Earnings Call Transcript - OM Q3 2020

Operator, Operator

Good afternoon, everyone, and welcome to our earnings call for the third quarter of fiscal year 2020. Participating for the company today will be Leslie Trigg, President and Chief Executive Officer; and Rebecca Chambers, Chief Financial Officer. During the call today, we offer commentary on our commercial activity and review our third quarter financial results, received after the close of market today, after which we will host a question-and-answer session. If you've not had a chance to review the earnings release, it can be found in the Investor Relations section of our website at outsetmedical.com. This call is being recorded and will be archived in the Investors section of our website. Before we begin, I'd like to remind you that it is our intent that all forward-looking statements made during today's call will be protected under the Private Securities Litigation Reform Act of 1995. Any statements that relate to expectations or predictions of future events, market trends, results or performance are forward-looking statements. All forward-looking statements are based upon our current estimates and various assumptions. These statements involve material risks and uncertainties that could cause actual results or events to materially differ from those anticipated or implied by these forward-looking statements. All forward-looking statements are based upon current available information, and Outset assumes no obligation to update these statements. Accordingly, you should not place undue reliance on these statements. For a list and description of the risks and uncertainties associated with our business, please refer to the Risk Factors section of our 424(b)(4) prospectus filed with the Securities and Exchange Commission on September 16, 2020, in conjunction with our initial public offering. With that, I'll turn the call over to Leslie Trigg, CEO. Leslie?

