Cepheid (CPHD) John L. Bishop on Q1 2016 Results - Earnings Call Transcript



Q1 2016 Earnings Call

April 28, 2016 5:00 pm ET


Jacquie Ross - Vice President, Investor Relations

John L. Bishop - Chairman & Chief Executive Officer

Daniel Madden - Chief Financial Officer & Executive Vice President


Daniel Arias - Citigroup Global Markets, Inc. (Broker)

Jack Meehan - Barclays Capital, Inc.

William R. Quirk - Piper Jaffray & Co

Karen Koski - BTIG LLC

Dan L. Leonard - Leerink Partners LLC

William Bishop Bonello - Craig-Hallum Capital Group LLC

Sung Ji Nam - Avondale Partners LLC

Derik De Bruin - Bank of America Merrill Lynch

Doug Schenkel - Cowen & Co. LLC

Tycho W. Peterson - JPMorgan Securities LLC

Mike S. Matson - Needham & Co. LLC

Miroslava Minkova - Stifel, Nicolaus & Co., Inc.

Brian D. Weinstein - William Blair & Co. LLC


Good day, ladies and gentlemen, and welcome to Cepheid's First Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we'll conduct a question-and-answer session and instructions will be given at that time. As a reminder, this conference call may be recorded.

I'd now like to hand the conference over to Ms. Jacquie Ross, Cepheid's Investor Relations. Ma'am, you may begin.

Jacquie Ross - Vice President, Investor Relations

Thank you, Sayd. Good afternoon and welcome to Cepheid's 2016 First Quarter Conference Call. On the call today are John Bishop, Chairman and Chief Executive Officer; and Dan Madden, 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. Once again, we have published a summary of our prepared remarks ahead of today's call. This summary is available on the IR home page of our website and on request from Investor Relations.

During today's call, Cepheid will make forward-looking statements, including guidance as to future operating results and future products. Because such statements deal with future events, actual results may differ materially from those projected in the forward-looking statement. 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, April 28, 2016, 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 L. Bishop - Chairman & Chief Executive Officer

Good afternoon, and thank you for joining us for a review of our 2016 first quarter, which represented a strong start of the year for Cepheid, with solid execution on a number of fronts. First quarter revenue of $144.8 million was ahead of expectations with solid performance across the business. System revenue of $24.3 million was up 30% year-over-year, the highest revenue reported for systems in any first quarter in the company's history.

Notably, our first quarter placements included our milestone 10,000th GeneXpert System. While we have been placing GeneXperts since 2006, it is notable that more than half of the 10,000 system installed base has been added in the last 10 quarters, clearly highlighting that we continue to see strong momentum in system adoption.

While we are no longer reporting system placements on a quarterly basis, I will share that the commercial system placement count for the first quarter of 2016 was substantially higher than any other first quarter in the company's history. Commercial system placements included nine Infinitys, highlighting another strong start to the year.

First quarter placements and revenue did include approximately 300 GeneXpert Systems that have been installed in India. An additional 200 systems are in-country and we expect most of these systems will be installed during the second quarter, which in total will therefore represent approximately 500 new system placements for India in the first half of the year.

Moving to Reagents. Our Xpert test portfolio now includes 20 tests in the United States and 23 internationally. For the first quarter, reagent and disposable revenue was $120.5 million, up 6%, or 10% in constant currency from the unusually strong first quarter of 2015, which benefited from a severe flu season. Sequential growth in our Reagent business was in large part offset by an almost $4 million decline in biothreat resulting from seasonal utilization. In fact, our Commercial Reagent business topped $100 million for the first time in the history of the company.

Our HAI franchise remains the largest dollar contributor to our Reagent revenue, although the Critical Infectious Disease franchise with continued faster growth in Flu, Flu/RSV and TB is quickly gaining ground. As you saw with the important MRSA next-gen and Carba-R releases this quarter, Cepheid remains committed to ensuring that we have the most complete and relevant HAI portfolio in the business.

That said, we continue to diversify our revenues as we introduce new products and other product portfolios. In 2012, HAIs contributed more than 50% of our total revenue. And in the first quarter of 2016, they contributed less than 40%. We expect this trend to continue as growth in the Critical Infectious Disease, Sexual Health and Virology product portfolios continues to outpace growth in HAIs.

Our 2016 HAI priorities include driving faster or further awareness and adoption of a number of newer tests, such as Carba-R, where we expect to contribute growth in the quarters and years ahead. Similar to MRSA, Carba-R is evolving into both a diagnostic and a surveillance opportunity. And we do expect some customers to introduce screening programs amongst high-risk patient populations in areas that have seen outbreaks of carbapenemase-producing organisms, or CPOs.

For example, there are a number of hospitals within the UK that are using Carba-R surveillance to detect CPOs following an increase in the prevalence of carbapenem-resistant organisms in the local area. As seen in data presented at ECCMID earlier this month, surveillance testing with Xpert Carba-R can reduce the time to result from days to minutes, allowing for faster rule out of negative patients and faster time to isolation for colonized patients, thereby reducing infection control-related costs and the total cost of care.

More broadly, we're aggressively working with our customers to reinforce the value and importance of molecular HAI testing. As you know, the debate for and against molecular testing for both MRSA and C. diff has been vigorous since the first molecular tests were launched in 2007 and 2009, respectively. While it is true that the volume of the debate has increased a little in recent quarters, we consider this a near-term tactical headwind rather than a structural shift away from molecular testing. The volley of publications, both for and against molecular HAI tests, will continue.

Case in point, a publication in JAMA Internal Medicine was a more recent affirmation of molecular C. diff testing. The study highlighted the potential importance of detection of C. difficile and asymptomatic carriers in a Canadian hospital. They used PCR on rectal swab specimens of patients to test for C. difficile on admission from the hospital emergency department and placed carriers on contact precautions, but without need for private rooms, a simple and inexpensive approach that could be implemented virtually in any hospital worldwide.

