Qiagen NV (NASDAQ:QGEN) Q2 2016 Earnings Conference Call July 29, 2016 9:30 AM ET
Peer Schatz - CEO
Roland Sackers - Chief Financial Officer
Dr. Sarah Fakih - Member of IR team
Vijay Kumar - Evercore ISI
Steve Beuchaw - Morgan Stanley
Scott Bardo - Berenberg
Doug Schenkel - Cowen and Company
Jack Meehan - Barclays
Brian Weinstein - William Blair
Isaac Ro - Goldman Sachs
Dan Arias - Citigroup
Bill Quirk - Piper Jaffray
Peter Welford - Jefferies
Jan Keppeler - HSBC
…..welcome to all of you for joining our conference call today, as well. Our speakers today are Peer Schatz, the Chief Executive Officer of QIAGEN, and Roland Sackers, the Chief Financial Officer. Also joining us today is Dr. Sarah Fakih, a member of our IR team.
On Slide 2 you'll see the customary Safe Harbor statement explaining that the discussion and responses to your questions on this call reflect management's views as of today, July 29, 2016. We will be making statements and providing responses to your questions that state our intentions, beliefs, expectations or predictions of the future, and these constitute forward-looking statements for the purpose of the Safe Harbor provisions. These statements involve risks and uncertainties that could cause actual results to differ materially from those projected.
QIAGEN disclaims any intention or obligation to revise any forward-looking statements. For more information please refer to our filings with the U.S. Securities and Exchange Commission. Also during the call we will be referring to certain financial measures not prepared in accordance with Generally Accepted Accounting Principles. You can find a reconciliation of these figures to GAAP in the press release and the presentation for this call.
I also have these quick points. First, we're providing a new level of disclosure with sales figures by customer class and regions and percentage changes at actual and CER rates. Historical data is available in the appendix to the presentation. Second, we are planning to hold an analyst and investor day in New York on Tuesday, November 15, which will be a few days after the annual Association for Molecular Pathology meeting in Charlotte. We will provide an update on the time and location for this meeting later in the quarter.
With that, I would like to now hand over to Peer.
Thank you, John. And I like to welcome all of you to this conference call. Our performance for the second quarter of 2016 shows the significant progress QIAGEN has been making to advance our position as a leader in molecular testing solutions. The results also confirm QIAGEN is at an important inflection point and is now setting a new sales growth trajectory. Let me go through our key messages.
First, we had a very strong performance in the second quarter. These results were actually ahead of our targets and this was due to the solid volume expansion across our life sciences and molecular diagnostics customer classes. Net sales rose 6% at constant exchange rates, which was ahead of our outlook of 4% constant exchange rate growth. Sales at actual rates rose 5% to $334 million, and this included 1 percentage point of currency headwinds. Adjusted diluted earnings per share were $0.24 at both actual and constant exchange rates and ahead of our target for $0.22, while free cash flow rose 75% to $78 million. Second, QIAGEN is at an important reflection point and setting a new sales growth trajectory.
As I just mentioned, the sales performance for the second quarter of 2016 was an important step up from the 2% constant exchange rate growth in the first quarter of this year. Most important, the 8% constant exchange rate and ex HPV underlying sales growth in the second quarter is comparable with our target growth rates for the second half of 2016, and this charts us on a solid trajectory to achieve our full-year sales growth target.
Our focus is also on achieving the full-year targets for higher adjusted EPS and to build on the sales acceleration while intensifying our focus on managing costs to improve operating leverage. Our growth drivers are leading this transformation. This portfolio now represents about 35% of sales and kept a double-digit constant exchange rate growth pace, and also supported the solid performances in all of our customer classes. The growth drivers included the QuantiFERON latent TB test growing above the 25% constant exchange rate annual target rate, along with ongoing strong placements of QIAsymphony automation systems and double-digit constant exchange rate growth related to QIAsymphony consumables. Keep in mind that about 40% of these QIAsymphony systems are also placed with life science and related customers.
We are also pleased to have completed the acquisition of Exiqon and have to have done this under the original offer terms. We have added a top player in the fast growing field of non-coding RNA, bringing in the synergistic portfolio in RNA analysis about bioinformatics fanatics that will make our offering even more compelling. The results and events of the second quarter give a demonstration of the progress QIAGEN has made over the last few years to transform this portfolio and develop an even stronger growth profile as a leader in molecular testing solutions. We have a unique competitive advantage in being able to leverage the vast majority of this portfolio across the continuum of customers in both the life sciences and molecular diagnostics area. This has taken a lot of hard work and effort, and it took about a year longer than we expected, but we are now moving ahead with a clear perspective for significant value creation.
Third, we have announced an increased commitment to return $300 million of capital to our shareholders by the end of 2017. Our intent is to significantly step up our returns beyond the announcement earlier this year for the fourth $100 million share repurchase program. This increased commitment is a result of our conviction that we are facing an attractive trend change and significant value creation at QIAGEN. Through the efforts of the last few years, we've created a very strong commercial portfolio and have a very attractive R&D pipeline.
We are intensifying our focus on translating these efforts into faster sales growth while managing costs to gaining more operational leverage. And as a final point, we are on track for higher sales and adjusted earnings. We have updated our targets following the acquisition of Exiqon and we now expect this acquisition to provide about $10 million of first time sales in the second half of this year, and to also have a neutral impact on adjusted EPS, followed by accretion in the second year.
