When gene sequencer giant Illumina (NASDAQ:ILMN) rolled out plans last month to replace the high-performance models of its instruments with a whole new lineup, the market cheered, and the stock rose 17% in a single day. But, revelations in the Q4 earnings report and conference call hint at some challenges the company will face in 2017. The new products are exactly what the company needs on the road to renewed growth, but it may be a bumpy ride for a while. 

Schematic of Illumina's sequencing technology: sequencing by synthesis

Image source: Illumina

Instrument sales will continue to slow during the transition

Illumina follows a typical razor-and-blade business model -- the company makes money both from sales of its gene sequencing machines and from the consumables used each time a customer uses a machine. Unfortunately, Illumina's instrument sales have logged six straight quarters of negative growth, with Q4's 23% plunge the latest in the streak. The high-end HiSeq line has been singled out as the biggest problem area, so the new high-end NovaSeq line will likely address the instrument sales issue in a major way... eventually.

In the short term, a product transition such as this one will present challenges. The immediate impact is that many customers who had planned to buy top-of-the-line HiSeq and HiSeq X instruments have put their orders on hold pending the evaluation and availability data of NovaSeq. Last quarter, management said, "the overall demand for X continues to stay stable in that 20 to 30 units a quarter range, and we expect that to continue going into next year." In the Q4 announcement, management revealed that Q1 shipments of HiSeq and HiSeq X combined will likely total only 10 units.

That's a big drop. In the Q3 announcement, management pointed to the loss of a single HiSeq X unit sale as a significant reason why revenues missed expectations for that quarter, and now there is a headwind of 10 to 20 lost HiSeq sales in one quarter, at $6 million to $10 million each. That probably accounts for the difference between Q4's revenues of $619 million and Q1 revenue guidance of $565 million when anticipated sales of NovaSeq are taken out.

This is, of course, a temporary problem, but it could linger through the year. Management expects that the majority of the customers of the X units -- and most of the backlog of 37 units -- will convert to NovaSeq. But investors will have to be patient -- the flow cell format that will make NovaSeq most attractive to HiSeq X customers (due to faster speeds and lower operating costs) is the S4, which is not due to ship until the end of the year. Further, management noted that the sales cycle for a product such as NovaSeq is months rather than weeks. So it would not be surprising to see sales of NovaSeq be soft -- and those of HiSeq almost non-existent -- for most of 2017.

Supply sales will help, but they will decelerate, too

Sales of sequencing consumables, the "blade" in the razor-and-blade model, were highlighted as a bright spot in Q4. Indeed, revenue growth of 20% year over year for the category that makes up over half of overall revenue was a major factor in the company's 5% gain to $619 million. But that 20% was the lowest growth in sequencing consumables for any quarter since 2014. Declining instrument sales have had the inevitable impact of dragging down consumables growth as well. 

Looking ahead to full-year 2017, it's likely that the product line transition will have a negative impact on supplies growth as well since the installed base of HiSeq and HiSeq instruments generates roughly two thirds of sequencing consumables sales. CFO Sam Samad said in the company's Q4 earnings call:

Additionally, as we work through the transition from HiSeq to NovaSeq, customers will pause experiments, work down consumables on hand, place fewer inventory buys, and take time to validate their new workflow. Hence, consumable sales will also be impacted as a result of this transition leading to decelerating sequencing consumable growth versus prior year for a number of quarters and flat to slightly down sequencing consumables sequentially.

But there are bright spots

Outside of the transition from the aging HiSeq line to the shiny, new NovaSeq instruments, Illumina's business remains healthy. The mid-range NextSeq line has been highlighted for several quarters as selling particularly well. The machines are favored for clinical applications, especially among Chinese customers for non-invasive prenatal testing (NIPT). Sales figures for NextSeq are not broken out, but sales to China increased 50% in Q4.

Microarray scanners -- devices used to process large numbers of samples quickly and cheaply, looking for mutations or variations -- have also been a nice source of growth in 2016, rising 19% over 2015 and reaching 16% of total revenue. 

For the first time this quarter, Illumina provided numbers for sales of the low-end MiniSeq line that was introduced a year ago. There are 370 units in the installed base, with 110 shipped in Q4. At about $50,000 per unit, that added over $5 million to revenue in the quarter, or almost a percentage point of growth. MiniSeq utilization (a measure derived from the amount of consumables used by a given machine) is also coming in higher than expected, with the installed base generating $20,000 to $25,000 of supplies sales annually per unit versus the original estimate of $12,000 to $15,000, meaning the rapidly growing MiniSeq installed base is already yielding around $2 million per quarter of supplies revenue.

The longer view on the business

Management guided for revenue growth of 10% to 12% for the full year of 2017. I think that's pretty optimistic due to the challenges described above. Guidance for Q1 was for growth of only 3% at the midpoint, meaning that the business will need to generate almost 14% more revenue in the last nine months of the year than it did in the equivalent period in 2016 in order to hit 11%, or the midpoint of guidance. That will be a tall order, given the disruption caused by the product transition.

But long-term investors should take heart. The new NovaSeq line should eventually reinvigorate sales and maintain or increase Illumina's lead over the competition. The lower operating costs should enable new applications and generate new demand for high volume sequencing. It will also simplify Illumina's lineup, which will result in efficiencies for the company. Patience should reward shareholders, but 2017 may very well be a rough year.

Jim Crumly owns shares of Illumina. The Motley Fool owns shares of and recommends Illumina. The Motley Fool has a disclosure policy.