Novadaq Technologies' (NVDQ) CEO Rick Mangat on Q2 2016 Results - Earnings Call Transcript

| About: Novadaq Technologies (NVDQ)

Novadaq Technologies Inc. (NASDAQ:NVDQ)

Q2 2016 Earnings Conference Call

July 27, 2016 04:30 PM ET

Executives

Steve Kilmer - Investor Relations

Rick Mangat - President and Chief Executive Officer

Roger Deck - Chief Financial Officer

Analysts

Jason Mills - Canaccord Genuity

Matthew O’Brien - Piper Jaffray

Rick Wise - Stifel

Margaret Kaczor - William Blair

Charles Haff - Craig-Hallum

John Gillings - JMP Securities

Tao Levy - Wedbush Securities

Ben Haynor - Feltl and Company

Doug Miehm - RBC Capital Markets

Operator

Greetings, and welcome to the Novadaq Second Quarter 2016 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host Mr. Steve Kilmer. Please go ahead, sir.

Steve Kilmer

Thank you, Stacey. Good afternoon, everyone. Thank you for joining us today to review Novadaq Technologies’ financial results for the second quarter of 2016. On the call today representing Novadaq are Rick Mangat, our President and Chief Executive Officer; and Roger Deck, our Chief Financial Officer.

Before we start, I want to remind you that certain statements made in this conference call maybe considered forward-looking. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements to be materially different from those implied by such statements and therefore these statements should not be read as guarantees of future performance or results.

All forward-looking statements are based on Novadaq’s current beliefs, as well as assumptions made by and information currently available to Novadaq, and relates to among other things, results of future clinical tests of the SPY, FIREFLY, PINPOINT and LUNA imaging systems, anticipated financial performance, business prospects, strategies, regulatory developments, market acceptance and future commitments. Listeners are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this conference call.

Due to risks and uncertainties, including the risk and uncertainties identified by Novadaq in its Public Securities filings, actual events may differ materially from current expectations. Novadaq disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events, or otherwise.

I'd now like to turn the call over to Dr. Mangat.

Rick Mangat

Great. Thank you, Steve. Good afternoon everyone and welcome to Novadaq's Q2 2016 conference call. Before Roger begins todays call by reviewing our Q2 financial highlight, I'd like to give you a review of my background and in particular that relates to Novadaq. While I recently met with many of you either in call center or over the telephone since taking over as CEO, I'd not been able to meet everyone who maybe on the call today. I hope to have the chance to do that over the coming weeks.

As the co-inventor of SPY technology and cofounder of the company, I've been deeply involved in driving Novadaq's commercial operations for the past 16 years. Over the course of those years, I've been involved in all critical aspects of our business. From 2000 to 2010, I led the company's commercial and operational function, including US and all US sales and distribution, marketing, R&D, engineering, product development, clinical and regulatory sales, reimbursement and intellectual property.

As I was personally responsible for obtaining the first clinical SPY technology patent, and for working with the FDA to get SPY designated as the first combination product to be filed 10-K by the agency. On the commercial strategy side, I was the primary contact for establishing and maintaining the LifeCell partnership, the eventual unwinding of that partnership and the establishing of Novadaq's current partnership with LifeNet Health.

As General Manager, I was responsible for the company's global strategic and tactical commercial plan, including the build out of our direct sales and marketing teams. I am pleased to say that all the existing members of our management team whom I have worked with for many years, remained in place to continue to support me in my new role as Novadaq's CEO and we are all absolutely committed to driving the business forward to achieve the company's goals.

With that said, I'm going to turn over the call to Roger to discuss our Q2, 2016, financial results and our full-year revenue guidance. Afterwards, I will provide you with a summary of where our business stands today and why we remain so optimistic about our opportunity for growth going forward.

Roger Deck

Thanks, Rick. And good afternoon. I'd like to begin today's call by summarizing our Q2 results. Revenues increased by 34% to 20.1 million in Q2, 2016, from 15.1 million in Q2, 2015, an increase sequentially by 13% from Q1, 2016. We're pleased to report the recurring revenue was the fastest growing of our revenue categories, increasing by 38% to 7.8 million in Q2, 2016, from 5.7 million in Q2, 2015, and increasing sequentially by 12% from Q1, 2016.

In terms of procedures, approximately 13,300 imaging procedures were performed in Q2, 2016 applying year-over-year growth of 39%. During the quarter we installed 55 devices, increasing the North American install base to 815, an increase of 33% from June 30th, 2015. Approximately half of the device installations in the quarter were SPY systems, with the remainder consisting of PINPOINT and LUNA systems.

As with the case in Q1, 2016, we sold roughly the same number of systems as we installed in the quarter. Increasingly, our capital sales category includes individual components or accessories as part of our broader solution sale. As a result, calculations of ASP and apparent trends can be misleading and going forward we do not plan to disclose the number of systems sold. Instead we'll focus on the growth of our total install base, the true underlying driver of our overall performance.

Our recurring revenue per device increased to $9539 in the quarter, implying annual revenue in the $40,000 range. Growth profit percentage was 72%, which is slightly higher than the 71% experience in Q2, 2015 as well as Q1, 2016. Operating expenses increased to 31.1 million which included approximately 4 million of cash and non-cash expenses associated with the departure of the former CEO.

After deducting these expenses, net operating expenses of 27 million were approximately 17% higher than in Q2, 2015. For the first half of 2016, net operating expenses which is to say expenses after adding back CEO departure related expenses were 15% higher than operating expenses in the first half of 2015. The increase in net operating expenses from Q1, 2016, related primarily to the expansion of the sales team, which continued into Q2, 2016. We believe selling expenses will be stable for the balance of the year.

A key financial measure we monitored closely is our consumption of cash. One of the most useful indicators for future cash requirements is what we call a cash burn, is defined as our net loss after adding back stock-based compensation depreciation and amortization. Our Q2, 2016, cash burn was 10.1 million, which included 1.9 million of cash cost associated with the departure of former CEO. After deducting cash departure related cost, net cash burn for the quarter was 8.2 million, which was slightly less than our net cash burn in Q2, 2016.

