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Executives

Bill Moffitt - President and CEO

Roger Moody - CFO

Mike McGarrity - Chief Marketing Officer

Analysts

William Quirk - Piper Jaffray

Bruce Cranna - Leerink Swann

Scott Gleason - Stephens Inc.

Kristen Stewart - Credit Suisse

Nanosphere, Inc. (NSPH) Q2 2008 Earnings Call Transcript August 14, 2008 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2008 Nanosphere Incorporated Earnings Conference Call. My name is Shamica and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions).

Before the call begin, Nanosphere would like to state that certain statements made during the conference call which are not based on historical fact, maybe deemed to constitute forward-looking statements within the meaning of the Private Security Litigation Reform Act of 1995. Because these forward-looking statements involve known and unknown risks and uncertainties there are important factors that could cause actual results, events or developments to differ materially from those expressed or implied by these forward-looking statements.

Such factors include those described from time to time in the Nanosphere’s filings with the United States Securities and Exchange Commission including without limitation the risks described in Nanosphere’s most recent quarterly report on Form 10-Q on file with the SEC. Please note that Nanosphere undertakes no duty to update this information.

I would now like to turn the presentation over to your host for today’s call Mr. Bill Moffitt, Chief Executive Officer. Please proceed.

Bill Moffitt

Thank you, Shamica. Good afternoon, everyone, and thank you for joining for Nanosphere’s investor conference call covering the second quarter. In a few minutes I will turn the call over to Roger Moody, Chief Financial Officer of the company who will review the results we released this afternoon and to Mike McGarrity, Chief Marketing Officer of the company who will provide an update on our customer activities and sales and marketing programs.

But before turning the call over to Roger and Mike, I’d like to discuss with you the progress we are making toward building Nanosphere into a leader in molecular diagnostics and give you my perspective on our second quarter results.

As Mike will review with you shortly, new customer placements continued at about the same pace as previous quarters and we continue to receive good feedback from our customers regarding the Verigene System, its ease of use and how it meets their needs.

As Roger will review with you, revenue was down sequentially from the first quarter due to the fact that all instruments placed in the second quarter were reference agreements and reagent rentals, where we recognize system revenue as a component of future cartridge sales.

Cartridge revenue actually increased significantly in the second quarter indicative of our moving customers through the validation process and on to utilization. Let me remind you though that it is still early for this to be considered a meaningful trend, but nonetheless, this is a key indicator of adoption.

As you know, this a menu driven business, and while we continue to be encouraged by the positive reception of the Verigene System in the market, we are disappointed with the time it has taken us to get our next important assay to market.

At product launch in the fourth quarter of 2007, our objective was to place initial systems, gain customer endorsement and ramp up as the menu expanded. The cystic fibrosis assay now in final stages of clinical trials has taken longer than anticipated and that has resulted in the delay of system placements for a number of customers in the pipeline and in ramping customer cartridge volume.

This delay is the result of testing procedures used in the clinical trials. Before starting clinical trials we reached agreement with the FDA regarding certain testing procedures and how to ensure that we provided adequate testing of even the rarest of mutations in the 23 mutation panel recommended by the American College of Obstetrics and Gynecology.

We reached agreement on a protocol using cultured cell lines that would be spiked into white cell depleted whole blood, thereby, recreating a sample from which to extract and process DNA for the assay process. However, as it turns up, these cultured cell lines are not as robust as naturally occurring human white cells, and this prove to be troublesome for certain sample preparation systems.

As a result, we reviewed this with the FDA and now have a new, different agreed upon approach which will provide more robust data. But obviously such a change causes delays in completion of the trials. This change and the lead-time required from our supplier of cultured cell lines added to the timelines for these trials.

We expect to begin testing at our third and final clinical site in the next few weeks. And assuming successful completion of the testing at that site, we anticipate being able to file our 510(k) later this quarter or early in the fourth quarter.

Let me reiterate that we have a number of new customers in the pipeline awaiting the cystic fibrosis assay as well as existing customers where this assay will add the cartridge volume in the install base. We believe our value proposition for ease of use and high count multiplex assays will us the competitive advantage.

