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WuXi PharmaTech, Inc. (NYSE:WX)

Q2 2014 Earnings Conference Call

August 14, 2014, 08:00 AM ET

Executives

Ron Aldridge - Director, Investor Relations

Ge Li - Chairman and Chief Executive Officer

Edward Hu - Chief Financial Officer and Chief Investment Officer

Analysts

Bin Li - Morgan Stanley

Serena Shao - Merrill Lynch

Tycho Peterson - JPMorgan

Matt Bacso - William Blair

Jack Hu - Deutsche Bank

Bryan Kipp - Janney Capital Markets

Tim Evans - Wells Fargo Securities

Dave Windley - Jefferies

Operator

Thank you for standing by and welcome to the WuXi PharmaTech Second Quarter 2014 Earnings Results Conference Call. (Operator Instructions) I must advise you that this conference is being recorded today, August 14, 2014.

I would now like to hand the conference over to your first speaker today, Mr. Ron Aldridge, Director of Investor Relations. Please go ahead, Mr. Aldridge.

Ronald Aldridge

Thank you, Billy, and good morning or good evening to everyone participating in our second quarter 2014 earnings conference call. Hosting this call today is Dr. Ge Li, Chairman and Chief Executive Officer. Joining him is Edward Hu, our Chief Financial Officer and Chief Investment Officer.

Turn to Slide 2 please. During today's presentation and question-and-answer session, we will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts, but instead are predictions about future events. Although we believe that our predictions are reasonable, future events are inherently uncertain and our forward-looking statements may turn out to be incorrect. Information on many of the risks relating to our forward-looking statements can be found in our filings with the SEC. Our forward-looking statements speak only as of the date on which they are made, and we assume no obligation to update any forward-looking statements except as required by law.

Turn to Slide 3 please. Also in discussing our financials, we will use certain non-GAAP measures, which exclude the impact of share-based compensation expenses and the amortization of acquired intangible assets and the associated deferred tax impact. We believe these non-GAAP operating measures are useful for understanding and assessing underlying business performance and operating trends. Reconciliations of our GAAP to non-GAAP second quarter and first half 2014 results of operations are found in today's earnings release, which has been posted to our website and in the appendix to this presentation.

In the question-and-answer session after our presentation, questioners will be allowed to ask one question and one follow-up question.

And now it's my pleasure to introduce Dr. Ge Li to review our second quarter 2014 performance and to discuss our third quarter and full year 2014 business outlook. Dr. Li?

Ge Li

Thank you, Ron, and good evening or good morning, everyone. Turn to Slide 4 please. WuXi had a solid second quarter. We achieved a record quarterly revenues and we expect a sequential growth in the third and fourth quarters. We continued to achieve record quarterly revenues. Our growth was broad-based across all business. Once again, our small molecule manufacturing and biologics business led the way. We expect our small molecule manufacturing and the biologics to be the key drivers of growth for the next several years.

Also we have our major business segments, China Lab Services, US Lab Services and the Manufacturing Services achieved strong growth. And as a result, we exceeded our second quarter revenue guidance. We expect to accelerate revenue growth in the second half of 2014, capitalized on the growing late-stage and commercial product pipeline of small molecule manufacturing, run by our largest manufacturing business, growth in (inaudible) and the investment in new business. As a result, we raised our revenue guidance for the full year to the range of $665 million to $670 million from previous guidance of $660 million to $670 million.

Slide 5 please. We also had a good quarter in profitability. Gross margin in the second quarter improved more than one full percentage point year-over-year, and we expect the performance to be sustainable throughout this year. We now expect a full percentage point improvement in gross margin for both GAAP and non-GAAP for the full year due to the productivity improvement initiatives, cost control and the effect of depreciated RMB relative to the US dollar.

While we previously expected 1 percentage or 2 percentage point decline in operating margin for the year because of the increased investment, we now expect 2014 operating margin GAAP and non-GAAP to be only slightly lower compared to 2013 due to improved gross profit margin and the impact of the depreciated RMB against the US dollar.

