3 Things You'll Want to Watch in Illumina's Q4 Earnings

By Keith Speights Markets Fool.com

In 2016, Illumina's (NASDAQ: ILMN) stock dropped nearly 30%. This year has already been much better for the genomic sequencing leader, with shares climbing 25% in less than a month. That nice rebound could be at risk on January 31 when Illumina announces its fourth-quarter and full-year 2016 results. Here are three things you'll want to watch with the company's update.

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Image source: Illumina.

HiSeq system sales

Illumina reported disappointing results in the third quarter. Lower-than-expected sales of its high-throughput systems was the primary culprit. There were two reasons behind the lower sales last quarter.

First, the U.S. government changed how it funds capital projects. This change resulted in 35 HiSeq X system sales being delayed. HiSeq X systems are Illumina's most expensive sequencing systems, costing $6 million to $10 million each.

Second, more customers are switching to the company's NextSeq desktop sequencing systems from the high-throughput HiSeq 2500 and HiSeq 4000 systems. This cannibalization hurts Illumina, because the NextSeq system costs roughly $440,000 less than the HiSeq 2500 and $650,000 less than the HiSeq 4000.

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Don't expect either of these issues to be resolved when Illumina reports its fourth-quarter results. However, one key thingfor investors to watch will be whether or not the problems appear to have worsened.

Also, look for any signs that Illumina has found ways to reduce the impact of these factors. For example, around 37% of its business has historically stemmed from academic and government entities. A significant increase in sales to the private sector could offset some of the problems associated with the federal government funding change.

Consumables revenue

There was good news and bad news in the third quarter related to Illumina's consumables revenue, which is to be thought of as the "blade" in the company's razor and blade business model. The good news was that consumables revenue was up 23% from the prior-year period. The bad news was that the increase fell short of expectations.

The reason consumables sales didn't meet targets in the third quarter related to some customers shifting away from Illumina's HiSeq systems to other systems. While the lower-cost NextSeq system appears to be the primary alternative for these customers, CEO Francis deSouza also indicated that some customers are shifting to the more expensive HiSeq X systems.

In the company's third-quarter conference call, CFO Marc Stapley said that the lower consumables spending stemming from customers transitioning to other systems should only be temporary. Investors will definitely want to see if Stapley's optimism was warranted when Illumina announces its fourth-quarter numbers.

Forecasting project update

One of the worst things a company can do to undermine investors' confidence is to make projections and fail to deliver on them. Unfortunately, that's what happened with Illumina in 2016.In the aftermath of several forecast misses last year, Francis deSouza committed to setting things right.

DeSouza announced a major initiative to improve internal forecasting. This effort was to be led by Marc Stapley and consist of two phases. In Illumina's third-quarter conference call (held in early November), Stapley said that the first phase, with a focus on identifying major opportunities for improvement, would be completed by mid-December. The second phase, implementing longer-term tools and process changes, would be undertaken in 2017.

Expect a progress report on this forecasting project when Illumina discusses its fourth-quarter performance. If the company can get its house in order with projecting shipments and financial numbers more accurately, that will go a long way in making this year a better one than 2016.

Looking ahead

The primary thing that jumps out to me when examining Illumina's difficulties last year is that the issues appear to be largely temporary in nature.

That U.S. government change in how it funds capital projects won't diminish the need for genomic sequencing over the long term. The availability of less-expensive systems offered by Illumina might result in cannibalization of sales of more-powerful systems in the short run, but it should also expand the market size over a longer period.And Illumina's problems with forecasting should certainly be one the company can fix relatively quickly.

Don't be surprised if Illumina's fourth-quarter numbers aren't impressive. I continue to believe, though, that the company's long-term prospects remain solid.

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Keith Speights has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Illumina. The Motley Fool has a disclosure policy.