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Orasure Technologies, Inc. (OSUR)

Q1 2008 Earnings Call Transcript

May 6, 2008 5:00 pm ET

Executives

Judy Clarke – IR

Doug Michels – President and Chief Executive Officer

Ron Spair – COO and CFO

Analysts

Ed Shenkan – Needham & Co.

John Putnam – Dawson James

Jeff Frelick – Lazard Capital Markets

Dave Turkaly – Susquehanna Financial Group

Caroline Corner – Pacific Growth

Aaron Lindberg – William Smith & Co.

Operator

Good day everyone and welcome to the OraSure Technologies 2008 first quarter financial results conference call and simultaneous webcast. As a reminder, today's conference is being recorded. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. (Operator instructions)

For opening remarks and introductions, I'll now turn this call over to Judy Clarke at OraSure Technologies. Please go ahead.

Judy Clarke

Good afternoon everyone and thank you for joining us today. I'd like to begin by telling you that OraSure Technologies issued a press release at approximately 4:00 p.m. Eastern Time today regarding our 2008 first quarter financial results and certain other matters. The press release is available to you on our Web site at www.orasure.com or by calling 610-882-1820. If you go to our Web site, the press release can be accessed by opening the Investor Relations page and clicking on the link for News Releases. This call is also available real-time on our Web site and will be archived there for seven days. Alternatively, you can listen to an archive of this call until midnight May 13, 2008 by calling 800-642-1687 for domestic or 706-645-9291 for international. The access code is 43942293.

With us today are Doug Michels, President and Chief Executive Officer; and Ron Spair, Chief Operating Officer and Chief Financial Officer. Doug and Ron will begin with opening statements which will be followed with question and answer sessions.

Before I turn the call over to Doug, I must also remind you that this call may contain certain forward looking statements, including statements with respect to revenues, expenses, profitability, earnings per share and other financial performance, product development, performance, shipments and markets and regulatory filings and approvals. Actual results could be significantly different. Factors that could affect results are discussed more fully in the SEC filings of OraSure Technologies, including its annual report on Form 10-K for the year ended December 31, 2007, its quarterly reports on Form 10-Q and its other SEC filings.

Although forward looking statements help to provide complete information about future prospects, listeners should keep in mind that forward-looking statements may not be reliable. The company undertakes no obligation to update any forward-looking statements to reflect events or circumstances after this call.

With that, I'd like to turn the call over to Doug Michels.

Doug Michels

Thank you, Judy, and good afternoon everyone and welcome to our first quarter 2008 earnings conference call. Ron Spair will begin this afternoon's call with a review of our first quarter results followed by a discussion of our second quarter and full year 2008 financial guidance.

Earlier today, we issued a press release detailing our first quarter results. As you can see from this release, our first quarter results financial performance was in line with guidance. However, since our last call, there have been a number of unexpected developments in our business and the markets that we serve which necessitate an adjustment in our guidance for the rest of the year. Following Ron's remarks, we will open the floor for your questions on these developments. After that, I will provide an update on several aspects of our business, including our principal strategic initiatives and our efforts to grow the business. We'll conclude by again opening the floor for your questions. So, now let's go to Ron's financial overview.

Ron Spair

Thanks, Doug, and good afternoon everyone. First, I'll start with a brief review of the first quarter results. Total revenues for Q1 were in line with guidance at $18.1 million. Increased sales of OraQuick ADVANCE, our insurance risk assessment products and professional cryo products were offset by expected decreases in revenue from our OTC cryosurgical wart removal products and substance abuse testing products.

A 6% growth in our infectious disease revenues was the result of continued strong sales of our OraQuick ADVANCE rapid HIV test. Sales to public health during the quarter increased 45% over 2007 as a result of continued growth in our base business and increased sales related to the Centers for Disease Control and Prevention's efforts to increase HIV testing among populations disproportionately affected by HIV. These increases were partially offset by the absence of bulk purchases by the CDC and the Substance Abuse and Mental Health Services Administration, SAMHSA, that were recorded in the year ago period.

Our sales to Abbott decreased 11% as a result of their ordering patterns for the U.S. hospital market. International sales of OraQuick decreased 14% compared to the same period in 2007 largely as a result of a 25% decrease in revenues from Africa. Our cryo revenues during Q1 experienced an overall decrease of 41% compared to 2007. This was expected and forecasted as this decrease was primarily due to the absence of U.S. OTC sales resulting from the termination of our distribution relationship with Prestige Brands at the end of 2007. First quarter 2007 sales to Prestige were $2.1 million.

Our international OTC sales for the first quarter of 2008 were $1.6 million, a 22% decrease from 2007 that largely resulted from reduced sales in Europe due to the variability of distributor purchasing patterns. First quarter cryosurgical sales to the professional markets increased 17% to $1.8 million compared to $1.5 million in the same period of '07.

In the substance abuse testing area, sales were $3.3 million for the first quarter, a 17% decrease compared to 2007. Sales of our Intercept drug testing system totaled $2.4 million, a 19% decrease from 2007. Total workplace testing business was down 34%, our international sales were down 13% and our criminal justice sales decreased 4% compared to 2007. Our direct sales grew 34% for the quarter.

The company's workplace testing business continues to be directly impacted by the decline in employment rates in some of the market segments which buy our Intercept product. The international market has also experienced a decrease in public sector funding which has slowed the implementation of drug testing by criminal justice customers.

