Neogenomics, Inc. (NASDAQ:NEO)
Q2 2014 Earnings Conference Call
July 17, 2014 11:00 a.m. ET
Douglas VanOort - Chairman of the Board of Directors and Chief Executive Officer
Steven Jones - Executive Vice President, Finance
George Cardoza - Chief Financial Officer
Steven Ross - Chief Information Officer
Jerry Dvonch - Director, External Reporting
Maher Albitar - Chief Medical Officer and Director, R&D
Amanda Murphy - William Blair
Drew Jones – Stephens
Debjit Chattopadhyay - Roth Capital Partners
Jack Wallace – Sidoti
Greetings, and welcome to the Neogenomics' second quarter 2014 financial results conference call. (Operator Instructions) I would now like to turn the conference over to your host, Mr. Doug VanOort, Chairman and CEO, Neogenomics. Thank you. Mr. VanOort, you may begin.
Thank you, Manny [ph] and good morning. I'd like to welcome everyone to Neogenomics' second quarter 2014 conference call, and introduce you to the Neogenomics team that is here with us today.
Joining me in our Fort Myers headquarters, we have Steve Jones, our Executive Vice President for Finance; George Cardoza, our Chief Financial Officer; Steve Ross, our Chief Information Officer; and Jerry Dvonch, our Director of External Reporting; Dr. Maher Albitar, our Chief Medical Officer and our Director of R&D, is joining us from our Irvine, California lab.
Before we begin our prepared remarks, Steve Jones will read the standard language about forward-looking statements.
This conference call may contain forward-looking statements which represent our current expectations and beliefs about our operations, performance, financial condition and growth opportunities. Any statements made on this call that are not statements of historical fact are forward-looking statements. These statements, by their nature, involve substantial risks and uncertainties, certain of which are beyond our control. Should one or more of these risks or uncertainties materialize or should the underlying assumptions prove incorrect, actual outcomes and results could differ materially from those indicated in the forward-looking statements. Any forward-looking statements speak only as of today, and we undertake no obligation to update any such statements to reflect events or circumstances after today.
Okay thanks, Steve. We'll begin our call today with some brief remarks about performance in the second quarter of 2014 and then provide an update of some key initiatives including our recently announced acquisition of Pathologic. Steven will then discuss our financial results in more detail.
We’re very pleased with Neogenomics performance in the second quarter of 2014. Test volume growth was 40%. Revenue growth was 32%. Gross margin improved by 360 basis points. Cash flow from operations was a record $4.3 million and a number of important growth initiatives were readied for lunch.
In addition, just after the end of the quarter we completed our first acquisition. Our teams are committed in working hard to position Neogenomics as one our industry’s premier cancer-testing laboratories. Steve will describe the financials in more detail in a few minutes, but I would like to provide some context for you.
The 40% volume growth compared with last year's second quarter actually exceeded our own expectations. The growth was broad based and was nearly equally split between each of the three sales regions across our country. Also noteworthy is that nearly a third of the growth versus last year came from new clients that started with us in the first half of 2014. We’re really proud of our sale team for that strong performance.
We believe the cancer-testing market is growing, but that our growth primarily reflects market share gains in the hospital and pathology markets as a result of our comprehensive cancer-testing menu and particularly because of our innovative molecular testing product line. In fact, molecular testing volume increased by 61% compared with last year and now represents our second largest testing department. Clearly, innovation continues to be an important factor driving our performance.
Volume growth also reflects our commitment to deliver consistently strong service levels. Still our customer acquisition rates were strong, customer retention rates also continued to be very high.
Revenue growth was 32% despite an approximately $1 million reduction in revenue recorded as a result of the National Correct Coding Initiative or NCCI matter relating to the billing for Medicare FISH test. The governmental agency responsible for clarifying this rule, CMS, has still not provided any guidance. And so we recorded revenue based on what we believe to be the most conservative interpretation of this rule. Had we used the different interpretation, revenue growth would have been reported as 39% compared with last year.
Despite the 5% reduction in average price per test all from the NCCI matter, we were pleased that incremental gross profit was strong. Gross margins were up to 49.5%, an increase of 360 basis points from the second quarter of last year.
Cost per test declined by about 12% compared with last year's second quarter and productivity metrics improved once again, as the number of tests processed per lab employee increased by over 10% in the second quarter compared with last year. In fact, cost-of-goods-sold per test hit a record low in the quarter. We’re extremely proud off our operating teams for that performance. Indeed it’s a testament to the commitment to the excellence that all of our employees display on a daily basis.
Selling, general and administrative costs increased significantly as they grew by 45% compared with last year. This is a far greater increase in spending that we’re typically comfortable with. However, we believe that about half of the increase in spending in SG&A relates directly to specific growth or cost reduction initiatives. For example, on the growth side we increased sales and marketing expense by 60% compared with last year as we expanded our sales team and invested in better sales and marketing infrastructure to drive growth on a sustainable basis.
