Ladies and gentlemen, good afternoon. At this time I would like to welcome everyone to Cepheid's 2012 third quarter conference call.
During the presentation, all participants will be in a listen-only mode. A question-and-answer session will follow the company's formal remarks. [Operator Instructions]. Today's conference call is being recorded.
And now, I would now like to turn the call over to Jacquie Ross. Please go ahead, ma'am.
Good afternoon, and thank you, [Sayid], and welcome to Cepheid's 2012 third quarter conference call. On the call today are John Bishop, Chief Executive Officer, and Andrew Miller, Chief Financial Officer. Today's conference call is being broadcast live through an audio webcast and a replay of the call will be available later today at www.cepheid.com.
During this call, Cepheid will make forward-looking statements including guidance as to future operating results. Because such statements deal with future events, actual results may differ materially from those projected in the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements can be found in Cepheid's Annual Report on Form 10-K, quarterly reports on Form 10-Q and other filings with the US Securities and Exchange Commission, as well as in today's press release. The forward-looking statements, including guidance provided during this call, are valid only as of today's date, October 18, 2012, and Cepheid assumes no obligation to publicly update these forward-looking statements.
During the call Cepheid will discuss non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures can be found in today's press release made available on our website.
With that, I'd like to turn the call over to Cepheid's Chief Executive Officer, John Bishop.
Good afternoon, everyone, and thank you for joining us for a review of our third quarter results.
Third quarter revenue of $80.5 million was consistent with our preliminary announcement on September 26 and represented year-over-year growth of 15%. As expected, we exited the quarter with significant back orders for clinical reagents. As of September 30, these back orders amounted to $6.7 million including $1.9 million in HBDC reagents and $4.8 million in commercial clinical reagents, primarily MRSA surveillance and C. difficile. Had we been able to ship these orders, third quarter revenue would have been $87.2 million, representing growth of 24%. Separately, FX was once again a factor this quarter, negatively impacting growth by more than 300 basis points.
Clinical revenue of $67.5 million grew 13% over the third quarter of last year, again impacted by supply interruptions. Including the back orders, growth would have been 25% year over year. Within clinical, commercial clinical revenue of $56.2 million grew 4% from the third quarter of last year. Including the back orders, commercial clinical revenue would have been $61.1 million, representing 13% growth.
That said, we believe the impact of the back order situation went beyond pushing revenue from Q3 into Q4 but also impacted new business development. Notably, the US sales team ended up spending significant time supporting customers through the allocation situation, which impacted new revenue generation in the closing phase of the quarter.
At a macro level, system placements were also impacted by a tighter capital spending environment in the US as discussed on our July call. To be clear, the trend we're seeing is not a loss of system placements due to competitor platforms. It is a more aggressive competition for capital budget of all types -- for all types of capital purchases within institutions such as, for example, electronic medical records, which lengthens the selling cycle, downsizes potential platform investments, and is encouraging potential customers to explore a broader range of acquisition methods.
Reflecting all these factors, total commercial clinical system revenue represented $8.3 million of the $13 million total clinical system revenue. We added 115 commercial GeneXpert placements during the quarter, including 43 in North America and 72 internationally, bringing our cumulative total of commercial placements to 2,765. Four of our system placements in North America were Infinity Systems driven by multiple test adoption by both new and existing Xpert customers. And once again we saw a good contribution of system placements associated with our LABSCO collaboration.
Moving to reagents, total clinical reagent revenue was $54.5 million. Including the $6.7 million of backorders, clinical reagent revenue would have been $61.2 million, an increase of 34% from the same quarter a year ago. Of total clinical reagent revenue, commercial clinical reagents were $47.9 million, or $52.7 million including the back orders. This would have been growth of 21% despite FX headwinds of more than 300 basis points.
As discussed at our analyst event at the end of September, our manufacturing challenges were encountered in conjunction with the development of higher capacity production tools and processes, limiting our ability to manufacture at the volumes necessary to meet growing demand. In terms of resolution, we are confident that we have identified and are implementing solutions for the issues we experienced in the third quarter. We are back to a steady state for parts inflow, but we're not yet flowing at the rate necessary to meet full production demand. As a result, this will cause some products to continue to be on allocation for the month of October, with all allocations ending in November. While we are still playing catch-up at this time, we have already shipped substantially more than the $6.7 million in back orders we exited Q3 with, and we're confident that we're on track to clear all back orders and return to shipping immediately by mid to late November. At that time we will begin to rebuild inventory levels.
As we look toward further increases in test demand, we're looking to reduce some of the complexity in parts production by establishing our own in-house molding capability. As you may be aware, we are in discussions with one of our molders to bring that operation in-house. We should be able to update you on that early in the new year.
Now moving back to the quarter and including the back orders, year-over-year growth in our commercial clinical reagent business was driven by MRSA which grew 15% and C. diff which grew 40%, despite the challenges experienced by our sales and marketing teams as a result of the product supply situation and of course the FX headwinds.
Currently only available outside of the US, Xpert CT/NG got off to a promising start in the third quarter with more than 50 customers adopting the test at what is seasonally a very slow quarter for the European market. Early adopters as expected have tended to be existing GeneXpert system customers who previously sent the test out to a reference lab. In the US we continue to target FDA clearance before the end of the year.
