Luminex Corporation
Q2 2013 Earnings Call Transcript

Published: 30 Jul 2013

[Operator:]

Good day, ladies and gentlemen, and welcome to the Luminex Corporation's Second Quarter 2013 Earnings Conference Call. My name is Jason and I'll be your operator for today. Today's call is being recorded. At this time, all participants are in a listen-only mode. Following the prepared remarks, there will be a question-and-answer session. (Operator Instructions) I would now like to turn the presentation over to Harriss Currie, Senior Vice President and Chief Financial Officer, for opening remarks. Please proceed, sir.

[Harriss T. Currie:]

Thanks Jason. Good afternoon and welcome to Luminex Corporation's conference call to review second quarter 2013 financial and operational results. Today, Pat Balthrop, our President and Chief Executive Officer; and I, will discuss these results that were released today after market close. In addition to the audio portion of our conference call, we have prepared a slide presentation that is on our website at www.luminexcorp.com and will be available for six months. I would remind everyone that certain statements made during the course of this presentation may not be purely historical and consequently may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements speak only as of the date hereof and are based on our current beliefs and expectations and are subject to known or unknown risks and uncertainties, some of which are beyond the Company's control that could cause actual results or plans to differ materially and adversely from those anticipated in the forward-looking statements. Factors that could cause or contribute to such differences are detailed in our Form 10-K for the year ended, December 31, 2012, and our quarterly reports on Form 10-Q for subsequent periods, filed with the Securities and Exchange Commission. We encourage you to review these documents and the cautionary language we have included at the beginning of the slide presentation we are presenting today. We undertake no obligation to update these forward-looking statements. Also, certain non-GAAP financial measures, as defined by SEC Regulation G, may be covered in this presentation. To the extent that any non-GAAP financial measures are covered, a presentation of and reconciliation to the most directly comparable GAAP financial measures will be included in this presentation and be available on our website in accordance with Regulation G. I'll now turn the call over to our President and CEO, Pat Balthrop.

[Patrick J. Balthrop:]