As a result, we now expect net sales growth for the full year of about 6% to 7% on a constant exchange rate basis. This is based on adding the Exiqon contributions on top of the prior outlook for 6% constant exchange rate total sales growth we had announced in January 2016. That outlook was comprised of about 1 percentage point of growth from the acquisition of MO BIO in 2015 and about 5 percentage points from the rest of our portfolio. Keep in mind, this updated outlook continues to anticipate about 1 percentage point of headwinds for the full year from low U.S. HPV test sales, but this could round up to 2 percentage points. In any case, U.S. HPV test sales are expected to be about $30 million for 2016, and represent only 2% of sales.
I am now on Slide 5 and would like to put our sales performance into more context. The slide gives you an overview of the year-on-year trends over the last few quarters and years, and the changes are shown at constant exchange rates for the comparable prior periods. As I mentioned, the 6% constant exchange rate sales growth for the second quarter was the fastest rate over this period. Despite some slower trends in the second half of 2015, you see the momentum of our portfolio transformation, and this is reflected in the rising total CER sales growth rate. You also see how the headwind from the U.S. HPV test sales is fading, and this is reflected in the lines moving closer together.
In other words, our sales growth trajectory is moving into the higher single-digit range near term, and the expanding contributions of the growth drivers, improving market sentiment in the life sciences, support this trend. We are confident of achieving our full-year 2016 sales goals since the results for the first half show a distribution for 2016 of about 47% in the first half and about 53% now in the second half and this is a similar distribution to 2015.
I'm now on Slide 6, to update you on some of our achievements in the second quarter. Sample technologies is an incredibly strong franchise at QIAGEN and internal innovations and targeted acquisitions have further enhanced our leadership position. I will briefly touch on a few of our growth drivers, as well, and these include the QIAsymphony automation system, the QuantiFERON latent TB test, the personalized healthcare portfolio from molecular oncology testing, and our portfolio for next generation sequencing bioinformatics.
First, sample technologies continued to deliver solid single digit constant exchange rate growth in the second quarter of 2016 based on improving life science customer trends, and, in particular, higher sales of primary sample technologies. We are moving ahead with the integration of the mobile products with our own technologies to offer, an absolute market leader, even more differentiated solutions, to extract and purify DNA from the most difficult samples for the analysis of microbiomes. This is a very hot field of research.
Our personalized healthcare portfolio consists of three elements, which sum up to a total of about $110 million to $120 million of annual sales. The first involve sales of our therascreen and ipsogen companion diagnostic kit. And here we saw largely steady sales trends in the second quarter. The second involves the sale of related products, automation systems and OEM manufacturing of these products.
The third involves milestone revenues from co-development projects with pharma companies. This third component was about $35 million in 2015 at constant exchange rates. Although we continue to see a good increase in the number of projects, the milestone revenues continue to show volatility, and this was again the case in the second quarter when these revenues fell 15% to about $6 million at actual rates compared to the second order 2015. We are providing this new level of disclosure on co-development revenues to help you understand this volatility. As we've said before, the strategic value of these deals comes not from the milestone payments during development but from the revenues generated by the resulting assays.
Turning to the QIAsymphony automation system, we are moving ahead towards our goal for more than 1,750 cumulative placements by the end of this year, and that compares to more than 1,500 at the end of 2015.
I'm now on slide 7 to give you an update about the QuantiFERON latent TB test. We continued to see solid growth during the second quarter of 2016 above the 25% constant exchange rate growth we have set for this year, and even faster growth in the United States. We're starting to reap the benefits from the incremental investments into more sales and marketing resources and accelerating the conversion of a $1 billion total addressable market opportunity. We're also adding to the body of clinical data for QuantiFERON, in particular for the fourth-generation version that was launched late last year in Europe and other markets. About 20 independent investigator initiated studies are currently underway involving almost 30,000 patients to add to the strong evidence base to date. These new studies involved different TB testing groups such as healthcare worker screening, TB exposure contact tracing, co-testing in HIV patients, and required TB screening for students, employees and immigrants.
In regard to TB guidelines in the US, a final positive B rating from the US Preventative Services Task Force, or USPS TF, is expected this year. This will provide an opportunity to further position QuantiFERON as the modern solution for the primary care setting, and this includes students and back to school testing. I would also like to address the FDA warning letter related to QuantiFERON, which is an issue we are taking very seriously. The letter described among its findings deficiencies in procedures related to complaint handling, medical device reporting, and corrective and preventative actions.
These observations were made after the acquisition of Cellestis but while so operating under their quality system. We have reviewed our plans to correct the situation with FDA and have already taken many actions. These include having completed the transition of QuantiFERON to the QIAGEN quality system, and preventive measures are now in place to move even faster to get acquired companies into the system.
We have also insourced a significant share of QuantiFERON production into our FDA-approved German townsite from third-party suppliers. It is hard to predict when the issue will be resolved but it is important to note that QuantiFERON continues to be fully authorized for marketing in the U.S., Europe and around the world.
I am now on slide 8 to review a new wave of exciting life sciences product launches that have quite significant revenue potential in the coming years. We are creating new differentiated solutions that enable scientists to gain insights faster, better and more reliably in large and fast-growing research areas. As a first topic, liquid biopsy is obviously a big focus of our innovation efforts given the deep history of QIAGEN as a pioneer in this area. One of the new products is the PAXgene blood system for cell-free DNA. And we want to replicate the great successes we had with the PAXgene blood RNA and DNA systems, as well as the tissue RNA solutions.
The cell-free DNA solution is a breakthrough for customers involved in prenatal testing and cancer research. We have drawn upon our deep expertise to deliver an innovation that is essential but not easy to create, and that is to integrate the process for collecting a blood sample with the process to stabilize the cell-free DNA circulating in the blood in order to insure unbiased and targeted DNA purification. We view liquid biopsy sample technologies as a market opportunity well above $100 million at this time, and to be significantly higher as this technology evolves.
