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Insulet Corporation (NASDAQ:PODD)

Q3 2013 Earnings Call

November 7, 2013 5:00 PM ET

Executives

Brian Roberts – CFO

Duane DeSisto – President and CEO

Analysts

Kim Gailun – J.P. Morgan

Danielle Antalffy – Leerink Swan

Bill Plovanic – Canaccord Genuity, Inc.

Tom Gunderson – Piper Jaffray & Co.

Ben Andrew – William Blair & Company

Raj Denhoy – Jefferies

Mimi Pham – ABR Healthco

Chris Cooley – Stephens Inc.

Jayson Bedford – Raymond James

Suraj Kalia – Northland Securities

Operator

Good afternoon, my name is Linda, and I will be your conference operator today. At this time, I would like to welcome everyone to the Q3 2013 Insulet Corp Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question and answer session. (Operator instructions)

Thank you. Mr. Brian Roberts, Chief Financial Officer, you may begin your conference now.

Brian Roberts

Thank you, Operator. Good afternoon everyone, and thank you for joining us for our third quarter 2013 conference call. I’m Brian Roberts, Chief Financial Officer of Insulet. Joining me on the call today is Duane DeSisto, our Chief Executive Officer.

Before we get started I like to remind everyone that our discussion today may include forward looking statements as defined under the securities laws. We intend these [ph] forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in Section 27A of the Securities Act and Section 21E of the Securities Exchange Act and are making the statements for purposes of complying with those Safe Harbor provisions.

These forward-looking statements reflect our current views about our plans, intentions, expectations, strategies and prospects, which are based on the information currently available to us and on assumptions we have made. There are risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements.

Information concerning the company’s potential risks and uncertainties is highlighted in the company’s press release issued earlier today and in the Risk Factors section of the company’s SEC filings including the company’s annual report on Form 10-K for the year ended December 31, 2012.

These risk factors apply to our oral and written comments. We assume no obligation to update publicly any forward-looking statements whether as a result of new information, future events or otherwise.

I’d also like to remind you that the guidance we are offering today represents a point-in-time estimate of our future performance. You will find a link to the webcast of this call, as well as to today’s press release at myomnipod.com in the Investors Section.

And now, I’ll turn the call over to Duane.

Duane DeSisto

Thank you, Brian. Good afternoon everyone. The third quarter was one filled with tremendous accomplishments for Insulet as the new smaller OmniPod continued to receive an extremely enthusiastic response in the market place.

Demand for the OmniPod continues to exceed our expectations with new patient starts more than 40% higher than a year ago with no signs of this growth slowing in Q4. We have transitioned over 90% of our existing direct customer based to the new OmniPod and we now have capacity to reduce nearly a million OmniPods per month.

The robust demand for the new OmniPod draw strong revenue growth in the quarter as OmniPod revenues increased by approximately 30% year-over-year. In addition, we generated positive cash flow for a second consecutive quarter as our cash balance increased to $154 million from $151 million.

Enthusiasm for the new smaller OmniPod remains high as our easy-to-use tubeless design appeals [ph] to customers and health care professionals alike. OmniPod is design with this automated and painless insertion is particularly attractive for children in key demographic. In the third quarter alone, we experienced nearly 70% year-over-year increase in pediatric patient starts and more than 100% increase in children under 10 years old.

We’re also making terrific progress expanding the base of health care professionals prescribing the OmniPod. Our ability to broaden and deepen our prescriber base has always been a key to sustain and maximize our growth potential with the new OmniPod. Nearly nine months into the launch [ph], I believe we have made significant stride in this area which puts us in great position as we look towards 2014.

Since the launch of the new OmniPod, more than one and four practices are new prescribers. Orders from these offices represent approximately 20% of our initial shipments. Importantly, these practices are coming back with additional prescriptions, an indication that they are happy with how they’re initial patients on the product have performed [ph].

The sales team is also leveraging the new OmniPod to deepen our relationship with the existing prescribers. And more than 20% of our existing practices year-over-year initial shipments are more than doubled.

Demand for the new OmniPod has also been extremely high from our existing customer base. Commencing in late June, we embark on ambitious plan to transition the base over one way or recycle [ph]. In addition to getting the smaller pods, all in-warranty customers receive the system’s new PDM at no additional cost.

Over the past several quarters, we have commented that we experience disruption and reorder patterns ahead of this transition. As customers utilize the remaining first generation OmniPods and try to time the reorders to receive the new OmniPod as quickly as possible. As people ignored their normal reorder dates and attempt it to move ahead in line we have the significant spike in core [ph] volume to our reorder team in the third quarter.

In July alone, we feel that approximately four times our normal reorder core [ph] volume. Although this taxed our internal resources, the teams worked diligently to catch up and execute the transition as quickly as possible.

Currently we estimate that more than 90% of our direct customer base has transition to the new OmniPod. And we continue to work closely with our distributor partners as they complete their conversion as well.

We’re also pleased to note that customer service levels have stabilized as core [ph] volumes have normalized back to the pre-transition levels. Reorder utilization appears to have returned to a more normal patterns thus far in the fourth quarter.

International demand for the new OmniPod also continues to be strong. Ipsen [ph] noted earlier this week that since the beginning of the year, the diabetes revenue has increased by more than 100% as compared to the prior year. OmniPod continues to take share in key markets such as the Netherlands, Germany and Switzerland just to name a few.

It’s worth noting that [ph] potentially competitive products that have either recently been approved or expected to be approved in coming quarters here in the U.S. have been on the market in Europe for quite some time. Despite these product offerings we have been able to effectively more than double our European business year-over-year, unlike the U.S. have increased the way the [ph] patient additions each quarter.

Our partnership with GlaxoSmithKline also continues to perform well. With help for approval [ph] now in hand, we will commence the transition to the new OmniPod in Canada this quarter. Once the conversion is finish in Canada, all patients worldwide will then [ph] transition to the new – transition to the new OmniPod.

To meet this growing levels of demand, we’re pleased to note that we put our third manufacturing line into operation in late August, slightly ahead of plan. The operation team continues to execute at a high level as we have doubled production from a level of 20,000 OmniPods per day in July, to current levels of approximately 40,000 OmniPods per day.

