5 million for the year ended December 28, 2008 compared to the year ended December 30, 2007.

 

Interest expense related to our convertible debt issued in February 2007 was $4.0 million and $3.6 million, respectively, for the year ended December 28, 2008 and the year ended December 30, 2007. The increase represents an additional month and a half of interest expense recorded in the year ended December 28, 2008 compared to the year ended December 30, 2007.

 

In addition, we recorded $1.9 million in net foreign currency transaction gains for the year ended December 28, 2008 compared to immaterial losses recorded in the year ended December 30, 2007. The gains resulting from our net foreign currency transactions for the year ended December 28, 2008 are due to fluctuations in foreign currency exchange rates coupled with a change in our foreign entity functional currency designation from the local currency to the U.S. dollar beginning the third quarter of 2008. As a result of this change, in the third quarter we began re-measuring our foreign subsidiaries’ nonmonetary assets and liabilities and related income and expense accounts to the U.S. dollar and recording the resulting net gain as income. Previously, under local functional currency designation, the effects of translation were recorded within stockholders’ equity as other comprehensive income (loss).

 

Provision (benefit) for Income Taxes

 

 

The provision consists of federal, state and foreign income tax expense for the years ended December 28, 2008 and December 30, 2007, respectively. In addition for the year ended December 30, 2007, the provision was reduced by $17.1 million as a result of the release of the valuation allowance against a significant portion of our U.S. deferred tax assets.

 

As of December 28, 2008, we had net operating loss carryforwards for federal and state tax purposes of $87.7 million and $148.3 million, respectively, which begin to expire in 2025 and 2013, respectively, unless previously utilized. In addition, we also had U.S. federal and state research and development tax credit carryforwards of $12.6 million and $13.9 million, respectively, which begin to expire in 2018 and 2019, respectively, unless previously utilized.

 

Pursuant to Section 382 and 383 of the Internal Revenue Code, utilization of our net operating losses and credits may be subject to annual limitations in the event of any significant future changes in our ownership structure. These annual limitations may result in the expiration of net operating losses and credits prior to utilization. Previous limitations due to Section 382 and 383 have been reflected in the deferred tax assets as of December 28, 2008.

 

Based on the available evidence as of December 28, 2008, we were not able to conclude it was more likely than not certain U.S. and foreign deferred tax assets will be realized. Therefore, we have recorded a valuation allowance of $2.8 million and $12.4 million against certain U.S. and foreign deferred tax assets, respectively. At December 30, 2007, we concluded that it was more likely than not that a significant portion of our deferred tax assets will be realized and, accordingly, we released a portion of our valuation allowance, $17.1 million, of which was recorded as a reduction to the tax provision.

As of December 28, 2008, no material changes have been made to our uncertain tax positions recorded in accordance with FIN No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.

 

Comparison of Years Ended December 30, 2007 and December 31, 2006

 

Our fiscal year is 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, and September 30. The years ended December 30, 2007 and December 31, 2006 were both 52 weeks.

 

Revenue

 

 

Product revenue consists of revenue from the sale of consumables, instruments, oligos and associated freight charges. Consumables and instruments constituted 59% and 37% of product revenue for the year ended December 30, 2007, respectively, compared to 64% and 28% for the year ended December 31, 2006, respectively. The change in sales associated with our product mix is due to increased sales in instruments primarily attributable to the Genome Analyzer, which was introduced during the first quarter of 2007. Growth in consumable revenue was primarily attributable to strong demand for our Infinium products.

 

Consumable revenue increased by $93.6 million over prior year, of which $81.1 million primarily represents increased sales volume of our Infinium products. The increase in revenue associated with our Infinium products can be mainly attributed to our HumanHap family of BeadChips, the Human 1M DNA Analysis BeadChip and our iSelect Infinium BeadChips for more focused content applications. Of the overall increase in Infinium BeadChip sales, approximately 82% is due to a higher volume of shipments, while the remaining 18% can be attributed to new product introductions and slightly higher average selling prices.