The second area involves digital next-generation sequencing. This is a unique technology developed by QIAGEN and we're using it to expand our QIAseq portfolio for next-generation sequencing across DNA, RNA and micro RNA. Digital NGS is clearly a differentiating technology that we can offer for use in many applications. And we also see here a market opportunity of more than $100 million.
The third area involves single cell analysis, which is also a very promising application for next-generation sequencing. QIAGEN has taken a strong position as a leader in helping researchers overcome challenges to improve our understanding of whole genomes and gene regulation from single cells. Challenges here are rooted in the limited amount of sample material and data that can currently be generated. We are launching new and completely PCR-free workflows for use with DNA and RNA that start with the cell and go through to the DNA library step for use on any NGS platform. These kits leverage a unique multiplication method and an efficient library construction technology to prepare highly accurate sequencing. And this is a big step for QIAGEN into another $100 million market opportunity.
I'm now on Slide 9 to give you a closer look at our new proprietary digital NGS technology, which aims to show you why we're excited about this innovative addition to our growing portfolio of QIAseq universal NGS panels. Industry experts confirm that the existing solutions for NGS panel design are far from perfect. The efficiency and effectiveness of the current workflows have been hampered by problems in the early workflow stages, such as the formation of PCR duplicates during amplification, and also general amplification bias due to non-uniform PCR reactions.
These key issues are addressed through the new proprietary molecular index technology. This technology was developed by QIAGEN and makes use of molecular indices that are attached to discrete DNA molecules during the initial target enrichment step. This means the indices can be recognized at a later stage and referenced to the original target DNA molecules, and the specific indices can be quantified with maximum high resolution power.
Accurate differentiation and quantification of specific DNA molecules is very important for many NGS applications, such as gene analysis, gene expression analysis, and variant analysis. This addition of digital sequencing based on molecular indices to the QIAseq portfolio provides our customers with a sample-to-insight technology package across DNA, RNA and micro for use on any sequencer. As a last and important point, we will transfer the molecular index technology to the GeneReader NGS system to further enhance the performance benefits of this workflow.
I am now on Slide 10 to review our progress in terms of commercialization and content development for the GeneReader NGS system, which is our complete sample-to-insight next-generation sequencing workflow. At the recent ASCO meeting in Chicago we added liquid biopsy as a sample type option for our QIAact actionable insights tumor panel, which is the first in a family of panels designed for use on the GeneReader system. This is the first targeted gene sequencing panel that can be used with either liquid biopsy or tissue samples. Also at ASCO we announced the formation of the Lung Cancer Expert Alliance. This is a consortium of world-leading pathologists and clinicians in the field of lung cancer who have joined together to guide and advise QIAGEN in the selection of content and design of new panels and workflows.
We appreciate this support since it will be highly valuable in developing the GeneReader sample-to-insight workflow and related solutions for use in lung cancer. The launch of GeneReader is progressing in Europe and the United States, and we have now expanded commercialization to the Asia-Pacific region. We have also expanded our roadmap for system improvements and more content. In addition to the previous announced plans for new content solutions related to breast and lung cancer, we intend to add new solutions to blood-based cancers in gene expression signatures. Furthermore, all of the upcoming panels will feature our new digital sequencing NGS technology. We are very pleased with the positive customer feedback on the GeneReader and we will keep you updated on our progress during this first year.
With that I would like to hand over to Roland.
Thank you, Peer. Good afternoon to everyone in Europe and good morning to those of you joining from the U.S.
I am Slide 11 to review our financial performance for the second quarter and first half of 2016, as well as our outlook for the third quarter and the full year. As Peer mentioned earlier, the results for the second quarter were actually ahead of our targets, and the performance of the first half of 2016 has strengthened our confidence in achieving the goals we have set for the full year. For the second quarter, net sales grew 6% at constant exchange rates, and this was faster than our target for 4% constant exchange rate growth due in particular to the high single-digit constant exchange rate growth in our three life science customer classes, especially pharma at 9% constant exchange rate, and applied testing at 10% after rebounding from a weaker trend in the first quarter. About 1 percentage point of total constant exchange rate growth came from the late 2015 acquisition of MO BIO, but the rest of the portfolio provided 5 percentage points. This was an important step up from the 1 percentage point of the year-on year organic growth seen in the first quarter of 2016. At actual rates, net sales rose US$334 million based on one point of currency headwind.
Moving down the income statement, adjusted operating income declined 12% in the second quarter. As we set out for this year, we plan for significant incremental investments during the first half to enhance our mid to long term growth prospects. This was expected to weigh on the adjusted operating income margin for the first half of 2016, which was 19% of sales compared to 24% in the first half of 2015, but we expect to see better year-on-year trends in the second half, by the full-year margin in 2016 to be at about the same level as 2015.
In line with our plan, the adjusted operating income margin was 21% of sales in the second quarter of 2016 compared to 25% for the same period in 2015. Also keep in mind that the results for the second quarter of 2016 was a sequential quarterly increase of 3 percentage points from the 18% adjusted operating income margin in the first quarter of the year. The adjusted gross margin was 70% of sales compared to 71% in the year-ago period. And we continue to anticipate a full-year margin at this level.
As anticipated, sales and marketing expenses were higher as a percentage of sales, and this was mainly for incremental investments such as adding sales representatives for QuantiFERON TB and in the life science market. Other areas have included some investments for GeneReader commercialization and regional expansion activities such as in Asia and the Middle East.
R&D investments were also higher as a percentage of sales, in part to accelerate content development for the GeneReader system and further expand our life science portfolio. General and administration costs were also slightly higher as a percentage of sales in the quarter, in part due to the higher cost to expand our digital capability.
