Cepheid Management Discusses Q2 2012 Results - Earnings Call Transcript

 |  About: CEPHEID (CPHD)
by: SA Transcripts


Good day, ladies and gentlemen, and welcome to Cepheid's 2012 Second Quarter Conference Call. My name is Keisha, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I will now like to hand the conference over to Ms. Jacquie Ross, Cepheid's Investor Relations. Please proceed.

Jacquie Ross

Thank you, Keisha, and welcome to Cepheid's 2012 Second Quarter Conference Call. On the call today are John Bishop, Chief Executive Officer; and Andrew Miller, Chief Financial Officer. Today's conference call is being broadcast live through an audio webcast and the replay of the call will be available later today at www.cepheid.com.

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

The forward-looking statements including guidance provided during this call are valid only as of today's date, July 19, 2012, 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 Chief Executive Officer, John Bishop.

John L. Bishop

Good afternoon, everyone, and thank you for joining us for a review of our second quarter results. The second quarter was characterized by solid growth. In fact, the sixth consecutive quarter of year-over-year growth in excess of 20%, despite increasingly challenging comps and unfavorable impact from FX and lower-than-expected HBDC revenue. I'll go into some detail momentarily, but our achievements in the second quarter included: first, solid system placements, particularly in light of continued economic uncertainty in Europe and renewed concerns in the U.S. regarding the potential impact of Healthcare Reform; second, good progress on our gross margin improvement, up 260 basis points from last quarter, reflecting the benefits of our ongoing diligence and the additional programs implemented in our manufacturing and logistics operations at the end of Q1; third, FDA clearance of our GeneXpert Infinity-80 System, which was exhibited at this week's AACC Meeting along with our new Infinity-48S, the new compact footprint version of our very successful Infinity-48. We expect the Infinity-48S will be available internationally and in the U.S. before the end of the year, while the Infinity-80 System is now globally available. And finally, our Xpert CT/NG test was CE Mark and has been commercially available to European customers since the middle of June. Additionally, the test was submitted to the FDA in early June with a targeted commercial release in the U.S. before the end of this year.

In detail then, total revenue of just over $81 million, was up 21% from a very strong second quarter in 2011 despite FX headwinds of over 200 basis points and up 5% from the first quarter of this year. Clinical revenue of $70 million, grew 22% from the second quarter of last year, again, despite the FX headwinds. On a sequential basis and coming off a particularly strong first quarter, our commercial business was solid with revenue growth in both systems and reagents.

Revenue associated with our HBDC business was roughly flat with last quarter, and in fact, several million dollars less than anticipated for 2 reasons: first, about $1.7 billion of HBDC system revenue could not be recognized despite receipt and acceptance by the customer, due to an additional agreement to transport the system from the customer's warehouse to the customer's lab site for installation; second, UNITAID's enthusiastic but premature announcement regarding the possible significant reduction in price of our HBDC test resulted in many HBDC customers delaying orders. Combined, we believe that these factors negatively impacted total revenue by approximately $3 million in the second quarter.

Moving to Clinical Systems. Revenue of $14 million was modestly up year-over-year, but grew 11% sequentially. Since HBDC system revenue was basically flat from last quarter, sequential growth of $1.4 million was almost entirely associated with our commercial business where we continue to see steady adoption of the Cepheid systems. 133 new commercial placements during the quarter included 54 systems in North America and 79 systems internationally. This was strong performance even under the best of circumstances, but we believe it was particularly solid given ongoing and perhaps deepening economic and political concern on the minds of customers. 7 of the 54 systems placed in North America where our larger Infinity systems, which offer immediate opportunities to realize greater efficiencies in the lab environment. For example, one Infinity System placed in Texas during the quarter was acquired to replace batch-based molecular MRSA and C. diff test. Analysis demonstrated that the Infinity could be expected to free up as many as 5,000 hours of labor in the lab annually, resulting in an overall lower cost per test than the competing methodologies. In addition, to immediate efficiencies customers could also choose the GeneXpert System because of the ease of use, which would take -- they can add incremental modules as testing volumes increase and new test become available. The same Infinity customer in Texas, for example, plans to add Xpert CT/NG when it is commercially available. Our partner, LABSCO, continues to build momentum amongst hospitals with fewer than 150 beds, driven primarily by interest in C. diff and MRSA. Although as a group, LABSCO customers are taking full advantage of almost the entire Xpert test menu.

For obvious reasons, we expect LABSCO system placements to be on the smaller side, but we have been very pleased with the healthy proportion of the -- of GeneXpert XVI systems going into these accounts. In fact, more than 75% of the systems placed by LABSCO during the second quarter involved GeneXpert XVI cabinets.

Moving outside the U.S. We placed 79 commercial systems internationally. Further validating our decision to go direct in the first quarter, we placed 15 systems in Germany, primarily in support of the National Infection Control mandate that took effect in March of this year. As a reminder, we are also direct in the U.K., France, South Africa and the Benelux. It is also interesting to note that we are continuing to see an increasing number of our placements being outright purchases as opposed to reagent rentals. I highlighted the emergence of this trend the last quarter and in fact, in Q2, more than 1/2 of our placement and direct EMEA countries were purchases.

International placements included 2 Infinity-80 systems. The addition of the Infinity-80 to our portfolio highlights the unique scalability of the GeneXpert family. Unlike any other system commercially available, the GeneXpert System uses the same proven cartridge and module format to deliver the same accuracy, speed and ease-of-use regardless of test volume. Importantly, with a test capacity now in excess of 2,000 tests per day, we are extending our reach firmly into even the highest volume applications, thereby directly dismissing competitors' positioning of Cepheid as a low-volume throughput solution.

Rounding out our discussion on system placements and not counting the 24 systems that could not be recognized, our HBDC business contributed an additional 138 placements during the quarter, bringing the Q2 total to 271. Globally, our installed base is now 3,350 GeneXpert systems.