We exceeded our second quarter guidance for non-GAAP diluted EPS and achieved the top end of our guidance range for GAAP diluted EPS. Also, we're raising our guidance for full year 2014 GAAP and the non-GAAP diluted EPS.

Slide 6 please. While we are achieving strong revenue growth and good profitability, we are also investing to sustain the growth, while masking a broad range of areas for later groundwork for future growth. We also used our cash to purchase $66 million of our stock in the second quarter, completing our $100 million share buyback program. We've seen many exciting growth opportunities ahead of us. Therefore, we are increasing our planned 2014 capital expenditures to $95 million to $100 million.

The foreign exchange markets were relative stable in the second quarter after a volatile first quarter. In the second quarter, we recorded realized gains on foreign exchange forward contract of $1.6 million and a mark-to-market loss of $2.5 million.

Slide 7 please. Looking behind the numbers, the second quarter was marked by many operational achievements. We had several successful regulatory interactions. For small molecule manufacturing, we had a successful FDA inspection for the manufacturing of our API. For our toxicology business, our facility in Suzhou had favorable result from inspections by the FDA and the OECD. Our toxicology business units have now completed 92 R&D labeling, 50 evaluation programs for our customers' global submissions.

The US FDA approved a monoclonal antibody drug candidate that we manufacture in China for TaiMed, ibalizumab, for use in extended access program for HIV patients. This is the first we reported FDA approval of a biologics product manufactured in China for use under our US IND.

For cell therapy, we signed agreement with NewLink Genetics for manufacturing the new cell therapy product candidate for pancreatic cancer currently in Phase III clinical trials. Cell therapy is a fast growing new therapeutic area and we have build capabilities to develop and manufacture post-allergenic and autologous cell-based therapeutics. As a result of growing demand, we broke ground ourselves on a new cell therapy manufacturing facility in Philadelphia.

In the field of other accomplishments worth mentioning, we completed construction and began operations on our new material characterization facility in St. Paul that provides service required by the FDA for filings of medical device and biologics. A new high-potency API lab in Shanghai began operations in the second quarter. This facility will support other development and the clinical trial supply of high-potency small molecules at a kilogram scale. The first two of the Illumina X Ten sequencing machines arrived and are now operational, and the remaining units will arrive in the second half of this year.

And as a result of our solid growth across the board, our employee headcount crossed 8,000 for the first time in the second quarter.

And now, Ed will discuss our quarter in more details. Ed, please?

Edward Hu

Thank you, Dr. Li. Turn to Slide 8 please. On this slide, you can see that WuXi's revenue growth was solid across the board. We delivered a 14.8% year-over-year revenue growth. Manufacturing service revenue increased 19.3%, led by strong growth in small molecule manufacturing services. China Lab Services grew 14.2%, driven by rapid growth in biologics, development services and growth in lab testing services. And US Lab Services delivered solid 9.6% year-over-year growth, driven by strong growth in cell therapy and material characterization services.

Turn to Slide 9 please. Here you can see our sequential revenue performance. We had a record quarterly revenue for the second quarter, as did the Manufacturing Services and US Lab Services. China Lab Services also had an excellent performance, sequentially growing more than $16 million above the first quarter level.

Slide 10 please. This slide shows our GAAP P&L. Gross profit grew 18.9%, driven by strong revenue growth, productivity improvement, cost control and effect over the RMB with US dollar. Gross profit margin in the second quarter of 2014 increased 130 basis points over the same period of 2013 to 37.7%. Relative to our expectation, at the beginning of the year, the favorable foreign exchange rate had about 80 basis points in positive impact on the gross profit margin.

Operating income grew 9%, reflecting the strong gross profit growth as well as investments for future growth that we highlighted earlier in the year. Operating margin of 17.1% is up 100 basis points less than last year's second quarter of operating margin over 18.1% mainly due to higher G&A, R&D expenses and our investments in infrastructure.

As Dr. Li highlighted, we now expect gross margin for full year to be at least one full percentage point above last year's and for operating margin to be slightly lower compared to 2013 and improvement over our previous view due to improvement in gross profit margin and effective foreign exchange rate impact of weak RMB relative to the US dollar.