For the first six months ending June 30th, 2016, net cash burn was 13.7 million compared to 17 million in the first half of 2015. Other important factors affecting cash consumption are working capital requirements and capital expenditures. With respect to working capital, we've seen considerable growth in both accounts receivable and inventory over the past 18 months. I'd like to give you some color on those balances.

With respect to accounts receivable, we've experienced growth in capital sale, which we tend to complete an invoice quite late in the quarter, which results in higher accounts receivable balances. Also, we sometimes selectively extend payment terms with international distributors, where they identify alternative opportunities to invest resources in market development activity.

Once international markets are better develop, we expect to revert to more normal credit term, also as our business matures and recurring revenue becomes an increasing portion of total sales, we expect days sales outstanding of accounts receivable will decline. And obviously substantial component of working capital with inventory which we've ramped up to accompany our high growth. A substantial part of the increase relates to the initial inventory ramp-up relating to DermACELL. Once passed the initial build out stages, we expect we will be able to manage working capital more conservatively to track our growth rate.

Finally, we continue to make capital expenditures to support growth. Over 90% of our CapEx relates to imaging systems that are installed for evaluation. Evaluation devices are depreciated during the evaluation period and are reported as a disposal upon sale. In the first half of 2016, we've ramped-up installations in Japan and Europe. It's the early days in terms of revenue growth in those markets but are experienced today both well for international expansion in 2017 and beyond.

More recently in Q2, 2016, we launch what we call pay per LUNA agreements in wound care, which is a 100% recurring revenue model designed to align with facility reimbursements that’s available in that setting. Expansion of this model will require capital investment over time but we'll also meaningfully contribute to the overall shift toward recurring revenue. Importantly, such a model is profitable enough that the payback period on to OS installations is relatively short.

Our overall cash management plan was developed in late 2015 as a part of our 2016 budget process. Since January 1, 2016, we've had very favorable variances in terms of our operating losses currently offset by negative variances associated with the working capital expansion and increased investment in the install base I just summarized. This model will have us reaching minimum cash balance in the $60 million range in late 2017, after which time we expect to generate positive cash flow.

Before I turn the call back to Rick, I want to return for a moment to revenue growth. Based on the continued minimum momentum in our business and the strong recurring revenue, we are already generating in July, we expect to report year-over-year recurring revenue growth in the 40% to 50% range in Q3, 2016. In terms of our progress towards meeting our annual revenue guidance, provided we sustain the overall sequential growth rate of 13% demonstrated in Q2. We are coming just above the high-end of the range.

Our confidence in achieving this is driven by the acceleration in recurring revenue described a moment ago and based on our experience of seasonally strong capital sales in Q4. That concludes my remarks on the Q2 financial results. I'd like to turn the call back to Rick.

Rick Mangat

Thank you, Roger. Overall, we're pleased with Novadaq's performance in Q2 and feel confident about our ability to achieve the goal set for the second half of the year. As you just heard from Roger, our growth strategy or trajectory remains very strong. And we continue to be well positioned to meet or exceed our revenue guidance for 2016. Before taking questions, I would like to review each of our five products with respect to the account status and plans going forward.

First, with respect to SPY Elite. Spy Elite sales and usage continues to grow with the primary driver being toxic and reconstructive surgery. We now have approximately 20% US market share and breast reconstruction and the team is tossed with driving the share to standard of care which translates to 70% market share over the next three years. Given the clinical and economic data we’ve in this area I’m confident that we’ve the foundation to achieve this goal. In addition there are two other drivers that will catalyze this adoption; the first is the synergy we’re seeing between our DermACELL tissue and SPY. The ability to sell both products as a single solution to improve clinical outcomes while driving down costs is clearly helping of standard option around the country and centers which until now have been unable to acquire SPY Elite.

Secondly, breast surgeons in international markets and more recently in the US have started to use SPY to identify sentinel lymph nodes post mastectomy instead of the radioactive agent Technitium-99. This indication has off label in the US so we’re working to determine what the appropriate studies will be to bring this on label this is similar to our effort in [bank logic] oncology and the FILM study that you’re familiar with. The use by breast surgeons further increases the emphasis to acquire SPY as now it is both required at both the frontend of the breast cancer treatment and at the completion during the construction.

Next in regards to PINPOINT. PINPOINT adoption continues to increase in five key applications, colorectal surgery, gallbladder surgery or laparoscopic cholecystectomy, esophageal surgery, thyroidectomy and gynecologic oncology which as you know is not yet approved by the FDA. We’ve been very pleased with the increased use in all of these applications and in particular lap chole and thyroidectomy whereby the surgeon confirms the function of the parathyroid gland post thyroid.

Parathyroid function post surgery is critical in maintaining normal calcium levels in the body and as such confirmation of a functioning parathyroid post surgery is indicative that calcium levels will remain within range. Encrust European data has clearly shown that the use of PINPOINT to demonstrate parathyroid function directly correlates to post surgical calcium levels thereby patients are able to confidently be discharged one day earlier then what was the norm as further studies are published in relation to these five key applications for PINPOINT, we fully anticipate adoption to significantly grow.

The two studies we’re sponsoring PILLAR III and FILM are underway and recruitment continues. With respect to PILLAR III we’ve recruited 214 patients today and for FILM 30 patients.

In regards to the third area which is DermACELL and breast surgery I already indicated we’re seeing strong synergy for DermACELL and breast with SPY. The opportunity for DermACELL and breast surgery is significant as the current US market is approximately $400 million. There will be two significant drivers for DermACELL, the first being clinical data and the second reimbursements. Based on our clinical experience, and data released over the past 18 months, we believe, we’ve the best products on the market and data that will be published during the second half of this year from major US institutions will confirm this. DermACELL is covered for breast reconstruction by all Medicare administrated. On the commercial payer side DermACELL is covered by major payers such as United Healthcare and several Blue Cross plans. The majority of breast reconstruction patients are covered by commercial plans and so we’re working with all the key private payers to allow their member’s coverage for DermACELL and anticipate the reimbursement will not be an issue given the clinical data we’re now able to share with the payers.

In regards to the wound business which consists of LUNA and DermACELL wound we’re very early in our experience as we’ve just trained our dedicated wound team of 26 sales professionals in Q2. However, I must say that early indicators with respect to LUNA being brought into wound centers under a purely paper use model are positive and the acceptance of DermACELL has been encouraging. As you know due to reimbursement for LUNA in the outpatient setting we’ve created a model which allows for a paper use system which aligns with all the centers that are paid for that treatment and that should allow for wider spread adoption.