Thank you, Harriss. Welcome to our second quarter 2013 earnings call. In our prepared comments and presentation, I'll summarize the second quarter highlights, Harriss will then review the financial performance, and I'll conclude with a review of our 2013 priorities, after which we'll open the call for your questions. To begin, let's review a summary of the Luminex story and how our technology and business model is focusing on creating long-term growth and shareholder value. Luminex provides technology that enables a diverse group of customers the ability to find answers to their most difficult questions. Our platform offering incorporates the razor blade model where a customer purchases an instrument and then consumes an ongoing and future stream of high-margin items such as our proprietary tests. This model provides significant operating leverage as we expand the number of applications or tests that can be run on the system. This in turn creates a fast-growing continuous high-margin revenue stream for the Company. In order to serve this diverse group of customers, which spans from an academic research facility focused on targeted protein analysis to a hospital just setting up a molecular lab to a natural reference lab, we employ the corporate structure with two key segments that best serve these customers. The first segment we call the technology and strategic partnerships or TSP, a network of key strategic players in the life science market with which we signed long-term partnerships. The second segment in which we continue to invest heavily is our assays and related products segment. The Company has a number of initiatives that will contribute to current and future growth. These catalysts consist of unique and differentiated offerings designed to address unmet needs of our customer. These products will provide additional steam to our market position, particularly in molecular diagnostics. So let's review our highlights for the second quarter. We generated another solid performance in the quarter achieving total revenue growth of 12% over the prior year period, driven by 24% growth in assay sales and 266 multiplexing analyzers shipped, a figure that exceeded the high end of our quarterly expectation. Our assay growth in the second quarter reflects momentum in our core infectious disease and genetic testing franchises, both growing in the double digits with noteworthy contributions from our Gastrointestinal Pathogen Panel in the U.S. and our growing lab developed tests or LDT assay portfolio. This positive momentum in our assay segment is also a reflection of the progress made by our direct molecular diagnostic sales force which we initiated in January. We've been extremely pleased with the early results and positive customer feedback from this transition. However, in the second quarter, we and others in the molecular diagnostic market began seeing differences in the utilization of purchasing patterns of certain molecular assays, driven almost exclusively by the protracted administrative issues in the United States related to reimbursement of molecular diagnostic assays within the overall reimbursement system. These issues ranged from payors delaying the setting of a price for a new test code to payors processing claims but not having process payments for assays they have consistently paid for in the past. Unfortunately, the current situation lacks consistency and transparency across payors and regions making details and timing of a resolution difficult to predict. On our first quarter call, we acknowledged this situation and stated that we expected labs and payors to make progress resolving the problem. A number of our lab customers, both national and regional, have exerted significant effort and striving for resolution. Luminex, as a company and as a participant in industry organizations and coalitions, has also worked to resolve this problem, yet progress has been slow. I want to emphasise that these issues impact only a fraction of our total assay revenue. While the situation remains fluid, we feel it's prudent that investors focus for 2013 revenue forecast on the low end of our current revenue guidance range of $220 million to $230 million to account for this transient issue in the second half. Harriss will address this further in his section but I want to emphasise that I am confident that these issues ultimately will be resolved favorably. In June, we were pleased to see one of our fastest growing customers, Natural Molecular Testing Corporation, expand the use of our proprietary technologies by developing and commercializing a novel pharmacogenomic test. This new test called the Personalized Medicine Panel or PMP analyzes 42 clinically validated targets and is customizable to address the specific needs of this customer. We believe our platform provides significant advantages to Natural Molecular over alternatives and represents the prime example of the opportunity with our technologies and capabilities in the overall lab developed test market. Once the current reimbursement environment uncertainty is lifted, I'm optimistic about additional progress in this segment. I'll provide additional comments shortly. We also continue to make good progress in our commercialization efforts for our innovative Gastrointestinal Pathogen Panel in the U.S. Last quarter, we described how a significant percentage of early wins came from new adopters and this trend continued in the second quarter. To date, we have dozens of U.S. accounts, either live or in some stage of validation testing. We believe this early traction is due to high-volume labs recognizing the significant clinical benefit of this first-to-market molecular assay as well as our motivated direct sales effort. Lastly, we are pleased to renew our long-term partnership with EMD Millipore, a leader in the life science research market. This extension reflects the continued support and investment in our proprietary technology by our strategically important partners. Over the last few quarters, we've highlighted the overall size and significance of the lab developed test or LDT market, and that a lab's choice of platform depends on a number of parameters specific to that individual lab's needs such as breadth of test menu, technology reliability, system throughput, and capacity. We believe our well validated and highly flexible technologies offer molecular labs a unique solution that enables the customer to rapidly bring online a new diagnostic test while being able to handle increasing volumes once the assay is commercialized, and the recent announcement by Natural Molecular Testing Corporation reaffirms that view. Building on these advantages, we're excited that NMTC recently commercialized their Personalized Medicine Panel using Luminex technology. The PMP will provide clinically relevant information to the physician regarding how an individual patient may respond to various pharmacologic-based treatment regimens. In anticipation of questions regarding PMP's potential financial contributions to the second half of 2013 and how this correlates with our annual revenue guidance, I want to empathize that we are less than seven weeks in the commercialization with Natural Molecular who had inventory on hand from previous suppliers. Also, many molecular diagnostic labs, including Natural Molecular, have had challenges in 2013 due to the lagging overall reimbursement process by government agencies and other payors for tests classified into the newly implemented molecular diagnostic reimbursement codes. We have booked revenue from this customer, last year and through the second quarter, and we believe this reimbursement situation that I mentioned is temporary and that the opportunity for their panel is significant. We'll continue to monitor the situation before providing an additional update to investors regarding early ramp of PMP, but as of now, we're being cautious regarding the effect of this piece of business on our 2013 guidance. Moving to Slide 9, assay revenue was up 24% year-over-year in the quarter and our continued expectation for assay revenue is for a significant contribution to our future growth. So let's discuss our near term assay pipeline. In my previous comments, I mentioned the Company has ramped up its commercial efforts in the United States for the GPP, the Gastrointestinal Pathogen Panel, and our performance in the second quarter tracked in line with our internal expectations. We now have a fast-growing number of GPP customers and expect continued momentum in the second half of the year. For our newborn screening program and specifically our CE marked NeoPlex4 Assay, we remained in discussions with FDA and have little news to share. If and when there is progress on this front, we will keep you updated. I would remind you however that our 2013 revenue guidance factors little, if any, U.S. contribution in terms of revenue from this assay. Lastly, we continue to make good progress with our pharmacogenomic assay portfolio. In July, we received FDA clearance for an updated Cytochrome P450 2D6 assay and also announced the FDA submission of our 2C19 assay. Pharmacogenetics category represents a growth opportunity and our assays and technology are ideally suited for the high-volume labs where this testing is performed and we look forward to FDA clearance of 2C19 in the second half of the year. Moving to Slide 10, I'll provide a quick update our Sample-to-Answer system that we call Project ARIES. We remain on track with the overall development timeline. The alpha system has performed well in testing and feedback from early users has been very positive, with particular interest in this system's differentiated and automated LVT capability. We are demonstrating the system this week to current and future customers at the American Association of Clinical Chemistry Meeting in Houston. Assay menu development remains on track. We continue to plan for a portfolio of assays to accompany the commercialization of the system. As we approach commercialization, we'll provide more detail on our first wave of assays. For the investor community, keep in mind that we plan to provide a live demonstration of Project ARIES at the Association of Molecular Pathology Meeting in November. Additional details will follow as we get closer to that event. Now, I'll turn the call over to Harriss to review the financial data and afterwards I'll return to discuss our outlook for the rest of the year.

[Harriss T. Currie:]