The study period spanned a decade, and from the 2013 start of the intervention documented a remarkable 63% reduction in healthcare-associated C. diff infection cases compared to non-intervention controls. To put the results into perspective, after years of highly endemic C. diff infections, this hospital now has the lowest healthcare associated C. diff infection incidence rates amongst 22 academic institutions in the province of Quebec.

More broadly, even as the debates on MRSA and C. diff continue, there can be no debate that the focus on antibiotic stewardship and antimicrobial resistance is intensifying on a global basis. As a result, we are confident that the global molecular HAI market will continue to grow.

And Critical Infectious Disease had a strong first quarter as noted, with higher-than-expected flu revenue associated with continued gains in market share and a late spike in what was still a relatively modest flu season. We believe customers are increasingly recognizing the benefit of products with improved sensitivity and specificity, especially in seasons where influenza strain variants can impact conventional test performance. Our Xpert Flu/RSV test continues to be extremely well received globally and, in fact, now represents more than half of our total flu revenue.

RSV, of course, is most recognized as a threat for pediatric patients, but the CDC reports that it is responsible for more than 175,000 hospitalizations and 14,000 deaths of adults aged 65 and older, each year in the U.S. Rapid antigen tests have been shown to have a sensitivity as low as 29% in adults with many requiring culture confirmation of negative results. So RSV is growing in recognition for use in adult patients as well as pediatrics.

It's worth commenting that a number of our customers are using our Xpert cartridge as a front-line test for flu and RSV before reflecting negatives to a broader respiratory panel. This approach is consistent with what could be an emerging question in reimbursement, with a Medicare contractor, Palmetto for example, recently guiding labs to consider, quote, a targeted diagnostic evaluation before ordering a larger respiratory panel, particularly if there is a high likelihood that the patient has flu or RSV, close quote.

Our tuberculosis test is also part of our Critical Infectious Disease portfolio and we're pleased to note that a new consensus statement released within the past few days from the U.S. National Tuberculosis Controllers' Association and the Association of Public Health Laboratories covering the use of Xpert MTB/RIF to support decision making for airborne infection isolation, commonly referred to as respiratory isolation, in healthcare settings.

The new consensus statement recommends that in-patients with suspected infections pulmonary TB can be released from respiratory isolation after two Xpert MTB/RIF negative results. These recommendations from the NTCA and the APHL in conjunction with the expanded FDA claims that were obtained in February 2015 could help drive standardization of patient management and use of Xpert MTB/RIF in the algorithm for managing patients suspected of pulmonary tuberculosis infection in the United States.

Our Sexual Health business continues to grow, and we're particularly encouraged by the opening of a second Dean Street-style sexual health clinic in London, which points to the potential proliferation of this model for delivery of sexual health services. We believe that this very high volume point-of-care application for our GeneXpert Infinity System is a compelling reference for even the highest throughput customers.

Supporting this, in a soon-to-be-published study, Dr. Max Chernesky of McMaster University found the Infinity's work flow to be superior to other platforms in a head-to-head comparison between the Infinity, m2000, cobas 4800, and Viper XTR. Of the systems evaluated, Infinity's work flow was found to be superior in overall operating efficiency and turnaround time. Our focus of this year is therefore to build on the success we have seen in small to medium-sized accounts and drive adoption of our Sexual Health test in higher volume accounts.

Moving to Virology, revenue grew 40% sequentially, albeit off of a small base. This was clearly a new market for Cepheid when we introduced HIV and HCV products outside the U.S. about a year ago, and our learning curve has been steep, but is successfully developing.

As you know, these markets were developed around older technologies that effectively restricted Virology to batch-based testing performed in centralized locations. Multiple third-party evaluations have now found our Xpert test performance compares very favorably and in a number of cases outperforms the market leaders. And the flexibility of our system allows labs to offer more complete centralized testing round the clock and on weekends, thereby significantly expanding access to more timely test results.

Further, the ability to more broadly disseminate testing capability is being recognized. Granted, we're still in the early stages of market penetration, but we are making solid progress. As we continue to develop this opportunity in 2016 therefore we feel substantially better equipped to drive market share gains.

Similar to what we saw at Dean Street for CT/NG, Cepheid offers the only practical molecular solution for near patient HIV and HCV testing, with the ability of both pre-exposure and post-exposure therapies for HIV and new therapies for HCV. We see these as opportunities that Cepheid is well positioned to address.

With regards to the compassionate opportunity, we expect to achieve World Health Organization or WHO pre-qualification for both our HIV viral load and HIV qualitative test in the near term, with HCV viral load to follow. These are important milestones relative to the emerging markets, with many donors requiring pre-qualification prior to deployment of the test. UNITAID's goals for HIV call for 90% of HIV patients to know their status, and for 90% of those diagnosed with HIV to be receiving antiretroviral therapy or ART, and for 90% of those receiving ART to be virally suppressed.

In our view, the only way for these ambitious goals to be achieved is for a meaningful proportion of testing to move beyond centralized labs and be located substantially closer to the patient. Cepheid fully expects to be driving that transition in large part through the more than 5,000 GeneXpert Systems that are currently being primarily used for TB in these geographies.

I'll now move on to an update on the test and systems in our pipeline. First and as extension to the existing FDA-cleared bacterial isolates claim for Xpert Carba-R, we submitted data at the end of the first quarter to support additional claims for use with rectal and perirectal swab specimens. If cleared, these additional claims would allow the test to be used as an aid to infection control and the detection of carbapenem non-susceptible bacteria that can colonize or infect patients in healthcare settings.

HIV viral load and HCV viral load continued to progress through the clinical trials phase in the U.S., with HIV on track for submission to the FDA around the end of the year and HCV following in early 2017. Xpert Trichomonas for male urine claim is on track for FDA submission during Q2. Our Xpert MRSA next-gen is on track for release in the U.S. later this year and Xpert MTB/RIF Ultra is on track for release outside the U.S. later this year.

Now, Xpert Bladder Cancer is on track for a commercial outside the U.S. in the fourth quarter and our Xpert Xpress Flu is on track for commercial release outside the U.S. and for moderately complex settings in the U.S. this year. Finally, our Xpert Xpress Group A Strep has moved into 2017.

