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Insulet Corporation (NASDAQ:PODD)

Q3 2008 Earnings Call Transcript

November 6, 2008, 5:00 pm ET

Executives

Duane DeSisto – President and CEO

Carsten Boess – CFO

Analysts

Mike Weinstein – JP Morgan

Paul Choi – Merrill Lynch

Matt [ph] – William Blair

Bruce Cranna – Leerink Swann

Philip Legendy – Thomas Weisel Partners

Mimi Pham – JMP Securities

Bill Plovanic – Canaccord Adams

Shawn Fitz – Stephens Inc.

Hamed Khorsand – BWS Financial

Suraj Kalia – Sanders Morris Harris

Operator

Good day, ladies and gentlemen, and welcome to the Insulet Corporation third quarter 2008 earnings conference call. My name is Ann and I will be your coordinator for today's call. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. At this time all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of the presentation.

I would now like to turn the presentation over to Duane DeSisto, President and CEO of Insulet Corporation. Please proceed.

Duane DeSisto

Thank you, operator. Good afternoon, everyone, and welcome. With me today is Carsten Boess, Insulet's Chief Financial Officer. Thanks for joining us to discuss our results from the third quarter of '08, another solid quarter for Insulet.

We will be making forward-looking statements about various aspects of our business, so please refer to our most recent 10-Q for a full discussion of our risk factors.

I am very pleased to report that, in the third quarter, we continued to make significant progress in strengthening Insulet's commercial and manufacturing operations and we achieved two impressive milestones, our first quarter of revenue in excess of $10 million and our first month of positive gross profits in September.

Our impressive top-line growth was driven by approximately 160% year-over-year growth in new customers. In the first half of 2008, we strengthened our sales and marketing infrastructure, achieving nationwide sales force coverage to drive the growing demand for the OmniPod System.

Q3 was the first full quarter in which we were able to leverage this expanded organization and nearly 2,000 new customers began using the OmniPod System. This growth is coming from all over the country, with all territories now up to speed and growing strongly.

Several years ago, when we finalized the design of the OmniPod System, we were confident that the products customer-friendly form factor would appeal to people with diabetes and their physicians and that our pay-as-you-go model would appeal to both patients and third-party payors. We were sure that if we could deliver insulin pump therapy that overcame the challenges of conventional pumps we could eliminate the obstacles preventing so many people from choosing the best possible treatment for Type 1 diabetes.

As I've said before, we knew the tough part was going to be building the manufacturing capacity to meet the markets eventual demand for such an innovative product.

After our dramatic jump in production in the first half of 2008, we turned our efforts to the challenge of driving down the costs per OmniPod. We met this challenge by successfully transitioning the majority of the OmniPod manufacturing to China over the course of the third quarter.

In the second quarter, approximately 80% of our production came out of Bedford, with the remainder from China. In the most recent quarter, the inverse is the case, with approximately 85% of our production coming from China. This was a swift and impressive transition and I'm proud of our accomplishment.

As a result of this transition, we were able to maintain our production volumes at a consistently high level of approximately 200,000 OmniPod's per month, which enabled us to decrease per unit costs and break through to positive gross profits in September. We expect the fourth quarter to be our first full quarter of positive gross profits.

Our operational infrastructure is also positioned to deliver cost-effective growth of the innovative and easy-to-use OmniPod Insulin Management System. We reversed the trend of increasing operating expenses in the third quarter, while posting significant top line in new customer growth.

The increase in new customers is partially a reflection of the success of our DTC campaign. We continue to see impressive results from these DTC programs, including magazine and Internet banner advertising, direct mail, as well as ads on dLife, a television program targeting the diabetes community.

Our DTC campaign has dedicated links and 800 numbers toward our unique trial tool, the OmniPod Product Demonstration Kit or PDK. We believe this call to action is a significant competitive advantage and a key element of the success of these programs.

In Q2, our conversion rate, as a percentage of referrals, went from the 70% range to the 60% range. We've made progress on turning this trend around, although we're not yet where we want to be. As part of this effort, we've added a few more internal resources and still have a few key hires to go.

We've also augmented our referral processing by starting to work with select distributors to give us indirect access to certain key managed care contracts we didn't previously have ourselves. We continue to invest in further demonstrating the clinical and functional benefits of the OmniPod System and expand the market for its potential uses.

The Company is supporting the first investigator initiated clinical trial of the OmniPod System to deliver concentrated U500 insulin to patients with Type 2 diabetes. This study, which completed enrollment in the third quarter is being conducted by Dr. Wendy Lane at the Mountain Diabetes and Endocrine Center in Ashville, North Carolina.

The first subjects will complete the one year trial in the fourth quarter of 2008 and the full study will be completed in 2009. We received very encouraging feedback from Dr. Lane about the early success of this study and the OmniPod's ability to control blood sugars for this extremely hard to control patient population.

Before I turn the call over to Carsten, I want to take a moment to comment on the overall economic environment and its impact on Insulet. As the company continues to experience double-digit growth, it is difficult for us to know whether we are being impacted by the weakening economy.

However, we are aware of what the larger companies in the space have previously announced and we're monitoring this closely. In view of this, we are cautious about the fourth quarter and we expect to come in at the low end of the range of our previously communicated revenue outlook of $36 million to $41 million.

Now Carsten will discuss our financial results in more detail.

Carsten Boess

Thank you, Duane. In the third quarter of 2008, we achieved sales of $10.1 million compared to $3.8 million in the third quarter of 2007. During the third quarter of 2008, approximately 1,975 new patients began using the OmniPod System, a sequential increase of 20%. On a sequential basis, reported revenue increased 36% compared to the second quarter of 2008.

