NeoGenomics, Inc. (NEO) Q3 2012 Earnings Report, Transcript and Summary

Good morning. My name is Melissa, and I will be your conference operator today. At this time, I would like to welcome everyone to the NeoGenomics Third Quarter 2012 Financial Results Conference Call. [Operator Instructions] Thank you. Mr. Doug VanOort, Chairman and Chief Executive Officer, you may begin your conference.

Thank you, Melissa, and good morning. I'd like to welcome everyone to the Neogenomics' Third Quarter 2012 Conference Call and introduce you to the NeoGenomics team that's here with me today. Joining me this morning are Steve Jones, our Executive Vice President for Finance; and George Cardoza, our Chief Financial Officer. In addition, Dr. Maher Albitar, our Chief Medical Officer, is joining us from our Irvine, California office by phone. Before we begin our prepared remarks, Steve will read the standard language about forward-looking statements.

This conference call may contain forward-looking statements, which represent our current expectations and beliefs about our operations, performance, financial condition and growth opportunities. Any statements made on this call that are not statements of historical fact are forward-looking statements. These statements, by their nature, involve substantial risks and uncertainties, certain of which are beyond our control. Should one or more of these risks or uncertainties materialize or should the underlying assumptions prove incorrect, actual outcomes and results could differ materially from those indicated in the forward-looking statements. Any forward-looking statement speaks only as of today, and we undertake no obligation to update any such statements to reflect events or circumstances after today.

Okay. Thanks, Steve. I'll begin our call today with some remarks about our results for the third quarter, including an update on the key initiatives we are executing to drive growth and profitability. I'll then turn the meeting back over to Steve to discuss our financial results in more detail. Quarter 3 was a tale of 2 cities. The first is a tale about Washington D.C., where the decades-old practice of billing Medicare for the technical component of certain hospital testing was changed, effective July 1. This expiration of the TC Grandfather Clause, which we have described at length in previous quarterly investor calls, reduced Neogenomics' revenue and profit by approximately $1.3 million in the quarter. Although the impact of the TC Grandfather Clause was at the higher end of our estimated range, I am personally relieved that this massive change and disruption to our business is now behind us. Steve will provide a full recap of the change and the impact to our company in a few minutes. The other story is about the core business of NeoGenomics, where our revenue -- our volume grew by 42%. Our sales pipeline is healthy. Our service levels are strong. Our new product portfolio and plans are excellent. Our cost reduction and productivity activities continue at a strong pace. Our teams are executing our strategies well, and our people are optimistic about our prospects. In my opinion, NeoGenomics is increasingly becoming a leader in the growing cancer genetics testing market here in America. Revenue for the third quarter was $14.2 million. Despite the regulatory change, revenue grew by $2.9 million or 26%, compared with quarter 3 last year. Test volume grew 42% compared with last year's third quarter, driven by strong growth in our core business, with particularly significant growth in hematological FISH and molecular testing. The sequential decline in revenue from quarter 2 was almost entirely due to the TC Grandfather impact. As you know, our third quarter revenue was typically affected by seasonality, and this year's core volume trends in quarter 3 were in line with our historical patterns. Within the quarter, we did experience a greater softness in test volume early in the quarter, but daily test volume surged again in September to a record high. Revenue growth was also dampened somewhat by our management and sales team's focus for about 4 months, was to smoothly transition our customers and our business to the post TC Grandfather environment. We are quite pleased that our efforts were rewarded with extremely high client retention rates and positive customer feedback. Indeed, we are only aware of losing one client based on price negotiations that resulted from the TC Grandfather Clause despite our disciplined approach to pricing. As our sales and management teams were dealing with the TC Grandfather issue, our operations and medical teams were focused on preparing for future growth. As preparation, we added significant new operating capacity and readied some exciting new services. In mid August, we trained and positioned our sales and marketing teams to aggressively take advantage of our new capabilities in the marketplace. First, we launched a state-of-the-art 10-color flow cytometry product nationwide, and are now offering this on both a global and on a technical only basis to clients. 10-color flow cytometry provides significantly more information and the flexibility to test much smaller sample sizes. As we discussed in the press release, we are the only national lab in the country offering 10-color flow cytometry on a tech-only basis. We're very pleased with the initial favorable response to this new product introduction. Second, we began focused initiatives to market and sell our state-of-the-art molecular product portfolio to pathologists and oncologists nationally. Over the past 9 months, we have introduced 29 new molecular tests, many using the gold standard methodology of bi-directional Sanger sequencing. These new tests and test panels are expanding our market opportunity beyond our hematology services and into solid tumor cancer testing as well. In addition, we are in the process of launching a line of array-based testing services, the first of which is our NeoARRAY SNP/Cytogenetics profile. This test provides precise characterization of cytogenetic abnormalities, such as deletions, amplification, and uniparental disomy, and complements our extensive cytogenetics and FISH offerings. And third, we have continued to broaden our immunohistochemistry service line. We are now in the final stages of readying our launch at a new state-of-the-art digital image analysis system to complement our expanded IHC capability. This will help us to become a one-stop shop to our pathologist clients for all of their special needs. We also finalized construction and moved our laboratory in Irvine, California during the quarter. This new facility provides us with a new, purpose-built molecular facility, a new histology lab, and much-needed additional capacity for flow, FISH and cytogenetics testing. Irvine is now a full-service laboratory, and positions us to compete more effectively for business in the Western United States. The new lab will allow us to handle much higher volumes, as well as be more cost-efficient in processing them. Our operations performed well during the third quarter. Although our molecular lab was strained by a cramped facility before the move and by new equipment, new people and new product introductions, we're very proud that our molecular team managed to more than double the number of molecular tests performed in this year's third quarter than last year's with very high quality and at much lower cost per test. Service levels for all other tests, measured by turnaround time, were better than ever and consistently exceeded the high standards and goals we set for our company. Adjusted EBITDA of approximately $842,000 increased 22% from last year's third quarter despite the $1.3 million reduction in revenue from the TC Grandfather Clause expiration. Productivity levels were solid, and the number of tests completed per lab full-time equivalent improved by 10%, and total cost per test improved by 6% from last year's third quarter. We continue to work hard on initiatives to apply new technologies, and to enhance our laboratory information system so that we can continuously improve our processes and productivity. Now with the Irvine facility moved and some key new product introductions behind us, I expect to see an even greater rate of improvement in our cost per test results over the next few quarters. I'll summarize my remarks in the following way. All in all, we were pleased with the company's performance in quarter 3. Although the regulatory change certainly impacted our financials, we were strong enough to weather the storm, and I believe we have come out in a stronger competitive position. We now have much better pricing discipline and have reconfirmed the very solid relationships we have with our hospital and pathologist clients. We are making excellent progress, building and developing our company through investments and a variety of initiatives. We believe our key laboratory disciplines in cytogenetics, FISH, flow cytometry and molecular testing are among the very best in America, and we continue to invest in making them even better. Our investments in R&D are already resulting in new tests coming to market, and positioning us to drive growth in future periods. We remain very pleased and proud of our company's quality of service levels, and we believe our consistently strong service levels help to differentiate us in this industry. We're intensely focused on regaining our profitability as well. We believe that a combination of continued volume growth, productivity gains and cost reductions will help us achieve profitability again over the next 2 quarters. Although the lab testing industry is going through a lot of disruption right now, cancer genetics testing continues to be a very exciting and dynamic segment of the marketplace. As hospitals, pathology groups and competitors reposition themselves in this changing industry, Neogenomics' strategies and goals are clear and consistent, and we are winning in the marketplace. So as a team, we're excited about the company and its prospects, and we are intensely focused on continuing our growth momentum in the coming quarters. I'll now turn it over to Steve to comment more fully on our financial results.

