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Cepheid (NASDAQ:CPHD)

Q2 2014 Results Earnings Conference Call

July 17, 2014 05:00 p.m. ET

Executives

Jacquie Ross – VP of IR

John Bishop – Chairman and CEO

Andrew Miller – CFO

Analysts

Shaun Rodriguez – Cowen & Company

Tim Evans – Wells Fargo Securities

Jeff Elliott – Robert W. Baird

Peter Lawson - Mizuho Securities USA Inc.

Zarak Khurshid – Wedbush Securities

Bill Quirk - Piper Jaffray

Dan Leonard – Leerink

Bill Bonello – Craig-Hallum

Brian Weinstein – William Blair

Vijay Kumar – ISI Group

Derik De Bruin – Bank of America

Operator

Good day, ladies and gentlemen and welcome to Cepheid's Second Quarter 2014 Earnings Conference Call.

(Operator Instructions). As a reminder, this conference call is being recorded.

I would now like to turn the conference over to Ms. Jacquie Ross, Vice President of Investor Relations. Ma'am, you may begin.

Jacquie Ross

Thank you, Sayyid [ph] and welcome to Cepheid's 2014 Second Quarter Conference Call. On the call today are John Bishop, Chairman and Chief Executive Officer and Andrew Miller, Chief Financial Officer.

Today's conference call is being broadcast live through an audio webcast and a replay of the call will be available later today at www.cepheid.com.

During this call, Cepheid will make forward-looking statements, including guidance as to future operating results. Because such statements deal with future events, actual results may differ materially from those projected in the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements can be found in Cepheid's Annual Report on Form 10-K, Form 10-Q and other filings with the U.S. Securities and Exchange Commission, as well as in today's press release.

The forward-looking statements, including guidance provided during this call, are valid only as of today's date, July 17, 2014, and Cepheid assumes no obligation to publicly update these forward-looking statements.

During the call Cepheid will discuss non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures can be found in today's press release made available on our website.

With that, I'd like to turn the call over to Cepheid's Chairman and Chief Executive Officer, John Bishop.

John Bishop

Good afternoon everyone and thank you for joining us for a review of our 2014 second quarter results.

Overall, the team delivered solid execution across the board in the second quarter. With record total revenue, record commercial gross margin, record HBDC performance, multiple product launches and great progress on our test menu expansion programs.

In summary, second quarter revenue of $116.5 million reflected growth of 21% from the second quarter of 2013 with a 27% increase in our clinical business, significantly offsetting the expected $3 million decline in our legacy non-clinical business.

Revenue was ahead of our guidance of $113 million to $115 million driven by stronger than expected HBDC sales. In total, clinical grew almost $24 million from the same quarter a year ago including more than $13 million in growth in HBDC and more than $10 million in growth in commercial clinical. In fact, commercial clinical grew 15% from the second quarter of 2013 and was in line with our expectations overall with particular strength in U.S. clinical reagents.

HBDC delivered a record $30 million quarter. Commercial gross margin improved to a record 62% and we released three new products to markets outside the U.S. specifically Xpert HPV, Xpert Norovirus and Xpert CARBA-R.

Moving to some of the detail, this was clearly a record quarter in terms of both the number of GeneXpert system placements and system’s revenue, thanks to solid commercial performance in addition to the record breaking HBDC placements. I would like to acknowledge the Cepheid team that they enabled the shipment of an impressive 1,084 GeneXpert systems in the second quarter to put this in context that this is more systems than we shipped in all of 2012.

The 926 system shipped to HBDC included 774 GeneXpert systems associated with the China order we discussed last quarter. There were about 170,000 TB test also associated with this order from the Global Fund but as we have cautioned previously, you should still allow several quarters for this program to be implemented and ramped up in China.

Moving to commercial placements, we placed a solid 158 GeneXpert systems including 11 Infinity Systems in the second quarter. North American placements were at the lower end of our target range due to typical variability encloses but was more than offset by very strong reagent performance. Interestingly, while Q2’s 46 systems in North America compares to 51 in the first quarter, we actually shipped a meaningfully larger number of modules in the second quarter than we did in the first. This was a large part driven by the placement of nine Infinity Systems in North America in the second quarter compared to five in the first quarter.

Overall then our North America placements were significantly larger on average than the systems we placed in the first quarter and as a result realized ASPs for North American systems were up.

International commercial system placements of 112 included 2 Infinities were down from our record first quarter placements of 130 as expected. On a global basis, commercial system size and ASP increased nicely from the first quarter of this year driven by larger U.S. placements.

It’s worth reminding everyone that the system ASP is impacted by a number of factors including system configuration and geography in addition to the distribution channel and the purchase dynamics. For example, systems in North America tend to be larger and predominantly purchased outright by the customer and direct placements will have higher ASP versus those managed by distributors. Overall, end-user GeneXpert system pricing is quite stable but can vary quarter to quarter as a result of these factors.

Moving to commercial clinical reagents revenue of $70 million grew 16% from last year and reflected a very strong performance in North America. After HAI’s CT/NG was the next largest dollar contributor to reagent growth more than doubling from a year ago to deliver in excess of $5 million in revenue in the second quarter. Xpert CT/NG now represents an annualized business comfortably in excess of $20 million. CT/NG also drove about half of our second quarter system placements in North America excluding Xpert Flu.