We now have the capacity to produce approximately 1 million OmniPods per month. Our expectation is that we will continue to run the lines at or near capacity through the first quarter as we rebuild inventory levels and take into account shutdown in late January for the Chinese New Year.

Inventory supply was limited throughout the third quarter as we manage inventory levels closely with the goal of ensuring customers did not run out of product. As a result, we held inventory levels at the distributors to absolute minimum and left the quarter with more than $4 million of distributor orders unfulfilled. With supply now increasing, thanks to the third manufacturing line we have filled these orders and currently do not have any passed due backlog.

In October, we announced that we settled the Patent Infringement Law suit with Medtronic. As part of the settlement, we made a onetime payment to Medtronic and have agreed to a cross-license certain patent claims.

Importantly we agreed that Medtronic – with Medtronic that neither company will sew [ph] the other for patent infringement base on any of our existing products, features or components of our existing commercially available products.

We are very encouraged by the terms of the settlement agreement as it provides us significant freedom to operate and innovate off of our current offering with comfort that additional claims will not be asserted against us.

Turning to our pipeline of future products, we have thrilled to have hired Dr. Howard Zisser as the company’s first medical director. Dr. Zisser’s clinical expertise, background and reputation as an innovator in current and emerging diabetes technologies are on parallel [ph] and we believe he will make a significant contribution to Insulet.

Howard, has been spending his first few weeks getting up to speed on all of our future product and clinical initiatives, he will be spending a considerable amount of his time going forward helping us to define and develop products such as our CGM enable OmniPod and our OmniPod’s specifically designed to be use with concentrated insulin, our first entry into the type two space.

In regards to our CGM efforts, we are making progress with the partner around our goal of enabling an OmniPod with CGM technology. Our partner continues to analyze and review data related to the sterilization process and we are working closely together to determine the best path forward.

Additionally we continue to parallel path other parts of the project such as work around on insertion design and work with research partners around algorithms that will help make the CGM enabled OmniPod, a system that will continue to be the easiest to use in the market.

Our partnership with Eli Lily was signed in May and although it is still in the early days, we are progressing as planned. The teams are meeting regularly and we have commenced work related to modifying the software in our personal diabetes manager to account for the higher concentrated insulin. We remain excited about the potential of this project with the estimated potential of approximately 2 million people living with highly insulin resistant type II diabetes.

We have also continued working [ph] on several projects, we use the OmniPod for drug delivery outside of the diabetes space. Our partner in the ecology space is expecting to submit to the FDA in the coming months. Our earliest stage drug delivery projects and other disease stage are on track as well. The OmniPod has proven itself to be an effective drug delivery platform across disease states and we will continue to identify an sees new opportunities to stay arise.

In summary, we had exceptionally strong performance in the third quarter. The transition of basically the entire customer base is such a condensed time period was nothing short of moving a mountain. We are pleased to have that hurdle behind us.

It is clear that the new OmniPod is appealing to new health care providers and potential customers including people with diabetes who have never considered pumping before. New patient starts remain extremely strong and we continue to see more than 70% of our customers to be first time pumpers. The OmniPod remains the product of choice for people living with diabetes who want the freedom, discretion and easy to use of tubing-free pump technology.

Looking ahead, we expect to finish 2013 on a strong note with three manufacturing lines near capacity to support the increase demand for the new OmniPod and the rebuilding of inventory levels. In total we expect revenues $65 million to $71 million equating to approximately $244 million to $250 million of revenue for the full year. We continue to expect that we will be at or near operating breakeven by the end of the year.

Now, let me turn the call over to Brian.

Brian Roberts

Thank you, Duane. Consolidated revenue increased by 12% to $61.1 million in the third quarter of 2013, compared to $54.8 million in the third quarter of 2012. As a reminder, our third quarter results includes a reduction of more than $4 million in neighborhood diabetes revenue related to the impact of Medicare competitive bidding which took effect on July 1.

Adjusting for the impact of competitive bidding, year-over-year revenue growth in the quarter would have been approximately 20%. We had another strong quarter of OmniPod revenue growth which improves by nearly 30% over Q3 2012. Additionally, we left over $4 million in unfilled distributor orders at the end of Q3.

Taking these open orders into consideration, OmniPod growth would have been approximately 35%. New customer additions continue where to rate [ph] in excess of 40% year-over-year since March and we expect to continue to achieve this levels in Q4.

As Duane noted, the transition of our customer based was a significant effort during the third quarter. While we work through the transition, we continue to experience reorder reutilization disruption, with that rate appearing to normalize in September. With the customer transition now nearly complete, we expect reorder utilization to normalize for more predictable pace as expected in the fourth quarter.

Consolidated revenue for the first nine months of 2013 was $178.6 million compared to $153.5 million for the first nine months of 2012, an increase of approximately 16% year-over-year.

Gross profit grew by 12% for the third quarter to $27.4 million as compared to gross profit of $24.4 million in the third quarter of last year. Gross margin remained consistent quarter-over-quarter at 45%. We are extremely pleased with this result given the cost incurred to switch the existing customer base to the new OmniPod.

With the transition nearly complete, we expect to drive gross margin expansion in Q4 towards 50% as we reach the payback point during the quarter for many of the free PDMs. We continue to believe that in early 2014, the new OmniPod will drive U.S. gross margins in the low to mid-60s translating to a consolidated gross margin in the low to mid-50s. Gross profit for the first nine months of 2013 was $79.4 million, an increase of $12.4 million or 18% as compared to $67 million in the first nine months of 2012.

Operating expenses increased by $11.8 million to $44.7 million in the third quarter of 2013 from $32.9 million in the third quarter of 2012. This increase is attributable to over $10 million in certain non-recurring charges primarily related to our patent litigation settlement with Medtronic.

We believe the third quarter results are onetime in nature and continue to manage our operating expenses closely. Operating expenses should return to Q2 level in the fourth quarter which will allow us to be at or near operating breakeven by the end of the year. Operating expenses were $108.7 million for the first nine months of 2013 and $96.9 million for the first nine months of 2012.

