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OraSure Technologies Inc., (NASDAQ:OSUR)

Q2 2009 Earnings Call

August 5, 2009 5:00 pm ET

Executives

Judy Clarke - Investor Relations

Douglas A. Michels - President, Chief Executive Officer, Director

Ronald H. Spair - Chief Financial Officer, Chief Operating Officer, Director

Analysts

Aaron Lindberg - William Smith & Company

Sameer Harish - Needham & Company, LLC

Operator

Good afternoon ladies and gentlemen. At this time I would like to welcome everyone to the OraSure Technologies 2009 Second Quarter 2009 Financial Results Conference Call and Simultaneous Webcast. (Operator Instructions). Now for opening remarks and introductions I would like to turn the conference over to Miss Judy Clarke at OraSure Technologies. Please go ahead Judy.

Judy Clarke

Thank you. Good afternoon everyone and thank you for joining us today. I would like to begin by telling you that OraSure Technologies issued a press release at approximately 4:00 pm Eastern time today regarding our 2009 second quarter financial results and certain other matters. The Press Release is available to you on our website at www.orasure.com or by calling 610-882-1820. If you go to our website the press release can be accessed by opening the Investor Relations page and clicking on the link for news releases.

This call is also available real time on our web site and will be archived there for seven days. Alternatively, you can listen to an archive of this call until midnight August 12, 2009, by calling 888-203-1112 for domestic or 719-457-0820 for international. The access code is 4031205.

With us today are Doug Michels, President and Chief Executive Officer and Ron Spair, Chief Financial Officer and Chief Operating Officer. Doug and Ron will begin with opening statements which will be followed with a question-and-answer session.

Before I turn the call over to Doug, I must also remind you that this call may contain certain forward-looking statements including statements with respect to revenues, expenses, profitability, earnings per share and other financial performance, product development performance, shipments and markets, clinical studies and regulatory filings and approvals. Actual results could be significantly different. Factors that could affect results are discussed more fully in the SEC filings of OraSure Technologies including its registration statements, its annual report on Form 10-K for the year ended December 31, 2008, its quarterly reports on Form 10-Q and its other SEC filings.

Although forward-looking statements help to provide complete information about future prospects, listeners should keep in mind that forward-looking statements may not be reliable. The company undertakes no obligation to update any forward-looking statements to reflect events or circumstances after this call. Also, please note that today’s results will include a discussion of certain non-GAAP financial measures. Non-GAAP reporting is provided to help you better understand our business and certain items which impacted our results; however, non-GAAP financial results are not meant to be considered as a stand-alone measurement of performance or as a substitute for, or as superior to GAAP results.

You should be aware that non-GAAP measures have inherent limitations and should be used only in conjunction with OraSure’s consolidated financial statements prepared in accordance with GAAP. Our press release includes a table detailing the non-GAAP measures together with the corresponding GAAP results and a reconciliation to GAAP. We encourage listeners to review these items.

With that I would like to turn the call over to Doug Michels.

Douglas Michels

Thank you Judy and good afternoon everyone and welcome to our Second Quarter 2009 Earnings Conference Call. Ron will begin with an overview of our financial performance for the quarter and then we will provide financial guidance for the third quarter. After Ron’s review I will describe the progress we are making on the Company’s major clinical development programs and provide some more general business updates. We will conclude by opening the floor for your questions. Before Ron begins however, I would like to provide some context for today’s call and our performance during the first half of this year.

As you know we had a good first quarter. We exceeded our guidance on both the top and bottom lines primarily because of the performance of our infectious disease business. A major factor contributing to this success was the extremely smooth and successful transition from our distribution arrangement with Abbott to a direct sales model in the United States hospital market.

During the second quarter we encountered some challenges. As previously announced, based on feedback received from the FDA it became clear that our two principle clinical programs will require some more work and consequently the expected timing of FDA approval is delayed. In addition, we experienced difficulties manufacturing our OraQuick HIV test. This latter circumstance caused a reduction in inventory levels, negatively impacted our financial results, and prevented us from meeting our guidance for the second quarter. As indicated in our Press Release today, the manufacturing issue has now been resolved and we have resumed full-scale production of this product.

While we are disappointed with the pace of our clinical programs and with the manufacturing challenges, we remain optimistic about the future of OraSure Technologies and I believe our investors should feel the same for several reasons.

Despite the reduction in OraQuick inventory levels and the need to allocate product, demand for our OraQuick test in the domestic hospital and public health markets and internationally remains very strong. This is evidenced by the large backlog of orders with which we closed the second quarter and that we are now filling. Were it not for the manufacturing challenge second quarter revenues would have exceeded our guidance.

Despite the need to allocate overall OraQuick product among our customer base we were successful in retaining nearly every order and our relationships with our customers remain strong. The manufacturing issue was detected through routine end process quality control testing. This is significant in that it shows that our quality procedures are both robust and effective. We are able to detect quality issues in a timely manner early in the manufacturing cycle and we prevented this problem from affecting product in the field. There is no evidence to suggest that any OraQuick tests previously sold to customers were affected by the manufacturing issue.