Moving to systems, we continue to be very pleased with the evolution of our Honeycomb System. Final design for the system was locked during the quarter. And following the delivery of the first systems in Q4, the final system was delivered to biologics during the first quarter allowing initiation of the development phase of our Xpert Breast Signature product.

Moving to GeneXpert Systems more broadly, based on early market feedback and changing clinical practices, we have identified an opportunity to broaden our penetration in the U.S. point-of-care market by leveraging our broad test menu and accelerating the development of certain Xpert Xpress tests for use on our existing GeneXpert Systems.

For example, our initial experience with our new distributor partners has made it clear that CT/NG could prove a particularly strong performer in the point-of-care, with this test driving many of the early discussions that Henry Schein has been having with prospective accounts. This is consistent with a recent market research report from Kalorama that has suggested that Women's and Sexual Health may be an even larger opportunity than regulatory for the molecular point-of-care diagnostics market by 2020.

As a further example was illustrated with a recent paper in The New England Journal of Medicine, indicating that clinicians are starting to prescribe the use of antibiotics for community-acquired cases of MRSA skin infections, versus simply lancing and draining blisters and abscesses associated with the infections. This may well advance incremental opportunity for our Xpert MRSA SSTI product and is in line with our recently announced Diagnostics First marketing initiative.

Considering this potential demand for a broader menu utilization beyond respiratory test and the associated test volume requirements, we have decided to build on our experience with the CLIA-waived single module GeneXpert System, and plan to introduce our existing two and four module GeneXpert Systems to the CLIA-waived market. We believe that this coupled with our Xpert Xpress program to provide tests with significantly shorter times to results should provide a differentiated point-of-care product portfolio, which will be even more compelling when later combined with the Omni system.

We are currently targeting the 2017/2018 flu season to deliver the first Xpert Xpress test on the GeneXpert Systems for the CLIA-waived market. We previously announced the expansion of the portfolio of Xpress products with the addition of a standalone flu test to complement the Group A Strep and the combined Flu/RSV test. Further, we are initiating work on an Xpress version of our CT/NG test and will provide an update on the expected timeline when we publish our annual updated target menu in the summer.

Our updated U.S. point-of-care strategy is fully in line with and capitalizes on our early experience with our initial distributor. Further, I'm pleased to announce that in addition to our previously-announced agreements with Henry Schein and Medline, Cepheid has also signed a U.S. distribution agreement with McKesson.

All three partners will of course play an important role in broadening our footprint in the non-acute market, delivering our systems to both moderately complex physician's offices and CLIA-waived testing environments. We believe that utilization of our existing GeneXpert II and GeneXpert IV systems combined with our developing Xpress test menu will provide distribution partners with an even more compelling and differentiated molecular diagnostics offering intended to broaden our penetration of the point-of-care and the POL, which is included in that markets.

For the emerging markets, internally Omni testing has been underway for some of the Xpert tests targeted for this market, with a number of the tests successfully running on the Omni system. Majority of the test components are fully operational and functioning as expected.

This includes the electronics, medical aspects in addition to the fluidics, ultrasonics and software. However, we're going to invest extra time to ensure that the detection and amplification module of the system, which we refer to as the I-CORE, is functioning at a fully robust manner such that it will address both our current and future test menu. As a result, we now expect to deliver the Omni to the emerging markets no later than the third quarter 2017.

Our team is driving hard and there is a possibility that we will be able to complete development and enter the market sooner, but we would rather surprise with a shorter timeframe than announce additional delays in the coming quarters. We believe it is the right decision to extend development up front rather than release the system with a functionality that might be restrictive on future strategic plans.

From a guidance perspective, you will recall that our revenue expectations for Omni were quite modest for this year, so we're not making any Omni-related guidance adjustments associated with this introductory delay.

And with that, I'll hand the call over to Dan.

Daniel Madden - Chief Financial Officer & Executive Vice President

Thank you, John, and good afternoon, everyone. Please note that I will be discussing non-GAAP results unless otherwise specified. Total revenue of $144.8 million grew 9% from the first quarter of 2015, or 13% on a constant currency basis. System and other revenue of $24.3 million grew 30% from the first quarter of 2015, or 33% on a constant currency basis. And reagents and disposable revenue of $120.5 million grew 6%, or 10% on a constant currency basis.

North America revenue of $82.4 million was flat from a year ago, with a sizable decline in non-clinical revenue offsetting growth in our Clinical business. International revenue of $62.4 million grew 24% from the same quarter a year ago, driven by both our HBDC and commercial businesses. On a constant currency basis, international revenue grew 35%. Recall that our Q1 2015 revenue included $2.2 million of hedge gains that we did not have this year.

Non-GAAP gross margin of 51.5% was slightly ahead of our expectations and a good start towards the full-year target of approximately 52%. As expected, gross margin was lower, both sequentially and year-over-year, due to a less favorable mix which more than offset manufacturing efficiencies and a small royalty benefit.

Non-GAAP operating expenses excluding collaborative profit sharing were lower than expected at $65.9 million, primarily associated with the timing of clinical trial and other investments. Non-GAAP net income for the first quarter was $6.3 million or $0.08 per share. GAAP net loss was $6.6 million or $0.09 per share. A reconciliation of our non-GAAP results to our GAAP results is available in today's press release.

Moving on to the balance sheet. Cash, cash equivalents and investments decreased to $356 million, reflecting planned capital investments in office and manufacturing facilities to support our growth. DSOs increased to a more normalized rate of 46 days and inventory increased about $2 million to $150 million.

Moving to guidance. There is no change to the 2016 full-year guidance established in February. With that in mind, we continue to expect full-year revenue in the range of $618 million to $635 million and non-GAAP gross margin of approximately 52%.

We continue to expect full-year R&D to be flat to slightly down on a percent of revenue basis, although up on a dollar basis as we continue to invest in our test menu expansion and system extension programs. R&D was lower than expected in the first quarter, but this was really driven by the timing of clinical trial expenses and we expect these to escalate as we proceed through the year. Further, there is no change to our full-year expectations for sales and marketing and G&A, which on a percent of revenue basis, we expect to remain flat to down modestly compared to 2015.