Moving to reagents. Year-over-year Clinical Reagents grew 27%, despite the tough comparison to a very strong Q2 last year and the FX headwinds. Excluding HBDC commercial reagents grew 22%, driven primarily by the HAI portfolio, but representing year-over-year and indeed sequential growth in 9 of our commercially available tests. Overall, and building on the second -- on the largest, excuse me, sequential dollar increase ever in the first quarter, Commercial Clinical Reagents grew almost $2 million sequentially in the second quarter despite a decline in Flu revenue of over $1 million due to seasonality.

Revenue associated with our Xpert MRSA tests continue to grow in the second quarter with a steady flow of new prospects evaluating the product, which points to the ongoing development of the MRSA surveillance market. Our latest survey data suggests that more than 1/2 of all U.S. institutions are now doing some form of active MRSA surveillance, primarily targeted at high-risk patient populations. Compared to our previous survey, this suggests that hundreds of hospitals in the U.S. have transitioned from passive programs to active surveillance programs in the last 12 months or so. While most of these new active programs have been initiated using direct culture, this represents a significant expansion of Cepheid's opportunity as the strongest prospects for molecular MRSA tend to emerge once the limitations and frustrations of a culture-based MRSA screening program becomes apparent. It is well understood that molecular tests are faster than culture, offering the opportunity to identify colonized patients more quickly. Perhaps less well known is that molecular tests are actually more sensitive than direct culture, and there is a growing body of evidence that suggests direct culture may miss MRSA anywhere from 15% to 35% of the time. So while culture will remain the standard go-to method for new surveillance programs for the foreseeable future, we remain confident that the market will continue to transition to molecular over time.

Moving to C. diff. Cepheid continues to win new customers and leads with the majority of the molecular market. In the U.S., the 027 call out is proving to be a valuable differentiator, with more than 40% of our U.S. C. diff accounts now using the combined C. diff 027 product. We continue to believe that Xpert C. diff is the best performing assay on the market. By way of illustration, as part of a 3-hospital network win in Colorado during the second quarter, we displaced a recently installed small batch-based instrument for C. diff testing. While Cepheid's broad test menu and unparalleled ease-of-use were important contributors to the win, the customer was also looking for stronger and more consistent C. diff assay performance, and we were able to displace 3 of the smaller boxes with our GeneXpert systems. Overall, we continue to see strength here and once again, Xpert C. diff revenues grew more than 50% over the second quarter of last year.

Our third largest test, Xpert MTB/RIF, grew sequentially despite a decline in HBDC reagent revenue, reflecting strong growth in commercial sales of the product outside of the U.S. With only a few weeks of commercial availability outside the U.S., our Xpert CT/NG contributed but not meaningfully to the revenue in the second quarter. The products first customers, as expected, tended to be existing GeneXpert System users who currently sends CT/NG tests out to a reference lab, and initial customer feedback has been very promising. Of course, they welcomed the strong performance ease-of-use and speed that are trademarks of our Xpert family of tests. But so far, comments have also highlighted: first, the benefits of having a result in 90 minutes as opposed to waiting to begin treatment until a send-out result is available anywhere from 4 to 12 days later; second, great satisfaction with many of the unique features of our product, including the sample adequacy control, which positions us as the only test to validate the quality of the sample, the convenience of having the same protocol and the workflow regardless of specimen type and the significant efficiencies to regain from not needing to confirm positive results; and third, enthusiasm for performance overall, but particularly for the specificity of our NG call. During validation, one customer reported that a sample found negative by both our Xpert test and culture was identified as a false-positive for NG by a competing PCR assay.

Our systems and solution team newly expanded to the European market has been working with potential customers to assess the impact of adopting Xpert CT/NG. Two recent analyses in Rome and London, for example, highlighted how the test ease-of-use could significantly reduce the associated labor expenses resulting in an overall lower total cost. In one London clinic, for example, the analysis suggested that the lab could save up to GBP 280,000 per year in labor expenses alone, more than offsetting our higher price, not to mention the broader benefits of a more rapid test result that can be reported in hours rather than a week. We look forward to sharing more with you after a full quarter of commercial availability, but feel extremely encouraged with what we have seen so far.

Looking forward, we continue to execute well on our Xpert menu expansion initiatives. First, we completed our annual strategic planning exercise during the quarter and published our targeted Xpert test menu through 2017. There were no material changes to our near-term targets as a result of this process, and we currently have 14 tests in active development. Within these, all of our key projects, including HIV, HBV, HCV, HPV, vaginitis and CLIA-waived Flu, remained on track within previously communicated timelines. The complete targeted menu is available as part of our Investor Relations Presentation on our website, but plans discussed publicly for the first time include Xpert Molecular Path, Xpert Meningitis and Xpert Colon Monitor test. By the end of 2017, we are targeting up to 37 Xpert tests across a broad spectrum of disease categories to deliver the benefits of molecular testing to a broader patient population and to enable customers to consolidate much of their testing requirements on the GeneXpert System.

Moving on to specific topics. And as mentioned previously, Xpert CT/NG is currently under review at the FDA. It was submitted in early June, and we typically expect the review process to take around 120 days. Next, our CLIA-waived flu test is progressing, and we continue to target commercial release. For the 2013/'14 flu season. Clinical trials for our Xpert MTB/RIF test are ongoing, and we continue to target commercial release of the test subject to FDA review in the first half of 2013. We currently expect to complete the clinical trial this year with the submission to the FDA in early 2013.