Other income/expense were year-over-year at a slower rate in revenues. There were many moving parts in this line item. Growth in other income/expenses resulted from a $2.2 million gain on the sale of an investment by our corporate venture partner. Smaller equity method income investment from our joint ventures with PRA and MedImmune and other equity method investment from our venture fund investments, and higher interest income due to higher cash balance and higher investment return, partially offset by mark-to-market loss on foreign exchange forward contracts of $2.5 million, which compared to the mark-to-market gain of $3 million in the second quarter of 2013.

Income tax expenses rose 72.4% due to higher effective tax rates and an unfavorable comparison to the second quarter of 2013, which had certain non-recurring tax benefits including a $1.1 million one-time tax refund. We expect our 2014 full year effective tax rate to be about 19%, because certain expenses are not tax deductible such as mark-to-market loss from foreign exchange forward contracts and share-based compensation expenses for China-based parties.

Turn to Slide 11 please. Looking at a sequential GAAP margin, you can see that our gross margins in the second quarter were near the high end of our recent quarters, while our operating margin was near the midpoint. On Slide 12, our non-GAAP P&L was impacted by the same factors as our GAAP P&L, strong revenue growth, solid gross margin improvement from productivity initiatives, cost control and a positive effect from depreciated RMB relative to the US dollar. Non-GAAP gross margin increased 150 basis points year-over-year to 38.7%. Non-GAAP operating margin for the quarter was 20.8%, only 10 basis points lower than the second quarter of 2013.

Other income/expenses line benefiting from venture fund investment performance and interest income, offset by mark-to-market losses, and the high effective tax rate mainly due to the mix of taxable income, deductible expenses and the prior-year one-time tax refund.

Turn to Slide 13 please. As with our sequential GAAP performance, our non-GAAP gross margin was near top of our recent range. And our non-GAAP operating margin was near the midpoint. Slide 14 please. On this slide, you can see the second results exceeded our guidance. We exceeded the top end of revenue guidance by $1.4 million and the top end of non-GAAP EPS by $0.01.

Turn to Slide 15 please. Now let's look at more detail for our foreign exchange rate change impacting the quarter. About 90% of revenues from our China-based operations recorded US dollars and about three-quarters of expenses are recorded in RMB, because our business model is fundamentally about Chinese operations serving Western and global pharmaceutical markets. When RMB appreciates against dollar, which had been the case over the last several years, our expenses appreciated relative to our revenue, putting pressure on our margins, which is why we hedged by purchasing foreign exchange forward contracts. We aim to realize an unrealized gains on these forward contracts to partially offset margin pressure from an appreciating RMB.

You will recall that in the first quarter of this year, the RMB depreciated suddenly against the dollar in an unusual move. As a result, we reported $13.9 million of mark-to-market losses from movement of forward curve on this slide from the yellow line at December 31, 2013, to the green line at March 31, 2014. The difference between these two lines reflects an approximate 3% depreciation of RMB against dollar. And we have to record the impact of that depreciation on foreign exchange forward contracts extending out to the end of 2015. Hence, the relatively large amount of mark-to-market loss.

We also recorded $1.8 million of realized gain in the first quarter. As you can see from this chart, the forward curve moved much less in the second quarter, the light blue line reflecting the forward curve on June 30, 2014, is slightly higher than the March 31 line, resulting in a mark-to-market loss of $2.5 million in the second quarter. We recorded $1.6 million of realized gain from settled foreign exchange forward contracts in the second quarter of 2014. If the forward line remains where it is now, we'll continue to have realized gains throughout the remainder of 2014, because all our foreign exchange forward contracts are in the money.

The financial guidance that we'll give today for third quarter and full year 2014 reflects our assumption that RMB/US dollar rate will not change significantly throughout the remainder of the year. We do not intend to any new forward contracts in the second quarter as there was no clear indication of the direction of exchange rate in the US dollar and Chinese RMB.