Let me emphasize that sales to the US hospital market remains strong thereby further confirming the successful implementation of our direct sales model. We believe the prospects for this important market segment are very bright.

Finally, while the clinical programs for both OraQuick HCV and an HIV-OTC test will require additional time and resources, we are gaining clarity as to what specifically will be required in order to obtain these final approvals. As I will discuss later in the call, we remain focused on completing these clinical programs as quickly as possible in order to capitalize on the substantial market opportunities for these products. Thus, while we have experienced some recent challenges and the economic climate has not yet improved, we remain very optimistic about our future.

Now let me ask Ron to provide his financial review. Ron?

Ron Spair

Thanks Doug. Good afternoon everyone. Let’s start with revenues.

Second quarter 2009 revenues were $27.3 million representing a 9% decrease from the $18.9 million reported in 2008. Increased sales of our OTC cryo products were more than offset by decreased sales of our OraQuick ADVANCE rapid HIV-1/2 antibody test, our professional cryosurgical product, and our substance abuse testing products. We also experienced a decrease in licensing and product development revenue. As a result of inventory shortages of our OraQuick ADVANCE test we closed the second quarter with an order backlog of $2.2 million. Had we been able to fill these orders our revenue for Q2 would have approximated $19.5 million exceeding both our guidance and last years second quarter revenues.

The overall 6% decrease in our infectious disease revenues in the second quarter of ’09 were the result of a decline in sales of our OraQuick ADVANCE test in the public health and international markets. This decrease is directly related to inventory shortages we experienced in the current quarter as a result of a manufacturing challenge related to our OraQuick ADVANCE test.

Sales to public health decreased 16% from the second quarter of 2008. At the end of the quarter we had a $1.8 million backlog of orders for our OraQuick ADVANCE test from our public health customers. Had this manufacturing issue not occurred our second quarter revenues in the public health market would have resulted in an increase of 10% over the second quarter of 2008.

International OraQuick revenues declined 29% as a result of lower sales into Africa primarily due to the timing of certain testing initiatives and the related OraQuick product orders. We do expect sales in Africa to improve from current levels during the remaining six months of 2009.

Lastly, sales into the hospital market increased 47% during the second quarter. As you recall we switched to a direct sales model for US hospitals on January 1, 2009. This increase in revenues in the US hospital market is due to the higher average selling price realized under the direct model; however sales to our hospital customers were also impacted by the OraQuick manufacturing issue and as of June 30 we had a $400,000.00 backlog of orders for our OraQuick ADVANCE test. Had this manufacturing issue not occurred our second quarter revenues would have increased 71% in the hospital channel.

Second quarter 2009 cryo revenues increased 7% compared to the second quarter of 2008 with revenue increases realized in both the domestic and international over the counter markets. International OTC sales were up 27% over the prior period. Increased sales to our Latin American OTC distributor Genomma were partially offset by a decrease in European OTC sales to our distributor SSL. Genomma has successfully worked through their excess inventory levels from2008 and purchased $596,000.00 of product from us during the second quarter of 2009.

In addition, Genomma recently registered our OTC cryo wart removal product in Brazil which will result in continuing sales to Genomma during the remaining half of the year.

Sales to SSL continue to track below 2008 levels with sales of $739,000 in the second quarter of 2009 compared to $1.1 million in the second quarter of 2008. This reduction was the result of lower unit selling prices and a volume decrease in SSL out sales due to increased competition from lower priced products.

During the first quarter of 2009 we launched our own nationally branded cryosurgical wart removal product in the US OTC market. During the second quarter of ’09 we recorded $122,000.00 in revenues from Freeze 'n Clear Skin Clinic.

On the professional side our combined cryo sales decreased by 14% compared to the second quarter of 2008. Sales of our Histofreezer product to US physician offices decreased 20% in the second quarter of 2009 largely due to differences in distributor ordering patterns and the impact of international product diversion issues.

The diversion issues we aggressively addressed during 2008 have not been completely worked out of the channel. We believe they negatively impacted sales in the domestic physician’s office market during the second quarter of 2009 and may continue to do so until the supply of diverted product is exhausted.

Sales in the international market remained relatively flat in the second quarter of 2009 compared to the second quarter of 2008. We believe we have identified all sources of the diversion and have cut off sales of Histofreezer to all involved parties in an effort to finally remedy the situation.

Moving to substance abuse testing, revenues decreased 21% in the second quarter of 2009 compared to the second quarter of 2008. Sales of our Intercept drug testing system continue to be directly impacted by the current challenging economic and employment environment. Our insurance risk assessments sales decreased 11% from $1.7 million in 2008 to $1.5 million in 2009 while licensing revenues decreased from $804,000 to $525,000.