As previously communicated, on July 1, 2008, we began to receive compensation from Abbott Diabetes Care for customer service activities in connection with sales of PDMs, with an Abbott blood glucose meter in it. In the third quarter, this accounted for slightly over $1 million in revenue. Deferred revenue at the end of the third quarter reached $2.3 million, up from $1.7 million in the second quarter of 2008.

Gross loss for the third quarter of 2008 was $87,000 or negative 1%, representing an improvement of $2.3 million from the second quarter to the third quarter of 2008. We achieved this improvement by maintaining our production at high levels and transitioning the majority of production from Bedford to China.

A key initiative for Insulet is to drive down our production costs per OmniPod. We have significant leverage in our financial model, as higher volumes drives economies of scale. Reflecting this leverage, from the third quarter of 2007 to the third quarter of 2008 revenue increased 167%, while in the same period, our cost of revenue increased only 34%.

Operating expenses were $19.7 million in the third quarter of 2008, up from $10.8 million in the third quarter of 2007. The majority of this increase was related to increased sales and marketing expenses. We've also started to see the leverage in our operating model, as we did not increase our operating expenses sequentially from the second quarter of 2008 to the third quarter of 2008.

We reported a net loss of $20.8 million for the third quarter of 2008, compared with a net loss of $13.6 million for the third quarter of 2007, and a net loss of $23.9 million for the second quarter of this year. In other words, our losses peaked in the second quarter of 2008 and in the third quarter, we saw a reduction of $3 million. As of September 2008, Insulet's cash and cash equivalents totaled $74.1 million compared to $94.6 million at December 31, 2007.

Moving on to guidance, as Duane mentioned, we expect to come in at the low-end of the range of our previously communicated revenue guidance of $36 million to $41 million. We expect a full-year net operating loss in excess of $75 million.

We have substantially improved our per unit production costs and continue to expect to deliver positive quarterly gross margins for the fourth quarter of 2008.

In summary, we are proud of achieving five financial goals in the third quarter of 2008. One, we achieved higher than $10 million sales, growing 36%. Two, we broke through for the first time to positive gross margin. Three, for the first time ever we did not increase our operational expenses. They remained flat. Four, we have reversed the trend of increasing operational losses. And five, the same as the case with respect to cash flow, we burned approximately $4 million less in the third quarter than in the second quarter of 2008.

Now I'll turn the call back to Duane.

Duane DeSisto

Thanks, Carsten. In the first nine months of the year, we made dramatic progress in scaling up our manufacturing capacity, more than tripling our production. We have also made dramatic progress in driving down our production costs since the beginning of the year, breaking through to record our first month of gross profits in September.

At the same time, we tripled our sales force and launched the highly successful DTC marketing campaign, driving close to a three-fold increase in revenue in the first nine months of the year, compared to 2007.

Our operational infrastructure is well-positioned to deliver the cost-effective growth for our shareholders. I remain confident on our market opportunity and believe we are uniquely positioned to significantly expand the use of insulin pump therapy.

Looking ahead, with our expanded commercial footprint, our pipeline of future products, and our growing base of clinical work, Insulet in poised to capture the growing demand for the OmniPod System and advance our mission to improve the lives of people with diabetes.

And with that, operator, I'd like to open up the line for questions.

Question-and-Answer Session

Operator

(Operator instructions) And the first question comes from the line of Mike Weinstein with JP Morgan. Please proceed.

Mike Weinstein – JP Morgan

Thank you. Good evening. Just a couple questions to start with. First, what's the – Carsten, what's the gross margin on the $1 million or plus of the Abbott royalties? Is that a 100% gross margin? How do we think about that?

Carsten Boess

That is 100% going through to the gross margin line, yes.

Mike Weinstein – JP Morgan

Okay. And then the comment on China and the production in the quarter. Was the comment that China was 85% of the production the whole quarter? Is that what you said?

Duane DeSisto

That is correct.

Mike Weinstein – JP Morgan

So, Duane, then why is the cost per unit so high then? Given that if you would have told me six months ago that 85% of the volume would come out of China, I would have preferred a quarter that I would have – I certainly wouldn't have thought you'd be still where you are at a loss per unit on the product.

Duane DeSisto

So, it's a good question, Mike, but you have to take a look at it. The bottom line is we're carrying four months worth of inventory. So what we produced in the third quarter has not hit the P&L.

Mike Weinstein – JP Morgan

Okay.

Duane DeSisto

So what you see in running through –

Mike Weinstein – JP Morgan

But the product that is worth going through the P&L this quarter. Obviously, it was product that you manufactured in the second quarter.

Duane DeSisto

That's correct. And in September we started seeing some of the China product starting to hit the P&L. If you look at the balance sheet, we're running with three months to four months worth of inventory on hand.

Mike Weinstein – JP Morgan

Okay. So the important question that is where are you right now today in your cost per unit coming out of China?

Duane DeSisto

I'll let Carsten go through that.

Carsten Boess

Yes. So I think the way to take us through that is just look at the historical trend here. So if we go back to the end of '06 we were at a $75 per part, end of '07 we had taken it down to $40, end of Q2 of '08 we had taken it down to $30 and now we have taken it down to the mid $20s. So that gives you sort of a sense for what we're talking about.

Mike Weinstein – JP Morgan

That mid-20s is where your current output is as of right now?

Carsten Boess

That is correct.

Mike Weinstein – JP Morgan

Okay. And what gets it down to the $15 a less you had targeted? What needs to happen?