Acceleration of market penetration beyond our current linear rate of growth requires continued additions to our test menu. In that regard let me take a few more minutes now to review our progress across all development programs. Earlier this month we commenced clinical trials of our first generation respiratory panel, and believe we are on schedule to file this with the FDA by the end of this year. This panel includes tests for influenza A and B and RSV A and B and runs on the current version of the Verigene System after customer sample preparation. The second generation of this test panel targeted for the ’09-’10 flue season will run on the Verigene II, a complete sample-to-result system requiring no upfront customer sample preparation.

In response to numerous customer requests, we have recently concluded development of a genetic assay for HFE, the gene responsible for hemochromatosis. Hemochromatosis is the leading cause of iron overload disease, people with this condition absorb as much as four-times the normal amount of iron from their daily diet and cannot leave the body of this excess. This results in excessive build-up in joints and vital organs such as the liver, kidneys, pancreas and heart and the pituitary gland.

Excessive iron in these organs can lead to diabetes, irregular heartbeat, heart attack, arthritis, psoriasis to the liver, and liver cancer, as well as conditions such as depression, impudent, infertility and others. It is even been implicated in Parkinson’s disease, epilepsy, MS and Alzheimer’s disease.

Untreated, hemochromatosis can be fatal. Most prevalent in males of European dissent one out of every 250 Americans has this disease and one out of every 8 to 10 is a carrier of mutations.

There is currently no FDA-cleared test for HIV. Customers have relied on analyte specific reagents or ASRs and home-brew solutions. We will commence clinical trials for this test upon the completion of the cystic fibrosis trails and believe we are on track to file this with the FDA by the end of this year.

The development of this test underscores two important points. First, the relative simplicity and flexibility of product development as a result of our core nanotechnology. This test took less than four months to develop. Second, this demonstrates our ability to be responsive to our customers and develop our test menu in a manner that best solves their problems and meets the needs of specific demand markets.

As I mentioned a moment ago, the respiratory panel march Nanosphere’s entry into the infectious disease market. And as you may know, the Verigene II has been specifically designed to incorporate sample prep for both human genetic assays and infectious disease assays. We are currently building systems to commence clinical trails later this year.

Our strategy is to first file with the FDA for human DNA extraction from whole blood and then file test specific sample prep with each infectious disease assay as we submit those. We believe we are on track to bring this system to the market in mid-2009.

There is no question we see excitement building around the development of our high-sensitivity cardiac troponin assay. Numerous seminars and presentations at this year’s annual meeting of the American Association for Clinical Chemistry highlighted the significant interest in assays that can achieve greater sensitivity than those on the market today. Our progress keeps us on track for an anticipated mid-2009 introduction.

This will likely be the first such high-sensitivity assay submitted to the FDA for clearance. We are maintaining a productive dialogue with the FDA to ensure we appropriately address all aspects of performance, as we being again to design our clinical trails program. At the same time, we are beginning to organize a large multi-site trail, that we believe, will lead to even greater clinical value for troponin as a biomarker for cardiovascular disease, and specifically, this assay.

I’ll let Mike McGarrity comment a bit later in the call on our recent activities and market development plans for this cardiac troponin assay as well as the other tests we plan to commercialize next.

Over the next couple of quarters, we’ll also begin to discuss future assay development and continued menu expansion for the Verigene platform. We believe that as we expand our menu and continue to demonstrate the value of our system, our growth will begin to accelerate and we will generate even greater shareholder value.

Now, let me turn the call over Roger Moody, Chief Financial Officer of the company to review second quarter and year-to-date results. Roger?

Roger Moody

Thank you, Bill. This afternoon I’ll review Nanosphere’s second quarter 2008 financial results, which are accompanied by today’s press release and 10-Q filing with the SEC, both of which are posted on our website, which is www.nanosphere.us.

Second quarter 2008 product revenue was $195,000 as compared with $700,000 in the second quarter of 2007 and $303,000 in the first quarter of 2008. As Bill mentioned, product revenue in the second quarter was driven solely by Verigene cartridges and reagent rentals.

Our second quarter new customer replacements were all reference or reagent rental agreement, and therefore, included no outright instrument purchases. Since launch, approximately 25% of placements have been outright instrument purchases. This trend is one we expect to continue despite this past quarter.

In the second quarter there was no revenue from grants and government contracts as compared with $498,000 in the same period last year. As we have previously stated, we do not expect grants and contracts to be a significant revenue component.

Costs and operating expenses in the second quarter were $10 million as compared with $8.4 million in the prior year. The year-over-year increase reflects investments in product commercialization, manufacturing scale-up, and expanded product development, as well as expenses related to operating as a public company.