Turning to gross margin our overall margin for Q2 of 2009 was 57% compared to 59% for Q2 of 2008. Gross margins were favorably impacted in the current quarter by our switch in January 2009 to a direct sales model in the US hospital market. This favorable impact however, was more than offset by the impact of a less favorable revenue mix and increased product support costs during the current quarter as we worked to resolve the manufacturing challenges related to our OraQuick ADVANCE rapid HIV-1/2 antibody test.

Turning to operating expenses, our total operating expenses for the second quarter were up $234,000 or 2%. Second quarter 2009 operating expenses included a $3 million impairment charge related to payments previously made under a license agreement for HCV patents which we initially capitalized as an intangible asset. Our intention in capitalizing these payments was to utilize the license in certain developing countries through the sale of an existing rapid HCV test supplied by a third party manufacturer. We have been unable to penetrate this international marketplace with this third parties rapid Hepatitis C test. Furthermore, given the impact of the current global recession and the deteriorating status of certain third world economies, we do not believe that we will be successfully selling a third parties rapid HCV test in the foreseeable future. As such we recorded a non-cash impairment charge equal to the intangibles remaining unamortized book value as of June 30, 2009.

R&D expenses for Q2 were down 60% or approximately $3.7 million from the second quarter of 2008 primarily due to a decrease in clinical trial spending associated with our OraQuick HCV and OraQuick HIV OTC programs and a decrease in staffing costs. We do expect that our clinical spend will increase during the remaining months of 2009 as we begin to conduct additional clinical testing in order to obtain approved claims for use of our OraQuick HCV test with venous whole blood, oral fluid, and finger stick whole blood specimen types.

Sales and marketing expenses increased 7% or approximately $327,000.00. This overall increase was the result of an expected increase in staffing and related charges as a result of the recruitment of our direct sales force for the US hospital market, recruiting, compensation and relocation costs associated with new senior level marketing personnel and increased market research and consulting costs related to our domestic and international OTC cryo products.

During the third quarter of 2009 sales and marketing expenses are expected to increase as a result of costs related to certain customer retention incentives offered in response to the OraQuick manufacturing issues and expenses associated with hiring additional marketing personnel.

G&A expenses increased approximately 14% or by $545,000.00 primarily due to increased legal fees associated with the continuing patent infringement lawsuit filed by Inverness Medical and Church & Dwight. From a bottom line perspective we reported a pre-tax loss of $5.2 million or $0.11 per share. Excluding the $3 million impairment charge our adjusted non-GAAP pre-tax loss of $2.1 million or $0.05 per share would have exceeded our guidance and is an improvement from our pre-tax loss for the second quarter of 2008 up $3.1 million.

Turning briefly to our balance sheet and cash flow, our cash balance remains strong with cash and short-term investments of $79.2 million at the end of the second quarter. Our working capital of $89.3 million at June 30 is comparable to the working capital balance at December 31, 2008 of $90.9 million and our current ratio improved 6.95 at December 31, 2008 to 9.23 at June 30, 2009.

During the second quarter of 2009 we generated positive cash flow from operations of $1.1 million, an improvement from cash used in operations during the first quarter of 2009 of $2.7 million. This resulted in a year-to-date net use of cash from operations of $1.6 million compared to $1.9 million used during the first six months of 2008. The decrease in cash used in operating activities is largely due to a decrease in inventory of $2.3 million directly related to the utilization of a significant amount of cryosurgical raw material inventory along with our OraQuick manufacturing challenges experienced during the second quarter of 2009.

Accounts receivable collections also improved as we collected a large outstanding balance due form one of our international clients. Days sales outstanding improved from 62 days at June 30, 2008 to 58 days at June 30, 2009.

Turning to guidance for the third quarter of 2009, we are projecting revenues of approximately $19.0 to $19.5 million and a loss per share of approximately $0.05 to $0.06.

With that I will turn things back over to Doug.

Doug Michels

Thanks Ron. Before I discuss our clinical programs I want to address the update on the manufacturing issue which we faced during the second quarter and which is outlined in our earnings release today.

As previously announced during the second quarter, our OraQuick inventory levels were reduced and we were forced to allocate product to our customer base as a result of difficulties manufacturing a component for the OraQuick HIV test that met our internal quality requirements. I am pleased to report that we have resolved this issue. A root cause has been identified and we have implemented the necessary corrective actions to remedy the situation.

The primary problem has been traced to contamination from specific batches of latex gloves that interacted with a component in our test during the manufacturing process. This problem was extremely difficult to identify and isolate because the contamination was experienced only on an intermittent basis within certain batches of gloves. The problem was identified, contained, and remedied as part of our routine in process quality control testing ensuring that any OraQuick product released to the field met our quality standards. We are now back to producing OraQuick HIV tests at full scale and we expect to fill the backlog of orders and return to normal inventory levels over the next couple of months.