Operating loss for the third quarter increased to $17.3 million as compared to $8.5 million in the third quarter of last year. Excluding amounts related to the non-recurring charges, our operating loss would be approximately $6 million in the third quarter an improvement from both the third quarter of 2012 and the second quarter of 2013.

Interest and other expense was $4 million in the third quarters of both 2013 and 2012. Approximately $2.6 million of this expense was non-cash. Net interest and other expense was $12.9 million for the first nine months of 2013 compared to $11.6 million for the same period in 2012.

We reported a net loss for the third quarter of 2013 of $21.3 million or $0.39 per share compared to a net loss of $12.4 or $0.26 per share for the third quarter of last year. Net loss for the first nine months was $42.5 million or $0.79 per share compared to $41.7 million or $0.87 per share for the first nine months of 2012.

We generated a positive cash flow for the second quarter in a row with our cash and cash equivalence now it’s increasing to approximately $164 million at September 30, compared to approximately $151 million as of June 30. As of September 30, we had approximately 54.5 million common shares outstanding.

Finally, as Duane noted, we remain very positive about our prospects for 2013 and beyond, the new OmniPod continues to generate excitement in the industry and with the existing customer base transition behind us was solely focus in growing the business. We expect Q4 revenue to be in the range of $65 million to $71 million equating to $244 million to $250 million of revenue for the full year.

And with that, let me turn the call back over to Duane.

Duane DeSisto

Thanks, Brian. The excitement for the new OmniPod continues to exceed our expectations. One important practice is not prescribing the OmniPod are new [ph], over 20% of our existing practices have grown in excess of 100% year-over-year.

Pediatrics stars were up nearly 70% year-over-year, and we have seen more than 100% increase in children under the age of 10. These statistics demonstrates that the new OmniPod is a game changer in the area of continuous insulin infusion therapy.

The promise of OmniPod’s simplicity, ease of use [ph] in a small discrete size resonate with people living with diabetes. Short of a cure, people did not want to be constantly thinking about their diabetes. The OmniPod is helping them achieve this goal.

And with that Operator, please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Kim Gailun from J.P. Morgan. Your line is now open.

Kim Gailun – J.P. Morgan

Great. Thanks. Hey, guys.

Brian Roberts

Hi, Kim.

Duane DeSisto

Hi, Kim.

Kim Gailun – J.P. Morgan

So first question is just on the new patient adds and congrats on another solid quarter there, [indiscernible] listening for you guys. Curious, as you look at the fourth quarter what you’re forecasting for growth in new patient adds. Duane, as you commented that that kind of 40% plus momentum had continued into the fourth quarter.

Duane DeSisto

Kim, I think that’s correct. I mean, that’s how we feel. We’re pretty excited about it. I would tell you when we kind of laid out this year, the quarter we’re worried about was the quarter we’re going to go through this transition and it was – I guess, it was every bit as painful as we imagine but we’re pretty happy with how it turned out. We think we’re in a really good spot. We really are now focused on a go-forward [ph].

Kim Gailun – J.P. Morgan

Yes. Okay. And then just a follow up, you guys talked about 4 million in distributor stocking orders falling out of the quarter and so presumably you felt those already, so that wasn’t the fourth quarter. But does that mean that the third quarter would have been closer to 65 million and then kind of as we look at the fourth quarter, you’re looking at the mid-point of kind of 67 million? So I guess what I’m asking is sort of why not a bigger step up sequentially to the fourth quarter with those adjustments in there?

Brian Roberts

So I think there’s a couple of things to take in explanation [ph], certainly, the third quarter also have the impact of competitive bit [ph] so, I mean, if you want to adjust for both of those, then the perfect for [indiscernible] have got us probably 69 million or 70 million. Not at all of those orders are purely stocking, right. So for the distributor orders, I mean – our guess is some initial shipments of few other things that would have probably got then in a normalized pattern by the end of Q3 probably spilled [ph] into the beginning of Q4.

We’ll see exactly what the distributors ultimately want to have on the end – at the end of Q4 but at the same time, we do have all three lines cranking. We want to make sure that we have a prudent amount of inventory here on the shelves to be able to handle demand that is coming through. So the goal would be into the quarter isn’t to necessarily just ship out every pod we have to maximize exactly a revenue number and have those pods sitting on shelves. We want to make sure that we’re prudently doing it around the business. We got to plan around Chinese New Year at the end of January and make sure that we can meet all of the demand and all of the needs throughout the world.

Kim Gailun – J.P. Morgan

Okay. All right. That’s helpful. Thank you.

Duane DeSisto

Thanks.

Operator

Danielle Antalffy from Leerink Swan, your line is now open.

Danielle Antalffy – Leerink Swan

Thanks so much. Good afternoon, guys.

Duane DeSisto

Hi, Danielle.

Brian Roberts

Hi, Danielle.

Danielle Antalffy – Leerink Swan

Hi. I was hoping you could comment on the competitor is launching a Low Glucose Suspend pumps and I know it’s early days but now we’re probably about at least four weeks into a launch, they got late September approval. Just wondering if you’re seeing them in the market place and sort of what the feedback is and how that could be impacting? Is it all new patient adds for you guys.

Duane DeSisto

Look, I think they are targeting their installed-based right now and once again, 70% of our customers are coming from MDI, so. I mean, they’re out there. They’ll be talking it off I think. If you look at the marketing literature that’s been produced by Dexcom in terms of the performance of the sensors, the Dexcom sensor versus the Medtronic sensor, we’re more than happy to tell people, they have to be using Dexcom.

So short-term, we really don’t see that that product being a big disruption in terms of patient adds. I think in doctor’s office is where they’ll try to leverage that once again. I think we compete for mind share at the physician office now that the customers – I think, Danielle, the thing we are encouraged about is we’ve been selling against their product. We, by we, I mean, us and our partners and that in Europe now for months and it hasn’t slowed us down. It’s anecdotal but we think we know what the pitch is and we think we understand what the performance of our products been because we’ve been watching it over there in the various countries in the [indiscernible].