Leslie Trigg, CEO

Thanks, Lynn. Good afternoon, everyone, and thank you for joining us to review our third quarter 2020 results. I'd like to start by saying that we're very excited to be here on our first earnings call post-IPO and even more excited to start as a new public company with a strong third quarter result. We are pleased to report $13.8 million in total revenue for the third quarter, representing significant growth, both sequentially and year-over-year. Our revenue achievement exceeded our initial expectations for the quarter as Tablo adoption continues to accelerate within the acute market. We completed our initial public offering in September, raising approximately $255 million in net proceeds. So while we had the pleasure of speaking with many of you over the past months and years, for those we haven't engaged with yet, I'd like to provide a brief overview of the dialysis market, Outset, and Tablo before discussing third quarter commercial trends. At Outset, we built a first-of-its-kind technology, the Tablo Hemodialysis System, which was designed as a complete enterprise solution to enable dialysis to be done by anyone, anytime, anywhere. One of the main drivers of our determination to innovate in this space was the number of patients who require dialysis, which is a recurring nonelective and typically the only option for those suffering from end-stage renal disease or ESRD. Before Tablo, dialysis looked effectively the same as it did in the '90s, costly, cumbersome, and complicated. Tablo modernizes dialysis from the hospital all the way to the home. With Tablo's integrated water purification and on-demand dialysate production, all one needs to deliver dialysis is a faucet and a standard electrical outlet. And this enables providers to overcome traditional delivery challenges and lower their cost of care while simultaneously elevating the overall patient experience. From a commercial perspective, our near-term focus is on the acute care market, which we estimate represents a $2.2 billion total addressable market. We're also entering the home hemodialysis or HHD market, with an estimated $9 billion U.S. opportunity, which we expect to drive the second phase of our growth. We benefit from the ability to leverage a single integrated sales and field support organization to drive penetration across both markets since we're calling on the same customer base, national and regional health systems and innovative care providers. In the acute setting, Tablo resonates with C-suite decision-makers within these national and regional health systems because it provides meaningful cost savings and a short capital investment payback period, often less than a year. These cost savings dynamics are driven by Tablo's ability to reduce the need for infrastructure and specialized labor, combined with a lower cost of supplies. Further, Tablo uniquely enables the management of dialysis across the entire care continuum from the hospital to the home with a single device platform, which has never been done before. For the home market, we designed Tablo with automation and ease of use in mind. Animated touchscreen guidance and state-of-the-art sensors make setup and treatment management simple, friendly, and approachable, which expands the universe of patients who can be successful at home. Tablo empowers patients who traditionally have been passive recipients of dialysis care to take ownership of their treatment. And most importantly, we continue to hear reports from patients that they feel well while dialyzing on Tablo, with many patients anecdotally describing fewer intradialytic symptoms and less fatigue after treating on Tablo. In the month since our spring 2020 FDA clearance for the use of Tablo at home, we have carefully and deliberately begun to build the foundation for the adoption of our technology. We're really excited about the promise of Tablo in transforming the HHD market. And as a result, we're focused on delivering an exceptional patient and provider experience. And this means that our home rollout is intentionally very measured. Because what's more important than doing it quickly is doing it well. And along the way, we will be collecting training outcomes and retention data to demonstrate the impact Tablo had on the total cost of care. Over time, we believe our commercial efforts will benefit from several macro tailwinds, though our acute and chronic revenue growth is not dependent on them. For example, at 2019, a Presidential Executive order set the goal that 80% of new dialysis patients start at home or receive a transplant by 2025. CMS recently announced the first policy step towards this goal through its ESRD Treatment Choices Model, which goes into effect on January 1, 2021. Within this model, dialysis clinics will receive increases or decreases to revenue based on their success in improving home dialysis and transplant rates. The model mandates participation across 30% of all dialysis clinics nationwide. Second, also beginning in January 2021, all dialysis stations become eligible to enroll in Medicare Advantage for the first time. We believe this change will result in commercial payers taking an even greater interest in innovation that works to reduce the cost of dialysis and improve patient outcomes. Finally, COVID has added yet another plank to the Tablo value proposition. In addition to Tablo's cost reduction and efficiency benefits, hospitals using it through COVID also realized the advantages of the system's clinical versatility, rapid training, and point-of-care mobility. In terms of the COVID impact on the chronic care setting, we believe it will continue to influence patient preferences. The