Cost of product sales was $226,000 in the second quarter of 2008, resulting in nominally negative product gross margin. Our cartridge cost reduction programs including conversion to multi-cavity moulds and cartridge assembly automation continue to proceed on schedule.

Sales, general, and administrative expenses in the second quarter of 2008 were $3.8 million versus $3.1 million in the same period of last year. This increase includes approximately $300,000 in expenses resulting from increased skilled activity in support of our customers and pipeline development, and approximately $400,000 in legal, accounting, and consulting expenses necessary to operate as a public company.

Investment in research and development increased to $6 million in the second quarter of 2008 from $5.3 million in the second quarter of 2007. Most of this increase was driven by investment in personnel and contract services focused on research and development of infectious disease, ultra-sensitive protein tests. This increase also include spending on Verigene II prototype materials.

Our net loss was $9.8 million for the second quarter of 2008 as compared with $8.4 million for the same period in 2007. Our cash balance as of June 30th, 2008 was $94 million. Cash flows used in operations were $16.6 million during the first half of 2008. Summing up, our product revenue in the second quarter was sequentially lower, driven by reagent rental versus instrument sales and mix, while our spending in cash position are in line with our plans and expectations.

Now, let me turn the call over to Mike McGarrity, Nanosphere’s Chief Marketing Officer, who will review our continued customer expansion and market preparation activities related to our next product launches.

Mike McGarrity

Thanks Roger. We continue to make progress in Q2 toward our goal of establishing an installed customer base upon which to build penetration, utilization, and expansion. We have now shipped systems to 35 customers. On the move of molecular testing from the central reference labs to the hospital based setting is no longer debated. It is also now clear the three factors have and will continue to drive Nanosphere market share and customer acceptance.

Firstly, menu is the key to broad and sustainable adoption. Delivering test that bring diagnostic value closer to the patient is defined by the flexibility associated with our unique ability to multiplex to drive adoption. Our cystic fibrosis, hemochromatosis and respiratory assays deliver on this critical criteria.

Secondly, ease of use as defined by workflow process and hands on tech-time defines user criteria for platform selection. We have validated this value proposition in our initial sales offerings. This is evidenced by our demonstration to close ratio of greater than 80%.

Lastly, turnaround time defined by on-demand random access testing with clinically actionable results for few expansion of the market in the hospital lab setting.

Warfarin and respiratory assays are two examples and drivers of close to care molecular testing. We previously commented on our strategy to drive warfarin test adoption by conducting local and regional clinical studies. We confirmed this strategic approach at the recent AACC meeting and it begun to generate data from half a dozen of our customer side. This data will support the value of reduced time to INR and reduced dosage adjustments by incorporating patient genotype in the dosing algorithms. These sorter term endpoints predict reduced adverse spends, improve patient care, significant cost savings and risk management.

Two key takeaways from our early market experience are clear. First, while we have not yet delivered an all-encompassing menu, our customers confirmed that we do deliver a best in class system and approach for ease of use and turnaround time again as evidenced by our close rate of greater than 80%.

Second, menu expansion in Verigene II will position Nanosphere as a leader in genetic, pharmacogenetic and infectious disease testing. In parallel to these commercialization efforts, we continue to build-out our ultrasensitive troponin and marketing strategy design to educate and position our test as a new standard in cardiac risk stratification.

There is a well-established need and a compelling value to what we believe will be an unmatched combination of sensitivity and specificity. We are confirming that we deliver value to each and every constituent in the diagnosis and treatment of current acute coronary syndrome. This market viability was un-exhibited at the recent AACC meeting where three different symposia declared the value of greater sensitivity and therefore, faster disposition of ACS and non-ACS patients. We are in the process of expanding our market development efforts with recruiting for both internal and external resources to advance our comprehensive marketing strategy.

I’ll be happy to answer any questions on these developments during the Q&A and now I’ll turn the call back over to Bill Moffitt.

Bill Moffitt

Thanks Mike and Roger. Before moving on to take your questions and concluding this afternoon’s call, I want to emphasize two key points about Nanosphere in our business. First, this market on menu, the broader the test menu on a single platform, the fewer platforms any given laboratory will require and lower their cost of operation. Our core technology enables a very broad menu on a single platform including human genetics, pharmacogenomics, infectious diseases and protein biomarkers for a variety of diseases ranging from cardiovascular to cancer to auto-immune and neurodegenerative.