Finally, insurance risk assessment sales in the first quarter were $1.5 million, up 73% compared to $900,000 in the comparable period of 2007. While we are adding new accounts for this product line, the increase was largely caused by lower sales during the first quarter of 2007 due to the timing of our lab partners' purchases of devices and reagents in the latter part of 2006 and early 2007.

First quarter 2008 licensing and product development revenue included royalties of $458,000 from Schering-Plough pursuant to our settlement arrangement. First quarter 2007 revenues included $625,000 of funded R&D under our 2006 HCV collaboration agreement with Schering-Plough.

Turning to gross margin, our margin for Q1 of 2008 was 59%, a decrease from 62% for Q1 of '07, but up sequentially from 58% in the fourth quarter of 2007. This decline compared to Q1 of '07 was due to several factors, including an unfavorable product mix versus the year ago period, increased scrap and spoilage expense and higher unabsorbed overhead.

Turning to operating expenses, research and development expenses for Q1 were up 58% or approximately $1.7 million over 2007, largely as a result of costs associated with our ongoing OraQuick HIV OTC and HCV clinical development programs. Sales and marketing expenses increased 9% or approximately $445,000, mostly due to increased staffing and related charges and general marketing expenses, partially offset by a decrease in advertising reimbursement costs related to our international OTC cryosurgical product.

G&A expenses decreased approximately $397,000 largely as a result of a decrease in legal costs, outside consulting, and corporate taxes, partially offset by increased staffing related expenses. So, from a bottom line perspective, we reported net income of $2 million or $0.04 per share, which is in line with our guidance. This compares to $1.5 million or $0.03 per share for the same period of '07. Included in first quarter '08 other income is a payment of $4.9 million received from Schering-Plough under the terms of our settlement agreement executed earlier this year. First quarter '07 other income included a $1.4 million gain on the sale of our investment in a privately held non-affiliated company.

Turning briefly to our balance sheet and cash flow, our cash balance remained strong, with cash and short term investments of $90.4 million and working capital of $106 million at March 31, 2008. During the first quarter of '08, we used $3.7 million in cash flow from ops compared to $1 million used in the first quarter of '07. The increase in the use of cash was largely due to payments of royalty obligations and legal expenses that were accrued at the end of '07, as well as an increase in accounts receivable balances. Days sales outstanding was at 69 days compared to 66 a year ago.

Now, turning to our financial guidance update, as you know, a patent infringement lawsuit was recently filed by Inverness Medical and Church & Dwight, and this will result in an increase in our legal costs for 2008. In addition, there was an unexpected inventory buildup at our OTC cryo distributor in Mexico and a recent change in funding sources for the purchase of OraQuick HIV in Africa. Both events have affected our business. In the U.S., there has been lower than expected growth in sales of OraQuick ADVANCE to the hospital market and the continued economic slowdown has impacted hiring and workplace drug testing. As a result of these developments, we have decided to lower our previously released guidance for both revenues and EPS for 2008.

First, the revenue guidance. In the Mexican OTC cryo market, our distributor recently informed us of their reduced need for our product resulting from an unexpected return of products to them by a number of retail outlets in the latter part of the first quarter of 2008. As we have discussed previously, the treatment of common and plantar warts is a seasonal business and a number of retailers had accumulated an inventory level based on in-season demand that was not required over the winter months. Rather then retain this stock at the retail level, these retailers exercised their right to return product to our distributor, Genomma, who subsequently reduced their forecast for new purchases once the extent of the returns were known and revised supply requirements were recalculated.

The product return by the retailers will be retained for future sale by Genomma and we are working closely with Genomma to drive greater uptake of our product in the retail channel in Mexico and are exploring ways to draw down this inventory and generate new orders through sales in other Latin and South American countries upon successful registration of our products. We continue to believe that these markets have great potential, but the full realization will be somewhat delayed.

When we announced our full year 2007 results back in February, we highlighted a significant increase in our international revenues from OraQuick that occurred in Africa and Asia. We have been working on both existing and developing collaborations for many years in these regions and believe several of these business prospects to be reasonably assured for 2008. As we move through the first quarter of '08 and beyond, however, significant developments occurred with our African business.

In the case of one significant existing governmental customer in Africa, the primary funding source changed and with it the willingness to spend more on a per test basis for an oral fluid test versus a less costly blood based alternative. With respect to new business, we had great expectations for significant initiatives that we were pursuing in East Africa, a region experiencing political unrest and ethnic conflict emanating from Kenya. Although we continue to remain optimistic regarding the ultimate testing volumes that will accrue under new initiatives in this region, the timing of initiation is now less certain and consequently we are moving these potential revenues to upside.

Domestically, our OraQuick revenues continue to grow, particularly in the public health market. In the U.S. hospital market, Abbott's out-sales have not grown as expected. As you may recall from our February call, sales to Abbott and their out-sales for '07 increased nicely compared to '06. We expected this trend to continue in '08 largely as a result of the CDC's recent funding initiatives and revised testing guidelines. However, this did not occur in Q1.

In the U.S. substance abuse testing market, the economy and resulting slowdown in hiring continue to adversely affect pre-employment drug testing. This is evidenced by the fact that eight of our top ten clients experienced a 19% decrease in specimen testing volumes during the first quarter of '08 compared to Q1 of '07. Although we are projecting second quarter substance abuse testing revenues to increase from the levels attained in the first quarter of '08, we are not as optimistic about the prospects for an upturn during the balance of the year, absent a significant turnaround in the economy and hiring trends.