As this portion of our business continues to grow and we gain both clinical and economic data, I’ll have more to report going forward. The takeaway for now is that early indicators are strong but the proof will be in the ongoing adoption. So, as you can see our path forward for all five products is very clear. My team will now focus on executing in each area so that we can continue to drive top line revenue growth, increase the proportion of recurring to capital revenue mix, maintain strong margins and have a clear positive profitability in 2018 while maintaining a minimum cash balance of $60 million.

This concludes our prepared remarks for today. I’ll now turn the phone over to the operator and request that the line be opened for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from Jason Mills with Canaccord Genuity, please proceed.

Jason Mills

Hi, good afternoon guys, can you hear me okay.

Rick Mangat

Absolutely Jason, yes.

Jason Mills

Great, good afternoon and congrats on a solid quarter. I’ve three questions, I’ll just ask them and let you answer them in the order that you choose. First, we just want to touch on the transition with the CEO role, I’m just curious if you could just give us a sense for, if there are any projects or anything with the organization you believe maybe needs to staffed up or improved that perhaps the realm was focused on was there any, is there anything that concerns you with respect to the transition.

Secondly, with respect to DermACELL it sounds like the trends are going very well there, I’m curious and interested in perhaps the forum at which the clinical data about which you spoke will be presented and when that might be during the second half of the year?

On the reimbursement side, it sounds like good trends there as well, but we’re not there, any inflection points, any large insurers that you foresee within next six months that could be a boon on that front and then also maybe give us a flavor for how the revenue is trending in that line of a business?

And then lastly perhaps for Roger on the installed base, there is a flavor for the trend in the installed base and what gives you the confident that will continue to be strong for you in the second half? And thank you.

Rick Mangat

Okay, Jason thanks. I’ll try to remember those, so with respect to the first, the transition what I can tell you so far it has been relatively smooth with respect to projects that are being transitioned from a run, primarily the investor relations aspect or for what was being done that I wasn’t as involved in that I’ll be setting out. Specific projects that a company that I will be starting up, you will see that over in the marketing and reimbursement area is we’ll probably strengthen a little bit there and that’s really just a need on the sales team to help them support for their efforts and specifically on the reimbursement it’s not really, it’s more of an operational staff up so that we can support some of our standards on getting payment by doing preauthorization etcetera. So overall, my answer to you would be on the transition, no real concerns at this time.

With respect to DermACELL I mentioned you’ll see two publications that will first come out in French in the second half of this year and so what we’re planning for is that that data will then presenting – event at the American Society of Plastic Surgery meeting in Q4, it will be presented at symposiums and Novadeq will be hosting and so that’s really when that data will first be out on the podium but in French you’ll most likely earlier than that and that bodes well for us for a reimbursement perspective because some of those insurers that were going off, what they’re already looking for is all those publications, they’re looking for how do they compare to the market leader and is that equivalent or is that better and I think we’re going to bode well with that moving forward.

With respect to inflection points really the large insurers on the private payer side as I mentioned United Healthcare, Blue Cross are already covered with though one plan on any large inflection there we’re really working on some of the smaller payers now and in different parts of the country. And so, no major inflection with respect to payers or insurers and when revenue trend I think as we said before we don’t breakout DermACELL just because of the competitive nature of that market, but as you can see our recurring revenue is growing pretty dramatically until the DermACELL is a part of that.

So, I’ll turn it for Roger to answer the question around the installed base and I’ll just turn to Roger.

Roger Deck

Sure. In terms of overall strengths, I think we acquired out, we experienced the trend in 2015 where we had a relative weak Q1 and we built and strength through the air, I think we’re experiencing that again in 2016 in Q1 and actually to a certain degree in Q2 as well, we spent a lot of time recruiting and training our sales team and that activity is sort of ramped down as we get through the air and we start focusing on things like generating revenue. And so, you will also see that in terms of the overall trend in installed that I think you should expect to see strengthening through the year.

If you look at trends within the growth in installed base one thing that I would point to is that in the first half of last year we really had no meaningful installations of SPY systems as the focus on the SPY business was really on reestablishing usage in the installed base, the existing business. I think in Q3 we started to see some installs for SPY and then at the end of Q1, I mentioned that in the six months to then for Q4, Q1 about 40% of our installs have been SPY systems and so that actually ramps a little bit more this quarter 50% with SPY systems and that just recognizes a shift and the focus back towards SPY and the fact that’s really a scenario where we’ve got real power partly because of the synergies that we’ve with DermACELL. So, I think that SPY has come back to represent probably what is should represent in terms of the installed to sustain our growth going forward.

Jason Mills

Thank you that's very helpful color across all three of those and I’m impressed you remembered those questions. Just as a follow-up perhaps with respect to the recurring revenue, can you give us any more color as it relates to ASP trends in the quarter for the kit, are there any changes there and then on the DermACELL side are there any large contracted hospital that are coming up in the second half of the year that you are really targeting? I will get back in queue. Thank you very much.

Rick Mangat

So, on the ASP side we are not seeing any major change there on the kit side on the imaging kit side with respect to DermACELL and some of the larger systems absolutely, I think especially with the data that will be coming out and then presented at the ASPS that's what some of those larger groups are waiting for. So we started, I’ve actually started to ramp up that contracting group too who looks after those larger systems and so they’re reporting to Tom Tamberrino on the sale side, but we anticipate that part of the business to really start building up probably towards the end of this year. I want to say Q3 probably Q4, early Q1 but we have already got ourselves into the process where we are being invited for request for proposal etcetera on new contracts that are coming up in some of those, so quite optimistic on that front.

Operator

Thank you. Our next question comes from Matthew O’Brien with Piper Jaffray. Please proceed.

Matthew O’Brien

Good afternoon. Thanks for taking the questions. Roger just to clear up guidance a little bit I think you said 40% to 50% year-over-year increase in the recurring component of the business first of all is that right? And then, you also mentioned you are kind of 30% sequential improvement or what we should expect in Q3 and Q4, if I look back at 15 you actually did a little bit better than that. Is there a level of conservatism built in there especially with you guys going on from mental perspective to sell international etcetera?