Now moving on to the program updates.

Starting first with our pre-market approval or PMA application for an OraQuick HCV test, there have been a number of developments since our last earnings call. As previously announced the FDA recently made it clear that some additional clinical testing will be required to obtain approval for a venous whole blood claim and that we have to conduct additional clinical studies to obtain approval of claims for oral fluid and other sample types.

The reason for this additional clinical work is the FDA’s concern that the data previously submitted with our PMA application could have been affected by bias because the same operators performed the test and interpreted the results on multiple sample types derived from the same patient. The FDA is concerned that once an operator saw positive or negative results for a particular sample that he or she could be biased in interpreting the results for any other sample type taken from the same patient.

In order to obtain approval as quickly as possible we understand that we must provide the FDA with the data they require and we are now focused on doing just that. Protocols for the additional testing have been prepared and are now before the agency and once the protocols are finalized and approved we will begin the additional clinical work.

From a timing perspective we hope to complete the additional clinical testing required for a venous whole blood claim yet this year. The additional study for oral fluid and finger stick whole blood should begin in the fourth quarter with the goal of completion as soon as possible in 2010. In the meantime we will work to be sure that there are no other issues that require resolution and that a full facility audit is satisfactorily completed. We want to be in a position to obtain final approval in short order, once the final clinical data is submitted to the FDA.

Despite the delays in our clinical program on the HCV product we remain very optimistic about this product and the opportunity it represents for the Company. Hepatitis C infection remains a significant public health problem both in the United States and internationally. You may have seen a recent report in the New England Journal of Medicine which reported on the comparative effectiveness of the two available FDA approved drug therapy regiments for HCV. Among other things the report indicated that starting treatment before the disease has reached an advanced stage can double the treatment success rates. This further under scores the urgent need for better and wider spread routine testing so that those infected with HCV can be identified sooner and given treatment when it will be most effective. We believe that our rapid HCV test, once it is approved by the FDA, will be able to help address this urgent public health need.

We have also continued to make progress in other aspects of this project, for example our real time stability studies for this project are progressing nicely. In recent testing the validation lots that were used to establish product gating met acceptance criteria after storage for 16 months at 30º C. These studies are ongoing and their results will be used to support a shelf life approval by the FDA. We have also submitted a request for a CE mark for our OraQuick HCV test which, as you know, is required to sell the product in the European Union.

Turning now to our efforts to obtain FDA approval for an OraQuick rapid HIV test over the counter, we also received additional feedback from the FDA since our last earnings call. After reviewing the results of our observed use study in which an individual’s ability to take the test is assessed while a trained professional observes those activities, the FDA indicated that the agency would like to seek additional guidance from the FDA’s blood product advisory committee or BPAC before providing their guidance to us on the remaining clinical studies needed for approval. At the beginning of July we met with the FDA to begin the planning for an upcoming BPAC meeting which we expect will occur in November. That meeting with the FDA went very well. We are now continuing to work on the specific next steps for our clinical program so that we can gain alignment with the FDA before a definitive proposal is presented to BPAC. As we gain additional clarity on the specific requirements for approval we will provide updates as appropriate.

Turning to litigation there is really not much new to report regarding our patent infringement lawsuit with Inverness and Church & Dwight. As a result of some scheduling issues the deadlines for discovery and the Markman proceedings have been extended. The Markman hearing in which specific claim terms in the asserted patent will be interpreted is now scheduled for early October and we continue to be very confident in our position in this matter and we will provide updates again as appropriate.

On the organizational front we have strengthened our marketing team with the appointment of Manuel Mendez as our new Vice President of Marketing. In this position Manuel will have overall responsibility for marketing our products, developing and executing strategic marketing plans, identifying and evaluating new product opportunities and assisting in the development and execution of our overall strategic growth plan. Before joining OraSure Manuel enjoyed a distinguished 18-year career in the medical and scientific fields. Most recently he served as the had of global sales for global chemicals biosciences at Thermal Fissure Scientific and before joining Thermal Fissure Manuel spent 16-years with Abbott Diagnostics during which he built a successful career in general management, marketing management, sales management, and business development in locations ranging from Latin America to North America to Asia and Europe. We are very pleased that Manuel has joined OraSure and we anticipate that he will make a strong contribution to our management team.

Finally, I would like to provide some perspective on various aspects of our business. As Ron explained that despite the manufacturing challenges we believe our infectious disease testing business and particularly demand for our OraQuick HIV test is very, very strong. Had we not needed to allocate inventory due to the manufacturing issues our second quarter direct sales to the US public health market would have shown double-digit growth over the same period of 2008. We also continue to close new contracts in the public health market despite these manufacturing challenges. These contracts included multi-year purchase agreements with several of our top public health customers.