After reflecting on the impact these developments will have on our business in '08, we're now projecting revenues to approximate $83 million for the year and from $18.5 million to $19 million for the second quarter. The inter-year distribution of revenues also continues to be skewed toward the back end of the year as a result of the slower than expected ramp up of the CDC's incremental testing initiative and forecasted purchasing patterns of our international OTC cryo distributors. As Doug will highlight, we are active with many of the jurisdictions funded by the CDC to conduct incremental testing and we expect a number of new testing programs to come on line in the second and third quarters contributing to revenue growth.

The reduction in projected full year revenues will have a significant impact on our 2008 EPS. Additionally, legal expenses for the Inverness and Church & Dwight patent infringement lawsuit could have a significant impact on both quarterly and full year earnings per share. Given the uncertainties surrounding the magnitude and timing of such spending and some of our revenue projections, we have decided to take a prudent approach and project a loss per share of between $0.06 and $0.07 for the second quarter and a loss per share of between $0.10 and $0.11 for the full year. As the year progresses, we expect to reassess our revenue forecast and the amount and timing for litigation spend and will be updating our expectations accordingly.

And with that, I'd like to open the floor for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Ed Shenkan.

Ed Shenkan – Needham & Co.

Hey, Ron.

Ron Spair

Hey, Ed.

Ed Shenkan – Needham & Co.

On Genomma, for the second quarter and for 2008, what kind of revenues do you expect?

Ron Spair

We are actually not expecting any revenues in the second quarter from Genomma and would expect those revenues to be present but skewed more towards the end of the year when they would restart.

Ed Shenkan – Needham & Co.

Okay. And on the international side, you mentioned in Africa that there was some changes that took place, I think you said for funding. Could you just explain kind of what's going on and then what expectations are going forward in Africa?

Ron Spair

Sure. We remain convinced that Africa is a very attractive market in which to participate. However, there was an unexpected change with a funding source dedicated to Madagascar, one of our largest clients there. And as the tail end of the quarter approached, they informed us of a change from one funding source to another. This funding source was not prepared to fund OraQuick purchases. And as we moved out into April and had further discussions with them, we believe at this point – moment in time that there will be no further purchases until we are able to secure dialog with this funding source and look at and hopefully work with them to advance the OraQuick test as part of their funded testing program.

Ed Shenkan – Needham & Co.

So, your comments are specific to Madagascar, not to the rest of the African continent, is that right?

Ron Spair

That's correct. That's right on the funding. That's correct.

Ed Shenkan – Needham & Co.

Tell us about the rest of the continent. How is it looking forward for Africa?

Doug Michels

I think Ed, this is Doug, so our private sector business continues to grow and we continue to add new accounts there, which we are very pleased with. We're working on some major new initiatives with particularly East African countries that are very well funded and this refers back to the comment Ron made, unfortunately, given the civil unrest that's occurred over the last couple of months it's made even travel to those countries difficult. Although in our discussions with government leaders and program leaders, they're still very committed to expanding their testing programs and to using OraQuick. So for us, this is a setback, obviously. Difficult to forecast some of these political issues, but we continue to be very bullish on the opportunity.

Ed Shenkan – Needham & Co.

On the city and state orders in the U.S., with the increased CDC funding this year, are you finding that funding is cannibalizing what the cities and states would have ordered otherwise or how are things playing out?

Doug Michels

I'm going to address that a little bit in the back half of the call, but we continue to do very well on our direct sales to public health as Ron mentioned. I'll mention later our views on the CDC deployment, which is a bit delayed although the CDC has indicated that they're going to refund the program for the fiscal year 2009 and our position with the jurisdictions continues to be very strong. So again, this is somewhat of a timing related issue, but very strong position both there as with the city jurisdictions as well.

Ed Shenkan – Needham & Co.

I'll leave time for other questions. Thanks.

Doug Michels

You bet.

Operator

Your next question comes from a line of John Putnam with Dawson James.

John Putnam – Dawson James

Thanks. I guess I was trying to understand what's going on with the CDC a little bit better and I didn't realize you'd be speaking about that later, Doug. But I guess I'm just wondering why things are slower given the enthusiasm that seemed to be in order a couple of back around the turn of the year.

Doug Michels

Yes, the enthusiasm hasn't diminished. We are six months into the CDC program. The sites got their funding at the end of September. And as we mentioned, the jurisdictions – the monies were earmarked both for infrastructure and capacity building as well as for testing. We indicated numerous times in previous calls that we didn't expect to see a substantial ramp until the second or third quarter of this year just because the sites had to build that infrastructure. It has gone slower than we expected. I think the fact that the CDC announced that the program is going to be re-upped for 2009 and also indicated to the jurisdictions that some of this money could be carried over into the next fiscal year has been – hasn't exactly encouraged rapid implementation by the jurisdictions. But we still think we're in very good position to capture the largest majority of this new funding.

John Putnam – Dawson James

Thanks.

Operator

Your next question comes from a line of Jeff Frelick with Lazard Capital.

Jeff Frelick – Lazard Capital Markets

Good evening. So, if I am understanding this correctly, maybe Ron, you are taking down the guidance by about $8 million from the, let's say, the midpoint of call it $91 million to $83 million. We kind of knew about the workplace testing slowdown and I guess the Africa purchases primarily in Madagascar. So, am I safe to assume that the bulk of the reduction is on the OTC cryosurgical business and the U.S. hospital sales?

Ron Spair

I'd say that is correct. I'd say the cryo OTC probably accounts for about $3.5 million of the reduction and the domestic infectious disease about $2.5 million, Africa $1 million and SAT $1 million.

