Good day, ladies and gentlemen, and welcome to the Q4 2016 Fulgent Genetics Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would like to introduce your host for today's conference, Mrs. Nicole Borsje. You may begin.

Great, thank you. Good afternoon, and welcome to Fulgent Genetics Fourth Quarter and Full Year 2016 Financial Results Conference Call. On the call today is Ming Hsieh, Chief Executive Officer; Paul Kim, Chief Financial Officer; and Dr. Harry Gao, Chief Scientific Officer. The company's press release discussing its financial results is available on the Investor Relations section of the company's website, fulgentgenetics.com. An audio replay of this call will be available shortly after the call concludes. Please visit the Investor Relations section of the company's website to access the audio replay. Management's prepared remarks and answers to your questions on today's call will contain forward-looking statements. These forward-looking statements represent management's estimates based on current views and assumptions, which may prove to be incorrect. As a result, matters discussed in any forward-looking statements are subject to risks, uncertainties and changes in circumstances that may cause actual results to differ from those described in the forward-looking statements. The company assumes no obligation to update any of the forward-looking statements it may make today to reflect actual results or changes in expectations. Listeners should not rely on any forward-looking statements as predictions of future events and should listen to management's remarks today with the understanding that actual results, including the company's actual future results, may be materially different than what is described in or implied by these forward-looking statements. Please review the more detailed discussions related to these forward-looking statements, including the discussions of some of the risk factors that may cause results to differ from those described in these forward-looking statements contained in the company's filings with the Securities and Exchange Commission, including its 8-K for the fourth quarter of 2016 and the related press release announcing its financial results in the quarter as well as previously filed 10-Q for the third quarter of 2016, all of which are available on the company's website. Management's prepared remarks, including discussions of earnings and earnings per share contain financial measures not prepared in accordance with the accounting principles generally accepted in the United States or GAAP. Management has presented these non-GAAP financial measures because it believes they may be useful to investors for various reasons, but they should not be viewed as a substitute for or superior to the company's financial results prepared in accordance with GAAP. Please see the company's press release discussing its financial results for the fourth quarter and full year 2016 for more information, including the description of how the company calculates non-GAAP earnings and earnings per share and a reconciliation of these financial measures to income loss or income loss per share, the most directly comparable GAAP financial measures. With that, I'd like to turn the call over to Ming.

Thank you, Nicole. Good afternoon, and welcome to Fulgent Genetics Fourth Quarter and Full Year 2016 Conference Call. We are very pleased that you can join us today as we report the financial results of our first full quarter as a publicly traded company, following the completion of our IPO in early last October. 2016 was a year of significant corporate and financial milestones for Fulgent, capped off by very strong performance in the fourth quarter. I will discuss our accomplishments in the fourth quarter, provide an update of our growth strategy and long-term objectives, and then Paul will provide detail on our financial results as well as outlook for 2017. Let's first take look at our financial highlights in the fourth quarter. Revenue doubled over last year's fourth quarter and totaled $5.9 million, growing 17% sequentially. We also achieved GAAP profitability for the first time in our company's short history while we have continued to maintain non-GAAP profitability since [ prior ] our IPO. We are one of the few genetic testing companies to achieve GAAP profitability and one of the even fewer companies to have done this at such an early stage in our company's lifetime. Though we have not hit scale yet by any means, our differentiated business model leads to a strong GAAP gross margin of 68% in the quarter and $0.05 in GAAP earnings per share. Non-GAAP diluted earnings per share was $0.06 in the quarter, and operating cash flow was $1.3 million. We believe this strong growth reflects our success as a disruptive force in the genetic testing market due to our differentiated approach. We have built Fulgent around a proprietary technology, driven by our own growth in data algorithm with integrated platform that allows efficiently to have test at a lower cost which…

Thanks, Ming. Revenue for the fourth quarter was $5.85 million, which is double last year's fourth quarter and a 17% increase over the third quarter of 2016. Our revenue growth was driven by increased penetration into our current customer base and market share gains in our core hospital market, both domestically and internationally. And though still a very small portion of revenues, we continue to make headlines to establishing a presence in the third-party payer market by signing on regional states and are continuing to negotiate agreements with additional territories as well as various national payers. We expect to make incremental progress with third-party payers throughout 2017. We generated 53% of our revenue in the U.S. and Canada and 47% outside of North America in the quarter. Our strong revenue growth overall was driven by a significant increase in billable test volumes, which grew to approximately 3,900 tests in the quarter, a sequential increase of 13% over approximately 3,400 billable tests in the third quarter. Our average selling price was a record $1,509, which was a slight uptick from last quarter. Cost per test continue to decrease and was $437 for the quarter, excluding stock-based compensation of $168,000. This resulted in a record high non-GAAP gross margin of 71% in the quarter, an increase of over 700 basis points versus the fourth quarter of last year and up over 200 basis points sequentially. In terms of operating expenses, we're continuing to invest heavily into sales and marketing and research and development as we look to capitalize on the technological advantage of our platform and our expanding market opportunity. In the quarter, we invested in our sales force expansion, staffing support, operating infrastructure and cycle management to support our increasing volume and our growing engagement with the reimbursement market. We added…