 

Instrument revenue increased by $77.6 million over prior year, of which $68.7 million was due to increased sales of our sequencing systems, particularly the Genome Analyzer and cluster stations.

 

Service and other revenue includes revenue generated from genotyping and sequencing service contracts, extended warranty contracts and research revenue. Service and other revenue increased $11.3 million over prior year primarily due to the completion of several significant Infinium and iSelect custom SNP genotyping service contracts and sequencing services contracts. This increase in services represented $9.9 million of the variance, while the remainder of the difference was generated by an increase in extended warranty contracts of $2.2 million offset by a decrease in grant revenue of $0.8 million. We expect sales from SNP genotyping and sequencing services contracts to fluctuate on a yearly and quarterly basis, depending on the mix and number of contracts that are completed. The timing of completion of SNP genotyping and sequencing services contracts are highly dependent on the customers’ schedules for delivering the SNPs and samples to us.

 

Cost of Product and Service and Other Revenue

 

Cost of revenue, which excludes amortization of intangible assets, represents manufacturing costs incurred in the production process, including component materials, assembly labor and overhead, installation, warranty, packaging and delivery costs, as well as costs associated with performing genotyping and sequencing services on behalf of our customers.

 

The increase in cost of product revenue was primarily driven by higher instrument and consumable sales. Cost of product revenue as a percentage of related revenue was 37% for the year ended December 30, 2007 compared to 33% for the year ended December 31, 2006. The increase is primarily due to the shift in product mix towards instruments mainly attributable to sales of our sequencing systems, which were introduced during the first quarter of 2007. In addition, cost of product revenue as a percentage of related revenue was adversely impacted by the increase in non-cash stock-based compensation expense as well as $0.7 million associated with the amortization of inventory revaluation costs related to our acquisition of Solexa in January 2007. Non-cash stock-based compensation expense was $4.0 million and $1.3 million for the periods ended December 30, 2007 and December 31, 2006, respectively.

 

Cost of service revenue increased over the prior year primarily due to higher sequencing and genotyping services revenue. Cost of service revenue as a percentage of related revenue was 31% for the year ended December 30, 2007 compared to 28% for the year ended December 31, 2006. The increase in cost of service revenue as a percentage of related revenue was primarily related to unfavorable product mix driven by higher sales of our sequencing services, which were introduced during 2007.

 

Research and Development Expenses

 

 

Our research and development expenses consist primarily of salaries and other personnel-related expenses, laboratory supplies and other expenses related to the design, development, testing and enhancement of our products. We expense our research and development expenses as they are incurred.

 

Research and development expenses increased to $73.9 million for the year ended December 30, 2007 compared to $33.4 million for the year ended December 31, 2006. Research and development expenses as a percentage of total revenue were 20% for the year ended December 30, 2007 compared to 18% for the year ended December 31, 2006. Of the increase for the year ended December 30, 2007, $27.0 million was due to higher research and development expenses associated with our acquisition of Solexa in January 2007. Costs to support our BeadArray technology research activities increased $8.5 million for the year ended December 30, 2007 compared to the year ended December 31, 2006, primarily due to an overall increase in personnel-related expenses and increased lab and material expenses. Several new Infinium chip products, including the Human 1M DNA Analysis BeadChip, HumanCNV370-Duo BeadChip and HumanHap550-Duo BeadChip, have been introduced to the market in 2007. In addition, non-cash stock-based compensation expense increased $6.1 million compared to the year ended December 31, 2006. These increases were partially offset by a $1.0 million decrease in research and development expenses related to the VeraCode technology compared to the year ended December 31, 2006. We began shipping our BeadXpress System, which is based on our VeraCode technology, during the first quarter of 2007. As a result of completing the development of this product, the related research and development expenses have decreased.