Thanks Pat. Let's begin the financial review with a look at revenue. As Pat mentioned previously, total revenue for the second quarter grew by 12% over the prior year period. The growth was predominantly attributable to growth in our assay portfolio which grew by 24% for the quarter, growth in royalty revenue which grew by 11%, and 20% growth in other revenue which normalized after $1 million milestone payment in the first quarter. Assay growth was driven by solid performances by both our infectious disease and genetic product portfolios. Infectious disease assays grew over 20% compared to the prior year period while our genetic assay portfolio grew over 30%. Each segment benefited from our new products such as our GPP assay in the U.S. as well as from our LDT strategy. For the quarter, infectious disease sales comprised approximately 68% of total assay sales with genetic testing sales comprising the rest. This distribution is comparable to the second quarter of 2012. We sold a total of 266 multiplexing systems in the second quarter surpassing the 10,000 system milestone and finishing the quarter with cumulative shipments of multiplexing systems of 10,130. Of the 266 multiplexing systems placed in the second quarter, LX systems accounted for 129 units, we shipped 126 MAGPIX units and the remainder of our multiplexing shipments reflects MAP 3Ds. Also included in system revenue were sales of 13 automated punching systems from our Australian subsidiary. Consumable revenues grew 9% for the quarter, reflecting continued stabilization of purchase volumes from our largest customer. Here, we did experience some headwinds from our LSR focused partners. Based on feedback from them, we believe the second half of 2013 could experience stronger headwinds due to the impact on consumable utilization from tightening research budgets in the U.S. and in other select countries. There were 15 bulk purchases of consumables in the quarter totaling $8.9 million or 76% of the total, ranging from $101,000 to $4.3 million. Royalty revenues were up for the quarter by 11% representing total reported end user sales on xMAP technology of $109 million, an increase of 6% over the prior year. In the aggregate, our higher margin items, consumables, royalties, and assays, comprised 77% of current quarter revenue, a 2 percentage point increase from the concentration in the prior year, which factors a significant contributor to the more stable gross margin percentages we've displayed. Now, let's turn to the income statement. As discussed previously, revenues grew at 12% for the quarter. Gross margin for the quarter was 70%, marginally lower than the year ago period due to the mix of our higher margin items with a 100% margin royalty revenue decreasing as a percentage of total high margin revenue. We remain confident however in our ability to maintain gross margins in the 70% range through 2013. GAAP operating expenses increased 18% for the quarter. A couple of items of note with respect to the composition of our GAAP operating expenses for the current quarter are, R&D expenses were up 16% over the prior year period and represented 22% of revenue for the quarter. Included in R&D expenses for the quarter are approximately $2.3 million of costs associated with the development of the Project ARIES system and assays, the next-generation system for our MultiCode technology that were not present in prior-year results. We currently expect consolidated R&D expenditures for the full year 2013 to be closer to 20% of revenue based on our current revenue guidance range. SG&A costs were 39% of revenue. Of the components of SG&A, general administrative costs were up 11% year-over-year with sales and marketing constituting the bulk of the SG&A increase as a result of taking full control of our molecular diagnostics channel. In our comments today, we may reference certain non-GAAP operating measures, we believe that adjusting for certain items and the related tax reflects, reflects operating results that are more indicative of the Company's ongoing performance while improving comparability to prior periods, and as such may provide our investors an enhanced understanding of the Company's financial performance. For the second quarter, GAAP operating margin was 9%, a 4 percentage point decline from 2012 GAAP results, largely driven by increased R&D costs associated with Project ARIES and increased sales and marketing expenses. On a non-GAAP basis, the second quarter operating margin approached 17%, down from the prior-year percentage but inclusive of a significant amount of ARIES platform and assay development costs not present in the 2012 balance. The effective tax rate for the quarter was 28%. Our effective tax rate fluctuates depending on a host of factors such as the distribution of income across our global jurisdictions. We currently expect our effective tax rate for the year on a GAAP basis to be in the mid 30s. For the quarter, we generated GAAP net income of $3.7 million, or on a diluted basis $0.09 per share compared with income of $0.07 per share in the second quarter of 2012. On a non-GAAP basis, we generated net income of $7.2 million or $0.17 per diluted share, up $0.02 from the prior period. Now turning to our two core segments; we reflect to our operating segments, revenue of our technology and strategic partnership segment or TSP was up by 5% for the quarter, driven by a 13% increase in royalty revenue, slightly offset by declines in system revenue. GAAP operating profit of our technology and strategic partnership segment was a healthy 21% of revenue but did decrease by 4 percentage points from the prior-year period due to a modest decline in gross margin and an increase in TSP operating expenses driven by increased investment in marketing activities and cost increases resulting from recent facilities expansions. Revenue from our assays and related products segment or ARP was up 24%, driven by broad based growth among our infectious disease and genetic assay portfolios. GAAP operating loss of our ARP segment increased slightly driven by increased development costs associated with Project ARIES. We ended the quarter with $43 million in cash and investments, down $18 million from the March 31, 2013 balance. We'll discuss the components of the decline on the next slide. DSO on accounts receivable stood at 53 days at June 30 as compared to 55 days at December 31, 2012. As expected, receivables are returning towards what we believe is a sustainable range of 50 to 55 days. Inventory on hand at June 30, 2013 was approximately [2.25] (ph) of total inventory and is near our target range. This slide summarizes our second quarter cash and investment flow. We experienced strong operating cash flow adjusted for the effects of the excess tax benefits of employee stock awards, with offsets primarily for PP&E purchases and share repurchases under our Board approved plan. Overall, and as mentioned previously, we consumed approximately $18 million in cash and investments during the quarter. Year-to-date, we've expended approximately $14 million on our share repurchase plan and $7 million on the final settlement of our former molecular distribution agreements, both of not will repeat in the second half of the year as our repurchase plan is substantially complete and there are no additional molecular settlements. As a result of the expectations of positive operating cash flow for the second half and a modest windfall from the recent public announcement of the acquisition of Advanced Liquid Logic for which we held an ownership stake, we anticipate our cash and investment balance to be in excess of the beginning of the year balance by year end. Now on to 2013 revenue guidance. We are reaffirming our 2013 revenue guidance at a range of $220 million to $230 million. From a macro level perspective, we remain cautious about the life science research market and anticipate the current molecular diagnostic related reimbursement environment could tamper growth prospects in the second half of 2013. As Pat mentioned earlier, these reimbursement issues appear administrative in nature and should prove temporary, but nonetheless, we believe it's prudent to consider these in the context of our communicated guidance. While we manage the business for the long-term and ask investors to judge our performance over that period, we understand that quarterly performance is important. To address this issue, Slide 19 provides detail as to how our total revenue was distributed by quarter over the last four years. In 2013, we expect the quarterly revenue distribution that is similar to a more typical year and with the third quarter falling within the historical range. I'll now turn the call back over to Pat for some final comments.