Finally, Xpert Blood Culture clinical trials are ongoing, and we are now targeting FDA submission around the end of the year. Before I hand the call over to Andy, I'd like to share with you a few other updates. On HBDC, while revenue actually declined slightly from last quarter to just over $7 million, there can be no doubt that this program continues to build momentum. In just the last 6 quarters, we have placed a total of 700 systems in 74 different countries and delivered more than 1 million test cartridges to support the global communities' efforts to combat tuberculosis. With reference to our discussions on delivering the test to HBDC customers at an approximate $10 price point, I can report that we continue to work with UNITAID, USAID, and the Bill and Melinda Gates foundation on the details. While we are confident that all parties remain committed to finalizing an agreement, we fully expect that HBDC customers will continue to postpone purchases pending the availability of the test at a lower price point. With that in mind, we are taking an even more cautious view of HBDC revenue in the near-term, although it is clear that longer term, the lower test price should drive an even more rapid adoption of our Xpert TB/RIF test.

Finally, another item that has contributed to our cautious review of our 2012 expectations, while system placements were solid in the second quarter, we do believe that we are starting to see a heightening sensitivity to macro factors here in the U.S. with the Supreme Court opinion upholding the Healthcare Reform bill and the upcoming election. U.S. hospital administrators are looking more closely at what the bill means to them and the resulting uncertainty could cause capital equipment spending to tighten and for decision cycles to lengthen. While there are plenty of controversial items in the Healthcare Reform package that we'll not discuss here, we do believe that the quality, reporting and value-based purchasing initiatives will go a long way to ensure that the overwhelming majority of U.S. hospitals are investing in and measuring the results of their infection control programs.

By 2017, hospitals with the poorest performance across the range of initiatives now packaged in the ACA could see their DRG reimbursements penalized by as much as 8%. It is also worth noting that the best-performing hospitals have the opportunity to see their DRG payments increased by up to 2% under the value-based purchasing initiative. Combined, the phase-in of this carrot and stick approach is certainly prompting U.S. hospitals to consider what needs to be done to avoid these potentially sizable penalties and to seek available rewards. Clearly, Cepheid is part of the solution here, and we will continue to work with potential customers to demonstrate how investment in our portfolio, the best-in-class molecular HAI test can contribute to an effective infection control program.

As noted, our systems and solution team has been particularly effective here, and we remain confident that we will continue to see broad adoption of our GeneXpert systems throughout the entire U.S. hospital universe. That said, the near-term uncertainties are very real for our customers and we are, therefore, taking a slightly more cautious view with regard to system placements in the second half of this year.

With that, I'll invite Andy to address our second quarter financial results and guidance in detail. Andy?

Andrew D. Miller

Thank you, John. As always, please note that I will be discussing our non-GAAP results unless I indicate otherwise. Second quarter revenue of $81 million was up 21% year-over-year, driven by continued growth in our Clinical business. Note that unfavorable foreign currency exchange rates impacted year-over-year revenue growth by $1.4 million or 2%, and GPO fees classified as contra-revenue reduced growth by about 1%. Of total revenue, product revenue was $78.5 million, up 23% and the other revenue consisting of contracts, grants and research was $2.5 million.

Clinical revenue of $69.7 million grew 22% year-over-year and 4% from last quarter. Overall, Clinical revenue represented 89% of total product revenue. Within Clinical, system revenue of $13.9 million was up 5% from the same quarter of last year and up 11% from last quarter. Of total system revenue, the HBDC program contributed $2.8 million, up modestly over last quarter.

As John discussed, HBDC system revenue was lower than we expected, was about $1.7 million in HBDC system revenue deferred. Despite a sequential decline in Flu revenue due to seasonality and a sequential decline in HBDC TB revenue due to the UNITAID announcement. Clinical reagent revenue of $55.8 million was up $1.4 million or 3% from a record-breaking first quarter and up 27% from the same quarter a year ago despite FX headwinds. Growth was driven by C. difficile, MRSA and TB.

Our nonclinical business delivered second quarter revenue of $8.8 million. The year-over-year growth in this category was driven primarily by growth in the Biothreat and Partner elements of the business.

Moving to the income statement and starting with gross margin. Non-GAAP gross margin of 56.6% was consistent with our guidance for second quarter gross margin of around 56%. Compared to last quarter's 54%, the majority of the 260 basis point improvement resulted from our efforts to overcome the Q1 challenges we discussed on our call last quarter. The sequential decline in HBDC TB revenue negatively impacted overhead absorption and gross margin in the quarter. Excluding HBDC, commercial non-GAAP gross margin improved to 61% from 58% last quarter. We believe that our increased diligence in this area was effective in the second quarter.

Moving to the rest of the income statement. Non-GAAP R&D expense of $14.3 million, or 18% of revenue, declined $6 million, primarily due to the lower level of clinical trial activity in the second quarter. As a reminder, R&D and, more specifically, clinical trial costs will continue to be the primary variable in our business model in the coming quarters and years as we deliberately invest in our menu expansion programs. Non-GAAP sales and marketing expense of $13.4 million was basically flat from last quarter and continues to be stable at around 17% of revenue.

Finally, on expenses. Non-GAAP G&A of $8.8 million was flat from last quarter, although I note that at 11% of revenue this is still running a little high due to ongoing litigation costs. Overall, non-GAAP net income for the second quarter was $7.9 million or $0.11 per share. GAAP net income was $1.1 million or $0.02 per share.

Turning now to guidance. As John mentioned, there are a number of factors that are prompting us to take an even more cautious view of our expectations for the second half of the year. Potential impacts to our top line performance include: one, a potential lengthening of the capital sales cycle in the U.S. associated with uncertainty created by the Healthcare Reform bill, the upcoming election and the broader economy; two, pending completion of the potential agreement to buy-down the HBDC test price, sales of the HBDC TB product are likely to be negatively impacted. The extent to which system placements may also be delayed is another unknown Put simply, the range of possible HBDC outcomes for the full year is extremely variable at this time. And three, the volatility in foreign currency exchange rates, especially given the strong growth we have been seeing internationally. As discussed, this did impact the top and bottom line in the second quarter, and we expect it will continue to do so for the rest of the year.