For 2016, we continue to expect non-GAAP operating margin of approximately 5% and non-GAAP earnings per share to range between $0.22 and $0.28. On a GAAP basis, we expect net loss per share to range between $0.57 and $0.51. For the second quarter specifically, we expect revenue to be flat to slightly up versus the first quarter, with a double-digit-million dollar decrease in flu expected to offset most if not all of the growth in other products.

We continue to expect first half gross margin to be lower than the full-year non-GAAP gross margin target of approximately 52%, with a higher mix of HBDC, including another 200 GeneXpert Systems to India expected to impact mix in the second quarter. You should therefore look for second quarter gross margin to be marginally lower than the first quarter.

Before I hand the call back to John, I'll share a few comments on our 2017 business model objectives. First, I will note that we are making excellent progress on our enzyme replacement program and the manufacturing automation initiatives that together are expected to contribute more than 400 basis points of gross margin improvement next year. The new enzymes are on track to be included in products starting later in 2016 and the automation initiatives are also moving forward very nicely. With no delays for the timeline required to deliver the cost savings expected, we remain confident in our ability to deliver the cost improvements targeted for the full year 2017.

Manufacturing aside, we continue to actively manage the other elements of our business towards achievement of our committed business model targets. We are currently in the midst of detailed planning for 2017 where we prioritize areas of investment and establish budgets and constraints.

Put differently, it is the actions we are taking today that are laying the groundwork to meet our business model goals next year. We remain committed to delivering non-GAAP operating margin in the mid to upper-teens for the full year 2017 and are actively managing our 2016 activities and planning our 2017 activities with that commitment in mind.

With that, I'll turn the call back to John.

John L. Bishop - Chairman & Chief Executive Officer

Thanks, Dan. Again, this was a solid start to the year for Cepheid, with good momentum in system placements, strong execution on our manufacturing efficiency programs and good progress on our R&D projects overall. Notwithstanding the Omni delay, the system is shaping up well and we are confident that the decision to take extra time to enable us to deliver a system with the broadest potential strategic opportunity and value for Cepheid.

Speaking more generally, it is clear that the distractions from 2015 are behind us and I recently attended the ECCMID meeting in Amsterdam where the gathering momentum of the company was clearly visible. As we now move into the second quarter of 2016, I believe that we are in a far more stable and focused organization that is better equipped than ever to drive the tactical and strategic execution required of the business. I look forward to updating you on our progress in the quarters ahead.

With that, I'll invite the operator to open the call to questions.

Question-and-Answer Session


Thank you, sir. And our first question comes from Dan Arias from Citigroup. Your line is open. Please go ahead.

Daniel Arias - Citigroup Global Markets, Inc. (Broker)

Good afternoon. Thank you. John, what is the delay in the Omni launch for the emerging markets mean for U.S. commercialization in terms of timing? And then can you just talk to the strategy that you now envision there in terms of targeting POC accounts, first with the existing Xpert box and then shortly afterwards with the Omni box?

John L. Bishop - Chairman & Chief Executive Officer

Certainly. So relative to the U.S. time, we're releasing in, as we indicated, in 2017 there then clearly U.S. will be following that launch. So that would be back about potentially a couple of quarters following the emerging market launch in the U.S. market.

Now, as I look at the U.S. strategy, one of the things became really clear to us, and frankly, one of the items that we thought about and wanted to do a long time ago, was to look at bringing the GX IV and the GX II as well. So, in other words, a multi-module system into the point-of-care market for a CLIA-waiver. In those days, because we had never cleared yet, there was a lot of skepticism as to our ability from a regulatory standpoint to do that. Given our success right now and where we are, we're very confident that we should be able to get this through regulatory and into the CLIA-waived market.

The other item that's really changed the perspective is that as we've been looking at the market, that there's a lot of folks now also looking, competitors out there, and they have some reasonable products there. But they have very limited menu. We looked at it and we said, well, wait a minute, we have a very broad menu that can be applicable up against a much broader part of the market. So I mean as I already shared today, we're seeing very strong interest in CT/NG. In some ways, no surprise, but I think a lot of capability there to do that.

Now, you take that coupled with the Flu, Flu/RSV, Group A Strep, that's good. But then as you go into some of these markets, like I was indicating, with that new paper from New England Journal of Health (sic) [New England Journal of Medicine] (36:48), we have an SSTI product for MRSA that's been around now for a couple years. And that product is starting to grow now in large part because I think we're seeing opportunity here now for directed Diagnostics First aspect here to test those patients and then prescribe antibiotics appropriately.

Now, that's a change where now they're looking to use the antibiotics, where before on a skin/soft tissue infection there they were draining and then not treating. So incremental opportunities and I frankly think we're likely going to see more of those. So that, with the strategy now, gives us the ability to go into the market and then give an ability to have a multi-module system there that can address both the volume utility, because that's going to step up a little bit now versus where we were before, because of the breadth of menu which is now more broad and aptable into those markets.

So, overall, I think it's a major step forward to broaden the initiative. Now, once the Omni is available, then clearly we expect that to be a significant contributor as well. Now, obviously, the big difference is the Omni is the latest and greatest relative to component configuration. We talked about that on the release of the Omni and none of that has changed. What it does mean is the other systems of course are a little more costly. With the Omni program, I looked more to sell those, but we didn't have the multi-module capability we have GX IV.

GX IV, more expensive, so that means what we're going to be doing there is working with our distributors and we'll be fully enabling them to place these things on a reagent rental basis, which by the way, which is the way most everybody else is in the market right now, so we're not at a disadvantage there in the market. And I will say economically I think, as all of you are aware, we have a lot of capability because our low cost of goods on our systems, even with the GX IV, to very well work within that market.


Thank you. Our next question comes from Jack Meehan from Barclays. Your line is open. Please go ahead.

Jack Meehan - Barclays Capital, Inc.