[Patrick J. Balthrop:]

Looking ahead at the second half of 2013 and beyond, we remain focused on driving strong financial results through the execution of our strategic plan. We remain as excited about the opportunities in front of us as we are with the significant progress we've made during 2013. Within our proprietary assay portfolio, we're pleased with the momentum and early user feedback in the U.S. for our GPP assay and we continue to see excellent opportunities within our LDT strategy, as demonstrated by recent announcements. We continue to make good progress with our pipeline projects including Project ARIES, and on top of all that, we've implemented a direct molecular diagnostic sales force in order to serve our customers at the highest level that extend the Luminex message and brand even further. With all that said, we will continue to manage the business with an eye on our strong financial position and our responsibility to shareholders. This ends our formal comments. Jason, please open the line for questions.

[Operator:]

(Operator Instructions) Our first question comes from the line of Bill Quirk. Please proceed.

[David Clair:]

It's actually Dave Clair here for Bill. First question for me, I was hoping the reimbursement discussion that we had so far, are there any specific assays that seem to be feeling the impact more than others?

[Patrick J. Balthrop:]

Sure, so this may take a minute or two because I think it's important to kind of frame the issue appropriately. Reimbursement for molecular tests in the United States is a critical issue or all companies in our space as well as our customers. I won't rehash the landscape regarding what's happening with Medicare Part B, the actions of CMS, Medicaid, TRICARE, the role of the MACs, all that stuff that we've all been through. I know you've heard about all that, not just from us but also from large lab service providers including the publicly traded names. But it's important to keep in mind that every company is affected by the situation differently. In our case, here is the best way I can go about providing you an analysis. If you look at the two main categories of molecular assays that we have, they are categorized as genetic assays and infectious diseases. As Harriss mentioned, 68% of our revenue in the quarter was infectious disease assays and the other 32% were genetic assays. In the genetic assay category, that includes our CF assays and our pharmacogenomic assays such as our 2D6 assay and we also capture some lab developed test business within that genetic disease line, the way to think about that is, the vast majority of the tests in that category are performed on samples from outpatient patients who present at the physician's office or some other sub-acute location. The other portion is infectious disease which includes our RVP assays and GPP as well as some custom LDT products. Most of those assays, the infectious disease tests were performed on inpatients, most but not all are performed on inpatients, and the reimbursement for those tests is captured differently from the way it is for outpatients. The assays that have been most affected by the reimbursement uncertainty that we're experiencing have been those that are in the genetic disease category, the portion that's 32% of our revenue, and the reason is because those tests are reimbursed on an outpatient basis. So if we focus on that genetic disease outpatient area, our customers who buy CF assays as well as our PGx line, are the ones who've been experiencing most frustration with delays in reimbursement. But even within the genetic disease category, there are differences. There are no CF assays that are performed on Medicare patients obviously because most of those are for performing on women who are of child-bearing age, whereas the PGx assays are run on Medicare patients to a significant degree. And so it's important to note that – and also, it's important to note that as we've been told by our customers, that the claims that are being submitted are being processed but not paid. That's an important distinction because it's not that the claims are being rejected and it's not that they are being denied, but they're being processed but not yet paid because the prices for those reimbursement dollars, the prices haven't been set, so the reimbursement dollars haven't been flowing. So, it's affected our customers in a significant way and the situation continues to be a little cloudy. No one believes it's permanent in nature but more transient, which is I think what we probably referred to in our formal remarks, and then our customers are being appropriately cautious. I think if you were one of our customers, you would be reluctant to perform the testing when there's no cash flow, right. And so, for all those reasons, what I said in my formal remarks is that the situation affects a fraction of our business, genetic diseases which is 32% of our total, more so than infectious diseases, and within genetic disease, more PGx rather than CF, and any test that's performed on an outpatient basis rather than inpatient is more dramatically affected. And for all those reasons, you net this out, we're taking the appropriate amount of caution in our – as we look towards the second half of the year which is why you heard Harriss refer to pointing towards the bottom end of our guidance range. So, it's a very complicated question, but I think you would agree it affects different companies in different ways. The way to think about it in the case of Luminex is, we have 40% of our revenues that's in assays, within that 40% about two-thirds of that 40% is in infectious disease not dramatically affected, the remaining one-third of that 40% is in genetic diseases, and within that a portion of that genetic disease business is affected, primarily the PGx portion.

[David Clair:]

Okay, thank you very much for the answer there. It sounds like you're getting a little bit more cautious on the life science side of things too. Can you maybe give us some details what's behind the caution?