Thanks, Doug. I'll start by reviewing some of our financial and operating metrics, and then we want to open it up for questions. Since Doug has already reviewed our revenue metrics, I'll start with the operating metrics. The total number of tests reported in the third quarter increased by 42% over Q3 last year. For comparison, a number of other laboratory testing companies recently reported flat to negative growth in their volumes; thus, it is extremely gratifying that we continue to gain market share. Average revenue per test was $502, an 11.5% decrease from Q3 last year and a 7.3% decrease sequentially from Q2 this year. This decrease was almost entirely due to the expiration of the TC or Technical Component Grandfather Clause, and was in line with our previous guidance relating to this regulatory change. For those of you that are new to our story, the TC Grandfather expiration was a major regulatory change that went into effect on July 1, that relates to the way in which independent laboratories are reimbursed for the technical component of certain hospital inpatient and outpatient tests, reimbursable off the Medicare Physician Fee Schedule. For decades, independent labs were able bill Medicare directly for these hospital-originated technical component tests, which in our case, include TC, FISH, flow cytometry and IHC testing. Although CMS attempted to eliminate this practice in 1999, Congress grandfathered any hospitals that had a previous relationship with an independent lab prior to July 22, 1999, from the new TC billing rules. For the last 12 years, the TC Grandfather Clause was extended each year. However, on February 14, unbeknownst to the lab industry, language was inserted into a piece of legislation that became the Middle Class Tax Relief Act, which only extended the TC Grandfather Clause until June 30. Middle Class Tax Relief Act was passed by the House of Senate on February 17, and was signed into law on February 22. Thus, from start to finish, this was accomplished in 8 days, and the lab industry was not given any opportunity to comment on it at all. Incredibly, our industry was given just 4 months to prepare for a major billing change. In our case, we estimated back in April that this would impact 16% to 18% of our total revenue, with something on the order of a 30% to 45% decrease in prices because of what was sure to be newfound price competition in this segment of our business. We expected this price competition because previously grandfathered hospitals are not receiving any incremental reimbursement for inpatient testing and only modest incremental reimbursement for outpatient testing. At that time, we estimated that this would translate into a 5% to 8% reduction in our overall average revenue per test. As it turns out, we weren't too far off in these estimates, as our average revenue per test decreased 7.3% from Q3 -- from Q2 to Q3 2012. On a year-over-year basis, average revenue per test was down 11.5% compared to Q3 2011, which obviously impacted gross margin and overall profitability in the quarter. However, as a result of a 6.1% reduction in average cost per test over the last year, our gross margin only decreased by 330 basis points to 41.5% in the third quarter from 44.8% in Q3 last year. During the third quarter, we continued to see excellent improvements in our productivity with the number of tests completed per lab FTE, increasing by 10% from Q3 2011. This is on top of the 15% improvement in productivity we recorded in Q2 and the 28% we recorded in Q1. As we have stated numerous times, we believe we can fully absorb the price impacts to gross margin within a few quarters. There are 4 main drivers that will help us accomplish this. First, as we continue to get bigger, we will continue to realize economies of scale and increase our productivity. Our new California laboratory will help us greatly in this area. Second, we have identified and targeted a few areas in our testing processes where we have large opportunities for cost reduction, including our supplies cost. We expect gross margin to improve by as much as 2 percentage points from these targeted initiatives over the next 2 quarters, with about half of that amount realized in the fourth quarter of this year. Third, our molecular services continue to be the fastest-growing portion of our business, with revenues growing 150% over Q3 2011. As a result of changing our molecular testing platforms in Q2, we drove substantial increases in our molecular gross margins from about 5% in Q2 to about 20% in Q3. As we continue to drive economies of scale, we expect incremental gross margins on molecular testing to approach 40% to 50% in fairly short order. And fourth, during the Q2 conference call, we stated that we were in the process of implementing barcoding in our labs. Our barcoding IT consultants have shared with us that their other lab clients have typically seen a 5% to 10% improvement in cost per test as a result of implementing barcoding because it helps to quickly identify and correct bottlenecks in lab processes. We just turned up the first phase of our barcoding initiative in early October, and the second phase should be completed by year-end. We expect the efficiencies from barcoding to result in approximately $15 per test of cost improvements over the next few quarters, which we believe will improve gross margin by approximately 3 percentage points or more. Turning now to SG&A, total sales and marketing expenses increased just $115,000 or 6% versus Q3 last year despite the $2.9 million or 26% increase in revenue. This increase in sales and marketing expense was just 4% of the incremental year-over-year revenue growth, and is attributable to increased commissions. R&D expenses in the second quarter increased by $683,000 year-over-year from Q3 2011. This increase in R&D spending is directly related to the significant increase in our molecular test expansion activities and the new product development initiatives associated with our licensing agreement with Health Discovery Corp. As we discussed in the press release, we have launched 29 new