Even noting these items, we have decided not to narrow our guidance revenue range, keeping it at $333 million to $347 million. To be clear, this range continues to represent our best estimate of possible revenue outcomes for the full year 2012, and we see scenarios at both the top end and the bottom end. While we are maintaining this guidance range, there is a distinct possibility that our revenue could be towards the lower end of the range, given the incremental uncertainties since we originally issued this guidance back in January.

Moving to the bottom line. Our full year earnings guidance has been adjusted largely to reflect changes in our outlook for gross margin for our HBDC business, in addition to the ongoing impact of less favorable FX. Specifically, one, HBDC reagent growth has slowed pending the availability of a lower-priced test. This results in under-absorbed overhead associated with the build-out of our manufacturing facility in Sweden. Two, lower-than-expected HBDC sales in the second and third quarters resulting in lower profit contribution. And three, the accounting associated with the potential buy-down could result in a negative reported gross margin contribution from the HBDC business in the fourth quarter. Taking these HBDC items together, we are reducing our bottom line guidance around $7 million or around $0.09 per share for the HBDC business. Additionally, our guidance has been adjusted to reflect the bottom line impact of a stronger U.S. dollar, which has reduced our overall EPS guidance by $0.02. And finally, lower-than-targeted gross margin contribution from the newest members of our Infinity family of systems. This is expected to impact overall EPS by about $0.01 in the second half of the year.

In total and allowing for rounding, these items account for an approximate $0.12 reduction in our EPS guidance. Let me go into the HBDC impact here in a little more detail. First, and as John indicated, with the premature announcement by UNITAID of the potential deal, HBDC TB test volumes immediately declined in Q2 as customers delayed their purchases awaiting the $10 price. We expect continued purchase delays in the third quarter until a deal is finalized. The lower volumes in Q2 and Q3 from what we had previously planned result in a lower overhead absorption, lower gross margin and lower net income of approximately $3.4 million or $0.05 per share. Secondly, as you know, we have been discussing a possible arrangement whereby third parties would effectively subsidize Cepheid to make the tests available at approximately $10 by making upfront buy-down payments. Depending on how these agreements are structured, it is possible that the quarterly accounting for such payments may not reflect the underlying economics nor the intentions of the parties. Recall that the price for our TB test to HBDC customers declines over time as our volumes ramp. So the amount that the parties would be required to subsidize per test actually declines over time. As an illustration, to get to a $10 test from the current $16.86 price point, the subsidy now would be close to $7 per test. As volumes increase, however, the subsidy decreases until it is effectively 0. You can see TB tests pricing at various volume thresholds on the FIND website. The challenge from a gross margin perspective is that the buy-down payments, which we anticipate will be paid in advance, may be recognized on a straight-line basis over time regardless of the underlying per test economic subsidy or regardless of the volume shift in the quarter. In fact, the total period that the buy-down may be recognized over from an accounting perspective may extend far beyond the period that the subsidy is intended or needed to cover the lower price. The revenue we recognize is likely to be particularly disproportionate in the early quarters when the subsidies needed are the greatest.

As a result, we do anticipate that the first few quarters of HBDC sales following any buy-down agreement would likely contribute negative reported gross margins due to the accounting. Again, this is regardless of the timing of the receipt of the cash and regardless of the underlying economics of the arrangement. We should be clear that at this time, there is no formal agreement to buy down the price of the HBDC test, but we believe that an agreement will be reached and wanted to share the potential impacts with you at the earliest opportunity.

Back to our full year guidance. For the third quarter, we anticipate our non-GAAP gross margin will be roughly flat with Q2. We previously expected a sequential increase, but with lower expected HBDC TB sales until a buy-down agreement is finalized, we expect lower overhead absorption than we had previously planned.

In the fourth quarter, after considering the accounting for the potential buy-down arrangements, we are planning for an overall corporate products gross margin in the 53% to 54% range. This includes an anticipated negative reported gross margin from our HBDC business and factors in a non-GAAP gross margin in the 63% to 64% range in our Commercial business. You will recall we were targeting a non-GAAP gross margin in the mid-60s for our Commercial business and there is little change here, other than allowance for the GPO fee adjustment that we discussed last quarter and the lower margin on the new Infinity instruments in a quarter when we expect to have a strong mix of Infinity placements.

After taking all of these factors into account, for the full year, we expect non-GAAP gross margin of approximately 55% with a commercial non-GAAP gross margin for the full year of approximately 61%. The HBDC impacts discussed above negatively impact the overall gross margin by approximately 200 basis points. As always, you should keep in mind that product and geographic mix can and does cause quarterly gross margin fluctuations that can positively or negatively impact gross margin. That said, and quarterly fluctuations aside, we continue to expect to see our commercial gross margin trend higher over time.

Regarding operating expenses and another example of our cautious outlook for the second half, we are actively managing spending, assuming revenue towards the lower end of our guidance range. Importantly, however, our strategic initiatives, for example, involving menu expansion or direct sales force expansion, will not be impacted.

For 2012, we continue to expect non-GAAP R&D of between 19% and 20% of total revenue. There are no changes to our expectations for both sales and marketing and G&A, but we are targeting 16% and 10% of revenue, respectively, for the full year.

Relative to the second quarter, we expect third quarter operating expenses to increase between $1 million and $2 million, driven by timing of trade shows clinical trials and higher outside legal costs associated with the Abaxis litigation. On a per share basis, we expect GAAP net income between breakeven and $0.04 per share, and we expect non-GAAP net income per share of $0.38 to $0.42. We expect our fully diluted share count to be 70 million to 71 million shares.