We also invested to build an infrastructure and capability for clinical trials, develop our next generation sequencing platform, develop and launch our next generation of digital pathology products and develop our new proprietary prostate cancer test. We also invested to position ourselves for future cost reductions with additional spending for information technology, for lab automation and other activities. So, while the SG&A cost increase was high, we believe that payback on these investments will be very strong.
Profit was $274,000 or 1 penny a share. Incremental profit versus the prior year was obviously impacted by the $1 million reduction caused by the unresolved NCCI matter and by investments in growth initiatives that we believe will bear fruit in coming quarters. Even the sizable investments we made and expense, we’re very pleased with the level of profit we recognized in the quarter.
During the quarter, we fully completed a comprehensive renovation of our Port Myers lab and it looks great. Our new old [ph] lab now provides us with both increased capacity in a more efficient and cost-effective workflow. In order to accommodate our rapid growth, we also opened a small lab in Fresno, California as we’ve increased our cytogenetics technologist team. In addition, we’re currently expanding our large Irvine lab facility to allow for continued growth in molecular test volume.
In previous investor call, I described our key areas of focus. We continue to make good progress in achieving our objectives and this morning I'll briefly review a few of these as well as comments on our recent acquisition.
As you know, one of our key areas of focus for 2014 is to get lean. We’re pleased that as a result of a variety of initiatives we drove our cost-of-goods-sold per test down by 12% in this past quarter. However, frankly we’re a little disappointed that we’re unable to implement several cost reduction initiatives that we had planned to execute during the second quarter. These were delayed for several reasons. One of which was that we had to keep up with the record volumes while maintaining our high service levels. The good news is that we’ve about number of process improvements that haven’t yet been implemented. We’re looking forward to executing them now in the third quarter particularly in our FISH and molecular departments and we expect to realize gains from these activities as the year progresses.
We also expect to continue to drive additional volume of testing through our labs and to realize the economics of deal that will result from this and from continued workflow improvements.
Our goal is to reduce our cost-of-goods-sold per test by 8% to 10% for the full year 2014 and 2015 and continue to believe that we’ll be successful in reaching this goal.
Growth is another key focus area for our company. We're obviously pleased with the volume growth of 40%-in quarter 2 and especially pleased that no one client or group accounted to the bulk of that growth, as it was widespread. We don’t want to promise that we continue to sustain that rate of growth forever, but we do believe that our targeted 20% plus growth rate is quite achievable through 2015.
Our sales team has continued to perform very well and their productivity is strong. On average during the second quarter we had 27 sales professionals in the field and we added training, manage care and product management resources as a way to help sustain the high rates of productivity.
New products continue to be an important driver for growth. So far this year we added 30 new molecular and FISH based tests to our already comprehensive testing menu. This last week, we announced a significant expansion of our product line with 23 new and different cancer profiles based on next generation sequencing. These 8 hematologic profiles and 15 solid tumor profiles are very compelling. The profiles contain both molecular test as well as FISH test when appropriate.
As many of your know, molecular testing and cancer therapeutics are evolving quickly and it’s difficult for many physicians to keep current with the literature.
Our profiles which we branded as Neotype [ph] profiles are an up-to-date panel of tests targeted to specific diseases. These profiles include those driver genes our medical team considers to provide actionable information to clinicians. We believe this approach is also the most cost-effective approach for our healthcare system. Of course, our molecular test can also be ordered individually.
We believe that our innovative products we’ll have important benefits for physicians and their patients including better information about potential response to currently approved drugs and investigational therapies and the ability to test using smaller amounts of tissue or fluids. Importantly, we believe use of this technology will also allow us to become more efficient as our volume of testing increases.
We just launched this new line of next generation sequencing services and it’s too early to forecast the demand. However, we think this is important in growing area of oncology testing and we intend to be a leader in this area.
Importantly, we’ve also invested significantly in digital pathology and immunohistochemistry and planned to launch a substantially improved digital pathology service in the next several weeks. This product is important as we continue to rain out our service offering to be a one-stop shop for pathology and hospital clients around the country. It also helps us in the important clinical trial area as we can read and interpret results from around the world and any of our locations.
Diversifying our business is also an important area of focus as we balance our risk profile and take advantage of new opportunities and building our clinical trials business is one of our important initiatives in this regard.
As part of our exclusive strategic alliance with Covance's Central Laboratory we are jointly bidding on a number of request for proposal and are building our book of business.
Although we realize only a small amount of revenue for clinical trials this past quarter, we expect that to ramp up smartly over the coming quarters.
We continue to be on track to expand our capabilities to jointly provide anatomic pathology, histology and specialty lab testing services on a worldwide basis as we help install capabilities later this year at Covance locations in Shanghai, China and Geneva, Switzerland.