Jeff Frelick – Lazard Capital Markets

Okay. And then, I guess we kind of thought we'd probably see the CDC funding probably show up in the ER more so even than on the public health setting given that dollars have been, I guess, kind of awarded to the jurisdictions. What's the delay? Is it just follow-up on the CDC's part to make sure that people were kind of doing what they kind of submitted in the proposal to do? And I guess if we're expecting it to kind of play out in the second, third quarters still, should that still kind of give us a little bit more confidence in the guidance, maybe not to cut it so much?

Doug Michels

I think that you've hit the nail on the head. The CDC has not followed up on these grants and the implementation we believe as aggressively, obviously, as we would like. There's an accountability issue. The sites do have to report back to the CDC by the end of May on their program progress, how many individuals they've tested, what positivity rate they've seen, et cetera. But this is, what, eight months after the money was disbursed. And later in the call, I'll give you an update by jurisdiction as to how many sites have initiated and what we've seen so far. So, we've got a strong handle on this. The difficulty is being able to forecast what these jurisdictions are going to deliver based on the plans that clearly articulated what they said they were supposed to do.

Jeff Frelick – Lazard Capital Markets

What's changing, Doug, on the Abbott's out-sales, anything changing there?

Doug Michels

We saw significant increases in '07 versus '06 and we expected the same or similar kind of growth into 2008. That's slowed a bit right now. We're seeing a bit more competition in the hospital sector and we haven't seen quite as rapid uptake in the emergency department testing programs as we had anticipated, although we are seeing continued growth there. The CDC has doubled their efforts in terms of regional workshops, which we support and we've got a strong follow up program on that, but obviously we'd like to see more emphasis on this from Abbott.

Jeff Frelick – Lazard Capital Markets

So, in the Europe, is volume slowing or is testing occurring by alternate methods?

Doug Michels

I don't think that we are seeing the volume increase that we expected. There's some competition, but I don't think that's the major driver to the slowdown. I think we'd like to see greater adoption in the emergency department.

Jeff Frelick – Lazard Capital Markets

Okay. I'll jump back in queue.

Operator

Your next question comes from the line of Dave Turkaly with SFG.

Dave Turkaly – Susquehanna Financial Group

Just to push you a little, Ron, on the guidance, we are looking at $83 million for the year and we got $18 million and $18.6 million let's call it in so far. Then we're looking at an average of $23 million and change in the third and fourth. Do you expect it to sequentially pick up over third and fourth and help me get from $18.6 million broad strokes to something in the low $22 millions or wherever you think the third might be, that $3 million to $4 million sequential increase we need to hit. Where is that going to come from? Is that CDC or which part of your business?

Ron Spair

I think it's across the number of businesses. We see the infectious disease business growing in both the third and the fourth quarter with a larger spike in the fourth quarter, which has been our pattern over the last several years. Then we also see the substance abuse business picking up a bit in Q3 to a level that we believe is a little bit more sustainable over Q2 and then in the cryo business, Dave, that's where we see a recovery from a level of about $3 million in the second quarter or slightly there, then maybe a little bit more, and then to $4 million and $5 million. So, as the cryo patterns indicate from our distribution partners, it should grow up a little over the course of the year.

Dave Turkaly – Susquehanna Financial Group

Okay. Just to be clear, the infectious disease, I mean obviously the direct to U.S. health at 44 is a nice number in growth for the first quarter. Last year, you grew 30%. I'm looking at my model. I have 33% this year. I mean, if some of the spending comes on, I mean, I guess considering that's one of your bigger line items, could that be significantly stronger even than what you just reported at 45% in the first quarter, or is that sort of a high watermark and it's going to come more from cryo going forward?

Ron Spair

We continue to believe that we will see growth in the direct to public health business largely impacted by the success of the jurisdiction in implementing the CDC initiative and how concentrated that will be in any one quarter will drive the comps. It's difficult to predict that as we have spoken about previously here, but there are good initiatives in play and we also, as Doug mentioned, have indications that the funding will be reviewed or renewed for 2009, so we continue to believe that we'll make progress in that market. We will also see, as we move out here, more of a recovery in some of the international business.

Dave Turkaly – Susquehanna Financial Group

I'm not trying to – my whole thought process is you guys have a big clinical story, we'll talk about that next, and you've got the cash, so obviously there's been some challenges on the revenue side, but it's still a pretty steep increase to the back half. I just want to make sure you guys feel really comfortable with that being a kind of flattish year-over-year number. Given those challenges, it sounds like you feel pretty comfortable that some of these things will turn significantly in the third and fourth quarter.

Ron Spair

Yes, despite the revenue guidance being $83 million and our top line last year was $83 million, don't forget we add approximately $6 million in revenues through Prestige last year as well as the $2 million in funded R&D from Schering-Plough and you back those out, still showing year on year growth with that kind of pro forma comparison. I'm not saying we are pleased to be taking our revenue number down, don't get me wrong, but we are still very bullish on the growth in our infectious disease business. It's growing nicely and we expect it will continue through the remainder of the year and in future years.

Dave Turkaly – Susquehanna Financial Group

I got you. I guess onto maybe quickly to the cryo stuff, any update on the domestic side? Any color you can give us there? Are you still talking to people in terms of possibly getting a new distributor?

Ron Spair

We have made a decision on that, Dave, and we are marching down a path. But, for competitive reasons, we're not going to disclose that path that we are on, but we fully intend to participate in this market and continue to believe it's very attractive and there's a possibility that later in the year, we'll be out. We certainly expect to be in the market for 2009.

Dave Turkaly – Susquehanna Financial Group

Okay, thanks.

Ron Spair

You're welcome.