Duane DeSisto

There's a couple of things. One is now that the price of silver has dropped down, vis-à-vis the batteries, some of that has to flow through the P&L, so that's a piece. Keep in mind that was $2 per pod. The second thing is you have to have all the products out of China running through the P&L for that to happen. So, I really think, when we start taking a hard look at it, Mike, I think you'll start seeing those kind of numbers starting to pop up in the first half of next year is really where it comes. The price of silver has come down. To give you some indication, the price of silver has come down dramatically. It impacted the P&L in the third quarter by $0.10. It will probably impact the P&L in the fourth quarter by somewhere in the neighborhood of $1 and you won't start seeing that full benefit until Q1. So there is a lag on all the things that we are, in fact, doing, but we really have not backed off from where we think we'd be. And it's $200,000 –

Mike Weinstein – JP Morgan

When do you think you'll be at $15 or less?

Duane DeSisto

It will be in the first half of next year. It will be probably in the $15 to $18 range in the first half of next year is kind of where we'll be.

Mike Weinstein – JP Morgan

In terms of what you'll be producing or what will show up in the P&L?

Duane DeSisto

It'll start showing up in the P&L.

Mike Weinstein – JP Morgan

Okay. That's very helpful. And let me just come to a couple other items, one, the guidance commentary, you said you don't know really if you're seeing an impact from the economy or not. Maybe you can give us a sense of how October was versus plan?

Duane DeSisto

Look, (a) I'm loathe to that. What I will tell you is the productivity per rep continues to go up by double-digits, so we're not really seeing it. I've met with all the regional managers this week, so honestly, Mike, we haven't seen it, but we're – obviously we're much in tune to what the two larger players in this market space are saying, which is its out there, so have not seen it. But we just want to be cautious. Maybe the reason we haven't seen it is, for instance, that Medtronic has several hundred sales reps out there and we have, basically, 50. So we still think there is a significant amount of opportunity, but I think it would be incredibly naive on us, I think that somehow we're going to – if they really are seeing what they're describing to the market, that somehow it's going to avoid us completely. So we just want to be – we want to be smart about it. We have not seen a decline in the productivity of the sales reps. Conversely, the productivity has gone up double-digits from Q2 to Q3, so we're still seeing some good progress. But, like I said, the two bigger companies out there in more places than we are describing this phenomenon. So we're just being cautious.

Mike Weinstein – JP Morgan

Understood. So let me make sure I'm thinking about the math right, Carsten. To be really at the low end of the range you have to be flat, maybe even slightly down sequentially in terms of new customers?

Carsten Boess

That is correct. In terms of new customers it is at the level of 2,000 new customers, 2,100 new customers in the fourth quarter. That's correct there, Mike.

Mike Weinstein – JP Morgan

Okay. And then the last item and I'll let some one else jump in here. But could you just update us on the progress of the next generation Pod and when we should start thinking about that coming to market and the profitability profile of that product? Thanks.

Duane DeSisto

Okay. It's very early on. Obviously there's all kinds of engineerings and regulatory hurdles to get through, but it really looks like a – our goal would be the back half of 2010. Our target is 40% smaller and 25% less cost is the target. We still have a ways to go, but we haven't seen anything to-date that would discourage us at the moment.

Mike Weinstein – JP Morgan

And the answer to the last part of the last question, the obstacle to get it there, in terms of that getting that to market and at the cost profile you're talking about is principally in the chip, that's the challenge?

Duane DeSisto

It is. The single longest gating item is basically the completely redesigned chip, which is custom to us in the circuit board. So that's the long gating item. That's all the probably single biggest cost driver in the product also, so.

Mike Weinstein – JP Morgan

Right and that's why back end of '10 rather than sooner than that, right?

Duane DeSisto

Yes. We've dialed in that for those – anyone that's been through kind of the whole chip business, usually it doesn't come out right first time.

Mike Weinstein – JP Morgan

Yes. Okay, great. Thank you, guys.

Duane DeSisto

Thanks.

Operator

And the next question comes from the line of Paul Choi with Merrill Lynch. Please proceed.

Paul Choi – Merrill Lynch

Good evening, guys. Thanks for taking the question. Duane and Carsten, maybe if I could perhaps start with the – maybe an update on the back office issue you guys brought up during Q2? Maybe you can describe where you guys, how you guys have progressed and what we should expect in terms of timeline for resolving that?

Duane DeSisto

So, Paul, I think we're doing a bunch of different things. We continue, as you remember, we tried to outsource this completely, which kind of got us into trouble. We are continuing to go down that path. We have hired, I think, three or four key individuals. The supervisor person that we needed for that we have now identified and hopefully we'll have her onboard here. So we're working that internally and we continue to explore other outside options. Our goal is – I think we have a realistic shot at being kind of back up in the 70 range, probably sometime early next year. I think, from our standpoint, I think it'd be a little optimistic to think we can have it all turned around before that. But, so we're making progress, we're not backsliding, we're actually starting to gain back on it again, but it just takes finding the right people and just kind of grinding through this.

Paul Choi – Merrill Lynch

Okay, great. And then maybe a next topic. In terms of patient retention rates or I think last quarter you guys had mentioned it was around the 90% vicinity or so. Is it more or less the same this quarter or can you observe any changes there?

Duane DeSisto

No. It's been very consistent, little better but nothing worth talking about.

Paul Choi – Merrill Lynch

So a slight pick up.

Duane DeSisto

Yes.

Paul Choi – Merrill Lynch

Nothing discernable?

Duane DeSisto

Yes.

Paul Choi – Merrill Lynch

Okay, great. Now, just in terms of your rate of cash burn, as you guys are looking forward into what might be a bit of a softer economic environment, as you guys mentioned. In terms of your plan, how quickly can you guys adjust the discretionary elements of your spending, Carsten, and pull back on some things like the DTC and the test trialing kits, in terms of how quickly could you turn on a dime?