Turn to Slide 16 please. Our balance sheet remained strong. We have $374 million cash and short-term investments at end of June 30, 2014. We currently have $127 million debt as of June 30, mostly from bank borrowings. Our operating cash flow has been strong, but lumpy in the first half. Second quarter operating cash flow was low due to relatively lower revenues in the first quarter and the timing of corrections. Our capital expenditures were accelerated in the second half with our largest project being our two-year $100 million small molecule manufacturing facility expansion project in the city of Changzhou and approximately $10 million investment in Illumina X Ten sequencing instruments.

Our net cash has decreased sequentially as we have been active in purchasing our own stock. We bought back $6 million of our own stock in the second quarter at an average price of $33.25. That completes our $100 million stock buyback program.

Now I would turn the floor back to Dr. Li to discuss the performance of several of our major businesses. Dr. Li, please?

Ge Li

Thank you, Ed. Slide 17 please. This pie chart shows the breakout of our revenues and major business groups. As you can see in the pie chart, our incremental revenue contribution on the right, the largest incremental revenue is coming from biologics. It grew from 4% to 7.6% of total revenue between second quarter of 2013 and second quarter of 2014. Incremental revenue contribution was small molecule manufacturing, which represents more than 27% of total company revenue. Laboratory testing grew in line with total company growth and maintained its 18.6% revenue share. The other business was also a solid contributor to revenue growth.

Now let's look at each of them in more detail. Slide 18 please. Chemistry and discovery achieved 8.3% growth as both synthetic chemistry and medicinal chemistry had steady year-over-year growth. This growth rate had been impacted by the reduction in medicinal chemistry business from one multinational customer, which we currently disposed. We expect the sequential growth in chemistry and discovery revenues in the second half of 2014.

Slide 19 please. Laboratory testing service performed very well, growing 15% year-over-year. We also aligned the testing service into one division earlier this year to provide our customers with better (inaudible) of our preclinical testing services. The growth came from several business, especially genomics, biology, analytical development, and bioanalytical services. We expect this growth to continue in the second half and to achieve mid to high-teens full year revenue growth. One of the bright spot of our service in lab testing division is genomics, where we're seeing a strong demand for the sequencing service made possible by the purchase of our new Illumina X Ten instrument.

Slide 20 please. WuXi is the partner of choice in developing and manufacturing biological products in China with end-to-end service capabilities and the capacity. Revenue was up 120% in the second quarter and expected to double for the full year of 2014. Our biologics customers phase is now about 50 companies, including six of the top 20 largest pharmaceutical companies. The key source of growth in biologics over the next several years will be manufacturing. We are planning 15 GMP manufacturing campaigns in 2014 and 2015. We're making plans to build the biologics commercial manufacturing facilities to meet the strong demand we are seeing. Biologics will be a key growth driver for the company in coming years.

Slide 21 please. Another key growth driver will be small molecule manufacturing. Revenue grew 13.2% in the second quarter and expected to accelerate in the second half for full year revenue growth of about 20%. Our early-stage pipeline has doubled the number of our products and tripled in revenue over the past five years. Our late-stage pipeline has grown from one product three years ago to 20 today, consisting of eight commercial products and 12 in Phase III clinical development. Commercial pharmaceuticals have a long lag time, providing us with sustainable revenue stream.

You'll remember the last year, we've had FDA inspection for manufacture of an advanced intermediate for commercial products. In the second quarter of this year, we passed the second FDA inspection for manufacturing of our API. Our regularly expanding pipeline of early and the late-stage products is leading us to construct a new facility in Changzhou. The CD is about 120 miles away from Shanghai. Facility construction in Phase I will double the company's current manufacturing capacity and will be operational by fourth quarter of 2015. Upon completion of the entire product, the site will triple current capacity and could employ more than 1,500 employees to seamlessly move new chemical entities from early-stage process development to preclinical and clinical deliveries to commercial production.