Operator

At this time, I'd like to turn the call over to Michael Douglas. Participants please stay in queue and your questions will be answered at a later time.

Presentation

Doug Michels

Okay. Everybody knows I'm not Michael Douglas, but I want to thank you for your questions and we'll now discuss the various strategic and other business updates for this afternoon's call. Starting with our clinical development of the OraQuick HCV test, our clinical trials to support both our PMA submission to the FDA and our request for CE Mark approval in Europe are progressing very well. Both patient enrollment and testing at the several clinical sites that we've initiated are progressing and proceeding on schedule. As previously discussed, we expect these trials to continue through the second quarter of this year. Once completed, we will analyze the results and prepare our submissions.

We still expect to file a PMA application with the FDA this summer and intend to submit for European approval shortly thereafter. In addition to the clinical trials, field development studies are being planned and will be executed both domestically and outside the United States in various settings where we expect significant levels of utilization. We continue to work closely with Schering-Plough in our pre-market development efforts and in building our marketing launch plans.

On the OraQuick stability shelf life front, we also continue to make good progress on extending the shelf life of our OraQuick HIV test. Our real-time stability studies continue to progress and support an extension beyond six months. Product lots manufactured with certain process improvements have now completed testing after 12 months of storage and have met the performance criteria established at the start of this program. We've submitted documents to the FDA for approval of these process changes along with our stability protocol and acceptance criteria. These documents are currently under review by the FDA and we are in discussions with the agency. We'll continue with real-time stability testing over the next few months before formally submitting to the FDA for an extension of product shelf life this summer.

For markets outside the United States and Europe, we have already begun the process to increase the shelf life and product dating of OraQuick. In the next month or so, we will begin to manufacture product with extended dating at our Thailand supplier and we expect to begin supplying that product later this quarter to Africa and other countries that already receive product made in Thailand. Successfully extending the shelf life of our OraQuick HIV test continues to be an important priority for our infectious disease business, and of course, for our customers.

Another major initiative is the ongoing clinical work to obtain FDA approval to sell our OraQuick rapid HIV test over the counter. As discussed during our last call, in January, we submitted a revised IDE amendment to the FDA for the observed user clinical study. This is a study where we assess an individual's ability to interact with our packaging and comprehend the instructions for use, take the test and interpret their results while a trained professional observes these activities. The FDA provided a few additional comments and a further revised IDE amendment was submitted on which we received IDE approval, and we initiated the observed user clinical trial in April. Subject enrollment has gone well and we continue to initiate new sites in the study each week.

We are pleased to be fully engaged in consumer self testing with our OraQuick HIV test. As part of the study, we have also brought our medical resource and referral system for consumers online. This call center is available for all clinical study participants to access by telephone during the trial. The center is fully functional, manned with trained and certified call agents who are able not only to respond to questions about the use and performance of OraQuick, but also can provide information about HIV/AIDS and refer consumers to medical care within their geographic locations.

Finally, we are continuing to move forward with preliminary plans for the final unobserved user clinical study while the observed user study is underway. Our schedule has not changed since our last earnings call. We intend to submit a draft IDE amendment for the unobserved user study concurrent with our submission to the FDA of data from the observed user study once it is completed. We're still targeting the back half of 2008 for commencement of the unobserved study.

The final development program I want to discuss is our work with Roche to develop fully automated homogeneous drugs of abuse assays for use with our Intercept oral fluid collection device. The development of these oral fluid assays also continues to go extremely well. Prototype assays for all of the initial launch menu, which is a NIDA 5 test panel are now operational on automated instrumentation. As you may know, NIDA 5 includes test for amphetamines, methamphetamines, cocaine, opiates, cannabinoids or THC, and phencyclidine or PCP. We expect to begin customer evaluations of these automated assays in the next month or so and expand the evaluations to multiple sites throughout the year. When the tests have been fully developed, optimized and transferred to manufacturing, Roche will initiate the clinical studies with our assistance and the data generated will be used as the basis for 510(k) submission to the FDA.

Now, I would like to provide some additional details regarding the strategy for growing each of our businesses. As we mentioned earlier, the growth in our infectious disease testing business for the first quarter was primarily attributable to a 45% increase in direct sales of our OraQuick HIV test primarily to public health. We will continue our efforts to expand in the public health market and have put in place strategies to improve our results in the U.S. hospital and international markets.

In public health, sales have increased and should continue to increase as the result of the CDC's revised recommendations for routine HIV testing in healthcare settings and $35 million in additional funding dispersed by the CDC last fall to increase testing opportunities among populations disproportionately affected by HIV.

Of the 23 jurisdictions receiving grants under this program, to date we have shipped product to 14 and we expect another four jurisdictions to purchase product during the second quarter and we expect another two to purchase products shortly thereafter. Thus, 20 of the 23 grantees are expected to purchase OraQuick for a majority of their incremental HIV testing funded by the CDC. While jurisdiction implementation of increased testing has been slower than expected for this program, we have been working closely with each of the jurisdictions to ensure increased utilization as the year progresses.

In addition to this specific CDC grant program, there are other government funded initiatives, both federal and local, that are in place or expected to be announced in support of increased HIV testing. For example, at the end of last year, the Substance Abuse and Mental Health Services Administration, or SAMHSA, awarded 67 grantees funding for year one of a five year program to offer among other services rapid testing onsite or through referral to their clients. Of these 67 sites, 29 are currently OraQuick customers and we've made shipments to 21 of them under this program. We'll continue to work with these grantees as well to further expand this funded testing program.