Our nanoparticle-based micro-array approach to testing, enables a comprehensive menu ranging from single snip detection to the most complex high-count multiplexed assays. As we continue to add test to our product offering, the market value of our platform rises significantly.

My, second point ease of use will prevail as the standard. Customers will standardize on systems that provide flexibility and simplicity in operation and minimize tech-time. Our unit use cartridge-based system incorporates into one disposable all the elements of analysis including on-board controls that ensure quality of results.

Our approach ensures on-demand testing and results availability within a couple of hours from the time tests are ordered. A broad menu on a low cost, easy of use platform underwrites our business and addresses the problems and needs of this market.

The tests that we anticipate delivering to the market over the next few quarters represent a market opportunity in excess of $1 billion. Moreover, we anticipate bringing to the market even greater simplicity in the form of the Verigene II System, fully incorporating sample preparation.

We believe this expanded menu and the value proposition of each assay will drive accelerated market penetration. This unmatched capability will enable us to generate significant customer and shareholder value as we continue to penetrate the market.

Now, we will be pleased to take any questions you may have and Shamica I will turn the call back over to you. Shamica?

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of William Quirk of Piper Jaffray. Please proceed.

William Quirk - Piper Jaffray

Yes. Thanks. Good afternoon.

Bill Moffitt

Hi, Bill, how are you?

William Quirk - Piper Jaffray

Good. Thanks. First question, Bill is the comment about the fact that cartridge utilization rose in the second quarter, is that actually a sequential bump in terms of overall revenue or are you talking about actual utilization and what we have seen is little bit of stocking thus far?

Bill Moffitt

No, it is sequential growth in terms of cartridge revenue and it is sequential growth in terms of cartridge utilization.

William Quirk - Piper Jaffray

Okay. Very good.

Bill Moffitt

But not stocking activities.

William Quirk - Piper Jaffray

Okay, understood. And then in terms of the HFE test, how many mutations are you measuring here and I assume, Bill, that this is basically genotyping test, the kind of one that you had done?

Bill Moffitt

It is definitely a one we had done, it is a genotype test and there are three mutations that are being measured. You may recall, Bill, this was not in our original target list of assays to develop. There is essentially one company that offers the analyt specific reagents for this or I should say one predominant that offers them. And that company has recently announced that they will be removing that ASR reagent kit from the market, and so customers have come to us and said, we don’t have an FDA cleared alternative here, your system is really simple to operate, is there anyway you guys could develop this. And they came to us before even knowing that there might be a difficulty in getting access to reagents for this and our response was, you know, let us take a look. It was easy to develop less than four months from beginning to end. What we have not done is prioritize the clinical of this, though ahead of cystic fibrosis.

So, it is interesting to me, I mean, there are lot of ways you could look at this assay. From our perspective we are responding to a customer need in the marketplace because we can, and we can do so in a very efficient manner. The fact is hemochromatosis is actually ten times more prevalent in the population than cystic fibrosis. It’s just not as well known or is well understood, and it is a disease that you are born with. It manifests itself but for the most part in people by the time they are in their late 40s or early 50s, but it manifests itself in the form of cirrhosis, liver cancer, pancreatic cancer, kidney failure, cardiovascular disease and in fact those are all the things that medicines treats, having sort of miss the original cause, cause of the disease in the first place.

So, do we expect a huge bump in volume? No, not at all. But, from our perspective, this continues to add to the menu, it adds to cartridge utilization and it definitely demonstrates the power of our technology to be able to respond to problems in the marketplace.

William Quirk - Piper Jaffray

It’s a customer service test.

Bill Moffitt

That’s it.

William Quirk - Piper Jaffray

Yes, okay. Fair enough. And then just a question on R&D and just kind of how this operates, do we have separate teams that are operating independently or we doing things in kind of serial process, I guess what obviously I don’t want to speak from a line here but I suspect some people are obviously thinking CF is getting push out a little bit here, is that implications for troponin which is obviously of the near-term products or the biggest value driver that you have?