Our broad menu of test, draw sequential growth of $4.5 million in the second quarter, a strong performance that almost completely offset the greater than $5 million sequential seasonal decline in flu sales. HAI’s were the largest growth contributor driving more than $3 million of the sequential growth.

MRSA represented more than half of that growth followed by C.diff although everyone of our HAI test grew sequentially. These tests continued to be important. GeneXpert system placement drivers with more than two-thirds of our North American system placements driven in part by C.diff and close to half of our placements driven by MRSA.

Finally, commercial TB was down sequentially following the large single order we discussed last quarter. You will also recall that we introduced a strategic metrics pricing model throughout the 2013 in the U.S. For illustrative purposes, I will share with you that year-over-year U.S. HAI test volume growth outpaced associated revenue growth in the quarter. In fact, the U.S. HAI test volume growth was 12% compared to the second quarter of 2013 more clearly indicating the growth we are seeing in these tests. We believe we are continuing to gain market share in both molecular MRSA and C. difficile despite the best efforts of our competitors.

Our CT/NG business continues to come from a mix of test formally send out to reference laboratories and test previously run on competing platform notably BD Probetec and BD Viper. We should also highlight that a number of these wins beat out competing bids from the Hologic PANTHER. In fact we believe that we have the most efficient platform available even for the highest volumes CT/NG customers and we are seeing evidence of this play out. For example with the Dean Street Infinity Placement in London which is expected to run more than 50,000 CT/NG test this year.

This important reference supports our efforts to reach higher volume accounts here in the U.S. One of our Infinity placements in the quarter for example, beat out the Hologic PANTHER and Roche for an account projected to have an annual CT/NG test volume in excess of 10,000, including CT/NG. The account expects to consolidate 6 different assays, 17,000 tests in total on the Infinity reducing their all in cost per test by 45%.

The number of Infinity placement is indicative of the success we are seeing in higher volume accounts. However, we are still in the early days as it remains the case that most of our current CT/NG customers today would be what we consider low to mid volume. There is clearly significant opportunity ahead as we worked far more aggressively with the clinical community to position the Infinity System as we believe the most efficient and highest throughput system on the market.

Moving to some of our newer tests, Xpert HPV, Xpert Norovirus, and Xpert CARBA-R were all made available outside the U.S. during the second quarter, combined these contributed a less than half a million dollars to commercial clinical reagents in the second quarter but this should ramp through the remainder of the year. Norovirus is a seasonal business generally running parallel with flu but nonetheless got up to a steady start in the second quarter despite the offseason timing of the release. We had about 50 customers in our direct European geographies ordered the test in the second quarter. Xpert HPV is sparking strong interests amongst their European customers but as you would expect particularly outside the U.S. this test will likely have a longer adaption lead time to ramp.

Finally, of the three releases Xpert CARBA-R got up to the strongest start in the second quarter, more than 100 customers ordered the test in our direct geographies with particular interest in France. The test was only released of course in mid June. So we expect to give you a more comprehensive update later in the year.

Moving to geographic performance, international as we discussed had a slightly softer clinical reagent performance as expected coming off a record first quarter. This was due to ordering variability primarily around TB which was especially strong in Q1. I will share with you that year-to-date international commercial clinical reagent growth at 30% is in line with our internal plan.

In summary, our overall results this quarter were on target and continue to position us as the growth leader in molecular. Of course one of our most important strategic growth drivers is test menu expansion and with three test releases in the second quarter Cepheid’s track record on test menu expansion remain strong. We now have 17 Xpert test available internationally and 14 Xpert test available here in the U.S. Additionally, we have 12 tests in active development including the following; Xpert FLU-RSV, which will be submitted shortly to FDA for review and continues to be targeted for global release this year including CE-IVD release later this quarter. Xpert Trichomonas previously target for EX-U.S. rated the end of Q2 has moved into Q3 and the U.S. submission is now targeted in the first quarter of 2015.

Xpert Norovirus continues to be targeted for U.S. release around the end of 2014. Xpert HIV viral load continues to be targeted for CE-IVD release right around the end of the year and Xpert HIV qualitative and HCV viral load continue to be targeted for CE-IVD release late in the first quarter or early second quarter of 2015.

I would also like to provide you an update on some of our systems initiatives. First 10 color capability has been achieved. You will recall that a majority of our current test use six color capability. So the availability of 10 colors along with melt curve analysis significantly increases the number of targets we can address in an individual cartridge. A technology has been made available to R&D and the first test expected to make use of 10 colors is our gastrointestinal panel targeted for global release in the 2016/2017 timeframe.

Second, development of our high level multiplexing honeycomb tube system is progressing extremely well with some key milestones achieved in the honeycomb tubes fluidics and optics for the honeycomb module during the second quarter. Importantly, we have finalized tube micro well design and demonstrated PCR reactions within individual wells. Based on these achievements, we have elected to bypass the initial step of 400 well array and will directly proceed with the final development of a 1000 well array.

Looking forward, we are now targeting the achievement of simultaneous reactions within each well and the honeycomb tube around the end of the year. Importantly, this will demonstrate our ability to have a target and a control present in each well. We are also working to demonstrate full optics capability within the honeycomb module within the same timeframe. Pending completion of these activities, we expect to deliver the honeycomb system to our biologics R&D team. For active test development in 2015 and currently target our Xpert breast signature assay to be the first test to use the honeycomb system commercially in 2016 to 2017 timeframe outside of the U.S. Given the importance of this project, we will share more information on the honeycomb system development in coming quarters and pleased with our development progress and are excited about the potential for this innovation to extend the GeneXpert systems capabilities with strong potential application to our oncology program.