molecular tests this year. Many of these tests are already producing revenue, and our sales force is focused on fully exploiting the opportunity for growth associated with these new tests. Q3 R&D expenses also included $177,000 of incremental stock-based compensation expense that was due solely to the rise in our stock price from Q2 to Q3. The remaining general and administrative expenses increased by $747,000 or 23.5% from Q3 last year, primarily as a result of increases in the number of information technology and billing employees, depreciation expense and incremental bad debt expense on the revenue increases versus last year. In addition, G&A expenses included approximately $170,000 of one-time expenses related to our move into a new California lab facility. Net interest expense in the quarter increased $106,000 or 58% from Q2 last year as a result of the increased borrowing under a bank facility and additional capital leases. Net loss for the quarter was $975,000 or $0.02 per share compared to a net loss of $143,000 or $0.00 per share in Q3 2011. This decrease in profitability is due entirely to the loss of approximately $1.3 million of revenue from the unit price decreases associated with the expiration of the TC Grandfather Clause. Depreciation and amortization was $1 million in the third quarter and EBITDA was $315,000. Adjusting for the $356,000 of noncash charges related to stock-based compensation and warrant amortization, our adjusted EBITDA for the quarter was $842,000, which is a 22% or $145,000 increase over the $693,000 reported in Q3 last year. Thus, although the net income was down in Q3, adjusted EBITDA saw a nice increase over -- year-over-year. We slowed our pace of hiring way down in Q3, finishing the third quarter with 265 full-time equivalent employees and contract doctors, as compared to 261 at June 30 and 238 at December 31 of last year. Our accounts receivable balance net of allowance for doubtful accounts was $12 million at September 30, up approximately $700,000 from the balance of June 30. Our AR balance in terms of day sales outstanding was 78 days as of June 30, up 13 days from the level reported at June 30. This increase in DSO was mostly due to the expiration of the TC Grandfather Clause. We now have to client bill our hospital clients for the tests impacted by this regulatory change, and we typically are only able to bill our hospital clients once per month. In contrast, we bill Medicare everyday, including claims that are typically paid within 4 weeks. This has added approximately 30 to 60 days to the collection process for the test impacted, and added approximately 8 to 10 days to our total average DSO. Moving forward, we expect our DSOs to settle in the low- to mid-70s area. In terms of our overall liquidity, as of September 30, we had $2.3 million of cash and restricted cash on hand and $165,000 of availability under our working capital line of credit. We had a payroll hit just prior to the end of the third quarter, which makes our liquidity at quarter end look a little worse than it actually is. Our cash flow from operations in Q3 was $508,000 as compared to a positive $1.1 million in Q2. During the third quarter, however, we had to fund 7 payrolls, whereas, we only funded 6 payrolls on -- in Q2. On a year-to-date basis, cash flow from operations is negative $493,000. In quarter 3, we purchased $1.95 million of property plant equipment; however, we were able to lease finance $705,000 of this amount. Thus, the net use of cash from investing activities was $1.25 million. This net cash CapEx number is significantly higher than usual as a result of the leasehold improvements we had to fund in cash for our new California lab location. Typically, we're able to lease finance 75% to 85% of CapEx, and we expect to revert to this historical pattern beginning in Q4. Turning now to guidance we issued this morning for the fourth quarter of 2012. We generally begin to see a rebound in Q4 from our seasonality -- summer seasonality, but in this quarter, we've dialed in a small adjustment for expected impacts from the storm we've just had up in the Northeast. Thus, we are expecting $4.3 million to $15 million of total revenue in Q4 and earnings of around breakeven to 1 -- to negative $0.01 per share. Before turning it over for questions, I'd like to briefly comment on where we are in terms of seeking a NASDAQ listing. I can report that we filed our listing application with NASDAQ in early August, and we believe we have now completed all aspects of the listing process related to our application, except for meeting the minimum bid price requirements and a few administrative procedures that happened at the end. As we have stated before, NASDAQ's new listing standards require that an issuer have a minimum closing bid price of $2 or more for 90 consecutive trading days or $3 or more for 5 consecutive trading days. We actually traded above $3 per share for 4 consecutive days in late September, but unfortunately, the share price closed below $3 on the 5th day. If the stock price does not rally above $3 per share for 5 consecutive trading days before the end of November, we are hopeful we will meet the $2 criteria on or around November 30. Once we meet minimum bid criteria, our application will then be complete, and we'll go into a final review process. NASDAQ has informed us that so long as everything is in order with our application during the final review process, we could begin trading in as early as 5 days. Thus, barring any unforeseen events, we expect to be trading on NASDAQ sometime around the end of the first week or early in the second week of December. At this point, I would like to close down our formal remarks and open it up for questions. Incidentally, if you are listening to this conference call via webcast only and would like to submit a question, please feel free to e-mail us at sjones@neogenomics.com during the Q&A session. We will address your questions at the end if the subject matter hasn't already been addressed by our call-in listeners. Operator, you may now open up the call for questions.