Several other federally funded grants are expected to be issued in support of HIV testing, and while there may be limits on the availability of this funding and there are no guarantees with programs of this type, we expect our public health sales to benefit from these initiatives.

Our support of city-wide HIV testing initiatives also continues to be a priority for the OraQuick business. During the first quarter, there was significant activity in both Philadelphia and Washington, D.C. For example, testing in Philadelphia increased by about 33% over the first quarter of 2007 and the District of Columbia also purchased substantial additional tests during the quarter. The economy has impacted the budgets of several cities that we have been talking to and may impact the timing and amount of either new or existing initiatives. Nevertheless, we expect testing to continue to grow throughout 2008 primarily through expansion in various healthcare settings and we continue to provide support to and work closely with major cities such as New York, Los Angeles and Baltimore in their stated efforts to expand HIV screening.

Turning to the U.S. hospital market, while sales were somewhat lower during the first quarter compared to 2007, due to Abbott's ordering patterns, Abbott's out-sales were relatively flat. The hospital market is very important and we continue to add new hospitals and emergency departments to our list of OraQuick customers. We believe the lower growth rate of Abbott's out-sales is primarily the result of increased competition in this market.

In addition to focusing on signing new larger hospital systems, we are working closely with our existing customer base to expand OraQuick usage within emergency departments. As part of this initiative, as I mentioned earlier, we're supporting several regional CDC urgent care workshops targeting hospital administrators who are focused on establishing routine HIV screening in their emergency departments.

Turning to the international front, in Africa, despite the challenges we're facing, we're continuing to promote the advantages of OraQuick's oral fluid capabilities and to work within the changing funding and political landscape to ensure that our product plays an important role in testing initiatives launched in this part of the world. We're also working to build the foundation for sales in Ghana and South Africa and we are attempting to recover momentum in Madagascar as well as with new and promising initiatives in Kenya and Rwanda. We think that large testing volumes in these markets are achievable and we're pursuing these aggressively.

In Europe, sales forces for our distributors in Spain and the UK have been trained and we are encouraged by the customer interest and evaluations that have taken place. We're close to completing an agreement in France where there is recent high interest in rapid testing by the government. The registration process in Russia continues to move forward. In Brazil, our product is approved and launch plans are well underway and there's a high level of interest in the government for broader screening initiatives, as is the case in Mexico and Peru.

Turning now to substance abuse, our revenues for the first quarter of '08 were down compared to 2007 primarily as a result of the impact of economic conditions on the workplace hiring practices. Despite this decline, the oral fluid drug testing value proposition continues to be strong with our customer base and we've refined our sales and marketing strategy to address these conditions and position our substance abuse business for future growth.

Examples include focusing on markets that experience employment growth or that are unlikely to be impacted by a decline in the employment rate; implementing new or expanded marketing initiatives with third party administrators; securing new labs to adopt oral fluid testing in both the criminal justice and workplace testing markets; and increased direct marketing. We believe these additional strategies and approaches combined with new sales leadership for our substance abuse team will yield improved results.

In our cryosurgical systems business, a 17% increase in our international and domestic professional sales during the first quarter was offset by the expected absence of domestic sales of our OTC product here in the United States and lower international OTC sales. Each of the businesses have unique drivers and strategies are in place to foster future growth.

On the professional side of the business, in the U.S. we are continuing to strengthen our distribution network and we have successfully won business from our primary competitor in this market and increased our market share. New sales leadership at OraSure together with a fully staffed sales force should drive results in Q2 and for the remainder of the year.

In Europe, we have being experiencing slower than expected ramp up of new distributors and there's been some pricing pressure from competing products on the market. We're working closely with our partners and are providing distributors appropriate incentives to gain better focus and traction against this competition.

On the OTC side of the business, in Europe with SSL, our market share position in the UK consumer market is very strong. Channel expansion has gone slower than expected because of aggressive pricing and promotion by Wartner, which sells a competing OTC product in France, Germany and Italy. We are working right now on strategies to meet this competition and new launches are currently planned for Belgium, Spain and parts of Eastern Europe.

With Genomma, as Ron indicated, we're now working through an inventory buildup based on lower than expected out-sales during the wart offseason and our partner continues to aggressively promote POINTTS and we expect this inventory will move through the retail channels as the wart season progresses. We also continue to work through the registration process for Latin American expansion and we are targeting registration and launch in 12 additional Latin and South American countries by year end, and we will work to accelerate these opportunities.

On the litigation front, as you know, we were recently named in a lawsuit by Inverness and Church & Dwight for patent infringement under one of their U.S. patents. We believe our OraQuick ADVANCE HIV test does not infringe the patent asserted in this lawsuit or any other patents and we also believe that the Inverness and Church & Dwight patent is invalid and unenforceable. We've selected an outside IP litigation firm to represent us and we intend and will defend this matter vigorously. Although I am limited in what I can say on this pending litigation, we will certainly provide you with updates on material developments as they occur.

So, with that, why don't again open the floor to questions regarding our business update and any aspect of what we've shared with you so far this afternoon.

Question-and-Answer Session

Operator

(Operator instructions) Your next question comes from the line of Caroline Corner with Pacific Growth.

Caroline Corner – Pacific Growth

Thanks for taking my call. A couple of questions, the hepatitis C progress, good to see that's on track. When you file this summer for the PMA, should we expect to see some data released around there so we can see the data that you're actually filing or is that going to be more of a case where you give it to the FDA and then we'll find out about approval?