Danielle Antalffy – Leerink Swan

Okay, great. And just one as a follow up on the commentary around your sensor partnership, when can we expect to hear sort of more about that? Is it possible to hear more before year-end or via press release or something like that or is this something we have to wait for now next year at a conference and/or during your another earnings report?

Duane DeSisto

Yes, I think. Look, we’re looking more towards – if I had to guess right now based on where we are on the progress we made, there’s probably – once again, just to level set everyone, I mean, this still is kind of in the R as opposed to the D phase here but we think we’ll be in a much better position by the middle of next year.

Danielle Antalffy – Leerink Swan

Got it, thanks.

Operator

Your next question comes from Bill Plovanic from Canaccord. Your line is now open.

Bill Plovanic – Canaccord Genuity, Inc.

Great. Thanks. Good evening. A couple of questions. Just trying to kind of nail this down a little tighter, if the core OmniPod business was up about 30% year-over-year, that gives us just shive [ph] of $55 million number and maybe just a hair over $6 million for the old supplies business. Am I close enough or fairly close on that?

Brian Roberts

I mean, Bill, I don’t want to get pried [ph] too more specific than what we’ve talked about in the past but again, the OmniPod business did about 30% year-over-year growth. We obviously left some revenue on the table and just production that we couldn’t get fulfilled by the end of the quarter. But all in, it was a pretty solid quarter.

Bill Plovanic – Canaccord Genuity, Inc.

Okay. And then just clarify the GM on the sensors. I caught the statement but I want to be sure that – so the overall gross margin will approach 50% in Q4 and then it will head to mid-50s in 2014 and that’s the overall gross margin?

Brian Roberts

Yes, I mean, we’re driving towards the 50% gross margin for the fourth quarter with the transition that’s actually now behind us. And I’d say, probably by Q2 of 2014, we would expect that gross margin to be in the low- to mid-50s consolidated. Now, that consolidated number obviously is impacted by both the level of estimate or international revenues as well as neighborhood. It would imply that our U.S. gross margin at that point in time would be in the probably 63% to 65% range.

Bill Plovanic – Canaccord Genuity, Inc.

Considering that you’re now up to running your full capacity, what do you think on the disposable? What is the gross margin that you’re going to max out on that disposable on the pod at this point?

Brian Roberts

Well, I mean, again, right now, I mean, we’ve consistently for years been saying that we’re targeting that mid-60s number and certainly we have some plans within the operations team where we think we can ultimately pull that number even higher. Over the next couple of quarters, we have to eliminate a little bit of excess scraps that we – I think we’ll see go away as well as just some final shutdown related cost to the older line. Once we get to the mid-’14, we’re still going to wrap [ph] those levels, I think we’ll have a clear picture of exactly how high we can drive it, but hopefully, we’ll be able to drive it higher than that.

Bill Plovanic – Canaccord Genuity, Inc.

Okay. And last question. As you look at growth, I mean, Ypsomed had huge growth, they reported over 100%. What was the U.S. growth if we back out that Ypsomed contribution?

Brian Roberts

Again, we’ll just going to stick to kind of overall OmniPod growth as far as the way that we’ve been presenting this. So year-over-year, OmniPod was 30% and if you crack [ph] to the distributor stuff, then again, we are probably at 35% or so in that range.

Bill Plovanic – Canaccord Genuity, Inc.

Okay, great. Thank you.

Operator

Your next question comes from Tom Gunderson from Piper Jaffray. Your line is now open.

Tom Gunderson – Piper Jaffray & Co.

Hi. I just have two quick questions. One is you talk about the 70% increase in pediatric starts, make sense the smaller all the things you’ve said in the past. Duane, what percentage of starts are coming from under 18 or under 17, whatever you use and what percentage of overall business is pediatric?

Brian Roberts

You know what – it’s Brian, at this point, Tom, I think of our overall base, we’re somewhere probably in the 35% to 40% range of our patients being under the age of 18. It’s still our fastest growing segment, so hard to say exactly what percent we’re winning but right now, pediatric start probably make up roughly about half of what we’re winning in a given quarter over the last couple of quarters.

Tom Gunderson – Piper Jaffray & Co.

Got it, thanks. And then just kind of housekeeping, it’s just absolutely amazing to me watching you over time that you’re making a million of these things a month and if the – all I want to do is simple math, I understand you have to rebuild inventory. I understand Chinese New Year and you want to have some on-hand for whatever happens out there, but still a million a month would imply 100,000 users at some point if they’re using 10. Does that carry you from a capacity standpoint through ‘14 and into ‘15 or do you have to start getting that fourth line going?

Duane DeSisto

Tom, this is Duane, so I think if the number runs more than 10 on average because to some people has switched out every two days, so you’re not crazy off, it’s probably about 85,000 users or so but our plan – I’ll tell you what our plan is, our plan is to have the line up in three work in Q3 of next year, I mean, line four. I’m sorry, line four.

Tom Gunderson – Piper Jaffray & Co.

Line four up when?

Duane DeSisto

Q3 of next year.

Tom Gunderson – Piper Jaffray & Co.

All right.

Duane DeSisto

So we want to have that capacity because – I mean –

Tom Gunderson – Piper Jaffray & Co.

Because you’ll need it?

Brian Roberts

I’m hoping we’ll need it, right?

Duane DeSisto

And having been so close for pretty 120 days here –

Tom Gunderson – Piper Jaffray & Co.

Yes.

Duane DeSisto

It obviously is small wait [ph] around a railroad, trust me.

Brian Roberts

We’ve joked [ph] that we have a very clean warehouse because there’s been a lot of room to do stuff.

Tom Gunderson – Piper Jaffray & Co.

Those are my two. Thanks, guys.

Brian Roberts

Thanks, Tom.

Operator

Your next question comes from Ben Andrew of William Blair. Your line is now open.

Ben Andrew – William Blair & Company

Great. Good afternoon, guys. Following on Tom’s –

Brian Roberts

Hi, Ben.