[Patrick J. Balthrop:]

I just think if you look at what you're hearing from other companies, big and small, those that operate in the life science research segment, we don't really have a dramatically different point of view. If you were to go back and refer to say Thermo Fisher's comments about what they're seeing in the life science research market, I would say, we concur. The portion of our business that appears to be most affected by that change is I would say the consumable forecast that we're seeing from our partners, and we expect, which is a little different than what we communicated last time, growth rates in kind of mid to high single-digits for consumables for the year and that's primarily for two reasons, one is, what our life science research partners are telling us regarding headwinds and overall market conditions, and then secondly, one of our partners that's not one of our top three is going through rationalization of their inventory after a transaction that they were part of which is new from 90 days ago. And so, the portion of our business that is most dramatically affected is the consumables for the reasons that I just mentioned. Over the longer term, however, we're very encouraged with the longer term trends, we're pleased with 266 instruments shipped, we're pleased with our royalty and the royalty revenue track record and trajectory, and the end-user sales that we're seeing overall. And so, the portion of our business that is most dramatically affected turns out to be consumables as it relates to the headwinds Harriss mentioned.

[David Clair:]

Okay, thank you very much.

[Operator:]

The next question comes from the line of Dan Arias. Please proceed.

[Dan Arias:]

Pat, on Natural Molecular, do you have a sense for whether we're going to be looking for a one-to-one replacement on existing systems, and I guess on the consumable side, are you able to give us some way to think about modeling what's upside there for you guys based on what's on their panel, I believe they had talked about 10 markers specifically, so I guess how are you looking at forecasting there?

[Patrick J. Balthrop:]

I'm sorry, Dan, were both parts of your question about Natural Molecular?

[Dan Arias:]

Yes.

[Patrick J. Balthrop:]

Okay. Well, the situation with Natural Molecular, as I mentioned in my formal remarks, we're six to seven weeks in, they had inventory on hand that they had purchases from their previous suppliers, and as they kind of map, look towards the second half of the year, they have a significant portion of their business that's Medicare patients, and so they're experiencing the same things that I mentioned regarding Medicare reimbursement that's making them somewhat cautious. And so as we look towards the second half of the year, we're assuming that the trajectory there is not going to be kind of a hockey stick in nature, it's going to be a more gradual increase. And so, it's difficult for me to be more specific regarding the numbers there but it's obviously something that we considered as we prepared our guidance for the second half.

[Dan Arias:]

Okay.

[Patrick J. Balthrop:]

Anything else I can add to that that…

[Dan Arias:]

I guess I'm trying to, much like others, gauge what we have coming in terms of revenue relative to the previous supplier and I guess it's being clouded by the reimbursement issue, but so you know I was just trying to get some forecasting comment in terms of the way in which they are going to be purchasing, and I guess to that effect, how much visibility do you have of their purchasing patterns, is that something that you think leaves open the possibilities of some volatility?

[Patrick J. Balthrop:]

We have a pretty decent idea about what they are forecasting I would say for the next 30 to 45 days at any moment in time. Of course if they were to provide that number, Dan, they would be making some assumptions about whether the reimbursement situation stays the same or gets better. If it gets better, then I think that there's obviously upside, and when I say, it gets better, it kind of returns to something that's remotely similar to what was in place during 2012. So if you look at the number that we're forecasting for the year, and a piece of that that's Natural Molecular, there's some Natural Molecular in there but it's not kind of a huge number. And I think it's – you also asked about the comparison versus the previous supplier. The thing to keep in mind is that Natural Molecular has been a customer of ours for some time including through 2012 for certain products and they were buying other products from other companies. And so, if you look at kind of apples-to-apples, it's not easy to do because what we're providing them is part of what we used to provide them and the other pieces what is new business to us, and so you wouldn't necessarily expect an exact comparison.

[Dan Arias:]

Okay, thanks. Maybe just to move to GPP, you spoke a little about U.S., any additional comments on Europe? And then maybe also saw a publication in JTM on GPP, possibly it's a public health monitoring tool, is that something that you think might be a tangible market opportunity?

[Patrick J. Balthrop:]

The answer to the second question is, yes, and a lot of the markers, the infectious agents in GPP are reportable. So for example, if you were running a hospital lab and you have a norovirus positive that you detect with GPP in United States, that's a reportable event within the public health context. And so the public health market is I would say tangential in nature but the public health market is also constrained in terms of their ability to adopt new technologies. The way we're thinking about it Dan is, the CF market has a tangential play in the public health market and the same is true with GPP but it's not going to be a significant driver in our view. The thing that's going to drive adoption here is going to be clinical adoption to aid a physician in making a differential diagnosis. Going back to the first part of your question about Europe, the take-home message I guess about GPP is that the product has been very well received overall as a particularly powerful tool, and especially in larger institutions with complex high risk cases. In the United States, things are going well, we're on track, as we mentioned, we have dozens of contracted customers. We're growing nicely in the EU, but frankly, we're behind our expectations. I actually spent some time in Western Europe myself to try to understand it directly. A lot of the issues there are ones that you're hearing I'm sure from other companies, the National Health Service appears in the U.K. [indiscernible] going through constant restructuring, and other large institutions in the Benelux countries and Germany and so on. The downside of penetrating these large institutions is that there's a lot of bureaucracy involved. We made some changes there regarding our commercial organization and our resources, we think that's going to help, but the experience we've had in the EU has frankly not been stellar and we think we've made the right management moves in order to fix that but it's going to take some time for that to get traction.

[Operator:]

Your next question comes from the line of Brian Weinstein. Please proceed.

[Brian Weinstein:]

Question about any kind of feedback that you guys were getting on ARIES at CVS and also at ASM when we were showing it there, and then also, any risks still in the development, what are the big milestones or the big hurdles that you guys still have in the development to that product at this point?