Doug Michels

No, I don't expect that you'll be seeing data at that time. A little bit more color on the Hep C effort. Enrollment, as I mentioned, has gone very well. All sites have been initiated and we're on schedule. Dr. Lee is planning to provide a presentation at the ASM meeting in June, I believe, and we've also been engaged in some independent studies which are very encouraging. We've had ongoing dialog with the CDC, with SAMHSA and with HHS about funding and surveillance once this product is ultimately launched, and obviously we're actively engaged with Schering. So, things are progressing on all fronts on the HCV development program and we're pretty encouraged, very excited about this.

Caroline Corner – Pacific Growth

Very good. The detail you gave on the infectious disease as it pertains to the rollout within the 23 clinics that are part of the funding; you said 20 of those you are expecting to use OraQuick. It looks like they'll be putting in orders by early third quarter. Are they only using OraQuick or are they going to be using a mix? And then, what about the other three channels?

Doug Michels

Right. Okay, so one of our challenges and this is always trying to get a handle on the incremental, right, because as I mentioned in previous calls and I think you well know, virtually every one of these jurisdictions uses OraQuick in one way, shape or form. The 14 that have ordered incremental product under this new grant, those are all using OraQuick as their primary screening tests. The four additional that I mentioned should order in Q2. They again are all using OraQuick as their primary frontline screening test and the two that will come on shortly thereafter the same thing. So, 20 of the 23 that should be up and running at least by the end of the second quarter, real early into the third, will all be using OraQuick as their primary test. The three that we are still working to secure, by the way, but they haven't committed, two of them are two of the smaller jurisdictions. One of them is one of the mid sized jurisdictions based on the grants that were offered. So, we think we're in great shape with regard to this based on our original expectations. I wish the CDC was a little bit more aggressive in demanding that these sites deliver on their grant commitments. Hopefully, with our encouragement and support, we can help them achieve those testing goals.

Caroline Corner – Pacific Growth

Hopefully they will. My other question is about the litigation firm that you've selected for the Inverness lawsuit. Is this the same litigation firm that you've use previously? Then your in-house legal team at OraSure, is that still relatively intact, any new hires there, and how do you feel overall in general on the legal front?

Doug Michels

Our in house legal team is comprised of our General Counsel and his assistant who do a great job, but for occasions like this, we seek outside counsel and support. We interviewed several IP litigation firms. We selected from the top ten in the country and they came from geographically dispersed parts of the country and we have selected one of those firms. We intend to defend this, as I mentioned, very vigorously. We believe our non-infringement and our invalidity positions are extremely strong. This is a different firm than we have ever used in the past, one that has experience in the lateral flow space and obviously has broad and deep resources in the IP litigation arena.

Caroline Corner – Pacific Growth

Okay. Then a quick question, probably would have been better if I'd ask this in the first half, but with the gross margin, the increased scrap and spoilage expense, I'm assuming that's separate from the Genomma overhead issue. What is the scrap and spoilage that's affecting gross margin and is that going to be in place also going forward?

Ron Spair

We discussed this a little bit before, Caroline that some of the issues that we were contending with in 2007, we are going to carry on into the first half of 2008 here. But what we had in the first quarter was increased spoilage related to product that we had manufactured for shipment to the international marketplace, which did not take place specifically for Madagascar and consequently we took a reserve against that product because of the change that took place so late in the quarter related to our ability to ship that product.

Caroline Corner – Pacific Growth

Very good. Last question, sorry. With regard to automation of your production line, any progress there or any updates?

Doug Michels

We intend to progress the validation of the automation system shortly.

Caroline Corner – Pacific Growth

Okay. Thank you.

Operator

Your next question comes from the line of Aaron Lindberg with William Smith and Company.

Aaron Lindberg – William Smith & Co.

Thank you. What is your anticipation for costs associated with the litigation with Inverness and Church & Dwight in 2008?

Ron Spair

We have built into this a $4 million to $5 million number, Aaron.

Aaron Lindberg – William Smith & Co.

Okay. And then I know that you said that you're not going to go into a ton of detail on this, but can you give us some idea as to some of the efforts that have been taken thus far to resolve this patent infringement litigation and specifically leveraging your relationship with Abbott?

Doug Michels

It'd be inappropriate to talk about that, Aaron, but I'll say just general comments. Our position is always to see if we can arrive at a business solution to these legal disputes that work for both parties, and we're open to that. At the same time, we're going to defend our non-infringement position and enforceability of these patents aggressively. So, we'll kind of leave it at that and if we have anything material to report on developments in that regard, we'll communicate it.

Aaron Lindberg – William Smith & Co.

Okay. Can you help us understand your strategy for co-marketing the HCV test with Schering-Plough both in the U.S. and outside?

Doug Michels

We've disclosed that in previous announcements that Schering is going to detail the product to the physician office market segments worldwide. We will sell the product into those markets and we will capture 100% of revenues from those sales. Schering has agreed to a minimum number of physician detail equivalents by region and will also be obviously promoting the product and technology with the opinion leaders of, which obviously they've got a great position on a worldwide basis.

Aaron Lindberg – William Smith & Co.

Can you help us understand the strategy that you guys are developing, whether you view that as developing it on your own or developing it with Schering-Plough for penetrating that market? Maybe related to that, who else are you interested in working with in regards to disturbing the rapid HCV test?

Doug Michels

It would be inappropriate to comment on who the other potential partners are that we may or may not use in the professional channels. As we have more information to share about our marketing strategy with Schering, as we get a little bit closer to launch, we'll share that.

Aaron Lindberg – William Smith & Co.