Ben Andrew – William Blair & Company

Hey. Following on Tom’s question, talk about the cadence of sales rep and to what extent you’re still holding the group act [ph] such that we could see kind of a true [ph] acceleration whether it shows up in Q4, Q1 and Q2 and that if patient add starts absorbs them and [indiscernible] get you to that level and what you would need that fourth line.

Brian Roberts

I mean, certainly, we’ve been very open I think discussing that as we get this gross margin improvement to come through the P&L that our thought have been to take roughly about a third of it or so and you invest that back in our sales and marketing team and we’re knee-deep in our 2014 budgeting processes now, so I don’t have an exact number of heads that we’re looking to add at the moment but we’re certainly going to add I think a chunk ahead.

So if I had to get somewhere maybe 15, 20 type people into the commercial organization – ideally, a lot of those people will start recruiting later this quarter so that they’re onboard in Q1 which really gears us up for – as you guys are aware, kind of starting the March timeframe is when sales really start to crank up again into the spring and then through the summer. So January, February tend to be our slower period seasonally, so that’s the perfect time to have this folks onboard. Let them finished out year-ends at whatever company they’re at and then bring them on here, get them up and running and hard charging for Q2.

Certainly, one thing that we’ve seen is the last time we did this which was last year, we saw those reps absorbed at a pretty rapid pace and in fact, would [ph] pay for themselves pretty quickly. I think we expect to see the same thing happen again this year and we’re just kind of putting the final touches right now and what that plan should look like. So that’s definitely holding true and clearly, there’s a huge opportunity ahead of us and we want to be on offense and we want to be able to go and grab it.

Ben Andrew – William Blair & Company

Okay. And then my second question is if you look at the conversion of MDIs over the pumping which is absolutely the bulk of your target market. What is the kind of constraint on that? Is that kind of a standard number that’s coming in every quarter and whatever products are out there competing to get that as we see [indiscernible] or whatever type [ph] it’s going to have and then can others may be targeting some of those patients as well, start to worry a little bit about delusion of you all. So is that a number that can be moved, the products have improved here and that you can accelerate the conversion of MDIs?

Duane DeSisto

Look – Tom, this is Duane. I think – great question, but I think the reality of it is if you look at that MDI population, they know insulin pump exist, they, for the most part, most of this people have had diabetes for an extended period of time and they’re not interested in tubing no matter how cool the actual device itself may look. So for us, what we’re finding is the more time we’re spending in the office, the more time we’re spending with these prescribing physicians, the more comfortable they are giving us more people.

So the real trick for us has been – I would tell you, it’s kind of focused looking at the top 20 accounts in the territory, the next 20 accounts in the territory. Part of what we’re looking at in this planning as Brian described and the reason we’re looking at more capacity is we want to bring on some more sales people because we think we now have a model that we feel pretty comfortable with and we will have the production to support it, right, for us to bring on more sales and people in the middle of this year would have just been – there would have been more people yelling me at me just getting their product on time.

So I think from our standpoint, it really is about spending that time in these offices with these physicians, getting them comfortable. They all have this, again, they all have a significant number of MDI patients, so it really is, I think, from our sales process standpoint – and we feel good, a product without tubing appeals to this group of people and I know we got a Low Glucose Suspend, we got all these other things. I mean, keep in mind, these people would give themselves injections three to five times a day. And they knew pumping was out there and they chose not to do it.

So like I said, I think our form factor in what we’re doing is really resonates with this group and now, it’s about us executing these physician offices. And like I said, I think what’s becoming clear to us in our modeling as we go forward, we want to add some more people because we can do the ROI on it and it’s pretty clear as long as we can support these guys with product, that we think the opportunity is there and that’s really, like I said, that’s really been the focus over the last few months is just getting those lines up, getting that quality level up to where we want them.

Brian Roberts

Yes. And I’d only add to what Duane said, I mean, if you take away one metric from the prepared remarks that I think is a critically important one and goes to the heart of your question, Ben, is that when one out of every four doctors who have prescribed the product since March 1, our brand new doctors does. And so a lot of those doctors have gone now through the trial process. They had a patient on for three months or six months. They wanted to see how those patients are doing and now they’re coming back and prescribing more.

And so to be able to kind of continue to push more and more people through the infrastructure or the pipeline, if you will, a big key is to have more doctors prescribing the product. And for me, where the sales team has done a phenomenal job over the last – since launched, if you will, has really been able to get in front of a lot of doctors and for whatever their reasons to me has been, more on prescribing the OmniPod and have brought them into the full [ph] and are now prescribing it.

So as Duane said, that for physician point is either tube or no tubes, if it’s no tube, we are the only [ph] game in town. And again, interestingly, when we talk about some of these competitive products, for example, the 530G, there’s no pediatric label on that product, it’s 16 or above. Again, where we’re seeing huge, huge growth from our business and a lot of the people are MDIs are pediatrics.

So those are important factors for us but that doctor number is key because it just increases this overall prescription – this overall group of prescribers and that’s how the momentum continues, that’s how you make sure that there just wasn’t some group of people waiting for the new pod to come and they have come on now and that part is done and we’re still seeing this big sustaining power from the launch.

And the other piece of it is now that the transition is behind us, doctors wanted to see that happened, too. They wanted to get their customers over to the same platform or their patients over to the same platform and make sure that that went off relatively seamlessly. And although we’d seen (ph) some customer service bumps and bruises, all in, we think that the patient-base is very happy with the product and things are going great.

Ben Andrew – William Blair & Company

Thank you.

Operator

Your next question comes from Raj Denhoy from Jefferies. Your line is now open.

Raj Denhoy – Jefferies

Good afternoon. One [indiscernible], you mentioned in the last question, the 530G hasn’t been approved for pediatric patients and in my understanding was that Medtronic has applied for that. I don’t know when they expect to get it. But does a 530G with a pediatric approval give you more pods or do you continue to do that, it’s really not something to be worried about?

Duane DeSisto

This is Duane. I think from our standpoint, we’re competing with all those products, all that stuff in Europe and so we think we understand the position and we think we understand the marketing, so, right? I mean, look, competing with Medtronic on the day-to-day basis, right, we pay attention to everything we do, every angle that they can use, they can use. But at the end of the day, it’s a different group of people and for the most part. And I think we feel pretty comfortable about it.