You can see that we have reached an important inflection point for the sales growth projectory, and this has been supported by the incremental investments. Now we are shifting greater attention to normalizing the cost base in order to find more productivity gains in the coming quarters.
Moving further down the income statement, adjusted earnings per share were $0.24, and this was ahead of our target for $0.22 and reflects the contributions from top-line growth and cost management measures in the second quarter of 2016. The adjusted tax rate was 16% for the second quarter, in line with our target.
Moving to slide 12, I would like to provide you with an overview of the customer classes and their performances in the second quarter and the first half of 2016. As noted earlier, the acquisition of MO BIO in late 2015 supported underlying growth in all customer classes for the first half of the year. The Exiqon acquisition was completed on June 28 and the sales consolidation began as of July 1, so we will only see that contribution for the second half.
Our sales to academic customers in the second quarter of 2016 was 6% constant exchange rate growth on the back of marketing initiatives and new product launches. We have been adding specialists in the field to support our sales reps, and this came against a backlog of improving customer sentiment and the public funding levels in the US. We also saw better sentiment in Europe but customers were not as optimistic as in the US. We continue to expect an acceleration in demand in the second half of the year as more funding is released.
Pharma was clearly a bright spot, moving along at a dynamic 9% constant exchange rate pace in the second quarter against a very strong quarterly performance in 2015, and also achieving 8% constant exchange rate growth for the first half of 2016. Our sales reps are placing greater focus at this time when pharma and biotech companies are stepping up R&D investment. Here we saw double-digit constant exchange rate growth during the second quarter in instrument sales.
After a weak start into the year, applied testing sales rose 10% constant exchange rate and bounced back in the second quarter of 2016 with strong double-digit constant exchange rate growth in instrument sales. This customer class can be volatile and we continue to expect full-year growth at high single-digit constant exchange rates.
In molecular diagnostics, we also saw better trends with a 4% constant exchange rate sales gain in the second quarter, as our growth drivers, in particular the QuantiFERON TB test, the infectious disease portfolio, and QIAsymphony automation system consumables supported the underlying 8% constant exchange rate growth in this customer class that excludes US HPV sales. These results also absorbed lower revenues from core development project revenues for companion diagnostics.
I am now on Slide 13 to review our sales on a geographic basis. All regions delivered solid performances for the second quarter and the first half of the year. And we continue to generate rapid growth in the top seven emerging markets. This group of countries at 20% constant exchange rate growth in the second quarter and represented 16% of total sales. The Americas region had 3% constant exchange rate growth in the second quarter but reached a faster 6% constant exchange rate when excluding US HPV test sales, thanks to better trends among life science customers, particularly in the US, while and Mexico and Brazil also delivered growth.
In the U.S., the QuantiFERON latent TB test grew above the global 25% constant exchange rate pace, and underpinned better molecular diagnostics results. In the Europe, Middle East, Africa region, sales were 13% constant exchange rate in the second quarter and provided about one-third of sales. This region benefited from strong growth in molecular diagnostics, and this was across all our portfolio, with QuantiFERON TB, QIAsymphony and personal healthcare companion diagnostic kits.
Germany, the United Kingdom and Switzerland all delivered single-digit constant exchange rate growth, while Spain showed acceleration and Turkey again had double-digit constant exchange rate growth against weaker trends in Italy. Another catalyst for sales were from the expansion efforts we are making in the Middle East. Our ambition is to capture more opportunities that will be supported through a stronger [di-eg] presence through a new QIAGEN team in Dubai.
In the Asia-Pacific and Japan region we again saw two different trends during the second quarter. We saw another significant double-digit constant exchange rate sales drop in Japan, which faces ongoing micro-challenges, but we expect better trends in the second half of the year. At the same time the rest of the region grew about 15% constant exchange rate, led by China, maintaining a pace above 10% constant exchange rate growth in the second quarter. Solid performances also came from Australia, India, Singapore, and South Korea, and we are [from] our investment in these attractive markets.
Moving to Slide 14 I would like to give you an update on our balance sheet and cash flows. We are particularly pleased with the cash flow generation in the second quarter as free cash flow grew 75% to $108 million for the first half of the year. This was due to a significant improvement in drop in capital and a drop in the numbers of days of sales outstanding for our DSOs to below 70 for the quarter. These trends helped to support the increased commitment to return $300 million of capital to shareholders. In terms of liquidity and leverage, the net debt to adjusted EBITDA ratio remains favorable at 1.7 times. Even with a new capital return plan, we see the level remaining below three times net debt to adjusted EBITDA, and that is due to the strong cash flow generation from our business.
I'm now on Slide 15 for an update on the commitment to increase returns to shareholders. This is based on the more than $500 million of capital we have returned since 2012 through the purchase of our own shares and dilutive securities. This has included about $270 million returned to date through the three first share repurchase programs. We also removed about 5 million from the diluted share count, and also the overhand of an additional 5 million shares of dilution through the repurchase of convertible notes in 2015. The $300 million of returns incorporates the $100 million share repurchase that we announced in April 2016 and did not yet initiate due to the macro concerns, such as Brexit. The first tranche is expected to be $200 million and completed in early 2017, with remaining $100 million during next year. This is based on our conviction about the directive trend change and significant value creation opportunity at QIAGEN. Will keep you updated on our plans about the topic.
I am now on Slide 16 to review our net sales and adjusted EPS targets for the full year. In light of the Exiqon acquisition, we have updated this target to about 6% to 7% constant exchange rate for the full-year sales growth. This is based on adding about $10 million of first time sales from the Exiqon acquisition in the second half of the year of our prior year full-year guidance for about 6% constant exchange rate sales growth. Moving to adjusted EPS, our guidance remains for about $1.10 to $1.11 per share on the full-year basis for 2016. The Exiqon acquisition is expected to have a neutral impact on adjusted EPS in 2016. This outlook does not take into account any shares that could be repurchased in the second half of the year. As a last point, our guidance is based on constant exchange rates. However, we also provide estimates about potential currency impact. Based on rates as of July 1st, we now expect pressure of about 1 to 2 percentage points on the full-year constant exchange rate sales target and about $0.01 to $0.02 per share on the full-year adjusted EPS guidance at constant exchange rate.