As discussed during our last call, there remains a high level of focus on HIV prevention and specifically on the expansion of HIV testing and we believe that increased funding will be made available through various legislative efforts. As routine HIV testing gains wider acceptance and government funding priorities for HIV testing continue to materialize we believe our OraQuick business will indeed continue to grow.

As a result of the OraQuick product allocation during the second quarter we were successful in not only retaining virtually all of our customers, but we also delivered a very high level of customer service. Specifically we offered a number of alternative solutions to assist our customers in maintaining their HIV testing programs. One of the solutions was to provide our laboratory based OraSure HIV-1 oral fluid test as an alternative. Approximately 5% of our top public and public health and hospital customers utilized this option to keep their current testing programs up and running. As a result of these efforts we believe that none of our public health customers switched to a competing test product during this period and that only a handful of small hospital customers made a switch. We are very pleased with this result and we believe it is a testament to the value that our customers realized with the OraQuick product, our strong customer relationships, and a high level of customer service that we deliver day in and day out.

We also continued to expand the patent estate covering our OraQuick product line. A new patent was issued in June which closely covers the oral fluid application of our OraQuick technology platform currently on the market and we believe that one more patent may issue at some point with respect to our current HIV product and we expect to seek additional patents for the next generation OraQuick test currently under development.

In the hospital market our second quarter performance further demonstrates the successful transition to a direct sales approach in this market. Hospital sales grew 47% for the second quarter compared to 2008 and would have been much higher had we not been forced to allocate product. As discussed on our last call, we believe we successfully transitioned the business for virtually all OraQuick customers served by Abbott and our focus has now shifted to obtaining new accounts and this has gone well.

During the second quarter we closed approximately 135 new hospital accounts and we also began expanding and extending our agreements with large hospitals through purchasing organizations, or GPOs and we believe we are close to securing an agreement with a major GPO not previously served by Abbott. One of the biggest segments of the United States hospital market is operated by the Veterans Administration. Some time ago the VA announced that it would be moving to implement the CDC’s guidelines on routine HIV screening and that is now becoming a reality. In July a regulatory change was announced by the VA eliminating the need for both written consent as well as mandated, scripted, pre and post-test counseling for HIV testing. This change becomes effective August 17, 2009. As a result VA clinical providers will be able to eliminate these cumbersome steps and can simply obtain oral consent in order to implement HIV testing for patients. This change brings the VA policy and practice in line with the CDC’s recommendations and will enable VA providers to better implement routine HIV screening so that patients again can be diagnosed earlier and receive treatment in a timelier manner. We believe this change will help expand sales of our OraQuick test in the US hospital market.

As Ron indicated revenues from our cryosurgical business were up compared to the year ago quarter primarily as a result of our international over the counter business. As we expected, our Latin American distributor Genomma has worked through its excess inventory and began ordering product again in the quarter. We have also received orders from Genomma for the last two quarters of this year. In addition, we were pleased to learn that Genomma recently registered our product in Brazil which has helped this distributor support continued purchases.

In Europe a reduced transfer price from growing competition has negatively affected our sales to SSL and we do expect these factors will continue to impact sales during the next couple of quarters.

Finally, the diversion of our professional Histofreezer product by foreign distributors into the US market continues to reduce our domestic professional sales despite our best efforts to end this practice.

In the substance abuse area the economic downturn and rising unemployment continues to negatively impact sales of our Intercept product line primarily in the work place testing segment. Our criminal justice business is also down primarily due to funding cuts at the state and local level and some increased competition from other low cost labs. Our Intercept business is not likely to improve until we see improved economic and employment conditions.

Looking forward our collaboration with Roche Diagnostics on high through put assays continues to go very well. Studies to support the 510-K clearance have been started and the regulatory effort for these assays remains on schedule and we are also nearing completion of final business terms for a worldwide commercialization agreement and we expect to have that agreement signed in the near future.

Despite some significant challenges in the second quarter we continue to make good progress in many areas of our business. Our infectious disease business remains strong and continues to grow and the transition to a direct sales model for hospitals has been very successful and we anticipate continued growth in this important segment. We are pleased with the strong performance of our quality system and the diligent efforts to resolve the manufacturing issue. We expect our future revenues and gross margin to be positively impacted now that the manufacturing challenges are behind us.

Although our clinical programs have been extended we are gaining greater clarity on the specific requirements we need to meet to obtain these important approvals and finally, we are continuing to strengthen our senior management team which is clearly important for our future. With the first half of 2009 now over we remain optimistic and we are extremely committed to delivering a very successful rest of the year.

With that I will now open the floor to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Aaron Lindberg with William Smith & Company.

Aaron Lindberg - William Smith & Company

How much is the current ADVANCE backlog?

Doug Michels

It is $2.2 million at June 30th.

Aaron Lindberg - William Smith & Company

How about now?

Doug Michels

It’s actually increased a bit as a result of orders that we received in the international market place. Domestically I would say we’re around the same level as we just resolved this manufacturing issue a couple of weeks back.