Slide 22 please. US Lab Services is rebounding, achieving revenue growth of 9.6% in the quarter. The overall business is stable. And the two businesses are growing rapidly, cell therapy manufacturing and the material characterization. In cell therapy, we are working with 15 customers including NewLink Genetics with whom we've signed a contract for manufacturing our cell therapy product candidates for pancreatic cancer. Strong demand in this area is leading us to expand our capacity by building a new cell therapy manufacturing facility in Philadelphia to be completed around mid of 2015.

This expansion will support growing customer demand for development and CTMP manufacturing capabilities for allergenic and autologous cell-based therapeutics. In material characterization, regulatory requirements are driving strong demand, which we are meeting by building a new facility at St. Paul in June.

Slide 23 please. We continue to see strong demand for our service. We have increased the low end of our revenue guidance and we also increased our GAAP and non-GAAP EPS guidance for the year. We are also providing guidance for the third quarter revenue and the GAAP and non-GAAP EPS, which you can see here.

Slide 24 please. So to conclude, we are achieving strong revenue growth. We're making the investment necessary to sustain strong revenue growth. And we remain focused on our mission to build the best open access platform of technology and capabilities to enable anyone and any company to discover, develop and commercialize healthcare products to benefit the patients.

And now Ed and I will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Bin Li of Morgan Stanley.

Bin Li - Morgan Stanley

My first question is on the biologics. You've grown your revenue very rapidly. Can you tell us what's your backlog and how should we think about the margin impact as your revenue is growing so rapidly? Is the business, is it dilutive or accretive to your average margin?

Edward Hu

We continue to sign up new contracts. And the margin also dramatically improved. It's approaching the company average now.

Bin Li - Morgan Stanley

I have a follow-up question also on the biologics. I'm pretty intrigued by your cell therapy initiatives. Can you spend a little more time to tell us more about the business projection opportunities in this in terms of if you can quantify your backlog and also your current capacity versus the demand? Do you foresee that the demand will be growing rapidly that you have to expand your capacity not just in Philadelphia, but perhaps in China?

Ge Li

The cell therapy certainly is a growing area. And apparently, the business still offers more. But we do believe we're going to see strong growth in the area. So that's why we're expanding our cell manufacturing capacity in Philadelphia. We do have a plan to start to configure building GMP manufacturing suite in China.

Bin Li - Morgan Stanley

What do you think it's still in breakeven or to make profit?

Ge Li

In the US, cell therapy business is already making profit.

Operator

Your next question comes from Serena Shao from Merrill Lynch.

Serena Shao - Merrill Lynch

I have a follow-up question on biologics as well. So for your commercial manufacturing plans, do you have a more detailed plan for its construction? And how much capacity are you adding to the current existing biologics manufacturing capacity?

Ge Li

Our biologics manufacturing facility is starting to see quite full. That's why we are making the decision to expand our facility. And the new facility will be online in 2016. We are looking to add a minimal fixed line of 2,000 liter regs or strain.

Edward Hu

The construction will probably begin early next year.

Serena Shao - Merrill Lynch

Currently biologics is 7.6% of your total revenue. How much of that is coming from your biologics manufacturing business?

Ge Li

In the second quarter, the biologics manufacturing is low single digits, but it's rapidly growing. Third quarter and fourth quarter, it's going to exponentially grow.

Operator

Your next question comes from Tycho Peterson from JPMorgan.

Tycho Peterson - JPMorgan

Wondering if you could talk a little bit more just broadly about your plans in genomics now that you've got extended units and you're beginning to rest shortly? Could you maybe just about the backlog of work and the scope to which you plan to build that out?

Ge Li

Illumina X Ten instruments arrived and they're currently operational. And our genomics business actually is seeing nice growth and this is an area we're committed to invest.

Tycho Peterson - JPMorgan

Can you maybe just talk a little bit about the mix of customers for the genomics business then? Are they largely biotech companies? Are they China-based companies?

Ge Li

We have global customers, global pharmaceutical companies, biotech companies and the local businesses and hospitals as well.