The 10 color and honeycomb system projects are exciting developments for Cepheid and for our installed base of more than 7000 systems globally. They highlight that even with the most differentiated platform on the market today Cepheid is not standing still. We are working to further extend the market reach of our differentiated platform thereby helping to ensure that our leadership is sustainable for the long term.

With that I will hand the call over to Andy. Andy?

Andrew Miller

Thanks, John, and good afternoon everyone. As always, please note that I'll be discussing non-GAAP results unless otherwise specified.

Total revenue of $116.5 million was up more than $20 million year-over-year, driven by more than $10 million growth in Commercial Clinical, $13 million growth in HBDC, offset as expected by a $3 million decline in non-clinical. In total, our clinical business, which includes Commercial Clinical and HBDC grew 27% from the second quarter of 2013. Clinical represented 96% of total revenue and non-clinical and other represented 4% of total revenue.

Commercial Clinical was up 15% from the second quarter of 2013 with about $1 million growth in Commercial Clinical Systems and $9.5 million or 16% growth in Commercial Clinical Reagents. In total, Commercial Clinical revenue declined about $1 million sequentially as expected following a very strong commercial clinical performance in Q1. Notably, Commercial Clinical reagents, excluding flu, grew about 4.5 million almost offsetting the sequential decline associated with the end of the flu season.

Within Commercial Clinical, system revenue was essentially flat with last quarter. HBDC was up 81% from the second quarter of 2013 and up 65% from last quarter primarily due to the sizable China instrument order as well as growth in TB test revenue.

Moving to the income statement, non-GAAP gross margin improved from 46.6% a year ago to 50.3%, but declined modestly on a sequential basis as expected due to the heavier HBDC mix. Excluding HBDC, Commercial non-GAAP gross margin of 62% was a marked improvement from 60% last quarter and 56% in the second quarter of 2013 as our margin improvement initiatives within our operations organizations continue to progress.

Non-GAAP operating expenses increased about $1.7 million sequentially with higher clinical trial and expense pre-production inventory cost.

Sales and marketing and G&A were about flat on a sequential basis. Non-GAAP other expense remained at roughly $1 million attributed to the cash interest expense on the convertible notes partially offset by the interest income on the convert proceeds.

GAAP other expense increased to $3.4 million with approximately $3.5 million of convert-related interest expense, $2.4 million of which is non-cash. Note that cash interest expense is included in both our GAAP and non-GAAP statement of operations while non-cash interest expense is included in GAAP only.

Overall, non-GAAP net income for the second quarter was $2.3 million or $0.03 per share which improved from a net loss of $0.6 million in the first quarter of 2014 and from net income of $1.2 million in the second quarter of 2013. GAAP net loss was $9.8 million or $0.14 per share. A reconciliation of our non-GAAP results to our GAAP results is available in today's press release.

Moving to the balance sheet. Cash, cash and equivalents and investments were $385 million. DSO declined to 43 days. You will note that accounts receivable declined sequentially despite more than $10 million increase in revenue.

Inventory increased $4 million with a sizable strategic purchase more than offsetting a step down associated with the China system shipment.

Moving to guidance, with the strength we have seen in the first half of the year in our clinical business, we are narrowing our commercial clinical guidance towards the top end of the previous range, an increase in our HBDC revenue guidance. We are also making a modest $1 million reduction in our non clinical guidance to account for our current expectations for biothreat revenue in the second half of the year.

In detail, we are now forecasting full year revenue in the range of $452 million to $461 million. We expect commercial clinical revenue in the range of $340 million to $346 million, growth of 16% to 18% from 2013 with Xpert test revenue growing faster than instruments. We expect HBDC revenue in the range of $86 million to $89 million and we now expect non clinical revenue to be approximately $26 million down $1 million from our prior guidance.

Moving to gross margin, we continue to target full year non-GAAP gross margin of approximately 52% and non-GAAP commercial gross margin of approximately 62%. HBDC gross margin remains on track to achieve its full year target non-GAAP gross margin just above the mid single digits.

Turning to the bottomline, with the completion of our 2015 strategic planning process and based upon the progress we are making in a number of key operational and strategic areas, we have decided to accelerate investments into the second half of the year from early 2015. These are deliberate decisions that we believe will further extend our lead in the marketplace. For example, we are accelerating our efforts in oncology. In commercial ops, some key investments we have accelerated include additional sales reps, increased investments in sales and marketing leadership in a number of developing markets and some key target marketing positions. With this in mind, we are revising our bottomline guidance and now expect non-GAAP EPS of $.10 to $0.13 and GAAP loss per share of $0.54 to $0.51. For the third quarter, we expect total revenue in the range of a $107 million to a $110 million reflecting sequential growth in commercial clinical despite the anticipated seasonal step down in Europe, partially offsetting a significant step down in HBDC. Specifically, we expect Commercial Clinical revenue in the range of $83 to $85 million up 16% to 19% year-over-year and HBDC in the range of $17 million to $18 million. And we expect non-clinical to be about $7 million.

We expect non-GAAP gross margin of 52%. We expect OpEx to grow sequentially by approximately $2 million due to increases in R&D and sales and marketing expense. On the bottomline we expect non-GAAP EPS to range from a loss of $0.01 to a profit of $0.01 per share and GAAP loss per share of $0.17 to $0.15.