 

Selling, General and Administrative Expenses

 

Our selling, general and administrative expenses consist primarily of personnel costs for sales and marketing, finance, human resources, business development, legal and general management, as well as professional fees, such as expenses for legal and accounting services. Selling, general and administrative expenses increased to $101.3 million for the year ended December 30, 2007 compared to $54.1 million for the year December 31, 2006.

 

Sales and marketing expense increased $24.5 million during the year ended December 30, 2007 compared to the year ended December 31, 2006. The increase is primarily due to increases of $18.6 million attributable to personnel-related expenses to support the growth of our business, $3.3 million of non-cash stock-based compensation expense and $2.6 million attributable to other non-personnel-related expenses consisting mainly of sales and marketing activities for our existing and new products.

 

General and administrative expense increased $22.7 million during the year ended December 30, 2007 compared to the year ended December 30, 2006 due to increases of $8.7 million in personnel-related expenses associated with the growth of our business, $7.2 million of non-cash stock-based compensation expense, $3.4 million in outside legal fees and $3.3 million in other outside service expenses, primarily due to increases in consulting fees and increased tax, audit, and other public company costs.

 

Amortization of Intangible Assets

 

 

Amortization of intangible assets totaled $2.4 million for the year ended December 30, 2007. There was no amortization of acquired intangibles for the year ended December 31, 2006. The amount amortized in 2007 represents the amortization of our intangible assets acquired from Solexa in January 2007.

 

Acquired In-Process Research and Development

 

 

During the year ended December 30, 2007, we recorded $303.4 million of acquired IPR&D resulting from the Solexa acquisition. At the acquisition date, Solexa’s ongoing research and development initiatives were primarily involved with the development of its genetic analysis platform for sequencing and expression profiling. These in-process research and development projects are comprised of Solexa’s reversible terminating nucleotide biochemistry platform, referred to as sequencing-by-synthesis (SBS) biochemistry, as well as Solexa’s reagent, analyzer and sequencing services related technologies, which were valued at $237.2 million, $44.2 million, $19.1 million and $2.9 million, respectively, at the acquisition date. Although these projects were approximately 95% complete at the acquisition date, they had not reached technological feasibility and had no alternative future use. Accordingly, the amounts allocated to those projects were written off in the first quarter of 2007, the period the acquisition was consummated. Acquisitions of businesses, products or technologies by us in the future may result in substantial charges for acquired IPR&D that may cause fluctuations in our interim or annual operating results. There were no charges resulting from any acquisitions during the same period in fiscal 2006.

 

Litigation Settlements

 

During the year ended December 30, 2007, we recorded a charge of $54.5 million associated with two settlement agreements entered into subsequent to year-end. The total charge is comprised primarily of $54.0 million related to a $90.0 million settlement with Affymetrix entered into on January 9, 2008 for certain patent litigation between the parties. See Note 5 of Notes to Consolidated Financial Statements for further information regarding this settlement.

 

Interest Income

 

 

Interest income on our cash and cash equivalents and investments was $16.0 million and $5.4 million for the years ended December 30, 2007 and December 31, 2006, respectively. The increase in interest income over the prior year was primarily driven by higher cash balances from the proceeds of our February 2007 convertible debt offering, cash acquired as part of the Solexa acquisition, and improved operating cash flow. In addition, we experienced higher effective interest rates on our cash equivalents and short-term investments.

 

Interest and Other Expense, Net

 

 

Interest and other expense, net, consists of interest expense and other income and expenses related to net foreign currency exchange transaction gains and losses. Interest and other expense, net, increased to $3.6 million for the year ended December 30, 2007, compared to $0.6 million for the year ended December 31, 2006.

 

Interest expense was $3.6 million for the year ended December 30, 2007, compared to an immaterial amount for the year ended December 31, 2006. The increase is primarily related to our convertible debt offering in February 2007. For the years ended December 30, 2007 and December 31, 2006, we recorded $0.5 million and $0.4 million, respectively, in net foreign currency transaction losses, respectively. In 2007, these foreign currency exchange losses were offset by $0.5 million of foreign currency exchange gains associated with the sale of our secured convertible debentures with Genizon BioSciences, Inc. in the fourth quarter of 2007.