Moving to Slide 17, I would like to provide some more details and assumptions for our outlook for the third quarter of 2016 and the full year. For the third quarter, our target is net sales growth of about 8% to 9% at constant exchange rates. This takes into account about 1 percentage points of headwind from declining U.S. HPV test sales, but also includes an estimated $5 million of incremental sales from Exiqon for the quarter.
And to reiterate my earlier point, we expect operating income margin for 2016 to be at a similar level as 2015. That is due to our plans for this year for costs to roll back to a more normalized level following the incremental investment we made in the first half of the year. For adjusted EPS, we have set a target for about $0.28 per share at constant exchange rates, and this compares to $0.27 in the third quarter of 2015. This slide also contains adjustment assumptions for the third quarter and the full year. The adjusted tax rate for the third quarter is expected to be 16%. No changes have been made to the full year adjusted tax rate of 16% to 17%. With that, I would like to hand back to Peer.
Thank you, Roland. I am now slide 18 for a summary before we move into Q&A. Let me review what we have announced. First, we had a solid performance in the second quarter, exceeding our targets for net sales and adjusted EPS, while also generating a 75% increase in free cash flow. Our sales results for the first half of 2016 present the same distribution of sales as they have for the first half of 2015. And we are also on the right path to achieving our adjusted EPS targets for the full year.
Second, our results for the second quarter show QIAGEN has reached an inflection point for a new sales growth trajectory, and we're determined to improve profitability as this momentum gains traction. We are moving ahead on initiatives to continue this acceleration.
Third, we have increased our commitment to now return $300 million of capital to shareholders. This reflects our conviction that we are facing an attractive trend change and significant value creation opportunity. And as a last point, we have updated our full-year 2016 guidance for the addition of Exiqon to our portfolio. We continue to expect a record year of net sales and adjusted earnings per share at constant exchange rates estrogen prepares for more growth and 2017 and the coming years. With that, I'd like to hand back to the operator for the Q&A session. Thank you.
[Operator Instructions] The first question comes from the line of Vijay Kumar of Evercore ISI. Please go ahead sir.
Hi, guys. Congrats on a nice quarter. Maybe one big picture question and one follow up on the financial piece. Peer, it looks like the language around GeneReader, it seems to be a lot more positive. If I just look for the last few quarters, every quarter I feel like you guys are coming in ahead of plan internally. That's what it feels like to us. I just wonder, what is driving that enthusiasm around GeneReader? And any comments, I know you have an ongoing IT dispute or any update on when we can get a resolution or what it means.
Sure. Our customers are seeing in the GeneReader sample to insight workflow, a truly differentiated solution. It differentiates in terms of the way the content has been designed, the way the system is integrated from sample to insight, with all components and reagents coming from one source.
this is embedded in a support and service system that allows customers to meet their highest demands in those regards. And a very attractive economic model, the price per insight model. As we can combine all these workflow elements, we can therefore offer the PPI -- price per insight-- model that is also being seen at customers as very attractive. We have seen this resonate very well with customers. And you have probably seen first customer statements out there and first presentations being made at conferences where this is also being reiterated by customers. We will see more of that going forward. We have prepared this very carefully and we are very diligently rolling this out, and the trajectory is very exciting and one that we will continue to comment on going forward.
In terms of the other topic that you mentioned, obviously next-generation sequencing is an area where a lot of intellectual property comes to play. There are many lawsuits in this space, as well. Obviously you are familiar with the lawsuits that resulted out of the Columbia lawsuits against Illumina that also now impacted us as a collateral. This is something, obviously, in an ongoing intellectual property lawsuit. We would not want to comment in a more detailed way. The date and the motions for preliminary injunctions are publicly available. But, remember, we are very confident about our position. And this litigation is also limited to the United States.
We have very proudly launched the system and are very confident about our position to market it very aggressively going forward and around the globe. And we're looking forward to report on this trajectory as we move forward.
The next question comes from the line of Steve Beuchaw of Morgan Stanley. Please go ahead.
Peer, as we reflect back on the quarter, you entered the quarter with a view that we should see steady progress throughout the year. It seems like what you saw here in the second quarter was a bit surprising on the positive side to you. So, I wonder, as you look at the matrix of products and execution, if you could spike out for us the one or two things that you thought in the quarter were the most material upside surprises.
And then for Roland, just a couple of clarifications, on Exiqon, the 10 million impact for the second half of the year was a little smaller than I might have expected. Can you walk us through how we get to the 10. And then any commentary on forward expectations for improvement in working capital would be really helpful. Thanks so much.
Thank you, Steve. I think to the first question, before I hand over to Roland, clearly over the last few years we focused very heavily on building a very exciting portfolio that included next-gen sequencing. We built up the QuantiFERON franchise and a lot of other things, in particular, as you now see, in the life sciences. We are moving through the pipeline and there is more to come.
Starting about a year ago, we significantly increased our efforts on commercialization of some of the existing growth drivers and also the infrastructure around the GeneReader launch. This clearly moved our operating expenses up as we were boosting the revenue trajectories.