Aaron Lindberg - William Smith & Company

Okay so that takes care of that question. That was just wrapped up kind of mid-July end of July?

Doug Michels

That is right.

Aaron Lindberg - William Smith & Company

Okay and then you had said that you expect to work it off over the next couple of months, two to three months is that reasonable?

Doug Michels

That is certainly a plan. We need to ramp up our manufacturing capacity through the addition of temporaries coming in to help us on the assembly operations and we need to get them trained, shifts expanded, and we are working diligently to make that happen while all the while making sure that we keep our eye on the quality of the product that we’re turning out to the field. So, we are ramping that up and we hope to move through that backlog as quickly as possible.

Aaron Lindberg - William Smith & Company

Okay that sounds good, so primarily through shift expansions though?

Doug Michels

That is correct.

Aaron Lindberg - William Smith & Company

Okay and then what was the year-over-year unit change in ADVANCE sales to hospitals in Q2? I know you had said in Q1 it was pretty flat.

Doug Michels

On an as adjusted basis with the backlog accounted for we were within a few percentages where we were on a unit basis on out sales in the prior year’s quarter.

Aaron Lindberg - William Smith & Company

Okay so including the backlog similar and then when you take all of the backlog sales out it is obviously just down?

Doug Michels

That is right.

Aaron Lindberg - William Smith & Company

Okay got it and then can you give us an update on legislation related to the funding of HCV testing kind of like you did for HIV last quarter?

Doug Michels

Yes, you know there is a lot going on on the HIV front obviously, in the appropriations bills the Center Appropriations Committee, as an example. On the HIV front the bill provides for approximately a $20 million increase for HIV aids to the HCV the bill was flat funded for HCV. That was the senate version. The house version I think was comparable, but I am not certain off the top of my head.

Aaron Lindberg - William Smith & Company

Is there anything else going on just as far as broad legislative efforts to increase HCV testing?

Doug Michels

We are working very hard to raise this issue with the legislative community obviously. We are working together with our colleagues in the pharmaceutical industry to make sure that those individuals making the policy decisions understand the importance of early diagnosis and as I mentioned the facts are the facts. Early diagnosis leads to earlier treatment; earlier treatment has a 2-x improvement in response rates, so we are trying to make that visible and see if we can’t positively impact the funding equation.

Aaron Lindberg - William Smith & Company

Okay, so as far as just funding for HCV testing generally speaking though the primary driver is going to be the pharmaceutical companies coming out with new therapeutics versus anything on the government side?

Doug Michels

No, I think the government is keenly interested in seeing increased HCV testing. Obviously the more effective therapies are going to drive more interest there as well.

Aaron Lindberg - William Smith & Company

Okay and then can you give us an update on distribution strategies for ADVANCE outside of the US, particularly in developed countries Europe, Japan, the Middle East?

Doug Michels

Yes, as you know we have been working on this for quite some time. Not only do we have to have the right distributors in place, but in most cases the product has to be registered. Often times each of these countries have validation requirements as well as testing algorhythms that we need to be placed on. Obviously we are working very hard to meet all of those requirements. In Africa, as an example, we are looking to have the testing algorhythms in Kenya be modified so that oral fluid testing can be part of that routine testing algorhythm. We have appointed a new distributor in South Africa. We have appointed new distributors in India and Viet Nam, we have a very exciting opportunity in Indonesia that we are working on right now. In Latin America we have been given a go ahead by the ethical committee in Brazil to have the HIV authority begin their validation of OraQuick so there is a lot going on, on multiple fronts.

Aaron Lindberg - William Smith & Company

I wanted the developed countries.

Doug Michels

In the developed countries we continue to advance our efforts in Europe, that has been a little bit slower, as you know, then we would like, but we continue to push hard in the big five of the EU and then moving over into some countries in Eastern Europe.

Aaron Lindberg - William Smith & Company

Okay, and what is your plan for buying back stock?

Ron Spair

We evaluate that from time to time with our board of directors and we will be doing that later this month. In the second quarter we did not buy any stock in the open market.

Aaron Lindberg - William Smith & Company

Okay so it has kind of been put on hold, I think it was a $25 million original authorization and you did $5 million or so of it and then it is kind of just on the back burner for a little bit here?

Ron Spair

During the second quarter we didn’t buy any stock, as I had indicated, and that is something that we evaluate on a quarterly basis with our board of directors.

Aaron Lindberg - William Smith & Company

Okay and my last question is on stability testing for the HIV product. I appreciate the 16-month update on HCV, are you in a similar position with HIV?

Doug Michels

We are not quite at the 16-month stage with that. As you know we extended our dating to 12 months earlier this year. We do have an additional stability test on stability. We are at about 11 months on that right now. We expect that is going to continue to extend and obviously as it passes the 12 month period and we get sufficient extension to increase the dating on HIV we will If we look at the stability profile of the product as it is currently on stability we are highly confident that we are going to be able to extend the dating of our HIV products some time down the line.