Roger Deck

Sure. So, the first part is just to make sure that I was clear so I am anticipating the level of year-over-year recurring revenue growth that we will report in Q3 is going to be higher than what we reported this Q2. It's going to be in the 40% to 50% range versus 38%. And that is based on data that we have in July to-date. So we’ve had very strong growth in recurring revenue and that has enabled us to increase our expectations for where we will end up in that segment.

I think in terms of the overall growth I agree that the revenue ramp that we experienced in 2015 was actually a little bit steeper than what we have to experience in 2016 to meet the guidance. So we had very, very rapid growth through the year you guys are aware that we step back a little bit in terms of our capital sales going into Q1 again and so the slope doesn't need to be quite as steep this year. And for that reason I would say that we can, it’s simple math it's tells me we will meet the guidance or exceed the guidance by maintaining the sequential rate we have experienced. I think that's the answer.

Matthew O’Brien

Yes, that's helpful. And then Rick, you mentioned that the pay per LUNA I guess just kind of early days did you miss any system sales because you implemented that system in Q2 and is there an opportunity to bring more of the business lesser intention to get more of the business over to more of the kind of the paid per use spaces versus the straight up capital sale?

Rick Mangat

Sure. So what I can say is on the LUNA side yes, I mean, I think you are correct with respect to potentially missing the one or two capital sales there you are right we just felt it was the right thing to do for the business long term that was the right direction to have it in to 100% pace on the pay per LUNA.

With respect to moving the entire business over to that I think it really is the different model in the outpatient setting and the outpatient setting just because of the way we have our reimbursement related to each patient and the imaging that we perform on them. It works very well there. I don't think you are going to see some big shift on the inpatient with SPY Elite or PINPOINT towards that kind of model just because that the way the DRG system is setup. I think there we are going to continue to see evaluations and then rely these to capital purchase initially leases or rentals and then the following recurring revenue kind of ramp up which is made up of the kits and the service component of that. So bottom line is I think on the wound care you are going to see us moving to I would say about 95% model of pay per LUNA and the only area that maybe that will be outside of that is some of the VA system hospitals where they purchase the capital and that's a requirement in some of them or on the other aspect of the business you are not going to see that flow over.

Matthew O’Brien

That's very helpful. Just one more if I sneak it in here. You mentioned I think it's a little bit of a follow up to Jason’s question about you activate [indiscernible] cash you don't want to drop below $60 million bucks that gives you kind of a limited amount of flexibility as far as investing in the business, so are you going – is there the potential to really push more aggressively on a profitability side and give up a little bit of the growth profile of the business with this kind of new metric in place or is that not the case?

Roger Deck

Absolutely not and we have actually factored into there as well Matthew based on new things that we learn that we may need to accelerate certain portions of the business so that's actually worked in a bit of that proper into the budget so we will not be giving up growth for profitability or maintaining that 60 million and we feel very confident on the 60 million.

Matthew O’Brien

Very helpful, thank you.

Operator

Thank you. Our next question comes from Rick Wise with Stifel. Please proceed.

Rick Wise

Good afternoon. Hi Rick, hi Roger. A couple of things. Let me start getting back on the recurring revenue front. I’ve nothing to precise but our calculations that you are, we are seeing something in the $580, $590 recurring revenues per procedure kind of range. Can we just talk little more broadly what’s your vision about how you double it from here I mean it's been stuck in this sort of rough range in recent quarters and it's the stacking up of the reimbursement team part of that do you need new products, just help us understand the nearer medium longer term drivers there?

Rick Mangat

Sure. So Rick, I just need a better clarification so I can answer that accurately. When you are saying 580 to 590 are you saying the product ASP and how we plan to double that?

Rick Wise

No, no. We are just taking your recurring revenues and looking at procedures and sort of coming up with the rough calculation?

Rick Mangat

How we double procedures is what you are saying?

Rick Mangat

Basically.

Rick Mangat

Right, fair question. So, where it’s really going to come from and what I can speak to today are our existing procedures so if you are looking at SPY Elite it's going to come from breast reconstruction and as I mentioned that's going to – the increase there is purely going to come from one expanding the installed base as Roger mentioned where we are putting a lot more SPY systems out there but also just from being able to go deeper into certain accounts by getting additional users, we are seeing that by the fact that we’ve really staffed up on that referring component of our sales team that people go in there and do the farming the day in and the day out work.

With respect to PINPOINT, I think there is tremendous room there I mean, I am very pleased with what we are doing on colorectal it’s still the larger portion of the procedures that we do. But if you look at the growth rate and where the greatest growth came in the last quarter would actually be on the laparoscopic cholocestectomy and the thyroidectomy. I think we are going to continue to see that and what we are finding is that we get these systems in most cases into the colorectal department and it quickly spreads over to the endocrine department and general surgery and you see that’s ramping up per procedure. So, it's really going to come from I can assure you in terms of if you are looking at how do we double it, we don't need to go outside of the procedures, we are actually already focused on within these hospitals.

Roger Deck

And then Rick, if I can just follow-up on that I think we’ve been disclosing the number of procedure for a long time and I want to that's been part of our disclosure since we only had imaging so the number of imaging procedures. But you know that our recurring revenue includes things like service and tissue and so where you really see the average revenue per imaging procedure go up is where the attachment rates for DermACELL increases. So because we are only 18 months into the DermACELL initiative our attach rate has not developed to obviously where it's going to get to when you can start generating $300 per imaging procedure because you have added tissue you are going to see revenue per procedure really start to ramp.

Rick Wise

Yes that makes a lot of sense and thanks for the color on both of that. A couple more if I could. You are stacking up your reimbursement team on certain treatment, I guess the two part, two sides of the coin any sense how much, I mean should we think that the absence of the strong reimbursement team has virtue in the past, is that actually hindered growth in some kind of way and I would think it's the very rapid payback from comparatives what should we expect and when from this initiative?