Tycho Peterson - JPMorgan

And then on just the guidance, I'm just trying to understand the EPS guidance, because there's a little bit of lack of leverage. And I know you're talking about some reinvestments. But are there kind of incremental investments that you're baking into guidance for the rest of the year? And can you maybe also just talk about CapEx plans beyond the end of '14 as we start to think about 2015? Should we think about incremental CapEx similar to what we saw in '14?

Edward Hu

The EPS guidance was moved up by $0.02 in the bottom, mostly reflected (inaudible) probability from operating income level. And for CapEx, as you know, since we're planning to build commercial manufacturing facility beginning next year, so incrementally, I think '15 CapEx spending will be higher than 2014.

Tycho Peterson - JPMorgan

Just how do you see cash flow in the back half of the year? Is it little bit like this quarter? Do you see that picking up?

Edward Hu

Cash flow operating second half, actually from third quarter will be picking up. And total cash spending will be impacted by the second half CapEx spending. We see probably cash flow overall neutral.

Operator

The next question comes from Matt Bacso from William Blair.

Matt Bacso - William Blair

My first question relates to PRA joint venture. Can you remind us again what exactly that consists of and when you expect that to begin to ramp?

Ge Li

The PRA joint venture, the scope is focused on China, Hong Kong and Macau and focused on providing full service clinical trials on Phase I, Phase II, Phase III, also have functional outsourcing service, embedded service and basically outsourced into the pharma companies. So this business is taking hold. We have been building backlog. But the problem in China, it takes nine to 12 months to get a clinical trial approved. So we don't see a significant revenue this year. But starting from mid-next year, it should ramp up.

Operator

Your next question comes from Jack Hu from Deutsche Bank.

Jack Hu - Deutsche Bank

The first question is on your pie chart. So when I look at the numbers, lab testing actually grew about 0% from the first quarter, but grew 15% in second quarter. Dr. Li just mentioned you're going to grow mid-teen to high-teen for the full year, which means you're going to accelerate in the second half. Also the same scene for small molecule actually. It did grow 16% in first quarter, 13% in second quarter. But you just mentioned you're going to accelerate in second quarter as well. So my question is really what are the variables impacting them? Or is this just a quarter-over-quarter variation, which is normal?

My second question actually is a housekeeping question. You just mentioned full year basis, the operating margin will be only slightly off versus last year, versus the previous guidance of 100 basis points to 200 basis points erosion. However even I've assumed much higher tax rate in the second half, which is 19% for the full year, I still find your guidance is kind of conservative. So what are the conservative assumptions you are making between the EBIT line and the pre-tax income line?

Ge Li

Talking about the testing business, the first quarter is the slowest quarter. So we see the demand picking up and we feel pretty confident we're going to deliver the number. Also, we start to see a favorable trend on the outsourcing of the testing services.

Edward Hu

Operating margin, we said it slightly grew than last year, and that's reflected in EPS, because the other variables, the other income/expense line including FX gain or losses, which is not that easy to determine, so EPS guidance we provided in the best estimate we have right now.

Jack Hu - Deutsche Bank

It seems the mark-to-market loss is based on forward curve, based on the way it is presented. But I also recall it should be somehow based on the spot rate. When we look at the spot rate actually at the end of the (inaudible) is 6.15 versus 6.22 actually as of March 30. So theoretically, if (inaudible), we should be booking a mark-to-market gain here. How do you determine this forward curve?

Ge Li

The mark-to-market loss is actually priced based on the forward curve, the entire curve, not based on the spot rate. The spot rate is only for contracts. The forward curve, the light blue line is still above the March 31st forward curve. So that's why had this $2.5 million mark-to-market loss in the second quarter.

Operator

The next question comes from Paul Knight from Janney Capital Markets.

Bryan Kipp - Janney Capital Markets

This is actually Bryan Kipp on behalf of Paul. I think you said that you expect back half strength in manufacturing services, especially because of the biologics ramp and small molecule demand. You're facing tougher comps obviously year-over-year in the back half. Just wanted to get additional clarity on what's baked in there. Do you expect some conversion on some of your underlying advanced intermediate drug collaborations to more commercial in the back half? Just kind of pacing there whether it's Phase I, Phase II kind of conversions or is it just status quo? Just any help there would be great.