[Operator Instructions] Your first question comes from the line of Matt Hewitt.

First up, congratulations on navigating what I'm sure was a relatively challenging quarter, given the expiration of TC Grandfather Clause. A few questions for me and then I'll jump back in the queue. First, given the recent launch of some these newer tests, I'm curious if you have any anecdotal responses from your customers. Are these areas where they were in dire need of assistance? Or they're really excited about the launch of these tests? What can you tell us from an anecdotal point?

Well, let me try to answer that, and then I may turn it over to Dr. Albitar for further comment. Our clients are excited about these molecular tests. We are also educating them about the tests, what they do, their purpose, and how they can be used effectively in cancer care. I just talked with, this morning, one of our key clients, and he's very excited about our expanded menu. In terms of the menu, our molecular testing is -- we're, as Steve said, growing it dramatically. We've just educated our sales force, and so they're now better positioned to sell it. We've also included a number of panels we call NeoTYPE panels, which are getting -- beginning to get some traction in the marketplace. So very good customer response, but it's a learning process for many of our pathology clients, and we're in that process right now. Dr. Albitar, you have any comments about that?

I'd just like to add that we hear a lot from our clients that they are very excited about what we are offering. However, they need more flyers. They need more education. They need algorithms to help them determine how to order and what to order. At the same time, we are catching up in terms of providing an easy way for our requisitions to be updated. It's very difficult, as you can imagine, to keep all our requisitions up-to-date as we keep on adding new tests on a weekly basis almost. So it's a process and we have very good positive feedback from all our clients.