I'd now like to update you on our HBDC program. Total revenue of $11.3 million included $4.7 million for 149 systems and $6.6 million for just under 400,000 test cartridges. This was up more than 50% from last quarter and more than 100% from the same quarter a year ago, highlighting that the first phase of the buy-down effective in early August clearly freed up the delayed orders situation we saw in the second quarter.
With less than two months of post-buy-down activity in the quarter, it's clear that this program is achieving its goal of driving rapid adoption of Xpert-based testing programs, particularly when we consider that we exited the third quarter with an additional $1.9 million in HBDC test orders that we were unable to fulfill due to our supply interruption. In fact, there are now 849 systems placed as part of the HBDC program in 80 countries, although it remains challenging to forecast the likely near-term reagent pull-through on these systems as most programs are in the very early stages of implementation.
South Africa continues to be the most aggressive adopter and now has 184 GeneXpert systems installed. In the third quarter, programs in South Africa were responsible for about 50% of the HBDC reagent sales or 190,000 cartridges. India was the second largest with about 50,000 test cartridges, representing 13% of the HBDC reagent sales.
As you know, the second phase of the buy-down activity was concluded right at the end of the quarter with our partner USAID, who has matched the $3.5 million paid by the Bill and Melinda Gates Foundation to make the Xpert MTB/RIF test available to HBDC customers at $9.98. As a reminder, the third and final phase of the buy-down activity will be the completion of our agreement with Unitaid. You will recall that Unitaid announced back in June Board-level approval of their participation in this buy-down activity. We continue to expect completion of this agreement before the end of the year.
In summary, this remains a very exciting program for Cepheid that is driving broadened awareness of the unique capabilities of the GeneXpert system and offering potentially very meaningful leverage opportunities within our manufacturing operations that will benefit our commercial business over time.
Now, moving back to our commercial business, we saw good progress in the third quarter on our ever-expanding menu of Xpert tests where we expect to grow our business with existing customers and new customers alike. Xpert MTB/RIF clinicals are wrapping up and we continue to target submission to the FDA in early 2013. HPV, targeted for the CE-IVD release in late 2013, is now moving into beta trials. Xpert blood culture clinical trials are ongoing and we expect to submit to FDA in early 2013. CLIA-waived flu is progressing with a targeted commercial release for the 2013/2014 flu season. And the virology portfolio of products is progressing well in active development, with targeted releases in the 2014/2015 timeframe. In total, we have 14 tests in active development including vaginitis, multi-drug resistant organism test, bladder monitor and Norovirus, in addition to those that I just highlighted.
Before I hand the call over to Andy, I'd like to acknowledge that, specifically in our manufacturing operations, this is the second quarter this year where our previous track record of consistent execution has been challenged. While we in no way wish to downplay these near-term challenges, we remain excited about the growth opportunities ahead of us and I'd like to take a moment to remind you of some of the growth catalysts ahead.
In addition to ongoing growth in our core HAI franchise, we anticipate, first, commercial launch of our Xpert CT/NG test in the US before the end of the year and TB in the US in the first half of next year; second, an exciting product cycle starting at 2013 with the addition of HPV, vaginitis, MDRO and Norovirus to the Xpert test menu outside the US; next, more generally a broadening applicability of the GeneXpert platform with new tests, increasing our addressable market from less than $1 billion today to more than $5 billion in 2017; next, continued preparation of upcoming commercial launches in Cepheid emerging markets, including both China and Japan, and ongoing rapid adoption of the GeneXpert platform in both commercial and HBDC markets.
The theme of our analyst event of the end of September was No Growth Barriers. The technology developments we discussed at that meeting -- protein detection, high-level multiplexing, paraffin-embedded tissue extraction, and the HGX -- are intended to further extend the competitive advantage of what already is the most compelling molecular platform on the market. As one of your sell-side colleagues described it, the best mousetrap is getting better.
With that, I'll invite Andy to address our third quarter financial results and guidance in detail. Andy?
Thank you, John. As always, please note that I will be discussing our non-GAAP results unless I indicate otherwise. Additionally, note that my comments on our third quarter results exclude the $6.7 million in back orders. For comparison purposes, we are making available as part of our supplementary data on our website third quarter revenue results and growth rates normalized to include the back orders as revenue, but I will not add to what John has shared here.
Third quarter revenue of $80.5 million was up 15% year over year, driven primarily by growth in our clinical reagents business. Once again, unfavorable foreign currency exchange rates and the [GPLC] re-class impacted year-over-year revenue growth by 340 basis points and 90 basis points, respectively. Of total revenue, product revenue was $78.1 million, up 16%. And other revenue, consisting of contracts, grants and research, was $2.3 million.
Clinical revenue of $67.5 million grew 13% year over year, but was down 3% from last quarter due to the supply interruptions. Overall, clinical revenue represented 86% of total product revenue. Within clinical, system revenue of $13 million was down 6% both sequentially and year over year due to a more challenging capital environment in our US commercial business. Clinical reagent revenue of $54.5 million was up 19% from the same quarter a year ago, with growth roughly split between our commercial and HBDC programs.