[Operator Instructions] And our first question comes from the line of Karen Koski from BTIG.

Can you hear me?

Yes.

Great. I guess the first, when we think about the rep hires you made throughout 2016, how quickly are those reps coming up to speed? And how long until they have kind of meaningful impact in terms of volumes and revenue? And then what are your expectations for further rep hires in '17?

Karen, this is -- good question. And we do see -- it'll take a little bit of time for the reps to be effective, and we assume about 2 quarters for the rep can get into the speed and penetrate into market. So -- and as we continue looking into this market, we are hiring more experienced executives now. We have couple offer outstanding. We're looking forward adding more senior sales people to our team.

Okay. And then in terms of revenue guidance for '17, can you give us any directional commentary or specific percentages around what percent of your volume you expect to come from kind of the private pay part of the market? And then can you provide any more color around what some of your goals are in terms of lives under contract as you exit next year or this year, '17?

Karen, I'll give you some rough, in general, the global pictures, and then Paul probably can give you a little more detail in terms of our revenue guidance. We still expect majority of our -- the revenues that would be from cash payer. We are already conservative in terms of how do we deal with collection issues. That's why we claim collectible samples versus number of billable samples. I think that is more meaningful towards our business. We received still a low percent, under 10% of our revenue from the third-party payers even though we aggressively try to target the market. We just think that there was some room for us to operate. We expect majority of our business through cash payers and that we will also have significant revenue from the overseas. Paul probably can you give a little bit more color.

So Karen, I'll first make a couple comments about the payers, and then I'll provide more color as to where we believe the revenues are going to be coming from in 2017 and what we have not factored into our guidance. So first, with the payers. We're close to executing multiple regional and national agreements. Progress with payers is a priority for Fulgent. But having said that, we still are projecting only a small portion of our revenues in our guidance with the payers. It's only about 5% to 7% in 2017. And then payers are only a part of our strategy. Fulgent, we have a multi-pronged approach based on just the size of the market, the global size of the market. And the advantage that we have from a financial angle, we're able to do it because we're already profitable unlike other companies. We see the vast majority of our revenues coming in from the hospitals, both domestically and internationally. We see international -- we see international opportunities, even aside from hospitals, collaboration with other organizations. We see institutional demand from the research side internationally and Europe, Australia, Middle East, and then the opportunities over in Asia with the China joint venture. We also have a number of collaboration opportunities with other companies and labs that we're excited about in 2017. We see demand from research institutions and the sequencing service capabilities that we can provide for that portion of the market. We also are pursuing opportunities and RFPs with biopharma organizations where they can use our testing and data services. And then, of course, I talked about the payers. So when you take a look at these different layers of opportunities, there are a number of things that we're excited about in 2017. Now what we have factored into the guidance is mainly the hospital part of the market, the existing opportunities and customer base that we have internationally as well as the research institutional demand that we have in hand.

Okay, that's very helpful. And then, I guess, just one last one for me, which I think you kind of just answered. But did I hear you right on that you haven't factored in any revenue from the joint venture in Asia in '17 revenue guidance?

That's correct. So the status of the joint venture, it's very close to being executed. But for our guidance, the income statement, we assumed that the booking of the joint venture will be on the balance sheet versus grossing that up or consolidating it on a income statement basis. So we strip that piece out of our guidance. And then another piece of data. The revenue from our Asian customers in the fourth quarter was a little over $1.5 million. So when we guided to flat Q1 because a number of our Asian customers have already started sending samples to the joint venture, we stripped that portion out, and we're still in the middle of the first quarter, but the amount of business that could potentially go into the joint venture, as I indicated in my script, is between $1 million and $2 million.

And our next question comes from the line of Bill Quirk from Piper Jaffray.