That's great. And I guess, along those lines -- and I think you mentioned the NeoARRAYs you plan to launch here it sounds like in the fourth quarter. Are there any other tests? I know previously, you had talked about maybe launching a new Abbot test out of your Abbot partnership. Are those coming here in the fourth quarter? Or what should -- how should we be thinking about the new test launches?

Well, we continue to work on a number of test launches. We mentioned a number of them in our remarks. The next test, as a result of our strategic supply agreement with Abbott, we continue to work on, we continue to get samples in, we continue to test those samples. And we're very deliberate about our test rollout process and validation process. So we're using our support vector machine tool to get us as strong performance characteristics as we can, and we are in the process. But there are a number of other proprietary tests that we're making pretty good progress on, and in the validation process of those as well.

Okay. One last one for me, and then I'll jump back in the queue. The test volume, obviously, was very strong here in the quarter, 42%. I'm curious, it has declined here the last couple of quarters. Still remarkably strong, but where do you think that, that growth maybe shakes out in the fourth quarter, and more specifically, 2013? And maybe you don't want to necessarily guide, but how should we be thinking about it for 2013?

So we haven't actually announced any guidance yet for 2013. We will be doing that in our Q4 call, which will take place in late February, on or around February 21. With respect to Q4, if you were to just take our Q4 range of revenue, $14.3 million to $15 million that we outlined, take the midpoint of that range and divide it by 500, that's the volume we expect. We generally begin to see some seasonality rebound in Q4, sequentially from Q3. This year, as I mentioned in my remarks, we are expecting a modest hit from the storm. We have a number of large clients along the Jersey Turnpike area and some even on the Jersey shore. We have a lot of clients in the Connecticut area, and we have a number of clients in the Philadelphia area of Pennsylvania. It's hard to really quantify weather-related impacts, but we know, for instance, our night flight from Newark Airport has been canceled the last couple of nights, and so there will be a modest impact on that. All in all, though, we do expect revenues and volumes to increase, Q3 to Q4, and we think it will be sort of along the lines of how it's been in previous years, although last year was probably more pronounced than the year before that. But overall, we should begin to see some rebound.

Your next question comes from the line of Kevin DeGeeter.

Just on guidance -- in terms of the guidance for the fourth quarter, how do you characterize the level of confidence and visibility you feel you have in that guidance in the context of the TC Grandfather changes? Do you feel like you have your arms fully wrapped around the changes and how they impact the business? Or is there still a fair amount of learning to be done, and should we think about that when we think about the guidance you provided for the fourth quarter?

No, we think we've got our arms all the way around this. We got way out in front of the industry on this, and had quantified the impacts in the March, April timeframe. We had meetings with all of our senior -- with the senior members of our client hospitals in the, really, May, June and July timeframe. The prices were all sort of put in place mostly by the end of July, in time for the July bills. Any resistance or pushback we had from any of that activity happened in the July and August timeframe. I guess a few might have happened in September. But we feel real good about where we are. We expect average revenue per test to settle out in the 495 to 505 area. There's always some variability each quarter with respect to how many CRO tests were included in that number and what their average revenue was, and then whether or not the mix is changing. For instance, our mix has been changing with more lower-priced molecular tests over the last few quarters. But we feel really good about it. So the TC Grandfather, I think, is behind us, and we're focused on growth initiatives. And indeed, the number of [inaudible] price list that we're authorizing now is beginning to pick up again as the sales force focuses in on growth initiatives. Doug, you want to add anything to that?

No. I think that's well said, Steve. I will say that there are a lot of changes affecting our industry, but our pipelines are very strong, and we're trying to take advantage of the changes affecting our industry, but there are a lot of reimbursement challenges that our hospital clients and our pathology clients are facing and many of our competitors. So I think we're confident. We are continuing to build a very, very healthy pipeline of accounts. I think we're continuing to take market share as well. But the TC Grandfather Clause expiration is behind us.

Okay. Terrific. And on a different note, over the last 12 months, the company's moved aggressively to expand capacity both in Florida, now out in California with the new Irvine facility. How should we think about sort of the current levels of growth or the projected levels of growth for the future? How much time do you think this buys before you think you -- you make sort of the next round of investments here? And just how do you think about staffing and capacity utilization in the context of the current infrastructure footprint?

Well, in terms of our facility capacity, we've got enough capacity right now for a while. We've got very good capacity in California. We have good capacity in Tampa and in Fort Myers, and we're looking to enjoy squeezing more volume in, quite frankly. So no problem with facility capacity. In terms of hiring people, I think that we're better positioned to attract talent now than we ever have been, both from a location, a geographic location standpoint and as a result of our momentum. So I think acquiring the people capacity is not as big of a problem as it has been maybe in the past. In terms of investment, we will continue to invest particularly in the molecular area, but I think we -- we've added a lot of investment this year for Flow Cytometry, for our image analysis platform, for our molecular facility, for our California facility, and I don't really see that level of investment continuing into 2013.