We’re also engaging directly with several pharmaceutical firms particularly in the area of molecular testing based on our next generation sequencing testing platform. These relationships take time to develop, but we feel like we’re making good progress in this area as well.
Innovation offers us a number of interesting diversification opportunities. One of the more exciting of these opportunities is our development of a proprietary prostate cancer test. As you may remember, this is a molecular test performed on blood plasma and urine instead of prostate tissue biopsies. The two goals for this test are to distinguish the presence of cancer versus DTH in patients and to distinguish high-grade from low-grade cancer in those patients with prostate cancer. We believe our test can help make this determination without the patient having to undergo a painful and invasive biopsy procedure. We decided to rebrand this test as NeoLAB prostate. LAB is an acronym for Liquid Alternative to Biopsy.
We made good progress during the first quarter as we helped two advisory board meetings published an abstract based on data from 319 patients and formed a team of academic advisers to consult with us and furthering the test development. We’ve now made the test available for ordering with the condition that the ordering physician must provide clinical utilization and follow up data to us as part of the testing process. We’re targeting to test another 6 to 800 patients in this manner and to add another 200 patients as part of the trial underway in Europe. Overall, this new NeoLAB prostate cancer test continues to be the most promising proprietary test development initiative we have underway.
Yet another growth and diversification initiative is now being implemented with the acquisition of Pathologic. This was the first acquisition for Neogenomics and we’re excited about it. As you read in our press release a couple of weeks ago, Pathologic has a strong reputation for specialized anatomic pathology services and is a great complement to Neogenomics specialized cancer genetic testing.
Pathologic has many tests that are complementary to Neogenomics and Neogenomics has many tests that are complementary to Pathologic. We plan to offer Pathologic tests to Neogenomics existing client base and to offer Neogenomics tests to Pathologic existing client base. We’re particularly excited about offering our world-class molecular menu and industry leading FISH and cytogenetic services to Pathologic’s existing client base. The team of pathologists at Pathologic is excellent and we’re excited about combining the skills of our medical teams for the benefit of existing clients as well as for our emerging clinical trials initiatives.
While this is the first acquisition that Neogenomics has executed, I personally have quite a bit of experience acquiring an integrating laboratory having completed many acquisitions over the past 30 years. I’ve learned first hand what works and what doesn’t work in integrations and we plan to integrate this business with deliberate [ph] and thoughtfulness.
We’re keeping the main Pathologic Laboratory in West Sacramento, California open and hope to retain all of the talented employees working in that facility. We believe that lab is significantly under capacity and can handle more volumes at relatively low levels of increased cost. While there will be some cost-related synergies, we believe the main upside is the cross-selling revenue opportunity and the opportunity to fill up the West Sacramento Laboratory.
Pathologic is currently operating at a small monthly loss as a result of being under-utilised, but we’re committed to making this business profitable by early 2015. This acquisition was not very large and was both opportunistic and strategic. We’re genuinely excited about the opportunities this new capability offers to our employees, clients and shareholders.
Before I conclude my remarks, I want to comment about the NCCI FISH edit matter. We had hoped for some clarifications so that we could provide you with an update on this NCCI FISH edit matter. As background, the National Correct Coding Initiative, a department within CMS, issued a new guideline in December of 2013, concerning FISH reimbursement that has created significant confusion in the laboratory industry.
We tried very hard to explain the issue to CMS and on March 5, the ACLA and the industry received the assurance from CMS that a clarification would be provided shortly. After repeated followup unfortunately as of today over four months later we’re still waiting.
The impact of this confusing rule is significant. Had we built and accounted for FISH testing as before we would have realized an additional $1.05 million in revenue and an additional $870,000 in net profit in quarter 2. But because the rule is confusing and contradictory we’ve chosen to build an account on a conservative basis. We believe this is the right thing to do given the situation. We hope there’s clarification soon and we’ll issue an update as soon as CMS provides clarification to the industry.
In summary, we’re very pleased with the company’s performance in quarter 2 and we’re equally excited about the opportunities that lie ahead for Neogenomics. In fact, our team has never been so excited about the possibilities. Neogenomics is growing and gaining market share. We are getting leaner through good processed management and control and we are developing new products and businesses for the future. This is an exciting for precision medicine in general and for the benefits for cancer patients and for our healthcare system and an even more exciting time for us at Neogenomics as we continue to carve out our reputation for leadership in our field.
I will now turn it over to Steve to comment more fully on our financial results.
Thanks, Doug. I'll start by reviewing some of our financial and operating metrics for the second quarter and then we will open it up for questions.
Second quarter revenue was $20.7 million, a 32% increase from Q2 last year. Test volumes increased by 40% and average revenue per test declined by 5.3% to $455. The NCCI FISH matter reduced average revenue per test by $32 with other mix changes increased by $7 thus we only netted a $25 reduction for the quarter.