As we move into the fourth quarter, we expect a significant step up in revenue which is consistent with our normal seasonal trends for Commercial Clinical. For example, last year Commercial Clinical increased sequentially by almost $12 million, this year we also expect a sequential increase in HBDC given timing of orders.

As a reminder, within Commercial Clinical we expect the Q3 to Q4 increase to be driven by the following factors: the stronger commercial system closes that we typically see at the end of the year, a seasonal contribution from flu including from our new expert flu RSV test that we expect to have on the market in time for flu season.

Ramping revenue from the new products released outside the U.S. namely Carba-R, HPV and Norovirus which tends to be seasonal like the flu and revenue growth associated with our strategies to extend our reach beyond hospital laboratories.

Finally, and in the interest of disclosure, I wanted to share that we have this morning become aware that Roche has filed but not yet served a complaint for patent infringement relating to our expert MTB/RIF product here in the U.S. But we have not yet had the opportunity to assess the claim, our understanding is that the patent in question has expired at the July 01, 2014. I will remind you that expert MTB/RIF which cleared in the U.S. in June 2013 and that revenues to date are quite modest. With that in mind, we do not believe that this litigation even if successful would have a material adverse impact on our financial results. With that, I will now turn the call back to John.

John Bishop

Thanks, Andy. Even as Cepheid's impressive growth profile continues to develop. I am more excited than ever about our future as we enter a pivotal phase of development on multiple fronts. We are not only moving to step up our global initiatives but to begin to realize our innate potentials in the hospital, independent lab, and alternate site markets.

We are also in the process of rounding out our infectious disease menu with our virology products and to move toward further development of our oncology program, as we have stated on previous occasions Cepheid is well positioned for future growth. With that I’ll ask the operator to begin the Q&A.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) The first question comes from Shaun Rodriguez from Cowen & Company. Your line is open. Please go ahead.

Shaun Rodriguez – Cowen & Company

Hi good afternoon. Thanks for taking the question. So given the strength in commercial placements for the last few quarters and of course you have the expanding menu, I think clearly system utilization trends are going to be an important metric for folk. So if we look at your commercial clinical reagent revenue by the average install base in the period, it looks like you are pulling through maybe 2% to 3% less revenue per box on a year-over-year basis. So I was hoping you could maybe help us reconcile that with your commentary about clearly seeing trends towards more customers running more tests on average, more Infinity is going out into the field and I guess what I am hoping you include in that response is the impact of pricing of course the underlying volumes there but also having an increase mix of OUS impact these things.

Andrew Miller

Okay. Certainly the – so one as we have discussed previously and placing systems, a number of customers are still looking at expanding menu. They are ordering larger cabinets as you look at the placements particularly in the U.S. in the second quarter, only about 30% of those placements were in fact GX-4’s. So the remainder of all of those others are then GX-16 cabinets or Infinities and what we are finding is that people are still tending to purchase in EXCESS capacity, that’s one element. The other element is as we look at multiple test and I believe we spoke on the prior call, the first quarter call that as we have accounts starting with instances 4, 5, 6 or even more test that they cannot start all of those simultaneously, they only have a bandwidth of validating 2 or 3 tests at a time. So therefore, it extends the ramp rate. So now they have a larger system with an extended ramp rate to fully realize the full breadth of our menu that is involved there. So that will distort those numbers and so that add some complexity going forward. To the point that we made in the prepared remarks, yes with the metrics pricing that we introduced actually in 2012, it took more effect in 2013, where the user gets the benefit of combination of breadth of our menu in addition to volume of menu on the test that does give them a decreased price point per test. So we have seen that particularly as we introduced more in 2013 we are seeing a slowdown in the cost reduction profile but there is significant step up in test revenues associated with that.

So as we indicated in our prepared remarks, test revenues for some of the items there are up quite significantly in volume versus what we have seen at this point with the general test revenue. In particular one of our key strategies was in the group B strap which frankly has been on the market for a number of years, high price point and basically the idea is to do the testing in the antepartum setting in other words, prior to delivery versus just in the intrapartum setting where we had developed an interesting market but the broader market is in the antepartum setting. With the reset of the price point on GBS that strategy has been very successful and now we are getting a nice growth in revenue and we are getting a nice growth in volumes of tests going forward.

In addition to your question on OUS, OUS is growing very-very nicely; I mean we have seen very solid growth in Europe. We did have during the first quarter a onetime initial start up on some TB purchases on the commercial side which were not repeated in the second quarter but nice pick up of sale of product generally across the board. The other item which is going to frankly I think because tracking fully a little bit difficult is that we are now fully in the mode of developing our business not just in the hospital market but also in the independent laboratory markets. Those markets are even more competitive significantly higher volumes per site, more competitive on price point. So you will see an impact there on a lot of volume growth and revenue but not at the same ramp rate.

The third part of the market that will be coming into much more as we go with our clear wave products but I think we will get it an uptake with modern complexity FLU-RSV, it is the alternate site market. So previously we have been talking primarily just about the hospital market, the way you want to think about the company today is that we have clear applicability to all three of these market segment. It was previously pretty much the other major players specifically Roche Hologic which is Gen-Probe and BD at Avet which were in the independent laboratory market. Cepheid now is clearly breaking into that market. We are seeing some nice gains both in the U.S. and in Europe with the independent lab market and that has indicated coming along with the alternate sites. So what we are seeing now is very-very good growth and really starting to come in to our own across the entire breadth of all three of those segments. So that to get to your model of exactly tracking throughput for cabinets I am afraid we are going to exacerbate that problem for a period as we sell larger cabinets looking for expandability in the cabinet and then develop and penetrate these individual segments of the market.