Bill Moffitt

Okay, let me be real clear on the answer here, because I agree probably everybody on the line and other well would like to really make sure they understand how we operate and what’s the implications with CF are. Two points I want to make Bill, first of all and the answer to your question directly it is parallel teams. The people who are working on CF have absolutely nothing to do with the people working on troponin. Two totally independent teams, the people who are working on the respiratory panel have nothing to do with the people working on CF or troponin. So, there are multiple parallel teams at work, and these teams are anywhere from four or five people up to seven or eight depending upon the stage of development of the assay. It could be even more than eight I guess in some cases.

My second point here is, let me also again just and I apologize for repeating myself a bit but explain what happened to us on CF. The issue with CF was fairly straightforward. There are some exceedingly rare mutations in that 23 test panel, and the FDA wants to see any submission of any assay like for this test to include a number of samples, a relevant statistically valid number of samples even for the rarest of mutations. In some cases these things are less than 1000% to 1%, you could go through tens of thousands of patients in the population. Just people on the population looking for these mutations that's obviously just not practical, and so the agreement or the approach that the FDA has been looking at in some cases, in fact, if you look back historically at some of the CF assays, they don’t even include test data for some of these. Now the FDA obviously is scrutinizing more closely the whole molecular diagnostics area the whole industry inclusive of the FDA and manufacturers like us well are learning more and more about this stuff.

And so the agreed upon approach with the FDA was that rather than go look through thousands or tens of thousands of people for these mutations we could acquire buy from the outside cultured cell line that are genetically engineered to contain these rare mutations. And then what the FDA wanted to see was for us to extract that from whole blood. And one of the things that we are all learning is that sample preparation systems have a downstream effect on the molecular diagnostic platforms that are used.

So, it's appropriate to go from beginning to end. So, we agreed that the thing to do here was to take whole blood take the white cells out and then if you will sort of reinsert cells. These cultured cell lines are contained in this. We were bit skeptical as to whether that would actually work because the cultured cell lines are not as robust. But we agreed up with the FDA we are taking this approach, which turns out some of the sample prep system that are out there don’t handle that well. And as a result, since you want to demonstrate multiple sample prep systems in your clinical trials, some of our trial side struggled, with the process of sample prep and then analysis. So, we took this data back to the FDA and said, this is working very well. So, we have reached agreement with the FDA on a different approach to this completion of the trials and we have gone back to completing the trials now.

And so that the delay here is not development of the assay, the delay is in the approach and the time that it’s taken to get these clinical trials done. Some of that delay bluntly added to by the fact that we have to go back to the supplier of cultured cell lines and reorder a new entire set of cell line cultured cells. And these are cells, as you can imagine, these are growing, cell culture media. And so this is something you wait for the cells to grow and produce enough, and produce enough with the right genetic composition for you to have the sample that you’re looking for.

So, we are disappointed that this whole process has taken longer than we’d have liked or expected from the get-go, but I want to assure you that it is not an implication for the company’s ability to develop tests on a timely basis. That’s a long answer, but it’s very important to understand that?

William Quirk - Piper Jaffray

Understood, thanks very much for detail response.

Bill Moffitt

I appreciate it Bill, thanks.

Operator

Your next question comes from the line of Bruce Cranna of Leerink Swann. Please proceed.

Bill Moffit

Hi Bruce, how are you?

Operator

Mr. Cranna, your line is open.

Bruce Cranna - Leerink Swann

Can you guys hear me or not?

Bill Moffitt

Yes, we hear you now, Bruce.

Bruce Cranna - Leerink Swann

Okay. Sorry about that.

Bill Moffitt

That’s alright.

Bruce Cranna - Leerink Swann

Just wanted to be sure, maybe this is for Mike, on the instrument count, is it 35 placements or I guess, customers at quarter end Mike.

Mike McGarrity

Yes. That’s correct, Bruce.

Bruce Cranna - Leerink Swann

And how many instruments?

Mike McGarrity

We have 41 processor instruments in those 35 sites. So, we are averaging 11.11.2-ish per site processors.

Bruce Cranna - Leerink Swann

And, I am sorry, can you remind what it was at the end of the first quarter, I do not have that number in front of me?

Mike McGarrity

25.

Bruce Cranna - Leerink Swann

Okay. Great. And then, just I am clear on the 195k in the quarter, Bill your comment was that clearly no, I guess, no stocking if you will in that number, that’s really end user sales or end used?