And if I was a parent of a child that had diabetes and I was really interested in CGM, I’d go for the most accurate sensor which is our friends at Dexcom. I mean, I won’t be taking one that’s not as accurate. Like I said, I only pull up all the – what I got to do is pull up the marketing literature that’s out there and they had their comparisons. We feel pretty good about we have a very nice offering that if you are the parent of the pediatric child, we pretty comfortably can make you feel good about those two products combined.

Raj Denhoy – Jefferies

No, that’s fair. Maybe I could ask about the CGM device, CGM pod, I think you continue to sort of note that sterilization is the critical path there it seems and work continue to be done there. Is there any updates or anything that has happened there that maybe moves you one way or the other in terms of your views on that?

Duane DeSisto

I think we are incomplete calendar. We’re still poking around this. I love to tell you we have the answer and we got that part figured out. But to me that’s really the art [ph] in this. And don’t have the answer yet for that.

So in the meantime, we are running experiments on insertion, we’ve done a lot of studies and proximity in terms of insulin delivery incenting. So we’re doing a lot of different stuff but that is the one that I would tell you flat out that we’re still – we’re still working our way to various cycles and there’s not a quick answer to that. But we are – I’m in complete candid [ph] I tell you we’re not there yet. I mean, I can’t sit here and tell you I got a solution that I’m comfortable with yet.

Raj Denhoy – Jefferies

Okay. And just lastly on [indiscernible] it certainly isn’t what you [indiscernible] when you bought it, I’m curious of your thoughts now on that business going forward. What do you think you do in the Neighborhood at this point?

Duane DeSisto

Look, I think from our stand point – from our stand point to kind of reset everything, when we acquire Neighborhood, it was kind of make first by, we know that it is big [ph] addition to the back office. We thought we had the ability – we thought we had the ability by bringing Neighborhood on board, we could leverage – we could leverage our base business. We were aware of that fact that a competitive bidding was coming in. I think we had no idea it was going to come in the way it came in, in terms of the [indiscernible] Medicare.

So our view is pretty simple. I mean, the thing has drawn [ph] off a little bit of cash. I think it’s helped us immensely with the back office. And we are talking to the various strips suppliers. If you look at some of the big strips suppliers that are out there that didn’t get this competitive bids, they’re starting to come up with some creative ways to doing business with a lot of these patients.

So I’m not going yield your uncle yet [ph]. I would tell you it has been more complicated than we thought. But I think the initial reason that we really drove for this was really, really on this back office which is the key piece to our business for customers in the back office.

Raj Denhoy – Jefferies

Okay. And I tell you I do apologize I have one other [ph] kind of housekeeping question. The attrition rate in running about 9% or so, have you seen any move in that with the launch of the new pod?

Brian Roberts

I think actually we’re probably – right now, I’m still calculating to 9% using an annualized number. But I would tell you, looks like over the last month or two, we think that that number is trending downward. Yes, there certainly been as you can imagine to this transition and why I still kind of see this as a little bit over 90% complete as compared to 100% complete is some people have come out of the woodwork where we probably thought that maybe they weren’t on product anymore or more – using it more sporadically and they’ve come back and you kind of jump back into the queue to take a – take a reorder and get back on to the shipment list. So that’s a big positive but those haven’t calculated their way through the number yet if you will.

Raj Denhoy – Jefferies

Okay. Thank you.

Operator

Your next question comes from Mimi Pham, your line is now open.

Mimi Pham – ABR Healthco

Hi, good afternoon.

Brian Roberts

Hi, Mimi.

Mimi Pham – ABR Healthco

Hi. Can you firm for the third quarter [indiscernible] your new apps [ph] they increase sort of in the high single-digit range sequentially from the record level that you saw in second quarter?

Brian Roberts

Definitely up over Q2s numbers. Again, like I said north of 40% year-over-year increase from where we were in Q3. So I’ll let you guys kind of complete the rest of the math on top of that. But I think you’re probably directionally right.

Mimi Pham – ABR Healthco

Okay. And then in terms of the new center, that 25%, are they having a similar 70-30 split or they for some other reasons more comfortable putting OmniPod on out greater [ph] than your overall population, prescriber population.

Brian Roberts

Yes. We actually – we don’t really break at that level. So I don’t know the exact answer. But in the whole I would tell you that it’s still north of 70% our MDI patient, there’s nothing that would tell me those doctors’ office there’s really any [ph] difference.

Mimi Pham – ABR Healthco

Got it. And then last on the oncology partner’s submission. How close are you in that? Should we bank on some announcement by December?

Duane DeSisto

It’s a big pharma company. So I want to bank on anything. We continue to push forward and we feel good about our piece of it. But it’s big pharma company with lots of people, lots of business people, lots of lawyers, lots of people, just lots of people that you got to get check off the box.

Mimi Pham – ABR Healthco

But if you just commit that – I mean, you can put that out in press release versus waiting for the next earnings call?

Duane DeSisto

Yes. And I mean, if we get – if we get to the – if we get to a commercial agreement, yes, we will announce it for sure.

Mimi Pham – ABR Healthco

Okay, great. Thank you.

Operator

Your next question comes from John Wald from Benchmark Company, your line is now open.

Unidentified Analyst

Thank you. This is actually Erica [ph] in for John. We just have [indiscernible] questions for you. Hi. The first question just housekeeping, you said operating expenses is going to return to Q2 levels, are you speaking on a dollar basis or a margin basis there?

Brian Roberts

Dollar basis.

Unidentified Analyst

Okay, fantastic. And I know that in the past you’ve updated us on the fertility drug process, do you got something that you still think will be filled by the end of the year or do you think that that’s something forward [ph]?

Brian Roberts

I mean, we haven’t heard anything differently to say that they want have it filled within the next six-day, weeks. So I’d expect that to still hold through. But again, obviously something we don’t completely control. But if it’s not, it would be pretty closely thereafter, yes.