For those of you who have followed these things closely, we believe the NCCI FISH edits are now pretty well fully based into our average unit price. In the absence of any further changes to our [indiscernible] or a reversal of the NCCI FISH edit and excluding the impact of the Pathologic in acquisition, we expect the average revenue per test is settled at around $450 for the balance of the year.
Gross profit was $10.2 million, a 43% increase over Q2 last year.
As Doug discussed, we improved our average cost-of-goods-sold per test by 11.7% versus last year by increasing lab productivity, realizing leverage from higher volumes and from a variety of cost reduction initiatives. This more than offset the 5.3% reduction in average revenue per test, which in turn allowed us to drive our gross margin to 49.5% in the quarter. We drove 60% or $3.1 million of the incremental $5.1 million of revenue on a year-over-year basis to the gross profit line.
Turning now to SG&A. Total sales and marketing expenses increased by $1.2 million or 60% versus last year as a result of investments and more sales and marketing personnel and the incremental commissions on the strong increase in revenue.
General and administrative and R&D expenses increased by $1.8 million or 39% versus last year primarily as a result of more personnel and personnel-related cost for billing and information technology. The increased depreciation adds additional bad debt reserves on the incremental revenue.
Net income for the quarter was $274,000 or $1.00 a share and adjusted EBITDA was $2.1 million, up 16% from last year.
We finished the second quarter with 364 full-time equivalent employees and contract doctors. The Pathologic acquisition added an additional 65 employees in early July. Thus we now have approximately 430 employees.
Our accounts receivable balance, net of allowance for doubtful accounts was $18.8 million at June 30, which is $500,000 less than where it was at March 31. If you’re scratching your head right now, that because this is definitely unusual given our growth.
We grew revenue by $2.5 million or 14% sequentially from Q1 and still managed to collect more than we booked in revenue. This is truly an awesome accomplishment by our billing department and we’re deeply thankful for having such an extraordinary team of dedicated professionals. As a result our AR balance expressed in terms of day sale outstanding was 83 days as of June 30 down from 95 days at March 31 and from 103 days earlier in the year.
This superior level of collections allowed us to generate $4.3 million of cash flow from operations in just one quarter, which is almost double of our previous record in a quarter. This in turn allowed us to ponder around half of the recent Pathologic acquisition with cash generated in the quarter.
We had $5 million of cash on June 30 and $8 million of availability under our working capital line of credit for a total liquidity of $13 million at June 30 versus $10.5 million at March 31. We used $5.9 million of this liquidity on July 8 to plan the Pathologic acquisition. We purchased $2.7 million of property, plant and equipment in the quarter. However, we were able to lease finance approximately $1.6 million or 60% of this amount, thus the net use of cash from investing activities was only $1.1 million. Now that the Fort Myers Laboratory’s renovation is completed, we expect capex to return to more normal levels.
At this point, I would like to close down our formal remarks and open it up for questions. Incidentally, if you are listening to this conference via webcast only, and would like to submit a question, please feel free to email us at email@example.com during the Q&A session and we will address your questions at the end if the subject matter hasn't already been addressed by our call-in listeners.
Operator, you may now open up the call for questions.
(Operator Instructions) Our first question is from Amanda Murphy of William Blair. Please go ahead.
Amanda Murphy - William Blair
Thanks, good morning.
Amanda Murphy - William Blair
So, thanks for all the answers on NCCI, that’s really helpful. Obviously, there have been some positive proposals around this for the near year. So I’m curious. I know they were reviewing that code. Do we know wherever you stand with that, is that something that they punted enough here at this point or are we.. basically once we get to this year do we have pretty decent visibility than going forward into what the [ph] might be?
That’s a great question. Thanks, Amanda. There was a 609 page proposed rule that came out of CMS on July 3. We studied in a fair amount of detail and there is a lot of light in the rule that have [ph] concern. If the proposed changes to the practice extends relative to that units remain in the actual final rule that will get published later this fall that are in that proposed rule, then it would suggest about a 30% increase per billing unit for the technical component, FISH testing perform for Medicare beneficiary and similarly about a 5% increase in the technical component flow cytometry testing for Medicare beneficiaries. They also stated they were not going to impose a cap on any of the rate to the physician fee schedule with the rates in the inventory payment classifications schedule which is in place for hospitals, which was the subject of the proposed rule last year. So now we feel very good about the proposed rule that is come out of Medicare. It’s impossible that.. let’s say that it will go through exactly as suggested in the final rule, but generally speaking a lot of thought goes into Medicare rule makings and they generally do try to get it right. We feel like we get to winded our back on this one but until we see the final rule we won’t know for sure.