benefits of dialyzing at home have really taken on a whole new meaning compared to traveling back and forth to a dialysis clinic three times a week and sitting in closed quarters with other immunocompromised patients. So I'd now like to shift gears and discuss recent product enhancements and the commercial momentum that we drove in the third quarter. As you know, we intend to build on Tablo's value attributes through product updates and enhancements driven by our talented R&D, data science, and software engineers. This group is particularly focused on expanding our data ecosystem in ways that deliver economic and operational benefits to our customers, alongside initiatives that further improve device performance and lower our cost of revenue. To this end, we recently launched new functionality on Tablo Hub. As a reminder, Tablo Hub is our customer-facing platform that provides cloud-based access to treatment and machine data, strengthening patient care while simplifying billing and compliance-related reporting. As of Q3, this platform now also includes remote treatment monitoring, allowing clinicians to simultaneously monitor multiple patients on Tablo from afar. Providers can use remote monitoring whether the patients are in an ICU or a clinic or at home. This differentiating new feature is particularly timely as it helps reduce clinicians' exposure to COVID-positive patients during dialysis treatment. We also recently launched Tablo XT, which enables treatment for up to 24 hours. We've begun rolling out XT, both to new customers and existing customers that previously had purchased access to this new capability. Moving to commercial trends. Our traction in the acute market continues to grow, and we are really pleased with the pace and scale of commercial adoption. New contracts with national and regional health systems, in addition to expansion within our existing customer base, drove our strong Q3 results. During the quarter, we signed agreements with three new national IDN customers as well as three new thought-leading regional health systems. As a result of this progress, we are now engaged with six of the largest national health systems in the country and more than a dozen of the top regional health systems. For perspective, one of these new customers is a regional IDN with over 50 hospitals and long-term care facilities. This customer's purchase decision was tied to a focus on total cost reduction and operating efficiency, which Tablo offers compared to incumbent machines. And importantly, their decision was made outside of the health system's typical replacement cycle, which is a buying pattern we continue to see across our contracting. In the third quarter, we also secured a contract with the U.S. Department of Health and Human Services, which leaves an additional 50 Tablo consoles, expected to contribute $16 million of product and service revenue over a two-year period. These consoles will be placed into the Strategic National Stockpile for use during natural disasters and for the nation's COVID response. On the dialysis home front, our first patients began dialyzing at home on Tablo this past quarter. Since then, we've seen our home patient pipeline grow meaningfully, tracking to our projections. More broadly, we've also seen our commercial efforts translate into growing interest among health systems and innovative care providers. In addition to developing a strong customer and patient pipeline, we're also devoting resources to data collection on patient training time and retention on Tablo at home. So far, patients have been vocal about their positive experiences on Tablo, especially those with previous HHD experience on the incumbent machine who decided to switch to Tablo when it became available in their area. We're finding that it consistently takes about two weeks to effectively train a Tablo home patient, which our customers have noted as a very significant reduction compared to the four to six weeks it typically takes on the incumbent HHD technology. Retention, while early, is also tracking above our expectations. We also recently bolstered our leadership team. As we announced on Monday, we appointed Steve Williamson as our Chief Commercial Officer. Steve joins us from Becton Dickinson, where he was most recently President of the company's $1.5 billion Peripheral Intervention business. Steve has a proven track record for scaling commercial organizations while driving operational excellence, and we look forward to his leadership here at Outset. So in the quarters ahead, we're focused on three critical objectives: first, growing revenue in the acute and sub-acute market top down through national and regional health systems while also laying the foundation for deeper expansion into the home market over time; second, driving down the cost of our products; and third, scaling our business. Before ending my prepared remarks, I'd like to circle back to our mantra, which is better begins now. And each part of that declaration says something really important about our mission. The first word, better, underscores our determination to radically elevate the experience for patients and reduce the total cost of care for providers. The last two words, begins now, reveal our sense of urgency. After decades of receiving good enough, patients and providers deserve great. They deserve amazing. Not tomorrow, not next month, not next year, they deserve it now. And with structural market tailwinds at our back, first-of-its-kind technology and an aspirational execution-focused team, we believe we are uniquely positioned to deliver on this very promise. So with that, I'll now turn the call over to Rebecca.