In the second quarter we now saw that those revenue trajectories are building. We had projected them, we were planning cautiously, and they came in very well in the second quarter, and especially also with a very strong foundation for the second half of the year. This was one of the great highlights for us because, clearly now, we are focused on making sure that the operating expenditures as a percentage of sales are going to start seeing more operating leverage as that trajectory continues and we can go from boost mode to maintenance mode, admittedly at a high growth rate at the top line. So, this is probably one of the highlights I would point to in the second quarter. And we were cautious about that. We had been building it and planning it for quite some time, obviously, and this was part of our guidance early in the year. But to see that flow through is definitely something I would point to at this point. Roland?
Yes. Thanks. The two question -- Exiqon, the $10 million for the roll out, this was half and half in the third and fourth quarter. It might be a bit lower, as you have expected, because a significant part also of Exiqon business is actually a service business, like service businesses, and we are focusing on what again they are bringing to QIAGEN, especially around the product. And that is something which makes a difference. And have in mind what we are expecting for 2017 is actually double-digit constant exchange rate growth, also, from that business, so I think is impact around the service business. On the working capital side, we still expect a further improvement going forward. Clearly the 75% improvement in the second quarter, I think, was a very good indication on what is possible. DSO, I think being now below 70 days is a comfortable area. I would rather expect also, on the inventory side to see here some further improvement. We were clearly building up, as we talked about, some increased, additional inventory for certain product launches we did, but also for certain product tranches we did from site to site. I think we can now phase it down over the time, so that should have some impact, as well.
Your next question comes from Scott Bardo of Berenberg. Please go ahead.
First question just relates to some of the novel launches that you highlight for 2016, the digital NGS and some of the cell single analysis work, which look interesting. What I'm trying to understand, actually, is how reliant, so to say, are these new launches on the patent estate that is being questioned or under litigation. Are the potential growth contributions from these areas subject to the existing next generation sequencing biosynthesis, which you saw in this legal discussion of the moment? Or are these completely separate IPs that you will still be able to actually commercialize regardless of that outcome? That's a long winded question, number one, please. Question number two just relates to the companion diagnostics part of the business. I think I remember back three or four years ago this business growing very nicely, 15%, 20% plus. But the last couple of years, all of a sudden, the end of last year and this year -- has been a bit disappointing. And I appreciate there's some volatility in these milestone payments but that does not correlate necessarily with the success you have had there. So, can you give us some midterm outlook, the way you see this business growing? Has growth materially slowed or are we back to historic levels?
Sure. The first question, very easy answer. No dependency on any intellectual property that is currently under dispute. I would like to highlight, that is a very small area of intellectual property that is under dispute. So, it is not impact in any way, either on our revenue outlook or on new product introduction capabilities.
Number two is, the personalized healthcare franchise, again the companion diagnostic service revenues, which is basically a CRO and we disclosed the number now for last year was about $35 million in sales that we had last year. That comes from dozens of programs that we're doing with pharma companies, multiyear programs typically. As we are increasingly moving earlier into the pipeline we're getting more volatility on these milestones, meaning that there is more attribution. We have seen more attrition, actually, in the first half of the year. You probably saw a lot in the news, as well of programs that we are associated with. As companion diagnostics typically require, in most cases we are associated in some way or the other.
This is an area where we, in terms of revenue, are not really so focused on this being a contributor of profitability because it is profitable. We can match it with the expected expenses in a very short timeframe and have a full pipeline of projects. But going forward we would not expect that piece to grow materially. It will probably broaden in the portfolio, it might grow a little bit, but I wouldn't put a lot of strategic or value on that. It's valued at as a CRO basically and as risk mitigation that we ask for when we go into these partnership for pharma, as we're taking risk for their pharma drugs. Going forward, we're focused on the revenue from the kits. And that is, obviously if we believe in personalized medicine, which we clearly do, this is a very attractive area and we are seeing a pretty good pipeline. We might actually see first products come through later this year, certainly in 2017.
The next question is from Doug Schenkel of Cowen and Company. Please go ahead.
Okay, thank you very much. Good day, gentlemen. Peer, my first question is for you and it's on core sample prep. Commentary in your prepared remarks was a bit better than we have heard from you for a while. I think you talked about sample prep technologies growing at a solid single-digit pace in the quarter. I think it is fair to say that this has not grown a whole lot faster than low single digits over the last several quarters.
I am just wondering if you could talk about what your expectation is for the full year, and, maybe more importantly, how we should think about this significant portion of your portfolio in 2017 and beyond. You clearly have some very exciting growth drivers. That said, two-thirds of your revenue or so is still legacy products. If sample growth picks up, that could really move the needle, I think in a big way. So, I'm just wondering if you could comment on how you are thinking about that.
And then, sorry for the long one there, a quick second question for Roland. Keeping in mind the share repurchase program and the Exiqon deal, I just want to make sure that I heard you right when you said you expect net leverage to remain below 3 times through the end of 2017. I just want to make sure we have that right as we think about your appetite for additional potential strategic activity over the next one to two years. Thank you.
Sure. Sample technologies are an integral part of what we call the sample-to-insight experience that we give to customers. And we are increasingly seeing that being used in an integrated way, starting from a sample and then ultimately ending up with an insight that can be generated using our bioinformatics capabilities.
The sample technologies per se are a cross-section across all customer classes. I often see that misinterpreted as a pure life sciences area. That is definitely not the case. Our sample technologies are used in diagnostics and used in -- take, for instance, NIPT, where we have very strong positions in sample technologies. It is a smaller market segment but that is clearly a more clinical application where a sample technology solution is being used. We're getting growth. It was always a growing franchise. We have now over the last few years rejuvenated the portfolio, created a lot more products, similar to what we saw today with the sample technologies for cell-free DNA but also the microbiome technology single-cell sample technologies that are in areas that are getting a lot more research. Starting 2011, what we saw was basically a significant shift of the applications. If you go through the NIH grant profiles you will see that the shift was away from more traditional research into next-generation sequencing and clinical research. That is a shift that we followed and prepared. And some of the things you are seeing now is the fruit of these initiatives that we created as the shift became more and more visible. It actually happened very quickly and you see that also in the growth profiles of some of the other companies in this space. We are well-positioned with a nice portfolio now, focusing on clinical applications and even traditional product, what you call legacy product. They are very often improved with new protocols and new white papers that provide now capabilities and proof of principle, or validity, even, for some of these newer fast-growing segments. Roland?