John Bishop

And Shaun there is one thing I will add. So first of as we looked at the same store sales with an account or up, but of course it got many different size customers, if you just look at our international growth, the first half of the year in reagents it’s 30% that doubles North America customers tend to be smaller internationally than in North America. So when you do that simple calculation that you are doing you are going to see a trend downward. Also, we have seen -- we continue to progress into the mid-size and smaller hospital as well. But we don't have that easy utilization metric of those that only sale to high volume reference labs that all basically buy pretty much just one or two test and run it on a single large instrument. Okay?

Operator

Thank you. Our next question comes from Tim Evans from Wells Fargo Securities. Your line is open. Please go ahead.

Tim Evans – Wells Fargo Securities

Hi. Thanks for taking the question. Could you talk about the feedback you are getting from customers on CT/NG pricing and in particular do you find situations where you lose head to head competition sometimes based on price?

Andrew Miller

So I will answer both of those, clearly few back what we are getting is very good relative to overall utility of the system and it ranges from one of the accuracy of the test, lot of positive feedback on the sample adequacy control which is unique to the Cepheid test that's out there. Also, very good comments on the overall specificity and the sensitivity of the system that are generally the activity of the system. The other big benefit is we have commented before early on is the ease of use aspect but now what we are also starting to get is realization of the efficiency of an Infinity System at a higher volume setting both if you are looking at even on a batch mode but are more specifically on demand as you get into a number of unique clinics as we spoke about like Dean Street where they are unique, they are processing as we called out now over, 50,000 tests per year on demand and basically the Infinity is the only system that gives them that type of capability in the marketplace.

Now what we have found on pricing is that first of you need to look at the overall all in, that's one of the item that we are continuing to educate the market on that our cartridge includes everything, all of the controls, everything you need to run the test we are only adding the specimen.

As we look at competitive products we have seen that the difference in the all-in price versus what they are quoting on a per test price can range anywhere from 20% to 40% higher. So that's what we mean by as you get a comparison to the all-in price point. So generally right now we are getting the wins, understanding that the all-in price point in the overall efficiency of the system we are also getting very positive feedback on the ability to get an answer very quickly, keep referring to Dean Street but that’s a good key one, they have reduced their test retreat time down from ten days to two and now they are looking to focus on one, many others are in the same category.

Now the last part to your question specifically do we ever lose business head-to-head even with the benefits on a direct price point quote the answer that is clearly yes and we’ve had some instances in fact I’ll tell you one specifically where a competitor and they cannot sustain this kind of activity they were selling in the account themselves for over $20 a test, we had done the assessment on the Infinity for the account, we are actually under 20 and gave them a really good and they were in the process of converting, the competitor came back and gave them $7 a test. So clearly we lost that one and we’re not going to take that kind of business but as the competition moves to take that kind of business they put themselves in my view in the non-sustainable scenario as they are going to substantially degrade their own profits on a go forward basis. So as we look at reasonable pricing activities in a market versus those outliers were tending to more and more take the business versus losing the business.

Operator

Thank you. Our next question comes from Peter Lawson from Mizuho Securities, your line is open, please go ahead. Mr. Lawson your line is open if you have your phone on mute can you unmute your phone please.

Jacquie Ross

Sayyid, may be we should continue and go back to Peter.

Operator

Our next participant in queue is Jeff Elliott from Robert W. Baird.

Jeff Elliott – Robert W. Baird

Yes, I’m wondering now you have had more time to see Infinity really gain traction in the marketplace, what do you see than the average pull through on the Infinity Systems in particular?

John Bishop

Generally, what we are seeing there, Jeff, is broader utility of the menu as we called out in the prepared remarks where a new account coming and running 17,000 tests combined six or seven different test to operate on the Infinity, we’re seeing interest in driving there as we called out, HAI still tend to lead I mean c. difficile is still a big leader, MRSA but were getting a lot of interest in pull through with CTNG, so what’s happening is they were seeing now different tests that are sparking the interest in the account than driving pull through with the remainder of the menu in fact we’re opening up summarize well we’re even leading in now I call that GBS where people are taking on GBS and then next thing they are pulling through c. difficile or they are starting with the CT/NG and then we weren’t in the account in MRSA and they are pulling through the MRSA. So we are seeing now some very interesting combinations and as a result with the efficiency of operation of the system a lot more pull through on broader menu utility.

Operator

Thank you and our next question is from Peter Lawson of Mizuho Securities. Your line is open please go ahead.

Peter Lawson - Mizuho Securities USA Inc.

Hi, John. Sorry about that. So in countries where you are getting TB business through [WHO], are you actually seen non-[WHO] accounts buying the products, some kind of bleed through from during these emerging market countries.

John Bishop

Yes, we are. Peter, that's very interesting question. If I take South Africa as a good example of that, South Africa has been one of the big leaders relative to the HBDC pricing where we are seeing good traction there as well on the commercial side of the marketplace. We are also seeing similar activity in other parts of the world, Eastern Europe, some good examples with that. The other item that you call out, it has been very interesting to us frankly, it has been interesting to me personally is I have looked at how the tuberculosis has developed around the world and what I am finding now is basically watching our competition wherein previously you didn't see that much activity around tuberculosis. Now you see significant activity around tuberculosis on a broad base competitive level. So there are lot of folks that are trying to get into the HBDC which ultimately I expect that will be consolidating.

We really be referring to this as the emerging market which is what they are and I am seeing more and more of the competitors trying to emulate what we have done. Now the good news for us is we are the first mover there and we have substantial advantage relative to the performance of the system we are extending that performance basis now as we move into HIV and it's giving us a very nice leg up as we are considering already HIV tenders coming into the emerging market with what we can do there. So back to where I think you are going, one of the things we have seen absolutely very clearly this is a very-very strong strategic door opener. It is opening the door to commercial businesses and as we move in this, the overall margins as you look at these emerging markets will be up quite a bit above what we are looking at for just the tuberculosis pricing for HBDC as you look at fully developed country market, those margins probably won't be as high but certainly quite a bit higher than where we see we’re operating right now with the HBDC TB pricing.

Andrew Miller

And Peter what I’ll share with you is that in are rest of world or emerging markets commercial business TB is our number one revenue test in those commercial markets but what interesting is now C. diff and MRSA if you combine them, they are about equal to what we do in TB in those same countries. So we are seeing menu expansion not just TB taking whole but then we’re not seeing MRSA and TB together in those same countries are actually about the same amount of revenues we’re getting from TB commercial and then following that CT/NG a little bit smaller.

Operator

Thank you. Our next question comes from Zarak Khurshid from Wedbush, your line is open, please go ahead.

Zarak Khurshid – Wedbush Securities

Good afternoon everybody thanks for taking the questions. John, given the nice run-rate in CT/NG what do you think that business is headed overtime based on your MRSA and C. diff experience to date, CT/NG as potentially easily eclipsing on C. diff on rather $200 million down the road, if you could provide some color on that and also how you are thinking about CARBA-R that would be great, thanks.

John Bishop

Certainly. Well, as you know the CT/NG market is one of the largest markets in infectious disease, what has really changed for us and as you can see with the actual performance now when we first entered the market our positioning on initial point of entree was really targeting the sendouts, focused on those accounts that were less sophisticated in the market which really relegated us to more of a niche position in the marketplace, all of that is now changed and we see Cepheid right in there head-to-head with frankly in the U.S. the market leader which continues to be Hologic and Gen-Probe, right now but we are right in the mix with Gen-Probe with BD with Roche, we’re seeing exactly the same thing in Europe, we are taking competitive wins head-to-head with all of those significant systems, we’re also seeing growth and movement into the independent laboratory markets.

So whatever it say and what we are witnessing right now is Cepheid is really truly starting to come in to its own truly in there as one of the big players in molecular in the marketplace there such that our tests and our menus expanding. It brings it right under the core lab. We are getting the appreciation that we have a solid core lab system in the Infinity, so I am looking at very-very solid growth relative to CT/NG on a go forward basis. So, I think we are going to be right in there. Right now what you are seeing is you see the market leaders, Europe Roche is the market leader Hologic in the U.S. and the U.S. BD tends to be number two, Roche number three and I think we are going to be getting ground on number of those folks relatively rapidly here at this point in time. I frankly think that if you look our competitors they are getting ready report, one already did report. If you look at our overall growth on where we are at 21% or so the one competitor came in and they were negative, not even positive, negative 3%. We are positioned now to I think, in the not too distance future emerge clearly as number two in the molecular market and closing ground rapidly on the number one particularly as we come with our virology product.

Now, as you go to the CARBA-R product, this will be a very interesting market. It's a newly developing market as you know the carbapenemase resistance really started peaking an interest a year or so ago. What we are finding right now with the European release, the market is not fully cleared as they were exactly how they are going to fully going to utilize the product. So I am seeing a lot of interest in utilizing the product as a surveillance product on one hand but also as a diagnostic outbreak management product on the other. So at this point in time I would say it's a bit early as you look at the market for that product, right now I would put it probably on par with c. diff and behind the MRSA but we will have to see how that develops. If it moves more toward surveillance, then it's going to move more toward MRSA type of product and what was interesting we call that out in the prepared remarks that we had about 100 accounts that signed up very-very quickly, I mean we only released the product in June and we had 100 account sign up. So I can tell you coming from ECCMID in Europe that there was very high interest in the product than a lot of discussion about the need for this kind of product in the market. So we will where it goes. Right now I am expecting it's going to be a pretty good product.

Operator

Thank you. Our next question comes from Bill Quirk from Piper Jaffray. Your line is open please go ahead sir.

Bill Quirk - Piper Jaffray

Yes, thanks. Good afternoon everybody. So the commercial clinical reagents excluding flu, were up about $4.5 million sequentially. Is this the sort of sequential pace that we should expect to your obviously again adjusting for flu is again at the end of the fourth quarter or given that you had some pretty nice recent and very large account wins, could this actually accelerate from this pace? Thanks.

Andrew Miller

So that one is always difficult Bill to fully forecast as where we are right now. I mean as we have said we are getting some nice volume account wins here as we move into the independent laboratory market also, the larger hospital market. So you can have some of those depending upon the ordering pattern if you look at for example in Europe, where we had in Q1, some high volume order come through on TB and then they need to work through that. So it added some volatility on the quarter going forward, what I would say is on a general trend basis that we are definitely trending up, that the trend forecast is very positive in that direction but depending upon ordering pattern you could get some variability there.