Unidentified Analyst

Okay. Thanks for updating on those and it’s looks like you manage this transition really well. So we’re looking forward to seeing what you folks next quarter and in the future.

Brian Roberts

Thanks.

Duane DeSisto

Thanks.

Operator

Your next question comes from Steven Lichtman from Oppenheimer & Company. Your line is now open.

Unidentified Analyst

Hey, guys. It’s Resmae [ph] in for Steve. Can you hear me okay?

Brian Roberts

[Indiscernible] sure can.

Unidentified Analyst

Great. Just a quick clarification on the OUS number, obviously really strong demand there, but Brain, I think last quarter you mentioned that you guys are holding back some shipments to ensure adequate supply in the U.S. So was there still some supply constraint to [indiscernible] you and if so, could we maybe [indiscernible] a little bit of small bullish [ph] in international in 4Q?

Brian Roberts

We were equal the opportunity to hold backers. So we did it in the U.S. and internationally. Again, wanted to make sure that we were getting the pods in the hand of all the patients as compared to let them sit on shelves, be at our shelves or somebody else’s. We’ll see, certainly have some lack [ph] in production goals in the fourth quarter where we think we’ll produce north of probably 2.5 million, 2.6 million OmniPods in total.

And so, that will certainly help us to be able to ship some of a little [ph] more and allow them a little bit more comfort with the inventory levels. But again, to my earlier comments, we know that we’ve got to make sure we’re planning ahead a little bit here through the first quarter as well.

And so, we’ll have to see if there’s still a little bit of backlog if you will, but remains at the end of the year just so that we can kind of keep an adequate supply on hand.

Unidentified Analyst

Okay. That makes sense. Thank you. And just a really quick follow up on Tom’s earlier question. When that fourth line is up, how many pods will you be manufacturing a month?

Brian Roberts

That fourth line should produce again, somewhere in the neighborhood of 350,000, 400,000 pods per month. So it should put our monthly production somewhere around 1.4 million by then.

Unidentified Analyst

Great. Thank you.

Operator

Your next question comes from Chris Cooley from Stephens. Your line is now open.

Chris Cooley – Stephens Inc.

Good evening, and thank so much for taking the questions. Just two quick ones if I may here into a latter part of the call, when you think about launching into Canada here, in the current quarter, would you mind just kind of refraining that opportunity for some kind of expectations for how that will ramp up, certainly there’s a supply issue globally? So help us kind of think about how we should think about that in terms of its contribution to growth? Then I only got one quick follow up after that. Thanks.

Brian Roberts

Yes, another – yes, so we’re moving – we’re moving the Canadian patient pace to the new OmniPod here Q4. We receive the Health Canada [ph] approval back I think back in the spring. But we just wanted to make sure we could get through the U.S. first.

The GlaxoSmithKline guys, they’ve done a fantastic job. One of the really interesting things about the Canadian market is there’s a strong push in several other provinces, Ontario being one of them, to get pediatrics on to insulin pumps. I think one of the challenges that we see in the Canadian market unlike the U.S. is that to be able to get – and effectively the government is paying for the pump for a pediatric to go on, the challenge is they have to go to a certain centers to be able to receive those government reimbursement benefits and there’s a wave left [ph].

And we’ve worked with the Glaxo folks quite a bit to try to figure out those ways through diabetes education or other different types of programs so we can help kind of facilitate that and kind of open up the spec [ph] a little bit more. Today that’s had I’d say moderate levels of success. I think overall Canada has met our expectations and doing a really good job. I think the JSK [ph] guys are happy. But that is the one difference within the Canadian infrastructure if you will compare to the U.S.

But on an overall basis we’ve certainly planed the volume of pods that they need in Q4 to be able to transition everybody over and no concerns, I’d be able to get those to them and be able to get it done before the end of the year here.

Chris Cooley – Stephens Inc.

Okay, super. And then I just maybe try and touch a little bit on 14, I mean, you’ve had two great quarters now being positive on cash flow. How should we think about the cash flows as we think about going into ‘14 because clearly, you’re still investing from the rep’s standpoint, you’ll have the additional line but you’ll also have most like pretty steep acceleration and new patient starts as a result of pod consumption? So help us think about maybe how cash flow looks as we go into next year to the extent I can get out of [ph] preview of ‘14 guidance.

Brian Roberts

Sure. I mean, again, certainly, I think from the remarks, we talked a little bit about it. I mean, we have seen no signs whatsoever of patient start slowing down, so I think we feel very bullish about patient starts and if anything, we want to make sure that we’re staying very aggressive on being able to continue to increase that number and invest the investment into the sales team that we’ve talked about.

I think the nice part about it for us is that the whole goal and a lot of it is that we’re able to self-fund it and Q4 really becomes the first quarter in a long time where we’re very confident that we’re going to see gross margin expansion and those dollars being able to help us leverage this investment. The nice part has been we’ve effectively been operating cash profitable for over a year without any of the benefit of that gross margin expansion. So we’ve shown a lot of leverage within the operating side of the P&L and I think the gross margin side now just helps us accelerate that more.

All in, Q4, we did make our payments to Medtronic as part of the patent settlement in the fourth quarter, so that will come up to cash balance. Q4 will have our typical convertible debt payment and those things. So Q4 tends to eat a little bit more cash than the typical quarter, so that would [indiscernible] of 2014, we certainly expect to be EBIT profitable as well as cash flow positive.

Chris Cooley – Stephens Inc.

Super. Thanks so much.

Operator

Your next question comes from Jayson Bedford from Raymond James. Your line is now open.

Jayson Bedford – Raymond James

Good evening. Thanks for taking the questions. A couple on the transition, really, you’re making progress here, just wondering why isn’t it 100%. Is it solely a function of supply or are there kind of hold out those folks that still are ordering old pods?

Duane DeSisto

This is Duane. So we’re not making any more old pods, right? We put in the supply for GSK and a couple of these things. And so the reason it’s not 100% is we have to go through the distributors, get to those people and transition them out. And what you will find is that typical diabetes patient always had some extra product. So all we were doing now is working through the distributor. And as Brian pointed out, I mean, we’ve had some people that we would argue that we had put in the – went off product gathered [ph] before you that it popped back up and they’re looking for it.