As you review our financial performance for the second half of 2012, you will note that we expect GAAP and non-GAAP EPS to increase substantially from the first half. In fact, at the midpoint of our guidance, we expect second half EPS to be $0.21 higher, even taking into account the HBDC impacts. As we prioritize our second half investments, we believe we have balanced keeping our key strategic initiatives on track while tightly managing the headcount and operating expense growth. As a final note in 2012, we are targeting CapEx of between 6% and 7% of revenue, primarily due to continued expansion and automation of our manufacturing operations to support the growth in our GeneXpert test revenue. I'll now turn the call back to John.

John L. Bishop

Thanks, Andy. While there is uncertainty on the broader economic environment, particularly in Europe and on the impact of Healthcare Reform here in the U.S., it is clear that the GeneXpert System and our growing test menu is delivering positive benefits to customers throughout the world. There is hardly a day that goes by where we are not hearing from accounts about the life-saving and economic benefits of our products. This is, of course, true in both our commercial and HBDC markets. In the near-term, our participation in the HBDC market does add some complexity and indeed a level of uncertainty to our model that makes it a bit more difficult to see the progress we are making in the commercial business. Rest assured, that we will continue to be as transparent as we can to help you understand exactly how these 2 elements of our business are progressing.

In the meantime, and given the uncertainties we are facing in the immediate term, we are actively managing our investments to ensure our strategic initiatives remain on track. We are confident that we remain best positioned to meet the challenges of today's markets and that we are strongly positioned for future top and bottom line growth. With that, I'll ask the operator to begin the Q&A.

Question-and-Answer Session


[Operator Instructions] Your first question comes from the line of Brian Weinstein with William Blair.

Brian Weinstein - William Blair & Company L.L.C., Research Division

A question on HBDC. Considering that the UNITAID announcement happened very late in the quarter, can you talk about trends that you are seeing prior to that to those last 2 weeks? And then what makes you so confident that you're going to be able to get a deal done here, I mean what happens to volumes and expectations if this lingers out into the Q3, Q4, Q1 of next year, potentially?

John L. Bishop

So yes, Brian, what we're continuing to see prior to the UNITAID announcement is continuing building momentum relative to implementing the GeneXpert System. In fact, that's the reason why there is -- this activity to try to put together a coalition to affect the buy-down because there's growing momentum already. However, all of the groups because of the value of the test that's out there are very interested in getting this $10 price point out in the market. So as a result of the premature statement on what was going on, we saw an immediate reaction to that, a suspension in shipments, and we indicated something on the systems, but actually even more on the systems we have a number of the new countries where they want to ship an amount of tests with new system. So it actually suspended some systems in addition to tests. Now going forward, as we indicated in our prepared remarks, we are actively working with the Gates Foundation, USAID and UNITAID, directly with their various representatives there to address working out the details of the transaction. So those continue to be underway. What we are concerned about is that we think it likely that as time continues until we reach that agreement that we'll, as we have indicated, see a continued delay in orders. Now that said, that will not be a suspension totally in orders, but there is a lot of folks who are on their way. They clearly see the value. I mean, as I've indicated, we're getting calls almost daily. We're literally saving thousands of lives at this point. So the answer just really getting broader, not less adoption. Now if for any reason, agreement were ultimately not reached, then I would refer you to the FIND website because as the volumes build, the price point does come down. And frankly, we're right now about $16.86. And given where the volumes already are with that, the price point would likely go to a $14 price point as indicated on the FIND site already. So the key impact, I think, it would slow the ultimate adoption rate at the rate we're seeing right now a bit. But at the end of the day, I think it's going to just continue to grow. In fact, just recently and this was news to us, we received now reports from South Africa that a number of the regions there have totally discontinued smear testing, and they're now doing nothing but going straight to the GeneXpert test instead of running smears. So that speaks volumes relative to the ramp ongoing, the benefit that the test is providing, but yes we do need to complete working out these details relative to the buy-down proposal.


Your next question comes from the line of Dan Leonard from Leerink Swann.

Daniel L. Leonard - Leerink Swann LLC, Research Division

I was just hoping to get some color on the trajectory of your non-product line, given that it's up 25%, year-to-date. How should we think about modeling that? Is that sustainable?

Andrew D. Miller

Of the top line...

John L. Bishop

You're talking about the other revenue line, Dan, not product associated?

Daniel L. Leonard - Leerink Swann LLC, Research Division

Yes, the Cepheid distributor partners and also the biothreat, the nonclinical revenue.

Unknown Executive


John L. Bishop


Andrew D. Miller

No, that -- we guided that last quarter at roughly $29 million for the full year and that's where we expect it to be at this point in time, $28 million or potentially a little bit lower. So that was -- that just basically if you look at last year you see biothreat had a very low number last year in the second quarter.


Your next question comes from line of Dan Arias with UBS.

Daniel Arias - UBS Investment Bank, Research Division

Just a question on the profitability of the business. I guess looking a little bit farther out than near-term. If I look at the revised menu plan that you guys have and that John referenced, it looks like there are 13 tests or so that are launched in the 2014 to 2015 timeframe. And I guess in one sense this is a ways off, but may be in another sense when it comes to logistics or planning or maybe headcount, it's not. So I guess can you just talk to the things that you think are most important in the midterm or the longer term in terms of managing costs as you're expanding so rapidly, and then maybe how confident are you that the operating expenses as a percentage of revenue in the out-years can look like the 19% or 20% that you're looking for now?