Our non-clinical business delivered third quarter revenue of $10.6 million. Year-over-year growth in this category was driven primarily by biothreat, as you can see clearly from our collaborative profit-sharing expense.
Moving to the income statement, and starting with gross margin, non-GAAP gross margin of 50.7% was well below our expectations due to lower commercial shipments in the quarter, compared to last quarter's 56.6%. The higher HBDC mix negatively impacted gross margin by 250 basis points. Commercial gross margin was 57% compared to 61% last quarter. Unfavorable absorption and manufacturing variances from the supply challenges were the primary drivers to the 400-basis-point sequential decline in commercial gross margin.
Moving to the rest of the income statement, non-GAAP R&D expense, up $14.4 million or 18% of revenue, was flat with last quarter. Non-GAAP sales and marketing expense, up $14.2 million, was also about 18% of revenue. Finally on expenses, non-GAAP G&A of $9.5 million represented 12% of revenue, higher once again due to litigation expense.
Overall, non-GAAP net income for the quarter was $0.9 million or $0.01 per share. GAAP net loss was $21.3 million or $0.32 per share. This included a charge for the settlement of the Abaxis litigation of $15.1 million or $0.23 per share. The remaining $2.1 million of the $17.25 million settlement will be recorded on a straight-line basis through mid-2015. A reconciliation of our non-GAAP results to our GAAP results is available in today's press release.
Turning now to guidance, for the full year, we are now expecting total revenue at the low end of our prior guidance range or approximately $333 million. With year-to-date revenue of $238.8 million, this suggests fourth quarter revenue of approximately $94.2 million. Included in total revenue, we expect clinical revenue for the full year of approximately $289 million, comprising around $42 million in HBDC and $247 million in commercial clinical.
Within commercial clinical, we expect full-year system revenue will be down around 20% from last year and we expect full-year reagent revenue will grow in the low to mid-20s. Year-to-date clinical revenue is $204 million, suggesting fourth quarter clinical revenue of around $85 million, of which approximately $16 million is expected to be HBDC and $69 million is expected to be commercial.
Non-clinical revenue for the full year of approximately $35 million, suggesting fourth quarter non-clinical revenue of just over $7 million. Other revenue for the year of approximately $9 million, suggesting fourth quarter other revenue of just over $2 million. Of course there is a range of possible outcomes for each of these items so the actual revenue in each of these areas could be plus or minus a couple of million dollars from these guidelines.
There are some factors you should consider as you review this guidance. First, we exited the third quarter with $6.7 million in back orders. Had we been able to deliver the orders we received in the third quarter, third quarter revenue would have been $87.2 million and the fourth quarter revenue required to meet our full year guidance would be $87.5 million.
Second, we expect a strong HBDC performance in the fourth quarter as we will benefit from a full quarter of the $9.98 price, which should encourage broader adoption. Third, the fourth quarter can be a stronger quarter for capital purchases, though as an offset, you should keep in mind the emergence of a more challenging capital environment and the potential for ongoing time spent by our sales team associated with the product supply challenges.
And finally, even if we consider that small volumes of tests were lost due to the back order situation and that the sales organization continues to have to focus on managing customers through the allocation process rather than focusing 100% on closing new business, we continue to expect solid growth in our commercial clinical reagent business.
In terms of gross margin, it's clear that the challenges in operations will impact our gross margin performance for at least some of the fourth quarter. As a result, we currently expect fourth quarter non-GAAP commercial gross margin to be just above 60%, and including HBDC, total non-GAAP gross margin of 51% to 52%. For the full year 2012, we now expect non-GAAP gross margin of around 53%.
On the subject of HBDC, I'd like to share a quick reminder of the accounting treatment. To date, Cepheid has received $7 million from the Bill and Melinda Gates Foundation and USAID to support the availability of the Xpert test to HBDC customers at $9.98. This compares to the $16.86 price that Cepheid would be charging customers at Q3 volumes in the absence of support from these NGOs. Until such time as the Unitaid agreement is signed, there is no change to the accounting treatment. Just as we have been doing since the start of the HBDC program, Cepheid is recognizing revenue of $16.86 for each test sold, only now $9.98 is paid by the customer and $6.88 is drawn from the $7 million funded by the NGOs. At this time, we expect the Unitaid contribution to the buy-down to be up to $4.1 million.
When Unitaid is signed, all remaining funds at that time from all three agreements shift to straight-line accounting, spread over different periods. Based upon an assumed closing of the Unitaid agreement sometime in December, our current expectation is that the reported HBDC gross margin for the fourth quarter will be approximately 12%. Again, I should stress that this lower gross margin is a factor of the accounting treatment only; the economic gross margin in the high teens will balance over time.
On our IR website we are making available additional information on the likely accounting for the HBDC buy-downs once the third and final agreement is signed. Looking forward and with the full impact of the buy-down accounting in effect, HBDC reported gross margin will be lower in 2013, and we'll give guidance on this on our January call.