[Patrick J. Balthrop:]

I would say that feedback that we're getting, as I mentioned in my formal remarks, has been positive. The key messages we're hearing are particularly with the higher volume labs that were focusing on the ability to consolidate menu onto a single platform. The ability to configure this system for highly automated LDT methods is particularly attractive. I heard that when I was visiting customers in the EU this quarter and the various customers that I visited personally in the United States over the past four, five months have confirmed that. The key for us is, we believe is going to be to make sure that we have a substantial menu when we launch the product and we're on track for that. We do expect to enter the market in 2014, and so that hasn't changed. The significant milestones are ones that might be a little esoteric to you, Brian, but as you move from alpha to beta and you submit the assays and so on, that you just make sure that the assay performance is what you expect and the software interaction that the customer has with the system and with the software is what you expected. So, we are highly confident just because of the, A, our experience, and B, the feedback that we're getting. So I would just say, if anything changes, we'll let you know, but so far, it's a program that's on track per our expectation.

[Brian Weinstein:]

Great. And then second question is, are you guys still working with Advanced Liquid Logic and is there any kind of impact to that relationship given the acquisition by Illumina last week?

[Patrick J. Balthrop:]

Obviously, we were an early investor in ALL, Brian, as you already know. So we know the company and we know the technology well. Harriss mentioned during his remarks that we expect to book a gain in the third quarter as a result of the acquisition by Illumina. We continue to work with ALL primarily in our bio-defense area. We've always believed that the technology had potential and was suited for certain applications and I would say our bio-defense and library construction and life science research are two of those. We spent a better part of two years and significant effort understanding that technology and when we evaluated it, considering reliability and the diagnostic context based on discussions with various regulatory authorities, we thought the likelihood was not certain that the technology would end up being viable in in-vitro diagnostics context. That said, we look forward to continuing to work with the technology and work with Illumina. Obviously, we were involved in discussions prior to the transaction as a shareholder in the company and as we continue to execute our plans and take advantage of our license in the fields that we have, we're optimistic in those particular fields about our ongoing relationship with Illumina.

[Operator:]

The next question comes from the line of Zarak Khurshid. Please proceed.

[Zarak Khurshid:]

So I was wondering if you could provide some granularity on the transplantation side of the business, are things pretty much on track there and are you still anticipating an improvement in the back half?

[Patrick J. Balthrop:]

So transplantation within our partnership business, is that your question?

[Zarak Khurshid:]

That's right.

[Patrick J. Balthrop:]

So we have among our various partners, and we have many partners, we have two of them that are active in the transplant space. There's the One Lambda division of Thermo of course, and then Immucor who was not one of our largest partners but is a relatively new partner into the Company as a result of having of acquired the LIFECODES business from Gen- Probe. As we look towards the future, we're very confident in our position in transplant overall and the reason is because of the importance of multiplexing proteins and nucleic acids on the same platform, and one of the things that is a little understood about this particular segment is that over the past say five years, almost all the growth in that segment has come from immunology-based methods where the technologies like sequencing and so on cannot really compete very well. Of course, as you probably know, it's no use to sequence antibody genes because they are recombined in a unique way in every B cell. And so even if you knew the antibody sequences of every B cell in the body, it would still be impossible to use that information to infer anything about what the antibodies would buy into, which is why you need to use a traditional immunological based method which is where our technology comes in. So the only way to check for specific antibodies and what they do is to do antibody testing. So with all that said, there's been some transition from One Lambda as a private company, the Thermo has gone very well, and we continue to work very closely with them. The transition for the smaller of our transplant partners, which is Immucor, is a relatively new thing and we're continuing to work with them and they're kind of making some adjustments regarding how they're managing the portion -- Immucor is managing the portion of their total portfolio that is represented by LIFECODES and those are some of the comments I was making a little while ago. So, as we look towards the future, we continue to be very optimistic but it's important for us to make sure we work with our partners to deliver a differentiated product. We're very optimistic about the FLEXMAP 3D 500 plex capability system that we have, we think it has a significant role in HLA and transplant overall and our partners agree. So we have a very bright future there but it's going to continue – it's going to require for us to continue with the same level of diligence and coordination with our partners that we always have had.

[Zarak Khurshid:]

Got you, but kind of going back to last quarters and your commentary, it sounded like you were anticipating a healthy improvement in that business overall, is that still kind of the thinking for the back half?

[Patrick J. Balthrop:]

I'm not sure what you're referring to about what I said last quarter, so let me just tell you what truth is. When the transition was made from One Lambda being private to Thermo, we worked with both companies, but in this case particularly with Thermo, to ensure that transition went smoothly and we expect as a result of that there will be less volatility and more predictability in certain revenue items for Luminex, things like our quarterly consumables revenue, which as you may know could be dramatically affected by purchases, bulk purchases of consumables, our proprietary beads by a big partner like One Lambda was. To net it all out, if you look at royalties and end-user sales which are reported by our partners, on a year-to-date basis, year-over-year those two partners combined are up in the mid-teens. So we have no reason to believe that that trend won't continue based on what we know.

[Zarak Khurshid:]

Perfect, very helpful, thank you. And then lastly, on NMTC, just curious kind of what are the indications for that PMP task and could you give us a sense for sort of who are the doctors that are ordering that test?