Hi. Thanks. Good afternoon. Just wanted to ask a question around the guidance; could you describe some of the factors that help improve our visibility into the back half revenue build, just given the commentary around 2Q? And I guess off of that just you mentioned the first quarter commercial placements were higher than any first quarter going back, how much of that was the sales force? And is that the driver getting us to the second half revenue build? Thanks.

John L. Bishop - Chairman & Chief Executive Officer

Okay. I will – I'll take that part, then Dan will have some comments. So yes, certainly one of the things we've seen with the sales force alignment there, you know, I've spoken before about the instrument sales specialist going in, sort of specifically cold calling, getting more qualified leads there. And we've also talked about the funnel looking really good as a result of the sales force addition. So, I think these are early indicators that we're getting benefits there with the sales force expansion, certainly in North America. But in addition to that I mean we're seeing good growth internationally, not inclusive of the HBDC programs that are going forward there.

Now, the point you're making relative to test utilization on the systems, absolutely. That's definitely contributory. We're also seeing as the systems are being ordered that we're getting multiple tests being placed on the systems early on. So these are all going to contribute relative to as we look at growth going forward in the year. So, Dan?

Daniel Madden - Chief Financial Officer & Executive Vice President

Yeah. I think when you look at the shape of the year, when we launched guidance at the beginning of this year in our February call, we described kind of an average pattern made up of the last few years and talked about what percentage we've typically seen on average in this quarter. And at the time we highlighted that we expected it to be a little bit more back end loaded to that. So I point you to a couple of things.

First, that average that you typically have seen in Q2, I mean not typical but the average, was skewed a bit because you include Q2 2014, we had a very large order for almost 800 HBDC systems for China. If you look at last year, 2015, following a very strong Q1 and a more meaningful flu season, both in its severity and just a growing impact on our business because we are taking market share in flu, you'll see that Q1 to Q2 was flat. And so right now what we're looking at here is something similar for Q2, flat to slightly up, making up for a double-digit million dollar decrease in flu coming out of Q1.

And as we go into the second half, we expect increasing contribution from the North American sales force. We always said from the beginning, they're in the training that happened over the course of last year. They're starting to build their funnels, et cetera, but we expect an increasing impact from the sales force – North American sales force expansion as we move through the year. And of course, we have several new products, particularly outside of the U.S., with Virology that we expect to continue to ramp and contribute as we move through the year.


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

William R. Quirk - Piper Jaffray & Co

Great. Thanks, and good afternoon, everyone. Staying on the Omni for a moment here, John, does this require any re-engineering on the I-CORE? I guess are there any kind of injection molding parts that you guys are waiting on? And then secondly, regarding India, is the funding in place for the reagents? And if not or perhaps you can just kind of elaborate on what you expect from the timeline there? Thank you.

John L. Bishop - Chairman & Chief Executive Officer

Yeah, certainly. On the Omni question, yeah, we're looking at the I-CORE now, as I've indicated, to be sure that we're going to get robust performance. Looking at the timeline that we've given there, we wanted to cover all possible items that we needed to do, Bill.

So that was exactly what, as I said to the group, we're looking at this. I want to say, look, considering everything that we might have to do, not necessarily may have to do, let's work with that date because we don't want to disappoint the market relative to introductory dates. It's not good that one has to delay. But if we need to do it, let's do it one time. So we have built all the time in to give us the time that we need to cover anything that we need to do relative to ensuring that we get the robustness that we're looking for across the full breadth of current and future menu there.

On the second question was India. So on the India order, so as we've said, we have the 500 systems that will be delivered during the first half of the year, 300 systems of which are already effectively pretty much done. Relative to the test volume, there's about 800,000 tests associated with that. That is funded, so it's not a question of being up in the air. Of that, about 300,000 tests have already shipped. To go with that, you're going to get the majority of the remaining 500,000 tests will probably come in during the third quarter.

Jacquie Ross - Vice President, Investor Relations

The next one, Sayd.


Thank you. Our next question comes from Karen Koski from BTIG. Your line is open. Please go ahead.

Karen Koski - BTIG LLC

Thanks for taking the question. Just a question on guidance. It seems kind of gross margins and operating margins came in a bit ahead of consensus this quarter, yet you left gross margin guidance where it is. Can you provide a bit more granular detail of some of the upside and downside drivers of guidance exceeding or missing your 52% expectations?

Daniel Madden - Chief Financial Officer & Executive Vice President

Sure. So look, we've moved to annual guidance, as you know, and are targeting 52% for the year. And while we came in a little bit stronger than we might have expected in the first quarter, it was not dramatically different than we expected. And we're going to have some ups and downs, some minor ups and downs, in any given period. We actually had a pretty high mix of HBDC in the first quarter; we expect that to actually be even higher in the second quarter, just to be clear.

So generally, as we look to the year, we expect improvement in the second half versus the first half. And that's largely due to the manufacturing cost improvements that we put in place last year that will begin to show up in the greater – to a greater extent as we burn off the inventory that was built before those cost reductions went into place. And we have other cost reductions that we are working on in terms of enzyme replacement and other manufacturing automation and efficiency programs that will start to contribute as we really get to the very tail end of the year and into 2017.

I think the biggest thing that's going to make us fluctuate higher or lower than our target margin is generally going to be mix. We do have a variety of margins and products, and it's hard to always predict that mix with great certainty. So I think as we look forward, that's probably the biggest driver of the delta between being above or below 52% is really that mix of business.


Thank you. And our next question comes from Dan Leonard from Leerink Partners. Your line is open. Please go ahead.

Dan L. Leonard - Leerink Partners LLC

Thank you. I wanted to circle back to John's comment about revenue diversification. John, you mentioned that HAIs are sub-40% of your reagent sales now. Do you have any sense for what proportion of say new instrument motivation would be HAIs as opposed to the balance of your portfolio?