Maybe a little bit different tack on that. What progress are you making related to government funding for rapid HCV testing? That's something you've mentioned a couple times that's going to be important to that market segment.

Doug Michels

Absolutely. We have being engaged with the CDC as well as SAMHSA and we have also been engaged with stakeholders, whether it's the National Association of State and Territorial AIDS Directors or other advocacy groups that have a high level of interest in seeing expanded HCV testing. This is another area where certainly sharing the advocacy can have a big impact. We mentioned previously that there's about five times as much HCV out there as there is HIV. It's a growing problem, not only here but throughout the world and the cost of undiagnosed and untreated HCV is extraordinary and it's only going to get worse unless we get these people diagnosed and into care.

Aaron Lindberg – William Smith & Co.

Okay. A little bit different area, can you again – just on the strategy level of things, can you help us understand your progress and strategy related to expanding advanced sales internationally kind of outside of Africa and developed markets? You gave us some headlines around Europe, but what does that look like in terms of additional regulatory pathways for some of these other countries? When do we start to see some of that stuff come on line?

Ron Spair

We did hit a bit of a bump in the road in Europe this quarter where our UK distributor actually was acquired by Inverness. So, during the course of Q1, we went out, re-canvassed the market, identified an alternative distributor who's an excellent pick and entered into discussions with them, ultimately leading to an agreement and the beginning of training that's been done, purchases have started. So, we are active in that market. As Doug has indicated, we are also about to sign a contract for a distributor in France. However, the process to ultimately generate revenues in France is one that probably will take another year or so before that really takes place. We are working and looking at distributors in Italy as well as in Germany, Aaron.

Aaron Lindberg – William Smith & Co.

Okay. Is Inverness going to be selling another cryo product, a competing product in the UK, do you know?

Doug Michels

Cryo or HCV?

Aaron Lindberg – William Smith & Co.

Sorry, rapid HIV.

Doug Michels

Yes, they have the Determine product that they acquired from Abbott a few years back, you may recall.

Aaron Lindberg – William Smith & Co.

Yes. Interesting. Okay. Thank you.

Doug Michels

You're welcome.

Operator

Your next question comes from the line of John Putnam with Dawson James.

Doug Michels

Hey, John.

John Putnam – Dawson James

-- or Doug, you never really quantified how much in terms of dollars that is – can you help us out there?

Doug Michels

John, I missed the first part of your question, sorry.

John Putnam – Dawson James

On the SAMHSA discussion, you talked about the number of jurisdictions, but you never really quantified the amount of dollars involved in this effort, can you help us out with that?

Ron Spair

The total funding was approximately to $400,000 to $500,000 per grantee. The total funding is $31 million per year over five years. So the total funding, I believe, was in the $160 million range per year over five years.

John Putnam – Dawson James

So, that's really almost as much as the CDC's one year commitment, wasn't it, which is, what, $35 million?

Doug Michels

Annually, the SAMHSA number is just under the CDC number, but unlike the CDC initiative, these monies can be used for multiple other activities and it doesn't have the high level of focus on testing as the CDC initiative has, John.

Ron Spair

Hey, John, let me be crystal clear. The SAMHSA awarded 67 grantees $31.8 million in year one of a five year project. Okay? So, there's an anticipation that that $31.8 million will be made available each of the remaining four years.

John Putnam – Dawson James

Okay. But it doesn't all go into testing necessarily?

Doug Michels

That's correct again. So, it's up to a site by site decision as to how they use that funding, but it's encouraged for testing and I gave you the statistics on the number of sites out of those 67 that are currently using our product and that are currently testing. SAMHSA is talking about additional programs with the additional monies that are going to be earmarked specifically for testing. We believe that's going to present additional opportunities to the even larger base of their grantees and we are talking with them about the structure of that program and what that might look like.

John Putnam – Dawson James

Are these grantees jurisdictions or are they private organizations or municipal organizations?

Doug Michels

They're typically local service providers that are providing either substance abuse or mental health services and receive some level of SAMHSA grant funding. Many of them are drug treatment centers.

John Putnam – Dawson James

Okay.

Operator

Your next question comes from the line of Dave Turkaly with SIG.

Dave Turkaly – Susquehanna Financial Group

One quick one on the Hep C product you submit this summer, best estimate if you're willing to share in terms of when that product could be launched?

Doug Michels

As soon as it's approved.

Dave Turkaly – Susquehanna Financial Group

It looks like you could benefit from a new product. Just to be fair, the OraQuick is still growing nice, but gosh, the substance abuse and cryo had some issues, so I'm just trying to get a first cut at when another big opportunity comes on line for you.

Doug Michels

Absolutely, and Hepatitis C represents one of those. As I said, our intention is to make our submission later on this summer and generally it's a 6 to 12 month process assuming things are in order. We'd expect that based on the preclinical work that was done that we're going to have a solid submission and hopefully FDA will review that rapidly. We will also be making our submission for European approval shortly after we apply to the FDA and generally that's a faster review time.

Dave Turkaly – Susquehanna Financial Group

Okay. Thanks.

Operator

At this time, there are no further questions.

Doug Michels

Okay. Let me just take the opportunity to thank everyone for participating in today's call. Obviously, there's several challenges facing our business at the moment and we are focused and I assure you we will address them. At the same time, our OraQuick business continues to grow nicely and we are making excellent progress in our clinical development efforts. So, as you know, the management team and I remain committed to a very successful 2008 and to delivering significant value to our stockholders. So, I thank you again and wish you all a good afternoon and evening. Good night.

Operator

This concludes today's conference call. You may now disconnect.

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