Rebecca Chambers, CFO

Thanks, Leslie. As Leslie mentioned, third quarter revenue grew 423% year-over-year to $13.8 million. This result was driven by strong acute adoption, including the impact of our HHS contracts and COVID-related orders that we received during the second quarter as well as growth in consumables and services tied to our larger installed base. Product revenue grew 349% year-over-year to $10.8 million. Console revenue equaled $9 million compared to $1.9 million in the prior year period. Consumable revenue grew 263% to equal $1.8 million, driven by our larger installed base and increased ASP compared to the prior year period. Service and other revenue grew $2.7 million compared to the third quarter of 2019 to equal $2.9 million. Growth in service agreements across our larger installed base, including HHS and freight revenue, contributed to the growth. While COVID has been a tailwind for us in the second and third quarters, it is now embedded within the many Tablo advantages that drive our customers' purchasing decisions. Therefore, we don't anticipate meaningful revenue driven solely by COVID in the fourth quarter. Our base business is expected to continue to grow significantly, and as a result, we anticipate Q4 revenue to be similar to what we reported in the third quarter. Turning now to gross margin and operating expenses. I will highlight our non-GAAP results. I encourage you to review the reconciliation of GAAP to non-GAAP measures, which can be found in today's earnings release. Our Q3 non-GAAP gross margin was minus 36.3%, an improvement of 165 percentage points versus the prior year period. This year-over-year expansion was the result of significantly lower console material costs as our R&D and supply chain teams delivered on cost-down activities ahead of plan as well as a reduction in our finished goods balance and associated lower of cost or market accounting treatments. Sequentially, gross margin improved by four percentage points. Consumable margin expansion as a result of moving to a lower-cost logistics provider, coupled with higher services margins stemming from improved utilization of our field service team, contributed to the sequential improvement. Console margin was slightly lower sequentially as expected, given startup and labor costs to support our manufacturing in-sourcing initiative. These expenses offset a meaningful sequential reduction in the console standard cost. In the third quarter, we finalized the build-out of our console manufacturing facility and are tracking to launch our in-source console manufacturing efforts in the second quarter of next year. Our initiatives to move the production of Tablo cartridges from our existing contract manufacturing partner in Thailand to a new contract manufacturer in Tijuana, Mexico, also remain on track. We saw significant gains in our cost-down initiatives during the third quarter, and our plans to further drive gross margin expansion continue to advance rapidly. Looking ahead to the fourth quarter, gross margin is expected to improve sequentially. Further investment in the startup and labor costs to support our console manufacturing initiatives is expected to be more than offset by a full quarter of the cost reduction benefit as well as the release of a portion of the Tablo XT revenue deferral. Moving to non-GAAP operating expenses. Third quarter operating expenses equaled $21.8 million, up $8.9 million versus the prior year, driven primarily by investments in our commercial organization. Compared to the prior quarter, non-GAAP operating expenses grew $2.4 million. Higher commissions tied to bookings growth as well as an increase in G&A expenses associated with operating as a public company drove the sequential pickup in OpEx. As detailed in the GAAP to non-GAAP reconciliation in our earnings release, third quarter stock-based compensation expense was $13.9 million as we recorded expense tied to satisfying the performance vesting conditions for certain options upon the closing of the IPO. We expect to recognize an additional $10 million of stock-based compensation related to these performance options over the next two quarters. Looking ahead to the fourth quarter, our basic share count will be approximately 42 million shares. We reported third quarter GAAP net loss of $42.3 million, resulting in a net loss of $3.44 per share compared to a net loss of $16.7 million or $18.93 per share for the prior year period. Non-GAAP net loss was $28.4 million or $2.31 per share compared to a non-GAAP net loss of $16.4 million or $18.67 per share for the same period in 2019. As Leslie mentioned, we raised approximately $255 million in the IPO. We ended the quarter with approximately $378 million of cash, cash equivalents, restricted cash, and short-term investments. In summary, Outset has made exceptional progress to date on each of our 2020 initiatives. We have expanded our commercial footprint, launched exciting new product updates, improved our gross margin, and secured FDA clearance for HHD. We remain dedicated to delivering for our customers, their patients, our employees, and shareholders by continuing to innovate and execute. We look forward to providing an update on our Q4 progress during our next earnings call. Thank you for your time. We will now move to the Q&A session. Operator, please open the line.

Robert Hopkins, Analyst

Congratulations on your first quarter as a public company. I would like to ask about some of the details from the quarter. Rebecca, you mentioned that you generated approximately $1.8 million in consumable revenue during the quarter. Could you provide insight on how this number compares to your performance in Q2? Additionally, what utilization trends are you observing per system? Did the utilization meet your expectations for the quarter?

Rebecca Chambers, CFO

Yes. Thanks, Bob. Happy to do so. So in the second quarter, consumables were approximately $1.5 million. So a nice pickup sequentially and roughly in line with expectations. We did see, on a year-over-year basis, very strong ASP, which on a sequential basis was roughly flat. So the strength in ASP has continued that we were seeing in the second quarter. Utilization on a per machine basis was around 4.5 treatments per week across the installed base. And really, a couple of factors there. I would say we did place a number of consoles in the second quarter as you well know. And those number of consoles did include some of the COVID-related consoles that we referred to earlier in the script. Those consoles are trending towards expectations, though a little bit slower of a ramp than the overall installed base. So on a net-net basis, the foundational utilization continues to trend as we'd anticipate. And we do expect those COVID consoles in the fourth quarter to get back to more normalized trends.

Robert Hopkins, Analyst

Okay, very thorough. I wanted to discuss your comments on Q4 and how you are quantifying the COVID benefit. I apologize if I missed this, but could you clarify how you are measuring that benefit? It would help us understand the trend from Q3 to Q4 without considering the COVID benefit.

Rebecca Chambers, CFO

Sure, I'm happy to help, Bob. Leslie will add a few points. We quantified it and discussed a $7 million related to the Q2 order over the summer, of which we recognized about $3 million in the second quarter. Most of the remaining amount will be recognized in the third quarter, which was significantly notable as expected when we communicated our projections. This order, related to COVID, was recognized over these two quarters. When excluding this impact and focusing on the underlying trends of our base business, we observed steady sequential growth throughout Q3 and Q4, as well as in every quarter of 2020. Q4 is also performing better than our expectations from just a few months ago, and we have strong confidence in our position since we are still operating within a backlog environment. I hope this clarifies the trends for you. In summary, there has been significant growth in our base business once we account for the COVID-related impact in the third quarter.