Amanda Murphy - William Blair
Got it. Okay. And then in terms of the guidance I’m just curious how you’re thinking about the puts and tests on the revenue line. So, obviously you got Covance which is ramping up potentially and then new next gen panels that are out. So, just curious how you’re thinking about those versus [ph] within the revenue guidance.
We don’t like to break our guidance by product line because these things generally tend to get little scramble as you move forward. We do believe we’re going to see a meaningful increases in CRO revenue as the year progress as a result of some of these contracts we previously then awarded to ramp up but we really do not have a place where we’re ready to comment on that specifically. The next gen sequencing test is a week old now and we need to get some more traction in the industry. We stated probably on a number of occasions that molecular is our fasting growing component of our revenue stream. And indeed the molecular panels are growing faster than molecular as a whole and so we feel like we’re really positioned extraordinary well with the next gen sequencing panels, we rule out. They are based on the feedback we’ve gotten from clients. They are sort of exactly like clients were looking for and so we’re pretty excited about it, but I think we want [ph] for another quarter before we talk specifically about what’s possible there.
Amanda Murphy - William Blair
Got it. Okay, just last one on Pathologic. Obviously, that’s a little bit of a different business and kind of you did perfectly been in. So, how do you think about as long you as you’re from revenue synergies and sort of competing in some pathology vis-a-vis from that as a pathology?
Yeah we feel very good about it, Amanda. So, as you know Pathologic’s primary business is located in Northern California. We do not have lot of clients in that area. So, we’re looking forward to grow in that area. What we’re also looking forward to frankly is leveraging Path Logic’s product line for the benefit of our client. They have some terrific specialized pathology services that many our clients do not offer and we believe that they would like to utilize those services. They also offer a number of other products that our clients have been asking for. So, we believe that there is a nice revenue synergy on that side and as we said in our remarks offering our molecular and FISH based tests to existing pathologic clients we think is something that we can do very, very quickly. So, we’re looking forward to integrating their product line with ours in the market place.
Amanda Murphy - William Blair
Got it. Thanks very much.
Thank you. Our next question is from Drew Jones of Stephens. Please go ahead.
Drew Jones – Stephens
Good morning, guys. Thanks for taking the questions.
Drew Jones - Stephens
Sir, you talked a little bit about a lot of the growth coming from new clients here over the past for the past six months of the year. Can you give us some characteristics of what those new accounts look like and is it global with it still [ph] take only where these guys are showing interest?
Yeah, Drew thanks for the question. So, as I mentioned the growth was fairly broad based and it was as I said exceeded our expectations. There was a fair amount of hospital growth in there where we’re able to penetrate a number of hospital systems throughout the South. There was some big pathology client road both in the central part of our country as well as in the West and surprisingly some of our biggest territories even in the North East also grew pretty dramatically. So, it’s very broad based. I think our sales representatives are having a good time getting into clients and talking about the new testing that were offering them. So, our molecular testing menu is opening a lot of doors for us. We’ve got new tests that were introducing literally every two or three weeks and our clients are interested in our capabilities and the new testing technology. So, we’re able to penetrate a lot of new clients and frankly there are number that were just waiting to bring on board as soon as we have a digital pathology platform that we feel very confident about and that should be pretty soon.
Drew Jones – Stephens
And then you talked a lot about the investments that you’re making, 2014, obviously a year of investment. Can you give us a lookout to maybe where we exit 2015 and what the EBITDA profile might look like at that point in time?
No, we generally have a policy. We don’t give guidance until the February timeframe for each year. There is so many variables. We’ve got to get our arms around the pathologic integration and see just what is that kind of revenue search we can [ph] out of that to get some better feel for where the prostate test is going to shake out and some of these new molecular panels. There is a lot of really interesting new stuff coming down the horizon and we’re as excited as we have ever been about the growth prospects of Neogenomics, but it would be [ph] of us to try to quantify this at this particular time.
Yeah. I just maybe add to that [ph] on what Steve said is that we’ve placed a lot of beds. None of these are huge beds, none of these are the farm [ph] beds, but each one of them could be pretty significant. So next generation sequencing, digital pathology, prostate cancer test, clinical trials.. we have a lot of very interesting things going on and that’s why we feel pretty confident talking about the growth rates. Everything I think you can count on, Drew, is that we’re very process driven and that we plan to drop a fair amount of that under normal circumstances to the bottom line.
Drew Jones – Stephens
Great. Thanks guys. Congrats.
Thank you. Our next question is from Bill [ph] of Craig Hallum.
Good morning, guys. Congratulations on a solid [ph] quarter. Can you just give us a little bit more color about the enhanced digital pathology offerings sort of what how that is different than what you might have today? How it’s different from what else to that of market etc.?