John L. Bishop - Chairman & Chief Executive Officer

Well, we're seeing right now, Dan, the menu as we're looking at the new systems being placed, we're seeing a broader aspect of the menus. So basically I'm saying menu items coming in that are still involving HAIs. I mean we still see accounts starting up with MRSA, sake of discussion C. diff, but then we see accounts also starting with CT/NG, Flu, TB. So what we're clearly seeing now is systems being driven in placement with the broad portfolio of tests that we have available. And then depending upon the individual accounts that are out there, it's up to them as to what they're selecting out of the portfolio.

Daniel Madden - Chief Financial Officer & Executive Vice President

And, Dan, just to clarify, the reference to the 40% was in reference to total revenue, not just reagent revenue.


Thank you. Our next question comes from Bill Bonello from Craig-Hallum. Your line is open. Please go ahead.

William Bishop Bonello - Craig-Hallum Capital Group LLC

Great, thanks a lot. I want to go back to the point-of-care strategy one more time. I'm just wondering if you can give a little more color on a couple of things here, because it does – when you read it, it sounds a little bit like a strategy that might have been borne out of an operational problem. So I'm trying to get more comfortable that that's not the case.

Can you tell us a bit how the GeneXpert offering is going to compare with the Omni offering, aside from the cost of the equipment – in terms of your expectations on turnaround time, your ability to get CLIA-waived tests out, bench space required? And then, maybe a little color on, you talked about working with the distributors so you could have reagent rental. If that inventory's going to be on your balance sheet, their balance sheet, just would love to understand if you're sacrificing any competitiveness with this strategy.

John L. Bishop - Chairman & Chief Executive Officer

Yeah, so I'll answer the last part first, Bill. Actually, it's quite to the contrary, we're leveraging and we're extending our competitive ability beyond, well beyond what folks were anticipating going in here. So, I mean, the big issue is that we have existing menu. We're looking to leverage that evermore. We are seeing, as I've already indicated there, you take a look at your strategy and you say, hey, there's an opportunity to leverage what we already have. And that's the answer. The name of the game is we're leveraging what we already have. And that's going to really broaden and make everything better.

I shared with the group earlier the change relative to regulatory, which really impacted because this is not new. As I said, I looked at that idea on GeneXpert IV years ago, but now see an opportunity to really leverage and take advantage of that.

To your question specifically, the answer is no. We've always said that the full menu that's going to go on the Omni, the Omni would run the full menu of the GeneXpert. The GeneXpert is also fully capable of running all of that menu. So all of the Xpress tests, so the shorter time to result test that we're talking about, will fully run on the GeneXperts. We're not losing anything there at all on a go-to-market basis.

Now, your point is well taken that clearly the GeneXpert systems in their current embodiment are more costly than the Omni ultimately will be. But as we introduce the Omni, that was a single module versus a multi-module GeneXpert IV capability there, and that's worked very, very nicely in the tuberculosis markets worldwide. And we know that we can really leverage that as you look at breadth of menu now into the point-of-care market. So the answer is that it really makes sense to do that.

Yeah, it is more expensive, but we have a lot of ability to work with the distributors there with pricing to have them be able to enable to do a reagent rental program. Relative to your specific question on where is it going to be carried, I think we're probably going to end up with a mixture that we'll end up carrying some, distributor may be carrying some on their balance sheet on a go-forward basis.


Thank you. And our next question comes from Sung Ji Nam from Avondale. Your line is open. Please go ahead.

Sung Ji Nam - Avondale Partners LLC

Hi. Thanks for taking my question. I was wondering maybe if you could talk about point-of-care strategy if there was any in international markets outside of the emerging markets, in the more developed regions. Are there just not structures for that to be attractive for you guys? Or maybe if you could talk to that as well and whether or not the GeneXpert System could potentially address those markets if they exist. Thanks.

John L. Bishop - Chairman & Chief Executive Officer

Right. So that was a good question. The answer is yes. As it turns out right now as you look at the point-of-care markets around the world, slightly over $2 billion. As we look at that and we look at, to your question specifically, if you look at Western Europe, point-of-care market that exists there right now is something in the area of $800 million. Now, at this point we haven't really focused on that in our discussions. But your point is well taken; that's exactly what we are looking at as we move into the out years and it's certainly going to be a point of focus for 2017.

Because the obvious benefit that we have, we don't have CLIA-waiver restrictions going into that market. So it's a question that we are one looking into that market right now. We need to understand it going in, understand, okay, what tweaks do we need to make as we look at our selling, direct selling and/or distribution going into those marketplace. The existing GeneXpert Systems are fully aptable to that market along with the menu that we deem appropriate and we can select anything off of there.

So, in summary, your point is well taken. I think it's a significant opportunity that we're going to be looking into and moving more within the 2017 timeframe.


Thank you. And our next question comes from Derik de Bruin from Bank of America Merrill Lynch. Your line's open. Please go ahead.

Derik De Bruin - Bank of America Merrill Lynch

Hi. Good afternoon.

John L. Bishop - Chairman & Chief Executive Officer

Good afternoon, Derik.

Derik De Bruin - Bank of America Merrill Lynch

So just one question to help me understand this a little better, and then a financial question. The financial question, the first one is, is can you talk about the revised FX expectations, given that the dollar has weakened and how that factors into your top-line guidance? That's just one.

And then the second one is, I'm just again on the Omni strategy and the GeneXpert IV. From my understanding of the cost of these things, wouldn't it just be cheaper to run four Omnis in parallel as opposed to a GeneXpert and write off the system that way if we're talking about a cost advantage in doing that? Am I missing something?

John L. Bishop - Chairman & Chief Executive Officer

No, you're not missing anything there relative to that question. Down the road as the system is available, that's something that's certain to be looked at. You want to be able to run all those I think potentially with a central device. But as we look at time to market and the overall market opportunity, those are markets that we can access immediately right now with systems that are already proven on a worldwide basis.

Daniel Madden - Chief Financial Officer & Executive Vice President

Derik, in terms of FX, really the rates aren't meaningfully different than they were when we set our guidance or even when we reiterated our guidance in February. Now, certainly if you look at the compares that we just did, Q1 versus Q1, the dollar was still pretty strong and strengthening back in Q1 of last year. So we had a notable year-over-year comparison.