Bill Moffitt

That is purely end user pull-through of cartridges. There is no stocking and --

Mike McGarrity

There is a tiny bit of reagent rental in there, but not much, its almost all cartridge volume.

Bruce Cranna - Leerink Swann

Okay. Great, that’s good to hear. I guess, what I was wondering about whether or not you have seen any residual impact from the recall in the prior quarter?

Mike McGarrity

No, I don’t think we have seen any at all.

Bruce Cranna - Leerink Swann

So you feel that its exactly behind you?

Mike McGarrity

Absolutely. The thing I would say, the way to look at this right now is, if you just want to go back, sort of, recap the three quarters so far, right, instrument placements, the first quarter out we have gone 12, 13 and 10. Right. It’s linear. I mean, all of those numbers are about the same number. Right?

Bruce Cranna - Leerink Swann

Yes.

Bill Moffitt

The growth rate right now is linear, and we firmly believe, based on our pipeline, based on the way this market behaves, based on the receptiveness we see into the product that we will get acceleration in this growth rate, but it takes additional test menu. And they will analyze the real disappointment over the CF assay.

Bruce Cranna - Leerink Swann

Yes. And then Bill on HFE I know you mentioned, I think you said you got it done in about four months. If you’re working on it exclusively, what do you think could be your total time to market including regulatory? I guess what I am getting out it that you guys are looking at 510(k) here, presumably?

Bill Moffitt

Yes, it’s a 510(k). It will go to trails when the CF assay is completed its trails. And the trails shouldn’t take us more than about, I would think, six to eight weeks and then we would submit the 510(k). So, we believe we get that submitted before the end of the year.

Bruce Cranna - Leerink Swann

Okay.

Bill Moffitt

Now, I will say it’s been completed for a bit of time and sitting on the shelf waiting to owing the trails. Another point to make here, we have parallel assay development teams, we also have the ability to run parallel clinical trails, but only so many. And so we have two, if you will, ongoing right now, and that is completion of the cystic fibrosis, and we have started the respiratory panel trails at the first external site for those. So, that’s up and running now. So, we have got those two in process. We need to complete one of those before we started HFE, and of course, the one that we will complete the soonest as likely as cystic fibrosis.

Bruce Cranna - Leerink Swann

Yes, that makes sense. And what do you think your, if you don’t mind me asking, your total expenses in developing something like HFE kind of from square one, if you will?

Roger Moody

I don’t know that we have actually tabulated what it was. It wasn’t a lot. I mean, it’s, again I think about the amount of man hours involved and the cost of disposables that we burn through internally, and this is truly on off the top my head number, but significantly less than a $0.5 million.

Bruce Cranna - Leerink Swann

It’s great. And thinking about the end-user community, is it really tends to be attested to not being send out today from hospitals or is that not that the case?

Mike McGarrity

The majority of the tests are either set up versus a home-brew or sent to labs that have the capability and IP license for that test.

Bruce Cranna - Leerink Swann

So, there are hospitals doing this as a home-brew in their own labs?

Mike McGarrity

There are few, but the majority of them are looking for a solution to send out.

Bruce Cranna - Leerink Swann

That’s what I am getting at. So, does it economic in –?

Mike McGarrity

The price benefit of bringing the test in an IBD clear devices what’s drip or drove the solicitation, as Bill refer to, of our current customer base end, it will be a great test for you to able to run on your cartridge, and can you bring on us.

Bruce Cranna - Leerink Swann

Yes, I know it sounds like win-win. And what do you guys think the market size is, just out of curiosity?

Mike McGarrity

Well, I think this is one of those where you look at the actual market and the potential market. I think that Bill had both aspects of it. If you are looking at the current actual market, it’s not going to be game breaker. But if you will look at the opportunity that educate in advance the testing for the mutations, it’s very, very clinically relevant.

Bill Moffitt

Bruce, the fact is hemochromatosis is only 10 times more prevalent to population than cystic fibrosis. So, one could argue that in the normal steady state they are at least at the level of testing of cystic fibrosis which would be a couple of million tests a year. But it is no where near that now.

Mike McGarrity

We have a fair amount of both customers and potential customers that are in our pipe that are really excited about this.

Bruce Cranna - Leerink Swann

No, it’s good, it’s good. It sounds interesting. Thanks guys. I’ll get back in queue.

Bill Moffitt

Thanks Bruce

Operator

Your next question comes from the line of Scott Gleason of Stephens Incorporated. Please proceed.