Rick Mangat

I mean, I think you hit the nail on the head there Rick, it really has been something I would say we have been a little bit behind on in terms of staffing up that area. The payback and I can give you a little bit more detail as how it works. So what happens is as you go into an account and when you have the reimbursement team to support that you get the account to find something what is called the business associates agreement and that basically allows us then to work with that account and their patients to make sure that the physicians and the center is actually getting reimbursed for the procedure. And when you do that it really helps your usage from multiple aspects one is sticking at the account, two because you are doing all these pre-authorizations which in some states are required across the board for all patients, but if you look at Texas if you want to go in for a breast reconstruction you have to get a pre-authorization. So when you get that you also are much better at scheduling those cases. So our people are clearly aware of when that case is going to be taking place. It has been pre-approved only with our products and so it gives you that ability to make sure your products being used when it's being used and so you definitely see an impact. One of the variables that I do follow myself in math and looking at the business is our growth rate and signing up those business associates agreements and then how does that reflect to increasing revenue from that account and that's the reason why I am staffing up that area is by looking at that data and saying when we have done this in accounts we see the business pick up, we see the revenue per hospital increase. And so I would say as we staff these positions up in Q3 you will start to see an impact definitely in Q4, early Q1.

Rick Wise

That's exciting and just last from me if you could speak about the pipeline you didn't really talk about it much and again from two way aspects Rick, if you leading the charge are priority changing here you have got so much on your plate that in the near term from the company focus is shifting to more commercial execution as you discussed and pipeline, aggressive pipeline is that less of priority or no that's wrong and maybe more specifically this rumor molecule at the time I think in the past has been discussed, we would get something later this year is that not going to happen and just again any color in that area?

Rick Mangat

I think you can fairly sense that I am definitely focused on the core business at this time. However, I can tell you that at the same time proportion of my time which I think is appropriate is spent on that pipeline. It's very important to us. It's something I have been directly involved in over the last few years, I am very familiar with it. There is no real coming up to speed on it. So, we will continue to drive that pipeline of products I think the one difference you will see is that I won’t be talking about a lot of the pipeline products just because of the competitive nature that we could potentially be in with different competitors next year and so you really hear me talking about it when we do launch those products.

I can say on the molecule side I think it's an exciting area. It's an area that could really broaden our ability to image structures and functions. We think that with our expanding installed base and engineering expertise that really retains the competitive advantage when we are working with some of these different molecules and the fact that how quickly we can get them out into these surgical or even potentially wound care centers. And so, I would say to you is that there is a clear focus on the pipeline as well for me. Number one though goal is meet our current targets and then I would say, I would still probably spend about 15%-20% of my time looking at what’s going on with respect to that pipeline working with our group and Vancouver our clinical group, but you are not going to hear in terms of timing or how we are going to launch these products until we actually do it.

Rick Wise

Appreciate that. Thanks.

Operator

Our next question comes from the Margaret Kaczor with William Blair. Please proceed.

Margaret Kaczor

Hi, good afternoon everyone. First, you guys discussed at the beginning of the call not giving that system ASP information going forward and what I assume that means please correct me if I am wrong that more of the systems are going to be replaced on the placement basis rather than outright purchases and so the question becomes how does this change the potential capital revenue growth trajectory this year or next year that you guys have been doing? And then, obviously moving in to the overall revenue per system which I assume is the same or maybe even higher under this type of the model?

Roger Deck

Yes, so Margaret I think that shifting to the extent we can shift the model towards pay per use per use in LUNA I think that would expand the delta between installations and sales. I think really the comment what was behind the comment is that we include in our capital sales category things like scopes and cameras and accessories and in terms of adding those to the total capital number I know people are interested in calculating what’s the average product, what’s the ASP for PINPOINT as an example and more and more we are getting data within those numbers that are going to lead to misleading results. I think I’ve mentioned before that PINPOINT system can be configured very broadly as it can include a lot of third party components that increase the ASP significantly. But in certain markets we are finding that our best opportunities to operate is to upgrade towers that are out there already in which case we only include the highly proprietary elements that we have which I think is a great business model. But that sort of things I know the way that people are using the information they’re going to say, look I think your ASP on PINPOINT is going down and so I am sort of foreseeing this is going to become more and more factor for us and I just don't think it’s important information. I don't want to be as clear in terms of competition etcetera about what our ASPs are and that's I am just sort of highlighting that that's likely what we are going to be doing in the future.

Margaret Kaczor

Sure that makes sense and really the question builds back to kind of that capital revenue growth trajectory, so do you guys expect that to change as you maybe do have these changes under billing, if you just discuss?

Roger Deck

Well, I would say that in this quarter I mentioned that recurring revenue was our fastest growing segment. I already told you I think that is going to be increased next quarter and overtime that the level of growth in recurring revenue is going to continue to expand beyond capital. So international sales, I think will always have almost all capital but in our domestic business you are really going to see your recurring revenue ramp up and much less reliance on capital sale.

Margaret Kaczor

Okay and then Rick you have been built in the past about the opportunities internationally so when should we start to see the upside in those numbers and what has been gating factors so far, approvals, is it awareness and what can we think in places like Japan and China that you guys have under grow little bit?

Rick Mangat

Sure. So the gating item is more awareness then is approval in our key markets now we have approval across the board for our products outside of DermACELL, so for PINPOINT and for SPY. The key markets when I look at them in Asia are really China, Japan, India, and then when going into Europe, Germany and the UK. The part we have been investing in over the last year and will continue through to the end of this year quite heavily is putting some of our own feet on the grounds so Novadaq people along with our distributors. We have already done that in China, Japan and just recently in India as well. We are direct in Germany and we support the business in the UK but we won’t put anyone direct there. And so what we have really done up is now is developed those key opinion leading sites in those areas. We have sold some initial systems to where I would call are the key centers to drive the business throughout the region and so those investments have been made. The data has been collected locally and starting to get published in those markets, which is critical for them. We have also worked on reimbursement which is not as larger factor in all of the areas, but is in some such as Japan and so we have been working through that process. I think we will get some positive use there in the early part of next year. But I would say 2016 has really been about getting some revenues internationally but we’re selling the groundwork for an expansion from that revenue base coming and probably on from the second quarter of next year. I won’t say the first quarter because just knowing those markets in quite a bit of detail that’s not when they purchase capital, you’re seeing it flowing in when their budgets are released from the second quarter and then very heavily through the third and fourth quarters of next year.