So I think from my standpoint, I mean, we feel good about it. We think we think we have most of them but I can’t sit here and tell you it’s 100%. So we’re close, I mean, we’re pretty close with it.

Jayson Bedford – Raymond James

Just on that, you mentioned in the release that the 90% of the existing direct customers of transition, what about the non-direct customers, is it –

Duane DeSisto

And that’s the piece. I mean, we work through the distributor with – when we say non-direct, those people that are going through distributors that have particular alliances with healthcare plan, so we work through the distributors, the distributor works with the customers. So some of these people may have been converted [ph], we just haven’t received the feedback yet or like I said, they’re in the process of doing that.

Brian Roberts

Yes, I’d add, I mean, so we do receive what I call imperfect data back from distributors which is why – I don’t think we’re that confident saying we’re 100% done. I mean, again, I think the transition, the mountain has been moved [indiscernible] behind us which I think overall is great news. But to clear on one point, all customers who are calling in, needing pods, they’ve been getting all the new pods. We haven’t sold an old pod here in the U.S. in probably five months now. And effectively, from our perspective, we’re basically done.

Jayson Bedford – Raymond James

All right. Okay. And then again, just looking at pediatrics, what percent of those under 18 years old with Type I diabetes using insulin pump?

Brian Roberts

I mean, the overall metric in the U.S. is probably high 20s in total. I mean, just a gut feel says that that number is going up there because I think the benefits on being on an insulin pump is something that I think a lot people focus on and say this is good for my child and I think it’s pretty hard for parents to when they have to deliver lots of needles every day. So my guess would be higher but I don’t think we’ve seen a statistic to actually back that number up.

Duane DeSisto

And if we [ph] guess, I mean, the last that I saw it like is probably a year and a half old. So it’s been awhile.

Jayson Bedford – Raymond James

Okay. Thank you.

Operator

Your next question comes from Suraj Kalia from Northland Securities. Your line is now open.

Suraj Kalia – Northland Securities

Good evening, gentlemen.

Duane DeSisto

Hi, Suraj.

Suraj Kalia – Northland Securities

Hi, Duane and Brian. A lot has been asked in terms of diabetes. That’s the buzz in town today. And Duane, maybe an unfair question, but let me reverse this question and ask you, when let’s say, OmniPod and the [indiscernible] compete and the OmniPod loses business, what is the primary reason according to you that you’ll lose the business? And the reason I asked them, just trying you to let you correct what you said, it’s the tubing pump, yes it has a friendly [ph] user interface. It’s quite intriguing to see if you have lost business, why would you lose business?

Duane DeSisto

Suraj, and I know this will sound probably you’re going to snicker but honestly, when we sit in the meetings, when I sit in with the sales people, there’s really only one guy we compete with at the doctor’s office that we see head-to-head everywhere and that’s – honestly, that’s Medtronic. I mean, we know the new guys out there and they’re out there running around and they’re going to raise some money and it’s all good. Look, in the end, we really don’t see them as direct competitor. It really is – and I know it sounds a little arrogant and I’m not trying to be, but we just don’t see them, I mean, that’s the fact.

We talked about what’s going on. We see MiniMed’s efforts with their new 530G and how they’re trying to spin it, and that’s the stuff we focused on. Maybe three years from now, it will be different, but right now, it’s just not. And like I said, I’m not saying we don’t lose them on some occasion but I don’t have a single sales rep and I got 100 plus of these guys out there sitting there saying, you got to come up with a solution for them. That’s never in the conversation with emails or with the discussions at the moment. It may change over time but not now.

Suraj Kalia – Northland Securities

Fair enough. And finally, Duane again, you all have done a fabulous job in terms of going this concept of the penetration and the numbers speak for themselves. Duane, at what point do we start seeing the SG [ph] start taking down faster than the top line growth? And essentially, I’m just trying to understand at what point this operating leverage really take in, not necessarily asking for guidance but when you’ll think on a strategic basis, is that like 70,000 patients? Is it 20, 50 [ph]? How do you all see this?

Duane DeSisto

Look, I think when we look at it and I’ll have Brian comment on it, but we’re looking at the real trick for us in this model based on the modeling we do, we start getting the U.S. business, the non-distributor, non-international business. In that 65% margin range, we have the ability to take a third of that, that uptick in margin, grow the sales force in adequate amount that we think can continue to drive this outline and the rest of the money can come to the bottom line.

The real trick for us here is over the next couple of quarters, now that we’re through the moving the mountain of trying to transition thousands of people kind of almost overnight, for free [ph], by the way, and is really, the real trick for us is to keep focus on the production of margin and then that’s going to supply everything else. And I’ll let Brian pick it up from there.

Brian Roberts

Yes. I kind of let the results speak for themselves. I mean, we’ve been operating cash profitable for over a year, so just backing up for the non-cash expenses. We can have a whole different conversation on things like the black shows [ph] model and the value that that creates within the P&L.

Again, I mean, our view is that we’re going to be effectively EBIT breakeven positive kind of by the end of this year here. I just said a few minutes ago that we’re going to be EBIT positive next year. We’ve generated two positive quarters of cash flow and I think we’ve done a tremendous job of being able to manage both sides of kind of growth and getting ourselves to the point where profitability is right here on the horizon.

On the whole [ph] from our perspective, I think we’re creating a lot of that leverage and certainly we’re – we’ve had a relatively flat gross margin for a couple of years, waiting for this day to come with the new pod transition and now in the hands of the customer-base and, again, making north [ph] of 2.5 million of these things in the fourth quarter, I think we’re positioned really, really well.

Suraj Kalia – Northland Securities

Gentlemen, thank you for taking that questions.

Duane DeSisto

Thank you.

Operator

There are no further questions at this time. I’ll turn the call back over to the presenters.

Duane DeSisto

I want to thank everyone for joining us today and we look forward to updating you on our future call. Have a good evening.

Operator

This concludes today’s conference, you may now disconnect.

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