Scott Gleason - Stephens Inc.

Hey Bill, hey Roger. Thanks for taking my questions.

Bill Moffitt

Hey Scott. How are you?

Scott Gleason - Stephens Inc.

Very good. Thanks.

Bill Moffitt

Good.

Scott Gleason - Stephens Inc.

And just to start up, Bill, can you maybe walk us through, when a customer orders a system, is there a delay before you start releasing a disposable ramp because of validation of the system in laboratory?

Bill Moffitt

Sure, let me let Mike talk you that for you.

Mike McGarrity

Hey, Scott. The processes we set up with the customer the expectations of the validation program, and I think I have commented before we have made a lot of progress in this area. The validation program for each customer can be a little bit different, although there are some pretty clearly defined protocols for validation. We set-up a program where we provide support for the customer in gathering samples, setting up the program for validation. Where we have developed a better plan and I think now offer a comprehensive approach is in sample prep methodologies.

And what we have learned in the first couple of quarters of commercialization here is that sample prep methods are, they are all different. They all present different chemistries, and based on our unique direct to detection approach, we have to really go through a good rigorous validation process for those customers in order to ensure a seamless ramp-up and conversion to utilization.

And I think maybe we were aggressive in our goal of 30 days of getting customers shipped and validated in 30 days, and we have probably seen that stretch, the positive aspect of that is that we are working through with each customer, the validation of their sample methodologies. And the real positive is that as Verigene II comes, then it’s the need to do this work with each and every customer.

So, we are excited about putting that work behind us, and yet I think at this point we have got a good process and approach to that. It really was about building a process-based approach to each customer based on how sample types bigger. The type of the preservatives that they use for the type and the sample prep methodologies and the chemistries associated with varying prep methods.

We have made a lot of progress there, and I think we will be good between now and Verigene II. But obviously our pipeline is excited for Verigene II, but it takes away that whole work, work to all.

Bill Moffitt

I agree.

Scott Gleason - Stephens Inc.

And Roger you mentioned that utilization was up versus some quarter-to-quarter sequentially. Can you guys give us a sense of, on a percentage basis, what you saw in terms of cartridge utilization.

Roger Moody

Well, what we said was that aggregate cartridge revenue was up substantially and it was up -- it’s probably too early to call out the percentage or break-out of segment, the various revenue component. But I will tell you that it was up substantially because the instruments placement or new instrument outright sales went down entirely from the first quarter. So, we are comfortable that utilization is there within the current customer base and that we are continuing to see these customers ramp from the validation period up to utilization and usage of our system.

Scott Gleason - Stephens Inc.

Great. And just one last question, I just want to check and make sure you guys haven’t seen any returns of systems or on the lease program during the quarter?

Roger Moody

We have not seen any.

Bill Moffitt

No.

Scott Gleason - Stephens Inc.

Okay. Great. Thank you very much, guys.

Bill Moffitt

Thanks, Scott.

Operator

(Operator Instructions). Your next question comes from Kristen Stewart of Credit Suisse. Please proceed.

Kristen Stewart - Credit Suisse

Hi. Good evening.

William Moffitt

Hi, Kristen.

Kristen Stewart - Credit Suisse

I was just wondering if you can comment a little about what your cartridge utilization looks like between hyper coag and the warfarin, and then Bill maybe if you can give me some of your high level thoughts on CMS’s national covered decision, or I guess proposal on pharmacogenomic testing for warfarin response? And what that could mean for the outlook there?

Bill Moffitt

Alright. Kris, I will let Mike start out there and then I will give a couple of comments at the end.

Mike McGarrity

Hey Kristen. If you are looking at the utilization of our system we have commented that our customer -- our current customers have brought up our system for warfarin and coag. And we have some customers that initially were interested in warfarin and we’re able to, based on demonstration of the value of the system and the benefits, freeing up coag as well. I think you are aware of the work that’s going on in the marketplace to built warfarin utilization, understanding, acceptance and application of the warfarin test. And we are confident that those long-term market efforts are going to happen.