Yes. The question on [indiscernible] I think what we said, what you got right in terms of ratios on adjusted EBITDA. But I think what is important for us, I think is an extension of our commitment that we allocate our profitability fairly between the return to shareholders and at the same time keeping flexibility also for bolt-on acquisitions for QIAGEN. I think looking forward now, on the basis of Q2 is I actually feel very comfortable that now in 2016 and also especially in 2017 our profitability, also cash flow generation, goes in the right way. And we will give you more insight on that probably on our analysis day. That is something which we do believe, this is $300 million we have, we are doing exactly that, giving us allocation on keeping the flexibility where, at the same time, stepping up returns to shareholders.
Next question comes from the line of Jack Meehan from Barclays.
I have two questions on QuantiFERON. Could you just give us an update, timeline, which you anticipate for warning letter in ideation? Do you believe the issues have been addressed with the new manufacturing in-house and the quality systems? And then, just as you look through your end in the U.S., what are some of the puts and takes on the growth rate with the salesforce and the USPS DS decision? Thank you.
Sure. First of all, we are taking this very seriously. I would like to point out that we have not received a FDA warning letter in the last at least decade in this space and FDA issues about 100 a year to this industry. That said, that was under the QIAGEN quality system. As we are now moving over the QuantiFERON portfolio to the QIAGEN quality system, as that has now happened, we feel a lot better about that. Nonetheless, we're working very diligently to also deliver the respective requirements. We believe that this will be concluded at some point possibly later this year. But, remember, very often these processes don't have an official closing. But we think we are on a good path and we have all of the resources on it to make that happen as quickly as possible.
In terms of the QuantiFERON commercialization, you clearly see that customers are very excited about this product. And we have seen growth rates spike actually considerably, in particular in North America. This is also where we significantly increased the commercialization efforts are putting this in a more long term trajectory. Remember, when customers adopted these technologies, they typically try and adopt it at a certain run rate, and then the standards are validated within such an institution, you get into a more long term growth rate. And this is something we're starting to see now with the first institutions and moving it forward as aggressively as possible. The trajectory is very exciting for QuantiFERON around the world, I have to say, also based on some of the new evidences that we were able to demonstrate in scientific publications.
The next question comes from the line of Brian Weinstein of William Blair. Please go ahead sir.
You had some upside that developed this quarter but you left the total range the same, outside of actually first. So, can you talk about, was there anything that was pulled forward a little bit in the quarter? Is there a different outlook somewhere or are you just being conservative? And then a second question financially is, at what point of CER for you guys do we really start to see leverage? Is it a consistent 7%? Is it 8%? I think it used to be 5%, 6% but we haven't seen that leverage yet. At what point of CER do we really start seeing some leverage?
The question, if we look at 2016, it is really slowly where we want to deliver on the full-year numbers. This is why we keep on pointing to the full-year targets that we set. They are the same that we set at the beginning of the year, the same that we reiterated at the end of the first quarter, and we are continuing on this path. We were able to show that the path is a doable path. 47% of revenues came in, in the first half of 2016 comparable to what we had in the first half of 2015. So, from that perspective, our focus is really on the end of year number, and this is why we are maintaining that focus also in terms of our guidance at this point. Roland, do you want to take the second?
Yes. The second is actually an easy answer. You will see that in the third and fourth quarter already. As I said, we clearly were very straight earlier this year when we gave also guidance for 2016 as we said that we had incremental, on what we wanted to do incremental investments the first part of the year. That is done and we have seen the impact of that already quite early now already in the second quarter.
At the same time, now, we are expecting leverage to come back to that inflection point on profitability, and going to start most likely in the third quarter on the move from there. The margin side, I think we gave a clear indication of what we said before. But you will see the sequential improvement coming up.
Next question comes from line of Isaac Ro of Goldman Sachs. Please go ahead.
Hi, guys. Thank you. You didn't spend a lot of time in the prepared remarks on informatics, bioinformatics. I was just curious what the growth was in that business this quarter and in the outlook for the back half.
Sure. Obviously we wanted to focus on a few of the other things, as a lot happened in some of the other portfolios. We did have some interesting launches in RNAseq in the second quarter. This is a very important area of research and also increasingly clinical use. In this franchise our focus this year is on the QIAGEN Clinical Insight's rollout. We are seeing very good adoption and some also great expansions in terms of networks that originally adopted this technology. What we are currently focusing on is the integration of that into GeneReader and sample to insight workflows. So, that business, which, as you remember, is somewhere in the range of 4% of our sales, is developed on plan in the first half of the quarter, and we have a solid outlook.
The next question comes from Dan Arias from Citigroup. Please go ahead.
Thanks for the question. Roland, maybe just clarifying on your OpEx comments, what percentage of the incremental investments that you're making for the year were made in the first half? It sounds like it's a vast majority but it would be great to put a number around. And then if we think about the profitability step up in the back half, do you see margins being relatively similar in 3Q and 4Q, or do you think we should think more about a sequential ramping for the end of the year?