As you get into Q2 of 2015, the dollar had stabilized and it really hasn't changed dramatically versus most of the currency that we're impacted by since then. So I think from what I call a raw FX comparison, we would expect less of an FX impact from this point going forward than we've seen over the last several quarters.

Having said that, one thing to keep in mind is hedging. So last year we had over $7 million of hedge gains that we got $2.2 million in Q1 of last year, a little bit more in Q2. And then it came down to something closer to $1.5 million in Q3 and Q4. So those hedge gains are essentially gone now just based on the way the hedging program is and the fact that we'll be replacing those hedges that affect us this year, they were set when the dollar had stabilized a bit.

So I think as we look going forward, no expectations or changes on our guidance. The rates as they are right now are not out of line in any way with the rates that were in place as we were setting that guidance and we still expect the hedge gains to show up in our year-over-year comparisons.


Thank you. Our next question comes from Doug Schenkel from Cowen. Your line is open. Please go ahead.

Doug Schenkel - Cowen & Co. LLC

Hi. Good afternoon. Dan, I have one question, it does have three parts though, so it's all on gross margins. The first part is in your prepared remarks, you talked about an expectation for more than 400 basis points in gross margin improvements related to enzyme and automation-related improvements. You've previously talked about over 300 basis points of enzyme gross margin improvements by the end of 2017, over 100 basis points of gross margin improvements related to production automation. What's unclear is how you're treating manufacturing efficiency programs, which were targeted at 200 basis points. First part is, I just want to make sure there's no change to the guidance you provided again back in January?

The second part is, does the Omni change impact the 2017 gross margin outlook at all? And the third part is, assuming there's no changes, you're guiding us to expect over 600 basis points of gross margin improvements between the end of 2016 and the end of 2017. From a modeling standpoint, just in terms of trying to look ahead and think about how we should be measuring success here, what is the base that we should be adding that 600 basis points to? Is it Q4 of last year, Q4 of this year, full year 2015, just so we can make sure we're all on the same page there, getting an answer would be helpful. Thank you.

Daniel Madden - Chief Financial Officer & Executive Vice President

Sure. Yeah. Let me try to sort this out for you. It is – I recognize it is a bit confusing, there's lots of numbers flying around. So, let me go backwards on them. So I think the reference for the improvements that we've been talking about for a couple of quarters now is really over 2015 full year. Okay. So we were at 51.4% in full year of 2015, and we talked about 600 basis points of total improvement, it had a lot of components.

So first of all it had 300 basis points of enzymes. It had 100 basis points of manufacturing automation and efficiencies. It had an additional 200 basis points of manufacturing cost reduction programs that were implemented in 2015, but were going to show up kind of as we move through the year and as we burned off the inventory that was built before those impacts went in. And then of course we talked about royalties. And again, the royalty reference is relative to full year 2015, 300 basis points.

So just to be clear, the 400 basis points that I referred to are the improvements that were not already completed in 2015. So 200 basis points are already done in 2015, it's just a matter of timing before they roll through our P&L. We talked about, about 50 basis points out of that already showing up in Q4 of last year. And so those are already kind of flowing through and you'll see those increase a little bit. It will be difficult to see sometimes, it's a small number in total in any given quarter. And you know there are a lot of other mix effects going. So again, 300 points of enzymes, 100 points of new manufacturing automation, that's the 400 basis points that I referred to in my remarks today. The 200 basis points relative to full year last year are programs that we don't talk about because they're done. And then of course, we still have the 2015 versus 2017 comparison for the royalty roll-off. So no change at all to any of our numbers; still feel very confident that we're going to take those.

I think the one other point that you had relative to the Omni impact on 2017. No, I wouldn't expect that to affect our gross margins, our total gross margins at all. We still do pretty well in the emerging markets with the GeneXpert. As John mentioned, we made some Omni sales as we get into the later part of 2017, perhaps earlier, we're able to accelerate that a little bit. So, no, I wouldn't expect any impact to gross margin or the gross margin target that we've set out based on the Omni.


Thank you. Our next question comes from Tycho Peterson from JPMorgan. Your line is open. Please go ahead.

Tycho W. Peterson - JPMorgan Securities LLC

Hey. Thanks. Two questions: first, I'm wondering if you can just provide a little bit more context around the delays. If I look back at the slide you put out at the beginning of the year for milestones, you're now kind of pushing out a third of those between HCV viral load and Omni, and in the case of Omni out 12 months to 18 months. So can you maybe give a little bit more color as to when these robustness issues came to light during the quarter since you are so adamant about the timelines at the beginning of the year?

And then a follow-on is on antibiotic stewardship programs. I'm just wondering if you can talk a little bit about how you see the competitive landscape evolving there. There are a number of Multiplex platforms out there. BioFire seems to have done a pretty good job ramping. You've got Accelerate coming. And then that combined with the MRSA patents rolling off, I'm just wondering if you can talk about the competitive dynamics around antimicrobial going forward for the next couple of years?

John L. Bishop - Chairman & Chief Executive Officer

Okay. Certainly. So, on the context of the HCV, that's a question. At the end of the day, you're in clinicals, and in some cases sometimes clinical trials take a little bit longer in order to complete what's going on. And that's certainly the impact on the HCV situation. So that hit that item.

Relative to the Omni delay, as we indicated, we have a number of tests that are running just fine. But as you're running those things you look at your whole current and then future menu, we want to be sure that everything's fully robust there. And that's not something you see until you get to the end of the program. You don't see something like that in the beginning of the program. You need to have a fully integrated running system to see all of those items. So that happens with these kinds of programs from time-to-time. Unfortunately, it has happened here. The name of the game is when that does happen that you want to manage it and say okay what is going to be the real timeline to get onto the market. And that's the reason why they've indicated there that we've given ourselves plenty of time looking at all scenarios to be sure that we get the level of robustness that we're looking for.

Is there a real possibility that we could come out ahead of the time line? The answer is yes. There's a real possibility there, but we want to be sure that we have plenty of leeway to do what we think we need to do.