 

Provision (benefit) for Income Taxes

 

 

The provision (benefit) for income taxes was ($10.4) million and $2.7 million for the years ended December 30, 2007 and December 31, 2006, respectively. The provision consists of federal, state, and foreign income tax expense offset in 2007 by the release of the valuation allowance against a significant portion of our U.S. deferred tax assets.

 

During the year ended December 30, 2007, we utilized $72.9 million and $10.8 million of our federal and state net operating loss carryforwards, respectively, to reduce our federal and state income taxes. As of December 30, 2007, we had net operating loss carryforwards for federal and state tax purposes of $28.7 million and $99.1 million, respectively, which begin to expire in 2025 and 2015, respectively, unless previously utilized. In addition, we also had U.S. federal and state research and development tax credit

carryforwards of $9.2 million and $9.3 million respectively, which begin to expire in 2018 and 2019 respectively, unless previously utilized.

 

Pursuant to Section 382 and 383 of the Internal Revenue Code, utilization of our net operating losses and credits may be subject to annual limitations in the event of any significant future changes in our ownership structure. These annual limitations may result in the expiration of net operating losses and credits prior to utilization. Previous limitations due to Section 382 and 383 have been reflected in the deferred tax assets as of December 30, 2007.

 

As of December 30, 2007, we concluded that it is more likely than not that a significant portion of our deferred tax assets will be realized and, accordingly we released a portion of our valuation allowance, $17.1 million of which was recorded as a reduction to the tax provision. In addition, we established current and long term deferred tax assets on the consolidated balance sheets of $26.8 million and $80.1 million, respectively, and decreased the goodwill balances recorded in conjunction with the CyVera and Solexa acquisitions by $2.1 million and $18.4 million, respectively. Based upon the available evidence as of December 30, 2007, we are not able to conclude it is more likely than not certain U.S. and foreign deferred tax assets will be realized. Therefore, we have recorded a valuation allowance of $2.9 million and $25.4 million against certain U.S. and foreign deferred tax assets, respectively.

 

Liquidity and Capital Resources

 

Cashflow

 

 

Historically, our sources of cash have included:

 

 

Our historical cash outflows have primarily been associated with:

 

 

Other factors that impact our cash inflow and outflow include:

 

 

We currently invest our funds in treasury notes, commercial paper, auction rate securities, corporate bonds and U.S. dollar-based short maturity mutual funds. We do not hold securities backed by mortgages.

 

As of December 28, 2008, we had cash, cash equivalents and investments of $696.0 million compared to $386.1 million as of December 30, 2007. Included in the investment balance as of December 28, 2008 were auction rate securities of $55.9 million issued primarily by municipalities and universities. The markets for auction rate securities effectively ceased when the vast majority of auctions failed in February 2008, preventing investors from selling their auction rate securities. As of December 28, 2008, the securities continued to fail auction and remained illiquid. As a result, we have recorded an unrealized loss of $8.7 million for the year ended December 28, 2008, resulting in a reduction to the fair value of our auction rate securities to $47.2 million as of December 28, 2008. This value was determined in accordance with SFAS No. 157. We used Level 3 hierarchical inputs, due to the lack of actively traded market data, including management’s assumptions of pricing by market participants and assumptions about risk. We based our fair value determination on estimated discounted future cash flows of interest income over a projected period reflective of the length of time we anticipate it will take the securities to become liquid. Additionally, we classified these securities as long-term investments as of December 28, 2008 as we believe we may not be able to liquidate our investments within the next year. As of December 30, 2007, these securities were classified as short-term as the failures of these auctions did not occur until February 2008.