[Patrick J. Balthrop:]

I don't want to turn into a physiology geek on you here and it will be dangerous it seems to me to do that I'm afraid, but as you know, there are a variety of compounds that are metabolized by the body based on certain pathways and in the pathways that the enzymes that are used to metabolize the drugs into their active ingredients exist primarily in the liver in this case. So, 2D6, 2C19, 3A4, 3A5, some of those other various markers are used primarily in cardiac drugs as well as pain meds and as well as in some psychiatric types of drugs. And so, I don't work for NMTC, I can only tell you what I understand and that is that they call on physicians to treat patients in those categories and others where the drug that is being prescribed is consistent with the pathway and then they can run the test on them and the physician can use that information about the genetic signature of each patient to help them with their dosing. So, is that helpful?

[Zarak Khurshid:]

Yes, very much. Thank you.

[Operator:]

The next question comes from the line of Brandon Couillard.

[Brandon Couillard:]

Harriss, just to turn back and looking at the P&L here, how should we think about operating expenses going into the second half of the year, particularly around R&D and then sales and marketing?

[Harriss T. Currie:]

So expectations around R&D as I mentioned earlier is that R&D will remain roughly flat, and as revenues grows, we expect to end the year with R&D expenses in the range of 20% of total revenue. Sales and marketing, which is a component of SG&A, for the most part has increased to where we expected with respect to the management of the molecular pipeline ourselves. There certainly could be modest incremental increases there but not a lot in G&A, as we said many times, over the course of the year, not relative to the prior year because we've incorporated costs associated with the integration ongoing work with some G&A component around the ARIES system, but G&A should be roughly flat for the rest of the year. So operating expenses on a sequential basis you wouldn't expect significant increases other than the R&D components potentially and some sales and marketing for the rest of the year, but as a percentage, operating profit as a percentage should improve for the remainder of the year.

[Brandon Couillard:]

And can you quantify the gain you anticipate from the Advanced Liquid Logic takeout and then perhaps an update around CapEx expectations for the year?

[Harriss T. Currie:]

As you may know, we had an investment of right around $4 million in Advanced Liquid Logic and you would expect in our third quarter results to see a gain on the disposition of those shares of just over $5 million, gain just over $5 million. So we netted just over $9 million in cash which is what we referred to and what I referred to in my comments rather.

[Brandon Couillard:]

Okay, and then the CapEx view?

[Harriss T. Currie:]

Yes, CapEx should really begin to settle in, less than we spent in the first half of the year. Again, significant amount of CapEx associated with getting our systems and infrastructure enabled to meet the demands of serving customers directly and for the most part the significant portion of those expenses are behind us.

[Operator:]

(Operator Instructions) Your next question comes from the line of Sean Rodriguez. Please proceed.

[Sean Rodriguez:]

I'm just trying to dig into the reimbursement commentary a bit more, guess I'm still having a hard time understanding how this would impact you so quickly as the test vendor, especially for cystic fibrosis? I guess in my mind, lower utilization suggests that physicians are ordering the test lesser or rather doing it less and it's hard to see how this would happen in CF as the guidelines are clearly pretty well-established and as most of that business runs through the big reference labs, it's just hard to see them slowing at all due to collection issues, so I guess more just an explanation of the disconnect or maybe it's really more a connection that you're suggesting between when they get paid and when you get paid?

[Patrick J. Balthrop:]

The first thing I would suggest is that you look at our fling, Sean, as you know already but just as a reminder, our single largest customer across with our Company is LabCorp. They are also the largest cystic fibrosis test performing lab in the country and in the world, and if you look back, last week it's a statement they made about this whole reimbursement situation. They highlighted cystic fibrosis as an area that is representing a headwind for them and frankly I want to speak with them but I think that they are a little bit confounded by that. For example, TRICARE, which as you know is the reimbursement authority for the military, had put CF on a no-pay list, and then after evaluation and discussion with LabCorp and others, they reversed that position for obvious reasons. And so how all that – that is just kind of one example, the private payors are also slowing down payments regarding certain categories, CF being one of those because in some cases, they don't have the prices set. It's not that they are not going to reimburse but they just don't have the prices set because they are waiting for the MACs to do that. And so, as we talk to our customers, one of the things that they are struggling with is the prospect of performing testing and not getting paid for an extended period and so that's affecting things like how they manage their purchasing patterns and so on. So if you're a little confused by the situation, frankly I think that puts you in the same boat with me and a lot of other people, but as far as how's that affecting customer behavior, I think that they're just being cautious regarding the tests they perform and the inventory they keep on hand and so on because of the uncertainty.

[Sean Rodriguez:]

Okay, that's really helpful, I appreciate that. So you're saying, in some cases it's more uncertainty, more of a collection issue on the part of LabCorp specifically in this example, but I guess the question again to be clear is, so this is leading to them perhaps just holding less inventory for those tests? I'm just again trying to make the connection between them and their collections and them not ordering tests from you as regularly.