Margaret Kaczor

Okay. And then, just on DermACELL I think last quarter you guys had said DermACELL was kind of almost $10 million to $11 million run rate, you guys still on acts for that or it seems like you are going well above that based on the guidance for Q3. So how should we think about seasonality throughout the year there?

Rick Mangat

Yes, we are doing very well on that part of the business. We are definitely on track I would say to meet or exceed that guidance. With respect to seasonality I think you will just see kind of at the stage we’re at right now, we don't get affected as much there with the seasonality of procedural things done, but I would just say that as we progress through the year you will see those kind of the linear growth in that business if you continue to see that it and as I said we definitely need the guidance we gave on it.

Margaret Kaczor

Great and just one last one from me just following up on Rick’s question. I think you guys had said something about competitors’ next year new molecules being able to protect your competitive positioning. Is there something that we should be looking at from that competitor dynamic or is that just comments from you guys? Thank you.

Rick Mangat

No, that was Margaret it was just more a general comment, we are not aware of anything but we are not going to tip our hat either on when we are launching anything going forward. I don't know of anything that's coming. We are not aware of it definitely not on the device side and I think I would have heard about it on the molecule side as well.

Margaret Kaczor

Wonderful. Thanks guys.

Rick Mangat

Thank you.

Operator

Thank you. Our next question comes from Charles Haff with Craig-Hallum. Please proceed.

Charles Haff

Hi, thanks for taking my questions and congratulations on a strong quarter. Roger, I had a question for you on your cash flow statements that you made. So positive cash flow I think you said in 2017 correct me if I am wrong there and then on the gross margin assumption that you are thinking about for 2017 given the fact that DermACELL has lower gross margins than the other products. Do you have any thoughts there on gross margins? Thank you.

Roger Deck

Sure. So in terms of gross margins, I think I have mentioned before some of the factors that would result in those increasing a bit and decreasing a bit, I think we’ve already alluded to pretty strong growth in DermACELL so that's going to put a little bit of downward pressure on the growth profit overtime and we will try and we will work hard to keep it above 60%-70%, slightly below 70% I think that's the possibility.

Sorry Charles, I just dropped you first question just give me a hint.

Charles Haff

Sure. Just wanted to reiterate the comment that you made on cash flow, did you say in first half of 2017 or full?

Roger Deck

I got it. The comment was that in the later part of 2017 probably in Q4, 2017 I think we will eliminate our cash burn and so in the final quarter of 2017 possibly in the first quarter of 2018 we will be cash flow positive. For the year 2017 we are going to consume some cash, but I think you are going to see that number come down quite nicely from where we were this quarter. I think Matt O’Brien asked earlier about how aggressive are we in terms of the top line and I can tell you from a cash perspective what we have done has been very, I don't know whether you want to call this conservative or the opposite. But, we are building inventory to support this growth and as we see that growth in the next three, four quarters I think we will be really the elder in that part in. so we have gone, we have kind of gone early with our investment in the balance sheet and we will start working that off fairly quickly next year.

Rick Mangat

And also if I could just comment a little bit on margin because I do get this question over the last few weeks, so I am quite a bit with respect to DermACELL I think what you need to realize though too is that two different margin points. One on the breast side and then one on the wound, so although our breast margins are lower I think we will see some move for improvement there just to our volumes go up with those larger pieces that's a lot more expensive when your volumes are lower in order to actually obtain them and so I think we will see some positive momentum there and then on the wound side of our business I think what’s get there, we are paid in that higher bucket of reimbursement we are 100% covered in the United States by Medicare for that and so our margins there are actually much higher than what we see.

So as also grow that wound part of the business it's going to take some of that tissue margin pressure off so you will see two things kind of unfold. One is as we grow the breast business we are just going to get some margin improvement due to volume and we actually, we saw even slight amounts of that just going from 2015 to 2016, I think we will continue to see that. And then, as we grow our wound care part of the tissue business we will really be able to alleviate some of that margin pressure.

Charles Haff

Okay great. Thanks for the additional color Rick. And then on the pay per LUNA agreements you mentioned that there was short payback period. Were you referring to the payback period for Novadaq or for your customers? Can you give us a little more flavor around how from the economic proposition on the pay per LUNA agreements? Thank you.

Roger Deck

Sure. So the great part of that model is for our customers the payback is on every case. So they don't take any risk. They can never lose money from an imaging standpoint. My comment was actually for Novadaq’s perspective and the point that I was trying to make is that obviously we were bullish about the opportunity. We think it could become very large but I think the extent of the investment in capital will be limited by the fact that the payback is short. So when we look at what our monthly revenues is expected to be versus the cost of the device I don't think you are going to see our balance sheet explode even in the event of that's widely successful program.

Charles Haff

And which kind of breakeven procedure volumes that you look for from the LUNA customer?

Roger Deck

I think its early days. I think we have seen procedural volumes already that are quite a bit higher than in the operating room because often you can do a number of cases per day. I think we expect to be in the range of probably 120 to 200 devices. I know that's a wide range maybe we nerve that range a little bit that’s pretty in the future.

Charles Haff

You said 120 to 200 devices?

Roger Deck

I am sorry, 120 to 200 cases per device.

Charles Haff

Okay. Okay. Great. Yeah no problem. Thank you guys. Appreciate it.

Operator

Our next question comes from John Gillings with JMP Securities. Please proceed.

John Gillings

Hey guys can you hear me okay.

Rick Mangat

Yes we can John.

John Gillings

Okay perfect. So a couple of people have hit on this already, but I just want to circle back to this something that the people have been asking me about so Rick I just want to look at sort of some of the differences that we might be able to see from the outside looking in the way that you envision running the company whether things in the day to day operations, allocation of capital between sort of execution versus research or the way that you communicate with the street. I think you can just give us a little color about your vision or the next step of Novadaq’s development and maybe any milestone that we should watch for?

Rick Mangat

John, I don't think you will much change in terms of the allocation of resources with respect to dollars. I think what you will see is I have got a very clear understanding having kind of built the sales team with our VP of sales Tom over the last 18 months of really what are those obstacles facing the sales teams such as things as reimbursement areas such as marketing. And so, I have got clear understanding of what we need to do in those areas. So I will put a focus on getting those done immediately so extremely quickly. I think everyone is a little bit different. I think my style will be different when it comes to investor relations with respect to clearly how I present for those of you who happen to [indiscernible] you would see that. I think you will get a different perspective from me with respect to future launches of product. You are just not going to hear as much until it actually occurs. And I think that gives us the significant competitive advantage going forward whether anyone is the competitor or not, I feel very strongly with what we’re going to do with our five millimeter scope already that will be launched here in August.