 

In November 2008, we signed a settlement agreement allowing us to sell our auction rate securities at par value to UBS at our discretion during the period of June 30, 2010 through July 2, 2012. To account for this settlement agreement, we recorded a put option of $8.7 million and recognized a corresponding gain in earnings during the fourth quarter of 2008. The fair value of the put option was determined using a discounted cash flow approach including estimates of interest rates, timing and amount of cash flow, with consideration given to UBS’s financial ability to repurchase the auction rate securities beginning June 30, 2010. The fair value of the put option approximates the difference between the par value and fair value of the auction rate securities. The auction rate securities were previously classified as available-for-sale, and unrealized gains and losses were recognized in other comprehensive income. By signing the settlement agreement, we no longer have the intent of holding the auction rate securities until recovery as we will now recover any unrealized loss through the settlement agreement. Accordingly, we elected a one-time transfer of the auction rate securities from available-for-sale to trading and reclassified previously recorded unrealized losses from other comprehensive income to earnings. We will continue to recognize gains and losses in earnings approximately equal to changes in the fair value of the auction rate securities at each balance sheet date. These gains and losses will likely be offset by changes in the fair value of the put option as we elect the fair value option subject to our assessment of the counterparties ability to perform. See Part I Item 1A: “Risk Factors — Negative conditions in the global credit markets may impair the liquidity of a portion of our investment portfolio.”

 

The primary inflow of cash during the year ended December 28, 2008 was from the sale of 8,050,000 shares of our common stock to the public in August 2008 at a public offering price of $43.75 per share, raising net proceeds to us of $342.6 million, after deducting underwriting discounts and commissions and offering expenses. Additional cash inflows during this year resulted from the sale and maturity of our investments in available-for-sale securities of $411.8 million and $44.3 million from the exercise of our stock options.

 

The primary cash outflows during the year ended December 28, 2008 were attributable to the purchase of available-for-sale securities for $568.7 million, the one-time payment of $90.0 million made to Affymetrix in accordance with the settlement agreement, the repurchase of an aggregate of 3.1 million shares of our

common stock for $70.8 million and $59.7 million in capital expenditures primarily for construction-in-progress associated with the expansion of our San Diego facilities, additions to manufacturing equipment as well as the development of our manufacturing facility in Singapore. Additionally, on August 1, 2008, we completed our acquisition of Avantome, Inc. As consideration for the acquisition, we paid $25.8 million in cash, including transaction costs, and may pay up to an additional $35.0 million in contingent cash consideration based on the achievement of certain milestones.

 

Our primary short-term needs for capital, which are subject to change, include expenditures related to:

 

 

We expect that our product revenue and the resulting operating income, as well as the status of each of our new product development programs, will significantly impact our cash management decisions.

 

Our outstanding convertible notes became convertible into cash and, if applicable, shares of our common stock as of April 1, 2008. The notes continued to be convertible through December 31, 2008. Subsequent to year end, on December 29, 2008, a noteholder converted notes in an aggregate principal amount of $10.0 million. Generally, upon conversion of a note, we must pay the conversion value of the note in cash, up to the principal amount of the note. Any excess of the conversion value over the principal amount is payable in shares of our common stock. To reduce the potential equity dilution upon conversion of the notes, we entered into a hedge transaction. See Note 8 of Notes to Consolidated Financial Statements for further discussion of the terms of the Convertible Senior Notes. Beginning January 1, 2009 the notes ceased to be convertible since the trigger for convertibility was not met during the last calendar quarter of 2008. Fluctuations in our stock price could cause the conversion feature to trigger in future quarters, resulting in an impact on our working capital.

 

We anticipate that our current cash and cash equivalents and income from operations will be sufficient to fund our operating needs for at least the next twelve months, barring unforeseen circumstances. Operating needs include the planned costs to operate our business, including amounts required to fund working capital and capital expenditures. At the present time, we have no material commitments for capital expenditures other than development of our additional facility in Little Chesterford, United Kingdom. The development of this facility is estimated to cost $14.5 million during 2009 although actual costs may vary significantly from our current estimate. Our future capital requirements and the adequacy of our available funds will depend on many factors, including:

 

 

As a result of the factors listed above, we may require additional funding in the future. Our failure to raise capital on acceptable terms, when needed, could have a material adverse effect on our business.