Now, relative to the antimicrobial marketplace, yeah, that's – it's an interesting question where you have a mixture of technologies coming onto the market relative to broader-based antimicrobial resistance. These would be Accelerate. Roche had a symposium at ECCMID talking about Smarticles, that type of thing going into those areas.

So there's some interesting aspects that folks are doing there. But at the end of the day what you're going to be needing to do in a number of these areas, it's like we just said with our launch of our program Diagnostics First, you want to be able to immediately detect, identify those items. You'll be able to make a lot of decisions immediately on antibiotics, now broader as you look at more broad scope antimicrobial resistance.

Then those are going to figure in. And I think you'll look at programs like an Accelerate more and other technologies I think would be applicable in those areas as well. So I think, yeah, we're going to see a lot of alternatives coming into the market, but by the same token, the market in and of itself needs to develop more. And frankly I think having more competitive activity at some level is going to help overall market awareness and drive further development of the market.

I do think that on a go forward basis that Cepheid continues to be very well positioned vis-à-vis nobody has a 10,000 system installed base out there. And as you've seen already with our first quarter that base is continuing to very rapidly expand in the market. As you look at antimicrobials nobody has a menu. It's expensive is what we have as we look at the portfolio.

So, in summary, what I would say is, yes, there's more different type of systems coming into the market. It is an interesting market. The competition there will be there. There's some interesting products coming along, but in an event, we're still very well positioned to maintain our leadership role in that marketplace on a go-forward basis.

So with all of those moving parts there, I'm very confident. In fact I will comment and – that I was at the ECCMID meeting, I saw at least one of you at the ECCMID meeting there. And I can you the momentum that I saw at the meeting for Cepheid was I mean better than I've ever seen it. I mean we had a lot of very, very positive momentum going on there. And heavy attendance at the symposium where we saw a lot of interest scientifically on what we are looking at in that regard. So quite to the contrary, competition coming into the market, but Cepheid is well positioned for growth and the momentum is growing.


Thank you. And again, ladies and gentlemen, in the interest of time, please limit yourself to one question. Our next question comes from Mike Matson from Needham & Company. Your line is open. Please go ahead.

Mike S. Matson - Needham & Co. LLC

Thanks. I hate to ask another point-of-care question, but just wondering with the three distributors that you signed up, so Henry Schein, Medline and then now McKesson, can you just explain what their roles will be in which segments of the market they're going to be going after?

John L. Bishop - Chairman & Chief Executive Officer

Well, actually we're not unique in that regard. These distributors basically all compete with one another and they're overlapping in the marketplace. They're all going to be going after both the moderately complex, and as you'll recall, when we spoke about this earlier, moderately complex opportunities there in the point-of-care we view is about 10,000 opportunities as you look at then the much larger 100,000 number going forward. So you need a large footprint and reach to get at all of those markets. We're not unique in that regard. These folks are carrying competitive products at the same time.

So your next question might be, well, okay, if that's the case how do you differentiate yourself? And that's a key attribute that I was just talking about with the updated strategy today is that we're big-time differentiated already with capabilities that nobody else has as all of these distributors are just now going into the market with molecular products for the first time.


Thank you. Our next question comes from Miro Minkova from Stifel. Your line is open. Please go ahead.

Miroslava Minkova - Stifel, Nicolaus & Co., Inc.

Yeah. Hi. Good afternoon. Let me ask a question on the Virology tests in Europe. You noted some good growth off a relatively low base. Can you give us a sense for how big this could be this year for you? Does it play into the second half acceleration that you appear to be projecting? And what does the ramp look like?

John L. Bishop - Chairman & Chief Executive Officer

Well, Miroslava, yes, that definitively gets to the second half ramp that we've been talking about. On the program we're seeing good interest. As I indicated, there have been a number of publications, evaluations that have actually been done in Europe, comparing our product there with the two lead competitors. We're showing, with those publications, that the products worked every bit as well, many of them actually better there.

And then, as I've indicated, for a number of the labs – even the central labs coming in where we've had some wins – they're bringing the product in. And it's interesting because we don't necessarily need to do an immediate total displacement. In some cases, we've won the full business. In some cases, we go in and they'll start with the products where they are, would like to be able to run on a 24-hour basis, and then, run on the weekends. So it gives them the ability to do that, and we're seeing those attributes being realized in the market.


Thank you. And your final question comes from Brian Weinstein from William Blair. Your line's open. Please go ahead.

Brian D. Weinstein - William Blair & Co. LLC

Hey, guys, thanks for taking the question. Just want to be clear on North American growth, which was flat. Can you let me know what was the year-over-year impact for Flu? What was the year-over-year impact on non-clinical? And then what is your expectation for growth in North America embedded in your guidance given the sales force is fully staffed and trained, and you did have large instrument placements in North America last year? Thanks.

John L. Bishop - Chairman & Chief Executive Officer

Right. So, Brian, one of the things we said relative to Q4, (1:10:54) North America, we had $4 million come out of the biothreat that was in that total number. So that was a deduct against the growth number as we look at last year, we knew going in. And that's the reason why we said early on that Q1 was going to be a tough compare of this year versus last year because last year was a very severe flu season going in, we had a number of other factors which made Q1 last year a bit different than where we are looking at this year. So, frankly, going in I was very pleased with what I saw on performance for Q1 considering all of those items. Feel good about where we're going. The momentum that we're seeing already with the systems looks good.

Now, relative to your question on growth, what have we indicated on...

Daniel Madden - Chief Financial Officer & Executive Vice President

Well, we haven't said. But what I can tell you is that we would expect, as we move through the year, that you would see – we do expect double-digit percentage increases on a year-over-year basis in our comparisons as we go forward this year.


Thank you. At this time I would like to hand the conference over to Ms. Jacquie Ross for closing remarks.

Jacquie Ross - Vice President, Investor Relations

Thank you. 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.


Ladies and gentlemen, this concludes our program for today. You may all disconnect and have a wonderful day.

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