Back to our guidance for the fourth quarter, and with regards to operating expenses, we expect an increase of $1 million to $2 million from Q3. We expect fourth quarter non-GAAP R&D of approximately $18 million, with the increase primarily driven by higher clinical trial expenses, including for our blood culture and flu CLIA-waived tests here in the US, for our HPV tests targeted for release next year outside the US, and for the portfolio of tests we're targeting for China and Japan.
We expect sales and marketing to increase about $1 million for higher commissions on higher commercial sales. We expect G&A to decline roughly $2 million due to lower litigation expenses. And finally, we expect collaborative profit sharing to move back to more typical levels consistent with the first two quarters of the year.
Moving to the bottom line, we expect fourth quarter GAAP net loss of $0.03 to $0.01 per share and non-GAAP net income of $0.10 to $0.12 per share. This would result in a full-year GAAP loss of $0.42 per share to $0.40 per share and a full-year non-GAAP net income of $0.21 per share to $0.23 per share. A reconciliation between the GAAP and non-GAAP guidance has been provided in our press release.
Looking to 2013, we will give formal full-year guidance as part of our fourth quarter and full-year 2012 earnings announcement in January.
I'll now turn the call back to John.
Thanks, Andy. While the last few quarters have been challenging, it does not change the strategic value proposition or vision of our business. There's hardly a day that goes by that we're not learning about real-life GeneXpert system stories, improving the hospital operating efficiencies, and more importantly, saving lives.
Operator, we'll now open the call to general Q&A.
Thank you. [Operator Instructions].
Our first question comes from Isaac Ro from Goldman Sachs.
Isaac Ro – Goldman Sachs
Thanks for taking the question. I wanted to put aside all the items that you mentioned on HBDC, thanks for the detail, and focus instead on the clinical business and specifically your visibility there on continued growth for the clinical business. Could you maybe address specifically what you're seeing in hospital spending patterns for new capital purchases among the hospitals that you don't yet have placements for on the equipment side? And then secondly, could you comment on the pricing dynamic on the reagent side, and specifically how you think that will flow through gross margin over the next few quarters as the rest of the business stabilizes?
Well, I think on the capital equipment side, it's consistent, Isaac, with what we saw in Q2, that capital continues to be available, but much more competitive as a result. You know, it's much more stringent relative to going through the process. In fact, I was just recently on a call with our US sales managers as a group talking specifically about the issue, and they're saying a continuation of same-same going out there, again, nothing unique to Cepheid but just general environment.
So the point being that with the systems and solutions group, we continue to need to press to make our case. We are winning those. You see that, although there was a step-down in Q3 relative to the total number of placements. And depending upon -- we do see some regional differences -- depending upon some regions, they're starting to be more interested in other acquisition modes. In other words, operating leases versus an out-and-out purchase type of a situation, although at the present time the bulk of our system placements continue to be out-and-out purchases.
Now on the reagent side of that situation, the ASP's competition is coming into the market. We have said before by way of example that on MRSA, where our ASPs continue at around $38 per test, we've seen people out there pricing well below the $25 price point. We continue to take the business. We've seen exactly the same thing, in fact even more aggressive than the C. diff area. We continue to take the business in the C. diff. So what we're seeing right now, as we look at it strategically, we're always conservative, we do plan for some impact, but we're seeing that our prices are holding up and we continue to be in good shape in that regard.
Now the one other item back to the capital markets, the items that we have right now coming up in front of us are some catalyst events, and specifically we're really viewing, and I'm viewing, the CT/NG as a game-changer. I mean, as I've indicated and I've shared previously, it turns out that not only do we want to match, we not only want to have very accurate test, but now it looks like we have the most accurate test. We released during the Analyst Day, it turns out, that our sample adequacy control is in fact giving indication of additional information there with the patients. We're going to be following up on that relative to clinical claims later on after the product is cleared on the market, but there's some additional opportunity there for that product. And we see that as driving additional catalysts for system placements.
So, right now, we already have a number of systems that have been placed in anticipation of getting the CT/NG. But once we have the CT/NG, I think that's also going to drive more placements out there and give us incremental leverage even in a tight capital environment.
Thank you. Our next question comes from Vamil Divan from Credit Suisse.
Vamil Divan – Credit Suisse
For taking my question. So I guess my question was more on just the timing of things over the last few weeks. You mentioned you came in pretty consistent with the preliminary announcement you made. At that point, the guidance that you gave for the full year remained what it had been. Now you're moving more to the lower end. I'm just trying to get a sense of what's changed because it looks like you have a little more of a backlog to get carried out by the middle of next month, and it seems like those system stuff shouldn't be impacted by any of that. So, just trying to get a better sense of kind of what the timing was and kind of what drove the change in guidance today versus a couple weeks ago.
Okay. Well, actually to be clear, the guidance versus what we've said even on the last call didn't change all that much. We actually indicated on the last call we expect it to be at the low area of the range, we indicated on that call, and that's what we are indicating today. In actuality, as you look at the pre-release that came out, at that point in time we had indicated we thought we'd have a back order situation in the $5 million range. That number actually moved up. We were seeing increasing demand on the products. So as you see now, we ended up closer to the $7 million level on the back order situation.