Off-Balance Sheet Arrangements

 

We do not participate in any transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (SPEs), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. During the fiscal year ended December 28, 2008, we were not involved in any “off balance sheet arrangements” within the meaning of the rules of the Securities and Exchange Commission.

 

Contractual Obligations

 

Contractual obligations represent future cash commitments and liabilities under agreements with third parties, and exclude orders for goods and services entered into in the normal course of business that are not enforceable or legally binding. The following table represents our contractual obligations as of December 28, 2008, aggregated by type (amounts in thousands):

 

 

 

 

Recent Accounting Pronouncements

 

Information with respect to recent accounting pronouncements is included in Note 1 of Notes to Consolidated Financial Statements.

 

 

Interest Rate Sensitivity

 

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The fair market value of fixed rate securities may be adversely impacted by fluctuations in interest rates while income earned on floating rate securities may decline as a result of decreases in interest rates. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We attempt to ensure the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in investment grade securities. We have historically maintained a relatively short average maturity for our investment portfolio, and we believe a hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not

materially affect the fair value of our interest sensitive financial instruments. For example, if a 100 basis point change in overall interest rates were to occur in 2009, our interest income would change by approximately $6.4 million in relation to amounts we would expect to earn, based on our cash, cash equivalents, and short-term investments as of December 28, 2008.

 

Market Price Sensitive Instruments

 

In order to potentially reduce equity dilution, we entered into convertible note hedge transactions, entitling us to purchase up to 18,322,320 shares of our common stock at a strike price of $21.83 per share, subject to adjustment. In addition, we sold to the counterparties warrants exercisable on a net-share basis, for up to 18,322,320 shares of our common stock at a strike price of $31.435 per share, subject to adjustment. The anti-dilutive effect of the note hedge transactions, if any, could be partially or fully offset to the extent the trading price of our common stock exceeds the strike price of the warrants on the exercise dates of the warrants, which occur during 2014, assuming the warrants are exercised.

 

Foreign Currency Exchange Risk

 

We have operations in the Americas, Europe and Asia-Pacific. As a result, our financial position, results of operations and cash flows can be affected by fluctuations in foreign currency exchange rates. The functional currency for each of our subsidiaries is the U.S. dollar. Accordingly, we remeasure the monetary assets and liabilities of our foreign subsidiaries to the U.S. dollar at month-end exchange rates and remeasure the nonmonetary assets and liabilities to the U.S. dollar at historical rates. Income and expense amounts related to monetary assets and liabilities are remeasured to the U.S. dollar at the weighted average exchange rates in effect during the relevant period, and income and expense accounts related to nonmonetary assets and liabilities are remeasured to the U.S. dollar at historical exchange rates. Remeasurement gains and losses are recognized as income, or expense, in the period of occurrence.

 

In addition, many of our reporting entities conduct a portion of their business in currencies other than the entity’s U.S. functional currency. These transactions give rise to receivables and payables that are denominated in currencies other than the entity’s functional currency. The value of these receivables and payables is subject to changes in exchange rates because they may become worth more or less than they were worth at the time we entered into the transaction due to changes in exchange rates. Both realized and unrealized gains or losses on the value of these receivables and payables are included in the determination of net income. The net currency exchange gain recognized on business transactions was $1.9 million for the year ended December 28, 2008 and is included in other income and expense in the consolidated statements of operations.

 

 

The Report of Independent Registered Public Accounting Firm, Financial Statements and Notes to Financial Statements begin on page F-1 immediately following the signature page and are incorporated herein by reference.

 

 

None.

 

 

We design our internal controls to provide reasonable assurance that (1) our transactions are properly authorized; (2) our assets are safeguarded against unauthorized or improper use; and (3) our transactions are properly recorded and reported in conformity with U.S. generally accepted accounting principles. We also maintain internal controls and procedures to ensure that we comply with applicable laws and our established financial policies.