John L. Bishop

Okay. So I'll answer your last part of your question first. We're quite confident relative to our ability to get to the operating expense ranges that you're talking about there. As we look at the menu of tests that we expect to be introducing, one of the things you're going to start to see is in number of cases for many of these tests, particularly as you move into the virology products that they are going to be higher price points, expect our margins on those products are going to be better. The other item is that we want to take, and we're going to be better positioned also going forward as we're building just a general volumes across the board and production demand with both our U.S. operation here and the operation in Sweden. So that's going to give -- much better position us to absorb the associated overhead. As we have indicated with our product, the biggest part of the cost there for the product is overhead, because we have designed a very robust, but yet very sophisticated automated manufacturing system. And as our volumes ramp, it gives us a lot of leverage going forward. Now with regard to the operating expenses, we are taking a very measured view. Predominantly, we're going to be making our investments where we are going to realize dollars being created. We are going to limit our investment for portions of the business that are functional within the business, but don't contribute direct sales. So by that I mean, we're really -- you're going to see us to continue to add direct sales representatives, field tech service specialists, systems and solution specialists out in the marketplace, both internationally and in the U.S. But for other non-revenue positions with the business, we're going to slow down the growth in those areas. We're also -- as we look at our strategic plans on menu, we really made conscious decisions on looking at the ramp rate in our clinical trial expense that we have discussed on previous calls to really put the emphasis on focus on those products that are going to drive potentially the higher rates of return earlier. And while we will get around to some of these other products, we push them out a bit in the schedule. So what that's done is to bring down a bit the cost of clinical trials that we'll be seeing in the nearer term and smoothing that a bit versus things that we have spoken about in the past. So taken together for all of these items that we're talking about, I'm very confident on reaching our operating margins that we're talking about within our strategic plans.

Andrew D. Miller

And Dan, there's one thing I'll add. If you look at what we've implied for the guidance for the second half of this year, you've got revenue growth somewhere between 16% and 26%, but even at the high end, the guidance implies OpEx growth of only about 8%. So you can see how we're managing it quite tightly even in a very short term.


Your next question comes from the line of Jon Wood with Jefferies.

Jon Davis Wood - Jefferies & Company, Inc., Research Division

So you signaled quite a bit of caution in the U.S. placement or kind of the deferral situation in the U.S., but no mention of the international. So I'd love to hear, John, your comments on just the capital environment in Europe, given that you're placing more of those under cash, cash-based arrangements, would love to hear how the pipeline looks there.

John L. Bishop

So good question there. And Europe specifically, of course, we're seeing no surprise to any of you a widening difference between northern Europe and southern Europe. So where we're getting these direct sales, there's 2 trends. One, direct sales are cash sales versus reagent rentals. The other thing is you're seeing larger systems. So effectively, I mentioned the Infinity-80s being placed there on the quarter. We're also seeing 16s. So we're getting larger systems along with the direct sales and right now we're seeing that continuing in Northern Europe. Southern Europe, of course, is a whole different ballgame there with the issues going on in Spain, Italy, et cetera. So there, we see our distributors still using the reagent rental programs, placing the smaller systems. Now what's going to be interesting for us and something we've just been talking about is as you look now at the menu expansion and the CT/NG is significant. It's also interesting because your HAI initiatives have really taken off more in Northern Europe. They have not really seen a lot of traction, if any, in southern Europe. That said, as we now expand the menu when we come with products like CT/NG, I think, those are going to be more amenable relative to starting to develop in southern Europe. But we have the headwinds of the economic situation there. So we'll have to see how things continue to develop out in those areas, but certainly I expect that more reagent rentals to continue for Southern Europe. So predominantly positive growth in northern Europe, we see that continuing at this point in time.

Andrew D. Miller

The one thing I'll add there, Jon, is that you look at our international clinical growth of 46%. Of course, if you looked at that in local currency, it's closer to mid 50s, so 55% growth. So even with the economic environment there in Europe, we're still seeing awfully nice growth.


Your next question comes from line of Zarak Khurshid with Wedbush Securities.

Zarak Khurshid - Wedbush Securities Inc., Research Division

On this theme of Europe, can you may be characterize sort of the breadth in overall strength of test utilization in Germany following the start of the Infection Control mandate and any color around kind of that program and the progress and success? It would be very helpful.

John L. Bishop

Yes, actually in Germany, our acquisition there or buyout of the distributor was very timely. We're very impressed with the actions of the management team there in Germany. They're doing a very good job. We called out the placements in the prepared remarks on the systems in Germany during the second quarter. There is good adherence to the initiative relative to HAIs. So certainly a key driver is the MRSA product. I think our other HAI products are looking good there as well. And I think that the CT/NG is going to be looking pretty interesting as we look at Germany going forward. So all in all, Zarak, as we look at that, I'm very pleased with what we see in Germany, and I think we're going to see good menu utilization pretty much across-the-board.


Your next question comes from line of Bill Quirk with Piper Jaffray.

William R. Quirk - Piper Jaffray Companies, Research Division

First question -- I guess only question for the time being is in terms of the comments, John, around the U.S. business and expectations for capital to become tighter and/or decisions to be taking longer to be made. Have you actually started to see this or is this an expectation just based on the Supreme Court's recent announcement, and obviously, just the political campaigns continuing in Europe?