Yeah, we have never really been a company that’s focused a lot on immunohistochemistry and digital pathology. As I think you know we have been focusing more on molecular and FISH and cytogenetics and flow cytometry. So this is a product line that many of our clients use and many of our clients use it as sort of an anchor for sending all of their testing to the provider that has the best digital pathology platform. And so we have been working on this literally for years. We believe that we’ve made some breakthroughs recently and the platform that we have allows clients to perform an interpretation for certain tests using our digital pathology platform where they can actually do the interpretation. And so it’s a very good complement to our tech only platform. We are actually pretty excited about for the use in clinical trials as well. We intend to have clinical trials being done around the world in which our pathologists will do the interpretation, and in the future, we think pathologists would be more confident in interpreting results at least preliminarily based on the image as opposed to looking at the glass. So this is an important area for our growth in the future, and we think that not only will we gain direct digital immunohistochemistry business but as a one stop shop then, we will be able to pull through other business with it.
And in terms of just client sending to the lab with the best digital pathology platform, what kind of defines that, is it the quality of the image or is it tools around the image, what makes a product the best digital pathology product?
Well, a lot of things, it’s the speed at which they can perform an interpretation, it’s the image quality, it’s some of the other tools that will help them provide that interpretation, ease-of-use, all of those kinds of things.
And then just a clarification on the guidance, I think I know the answer but I want to be crystal clear. Do you just feel that you continue to interpret the NCCI edits as you have been, so the guidance assumes no change?
Yes, that’s correct. As we stated in our Q1 conference call, should the NCCI edits be resolved favourably or overturned it would add somewhere on the order of $3 million, probably a little bit more than that now based on our volume growth, so revenue for the year end $0.04 or so a share of net income. If they are overturned and they are overturned within the window where we can go back and build for the pieces we never built for originally, we would immediately go back and built for all those pieces. And we have one year to do that under Medicare regulations.
And then just the last thing, I know you just did your first acquisition but just what are your thoughts on acquisitions in general going forward? I mean do you need a considerable amount of time to sort of digest this and see how you did with your first one before you do anything else or how should we think about that opportunity?
Well, Bill, this Path Logic acquisition was important for us, but it was also quite small and contained. So we believe that the industry will consolidate. And we believe that we will be a good consolidator and we’re going to be pretty active in looking at possible opportunities such as we have talked about in the past.
The next question is from Debjit Chattopadhyay of Roth Capital Partners.
Debjit Chattopadhyay - Roth Capital Partners
So when you think about the Path Logic acquisition, you mentioned on the call, they are riding [ph]– saw small operating loss for a month, what is the gross margin for that revenue segment that’s coming in, and how does it compare with you also right now?
So currently they are operating around 30% gross margin which is not too far outside the norm for that particular business. We believe that by doing that up with capacity, additional capacity utilization that we can get those in to the high 30s and possibly into the 40%, this is generally speaking a lower margin business in our core business but what it is, is the gateway for us. It opens the door to a whole lot of specimens that we can get that maybe are going to other labs right now. So all Path Logic is fine to a molecular cytogenetics FISH testing, we think we can pull that through and so pull through of the higher margin work will get their margins on a collective basis, more in line with where we are.
Debjit, let me just build in, just very briefly by saying that the acquisition of Path Logic effectively doubles our pathology staff and we really needed to add to our pathology staff as we consider what’s going to happen with clinical trials. We think our staff is going to be very busy interpreting results for these clinical trial projects around the world and we simply needed more pathologists and more specialized pathologists and that's going to be very helpful I think and carry decent margins.
Debjit Chattopadhyay - Roth Capital Partners
On the next-gen sequencing, I mean you had mentioned in your molecular testing, the faster growing segment, and within that the panels are doing better than expected. So as you migrate the panels over to NGS, how do you see the gross margin shake out for the business? I would assume the gross margin should be going higher if you go – move to the NGS platform?
That’s a theory and I think we are going to have a lot of data – some of them we proved that the real or that we maybe didn’t prove it out but generally speaking next generation sequencing has much better data [ph] efficiencies than Sanger sequencing. When we run a panel using Sanger sequencing, we’re running a bunch of individual Sanger reactions. When we run a profile using next generation sequencing, we can generally run the molecular piece of the panel only one dash [ph]. And so you’ve got efficiencies on supply costs, you’ve got efficiencies on technologist time and what not.
Now it’s important to understand that all of our profile panels have some component of individualized test with them. There is not a profile that we have where it’s just one NGS run. I know lot of other companies in the industry are trying to sell that. We really believe that you need to add FISH when it’s appropriate to do so, even flow cytometry when it’s appropriate to do so. And in some cases, there will be other molecular modalities like fragment length analysis that are necessary to run in addition to next generation sequencing. Is there anything that you would add to that Dr. Albitar.