Operator

Thank you. Our next question comes from Dan Leonard from Leerink. Your line is open, please go ahead.

Dan Leonard – Leerink

Thank you. John I was just hoping you could elaborate on your decision to accelerate your investment in oncology.

John Bishop

Absolutely. So what we are seeing, it's very interesting and I will tell you that our head of oncology came back from a trip just the other day and it was interesting and he was literally effervescent coming back from the trip because way he commented to me was couple of years ago where virtually unknown. It was hard to start to talk people about that and in his words at this point everybody wants us to take us to the prom. So what they are clearly seeing is that the benefit of the system brings we have indicated previously that we can do extraction directly out of paraffin-embedded tissue. We see strong applicability in the oncology market in the breast cancer, near term as well as the bladder cancer products. These products are also going to provide, so one, they are very meaningful products relative to outcome. Two, they are going to be meaningful products relative to gross margin for product to generate it. So, given the interest in the way the system is performing and can perform it makes nothing but sense to bring that whole program much more aggressively forward and get those products into the marketplace.

Operator

Thank you. And our next question comes from Bill Bonello from Craig-Hallum. Your line is open, please go ahead.

Bill Bonello – Craig-Hallum

Hey thanks a lot for taking my call. I have a question about profitability over time. I understand, certainly, that the down order revisions in EPS guidance have been largely a function of the accelerated investments, but I'm trying to get a handle on when we might start to see some of those investments kind of flow through to the bottomline. Are you still committed to a mid-20% operating margin by the end of 2017 or is that a kind of a flexible target depending on what future investment opportunity you see?

John Bishop

No, Bill to answer your question is very, very specifically, we are absolutely committed to the 2017 operating earnings time targets that you are talking about, the issue goes like this if I look at the company right now and where we are, what we’re clearly seeing is increasing traction in the market, increased depreciation of what the systems can absolutely do, coming at a timing that we’re introducing the virology products we need importantly get through the clinical trials and get them on the market in the U.S., so what we are seeing is that we have a company now and a product that in our view is absolute winner, the market really wants it, we’re gaining momentum, traction in the market segments we have.

Meanwhile, competition is trying to develop new systems in the marketplace, now it’s the time for us to strike and strike hard to extend our strategic advantage in the market to get that menu into the marketplace vis-a-vis the virology products and then to really further lengthen that and give the incremental utility with the oncology products coming into the market. Now, in order to do that the other item that we have found is that as we look as sales force productivity that as we’ve been very highly productive with an individual rep but it’s also one of those things when the territories gets too large that your productivity relative to new business can follow up there where you are maintaining too large of a base and so therefore what we’re going to be doing is accelerating forward.

We have a whole program, it’s going to roll into 2015, accelerate forward getting sales reps that out in the market, so we increased the phase time of the rep, I mean our story is that easy one to tell on one hand but on the other hand you are really want to appreciate the operating efficiency that it brings to the account and we need to get the reps phase time in order to fully make that happen. So we are going to be put in more feet on the street out there. To give you a general idea I mean as you look at it right now I mean a lot of people will make a case of that a sales territory, the cost of rep is about 300,000 per year, you can make a case that a $6 million territory lot of people operate even at less than your return as you look at our commercial gross margin even where we are right now at 62% is very good even on a $6 million or less territory even at $300,000 cost.

What we are looking at right now will be splitting territories on about an $8 million territory basis as we look at our current run rate for our reps we have a number of territories out there right now that were way-way over, the $8 million per territory number and so what we are going to do is accelerate those reps forward, get those people in here and get those territories pared back, substantially increase the productivity and basically extend and further accelerate our growth rate lead in the marketplace. So now is the time to do that. So we are in, in my view this critical period where I’m talking about pivotal development there as we look at this year ’15 little less than ’16 and then that positions us such that we have critical mass both in sales and marketing infrastructure and in menu and then coming aggressively in the oncology and therefore we are well positioned to carry out our strategic business balance that we’ve spoken about by 2017 timeframe such that we stick to those numbers. So what we are doing now, we’re making that investment but very much committed to the 2017, 20s as we are talking about their percent operating margin there and frankly the future gets even better beyond that.

Operator

Thank you. Our next question comes from Brian Weinstein from William Blair. Your line is open, please go ahead.

Brian Weinstein – William Blair

Hi, good afternoon. Thanks for taking my question. John, you had talked that the fourth quarter was going to see a step up and one of the reasons why was some of the stuff you're doing to extend beyond the hospital labs. Can you give us an update on specific efforts to gain footholds in the reference labs both OUS and U.S. and then any update on the U.S. alternate site strategy and how that's coming along? Thanks.

John Bishop

Yes, we are meeting specifically with individual independent, large independent laboratories both in the U.S. and in Europe. In Europe, we have had some meetings with a couple of biggest names over there. One of them and I don't know that they want me to hand out names, so I am going to not do that right now. But one of them in particular is looking at their own strategic plans, I’ll tell you what they have told us verbatim is that they need to go to 24/7 operation the Infinity System is the only one they can give them that ability and a fast efficient turnaround time going forward.