John L. Bishop

Yes, good question, Bill. And no, we've actually started to see it. I mean, I just came back from the AACC Meeting, and one of the things we do routinely, we have our Presidents Club and one of the things that we do during the year when we have the opportunity is we get together with President Club members and these are the best of the best relative to our sales team to talk with them on what do they need, how could we help them, be more effective in the field, but at the same time do an assessment of trends that are out there. So certainly this was a key topic of discussion relative to the available of the capital markets out there at this point. They said yes -- I mean some things that they have seen is they have some orders coming along and basically the review process got pushed out. And as a result, it pushed orders into subsequent quarter versus end up getting those orders being billed during the same quarter. Now the other item that we've spoken about previously we said that capital is available but you're competing with other folks out there, you got to make your case with the capital. And there our systems and solutions group is doing a good job, but we are seeing that tightening. So we actually had very interesting story. One of our people is very good friends with a competitive company and his friend called him and said, "Hey, I just lost a piece of capital equipment to you guys because we were competing for available capital," and they went with the GeneXpert instead. That said, we also had some during the quarter where larger GeneXpert System configurations were going to be ordered and then at the last minute, they came in and said, "Look, we're going to go forward with the available capital, but we're going to reduce the total amount." Now the good news of the bad news there for us is that our systems -- because of our modular configuration with the cabinets, we were able to easily accommodate exactly what they needed. So that's why I'm very pleased with our pricing strategy that we introduced recently there where we price on a by-cabinet basis and the account is not penalized for adding modules as they go forward in the futures. So that's working very nicely in this environment, but there is no doubt that we are seeing a tightening relative to spending the capital, which is pushing out the review times that are there. So I would just say just in general, capital does continue to be available. We're not seeing a freezing in capital, but you've got to make your case more strongly than previously even. And you're definitely competing with capital expenditures for other parts of the institution or the laboratory with what you're doing in that area. So that's the reason why right now, we're taking a bit more of a cautious tone here.

Andrew D. Miller

And Bill, while the capital equipment environment seems to be getting a little bit more challenging, we are still seeing very nice reagent growth in the U.S. So our clinical reagents in the U.S. grew 25% over last year.


Your next question comes from line of Isaac Ro with Goldman Sachs.

Isaac Ro - Goldman Sachs Group Inc., Research Division

I wanted to talk for a minute about the essential way in which your menus will enable larger total addressable market over the next couple of years. And if you could, if we just put aside the major categories that most people here probably are familiar with namely: HPV and CT/NG, if you put those aside and look at the balance of your portfolio, could you maybe ballpark how much you think that will expand your addressable market, either relative to your current addressable market or maybe in absolute dollar terms? I'm just trying to figure out, as we look at the next couple of years, what the trajectory could look like.

John L. Bishop

Well, so Isaac, what we'll do for you I think for future is we will prepare an exhibit for everybody, basically, get an inverted funnel, if you will, where we're coming from a smaller to a larger addressable market as we layer in these various products and market types that we're talking about. But to give you some general ideas as to where we are right now, you've already touched on the obvious ones on the virology size of the market which are in the area of about $1 billion opportunity. The others though they were coming along with, I think, certainly continued expansion in the STD market and one of the things I'll give credit to the Gen-Probe folks for was their initiation of the standalone Trichomonas product that's out there. I think they're doing relatively well with that. I think we've got a better solution coming with our combination Trichomonas and yeast product there for vaginitis that's out there. But that's all going to be additive. I'd see those markets growing. The other items, I think, TB is going to enhance the addressable markets potentially significantly. We're talking about 500,000 tests per year in the U.S. market even though there's a low incidence rate in the U.S. at this point in time. But the test volumes, there's a lot of demand and interest because of the quality of the product and the real concern about getting drug-resistant strains into the U.S. market. So we may likely see some market growth opportunity there. Now beyond that, we we're also going to start to substantially broaden the market, is as we step into the oncology arena. And as you look at those arenas with some of the early products in bladder and then in breast cancer, I mean, nominally that market just to give you a general gross number right now would be easily in the $500 million, $600 million range, maybe a bit more with some of those products. So I think that opportunity is going to be growing very nicely with the menu that we are developing at this point in time.


Your next question comes from the line of Ross Muken with ISI.

Vijay Kumar - ISI Group Inc., Research Division

This Vijay in for Ross. I just wanted to -- I mean, your comment on the general macroeconomic backdrop and the potential delays on the CapEx spending part. I mean I just found it sort of interesting the direct sales as a percentage are increasing. I would have thought that in this environment, you probably will come out higher proportion of reagent rental, so could you explain what's driving direct sales?

John L. Bishop

Absolutely, that's our systems and solutions group. I mean one of the comments and it's always been our vision and our business premise, certainly mine, as we look at this is that as you look at the rate of expenditure for diagnostic, there's absolutely no doubt that there is ample room for transferring more value to the diagnostic, while bringing down the total cost of health care and simultaneously improving the value of health care. We are absolutely demonstrating that with real hard dollars with our systems and solutions group. I gave you one example on the call where we talked about in the U.K. saving GBP 280,000 in direct labor. That was a big deal for them. We've given you some examples on the call previously on account in Singapore where we're saving them hard dollars of $2 million a year. And then there were many others where we're saving couple of hundred thousand, which is quite significant a year on a by-account basis. So it's because of that, where they're seeing hard dollar direct benefit that justifies and said, "Hey", it's a good investment for them to make that and realize those dollars, and that's the reason why we're getting the direct sales benefit. Now the other item as I've spoken to accounts many times in the past is it from a business standpoint for the institution. The institution is substantially better off spending their capital and bringing down the burn of their P&L because what happens on a reagent rental, they're just doing nothing but transferring what would be the cost on the balance sheet recognized on an amortized basis to a price that's added into the cost of their reagents, as they go forward month to month. Ultimately, that increases their operating costs, that does not decrease their operating cost and is frankly better business for them to decrease their operating cost, purchase their equipment and then outright purchase their test. And frankly, from the manufacturing standpoint, it's better for us, too. So it's a real win-win, and we're very happy that our customers are recognizing that making the investment in the system and then getting the savings benefit.


Your next question will come from the line of Jeff Elliott with Robert Baird.

Jeffrey T. Elliott - Robert W. Baird & Co. Incorporated, Research Division

For HBDC instruments, how long does it take between product placement and when you see the system running tests consistently? And can you provide any commentary on how the HBDC operating margin was tracking before the UNITAID announcement, and where do you think they'll go under the new test price?