Just to point out that the volume is very important to be efficient and we are at the point that – our volumes justify [indiscernible] we always say in next gen you can use many things for one vision, two vision, at the same time you can use many visions or fewer regimes. We are at the point where the government regimes, multiple times a week and still be very cost effective due to our current volume.
Debjit Chattopadhyay - Roth Capital Partners
Then on the process emphasis, you mentioned that you are going to make it available. Do you have handle on what – I mean are you going to be charging for the customers or to run the test or this is going to be part of the clinical trial or the trial that you plan to run the 600, 800 patients, I want to be particularly clear on that?
So we have a formal clinical trial which is a blinded study going on in Europe which will be a couple hundred patients, we hope, by the end of the year. So – but we also have sort of an open enrolment going on right now, which is a part of a US based clinical trial activity, where doctors who want to participate can send samples in and we will run the samples, we actually issue a test report. We are not charging for that right now, but we are asking that in consideration for getting a test report back, they give a patient follow up data so that we can get at the clinical utility data which as you probably know is just essential to convincing the payer to do this. So the 600 to 800 patients we are going to do on the open enrolment study are – it’s not a blinded study per se, but it does get that the clinical utility, and we think the combination of these two aspects that where we go next will be very helpful for us, for the physician, the product, they can get kinds of data we need to have the payer discussions ultimately.
Debjit Chattopadhyay - Roth Capital Partners
In terms of your operating leverage, you basically are at a point where with the 40% volume growth that you had in the quarter – lot of issues to the bottom line or do you think 2014 you still continue to increase in G&A and really position it for 2015?
I think we feel like we are sort of on the edge of being the place where we are comfortable in terms of how much we are spending on G&A. We, as Doug mentioned, we generally like to see higher incrementals on a year over year basis dropping the operating profit. These were kind of decisions that we made to ramp up scale fast, to ramp up IT fast, to ramp up a lot of these other new product initiatives because there is opportunity in the marketplace. We are not somebody, not the kind of company that just let everything fly for extended periods of time. We will keep investing where there is very good growth opportunities, but at some point after you make the upfront investments, you get a lot of leverage back on that. And we are expecting to see a lot of leverage on those investments here, beginning in Q3 and Q4. Having said all that, we got to get through the year here before we can really fully assess what 2015 is going to look like.
Our next question is from Jack Wallace with Sidoti.
Jack Wallace – Sidoti
In terms of the client acquisition, I mean that was the third of the growth here in the first half of the year, you said, yeah, why are clients coming to let you – and then you pass this quick turnaround times, I guess just help me understand, what’s keep – getting them to come to the door and what’s getting them to stay?
Yeah, what’s getting them to come in the door is a whole number of different things. One is our comprehensive menu which we keep growing. The second is specifically the molecular testing menu which is a pretty innovative and that we think the most comprehensive for cancer testing in the market. Third is our tech only platform for FISH and flow cytometry, in particular which we think is among the best if not the best in the industry. We certainly have been at the longest of anyone in the industry.
I think another key factor is the consistency of our service levels, we are very rigorous about maintaining very high service levels and that primarily is turnaround time, but it’s also picking up the phone when someone calls, it’s jumping out an issue when there is an issue, all of that sort of thing. So it’s a variety of factors – in our business, this is a service business, you can – you have to do a hundred things, right every single day in order to have a good service. And so we tend to be very process oriented to make sure that we are consistently improving each of those hundred things all the time.
Jack Wallace – Sidoti
And then for the 30 clients that seem to be maybe not returning, are those – you are seeing to be a loss from an inventory standpoint or is that just the nature of having about 100 [inaudible]
So, Jack, we look at this really closely and we tend to look at retention rates in the larger clients, and I can tell you that when we looked at it for 2013 we lost four larger clients, two of those were because their parent company entered into contracts, that are required them to start sending somewhere else, one of those because of run out of business, and the fourth was legitimate service issue. When we look at this, we generally have 96% to 98%client retention rate on the larger clients. And the reason for that is our interests are totally perfectly strategically aligned. Usually the larger clients are participants in at least some aspects of our tech only program and that we are enabling the pathologists to expand their own menu of services that they can offer to their oncology – community based oncology clients and so we really work very hard to be the kind of laboratory that they can extend to our clients menu of services into their client base. And that has worked very well for us, it’s been the same strategy for the last 10 years and we are seeing continued traction with that same strategy and that’s why so many competitors are now starting to imitate us with their tech only offerings.
Jack Wallace – Sidoti
And then lastly here, just to go back to the operating leverage question, just going forward, you’re going to have some variable expense in selling obviously and then once you’ve gotten filled up majority of your molecular testing menu, just you can continue the next gen sequencing, that turns it [ph] to more process, you’re going to see likely the research development bigger variable as well, -- I guess most type of proportion of that of the operating costs are going to be coming from G&A and if so, what’s a good level to think about kind of the plateauing level?