I think it just differentiates us from our competitors having seen the images and all of you will start to see them as they go out into the hospitals setting in August and so really what I want to do is kind of keep things on the product pipeline probably closer to my chest but being a lot more transparent on the actual operational perspective of the business which I am very close to and I think I can give a lot of good color on from that perspective to investors going forward. I have asked Roger to look at different tools and different things we can do to help our investors and analyst to better model the business and we are going to that exercise in the second half of this year and so we will try to introduce some variables that frankly I used to monitor the business and make decisions that I think are just more accurate and maybe then some of the things being used out there to model the business right now.

John Gillings

Okay that makes sense. That's really helpful. And then I just want to turn to wound care real quick and I know it's very early days and you gave some nice highlights at the beginning of the call. But I was just wondering if we can dig in a little bit if you could give us some color on the training and the development of the rest of you hired so far and also are you max out to that group now or could we potentially see more there as the year progresses?

Rick Mangat

And so, on the training and developing of those reps, they have to be trained both on LUNA as well as on tissue. What I would say is just because a lot of these reps do come from the wound environment, the tissue part is actually I would say a little bit easier for them to comprehend and understand. I also think that the data there, actually the existing data is stronger for the tissue and then immediately just because we have this perspective randomized trial that was published last November. It's the largest wound care tissue probably done ever and had very positive data pushing towards why you only require one use of DermACELL to treat a lot these wounds. And so that part of it I would say is a little bit easier.

And then, the LUNA aspect is really something that's newer to most of them. That's newer to these centers as well when you bring imaging in, but what I find is kind of interesting here is if you look at the sale when a rep goes in and I can tell just what I have seen in the last month and the reviews and the report sent back to me they always lead with LUNA going into the wound care center. However, what we will often see is potentially a purchase of tissue before we even see that LUNA go in and start to be used. And so, what it does is it opens the door for our people to get in the door. They get in, they work through the process of bringing LUNA in and building their relationship in that center, they start getting the tissue being used. And so, from that perspective I think the two are very synergistic I think our clinical team is working now on moving some registries for LUNA so that we continue to expand the data and what’s presented at the major FAWC conferences twice a year and just get more publications out.

he publications are going to be focused really quite heavily clinically and then as well economically from the perspective not of how much the reimbursement do you get for LUNA but rather what is that due to the economics of the wound care center. What we have seen so far I think you may have heard in the past as LUNA actually drives compliance or for example hyperbaric to a greater degree. LUNA also drives the use – the other procedures being done so whether you are referred then for a vascular procedure it can help in that scenario as well.

And so, we are excited about it. I think you can sense from me I want to be a little bit conservative but the early data on what we’re seeing very positive, I think the fact that the combination of these two will also make the team more productive. With respect to expanding that team I don't see anything in the horizon for the next quarter or two but if they perform and we start seeing the return, yes we will absolutely do it and I have got some dollars baked into our budget to do that if necessary.

John Gillings

Okay, perfect that's really helpful. And then, just one last one from me and I don't know Rick this will be better for you or for Roger but given the feedback for Novadaq particularly mentioned it’s fairly short in terms of the pay per use model in wound care setting. Is there a level of utilization where you would see a wound care center want to buy a system and is there something where we will see maybe two different revenue streams where some people do the pay per use that some people have higher volume and want to buy a system or how should we think about the two different possibilities there?

Rick Mangat

Absolutely and it's actually a great point and something I was just discussing last week with our sales team and I think you are going to see that because we are already getting that question when we’re working some of our pay per LUNA contracts through the system that once we reach extra mile we would like to have the option to purchase it. I can't tell you what portion is going to get to that it’s too early but there will be a mix between that. Ideally, I want to keep it heavier on the pay per use model and we’re going to price things as such to make sure it stays that way and so that it will be rather expensive to go a capital model with respect to the outlet as well as the service cost that they are going to incur.

And in wound care centers in general outside of again the government center they are not used to buying capital the most expensive capital they buy is hyperbaric chamber for about $80,000 so it becomes, it's very difficult for them to make that kind of investment.

John Gillings

Okay. That's great color. I appreciate that. Well that's all the questions I have for today and thanks Rick and congrats on a solid quarter.

Rick Mangat

Thank you John.

Operator

Our next question comes from Tao Levy with Wedbush Securities. Please proceed.

Tao Levy

Hi, good afternoon.

Rick Mangat

Good afternoon, Tao.

Tao Levy

So there is couple of quick ones here. In terms of just clarification and maybe unnecessary to you, in terms of the SPY Elites that 50% I think that was the number was that on shipments or sale?

Roger Deck

It was installations, so I was talking about the number of installations in the quarter the extent to which the install base grew I mean the half of that progress this quarter was SPY.

Tao Levy

It is SPY Elite right?

Roger Deck

Yeah.

Tao Levy

So if that's the case then it's is it going to be a similar number or like it is the higher number that were sold or is it more PINPOINT? I am just kind of trying to get the numbers to line up?

Roger Deck

Sure. I think that when I answered that first question, I think I went back to 2015. In 2015 early part of the year we are installing some SPY and installing some PINPOINT and what we have seen as with the SPY installation increasing. We've actually caught up with the rate at which we're selling SPY, so that we're actually pretty balanced across the portfolio in terms of the number we install versus the number we sell.

So, you know, one of the implications of that is that the, you know, when the owned install base or if you want to call the capital tunnel of SPY systems, I mean, it's static today and you know I've expressed some optimism in the past that as the year progresses across the product, across all product lines, we're going to see installations start to edge ahead of the number that we actually sell. Obviously, that will be the case in LUNA, since we're not generally selling them.

Tao Levy

Okay. And just as, you know, going forward, a yearly stripping out the LUNA out of that shift in number or understand again better model than going forward but is not, we're going to be that relevant in terms of capital sales anymore?