John L. Bishop

Sure. Well, your question there was a very good one between time where they buy it versus they actually start recognizing because remember we said on the prepared remarks where we had -- and there's one case, customers purchasing the units that goes into their warehouse. The timeframe for which they elect to say, "Okay, now the site's ready". We're going to dispatch that out of their warehouse to go and do site installation is highly variable. So I can't -- there's no real good measure to give you there. What you would expect -- I mean, the typical, as you know, in the U.S. is about 90 days or 3 months so you got 1 quarter lag. In the HBDC, I think, it's substantially more variable effect. I know it's substantially more variable than that for some of the reasons that I'm indicating right there. Now with regard to the operating margins, as we have indicated, our operating margins on HBDC were in the mid-teens and certainly better than our cost of capital even with the new pricing. Remember that with the pricing, this is effectively a buy-down. But as the volumes go up, our costs go down anyway, so we would expect that cost to go down and continue to maintain operating margins in the mid-teens. So similar to what you saw previously. Where things get a bit problematic right now is just the revenue recognition issue that is being handled from an accounting process frankly with our auditors there, which instead of 100% tying that buy-down to your curve. So if you look at the slope of your curve where that slope would actually be more steep going down that, that curve is less steep. As a result, we are within a particular time point getting a negative hit to the margin, which Andy was talking about. But if you look at the time recognition over total time, we'll fully recover all of the economics. Now by the time we get by this period, and we're into as a result of all this, I think you're going to see substantially higher volumes. And to give you an idea about that, I mean I indicated in the South Africa they've already moved away from doing smears and they're going direct to the TRTB test. If you look at the WHO data when they did their own marketing analysis at the time they endorsed the test, the smear test volume of that is out there. It's about 20 million a year, of which South Africa alone was doing 4 million smear tests per year. So that gives you and as you start to go straight to our test versus smears, that's a pretty interesting volume analysis. And as you get to these volumes, our price -- our costs move down substantially, and that's the whole idea of the buy-down. The idea of the buy-down is to basically cover the Cepheid's costs until we get to these higher volumes, and as you get to those higher volumes, you're fully sustained, and you maintain your operating margins. So ultimately, it's a big win for the HBDC market. We're substantially impacting it, saving more lives sooner versus later with this thing. So right now, we're just in this period of: one, uncertainty of getting the buy-down worked out; two, then working through the handling of the management of how all this is recognized financially on a go-forward basis.


Your next question will come from line of Eric Criscuolo with Mizuho Securities.

Jacquie Ross

Keisha, it sounds like we don't have Eric. Can we go to the next caller, please?


Your next question comes from the line of Vamil Divan with Credit Suisse.

Vamil Divan - Crédit Suisse AG, Research Division

I guess most has been answered. I guess one thing I would just ask here, I get a lot of questions of the CT/NG in kind of the expectation not just in Europe but in the U.S. here and appreciate the insights you gave in Europe so far, but as you mentioned coming from AACC and meeting with your sales force, I know the test is not approved here yet. Can you give any of just general sense on the kind of expectations you mentioned that one possible in Texas, but -- and more broadly what sort of interest are you seeing from your customers to adopt it in their hospitals?

John L. Bishop

So certainty, we're seeing a very good level of interest. And we've indicated actually in prior calls that a number of our systems were purchased with, in fact, excess capacity, anticipating the clearance of the CT/NG. I've indicated on the call before previously where we had some Infinity customers, by way of example, who are really clear as soon as the tests is available they are very interested in adding the test. So what we're seeing right now is a very high level of enthusiasm from the customer base and certainly hearing from our sales team as I indicated that I was just there in meeting at AACC myself with the team that was there. All of that looks very, very positive. And so now it's a matter of just looking do you get the FDA clearance. So as we said, we got that in, in early June. Generally, we're looking at about 120-day period, but it's up to the FDA relative to handling their clearance. So we are expecting to get the product on the market in the U.S. before the end of the year, but the overall level of enthusiasm is very good.


Your final question will come from the line of David Ferreiro with Oppenheimer.

David Ferreiro - Oppenheimer & Co. Inc., Research Division

I had a question on Infinity-80, maybe you can comment on where the early interest is coming from. And then as a secondary to that, how and if does the system playing into your marketing plans for CT/NG in the U.S.

John L. Bishop

So good question. It plays into the plans very broadly. On the Infinity-80, we've seen very good response to that for a couple of reasons. One you get the higher volume throughput in the same footprint as the original 48. Two, as you look at plans from some of our competitors announced development of systems that would give a run rate of about 1,000 tests per 8-hour shift, we're already there. And in fact, it was interesting serendipitously one of our competitors said, well, we're going to develop a new system where we can consolidate menu, which is what we've been saying with Cepheid right along at a rate of 1,000 tests. And we're going to have another now that can do 300. Well, we only have Infinity-80, which is effectively already there. You're running at about 900 test throughput on a CT/NG per 8-hour shift. We just introduced the 48S, which is a smaller version of the Infinity-80 format, so it uses exactly the same components, but it's a couple of feet smaller with the footprint. That was very favorably received. The overall throughput there is in the area of 500 tests per 8-hour shift. So those are positioned very nicely. The timing is good for both of those because as you move with your CT/NG, of course, those are in some cases high-volume tests. So we've spoken about our go-to-market situation of being a low-hanging fruit of those labs that were not able to do molecular for many, many reasons, and they have now -- they've been sending it out, but now they can be able to bring it in-house on the GeneXpert System. Now someone asked me during the AACC, what do you really see is the addressable market for CT/NG for Cepheid. And I'll change and update you that. We see the entire market based upon the reaction we're seeing to the accuracy of our product, that specificity issues as I cited coming out of Europe with the product and the other advantages, coupled with Infinity systems and throughput we see the ability to address that full market there, as I said, ultimately we will.


That's all the time we have today for questions. I will now like to hand the conference back over to Ms. Jacquie Ross for any closing remarks.

Jacquie Ross

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.


Thank you for your participation in today's conference. This was the presentation. You may now disconnect your lines. Good day.

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