You will see also a ramping over the quarter of year, so I would probably, again, if you look on the guidance and what we said for the third quarter, that probably converts in an adjusted EBITDA margin around 24 for the third quarter and probably going up to the 30 percentage ratio for the fourth quarter. And that is clearly the way we look at it right now. And on the cost side, as we said, the incremental costs we launched was heavily loaded, as you said, in the first two quarters. The larger part of them will just not re-occur on launch events we had on internal trainings, we had certain things which in that regard will not re-occur in that magnitude given all the launches, for example, we had end of last year, earlier this year. So, you will see that absolute dollar cost for certain operation expenses will even decrease in the third and the fourth quarter. And if you just do the calculation on more or less taking the expected revenue growth in the third and fourth quarter, a slight improvement, as we indicated, on the gross margin side, and put in a slight reduction, even just a slight reduction operational expenses, you will see that EPS is falling nicely through.
Next questions from the line of Bill Quirk of Piper Jaffray. Please go ahead.
Great. Thanks, good afternoon. Two questions. First off, I would love to hear your thoughts around Japan and specific to the academic and pharma side of the business. And then, secondly, on QuantiFERON -- what is the status of the U.S. federal penal system? I know they were looking at IGRAs as a potential alternative to the skin test. Thank you
Sure. The second question -- definitely the correctional system was an area of prime target of ours that we talked about a few conference calls back. That remains a very attractive area for us. We have been able to penetrate that area in many different institutions and we are seeing a very good uptake of this technology, interestingly enough, because you can test for latent tuberculosis when you have suspects coming in or convicts coming in. And they are, interestingly enough, moved around in the system very quickly thereafter. So, having a test that you can actually do on the same day in a few hours is a big advantage over having to go back to the person two days later to do an inspection. So, from that perspective we are seeing quite a good uptick.
And the first question was -- again?
The first question was just to comment on Japan with specific to the academic and pharma markets.
Japan -- thanks for pointing this one out, though -- is, indeed, an extremely difficult market at the moment, and one where most industry players are seeing a significant decline, even, in their business. We saw about also in the second quarter. There is an outlook for that to improve over the next 12 to 18 months. We think we have put this on a better footing, now that we have found somewhat of a floor in the second quarter. But the industry is still very wobbly. Despite all these stimulus packages and everything that was talked about, it remains a very difficult market. A lot of these stimuli did not really go into areas that had direct implications for molecular biology, or at least the research of the clinical applications that we are working on.
We are seeing some light at the end of the tunnel based on country-specific and company-specific activities that we did. But it remains a market that is definitely dilutive to growth, top-line growth, probably for the course of this year.
Next question comes from the line of Peter Welford of Jefferies.
Thanks for taking my question. It's actually on the capital return program. I wonder if you could outline whether you specifically cited that the extra $200 million will be returned as a share buyback, or are there other options also on the cards, either potentially a Dutch auction tender process, or even a special dividend or other process? Or is this very definitely a share buyback program that will be executed in a similar manner.
And then, secondly, as a follow-up to that, also I was wondering what was it that particularly drove this decision now/ Perhaps you can comment on what you're seeing now in the M&A landscape at the moment in terms of deal values, valuations and your feeling on how that's panning out at present. Thank you.
To answer the second part of your question first, I don't think it has to do with anything what you see right now, the landscape on valuation, on targets available or not. I think it just fully to do with that we are seeing a significant step up for us in the second quarter in cash flow generation, giving us confidence for the second part of the year and also for 2017.
Again, we are giving you more insights on our analyst day around that. And therefore we saw it the right time to stick to our commitment, what we have given earlier, which as I said, is also a allocation part within our profitability. And that is exactly what we are doing here. So, we think it has been also our obligation to say that we are going to again give $300 million incremental back then to our shareholders for the end of 2017. We have not decided yet exactly how we want to do it. As you know, under Dutch law there is a certain, different opportunities, there's different limitation, so we have to regular onset. We clearly do have a preference around share buyback right now.
To the first part of the question, Peter, we believe that we have a lot of things organically currently that are very exciting. We did two acquisitions, one in the life science area. Actually the last two years there were four acquisitions in this space. The pipeline is really good internally organically. And in addition to that we filled a few very nice additional pieces in. Our focus is really on executing and pulling that through into also operating leverage going forward and that remains the focus. Definitely there are always attractive opportunities out there, but if you look at the trajectory over the last few years, it has typically been in the sub $100 million space. The Company continues to have firepower to do these types of transactions but we are definitely more focused now on organic execution on the portfolio that we have.
The last question comes from Jan Keppeler of HSBC. Please go ahead sir.
Only a quick question on the QuantiFERON business. I think the last time we have touched on the topic of potential additional competition for this franchise. You mentioned that you do not have any indication that someone is currently working on anything competitive, which basically means then that any potential market entry is built on what longer down the road, maybe a couple of years. I think I am just looking for a confirmation of that. Is this still the case or has changed anything in the meanwhile, given the increasingly attractive market?
I think latent TB testing is, indeed, a very attractive market. And certainly other technologies are being looked at to be able to identify, for instance, gene signatures or other patterns that could be related to latent TB testing. But for screening assays, it takes a very long time to validate these things and there is just phenomenal data on QuantiFERON, looking at the data points that we have. And it is just a very slick and very cost effective and efficient assay that we have. Therefore, I think there are a lot of benefits that customers see in our product that make this one that is very competitive in the long term. Yet, we are in a high technology space. We are definitely also monitoring other areas and looking at other approaches to this and adjacent assays, and building the overall QuantiFERON related franchise in addition to just focusing on TB.
Peer, thank you very much. Also to Roland and all of you for your participation today. I would like to close this conference call and wish you all the best for the weekend. If you have any questions or comments please do not hesitate to give Sarah and me a call. Thank you very much.
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