Roger Deck

Sure, we did include a few LUNA system, so as I mentioned 50% was made up by PINPOINT and LUNA. I think, if LUNA becomes much larger, I think it might be worth pulling them out and giving some people the ability to think about the LUNA business separately from the other businesses.

Tao Levy

And then, I don’t know, the per click revenue that you're capturing from LUNA, is there an average number?

Rick Mangat

In terms of right now where we are, I mean, I think it's too early to kind of point to what's where we are in average. I think as Roger said, well we're trying to target somewhere between a 120 and 200 uses per year per device.

Tao Levy

But and with that I'm [indiscernible] with the amount you would collect?

Roger Deck

And it varies, you know, you got in there it'd be probably around there for about $350 or so per use.

Tao Levy

And then, so lastly, you mentioned involvement of filament or three. You know, at this pace, are you on track for what you previously disclose in terms of interim data releases, kind of like fourth quarter for filament, first quarter '17 for PILLAR?

Rick Mangat

Yeah. Right now, I believe we are. You know, it's a scenario that I'm getting a little bit more heavily involved with, you know, I think some is recruits a little bit quicker just because of the amount of patients in that arena. On the PILLAR side, you know, I need to understand, I'm looking at right now with different modalities, maybe speed up from the recruitment there. You know, what I can tell you is we're seeing very good commercial success on the colorectal PINPOINT side. And so, you know, anecdotally I can say you know have acquired from a few surgeons to as well I didn’t want to consent that patient, I thought there were going to be more of an issue with a lead due to some other factors with them and so I then I just did them as one of my regular patients. But it's something I'm going to look into a lot more closely going forward and looking at the mix of the size that we're using as well.

Tao Levy

Okay, great. Thank you, very much.

Rick Mangat

Thank you.

Operator

Our next question comes from Ben Haynor with Feltl and Company. Please proceed.

Ben Haynor

Good afternoon, gentlemen. Thanks for taking the questions and I get notably quick. On the ramp-up that you talked about rest of the reimbursement function, should we expect G&A to increase of this in the coming quarters or how should we think about that?

Rick Mangat

You know, I would, I'd leave that flat. There's other areas that I would say a little bit lower than which are forecasted, so I won't be adding much. These aren't very expensive people either.

Ben Haynor

Okay, great. And then, you know, when talking about getting to break even and leaving $60 million in cash in the bank. I guess, how do you see the ramp of recurring revenue and when should we expect that to kind of surpass capital. Is that something that could happen early on next year?

Roger Deck

Yeah. I think what we saw last year was that capital sales really ramped-up during the year. The slope has not nearly as steep this year. And I think in the early part of next year, certainly I think the recurring revenue will be pretty close to going through capital revenue.

Ben Haynor

Okay, great. And then one last housekeeping one from me. Where were you at in terms of sales personnel at the end of the quarter and then plans to add people for the remainder of the year?

Rick Mangat

Sure. And so, we're at in terms of our sales reps were at 89, people out there and the goal is to get to a 100. You know, I don’t think we have get exactly to a 100, just because of [indiscernible] or turnover but I would say within this quarter that team will be fully volatile.

Ben Haynor

Okay, great. Thank you, very much, gentlemen.

Operator

Our next question comes from Doug Miehm with RBC Capital Markets. Please proceed.

Doug Miehm

Hi, good afternoon. My question just has to do with the selling distribution expenses, which you know I know that around $4 million in administrative expenses. But now that number seemed to be a little bit higher than we were thinking in terms of selling and distribution. Now I see this as an investment for the future and you probably need to a couple of things, like hire those people on the reimbursement side. But how should we frame this given the, you know, $3 million dollars part of the --.

Roger Deck

Sure. That's a good point, Doug. And you know, I can tell you that, you know, for our sales and marketing cost, we closely monitor them. And at the current level, we feel that they are appropriate to really take advantage of the market opportunity for all five products. As I said we added this wound care team as well. You know, we've ordered a significant portion of our sales hand with to establish and in growing the recurring revenue stream and unlike capital sales, the returns from investing in that effort really take the number of quarters to materialize and that's why we kind of time to see some of those efforts and some of that investment materialize in the later half of this year, going into next year.

I think it gives us, these investments also give us the potential to really not just explain our product but really increase our lead over our potential competitors in this growth in imaging space. And if you look at our plan, you know, our plan really calls to maintain the structure and expenses for the next three or four years. So, as you see revenues grow across all platforms, there would not really be the commencer, I think reason the size of our team. You know, this team has built out to have a much higher top line revenue. So, the core focus will be now really on as a team there is on driving productivity efficiency and then the synergy of our products, by the sale of that team.

Doug Miehm

Excellent. And then just at the head, how you've been doing versus from your competition, a recent competition is there. We know that was good in Q1. Any update there?

Rick Mangat

Yeah. So, we've seen to not so not to, I won't say a lot, Doug, it's so really just in the handful of sites that maybe have got the striker system. What I can say is it's still very favourable to us. I think we're going to, we can't really improve that favourability percentage because it's kind of a 100% right now with respect to how we evaluate against them and our success rate. But I think you know, they're fairly going to start to put more of an effort but that's the importance of our launching the 5mm.

Because not only does it differentiate more greatly in terms of if you compare our 10mm to their 10mm, you know, there is a certain improvement on hours, which I would say is good. But when you compare the 5mm our 5mm's, there's an exponential improvement in terms of the image quality. And then what it also does is open up a range of procedures that we really up to now, we have not been able to go after. And even though we've seen the improvement in cases like lap cole, you really need a 5mm to do a lap cole, that's what they require. I think the people who have been doing it today have been making do without 10mm.

Doug Miehm

All right, thank you.

Operator

Next question comes from Vijay, Vijay Kumar. Okay. I would now like to turn the floor back over to management for closing comments.

Rick Mangat

Great. Well, thank you very much. And once again I'd like to again extend my thanks to everyone for your participation in today’s call and your continued interest in Novadaq. I'd also like to thank the Novadaq team for their ongoing contributions, to fulfil the company's progress. And we look forward to updating you on our financial results again during Q3, 2016, conference call later this fall. And I look forward to hopefully meeting many of you in person over the next few months.

Thank you.

Operator

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. And thank you, for your participation.

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