Great. Paul, first question, going back to the JV with Xi Long, can you -- forgive me, if you went into detail in the first part of the call. I did jump on a minute or 2 late. But can you just explain -- so you're going to recognize revenue from that as royalty revenue, is that correct? Or help us think a little bit about the pass-through here. I guess just trying to kind of normalize the P&L for the JV.

Okay. So I will turn the royalty uplift, which we haven't incorporated into our guidance, over to Ming. But as far as the first part of your question, so what we assume, because the agreements are close to being executed, is that we will book the asset of the joint venture on to the balance sheet versus grossing that up or consolidating that into the income statement. So any kind of revenue that the joint venture would get, we haven't incorporated that into Fulgent's income statement guidance. We assumed and we thought to finalize this with our auditors that the booking of the joint venture and the activity of the joint venture would stay onto the balance sheet of Fulgent. And then the other thing is the potential uplift in terms of the royalties, we haven't factored that into our guidance. But Ming can talk about how that is being devised, the value that we see in having our technology and products in the China market. So I'll turn it over to Ming.

Yes. Thanks, Paul. Bill, I'll just try to make a clarification because Paul has worked with the auditors to try to [ cover ] facts for the joint venture into the -- our financials, and that there is some paper work to do. But from the -- strategically, the reason we build the venture in China, one, is to provide our standards CLIA lab, CAP-certified diagnostic testing with a competitive cost bringing this test to China market. That's only part of our goal. The second part is build up a research arm, which help us to get more involved data analysis, develop new test and validate new test and find the way getting into the personalized medicine. And that's the research activities that we will do at the joint venture. And those one will be under the guidance of the -- our direction to build such a research arm and provide a more value-added service other than just genetic testing. If you take a look at the current status, there's so many activities especially in this space for the pharmaceutical companies from research labs. And some of those people, they recognized that they are no longer competitive in terms of building their own sequencing capability. So they outsource those one to certain companies, including Illumina, they provide a sequencing. In that sense, how do we compete in that space? What we bring the value to the pharma or to the other research institutes is our efficiency, our accuracy and our speed. And not only the DNA, RNA method based and how do we analyze the data, provide them getting into deeper for their scientific of drug discoveries. I think that's the value we bring to the picture. I think that's some of the area we'll see the benefits we will see in 2017. So we -- one area will provide the genetic testing in another area in the scientific research and the discovery we're beyond period of data sequencing where we're with our customers of labs and the pharmas to get it once they have a deeper into personalized medicine or drug discovery.

Okay, got it. And then just, I guess, a question about price versus mix versus volume here in the quarter. Your overall revenue grew faster than your volume did. So can you, perhaps, parse out a little bit of how much was that mix versus any positive price effect? And for that matter, was there, I guess, a positive or a neutral or a negative effect on ASPs from some of the initial private payer revenue that was recognized in the quarter?

I think, Bill, in general, probably you know is that we are purely dealing with the cash customers, and we have any private payer revenue for the first quarter, I think it's probably not that significant. We do have some, but I do not believe -- it's probably a few percent. Paul may give you a little bit more details in terms of -- in that aspect. But in general, we're prepared to compete in the genetic test market. We do -- we'll see that the price degradation in terms of those -- the volume test, especially in cancer, and we do see that we increased activities this year in the cancer test. But of course, some of those are panel -- large panels [indiscernible] this test. We expect the price degradation. We, by the way, haven't seen that one significant impact in our gross margin.

Okay, got it. And then just last question for me is when the joint venture is completed, would you anticipate just to bring out a press release and that, just to confirm that for investors?

Yes, once we get this -- all accounting on how to address the revenue or booking the asset issues, we will send out that press release and that we'll also probably send a press release once we -- the lab is operational, which should be shortly.

And our next question comes from the line of Erin Wright from Crédit Suisse.

Great. And just to be clear, does your guidance only reflect the increased coverage from the U.S. commercial payers that you signed on thus far? And could any sort of incremental payer relationships thereon offer upside to your guidance range at this point?

So we incorporated nominal amount of revenues for the third-party payers, approximately 5% to 7%. And that assumes the covered lives that we have and some progress in the other territories but not all. We think that we're being pretty conservative about the covered lives that we would have and the traction that we would have in the third-party payer market. But we just haven't factored a lot of that into our guidance, but it is a priority for the company. So by going after these territories, arming the sales organization, what this -- and making sure that the positioning capability of Fulgent is understood by the third-party payer market is a priority for the company. But we believe, looking at the guidance and the portion of the revenues that we have incorporated into the guidance, that's pretty conservative.