 

We have carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and

operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Securities Exchange Act), as of December 28, 2008. Based upon that evaluation, our principal executive officer and principal financial officer concluded that, as of December 28, 2008, our disclosure controls and procedures were effective to ensure that (a) the information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) such information is accumulated and communicated to our management, including our principal executive officer and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management have concluded that the disclosure controls and procedures are effective at the reasonable assurance level. Because of inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected.

 

An evaluation was also performed under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of any change in our internal control over financial reporting that occurred during the fourth quarter of 2008 and that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. The evaluation did not identify any such change.

 

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

 

We conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control — Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 28, 2008. The effectiveness of our internal control over financial reporting as of December 28, 2008 has been audited by Ernst & Young LLP, an independent registered accounting firm, as stated in their report which is included herein.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Stockholders of

Illumina, Inc.

 

We have audited Illumina, Inc.’s internal control over financial reporting as of December 28, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Illumina, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, Illumina, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 28, 2008, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheets of Illumina, Inc. as of December 28, 2008 and December 30, 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 28, 2008 of Illumina, Inc. and our report dated February 24, 2009 expressed an unqualified opinion thereon.

 

 

San Diego, California

February 24, 2009

 

None.

 

 

(a) Identification of Directors. Information concerning our directors is incorporated by reference from the section entitled “Proposal One: Election of Directors” to be contained in our definitive Proxy Statement with respect to our 2009 Annual Meeting of Stockholders to be filed with the SEC no later than April 27, 2009.

 

(b) Identification of Executive Officers. Information concerning our executive officers is set forth under “Executive Officers” in Part I of this Annual Report on Form 10-K and is incorporated herein by reference.

 

(c) Compliance with Section 16(a) of the Exchange Act. Information concerning compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference from the section entitled “Compliance with Section 16(a) of the Securities Exchange Act” to be contained in our definitive Proxy Statement with respect to our 2009 Annual Meeting of Stockholders to be filed with the SEC no later than April 27, 2009.

 

(d) Information concerning the audit committee financial expert as defined by the SEC rules adopted pursuant to the Sarbanes-Oxley Act of 2002 is incorporated by reference from our definitive Proxy Statement with respect to our 2009 Annual Meeting of Stockholders to be filed with the SEC no later than April 27, 2009.

 

Code of Ethics

 

We have adopted a code of ethics for our directors, officers and employees, which is available on our website at www.illumina.com in the Investor Information section under “Corporate.” The information on, or that can be accessed from, our website is not incorporated by reference into this report.

 

 

Information concerning executive compensation is incorporated by reference from the sections entitled “Executive Compensation and Other Information” to be contained in our definitive Proxy Statement with respect to our 2009 Annual Meeting of Stockholders to be filed with the SEC no later than April 27, 2009.

 

 

Information concerning the security ownership of certain beneficial owners and management and information covering securities authorized for issuance under equity compensation plans is incorporated by reference from the sections entitled “Ownership of Securities” and “Equity Compensation Plan Information” to be contained in our definitive Proxy Statement with respect to our 2009 Annual Meeting of Stockholders to be filed with the SEC no later than April 27, 2009.

 

 

Information concerning certain relationships and related transactions, and director independence is incorporated by reference from the sections entitled “Proposal One: Election of Directors,” “Executive Compensation and Other Information” and “Certain Transactions” to be contained in our definitive Proxy Statement with respect to our 2009 Annual Meeting of Stockholders to be filed with the SEC no later than April 27, 2009.

 

Information concerning principal accountant fees and services is incorporated by reference from the sections entitled “Proposal Two: Ratification of Independent Registered Public Accounting Firm” to be contained in our definitive Proxy Statement with respect to our 2009 Annual Meeting of Stockholders to be filed with the SEC no later than April 27, 2009.

 

 

(a) The following documents are filed as a part of this report:

 

(1) Consolidated Financial Statements: