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Applied DNA Sciences, Inc. (NASDAQ:APDN)

Q2 2014 Earnings Conference Call

May 13, 2014 9:00 AM ET

Executives

Debbie Bailey – Head-Investor Relations

James A. Hayward – Chairman, President and Chief Executive Officer

Karol Kain Gray – Chief Financial Officer

Analysts

Debbie Bailey

Good day, and welcome to our Applied DNA Sciences’ Quarterly Conference Call. My name is Debbie Bailey, and I’m the Director of Investor Relations. I would like to thank everyone for joining us today. On today’s call we will be hearing first from Dr. James Hayward; CEO and President, followed by Karol Kain Gray, Chief Financial Officer for the company.

We will conclude with answers to questions from our shareholders. Please note that some of the information you will hear during our discussion today may consist of forward-looking statements including without limitation those regarding revenue, gross margin, operating expenses, other income and expense, stock-based compensation expense, taxes, earnings per share and future products. Actual results or trends could differ materially.

For more information, please refer to the risk factors discussed in Applied DNA Sciences’ Form 10-K and Form 10-K/A for fiscal 2013. Applied DNA Sciences assumes no obligation to update any forward-looking statements or information.

At this time, I would like to turn the call over to Dr. Hayward.

James A. Hayward

Thank you, Debbie. Good morning to our audience, and thank you all for your loyalty and interest and for joining us today. Our mission is to restore profits, taxes, jobs, and intellectual property to their rightful owners by giving every item a way to prove its authenticity through its lifecycle and through its supply chain travels. Humans have DNA, a birth certificate, and a passport. To do this, we are making critical universe marking rather the critical universe with DNA, and providing individuals, enterprises, and supply chain influencers a means to identify authenticity and provenance, commodity-by-commodity and location-by-location.

Now, commodities travel through supply chains and respond to stopping the leaks by interdicting at touch points between trading partners and/or geographical borders. Locations are more self contained and respond to putting a ring around them to stop the leaks and then enabling deterrence typically by the law enforcement. We believe that we earn a piece of the stakeholders’ benefit to be realized through their payment for marking and authentication products and services, and for supplying business analytics related to supply chain leaks.

Industry mandates and government regulations accelerate our move up this curve as Applied DNA has seen in military electronics, and the Swedish DNA standard, and our London home trials, which by the way are now being picked up by other cities throughout Europe. When examples like these do not exist, typical in supply chains without a dominant stakeholder, Applied DNA is championing the cause rather than waiting for all entities to agree by removing the barrier to entry of foundational DNA marking with an industry fast mover. This is kind of similar to the Walmart effect upon bar coding.

Now, we are the best at this, because firstly no other company has stated this vision across both market types; no other company has technology, which is universally suited to mark as many substrates as we can; no other company has technology which is un-copyable, and DNA is recognized as the global forensic standard; and no other company has the remarkable stability that our patent portfolio provides for DNA.

Now, we are in the early phases of marking with a breakeven or tipping point varying from market to market based on the investment required for our mark customization for substrates and on the overall build out of our marking, detector, and reader product families.

Like most biotechnology companies our growth has followed a pattern. We burst upon the scene with an un-copyable DNA marker that is and was unmatched. We have since been building our business and science incrementally, carefully. Now, especially in the last two quarters, we are seeing the fruit appear from the early seeds we have sown. To carry the anology further, we are now beginning to harvest this fruit from our most mature markets. We are doing the heavy lifting to fertilize those in our early-stage markets, and we continue to sow others in markets or applications that look promising.

We have now seen our business evolve toward a much greater scale of DNA marking that we expect will yield additional revenue as the accumulated demand for authentication begins to flow back to the company. The size of our customers is also growing with multiple customers who are now having revenues from $3 billion to $30 billion annually. So, we are working with another tier, another class of customers, altogether. Now, our installed base has steadily increased for the last two years, with a significant increase in slope over the last two years as we increased the size of our sales team, their training and global responsibilities, and the number and sophistication of our channel partners.

Our technology has proved quite sticky. We almost never lose a customer, and we have enjoyed a 100% annual renewal of our contracts in critical areas such as our Military and Government programs. Based on the growth we have enjoyed for the first half of this fiscal year, we should be very close to an installed base of 100 customers by the end of fiscal year 2014.

Now, our uptake globally is proceeding exactly according to plan, with successful sales across much of the globe. Our business development strategy is succeeding. We look for early adopters in new industries. We prove a closed-loop application with a definitive return on investment for our customer and then we clone our success through partners and sales channels.

We have every confidence in our near-term ability to sign more enterprises of large size and impact. We are growing an impressive “portfolio of assets under management,” because the size of our customers greatly magnifies our own influence and our ability to penetrate and sell into their supply chains and their industry. A perfect example is our penetration of the textile industry. The technology is strong with the ability to follow marked fiber through every step of the supply chain from its birth to finish garments, to linens, to carpets, and to home goods.

We have now gained experience marking fibers at a scale of 50 million kilos, and we see that literally billions of kilos are well within our purview. As DNA-marked textiles proliferate throughout the world supply system, more and more retailers, distributors, and others are able to authenticate these marked items and assure their customers of their identity and authenticity. Federal agencies and large retailers have an interest in DNA marking of textiles, since we can provide the very first lock-tight opportunity to ensure that the textile label claims are real and that our national trading partners live up to their agreements.

Although it’s at an early stage, we were very anxious to share with you the news that we had signed a term sheet with a provider of plastic raw materials or polyolefins. Today’s global polyolefin market has the size of about 140 billion kilograms per year. This is a tremendous opportunity in a new very large market vertical. With the potential to impact industries from automotive to piping and to medical devices. And last year, we announced an agreement to mark copper for a large energy supplier in Europe.

Today, I’m pleased to report that our customer, Vattenfall, has reported an 85% reduction in metal theft in the areas marked with our DNA. When our DNANet product has been used to mark property in concentrated urban areas, we have examples of reductions in burglary of upto 90%. We really couldn’t ask for a more effective product.

Our cash-in-transit customers have reported a 75% reduction in cash losses, and more than a 50% reduction in attack rates. Recently, we announced the conviction of our 88th criminal, who committed cash theft from British ATMs, a very tangible ROI was clearly made in this case in the return of $40,000 in stolen cash to our customer.

Now, cash-in-transit was one of the first markets we penetrated, and we consciously chose this market as it offered proof of principle and helped us to build the reputation we have today for sound technology, reliable products with forensic authentication, and the ability to link criminals to their crime.

We are very proud of our Military and Government programs and our team that is leading these efforts. To date, we have 30 companies marking products each with a unique DNA mark that must be replaced annually, adding a time spent to overall security. Included in that list are now eight original component manufacturers and one of the top four defense contractors.

Last week, NASA’s Jet Propulsion Laboratory, a legendary facility with influence throughout the largest defense contractors announced that it has begun training on SigNature DNA authentication to ensure authenticity of parts entering its facilities. JPL will also be including our platform and it’s highly thought-of training sessions throughout NASA and in its private contractor relationships.

The last two weeks have seen some very strong winds on our backs originating from the Federal government. On May 6, the Federal Register published new federal regulation governing all the defense contractors. They are known as the DFARS, or Defense Federal –Acquisition Regulation Systems. Now these results arguably implement the strictest anti-counterfeiting federal legislation in history. Suppliers, particularly prime contractors must implement anti-counterfeiting systems or face consequences, and these are consequences (inaudible). Prime contractors must flow down the anti-counterfeiting systems to their suppliers, including some instances of commercial, off-the-shelf products beyond only those that meet military specifications. In our opinion, SigNature DNA will prove capable of fulfilling many of the requirements of the new legislations, and we have already demonstrated this successfully by marking parts under the current DLA program. In a related, but independent development, the U.S. House of Representatives, Sentate, Armed Services Committee called for a report on DNA marking of microelectronics from the Defense Department, should point out that was from the house.

The language provides further that the Department of Defense will evaluate expanding anti-counterfeit measures to additional classes of technology that are deemed high risk, an analysis of counterfeit alerts and problem advisories in the Government Industry Data Exchange Program, and a description of the Department of Defense efforts to collaborate with the defense industry on the development of standards associated with counterfeit parts risk mitigation.

Now here, the explicit mention of DNA marking in the Congressional document is really quite a breakthrough. Currently, Applied DNA is the only company DNA-marking parts for a federal agency.

Now, I hope that this has helped you to understand our value proposition and that you can feel the excitement here at Applied DNA Sciences. From cotton fibers to missile payloads, we have the technology to mark and authenticate it all, leading to a safer and more secure world for all of us.

Now it is my pleasure to introduce Karol Kain Gray, our CFO, who will review our performance for the quarter. And then, we will take some of your questions.

Karol Kain Gray

Thank you, Jim. Good morning everyone and thank you for joining us on the call today. I would like to take a few minutes to review the 10-Q financials filed yesterday on May 12, for the second quarter of our fiscal year ending March 31, 2014. Before I begin, I have included three slides for your information. The first slide is the comparison of revenues by quarter and year-to-date. The second and third slides present a statement of revenues and expenditures for the three and six months ending March 31.

We closed the second quarter of our fiscal year reporting revenues of $637,000, which is an 85% increase from the same quarter of the prior fiscal year. These are the highest revenues we’ve been able to report for the second quarter in the history of the company. This increase was a result of revenues from the recently announced agreement with a provider of plastic materials, an increase in sales to suppliers of components selling to the Defense Logistics Agency, and the company’s efforts in the textile industry.

For the first six months of this fiscal year, we have generated over $1.2 million of revenue, an increase of 86% or $572,000 from the same period last fiscal year, and highest revenues we’ve been able to report for the first six months of any fiscal year. Approximately $390,000 of these revenues came from an increase in sales to suppliers of the US Defense Logistics Agency. We now have 30 contracts signed and to date we have had a 100% customer retention in this vertical market. Each customer must renew the contract annually in order to receive a new unique DNA mark. Each DNA mark is only valid for a 12-month period. In summary, this fiscal year-to-date, Applied DNA Sciences has recorded over $1.2 million of revenues. As of March 31, 2014, $416,000 has been recorded as deferred revenue, which will be recognized over the next 12 months.

Last year, for the same period, Applied DNA Sciences did not record any deferred revenue. The increase in revenues earned is an indicator that our sales are continuing to grow and demonstrates the company’s ability to close contracts in a shorter period of time. When we compare the first two quarters of this fiscal year, we had a slight increase of revenues of $39,792 or 7%.

I know many of you have inquired about our operating expenses. I would like to assure you that we continue to look at ways to control our costs and implementing efficiencies wherever we can. The comparison of operating expenses from the same quarter last year does not tell the whole story. Operating expenses for the three months ended March 31, 2014 increased by $811,000 compared to the same quarter last year. The increase is primarily attributable to highest salary expense due to growth in our staff from 38 as of March 31, 2013, to 52 as of March 31, 2014.

The number of employees has only increased slightly since the third quarter of 2013. We experienced an increase in our research and development expenses due to our upgraded laboratory space in our new corporate headquarters. We continue to focus our efforts on research and development projects to support the expansion of the company's new market opportunities.

The company incurred a net loss of approximately $9 million and generated negative operating cash flow of $9.3 million for the six-month period ending March 31, 2014. The $9 million loss includes non-cash adjustments of approximately $4 million, which includes a loss on the change in the fair value of warrant liability of $2.2 million, and stock-based compensation of $1.65 million. These non-cash items had no impacts on our liquidity.

At March 31, 2014, the company had cash and cash equivalents of $1.98 million. Before I return back – report back to our CEO, I would like to spend a few minutes discussing the amended 10-K for fiscal year 2013 and 10-Q for the first quarter of 2014, which was recently filed with the SEC. As I stated in our last call, Applied DNA Sciences has been classified as an accelerated filer. It is important to note there is no change to the financial information provided in the initial 10-K or 10-Q filings.

The company was a smaller reporting company for fiscal year 2013, subject to slated disclosure requirements afforded to a smaller reporting company. When the company is required to exit as a smaller reporting company, which Applied DNA Sciences did at the end of fiscal year 2013, it may continue to provide scaled disclosure as a smaller reporting company through the filing of the annual report, but as an accelerated filer, it is required to include an Auditor Attestation Report on the company’s internal controls.

Our public float as of March 31, 2013, was in excess of $75 million. As a result of the company’s transition from a smaller reporting company to an accelerated filer at the end of fiscal 2013, the company was required to include the Auditor Attestation Report on internal control over financial reporting. At the time the company filed the Original 10-K in December 2013, we believe that the contents of the original 10-K were governed by the disclosure requirements applicable to a smaller reporting company and omitted the Auditor Attestation Report required for an accelerated filer. Thus, the amended 10-K and 10-Q were filed in early May. It’s important to note there was no change to the financial information provided in the initial 10-K or the 10-Q filing. I appreciate your time and I would like to now give our CEO, Dr. Hayward an opportunity to address some of your questions. Thank you very much.

James A. Hayward

Great, thank you, Karol.

Question-and-Answer Session

Debbie Bailey

Our first question, what is your most important low hanging fruit in terms of gaining revenue?

James A. Hayward

Well, this one is straight forward. In the supply chain assurance area, marking and authentication of cotton and other large textiles as well as marking of industrial materials such as copper and plastics are our immediate goals, and we have marketing operations already underway in all these verticals with multiple customers and potential customers in each moving into authentication along the supply chains and finished products, we will reach that to bring additional revenues to Applied DNA Sciences. And as I explained earlier, the more products marked with DNA, higher the demand for authentication all along the supply chain. That is increasing the amount of marked DNA products in the universe. In the physical security verticals, anti-theft products such as DNANet, home asset marking, and our Sentry 500 spray have demonstrated good traction and an immediate benefit in Europe and are gaining attraction in U.S. Cash and valuables in transit also continues to expand from the UK market across all of Europe.

Debbie Bailey

What are the margins on your various products?

James A. Hayward

Well in general, our cost of materials is very low. The product we’re making is used at very, very low levels. However, as a biotech company, our fixed and variable costs tends to be frontloaded. Therefore, with time and scale, we think our margins will certainly reap the benefits of both these factors. Our margins are fundamentally pharmaceutical in nature and very advantageous to our shareholders.

Debbie Bailey

Why do you rarely disclose numbers on your announcement?

James A. Hayward

Well, in fact we do disclose numbers when we receive permission. The problem is that doesn’t happen very often. Many of our customers ask for confidentiality when we make these announcements, not only in numbers, but sometimes even in names. We are a security company, and certain constraints come along with the kinds of customers we are likely to sign.

Debbie Bailey

Karol, I believe this one is for you, what is the breakdown of revenue?

Karol Kain Gray

Thank you, Debbie. Last year, for an example, 55% of our revenues came from the electronic companies providing a certain type of electronics to the military, 26% from the cash and valuables in transit business, 5% from textiles, and the rest from a variety of areas such as branding and grant activities. For your information, the second quarter of 2014 military-related revenues accounted for approximately again 46% of total revenues for the quarter, textiles accounted for 11%, and our cash value in transit for 9%.

Also, for the second fiscal quarter, approximately 50% of our business was in the U.S., 30% in Europe, and the remainder in other parts of the world such as Asia.

Debbie Bailey

Do you foresee needing to rent or build more space in the immediate future, if so when?

James A. Hayward

Less than a year ago, we moved into our current location, which is really state-of-the-art and perfectly suited to the work we do. We have plenty of office laboratory and production space. At that time, we updated all the facilities, which we believe should be adequate for the foreseeable future.

Debbie Bailey

What are you doing to raise company awareness in the public market?

James A. Hayward

A lot. We maintain active efforts in investor relations, media relations, government relations, social media, and our web presence. In the last 18 months, no less than 92 nature articles have been written about [your] (ph) firm. We are active and maintain accounts in Facebook, Twitter, YouTube, Flickr, (indiscernible). Senior figures in the company is (indiscernible) conferences in all major verticals, having established reputations as thought leaders in those spaces, and I’m very proud of our position as thought leaders, and we are thoroughly recognized for that position.

Senior management also appears at four or five large investor conferences each year, and issues approximately 40 press releases each year.

Debbie Bailey

What do you expect to be the next evolution of your technology?

James A. Hayward

Well, we are working on several tracks at once, and the potential is as both a businessmen and a scientist, really quite thrilling. If I had to pick one, I believe real-time forensic reading of our DNA marks in the field will be an enormous breakthrough for our business and for the safety of the world economy and for the ease of working with a (indiscernible) unit.

Debbie Bailey

How big is your market?

James A. Hayward

The impact of the counterfeiting market on a global economy has been estimated to be on track to reach $1.7 trillion, and almost (indiscernible) number by 2015 according to The International Chamber of Commerce. In addition to the loss of sales and damage to IP, this figure includes loss of jobs and (indiscernible). Our platform produces an ROI end market in both of the private and public sectors. As can be seen in our relationship with DLA, especially. A second way to gauge the market is by assessing the anti-counterfeiting spending that industries – in industries rather where the spending is publically known. For example, globally in pharmaceutics, the anti-counterfeiting spend is about $80 billion annually. We think that this maybe taken as an indicator of the spend in other verticals such as electronics and industrial media.

Debbie Bailey

How many sales peoples do you have?

Karol Kain Gray

Currently, we have seven sales people on staff.

Debbie Bailey

What are you plans for growing the sales force?

Karol Kain Gray

Well, we’re planning to grow sales in military, textiles, sports memorabilia, and physical security.

Debbie Bailey

How do you compensate your sales people?

Karol Kain Gray

We compensate our sales people by paying them salary and commission.

Debbie Bailey

And about how long does it take to train a sales person?

Karol Kain Gray

I would say, approximately three to six months.

Debbie Bailey

Are you looking to hire more sales people outside of your core industry?

Karol Kain Gray

Always. Certainly, we want to find the right person we would pursue the present opportunities.

Debbie Bailey

And our last question, do you foresee any future government grant?

Karol Kain Gray

Yes, we do. In the past, we’ve been awarded grants from NDA and DLA and have proved durability to secure and successfully execute grant projects.

James A. Hayward

Thank you very much everybody. And we look forward to hearing from many of you, and potentially meeting you. We look forward to our next Investor Call. Thank you for your time.

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