Aaron Lindberg - William Smith & Company

Okay, great. Thanks a lot.

Operator

Your next question comes from Sameer Harish with Needham & Company, LLC.

Sameer Harish - Needham & Company, LLC

I have a question on the VA contracts that you guys were talking about. Is that going to be under the direct hospital sales align or are you going to be reporting that in public health?

Doug Michels

No, it would be under the hospital line.

Sameer Harish - Needham & Company, LLC

Can you talk about, is the contract going to be hospital by hospital, or are you talking more to the VA as a general? I am asking to get a sense of whether or not you are going to see any price concessions for volume at the VA or not?

Doug Michels

The way that the VA contracts are they either do it at the hospital or at the VISM level. The VISM is the integrated network; I think there are 23 VISMs’ within the VA health system. Also within a VISM in addition to hospitals are community based outpatient clinics and other types of healthcare service organizations, substance abuse services and the like. But, our focus is obviously going to be certainly at the VISM level, you know those 23 or so, then at the hospital level and then going down to the community based outpatient clinics.

The VA purchases off of a federal supply schedule which we have had for several years. We do business today with many VA hospitals and with several VISMs and we expect that this change in policy and in the law actually is going to really open up significant opportunities within the VA. Most importantly it is going to provide the VA the opportunity to provide the same level of HIV prevention services to veterans that we in the public sector take for granted.

Sameer Harish - Needham & Company, LLC

But when you look at the VA market, the potential there and the market penetration that you have today, what would you say our penetration is in the VA?

Doug Michels

Well it is, I would say, somewhat representative of our penetration into the general hospital market where I believe we have a strong share position, but at the same time the VA has not been able to implement routine HIV testing programs. They were precluded by law. If the VA wanted to go out and implement broad scale HIV screening programs or testing programs they had to get an act of congress, congregational approval to do that. That law requiring that was actually repealed late last year. What had to happen though was the VA had to change their internal policies which were obviously aligned to deal with law. What the VA recently announced is that they have now modified their internal policies opening the opportunity for routine HIV testing as I described previously.

It is a great opportunity and there is about 168 hospitals within the VA healthcare system and they are organized, like I said, into these 20+ VISMs.

Sameer Harish - Needham & Company, LLC

Okay, now I wanted to focus a little bit on the guidance. How much of that $2.2+ million backlog is included in the third quarter guidance?

Ron Spair

There is an amount of it, but I don’t want to leave you with the impression that it is all in there, but we want to be a little conservative as to how we plan for the ramp up in manufacturing as well as in servicing our existing customer base and the orders that come in. I think what I will share with you is that we do expect sequential decreases in the SAT as well as the overall cryo area which is also factored into the guidance on the revenue on the top line that we put out there for you.

Sameer Harish - Needham & Company, LLC

Does that have more to do with seasonality?

Ron Spair

Certainly in the SAT business it is related to that and I think as we talked about earlier, you know the continuing challenges with SSL over in the OTC marketplace in Europe as well as some impact of diversion in the US professional cryo market.

Sameer Harish - Needham & Company, LLC

The relationship with SSL seems some quarters it is a good relationship, some quarters they under perform a little. Would you say this is more in regards to market share losses from competition or are they not meeting their distribution goals still?

Ron Spair

Well we restructured the way we do the contract with them and we were supporting some advertising and promotional spend over there. That is no longer taking place and I think that frankly we have seen in other geographies around the world that this product is particularly sensitive to DTC promotion efforts and not doing that, we believe, is impacting the business there. Plus we have also seen evidence of some low cost competition coming in in addition to what the market had in 2008, which has impacted their sales ability as well.

Sameer Harish - Needham & Company, LLC

Okay I got it, so less growth because of less advertising. Did Genomma already launch in Brazil or is that something that is up coming?

Ron Spair

That is up coming so they hope to be on the shelves for the up coming summer season.

Sameer Harish - Needham & Company, LLC

The sequential decrease in G&A was that tied to the legal primarily? Do you expect that to increase as legal increases?

Ron Spair

Yes, I mean we do expect that we will see some increase as we move through and towards the Markman hearings on the legal spend side, you are absolutely right.

Sameer Harish - Needham & Company, LLC

Okay fair enough. I want to follow up a little bit on the HCV. Can you give me a sense of what the target enrollment is for the two arms there, the venous side and then the oral and everything else?

Doug Michels

The venous whole blood side because we are going to obviously be using some of the data that was generated in the previous study is going to be less than the enrollment for oral fluid and finger stick. It is going to be in the hundreds, 500 to 700 and on the finger stick and oral fluid it is going to be in the 2000 range.

Sameer Harish - Needham & Company, LLC

Okay and is there anything substantially different in the oral and other side that when you compare versus other OraQuick trials that you have done in the past?