Okay, great. And maybe one more for me and then I'll jump back in the queue. In light of disruption, dislocation in the industry, particularly the portion of the industry focused on a TC-oriented business model, does that change your appetite for kind of tuck-in acquisitions or opportunistic acquisitions? Or should we think about the NeoGenomics business model as being driven primarily from internal growth here in the near term?

Yes, so we're working very hard to have very high growth rates from organic growth, but we would like to -- and we are looking at smart acquisitions. Now we believe what's happening in the industry is causing some disruption. We think we're competitively stronger than we were before. We anticipate that we are going to get an opportunity to look at a number of different companies in a variety of fronts. But let me explain what's important to us. What's important to us is growth and profitability. So we'll look at acquisitions where we have cost synergies, primarily, where there's some market synergy also, but we're not looking to buy something that's going to cause our profitability to be under pressure.

Your next question comes from the line of Lauren McGuigan.

I want to ask if you could provide an update on your plans to use the SVM technology to automate testing that currently has large manual components, specifically cytogenetics and whether you're considering sub-licensing the FISH automation software that you created and launched earlier? I think it was in September.

Excellent questions. We continue to make good solid progress on this. I sort of want to divide your question into 2 parts. With respect to the FISH application we announced in September, we are beginning to use that in selective cases. We anticipate that we will be able to extend the SVM technology into other FISH applications. We have prioritized that by looking first at those tests we currently use a manual FISH process for because when you move from a manual to an automated process, it does open up a little bit more reimbursement. However, having said that, we've long ago moved most of our FISH testing into the automated arena so there won't be a lot of opportunities where we'll get increased reimbursement. So we view it, really, more from the perspective of productivity improvements, and we think that there's a lot of potential for it to increase our productivity in the FISH lab and in the cytogenetics lab. The cytogenetics system that we licensed a working prototype for is in development now. We've spent money with mathematicians and various technologists every month, validating it. In order to have this system be used in a clinical setting, we need to validate it for all of the various types of cytogenetics carrier types that we see in any given month, and so there is an extensive amount of validation that has to go in. And basically, when you get the algorithms set up to the point where it can read and distinguish the various different types of cytogenetics images, you then have to train it, using preferably 50, 100 different images per type of test, and so it is a pretty significant undertaking. I would say that we continue to believe that we can, at least, begin using this internally at some point next year. With respect to sublicensing it to others, I think that will depend on how we feel the system works and the ease-of-use, but we continue to have high hopes that we'll be able to do just that.

Okay, great. Thanks for the color on that. And then maybe just a more general question, if I could. Any thoughts or commentary you have on the election next week and whether you think there will be a significant difference in terms of implications to the laboratory business, depending on which candidate ends up in the office, maybe both near-term and in the longer-term?

Laura, we wish we knew. We watch the same news as you do and everyone else. We don't know, frankly. There is a lot of current reimbursement pressure in the industry. Fortunately, NeoGenomics is -- other than the TC Grandfather issue, we don't think we're going to be impacted significantly or really at all by some of the things that are currently pending in the industry. But I don't think there's a lot more they can do, to be honest, to our industry. You've seen what's happened with some of our competitors. There have been some layoffs and there is some pressure there. So I think we're a little lucky at NeoGenomics. I have no idea who's going to win or what the impact is going to be going forward, but our products and services are very valuable. Our tests are cost effective. They're all reimbursable. We're not selling $5,000 tests. I think we're in a pretty good spot relative to offering good value to the healthcare system.

So Laura, just to piggyback on that a little bit. Obamacare, if it stays in place, really only has contemplated cuts in it to the clin lab fee schedule. There's a 2% reduction next year if it stays in place, and then a further 2% reduction on the inflation adjustment. We only have about 21% of our revenue built off the clin lab fee schedule, and 9 percentage points of that is molecular and they're coming out with new codes for molecular anyways. So that's not going to be impacted. So really, if Obamacare goes through, any of the reductions that would happen, would happen on about 13% of our revenue or 12% to 13% of our revenue. And again, we don't think that they're going to be that meaningful to us. On the other side, there's an opportunity in that theoretically, there'll be another 30 million people insured over some 2- to 3-year period here, and so there certainly could be some upside in terms of volume. Net-net, in the absence of any further data, I think we feel like it's probably a push for us.

Your next question comes from the line of [indiscernible].

In terms of -- when I look at your requisition numbers and tests per requisition, that was down sequentially for the first time. Now is that an anomaly or is that going to be the new normal going forward?