Leslie Trigg, CEO

Let me add a couple of points to the last part of your question regarding our perspective on COVID in the upcoming fourth quarter. Firstly, it's important to emphasize that dialysis is not an elective procedure; patients require it three times a week or more, year-round, regardless of the pandemic. This makes our business somewhat unique within the medtech sector. If COVID hotspots continue to emerge during Q4 and into 2021 across different regions, it won’t affect our confidence or projections for the fourth quarter or beyond. In terms of the positive impact from COVID, it is now integrated into the factors influencing customers to adopt Tablo. While COVID is a consideration, it is just one of several factors contributing to the decision to purchase Tablo, rather than being a standalone driver. The primary reason health systems are adopting Tablo relates to cost reduction. As you may know, there is no Diagnosis-Related Group for inpatient dialysis, meaning hospitals incur costs every time they provide dialysis. We mentioned earlier that national data indicates about 60% of inpatient stays involving dialysis lead to a negative operating margin for hospitals. Hence, the urgency for cost reduction has never been greater. I believe that COVID may further amplify this need, as health system executives are increasingly focused on cutting costs to enhance operating margins, especially with ongoing uncertainty regarding the return of elective procedures. Therefore, Tablo aligns well with strategic imperatives and serves as a powerful solution, regardless of COVID.

David Lewis, Analyst

I have a quick question for Rebecca and Leslie regarding console placements. Can you clarify how console placements in the second half of the year compare to the first half? Will they be higher in the second half?

Rebecca Chambers, CFO

Yes, David, I'll take the first bit. And absolutely, they will be higher in the second half of the year than in the first half of the year, and that is embedded in our guidance.

Leslie Trigg, CEO

Okay. So great. I'll take it from here. So yes, regional versus national IDNs. I think as we mentioned in the script, we now have signed master sales and service agreements with six of the largest national health systems, inclusive of the VA in the country, and three of those new sort of marquee national health systems came on to our roster in the third quarter. I guess, what I'm excited about is how well the national players are understanding the value of a single enterprise solution. What we're seeing typically with these national rollouts is kind of a typical cadence where they'll start with a smaller number of hospitals in their network, integrating Tablo and quantifying the cost reduction impact. How easy it is for them to train their own nurses to deliver dialysis. And then once that data has been established, we've seen their next step pretty quickly be spreading that model across perhaps a division or a group of hospitals and then fairly quickly over time, network-wide. So I would say we have a sales force that is equivalently focused on the top 50 regional hospitals and the national hospital health systems. But in general, we've been very, very encouraged and excited about how quickly the uptake has been occurring with these large national health systems in particular.

Rebecca Chambers, CFO

Yes, David, sorry, I was on mute. I was also trying to ask whether placements will increase in the fourth quarter, meaning I expect placements to be higher in the fourth compared to the third. If we exclude the large order we received in the second quarter, the trend appears to be different. Essentially, the trend in console unit placements will be flat or slightly increasing on a sequential basis. Additionally, we should consider the HHS order, which will contribute to console revenue, as we will benefit from a full quarter of both the console and service lines.

Amit Hazan, Analyst

Congrats on all the milestones. I'll add that as well. Let me maybe just start by seeing if I can get you to comment on 2021. And obviously, you're not giving formal guidance, but can you talk just qualitatively to any puts and takes that we should be thinking about, whether it's related to console placements or other items you would want to call out for us?

Rebecca Chambers, CFO

Yes, I'm happy to discuss this qualitatively. Thank you for the question. As we approach the end of this year, we're in the midst of our planning for 2021. The trends we've observed in the third quarter, which we anticipate will continue into the fourth quarter, are not merely specific to this period and provide us with confidence in our outlook for 2021. While I'm not able to offer detailed comments beyond that, I can say that we are pleased with the business performance. Our confidence for the fourth quarter is quite strong, which also supports a positive outlook for 2021.