Edward Hu

We have a pretty good visibility on manufacturing. We have quite a strong pipeline.

Bryan Kipp - Janney Capital Markets

And then I think somebody asked, but ensuring the number. Did you guys give that biologics backlog? I know you said there was about $50 million biologics backlog last quarter. Have you seen an uptick there ahead of launch of your new facility or building up the new facility?

Ge Li

I don't have the exact numbers, but it's probably in the 70s range now. And we also have a pretty good visibility from the customer discussions of the launch timeline. That's why the commercial facility needs to be online by end of 2016. You have to catch launch timelines for customers.

Bryan Kipp - Janney Capital Markets

Do you expect any gains from some of your venture investments in the back half or are you guys expecting modeling for nothing?

Ge Li

Probably not much for the second half.

Operator

The next question comes from Tim Evans from Wells Fargo Securities.

Tim Evans - Wells Fargo Securities

Ed, I'm trying to understand a little bit better how much of a margin drag you are currently experiencing from businesses where you're investing heavily. Is there anything that you can give us to help us understand that, maybe how much revenue are you currently generating from businesses that have below-average margins or something like that?

Edward Hu

It's approaching the company average in the coming quarters. The other business in the clinical trial or the PRA I mentioned is still losing money. And then other business in genomics and certain area that we are doing R&D work and prepare for service launch, those are kind of a drag.

Tim Evans - Wells Fargo Securities

And in the genomics business specifically, I mean it seems like you're going to need to generate a fairly significant amount of revenue in that business to fully utilize the X Ten. I'm just wondering do you feel like you have that level of revenue in your backlog when the system is full installed?

Ge Li

Yeah, we're working on that. Clearly, there's going to be demand from the customers on these types of services. So yeah, we're working on it.

Operator

The next question comes from Dave Windley from Jefferies.

Dave Windley - Jefferies

Following on the last question, can you describe in what way the demand for your genomics services comes in? Is that a standalone sale, or is that mostly companion to some other service that you're providing for the client and they ask you to also do the genomic sequencing activities?

Ge Li

A little bit of both. It's a mix of both.

Dave Windley - Jefferies

And when it comes in as a companion to what other services?

Ge Li

It comes with some clinical trial service and the discovery service.

Dave Windley - Jefferies

Ed, with the out-of-trend movement of the RMB in the first half of 2014, has that changed your hedging strategy at all? And as we get beyond the next quarter or two and the lines that you're depicting in the slide cross and you perhaps realize loss situation, how should we think about that impacting pre-tax income, say, beyond 2014?

Edward Hu

Right now, we've had to stop buying any new forward contract as it's not clear the direction of the RMB. And I think the Chinese government is trying to engineer a way that has both direction. So the currency will be moved in both direction that to fade off those speculators. We probably will intend to newer hedge contract when we see the direction that's clear, but also we're going to adopt our hedge economy when we buy any new contract. So there won't be any mark-to-market gain or losses on booking anymore if we hedge.

Dave Windley - Jefferies

And that will be active or implemented at what time starting in next fiscal year?

Edward Hu

Mostly likely, yeah, the next fiscal year.

Operator

The next question comes from Bin Li from Morgan Stanley.

Bin Li - Morgan Stanley

Dr. Li, I think in your remarks, you mentioned that your customers consist of companies, research institution, but also I think you mentioned hospitals. Can you tell us what type of services you're doing with hospitals? Is it diagnostics or probably is it something that you will do going forward if you're not doing it?

Ge Li

Currently we're in active collaboration with key opinion leaders on the research.

Bin Li - Morgan Stanley

Is it something in the plan that you might move to clinical diagnostics?

Ge Li

Well, never say never, right? Currently we want to extend our researching capabilities to benefit patients.

Ron Aldridge

So with that question, it concludes today's conference call. We thank you all for participating and we look forward to speaking with you again in November to go over the third quarter results.

Operator

And that does conclude today's conference. Thank you for your participation. You may all now disconnect.

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