Well, it's -- the test per requisition was flat at 1.55 in both June and September. The number of requisitions was down around 253, and the number of tests was down around 530. We usually see a small decrease or maybe flat volume from Q2 to Q3 because of seasonality. Last year, it was masked because we were in the process of on-boarding several new locations as part of a large group of affiliated oncology practices. But if you go back to Q2 to Q3 trends and years before last year, you'll see that it's typically down 1% or 2% or flat. And sometimes, it might be up 0% to 1%. So last year, it was just a little unusual. We don't see anything to be alarmed about in this. As Doug mentioned in his remarks, the volumes were soft in July, but they picked up in August, and we ended September with pretty much the surge in volume that we normally start to see at the end of September. And we're -- so far, the things -- trends are good so far in October. So we've got to wait and see what those impacts of the storm are, but we believe we will have growth in Q4 on a sequential basis.

Now as you launch more of these NeoTYPE panels and arrays, so how do you differentiate yourselves with these homebrew tests versus some of the FDA-cleared prognostic markets being introduced?

Well, we do both at NeoGenomics. We always have. The common methodology used for a lot of molecular tests is to use polymerase chain reaction analysis, which is a point mutation analysis. We moved away from that in the early part of this year into bidirectional Sanger sequencing because it's a much more robust test. In PCR-based tests, you might get one single point that you're looking at along the base pairs of DNA. In a sequencing tests, you're probably looking at somewhere between 200 to 300 base pairs of DNA along the -- along an entire exon. And you're literally sequencing it from each direction and finding all of the mutations along that, so you get a lot more data. What we've seen, so far, in the molecular area is that there are a few approved molecular tests. There's one, BRAF test, that's FDA approved. That works on the V600E codon, but there was a big paper at ASCO in June that talked about how the FDA approved test missed 11% of the mutations because it only looked at V600, and there were other mutations that were implicated in melanoma. And so because the test is FDA approved doesn't necessarily mean it's better. We feel like we're using the most robust technology that you can use. All of the Sanger sequencing tests that we currently use are what we would classically call a laboratory developed test, but they all go through extensive validation before we offer them clinically.

In terms of Sanger sequencing, I mean, what fraction of your test volume is currently going through the bidirectional Sanger sequencing? And how does that impact your margins going forward?

Dr. Albitar, I'd like you to comment on the first aspect of that, and then I'll take the margin aspect of it.

I would say more than 80% of our testing is Sanger sequencing, and the rest is quantitative PCR-based, like the BCR/ABL and so on. For mutation detection, all our testing, 100% of our testing is based on sequencing. However, I like to add to what Steve said. What distinguish us from the rest is innovation. We developed a methodology to increase the sensitivities of our sequencing, and our sequencing is not a routine sequencing. It is high-sensitivity sequencing. It is way better than the average, and I believe that's what distinguish us.

Indeed, we use some proprietary processes on the front end of our processes that make them much more sensitive and specific, and you may actually see us file some patent applications on those processes moving forward here. To get at your question on margin, you've got to understand the dynamic in the industry. The molecular industry is sort of early on in its fledgling state. The PCR tests that are out there are -- the test kits are sold by box manufacturers and have a razor/razor-blade strategy, where they sell a cheap box, but an expensive test kit. And so we found that we couldn't make a whole lot of money using PCR-based test kits, and I would venture to bet that other labs are finding the same thing. When we started moving to bidirectional Sanger sequencing, instead of buying test kits, we bought our own primers and we're making our own reagents and validating them. This has probably taken our cost of supplies down to maybe 40% of what it had been prior to that, and so it does make a meaningful impact on molecular margin moving forward. If you recall, in Q2, we announced that for the first time, our molecular lab had a positive gross margin. That was largely the result of moving toward the Sanger sequencing platforms. In Q3, as I mentioned in my remarks, we took a 5% margin in Q2 up to 20%, and we believe that we will be able to get between a 40% and 50% incremental margin on molecular tests in fairly short order, as our volume continues to grow. Molecular testing was somewhere on the order of 6% of our volume -- or 6% of our revenue in Q2. In Q3, that was 8.2% of our total revenue. And so at the end of the day, we've seen pronounced growth in molecular. Again, we had a 150% year-over-year increase. We expect the growth in molecular to continue, which makes it a lot easier to get economies of scale. And the new California lab that we have now put in place is set up and purpose-built, as Doug mentioned, for molecular testing, and we think we're going to be able to get real good efficiencies out of that.

In terms of your -- the NeoTYPE arrays that are being launched, so how does that fit in the current diagnostic continuum, and what are physicians doing without it and how is that impacting -- how is your array impacting their treatment decisions?

Dr. Albitar, we'd like to ask you to take that one.