So what's developing right now is we're seeing fourth quarter tends to be stronger with regard to seasonality impact on capital placement. So we do expect to see a potential step-up there with a note of caution as Andy indicated in his prepared remarks going in there. We are seeing growing demand on the tests, as we indicated already. We're seeing growing demand not only in our established, you know, our MRSA and our C. diff products, but then significantly in our other commercial products out there. And one of the other items that's showing up strongly even though Europe is having tough economic times, particularly in southern Europe, we had very strong growth coming out of Europe, and I expect that growth to continue as we move into the fourth quarter.
Thank you. Our next question comes from Jeff Elliott from Robert. W. Baird.
Jeff Elliott – Robert W. Baird
Yeah, thanks for taking the question. Just wanted to follow-up on something you mentioned last quarter. I think then you had 24 of the HBDC instruments that you couldn't factor in at that time due to delivery timing. Did those instruments get recognized this quarter?
Yes. Although there are some others that didn't get recognized at the end of this quarter. Our arrangements with the NHLS in South Africa probably every quarter there'll be some that are deferred at the end of the quarter. Less so this quarter than last quarter, but yes, those were recognized.
So to give you a little bit of -- a little bit more clarity as to what's happening there, in addition to the regular program, we have a supplemental program that NHLS is requesting, and it's a good program for them, for install and service capability on the systems. So the systems when they're delivered over there go into a warehouse. It's their warehouse but we pick them up and then do the install of those systems. We actually don't recognize the revenue on the systems until we pick them up out of their warehouse even though we ship them in to their warehouse. So what Andy just described to you, the systems, the 24 systems that did not get recognized in Q2 did leave the warehouse, they were installed, we recognized that revenue this quarter. And then we had some systems that are in the warehouse that were not yet installed; those will get recognized in the fourth quarter.
Thank you. Bill Quirk is next from Piper Jaffray.
Dave Clair – Piper Jaffray
Yeah, hi. Good afternoon. It's actually Dave Clair in for Bill.
Dave Clair – Piper Jaffray
Hi. The question from me, I was just curious, what steps are you taking to keep your customers happy while your products are on allocation here? And how, you know, what steps are you taking to make sure that we don't have any more manufacturing issues in the near term or long term here?
Exactly, reasonable questions on both counts, Dave. So for the customers, we're very, very concerned and looking to take care of the customers. So as we indicated in our prepared remarks that has really taken substantial time from our sales reps, our marketing group, we also have a commercial operations team focused in that area to really go in and work with the allocation management programs, so that we, to the extent possible, really minimize the impact with the accounts.
That said, I'm sure if you got hold of some accounts out there, that there's some pretty frustrated people that are out in the market. I certainly don't blame them one bit in that regard. Because one of the things that's been an interesting observation, or not so interesting observation in this whole thing, the impact of the GeneXpert, as we've said all along, is significant because of the accuracy and the ease of use. And the analogy that I've used with our people internally here, it's like going from burning candles to getting electricity. And once you do that, you don't like it when the electricity goes back off. So we've had all these groups involved in managing the customers at this point in time.
Now with regard to where your question may go is that, are we losing any customers? We don't see that. I was talking to the managers, sales managers, I said, just recently. We have some frustrated customers. But certainly we're not losing any customers at this point in time. Going on to the second part of your question, and before I do that, I should also say we're also working with the customers. So where they get short loss of materials or something like that, requires them to do more quality assurance, we're providing them credit for against future purchases on materials to make up for those materials that they're using up or forced to use up for quality control of a new lot of material coming in.
Now on the future aspect, as we indicated, this was a problem on plastic parts. We have our arms around the causative issues there. Those are being addressed. In fact many of them are already, on the parts side, have been addressed. And one of the things that we're doing is we are in the process, as I mentioned, to buy one of our molders. We expect to be closing that right around the end of the year. We're already looking at leasing and moving them into a new larger facility to give them substantially more capacity to handle the molding of our parts. We've already approved the purchase of injection molding equipment to go in there.
So what this will do, it's going to give us vertical integration and a lot more direct control on, one, the production of the tools themselves that produce the parts; and two, the molding operations, have everything consistent, same-same, which will go a long ways toward helping us not have this kind of a situation in the future.
Now the other item, because one of the things I indicated during our Analyst Day, there are certain things that are not. As you look at our production today, we have parts, parts come in, the parts then go into an assembly operation and then a filling operation, if you will, on the robo line scenario. We have biologics that feed into that. The problem was related to the parts. We don't have issues on biologics and, frankly, production capacity relative to the robo throughput scenario.
And what we're doing right now is to stay ahead of that situation. We have and we'll be qualifying a second robo line here in Sunnyvale during the month of December and we are going to have that qualified by the end of the year. So, effective first of the year, first of January, we'll have -- we'll be doubling our robo capacity here in Sunnyvale. We have the robo now which is new this year for Sweden, and we're looking next year at moving forward a second robo line for Sweden next year. So the idea being, frankly, we want to be prepared, if for any reason we had a surge in demand, we want to be able to accommodate that, as well as just overall planned demand growth, and we're looking to staying of the curve. So those are all specific items that are underway there.