I think if you look at our efforts, where they are really focused and the program that I referred to earlier, we are convinced and our customers and even people we have talked to that are involved in the longer-term programs that each customer is going to need to get the key constituents in their hospital, interested in understanding the benefits of this test, and that’s the laboratory, the pharmacy and the clinicians. And that’s why we are taking on the effort of these half a dozen our cell site could generate these work products and data sets that we can then provide customers of clear and compelling avenue if you will to adoption of the test with the long-term outcomes pending. Because we know that some of the shorter-term endpoints that I commented on related to reduced INR and reduction in not only dosage adjustments but the size of the adjustment for milligram standpoint correlate with reduced adverse events.

With the longer-term studies looking at reduce adverse events need to be powered substantially from a patient or follow-up standpoint. So, the shorter-term endpoints we believe and are committed to supporting our customers will lead to adoption on site-by-site basis.

Kristen Stewart - Credit Suisse

And are you currently selling more Coag cartridges versus warfarin?

Bill Moffitt

Yeah, our way it is significantly weighted to Coag. Actually our utilization on the Coag is ahead of our initial expectations on a per customer basis and we are working hard to get warfarin where we know it can't be and it should be. And then I will just add one more comment to the impact of menu because we have a number of customers in our queue that are waiting on CF but also interested in warfarin just like we had with Coag and its just the matter of trigger pulling. And that’s our -- we are very anxious to get the CF going because we know that each test brings the opportunity to put the system in for one test and the build menu. So we have current Coag users that are waiting on CF. We have people waiting on CF that are interested in Coag and obviously that’s the power of menu that we obviously have not yet been able to take advantage of but if you look at our pipeline over the next three, six, nine, 12 months we will be able to do that. Reception is the system is telling us that based on that.

Mike McGarrity

I think that's an important point. The critical mass of menu required to get any particular customer to buy into a system any system is a grade scale. And so come customers have a sufficiently strong demand for a single test to buy into that others its 2, some is 3, 5, 7 whatever, and test represent critical mass is obviously. But the key is as you expand with that it not only pick up that cartridge volume for the test that was the trigger test if you will, but it pick up the other volumes for the other test that they are going to run as well.

So, as we add to the menu, we get something that is well beyond a linear growth rate. And frankly that continues to fuel a lot of excitement around here about the fact, Bill has said a moment ago there is over a billion dollars worth of market opportunity represented by the test we come to market within the next couple three quarters here so. We are feeling pretty good about this especially in light of all the positive response from the customers on the system.

Kristen Stewart - Credit Suisse

And do you think medicare is looking into national coverage decision on pharmacogenomics may help accelerate some of the utilization of warfarin?

Bill Moffitt

I think it may, this one is interesting one I think. I have yet to talk to even the people who are questioning how broadly should you adopt or implement pharmacogenomic testing for warfarin. I haven't yet found anybody even those needless to say it's not a value. I think the base is how broadly should it be used and then of course what level should it be reimbursed.

So, the issue here really is, is there enough data? And I think what CMS is doing and saying, let’s just get all of this out on the table. Let’s find out exactly what data is out there? How much is there and what it tells? And is there enough critical mass of data or not? So, we know there is a couple of national studies that are going on or about to start. As Mike mentioned, we have got half a dozen different clinical trials going in this area as well. So, I think we will see in coming year or so whatever, more and more visibility to the value and importance of this and I think that will help raise the visibility and should increase demand as well.

Kristen Stewart - Credit Suisse

Then just to clarify, Mike you had said earlier 35 customers and 41 instruments placed. Am I correct?

Mike McGarrity

Yes, it’s correct.

Kristen Stewart - Credit Suisse

Are those all verified, I mean?

Mike McGarrity

Validated?

Kristen Stewart - Credit Suisse

Validated? I am sorry.

Mike McGarrity

Not all of them are validated, but we are -- our validation -- either they are in validation, or validated.

Kristen Stewart - Credit Suisse

Okay, perfect. Thank you guys.

Mike McGarrity

Yeah, just to be clear. We don’t count instruments that are put in for demonstration in that number.

Kristen Stewart - Credit Suisse

Okay, thanks.

Mike McGarrity

Alright. Thanks Kristen.

Operator

There are no further questions at this time. I’ll like to turn the call back over to Mr. Bill Moffitt. Please proceed.

Bill Moffitt

Thanks Shamica and thanks everyone for joining us for the call today. We continue to be very excited about the prospects for Nanosphere. We appreciate your support. We appreciate your time today. Thanks everyone and have a good evening.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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Source: Nanosphere, Inc. Q2 2008 Earnings Call Transcript
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