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Q2 Results - Highlights Within the Numbers

|Includes: Precipio, Inc. (PRPO)
Transgenomic (NASDAQ:TBIO) reported financial results for the second quarter ending June 30, 2011 on August 11th. While both revenue and net income/EPS missed our estimates by a wide margin, there were some highlights within the numbers and further detail provided on the conference call indicated that at least some of this "miss" will be recognized during Q3. As such, we would not characterize Q2 results as disappointing. And while we have made some slight downward revisions to our model, our investment thesis, recommendation and long-term outlook for Transgenomic all remain largely unchanged.    
Q2 revenue of $7.67 million was about 14% lower than our $8.95 million estimate. While revenue was up $2.6 million (50.5%) from the $5.1 million generated in Q2 2010, all of this growth is due to the additional revenue from the FAMILION business (i.e. - comparable y-o-y growth was flat), which was acquired in December 2010. Q2 revenue was lower than management had anticipated earlier in the year - management noted on the call that at least a portion of the difference should be realized during Q3, however.
Ø        Laboratory Services revenue: Revenue from Laboratory Services, which includes TBIO's molecular reference lab (which also includes the acquired FAMILION tests) and the pharmacogenomics research lab, was $4.9 million, up 292% from $1.2 million in Q2 2010 but well below our $5.9 million estimate. While FAMILION, with $2.6 million in revenue in the current quarter, accounted for the majority of this growth, noteworthy is that organic growth was also very strong (+80%, +$992k) and mostly driven by the pharmacogenomics research lab - which is the expected long-term growth engine for TBIO. Pharmacogenomics revenue was up $690k (223%) y-o-y to $1.0 million - this was below management's $1.5 million guidance provided during the Q1 call due to delays in obtaining reagents to complete the remainder of the orders received. This ~$500k difference is part of the revenue "miss" relative to our estimate. 
FAMILION revenue also came in lighter than we had expected, although management indicated on the call that        this should firm up during the second half of the year and benefit from new product introductions. 
Ø        Instruments revenue:  Revenue from the Instruments business, which includes sales of proprietary and OEM molecular diagnostic instruments and related consumables, was $2.8 million, down 27% from $3.9 million in Q2 2010 and also well below our $3.3 million estimate. While bioconsumables revenue at $1.5 million (-10%, -$155k y-o-y) came in pretty much dead-on where we expected, instruments revenue, at $1.3 million, was very light (-41%, -$897k) and significantly lower than our $1.8 million estimate. Management explained on the call that 3 instrument orders that they had anticipated booking in Q2 were pushed back to Q3 - had these been recorded in Q2, instrument sales would have been slightly ahead of our estimate. We have adjusted our model to reflect these orders being booked in Q3.
Gross Margins
Gross margin came in strong in Q2 at 59.4%, significantly better than our 56.5% estimate as a result of very wide margin in the Laboratory Services business. Efficiencies and synergies gained as a result of the FAMILION acquisition and leveraging fixed costs over a bigger revenue base already appear to be paying dividends. This was another significant highlight in the quarterly results and it is especially noteworthy that the Pharmacogenomics margin (within the lab services) came in at a very healthy 63.4%. This is noteworthy as costs in TBIO's pharmacogenomics business are mostly fixed and due to historically minimal revenue generated in this segment, the business previously could barely eke out positive gross income. The relatively big spike in pharmacogenomics revenue in Q2 highlights just how scalable the business could be. As we noted in our initiation report on TBIO, we expect pharmacogenomics gross margins to continue to expand with growth in related revenue.
This, along with relatively beefy margins from the FAMILION business, should help offset the expected decline in instruments-related gross profit as a result of expected declining sales from that business. The net result should be TBIO's gross margin continuing to widen over the next several years.   
Operating Expenses
Operating expenses were $900k higher than our estimate ($6.2MM A vs. $5.3MM E) which largely reflects $756k in stock option expense which hit SG&A in the quarter.  
EPS came in at ($0.13) compared to our ($0.03) estimate. Roughly $0.075 of the difference is due to higher than modeled non-cash expense related to revaluation of embedded options in the outstanding preferred stock (i.e. - conversion option in the preferred stock gained value due to TBIO's common stock price increasing). The remainder of the "miss" in EPS is attributed to lower than modeled revenue (~ $0.01), higher than modeled operating expenses (~$0.03) and a slight offset by the better than expected gross margin.
Cash position remains very healthy. Transgenomic exited Q2 with $2.6 million in cash and equivalents, compared to $3.1 million at 3/31/2011. Cash flow from operations was $51k and $87k in the three and six month periods ending 6/30/2011. The ~$500k sequential decrease in the cash balance through the most recent quarter was due to $270k used for PP&E and patents (investing activities) and $340k payments on leases and loans (financing activities), partially offset by the operating cash flow and a small benefit from foreign exchange. 

We model 2011 revenue of $33.0 million, which implies growth of 65% from 2010 (or about 8% on an organic, ex-FAMILION, basis). We look for Laboratory Services and Instruments to generate revenue of $19.1 million and $13.9 million, respectively. We think EPS comes in at ($0.15) in 2011 or about ($0.08) if the preferred stock revaluation expense and QTDP grant income are eliminated.      
Laboratory Services
Our $19.1 million revenue estimate for Laboratory Services includes $15.1 million ($3.7MM ex-FAMILION) from the Clinical Lab segment and $4.0 million from Pharmacogenomics. We assume sales of the FAMILION tests, which are seasonally soft in 1H due to the reset of insurance deductibles at the beginning of the year, show consistent sequential growth over the remainder of 2011 but on an annual basis come in about 12% lower than 2010. We model revenue from Transgenomic's legacy clinical lab business, which posted 8% growth in 1H, to come in about flat for full year compared to 2010. Meanwhile, the pharmacogenomics business should experience strong growth throughout 2011 - we look for $4.0 million in revenue from this segment, implying growth of 194% from 2010.  

We model the equipment portion of Transgenomic's instrument business to fall 13% in 2011 to $7.2MM (average of ~ $1.8MM/qtr) but revenue from the consumables business to hold up much better due to new cancer kit launches. We model bioconsumables to fall only 1% in 2011 to $6.7MM.     
We are maintaining our Ouptperform rating and $4.00/share price target.

For a free copy of our full 24-page research report on Transgenomic, please email with TBIO as the subject

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.