So we look at this, there is a lot of different ways, we think it around $150 million of revenue, you can really begin to optimize your panels. We believe that SG&A and R&D as a percentage of revenue -- at $150 million of revenue should be in the mid, maybe a little bit to the high 30s. And so it would be our goal to get the company into that level. Between now and then we are investing a lot of growth initiatives and we’re going to have lumpy quarters. There are no such thing as smooth trends when it comes to when you are investing, when you are not investing. So we generally like to talk about those things as generalized areas over the course of the year and manage everyone’s expectations about what the incremental profitability is in one quarter versus the next quarter, because of the lumpy nature of the investments.
Our final question comes from Frederick Copy [ph], a private investor.
A quick question on the going back to the plasma prostate test, you have mentioned, you spoke about domestic and global trial activity, and the conditional launch, and I was just wondering if there has been a re-assessment for the final launch that is anticipated for that? And two other things, the SVM based cytogenetic analysis system, and the SVM based automated FISH analysis system v2, do you anticipate implementing them to gain substantial cost savings and an opportunity for sub-licencing revenue in the future?
So we’re going to ask Dr. Albitar to take the first of those questions about where we are on prostate cancer and then I will come back to pick up the other two after that.
So for the prostate cancer, as Steve and Doug mentioned, we are planning in the domestic, the 600 to 800 sample testing, that we are offering the test as lab developed test. So the test literally is launched that it is conditional launching. So in that we are asking that the physicians were ordering these as to give us feedback on two things. One is the performance of the test, the second one is the utilization. We are collecting these on board, and frankly we have instructed to announce at this kind of conditional launching that we already started getting sampled. So we anticipate that 600 to 800 samples to be done in very short period and after that we will evaluate the details and make the argument for why the test is good, and it’s offering for [inaudible] helping recognitions in these tests. So until that time, we can’t say anything more at this time.
And with respect to the other questions, we license, it was in early prototype for SVM based cytogenetics analysis system when we entered into license agreement with Health Discovery Corp two and half years ago. We have spent a quite considerable amount of time and money further developing that. We do have what I would call an advanced data version of that, that we are using internally to get feedback from our technologists. This is quite a complex piece of software. We still have pretty good hopes for it but until we get our techs to embrace it and tell us that helps them do their job faster and better, it’s not something that we begin to start having any kind of sub-licensing discussions on. We do have the rights to sub-license it under our agreement with Health Discovery Corp and that would certainly be interesting if we can prove out the functional utility of the software in high volume working laboratory, but we’ve really just haven’t commented any further than that.
With respect to the SVM FISH system, we did file a patent on that, it’s not something we are using currently. It is something that we think there is some application for it but it’s a question of resource for us. We are working on the SVM cytogenetics system first and then I think we want to get quickly into the SVM flow cytometry system. At some point we will probably come back to FISH and see if we can help it make us more efficient in that areas.
So I have a couple of other questions that have come in via email here, that I just want to clean up before we wrap up. Can you talk what Medicare is of the percentage of payer mix after factoring in the NCCI FISH edits?
This is a great question. This is actually a nice silver lining for us. Medicare is now around 18% to 20% of our total payer mix as a result of our conservative accounting for this NCCI issue. Keep in mind that two years ago the expiration of the [TC grandfather] caused sharply reduced our billing mix, it literally moved 19% of our mix from Medicare into client – disappears to be moving around 5% to 6% of our billing mix over to Medicare as well. So when you consider that just three years ago Medicare was 43, 44% of our total health paying mix and they are 18 to 20% now. It effectively means that Medicare’s reimbursement policies will no longer be able to have anywhere near as being an impact on us, we have moving forward.
Next question is, we understand that the guidance you issued this morning was exclusive of any transaction related costs, and give us an idea of how much these costs were?
We have not received the final invoices for our services yet but in any acquisition you incur a fair amount of legal and accounting expense to do due diligence. I think we are looking at somewhere on the order of $250,000, the actual costs of completing an acquisition have to be expensed in the current period and I need to be very clear with everybody that our guidance is exclusive of any impacts of deal related costs that we incurred and we are expecting a fairly substantial amount of deal related costs that will ultimately be in the Q3 numbers.
With that, this is the last question I have. Operator, you can go ahead and wrap us up.
So as we end the call, I want to recognize all 430 Neogenomics team members around the country for their dedication and commitment to building this world class cancer genetics testing program. And on behalf of all of our Neogenomics team, I want to thank you for your time and joining us this morning for our quarter two 2014 earnings call and let you know that our quarter three 2014 earnings call will be on or around October 23 of this year. So for those of you listening that our investors are thinking about investing in Neogenomics we thank you for your interest in our company. Good bye.
Thank you. Ladies and gentlemen this does conclude today’s teleconference. You may disconnect your lines at this time and thank you for your participation.
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