In addition, we are adding to our organization. I mean one of the key items, given our very, very rapid growth, we're now focused on organizational development very heavily and getting the right management in place and bench strength in place. And one of the key positions we're currently recruiting for is a head of overall manufacturing reporting to our Chief Operating Officer there. And so I'd expect to get that position filled and onboard early in the year. And this person will really go a long way I think in helping just generally on the manufacturing process management aspects.
Thank you. Our next question comes from Evan Lodes from JPMorgan.
Evan Lodes – JPMorgan
Thank you for taking my question. Thank you for the number on the number of accounts in Europe that have begun to adopt CT/NG. I'm curious what your views on how that may trend over time given that you're currently at about 3% of your install base of systems. And then as a follow-up to that, as you're thinking about the US rollout, what percentage of the install base might you think would be a reasonable to expect to adopt a test in the near term? Thank you.
Okay, Evan, without giving you some of the specific numbers, the key item I'd point to initially for Europe, remember we had 50 accounts come online pretty quickly in what is the vacation season for Europe. So I'd expect continued strong progression as we go now into everybody being back in full operation mode going forward.
Relative to the US, I think we had really good uptake. If you go back and track some of our history with C. diff, we did very well there. And we'll see how we do with CT/NG, but the interest level, as we've already indicated, is very high. Relative to the US we have placements already, anticipation of that. And one of the items I can tell you is that new competitive systems are coming on to the market at this point in time and reports I'm getting back is that we are already blocking new competitive systems with people looking to get the GeneXpert and thereby not going with competitive systems in the US marketplace.
Thank you. Our next question comes from Sung Ji Nam from Cantor. Pardon me, your line is open. If you have your phone on mute, can you un-mute your phone please?
Sung Ji Nam – Cantor Fitzgerald & Co.
I'm sorry, I was on mute. Thanks for taking the question. So, going back to CT/NG, obviously good traction in Europe. Was curious as to, do you have a sense of if there's a certain volume, even though you have a broad install base in the US, do you think that the earlier adoption could come from maybe some of the lower volume or labs with lower volume CT/NG, or do you think it's more likely with, you know, more to do with your installed base?
Your question is a good one. I think we've indicated with the installed base but also new ones coming in, some of these, yes, the early adopters will be some of the lower volume accounts. Now, that said, what we're starting to see in the US is some interest from what I would call mid-level to higher-level volume accounts in the US. So, Europe has started off clearly with much more of the lower volume accounts, and we're now starting to move toward the more mid-level volume areas of interest in the US. Even though we're not out of the gate yet, we're seeing growing interest beyond the low-volume accounts already.
Thank you. And our next question comes from Jon Wood from Jefferies.
Jon Wood – Jefferies & Co.
Thanks a lot. This is for Andy. Just looking at the mechanics of the guidance, it looks like you -- you talked about clinical systems being down 20% this year, right? So that -- it looks like you're expecting clinical systems down something like 40% in the fourth quarter. Am I doing that math right? And if so, why is that number so weak even given kind of the constrained capital environment you're looking at today?
Jon, the 20% was rounded, but we are seeing -- we had an extremely strong Q4 last year, so our current guidance does contemplate a few million dollars less clinical system revenue given the current CapEx environment in the USthan we had in Q4 of 2011 when commercial clinical systems was almost $16 million. So we're basically contemplating a strong Q4 when it comes to commercial reagents and solid systems revenue in the commercial market, however, down pretty substantially from -- by a few million dollars from what we had Q4 of 2011 when we had 88 placements in the US, for example.
Thank you. Our next question comes from Dan Arias from UBS.
Dan Arias – UBS
Thank you very much. On system placements, you guys have spoken about seeing the trend of having institutions buy excess capacity ahead of what they need now. Is that something that you think can continue as the CapEx environment gets tighter? Or are you seeing or do you expect to see some customers rein it in and buy the capacity that they need now simply because of price?
Yeah, I think that's a good question and I expect to see the customers rein it in there. But frankly, that's the bad news. The good news is it plays to our advantage because one of the things that we've spoken about quite a bit is you want to think about our systems like a molecular server cabinet. So what we're seeing is they'll still, for example, focus and get the right-size cabinet. So, a GX-16 cabinet or even an Infinity-48S or an 80 cabinet, but then populate the cabinet with the right number of modules for their particular needs at this point in time, which then, with the cabinet installed, makes it easy to add the incremental modules as they get additional capital going forward and it goes hand-in-hand with their overall demand.
Thank you. Our next question comes from Dan Leonard from Leerink Swann.
Dan Leonard – Leerink Swann
I'm just trying to better understand the trajectory of the commercial clinical business in 2012. I mean it looks like the HBDC business is going to beat your original expectation of 30% to 50% growth by a lot. The non-clinical business will beat your expectation coming into the year as well by a good margin. Yet we're at the bottom of the guidance. So is the delta all commercial CapEx or is there some change in trend on the commercial reagent business as well versus the expectation?
The delta is principally in the commercial clinical systems, and we're seeing commercial clinical reagents in the lower to mid 20s, which is solid growth, but it is in the commercial clinical systems primarily. We indicated we expect HBDC to do about $42 million this year. You're right.