Carsten Boess

I have a few comments to that. One is that already in the third quarter, did we take the spending on, on our sampling program is slightly down. It was an average $2.5 million per quarter in the first two quarters. We took it down to $1.4 million in the third quarter. One of the reasons that you see a slight decline in our sales and marketing operational spend in the third quarter over second. I would say, generally, on the cash question that we are committed not to raise any more equity dollars and we will use either one of two scenarios to accomplish that and that is one of which is to monetize our growing, significantly growing working capital, being the receivables and being inventories. And the other is to adjust, as you talk about, Paul, the spending appropriately. We are working on both of these scenarios as we speak and they will be the foundation upon which we'll go to the market and guide 2009, come our next conference call in late February.

Paul Choi – Merrill Lynch

Okay. Just on the point of the capitalization, how quickly would that potentially be done and when would we potentially be able to see that happening?

Carsten Boess

Yes. So we are working on it as we speak. It will be part of what we will guide on when we talk to you guys again in the end of February and the intent is this will only be needed from a cash point of view towards the end of next year.

Paul Choi – Merrill Lynch

Okay, fair enough. I'll jump back in queue. Thanks.

Operator

The next question comes from the line of Ben Andrew with William Blair. Please proceed.

Matt – William Blair

Good evening. It's actually Matt [ph] in for Ben. I just wanted to talk a little bit about the Abbott arrangement. So if I do the math pretty straightforward, it sounds like it's about $500 per PDM that you're getting from Abbott?

Duane DeSisto

I think the only thing that I would give you – you can do the math. I think the only thing you have to be careful of is if you remember, there was an upfront piece which there was an upfront piece to our agreement with them, which we amortized on a quarterly basis, so – but – and I can't give you the number because we signed a confidentiality agreement. What we have, in fact, disclosed is what we feel is necessary vis-à-vis the accounts and the SEC, so –

Matt – William Blair

Has there been any kind of change to the price of the starter kit that you ship out to your patients?

Duane DeSisto

There is no material change to that.

Matt – William Blair

Is there any thought to doing that in the face of the economic slowdown?

Duane DeSisto

I would tell you I think we're kind of looking the other way and saying this is an opportunity to raise prices, given everything that we see going on in the space, but if you remember, all our contracts, typically, when you get these contracts for managed cares they're from anywhere from one, which is usually unlikely, but typically, two years to four years, so, it doesn't – that number you really don't change on a dime in any way, shape or form.

Matt – William Blair

Okay. And then the comment about going through the distributors to get access to the managed care organizations. Should we anticipate an impact to gross margins next year negatively due to that? Or can you just give us a sense for if that's any kind of materiality?

Duane DeSisto

Sure. At the moment it's absolutely nonmaterial to our business. It's absolutely nonmaterial to the business. What it does do is gives us access to a couple of these smaller plans that open up some areas of the country that we couldn't get in. So do I see it being material to the business? Not at the moment.

Matt – William Blair

Okay. Has there been any update with that last big commercial payor that's been holding out or is that – ?

Duane DeSisto

There's a meeting scheduled, I believe, at the end of November. So we are progressing slowly forward, I hope.

Matt – William Blair

Okay. And then one last quick one. A split of patients from daily injectors and then from existing pumps, is that still kind of 75-25?

Duane DeSisto

Yes. That's still a pretty good guideline. The kind of exciting thing for us is on the DTC, the respondents to our DTC campaign. It's coming closer to 50-50, which that hasn't trans – that really hasn't popped up in the numbers that we've seen yet, so we're still running pretty close to 75-25, roughly. I don't know exactly, but order of magnitude to have some dramatically change. But on the DTC, we're starting to get some interest from people, even if they're a year or two away from their pump coming up for renewal. It's been interesting. It's been about 50-50, so we are – like I said, until you convert them into real business here it doesn't mean anything. But we are cautiously optimistic that we're starting to reach some of these people that have never seen the product before.

Matt – William Blair

Just real quick to follow-up on that point, is there a way to work with them and pre-certify them for reimbursement then prior to actually shipping them a product?

Duane DeSisto

We are actually trying to figure out a way. We're working with a couple of insurance carriers to see if there is a way that there is potential swap out opportunities for some of those. So really don't have anything yet, but we are, in fact, exploring that opportunity.

Matt – William Blair

Okay. Thank you.

Operator

And the next question comes from the line of Bruce Cranna with Leerink Swann. Please proceed.

Bruce Cranna – Leerink Swann

Good afternoon.

Duane DeSisto

Good afternoon.

Bruce Cranna – Leerink Swann

Hey, Duane or Carsten, would you guys be prepared to give us a patient number at quarter-end on the OmniPod?

Duane DeSisto

I think if you just – Bruce, the best way to do it is if you just take 90% of the numbers that we gave the new patients we keep given you just add them up. Off the top of my head I don't know what that is, but.

Bruce Cranna – Leerink Swann

Okay.

Duane DeSisto

And the only reason we're getting out of that business, it's just, we start – we now have some gestational patients and it really, really starts getting confusing tracking all that.

Bruce Cranna – Leerink Swann

Yes, okay, fair enough. And then the 85% production from China, is that at quarter-end, just to be curious?

Duane DeSisto

Yes, no, I think if you take the overall – I think what really started is we started this transition in July, so kind of the July, keep in mind with the holidays and some of the other stuff. So there is a transition period. So the bulk of that came in, in the last couple of months. July was pretty much – it wasn't all out of Bedford, but its lot of it was out of Bedford. It was at a lower production rate because we are transitioning and then they kicked in, in August and September for us.

Bruce Cranna – Leerink Swann

Okay. And where do you think you are at year-end, Duane?

Duane DeSisto

I think where we are is we're probably moving along to the tune of a couple of hundred thousand Pods per month or a 100% coming out, we should have 100% coming out of China. Once again, let me just, so no one gets confused. It will be four pieces, four automated equipment still in Bedford that are operating, but the rest of the assembly will all be done in China.

Bruce Cranna – Leerink Swann

And what sort of production numbers are you thinking about in sort of mid '09? Are we still thinking 400 or thereabouts?

Duane DeSisto

Well, my guess is we probably – we're working with Flextronics to see if we can get the capacity of a single line up between that 300,000 number and 400,000 number. So today I would tell you it's probably looks more like 300,000, but those are kind of out of one line. We're taking a hard look. If we can produce 300,000 out of one line out of China that would be a very nice incremental uptick. No use of cash, vis-à-vis any kind of equipment. So we're working with Flex on that. We're still negotiating with Flex on how to handle all this stuff on a go-forward basis. We hope to have that wrapped up here in the next few weeks.

Bruce Cranna – Leerink Swann

Okay. And then again on the guidance, not to beat a dead horse, but you guys are just being cautious with respect to 4Q and I understand that. But can you just maybe help us think a little bit about if there is some economic sensitivity with OmniPod users? I assume, of course, there would be more the folks coming from multiple daily injection versus existing pump users. So do you guys – do you know roughly what sort of co-pays the typical patients looking at, coming from NDI to an insulin pump of any variety?

Duane DeSisto

You're talking the – you're talking about – leave the pump out of it, just on the supplies. I think box of syringes is a couple hundred dollars, so you're talking about somewhere in the neighborhood of a $40 co-pay as opposed to $150 co-pay. So, look, like I said, we haven't seen it yet, but there is enough people talking about it and sometimes perception becomes reality. So we just, like I said, what we don't want to do is have a misstep here. We've had a great year-to-date. We're going to finish up with a great year and the last thing in the world we want to do is be back here explaining something, i.e., that everyone else has already talked about. So we haven't seen it, but it's a realistic possibility. Like I said, I met with all the regional managers and what they've basically said to me is, look, at the end of the day, I don't know if we didn't get some guy from a rural area because he decided not to go on the shot. So go off his shots because he couldn't afford the co-pay. All we're measuring at the moment is the productivity per rep on a monthly basis and we continue to see that grow. So it's a little – like I said, it's a little tough for us right now, but we are very cognizant of what the other two big guys in this space have said is going on there, so.

Bruce Cranna – Leerink Swann

Yes. I understand. But do you think its fair – ?

Duane DeSisto

After the kind of year we've had, the last thing in the world we want is a misstep.

Bruce Cranna – Leerink Swann

Yes, well, fair enough, but I just was trying to get a handle on. My assumption was that whatever level of sensitivity there was it's really more specific to the injectors rather than existing pumpers.

Duane DeSisto

I mean, our business is 75% of those people, so.

Bruce Cranna – Leerink Swann

Yes, I know. I'm just doing some math. Last question for me, because we haven't talked a lot about the U500 trial. Can you just give us maybe some details there to the extent you're at liberty to in terms of number of enrollees and endpoints and stuff?

Duane DeSisto

I think the endpoint is the beginning of 2009. There is 20 enrollees that have come in over the first few months here and the thing that so, so exciting about it, it is people that are typically highly insulin resistant. And while not all people that are insulin resistant, are, by medical definition, obese, that is typical of the profile. In the early, early returns from Dr. Lane, she's actually had people that basically she's come to us and said if you did not understand, if you didn't know they had diabetes going in, you would never be able to know it based on the most recent scans. So we're very, very excited about it and so we'll see. Maybe there's another opportunity here. Having said that, I will temper it with U500 insulin, it's not approved for use in a pump. It has to be clinician initiated, so it's not like that turns into millions of dollars of business overnight. But it is, so far, it's a very, very exciting opportunity for us and Dr. Lane.

Bruce Cranna – Leerink Swann

Do you have any sense as to whether or not payors will pay for Type 2 use of the pumps?

Duane DeSisto

Well, the intriguing thing about it is, in those particular cases we have a couple of people that are about to go off it and Dr. Lane's written letters and they are going to go on. So it's a very small in, but we have a couple of managed care companies that these patients have performed so well on it that we will, in fact, get those on the product and get them reimbursed.

Bruce Cranna – Leerink Swann

Alright. Thank you.

Operator

And the next question comes from the line of Philip Legendy with Thomas Weisel Partners. Please proceed.

Philip Legendy – Thomas Weisel Partners

Hi, guys.

Duane DeSisto

Hi.

Philip Legendy – Thomas Weisel Partners

Couple of quick ones, first, maybe for Carsten. Do you – can you tell us how much of the selling and marketing expense was from sampling?

Carsten Boess

Yes. So the sales and marketing costs for the quarter was $10.1 million and $1.4 million – $1.5 million of that was approximate level of samples. And again, as I said previously, that is a reduction from a level of on average $2.5 million per quarter in Q1 and Q2.

Philip Legendy – Thomas Weisel Partners

And for those samples, are those still – I assume those are still units that were produced in Bedford that are being used. Is that be fair?

Carsten Boess

That is a correct assumption, yes, because again, that is moving through just as Duane explained, in terms of the product being produced and moving through over four months in the inventory.

Philip Legendy – Thomas Weisel Partners

Right and then just there have been a few questions on this, but as you – maybe give us an idea how do you expect the gross margin to ramp at Flextronics? You've talked about when you expect it to hit the P&L, but if we think about 100% production in Bedford next quarter, how should we think about the cost of the units that are hitting inventory in that first quarter and what kind of production levels do you need to get to, to get into that $15 to $18 range?

Duane DeSisto

That's in the neighborhood of the 200,000 to 300,000, somewhere in there is when you start getting into that $15 to $18 range. That's kind of buying level.

Philip Legendy – Thomas Weisel Partners

Okay.

Duane DeSisto

And we haven't seen – at the moment, we haven't seen anything like I said, we are in ongoing decision with Flex about a bunch of different things here that we hope to wrap up shortly, but so we haven't seen anything that would lead us to believe that those numbers are off.

Philip Legendy – Thomas Weisel Partners

Good. And then maybe just in rapid fire for Duane, would you give us inventory CapEx and accounts receivable? It wasn't in the press release.

Duane DeSisto

I'll turn that over to Carsten. If I give it to you I'm pretty sure probably it'd be wrong.

Carsten Boess

Receivables net at the level of $11.8 million. The inventory at the level of $16.5 million and the CapEx at the level of $1.5 million for the quarter. The first two being naturally the balance by end of the quarter.

Philip Legendy – Thomas Weisel Partners

That inventory number is up significantly from the last quarter. Is there – is that – should we just be thinking about that as an insurance policy in case something goes wrong in the new facility?

Duane DeSisto

Yes. We deliberately brought the inventory up, given that we're moving everything to China. And I would tell you we're also a little bit surprised at how quickly it turned around, so we were pleasantly surprised. There clearly is an opportunity, on a go-forward basis, to take a piece of that inventory and turn it into cash. Like I said, in the early phases, the Company, the one thing we didn't want to do is have anyone ever run out of product. So move an entire manufacturing facility from the U.S. to China, I'm not sure we could have had enough insurance, so – but that was a deliberate effort on our part and like I said, we were a little bit pleasantly surprised and they came up a little quicker than we thought.

Philip Legendy – Thomas Weisel Partners

Fair enough. Thanks, guys.

Duane DeSisto

Thanks.

Operator

And the next question comes from the line of Mimi Pham with JMP Securities. Please proceed.

Mimi Pham – JMP Securities

Hi, good evening. How should we think about your sales and marketing levels in fourth quarter? Should we be keeping them constant with third quarter? Are there any new initiatives or costs that we should be thinking about?

Carsten Boess

I'd be willing to volunteer is if you look at the total operational spend and we are very happy that for the first time we're reporting a quarter where that is not growing and therefore you're starting to see the leverage in the financial model, in our operating model. And what I volunteer here is that the total conversation of total – of operating expenditures will not increase to any significant level compared to the third quarter.

Mimi Pham – JMP Securities

Okay. In terms of your attrition, you said that it's improved but nothing to speak of. Do you expect in the economy that it might increase if a larger portion of your current customers drop out because they don't want to – afford the co-pays or don't want to continue to pay the co-pay?

Duane DeSisto

Look, at the end of the day, as – this business is driven by health insurance to the extent the unemployment rate goes up dramatically, people lose their health coverage, I assume. I have no reason to believe that that won't impact us. But the one thing I will tell you, which is interesting is, having listened to a couple of calls where people did get in a little bit of financial trouble, they're desperately trying to find ways to stay on the product. Because unlike other alternatives, for the most part being on this product and an insulin pump, it's not like your diabetes goes away, right. So the point is people are actually trying to find a way, but if you don't have the money, you don't have the money and you go back to shots I assume.

Mimi Pham – JMP Securities

Okay. And given the sort of weaker U.S. economy impacts on the pump market, are you looking closer at international expansion or is that something you might be more aggressive about?

Duane DeSisto

Actually, we're going to go through the CE audits sometime here in the next few weeks and we have, in fact, accelerated all of that to try to get that in place, hopefully earlier in '09.

Mimi Pham – JMP Securities

Early '09?

Duane DeSisto

Yes. We're doing – we'll be doing this, we're just, I think, as part of the submission they have to come out, audit our facility, so that's supposed to take place here in the next few weeks and then my regulatory guys should have a better handle on, from that point, how long it takes to get all that stuff going, so.

Mimi Pham – JMP Securities

And in terms of your top centers, do you get a sense of your market share versus the other pumps, are you getting 10%, 50% of sort of the new pumps sold or used at some of your top centers?

Duane DeSisto

If you take a look – if you just give me some sense, if you take a look at some of the numbers and you can take exception to a couple of these if you like, but from looking at the various reports out there, there is 30,000 to 35,000 new customers, new pumpers a year. You start taking a look at the kind of numbers that we're putting on there as an overall basis, we're getting a very, very large percentage of those new customers. So and in the top centers, look, at the end of the day, for the most part, if we lose out at the top center, it circles around the dream of continuous sensing in a whole closed loop system, because we're not positioned at the moment to take advantage of that. But ultimately we think we have a better solution than what's out there.

Mimi Pham – JMP Securities

Okay. Thank you.

Operator

And the next question comes from the line of Bill Plovanic with Canaccord Adams. Please proceed.

Bill Plovanic – Canaccord Adams

Great. Thanks. Good evening. I'm just first to just leverage off of Mimi's question in OUS and CE Mark, are there any opportunity or thoughts about partnering outside the U.S. as a way to raise some capital?

Duane DeSisto

We are, in fact, talking to companies outside the U.S. as a way to help grow the business. If that's a method by which we can raise capital, that's even better.

Bill Plovanic – Canaccord Adams

Fantastic. And then, Carsten, just remind us, if we're – expect 100% manufacturing by Flextronics as we exit the year, I know you have a couple of machines still in Bedford that you're running. What are the next steps? You had mentioned previously that you're looking to sell them those machines. There would be write-offs coming associated with that, non-cash of course. And then are we still looking for a full shutdown of Bedford? Is that still the plan at this point?

Duane DeSisto

The plan is, short-term, Bill. This is Duane. The plan is we continue to talk to Flextronics about that possibility. We probably continue to run for the foreseeable future a couple of those key machines over there, because they're too new to us and too complicated probably to transfer immediately. But the vast majority of the production would be coming out of Asia.

Bill Plovanic – Canaccord Adams

Okay. And then I didn't understand when you mentioned that you're working with a couple distributors to help you with the reimbursement. I know somebody else asked that, but little more color on that, if you could?

Duane DeSisto

Yes. Without giving the names of the particular companies, but what's happened is, in some of these territories, there're some small managed care plans. So if you go into XYZ county and what it turns out is these managed care plans deal with particular distributors. So what's happening is we generate the leads and these people are in a position where they take our product in the leads and they end up processing them for the individual customers.

Bill Plovanic – Canaccord Adams

And then, is that a big – I know it's not a big piece of your business, but is that a – do they take a significant cut to do that? How does if got to get paid?

Duane DeSisto

Yes they get paid, but once again (a) it's a small piece of our business and (b) it's less than probably the cost to acquire the customer in the first place. So, but they do take, they do get some money out of it. There is no question about it. No one does anything for free, but it's not material to our business so it's not going to drive the average sell price in any meaningful way and like I said, right now, it's a couple of – there is a couple of isolated areas that, we've actually like I said, we've actually signed up for and the process is actually working.

Bill Plovanic – Canaccord Adams

Okay. And then I don't know if you mentioned this, but how many direct reps do you have today and what's your goal over the next couple quarters?

Duane DeSisto

Today, I think we're set with either 49 or 50 and the interesting thing is, we're taking a real hard look as we start looking towards '09. To the extent, the productivity continues to grow for these guys, and we haven't seen a flattening out, we're holding off for a short period of time to really see – understand this. If we were to add sales reps, just to give me, I mean, we may be talking another five or six, but order of magnitude where so far we're very pleased with how many orders these guys are producing, so, and like I said, we haven't seen a flattening out at the moment. So we're going to hang in at this number for a little while, anyway.

Bill Plovanic – Canaccord Adams

Okay. And then in terms of the debt, you have the $85 million convert out there. Is there any other debt on the balance sheet at this point?

Carsten Boess

That is the only debt on the balance sheet, due 2013.

Bill Plovanic – Canaccord Adams

Okay. And then did you restate that you're still expecting an operating loss prior to any one-time charges of $75 million this year, did I hear that?

Carsten Boess

That is correct. Yes.

Bill Plovanic – Canaccord Adams

Okay. And then just lastly, I know that silver prices have come down. Where are you in negotiating for an alternative supply or alternative battery or are you still working on that? Can we still expect that? And then what about with your ASIC contract? Has that been nailed down yet? And those are my last two questions, I promise.

Duane DeSisto

Sure. On the ASIC side, we've nailed that down and we've started that whole process vis-a-vis the new product I assume you're talking about. And then with regard to the battery, we are in – we're testing several potential alternatives, some from the same supplier where we go from an 80% silver battery to the 40% silver battery and other potential suppliers. And I would tell you I think there's – while we have nothing pinned down yet, I do think there is opportunity out there to accomplish a lot.

Bill Plovanic – Canaccord Adams

Okay, great. Thanks a lot.

Duane DeSisto

Welcome.

Operator

And the next question comes from the line of Shawn Fitz with Stephens Inc. Please proceed.

Shawn Fitz – Stephens Inc.

Hey, Duane and Carsten, thanks for taking my question. Just a quick job, quick question. Given the great job that you all have done in terms of ramping up your manufacturing efforts in China, why shouldn't we expect to see inventories decline on a go-forward basis from current levels?

Duane DeSisto

To be – why should you or shouldn't you?

Shawn Fitz – Stephens Inc.

Why should we not see inventories go down from here?

Duane DeSisto

Look, it clearly is an opportunity. We have a lot of money tied up there and as we continue to get more and more comfortable what's going on in China, the inventories should go down.

Shawn Fitz – Stephens Inc.

Okay. Great.

Duane DeSisto

Our standpoint, it's a big opportunity.

Shawn Fitz – Stephens Inc.

Okay. So we shouldn't necessarily expect to see them start to decline in the fourth quarter, Duane, but at some point, I guess in '09? Is that the right way to look at this?

Duane DeSisto

In '09 is when you'll start seeing that happen.

Shawn Fitz – Stephens Inc.

Okay. And then just kind of a dig down little bit deeper. If we assume that your end market demand is about 15 units per month that gets us to kind of an end market demand in terms of total units of about 360,000. So under those assumptions, it looks to me that maybe you all are manufacturing 240,000 or so more units than your end market demand as it stands. Could you point to any kind of flaws in that thought process or that logic?

Duane DeSisto

Well, I think there's a couple things you got to keep in mind here. We're doing some work with these pharma companies, which are going to require some product down the road here. We're taking a hard look at the whole EU piece. So and then the last piece, like I said, our goal really was, and the thing you have to really keep in mind here, our goal was to really find out what Flex can do, right? So –because that gives me comfort knowing that I can crank it up when I have to or turn it back down when I don't need it. So the real test for us is really kind of stress test our whole operation over there at Flextronics. And like I said, it's been – it's responded pretty well.

Shawn Fitz – Stephens Inc.

Okay. Great. Duane, last question and Carsten, just given you all's kind of prudent cautiousness as we look into the fourth quarter, how should we think about 2009 in terms of modeling, given some of that cautiousness as we move into the fourth quarter?

Carsten Boess

I think the best answer to that is that we'll come back and guide 2009 at our next call. Given the uncertainty in the market right now, that's the right answer to that.

Shawn Fitz – Stephens Inc.

Okay. Fair enough, guys. Thanks for your time.

Operator

And the next question comes from the line of Hamed Khorsand with BWS Financial. Please proceed.

Hamed Khorsand – BWS Financial

Hi. Just a quick question. In Q2 it seemed like you were hitting a bottleneck with fulfilling orders. How much of the acceleration in new OmniPod users was associated with you clearing up the bottleneck and could you provide a little bit more insight as to what the current bottleneck situation is like.

Duane DeSisto

Yes, look, I think the best way to describe this is we've generated more leads and more referrals in Q3 and the bottleneck that we created in Q2 has stabilized and has started moving back in the right direction. But the growth has really been due to the fact that we're generating more demand on the top line.

Hamed Khorsand – BWS Financial

Okay. Thank you.

Operator

And the next question comes from the line of Suraj Kalia with Sanders Morris Harris. Please proceed.

Suraj Kalia – Sanders Morris Harris

Good evening, gentlemen.

Duane DeSisto

Good evening.

Suraj Kalia – Sanders Morris Harris

Duane, in terms of the transition to China and if I heard correct about 85% of the product is being currently manufactured in China, can you share with us what the internal expectations or knowledge of the manufacturing failure rates or quality control costs, however you may want to define it, in China versus Bedford? What metrics are you using or what's the internal benchmark you're using for China versus Bedford?

Duane DeSisto

Sure. The failure rate in China to-date has been less than what has been in Bedford. The interesting thing about though our agreement with Flextronics is we have a fixed rate that we programmed into the price. So all the pricing we discussed today has a fixed scrap rate. The only thing that's not covered in that is, for instance – and when you think about China, think about that as, with the exception of the circuit board that they build for us, it's an assembly operation. So we ship them all the components. So, to the extent, the components go over there and they're bad, that scraps on us. But to the extent that they produce bad product, right now it's fixed at about a 3% rate, I believe.

Suraj Kalia – Sanders Morris Harris

Okay. And one final question, Duane. In terms of patient conversion, right from the time that you'll identify a patient, whether its through DTC, whether its through a referral, what you might have, whether its patient who's converting, what's the conversion time, if I may define it that way, currently from the point you'll pinpoint that person to the point he's actually, you actually make the sale?

Duane DeSisto

I would tell you it's a couple of things. One, if it comes through our DTC campaign it probably takes – where our leads generated, comes into the office, the leads forwarded to the sales rep. The sales rep makes contact with the patient and then it all hinges around when they go into see their doctor. But the bottom line is if you go to a physicians office and the physician is there with the patient to put the person on the product, from the time we see that, if it's a managed care plan that we currently are contracted with, we can take that, probably turn it around in seven days to ten days and have the product back in someone's hands. If it's not within the managed care umbrella that we currently have, then it starts getting a little more complicated. So the turnaround time, if you're in network with us is very, very quick. If you're not in network with us, then we have to struggle through the managed care piece.

Suraj Kalia – Sanders Morris Harris

And last question. In terms of some of the users of Medtronic's pump, I know the selling strategy is to convert the marginal patient, some of the newer guys coming online. But would you share what number of patients, percent wise you think, out of the total pooled you'll have you would say are Medtronic converts?

Duane DeSisto

I would tell you, if you really want to take our numbers and its running about 75-25, 25% being switchers and multiply that times their market share, which is probably about 80% and I think that's kind of order of magnitude what you would see as switchers. Look, Medtronic does a very, very good job of mining that installed base and turning that installed base and getting to the patients before they ever get to the market. As we said, the key for us long-term, in addition to taking the new patients, is what we really want to do is make people aware of the product, try our product and plant the seed of doubts so when the phone rings and they let them know that they're ready for an upgrade, they say, "Wait a minute, I just want to go see the Insulet guys." So that's where we're at.

Suraj Kalia – Sanders Morris Harris

Gentlemen, thank you for taking my questions.

Operator

And the next question comes from the line of Paul Choi with Merrill Lynch. Please proceed.

Paul Choi – Merrill Lynch

Great, thanks guys for taking the follow-up. Just a pipeline question. Can you give us an update on where the CGM development is going right now and when we can expect perhaps a first milestone?

Duane DeSisto

Sure. I think it's taken longer than we thought. Both companies have come back to us. They originally going to submit the PMA. They've asked us now to submit the PMA and we are in the process of evaluating the cost and the timeline if we have to do that. So it's going slower than we thought. Our hope is still that we're into the FDA next year, but it has gone slower than we had anticipated.

Paul Choi – Merrill Lynch

Okay. Thanks a lot.

Operator

And the next question comes from the line of Bill Plovanic with Canaccord Adams. Please proceed.

Bill Plovanic – Canaccord Adams

Thanks. Two interrelated questions. The first is the upfront payment you received from Abbott, how long is the amortization schedule for that?

Carsten Boess

Five years.

Bill Plovanic – Canaccord Adams

Okay. And then secondly, what's the flexibility of that contract? Really getting if somebody acquired you down the line, is that an easily breakable contract or how does that work if they have to wait till its up?

Carsten Boess

Yes, what you're asking is whether there's a change of control mechanism in the contract, the answer is yes.

Bill Plovanic – Canaccord Adams

Great. Thank you.

Operator

And there are no further questions at this time. I would now like to turn the conference back over to Duane DeSisto, President and CEO of Insulet Corporation for closing remarks.

Duane DeSisto

Thanks, everyone for joining us, and we look forward to updating you on our next call. Take care.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Have a good day.

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Source: Insulet Corporation Q3 2008 Earnings Call Transcript
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