Doug Michels

No not at all. The only difference is that by protocol those specimens are going to be collected and run and the results interpreted completely independent of one another by protocol and that is to absolutely eliminate and ensure that there is no “potential” for bias.

Sameer Harish - Needham & Company, LLC

Okay I appreciate the update on the HIV side. Your comments pretty much answered all of my questions. I just have the one. Is there any other agenda that the FDA has for the November meeting? If you could talk a little bit about that I would appreciate it.

Doug Michels

No, we have shared with you what we have learned from the FDA. It is pretty clear to us that before they give us their final guidance they want to run that by the advisory committee and our objective is to work with the FDA so that when we go together to that advisory committee we have as close to joint proposal as we possibly can for what remains yet to be done. Our objective is to get some definitive guidance on the remaining studies and also some clarity on what the success criteria is so that we can come home, develop the protocols per their direction, get them submitted, and execute on those plans.

Sameer Harish - Needham & Company, LLC

Okay. Do you think reducing the size of the unobserved trial is still in the cards?

Doug Michels

I don’t think that we necessarily speculated on that one way or the other. I think we have said previously that the value of including known HIV positives like we were asked to do in the observed use study, at least from our perspective, has less value in an unobserved study, but I the FDA wants us to do it we will debate that issue, but in the end it is going to be their call. We will do what they ask us to do and we will try to do it as quickly as possible. We want to get this product approved and on the market.

Sameer Harish - Needham & Company, LLC

I appreciate the color on the impacts of manufacturing, as you said, on revenue. Could you give us kind of a similar indication on how it impacted gross margins and what it may have looked like in the quarter without the destruction?

Ron Spair

Definitely there are impacts that we experienced in many areas: specifically scrap and spoilage, and also the amount of effort that was diverted by our internal staff towards working on the resolution of the manufacturing issue. Plus, overall we turned out and manufactured less product and so the actual unit cost would be higher for a product produced in the second quarter than it was in the first as a result of absorbing overhead over a lower number of units. So, I would comfortably say that we would be north of the 60% range that we had, not as high as the 64% that we had in the first quarter, but north of 60%, because we did see somewhat of a drag on gross margins in the cryo business which probably brought it down by 170 basis points versus the comparable period a year ago. That is related to the cryo sales themselves and the professional OTC market as well as the lower royalties that we enjoyed during the second quarter from our IT patent license with Schering-Plough for the sale of their cryo product in the US OTC market.

Sameer Harish - Needham & Company, LLC

Okay great, thank you.

Operator

Your next question is a follow up from Aaron Lindberg - William Smith & Company.

Aaron Lindberg - William Smith & Company

Have you added more chains beyond Rite Aid for the US OTC product?

Doug Michels

We have cds.com and Lewis Drug out in the Midwest.

Aaron Lindberg - William Smith & Company

Okay and the 510-K for the high through put assay, where are you at with the individual drugs on that one? Do we still have PHC and some things kind of lagging behind others?

Doug Michels

We are right on track to our previous update. All of the assays, with the exception of PHC are either about to enter or have started the clinical studies. PHC is going to be delayed into 2010, but that program is on track and the results look very good.

Aaron Lindberg - William Smith & Company

PHC delayed into 2010 before it goes into the clinic?

Doug Michels

Yes.

Aaron Lindberg - William Smith & Company

Okay and then what do you expect the cost of the additional HCV trials to be and is it fair to assume that you guys bear all of the expenses without any additional help from Sheering?

Doug Michels

The latter observation is right on. We will bear all of those costs ourselves and frankly we are working through the total costs associated with those trials right now.

Aaron Lindberg - William Smith & Company

Okay I think you had previously indicated that you had started the CLEO waiver work for HCV. Does that have to be redone or is that something that you can continue and submit along with the rest of the study data?

Doug Michels

No, our intention was to be in the midst of conducting the CLEO waiver studies now, obviously, based on the old schedule. We will not begin those studies now until fourth quarter, first quarter 2010 and then, as you know, we can’t submit those studies until we have our PMA ultimately approved.

Aaron Lindberg - William Smith & Company

Okay and then how have the HCV set backs impacted the relationship with Sheering?

Doug Michels

They have not. The relationship with Sheering remains strong and I know both of us are very eager to get this product approved.

Aaron Lindberg - William Smith & Company

Okay, awesome, thanks.

Operator

As it appears we have no further questions, Mr. Michels I will hand it back to you, sir, for any closing comments.

Doug Michels

Okay, I just want to thank everyone for participating in today’s conference call, for your continued interest, obviously, in the Company, and for your continued support. I hope you all have a great afternoon and a good evening. Thanks everyone.

Operator

Ladies and gentlemen that does conclude the conference call for today. We thank you for your participation. (Operator Instructions)

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Source: OraSure Technologies Inc., Q2 2009 Earnings Call Transcript
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