Leslie Trigg, CEO

Sure, I'll address that. The short answer is that things are going very well. We've been pleasantly surprised by how quickly our pipeline is being filled, especially among health systems that see this as an opportunity to enhance their episodic revenue streams with a more consistent chronic revenue stream outside the hospital. Another important realization for health systems is that they have access to all the resources that make them great partners for patients, including their network of physicians, nephrologists, and care extenders. Many already have nurses and nurse practitioners providing home care, which gives us a comprehensive support system. Although it’s still early days, I’m pleased to see a number of prominent national organizations showing strong interest in the home care model and eager to expand their capabilities in managing patients from acute care to home care settings.

Danielle Antalffy, Analyst

I have one question for you, Leslie, and my second question is for Rebecca. So Leslie, when considering the acute therapy sale, how should we view your penetration in the hospitals where you have some presence? I'm trying to understand how much of the incremental growth will come from same-store sales versus new centers opening, especially since it's still early and there's significant growth potential. Then I'll follow up with Rebecca after that.

Leslie Trigg, CEO

I think there are a couple of points to consider. First, we believe we're just getting started and have a long runway ahead, especially focusing on the top 50 regional health systems. We noted that we are currently engaged with over a dozen of them, which indicates a significant opportunity still available until we reach 50, not to mention the smaller hospital networks beyond that. Additionally, on the national front, we're making excellent progress, having established a presence in six of the top national systems. Our strategy focuses on building our penetration within these networks, so we closely monitor both the number of individual facilities and our overall customer count. The potential for growth within these national systems is impressive. Each of the six national clients we've publicly mentioned presents substantial opportunities for further expansion in their respective hospital facilities nationwide.

Rebecca Chambers, CFO

Yes. Thanks for the question, Danielle, and that's a fair point. We were very pleased with our quarterly results. However, I want to emphasize that one quarter doesn't necessarily indicate a trend. We are confident in the plan we outlined and are executing it as intended. We believe we can deliver these new manufacturing in-sourcing initiatives for the console and the second source initiative on the cartridge side in the second quarter. That should remain our base case, and we will continue to make progress toward that plan. But again, one quarter is not enough to call a trend just yet.

Frederick Wise, Analyst

Maybe another aspect that you highlighted in terms of investment, Leslie, revolved around the sales organization. I'm just a bit curious to hear your, I'm sure, ever-evolving thoughts about the team, where you're investing and where you are focusing people?

Leslie Trigg, CEO

Sure. Yes, I'm happy to answer that. People are very important at Outset. We often emphasize that our goal is to provide not just a device, but an experience to patients and providers. With this mindset of delivering a unique experience, we rely heavily on the quality of the individuals involved in the execution. Therefore, we spend a significant amount of time considering the right people for the right roles at the right times. With this in mind, our investments are primarily focused in three areas. First, our national accounts team, which includes geographically focused capital sales representatives. We are making progress in ensuring strong representation in the major regions that encompass our top 50 regional health systems. We are especially proud of our robust national accounts team. Second, we invest in our Tablo program specialist team, or TPS, which serves as our day-to-day leaders for implementation, overseeing not just the installation but the overall Tablo program rollout. They play a crucial role in ensuring that training is effective and that the initial treatments are successful, helping nurses, technicians, and physicians gain confidence in using Tablo for their patients. Expanding the TPS team is a key focus as our installed base and new order growth continue. Lastly, our field service support team is vital to our success as well. The field service engineers work alongside the TPS team and are essential partners in ensuring successful implementations at new facilities. These three groups within our field organization are where we are concentrating our investments as we experience significant growth in our acute installed base.

Operator, Operator

Thank you. As a reminder, a replay of this call will be available as a webcast in the Investors section of our website, as well as through the dial-in instructions included in today's earnings release. Thank you again for joining us today. This concludes our call, and we look forward to our next update following the close of the fourth fiscal quarter. Thanks, and good night.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect. Everyone, have a good evening.