And one of the things, Dan, though, as you look at that, I wouldn't, you know, the CT/NG is going to be a very interesting catalyst because what'll happen as we get into 2013, certainly what I'm expecting to see, is that's going to drive the additional demand or incremental demand relative to the reagents. But frankly, one of the other items is I think it'll be a catalyst even in the tight capital environment for systems as we get into next year. And one of the things we may likely see, it's been historically that the HAIs have been driving in the US our systems placement, we may now see that flip around a bit and the CT/NG drives systems placement, pulling through HAI clinical test revenue after the fact.
Thank you. Our next question comes from Brian Weinstein from William Blair.
Brian Weinstein – William Blair & Co.
All right. Thanks for taking the question. Related to the CapEx environment, you guys are obviously not closing some of the deals now, but I'm assuming that you're building a funnel of accounts that you're talking to. Can you kind of characterize what that funnel looks like? And then also what is going to cause, in your opinion, the CapEx environment to loosen up a bit? You had said originally that you thought that the election was one of the things that was maybe holding it up. But what's going to cause, in your opinion, the CapEx environment to maybe get a little bit better? Thanks.
Okay. So, yes, Brian, the funnel is looking pretty good. As we look at Q4 visa vie the seasonality that we're talking about, as we get into next year we'll talk more about that on the next call. But we have some catalyst events which are, like the CT/NG specifically, which are going to help in that regard.
Now to your question on what's going to help it loosen up, I think clearly on the call comments that we had previously, getting post-election, who's going to be in office, getting some clarity there with regard to the healthcare initiatives, which way is that going to go. One of the other items and some comments I heard just recently talking with the sales managers is some accounts being, as part of this whole thing, cautious on what will be compliance initiatives, that there's a litany of compliance initiatives being kicked off for the hospitals. So as they understand we work through those, get some clarity on the healthcare initiatives, who's going to be in office, I think that that's going to help to loosen things up and get things going more -- looking more like 2011 versus what we've seen this year.
And the only thing I'd add is more broadly, clearly, the broader US economy has been weakening as the year progressed and fears of a recession potentially going into next year. So those are, you know, we're currently I think seeing some impact in our customers of just the broader economy as well.
So, one of the comments I’d just give you there, because everyone's in the midst of, I guess we're still in the early part for our industry, but in the midst of earnings releases and we've been tracking along with everybody else. And while we're certainly not going to stand here and say this was our best report card, comparatively speaking on growth as I've seen some of the others, we're continuing to very, very substantially outgrow a number, well, in fact, everybody that I've seen so far out in the, certainly in the molecular field, and a number of others are everywhere from flat to negative. So, not positive like we're talking about, but negative.
Thank you. Our next question comes from Shaun Rodriguez from Cowen and Company.
Shaun Rodriguez – Cowen & Co.
Hi, thank you. Andy, I was wondering if you could provide a little more detail on gross margin. In Q1 you talked about your work to get the freight costs back down to a normalized level in the second half. So, first question being, did these start to materialize as expected? And additionally, could you break down the impact in Q3 of drivers beyond mix like the [GPLCs], the lower yields and scrap costs, and how you think about these when you build your Q4 gross margin guidance? Thank you.
Yes. So when you look at gross margin in the third quarter, basically the way to think about it is we actually spent more in manufacturing to produce less. So if we kept our manufacturing spend flat and we produced less than we did last quarter, and so as a result, the per unit cost was higher, basically because so much of our costs are fixed. We've got fixed overhead and we apply them to the units we produce. So the per unit costs went up because that fixed spend was over fewer units.
And then on top of that, we actually spent more this quarter as we tried to ship as much as we could of product out the door. So we ran 24/7 to get as many cartridges assembled as we could, had put in place more upfront testing of those cartridges, QA went on 24/7. So our costs also went up. So the challenges that we faced this quarter are what drove the commercial gross margin down from 61% last quarter and what we expected this quarter it to be, drove it from 61% down to a 57%, so 400 basis points. And that basically is close to about $3 million of margin impact. I mean that's basically the main factor.
Scrap, which was an item in the first quarter in freight, they were really not significant items this quarter. Scrap was basically only about 150K higher than last quarter when we had that 61% commercial margin. So it's really the challenges we face this quarter are what caused the margins variance. We're expecting some of those challenges to continue partially in the fourth quarter, which is why we are now guiding to that commercial gross margin being just over 60%. I believe last quarter we were guiding it into a couple of points higher than that.
Thank you. Our next question comes from Zarak Khurshid from Wedbush Securities.
Zarak Khurshid – Wedbush Securities
Hi, guys. Thanks for taking the question. So it seems like India has come on pretty strong lately after a relatively lackluster uptick initially. Can you just talk about kind of the penetration of that market, what are their key hurdles, and how you envision that opportunity evolving over the next couple of years? And also if you could just give us a sense on what you view as India's commitment to direct resistant TB detection, that'd be great. Thanks.
Okay, Zarak. Yeah. So India, yes, it has been coming on. We're still, given the size, I think that's probably where you're going, you know, very, very large market over there, major opportunity. I mean the comments we're hearing that the Indian government now is very, very serious about getting TB under control because now they're concerned with extreme drug resistant, not just drug resistant tuberculosis, so there's big factors there. We've all heard about the cases of totally resistant TB, and you certainly don't want to get that out anywhere in the world. So, big market opportunity, but early days.
India is a very complex market, as I'm sure you already know very well, and it's definitely, it's one of the BRICs country, so we're going to be working through there. You've got the HBDC aspect of that market, but then you've also got the commercial market. Then there's a blending there where you have HBDC patients treated within the commercial community.
So one of the items that we're going to be working on specifically for next year is, one, setting up a better sales and marketing infrastructure for India, in fact, for all of the emerging markets. We'll talk to you a lot more about that on the next call going forward as to how we're going to get at those markets and end up with I think a very interesting opportunity both on the HBDC side but importantly on the commercial side.
One of the major factors that I think is being lost in all of the discussion with HBDC and one of the concerns that I'm hearing is, wow, is Cepheid becoming a HBDC company? The answer to that is no, but what you are seeing is the impact of the quality of a test that can be developed using the GeneXpert and the impact that that is having worldwide. And what I think we're going to start seeing is reach back on that where it's opening doors in a number of these countries but it's going to open more aggressively the commercial doors along while we're moving aggressively with the HBDC markets on a go-forward basis. So we'll talk to you a lot more about that on the next call on how we're going to be going after not only India but, on a similar vein, I think you're going to be seeing activities in other markets around the world like Brazil by way of example.
Thank you. Our next question comes from Eric Criscuolo from Mizuho.
Eric Criscuolo – Mizuho Securities
Thanks for taking my question; just filling in for Peter. On the CapEx environment, I know that you have spoken about it being challenging for a while now as everyone in the space. But has it gotten -- did it get worse this quarter compared to last quarter or is it still kind of steady state and just down?
Compared to last quarter, I would say it's about steady state from where you are -- where you were last quarter. And it's just much more what we said, taking longer to make the case, getting much more stringent review within the institutions, and basically competing with electronic medical records initiatives and other initiatives within the institution versus diagnostic initiatives.
Thank you. Our next question comes from Vijay Kumar from ISI.
Vijay Kumar – ISI
Question. So I had a question on the backlog. How do you guys define backlog, you know, when you ship cartridges, so, how do we differentiate, is that coming from back order versus new demand? Thank you.
Vijay, I want to make sure you're clear. When we're talking about back orders, that is not our normal backlog. That's actually the unusual items that happened this quarter where we had orders that were there, the customers wanted them, and we couldn't ship them because we were out of product. We always have backlog because we have customers who are on standing orders where we ship a certain amount every month. That's not in this number.
Vijay Kumar – ISI
Got it. I guess when you ship the cartridge, I mean how do we know, like, I mean, that's coming from back order being fulfilled versus incremental new demand, I guess was the question?
Well, we track that within our customer operations group, but from a reporting standpoint there is no point on there. The idea is we should not be ending the quarter with back orders.
In fact, this is an anomalous situation for us; we haven't had that before. And that's clearly not a good thing, that's not where we want to be. So I don't want to be ending the quarter with back orders. The idea is we expect to have, and that's where we talked about rebuilding inventory because we carry an inventory buffer such that if we do have a surge in demand there, that's all contemplated in our production as production is planned. So, that's where we're looking in December, to start to build back that inventory buffer so that we do not have, even with a mild, you can always outstrip your buffer, but with a mild surge in demand that we don't have a "back order" situation.
And Vijay, you can tell by our guidance plus the statements John made. We're not expecting to be in a back order situation beyond the middle to late part of November. So that means as you look at Q4, we're expecting to have had shipped not just the demand for Q4 but also the back orders from Q3. And that's why our revenue guidance is for $94.2 million versus the $80 million we had this quarter.
Thank you. Our last question comes from David Ferreiro from Oppenheimer.
David Ferreiro – Oppenheimer
Given the updated delayed approvals on a number of products this year, what's driving your confidence in your expectations for CT/NG approval by yearend? And second, generally, if you were to step back after approval and look out I guess, one year after the launch of CT/NG in the US, would you view it as a successful launch in terms of testing market share? Thanks.
So, on the first part, I mean, our view of the FDA comes from extended experience and working with the FDA. As you go through the process, no surprise. I mean as you're going through working on a particular product, there are conversations that go on back and forth. So we have some visibility in that regard. Your point is well taken, I mean the FDA can take more time than what one anticipates. But based upon everything we're seeing at this point in time, we expect to have the clearance before the end of the year.
Now, relative to the second question, we'll talk more about those anticipations as we get to our call which we'll give, we'll talk about our plan and guidance for 2013, coming into that. The comment that I would leave you with there though is that we are already seeing momentum increasing with the CT/NG. We're seeing the level of interest increasing with the CT/NG even over that level of momentum and the enthusiasm that we were talking about on the last earnings call.
Thank you. I'm showing no further questions at this time. I would like to hand the conference back over for any closing remarks.
Thank you, [Sayid]. Today's webcast will be available for replay on our company's website shortly and will remain available for at least 90 days. If you have questions following today's call, please contact Cepheid Investor Relations at 408-400-8329. Thank you for your interest in Cepheid, and have a great afternoon.
Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect, and have a wonderful day.
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