[Patrick J. Balthrop:]

I apologize if I wasn't clear. I think I gave a rather long winded response to the first question I got which was about reimbursement. What I was trying to say was that this reimbursement thing situation affects a fraction of our business, and of the portion of 40% or so of our business that was in the assay category, roughly a third of that 40% is in the genetic disease category, and within genetic disease it's the PGx area that's more dramatically affected by this than the genetic disease area, but it's not to say that CF is unaffected and I'll just, as I said earlier, point you to LabCorp's public comments about that just as an example. I'm not speaking for LabCorp, I'm not trying to do anything other than to use that as a confirmation, if you will, of the frustration that customers are feeling here, but the part of our business that's most dramatically affected by this is the Medicare portion, and within the Medicare or within our assay portfolio, the portion of our assay portfolio that's most dramatically affected by the Medicare in one way or another is the pharmacogenomics portion. So that's the piece of our business that's most significantly affected regarding our growth rates and so on, less so than CF, but CF has been affected primarily because of the administrative [indiscernible].

[Sean Rodriguez:]

Okay understood, thank you. And an LDT question, I guess can you just walk us through the components of revenues to Luminex for an LDT, is there a royalty component here along with the consumables? And then I guess the related modeling question would be, where we can actually track LDT related revenue? I guess in my mind it's not a clear fit with assay revenues, but in your consumables line within the ARP, there's not much there, so really just understanding where it goes exactly.

[Patrick J. Balthrop:]

So we have a number of lab developed tests agreements in place and each one has its nuances, but the way to think about it is that we have a relationship with a customer who validates particular method using our technology, and when they perform a test, they pay us a fee, if you will, and that is captured within our assay group, and within the assay group, it's captured within whatever category it may fit. So, if it's an LDT for an infectious disease, a marker or a panel, then we would capture within the infectious disease area, if it's an assay or a panel that fits for say PGx or an inherited disease, it would go into the genetic disease category, but the customer – again, each one is a little bit different but a typical example would be that under the contract when they run a test, they pay us a set price if you will for that test when it's performed.

[Sean Rodriguez:]

Got it. Thanks very much, guys.

[Operator:]

The next question comes from the line of Dana Walker. Please proceed.

[Dana Walker:]

You talked about how your spending is increasing in your TSP segment, can you talk about some of the things that you are funding?

[Harriss T. Currie:]

We can't give you any specifics but we can tell you that we've had to expand our facilities to accommodate both increased production for our existing units, some increased production for Project ARIES, it obviously doesn't exist yet, they will ultimately fall in ARP, but because its existing production facilities had been allocated in the ARP, marketing activities, formation of our partner management group that previously didn't exist, it's in TSP. So there's a number of small components that collectively add up to increased TSP operating expenses.

[Dana Walker:]

Okay. Second question, if we think back to the EraGen transaction, do most of the revenues from Luminex Madison fall under the infectious disease realm?

[Patrick J. Balthrop:]

Yes.

[Dana Walker:]

So that line of your business and those relationships with, whether it would be LabCorp or others, is not meaningfully touched by this administrative/reimbursement malaise that's at work?

[Patrick J. Balthrop:]

Yes, I would say the – as I run down the list of our assay portfolio in my head, the portion of our business that's most dramatically affected by the malaise as you describe it is our genetic disease assay category which is primarily products that are designed, developed and manufactured in Toronto.

[Dana Walker:]

Question number three, as you talk about a moderation of expectation for bead demand in life science research in the near-term, is that solely a funding issue or is there in your judgment some type of a relevance issue where new platforms and/or new need is driving spend away from what you do?

[Patrick J. Balthrop:]

I don't think it's – no, I would say it's primarily just an indication of where our partners are telling us we should expect as it relates to their forecasting. If you look at the longer-term trends which remain encouraging, 17% royalty growth year-to-date as an example, a big portion of that is in life science research. The life science partners that we have, the two big ones which are EMD Millipore and Bio-Rad, have collectively increased their xMAP instrument placements 20% over 2012 – excuse me, in 2012 over 2011. They're maintaining that instrument placement pace for 2013. So all those things point towards I think a healthy overall life science research business, but of course if our partners moderate their purchases in the third and fourth quarter for those headwind reasons I mentioned, that could affect how that revenue is captured in a particular reporting period. So that's what we were referring to.

[Dana Walker:]

Final question relates to systems need an interest. Would you suggest that what we saw in Q2 is likely to be representative of the mix and the count of systems bought from this point forward or would you think this was an anomaly?

[Patrick J. Balthrop:]

We're not really changing our traditional 200 to 250 range that you've heard us talk about in the past. Obviously 266 is over 250, I get that. Regarding the mix, the LX 200 versus MAGPIX mix is one that we continue to pay close attention to, and the good news is that we and our partners as it relates to long-term contribution are ambivalent as to whether they place an LX 200 or a MAGPIX regarding how much revenue and overall profit that our customer would generate, but having the portfolio we think is a key strategic issue because it gives our partners and their sales people a fair amount of flexibility to tailor-make, it you will, an offering for a customer. So, to be candid, I think we expected more MAGPIXes year-to-date than pure LX 200 than we've seen, but the fact that it's happened isn't really an indication of a long-term trend one way or the other. We're pleased with how that's going. Now, I'm not prepared to say that we should expect over 250, greater than 250 instruments a quarter for the next two quarters, I think we just have to wait and see, but we're obviously pleased with the fact that under these conditions, we and our partners are doing a good job regarding placing instruments.

[Dana Walker:]

Very well, thank you.

[Patrick J. Balthrop:]

Okay, so since no more questions, I'll just close by saying thank you for attending our earnings call today and for your continued interest in Luminex. We look forward to another strong year and hopefully seeing you in person sometime between now and the end of 2013. Thank you very much.

[Operator:]

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect and have a great day.