Yes, that's a very good question actually. It's -- our goal is to make our clients, the practicing pathologists, offer the most accurate details. The NeoARRAYs compliment our cytogenetic and FISH testing. Frequently, you speculate on your report for the cytogenetics and you say, "Well, there's this abnormality in this chromosome or that chromosome." The NeoARRAY will define these abnormalities. And as you know, in cytogenetics, the abnormalities can have very significant impact on how you risk classify the patients. That's one thing. The other thing seen is there are a lot of scenario where the cells will not grow, and you cannot get data from routine cytogenetics so you can do the NeoARRAY on these cases. So the NeoARRAY complement our cytogenetics and our FISH testing, provide more precise characterization for the abnormalities that's in the genome of the cancer, and add another level of better understanding of the disease that the clinician is dealing with and there a lot of criteria and clinical practice guidelines out there to help the clinician how to use these information.

I mean, is there an alternative treatment paradigm available even [inaudible] clarity in terms of information? Would that really impact outcomes? And if it doesn't really impact outcomes, what is the reception that you're getting from the physician community?

We have numerous requests for asking for this type of service. There are in some situation, where there is -- the finding may impact how you manage the patient, but there are a lot of cases or scenarios, where the field is evolving and the information are being used and digested and looked at, but there is no strict guideline what to do, but there are situation where the clinical decision would be changed.

One last question...

We've got one more caller here. Can we take this one offline? And we'll get you whatever clarity you need in a call with Dr. Albitar. I do want to try to wrap this up within the hour we've got.

Your next question comes from the line of Mark Zinski.

I just wanted to go back to that operating metric average number of test per requisition. Is it fair to infer that the new molecular test you're issuing should, if effectively cross-sold, increase that statistic going forward? Or are the new molecular tests kind of being ordered separate from existing tests?

We certainly hope that it will increase that metric. We position all of our molecular tests as adjuncts to existing tests, not replacements of existing tests.

Okay. So the fact that it was kind of flat year-over-year doesn't in anyway kind of indite your cross-selling abilities?

We don't think so. We've seen some mix changes over time. Our cytogenetics mix has -- the growth has slowed down, as has our flow cytometry mix. And so I think the reason why it hasn't gone up yet is just because we're still settling into the new cytogenetics and flow cytometry ordering patterns more so than -- the molecular hasn't kicked in yet.

Okay. Since your sales are going to materially increase here going forward, are you feeling good about your working capital position over the next 12 months?

So we get asked this question probably 5 times a week from institutional investors. I'm going to sort of translate this question into, do we have any plans to do any kind of equity transaction in the near future? We get asked this all the time. Our answer really hasn't changed. Absent a specific need for a lot of cash, we're not likely to do a large equity transaction anytime soon. We actually believe our stock is still relatively undervalued relative to any meaningful comp in the industry. Having said all that, however, we were notified recently that one of our long-time shareholders would like to exercise part of their registration rights, and has asked the company to assist them with completing a secondary offering by year end. We believe that a few other long-time shareholders may participate in such transactions as well. Depending on the timing of this secondary offering and whether the NASDAQ listing has been achieved and where the stock is trading at that time, the company may elect to participate in the offering, and issue of modest number of shares to increase its liquidity. Thus, you may see us make a, what I call a provisional S-1 filing sometime in the next couple, 3 to 4 weeks, to give us the flexibility to participate in this offering if we so choose, but we have not committed to it. It's not a guaranteed thing. It's going to be subject to market conditions at the time. I think we think of our liquidity right now as adequate for our current book of business. But when we look at all the growth coming our way next year, if we have an opportunistically -- if we have a way to opportunistically increase our liquidity, we can. Keep in mind, also, that we have the ability to take our accounts receivable line of credit up by another $1 million, and we have the ability to issue as much as $2 million of unsecured debt under that facility. So we have a lot of liquidity options open to us. Obviously, if we thought that this was something that was going to impinge on us in the near term, you'd see us commit to doing something much more definitively. But as of right now, anyway, we're okay. We believe we're okay with where we are.

Okay. And then last question in terms of sales by geography, I think -- you kind of seem to indicate that you think that there's more kind of upside potential out west in terms of client acquisition, especially with the Irvine facility. Is that -- am I reading that correctly?

Yes, that's true. We think there's a lot growth opportunity for us in the west.

We have not gotten any questions by e-mail yet. So Doug, I'll turn it back over to you to wrap us up.

Okay. Thanks, Steve. So as we end this call, I would like to recognize all 265 of the NeoGenomics team members around the country for their dedication and commitment to building a world-class cancer genetics testing program. On behalf of our NeoGenomics' team, I want to thank you for your time in joining us this morning for our Quarter 3 2012 earnings call, and let you know that our Quarter 4 2012 earnings call will be on or around Thursday, February 21 of the next year. For those of you listening that are investors or thinking about investing in NeoGenomics, we thank you for your interest in our company. Goodbye.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.