Okay, great. And I guess how are these discussions progressing? What has been surprising to you thus far? And I know it's still early, but once you sign on the commercial business, how has the traction been thus far?

Yes. Erin, definitely, we should run lot of tests and we do not charge them anything. So our strategy is that we do value our test. We think we should be not in front of this area and try to give the sample away. I think we want to bring healthy competition to this market, and we also would like to bring the discipline how to address the -- build a sustainable business model in this market. So we are more focused on the quality and the sustainability of trying to enter into this market. We'll not try to compete and give the tests away, and that's why we're not guiding a large volume in terms how do we get the volume. We guided what we can feel that we can collect, and that will be main -- more focus for our business model.

Okay, great. And then as we think about sort of the quarterly progression throughout 2017, should we be aware of any sort of seasonal factors? I know you gave us some trajectory into sort of the first quarter. Are there any other kind of anomalies that we should think about over the course of the year?

No, not really. We believe that the growth rate in each of the quarters in 2017 sequentially should be quite nice.

Okay, great. And then can you speak to your opportunities kind of in China beyond that Xi Long relationship? I guess, what else you can do there?

I think, Erin, first, I think in China, it is a very competitive market, and we know that entering that market it's going to be challenging. But we do feel that we have advantage in terms of pricing and that's the benefit. We bring the quality test at a competitive price to that market. We do not have the dealing with the third-party payers issue because everybody paying in cash. And that's why we are -- where we target the market. But in addition, there is tremendous benefit. We could benefit in that market through the prenatal carrier screening or certain tests which is the -- such as like the diagnostics the people based on the -- how do they benefit through the genetic test. So we see the opportunities and that we also see the research capabilities from that China site, and that would be benefit for us in the long-term capability to compete in this space.

Great. And then can you speak to sort of the status or what your experiences thus far with some of your military relationships as well as your DoD relationship with LabCorp?

That businesses we do, it takes time to develop. But we already see the sample increase from that activities. So it is a healthy relationship with our both customers and the OEM customers.

And our next question comes from the line of Nicholas Jansen from Raymond James.

First, on the Xi Long JV. Were you guys expecting this accounting method to be the way it was resolved when you guys were initially thinking about the growth rate of the business? Just trying to get a better understanding of the $30 million to $36 million kind of revenue outlook. Wasn't sure if The Street's assumptions were assuming more growth there but now that's being kind of excluded from the presentation.

So it was intentional. I mean for us, the opportunity in China in the joint venture, it's a long-term strategic investment rather than us trying to calibrate something for revenue. Given our profitability, we are in a position to make a long-term strategic investment in a huge market in China. We believe we're the only company to address the China market in a meaningful way. So we made a decision that the joint venture and servicing the customer should be the priority for us in addressing the China market. So we certainly could have not done the joint venture or we could have kept the customers continue to come to us. But from a strategic stance, it made much more sense to have the demand go through the joint venture.

That's helpful perspective. And then my second question would just be on the expense curve. I think you made some smart strategic investments in the fourth quarter. You had $2.7 million worth of operating expenses. Just trying to get a sense of, is that a good run rate to grow off of from here or were there -- or should we see another kind of similar-sized step-up in the March quarter?

We think the March quarter, the operating expenses should be just a tad bit higher in the areas of research and development and sales and marketing. G&A could be higher by a couple of hundred thousand dollars just because we have the annual audit that's happening. And then beyond the first quarter, you should see a general progression in increasing operating expenses in all of our categories.

Great. And then I guess my last question in terms of COGS per test, continued nice improvement there. Ultimately, what's the expectation for kind of non-GAAP gross margin when we think about '17? And certainly, where ultimately can that level go as your volumes continue to double in '17 and beyond?

As we continue increase the volume, then we continue -- should be enjoy the benefit of cost reductions. As you take a look now, we literally have not much test volume. But as we increase the test volume, we can see the efficiency of driving the cost down.

And maybe I can add a little bit to this. Also depend on the test, if you talk about small panel or middle-size panel, the cost will be much lower than that. So our COGS, we buy everything there as we see a lot of exome samples, and that's why the ASP is -- it still stay strong, not see the lower numbers there. So it really depends on what tests come in more in the future.

I'm showing no questions in the queue at this time. I would like to turn the call back over to Ming Hsieh for closing remarks.

Okay. Again, thank you very much for joining our call, and I'm looking forward to updating you in the next quarter. Again, thank you.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone, have a great day.