With specific discussions and accounts here in the U.S., as they are looking at large volumes and efficiency of operation we are seeing a similar types of comments and adaption in the U.S. but right now in the U.S. we are still in early days because they are going to be adapting some of their various products on the menu that will be there and then as we come I think with the virology products it's going to position us very well to go into those products immediately with those segments of the market. So I would love to give you more specifics when we can and as we can Bryan both U.S. and OUS relative to individual accounts but as we are dealing with those folks right now lot of them don't like to have their names announced publicly in the market.

Andrew Miller

Brian and the only thing I will add is the fact that we actively called it out. We don't like to talk features that we are not really actively involved.

John Bishop

Now on the alternate site that was the other part of your question, I am going to give a lot more of that later. Don't worry we are running short on time already tonight but we will give you some specifics on that. We have a clear-cut program that’s coming together on getting to the outside and I am pretty enthusiastic about what we are going to be doing there.

Operator

Thank you. Our next question comes from Vijay Kumar from ISI Group. Your line is open. Please go ahead.

Vijay Kumar – ISI Group

Hey guys thanks for taking my question. Just one housekeeping on the guidance for third quarter, it looks like most of the Delta came from HBDC. I'm curious, when you had a big China order and I'm assuming some of the systems need to ramp up on the consumer front so on a go-forward basis, what's the right way to think about China ramp-up?

John Bishop

Well, on the China ramp up specifically recall that we shipped 117,000 tests with that 774 systems. We have been saying though they need to get those rolled out so we deliver them with funding from global fund. Those do need to get rolled out. So I would say as we said in the prepared remarks, it’s going to take several quarters. I would not look for any meaningful ordering through lot of those systems until coming into 2015 at this point in time. Like also as we have indicated with the date that we are calling out, HBDC was strong but make no bones about it, the commercial clinical was quite strong also. So that's where we saw lot of strength in the quarter.

Operator

Thank you. Our next question comes from Derik De Bruin from Bank of America. Your line is open. Please go ahead.

Derik De Bruin – Bank of America

Hi. Good afternoon. So, on the virology strategy, how many of your current labs are basically doing in-house virology testing? You went a lot through the metrics in terms of what it costs to send out -- the cost advantage of doing things in-house versus sending out and I'm just curious if those same metrics apply here? Is the virology programs -- do you think those will be a meaningful driver of new system plays?

John Bishop

So the short answer and the last part of your question I think the answer of that is yes. The answer of the first part of your question is if you look at the hospital market, I think as we discussed on the prior call, according to third party data there are very low percentage of hospital something like 4% of those running molecular are actually doing the virology testing which then concentrates that market in the independent laboratory market. So that's the good news there. Previously, where we were talking about just the hospital market, then your comments should be right on where we will be looking at a small percent of the market that's actually running testing but now we are talking about being aggressive in the independent lab market, different ballgame. So as we look to introduce those products we are going to be going directly after the independent laboratory market in addition to giving the hospital market the opportunity to run the test in house if they so desire to do that.

Operator

Thank you. Our next question comes from Patrick Donnelly from JP Morgan. Your line is open please go ahead.

Unidentified Analyst

Hey guys this is (inaudible) two quick follow-up to kind of questions earlier. First on the incremental spending, can you quantify the number of reps you are adding and how much is the incremental cost are going to fall on sales and marketing versus the oncology?

John Bishop

So I would say directionally without giving you the definitive numbers in that regard that the majority of the spending will be in sales and marketing. The oncology is significant but the bulk will be in the sales and marketing situation and then the reps it will be a meaningful percentage increase relative to where we are right now but that’s – and the reason why I am hesitating it’s going to be variable depending upon how quickly we successfully recruit and get those people into the field. So as we mentioned that’s all going to be part of a 2015 program that we’re looking forward to pull that into part of it into the fourth quarter in particular so that’ll be ramping for some of those reps and then getting the bulk of them on during the 2015 timeframe.

Andrew Miller

Yes, type of the incremental investment it’s about $6.5 million in total much of it in the fourth quarter.

Operator

Thank you. And our final question comes from Jose Haresco from JMP Securities. Your line is open, please go ahead.

Jose Haresco - JMP Securities

Hi guys, thanks for taking the question. Just following up on the questions on the sales force increase, could you remind us how big your sales force is domestically and internationally right now? As you think about that ramp-up, can you give us a little bit more color on the domestic international ramp for that sales force?

Andrew Miller

Well, sales force we have right now as we look at our territory sales executives which is about 27 or so for that and then for our instrument sales specialists there’s about another dozen of those folks we argument that with incremental systems and solution people not big numbers in that area. As we look at the international areas there we are looking at about 59 total in those markets, of course those broken up. As you look at the individual market Germany is the largest and then followed by the other markets we have quite a few people in the UK and then coming along in France and Italy specifically.

Operator

Thank you. I would now like to hand the conference over to management for closing remarks.

Jacquie Ross

Thank you, Sayyid. Today's webcast will be available for replay on our company's website shortly and will remain available for at least 90 days. If you have questions following today's call, please contact Cepheid Investor Relations at 408-400-8329.

Thank you for your interest in Cepheid and have a great afternoon.

Operator

Ladies and gentlemen, thank you for participating in today's conference call. This concludes our program. You may all disconnect and have a wonderful day.

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Source: Cepheid's (CPHD) CEO John Bishop on Q2 2014 Results - Earnings Call Transcript
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