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NxStage Medical, Inc. (NXTM)

Q2 2010 Earnings Call Transcript

July 22, 2010 9:00 am ET

Executives

Kristen Sheppard – VP, IR

Jeff Burbank – President and CEO

Robert Brown – CFO

Analysts

Ben Andrew – William Blair

Bill Plovanic – Canaccord Adams [ph]

Joshua Zable – Natixis

Kim Gailun – JP Morgan

Darren Lehrich – Deutsche Bank

Suraj Kalia – Rodman & Renshaw

Operator

Good day, ladies and gentlemen and welcome to the NxStage Medical second quarter 2010 financial results conference call. My name is Nancy, and I am your operator for today. (Operator instructions) I’d now like to turn the presentation over to your host for today’s call, Ms. Kirsten Sheppard. Ma'am please proceed.

Kirsten Sheppard

Thank you and good morning. Welcome to NxStage Medical’s second quarter 2010 conference call. With me here today are Jeff Burbank, NxStage’s CEO; and Robert Brown, our CFO.

For your convenience a replay of this call will be available shortly after the conclusion for two weeks. In addition, the press release for the second quarter and a recording of this call will also be archived on our website under the Investor information section.

Before starting I would like to remind you that statements, we make on this call which are not purely historical regarding the company’s or our intentions, beliefs, expectations and strategies for the future are forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

These forward-looking statements may include topics such as the results of our operations, growth of the home and more frequent hemodialysis market in general, market adoption and demand for our products. Our expectations regarding cash flow and relationships with key customers, as well as our expectations regarding our nocturnal indication, beliefs as to the expected impact of current economic conditions on our business, anticipated improvements in the operating efficiencies, gross margins, product quality, and financial guidance for the future.

Because such statements deal with future events they are subject to various risks and uncertainties and actual results may differ materially from these forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements are discussed in our SEC filings, including our quarterly report on Form 10-Q for the quarter ended March 31, 2009.

In addition, any forward-looking statements made on this call represent the company’s views only as of today and should not be relied upon as representing our views as of subsequent dates.

Future events and developments may cause these expectations to change and while we may elect to update forward-looking statements at some point in the future, the company disclaims any obligation to do so, and therefore you should not rely on these forward-looking statements as representing our views on any dates subsequent to today.

Now, I’d like to hand the call over to our CEO, Jeff Burbank.

Jeff Burbank

Thanks Kirsten. Good morning everyone. I will start by reviewing the quarter’s highlights and provide thoughts on our progress and prospects. After that, Robert will review our financial results along with our guidance, then we will take your questions.

Q2 was a record quarter for NxStage with all three markets outperforming. Revenue, gross margin, adjusted EBITDA and cash were all records. Revenue increased to 44 million, up 21% from last year and well above the top end of our guidance. This was also our largest quarterly sequential growth in total revenue ever. Home drove this performance with the third straight quarter of record sequential growth.

Gross margin increased to 31%, a 200 basis point improvement from the first quarter. Adjusted EBITDA neared our breakeven target at a loss of $200,000, which was great given the number of machines we have sold and their impact on this calculation. All this good work resulted in positive cash flow of $1 million, well ahead of our cash flow plan.

We believe we are in good position at the halfway point of the year. We are confident in our ability to deliver continued sequential improvements in our fundamentals. Based on these results, we are increasing our projections for a sequential growth in the home, and raising our revenue guidance for the year from 163 million to 170 million to 170 million to 175 million.

Turning to an update on those three markets. First home, I am pleased to announce that we finalized a new strategic agreement with DaVita for the home. DaVita has made substantial investments in building their home hemodialysis capabilities, and in partnership with NxStage, they have become the largest hemodialysis provider in the world. We believe this new agreement capitalizes on that progress.

I believe this agreement represents a good way to move forward with such a key strategic partner, while ensuring all stakeholders will benefit from superior execution. This was accomplished with the use of warrants as a rebate for DaVita achieving significant home patient performance targets. With this agreement now finalized, we will continue to focus on our four growth drivers, reimbursement, going deep, clinical data, and product.

Continued progress in these areas contributed to a strong quarter in the home with revenues growing 9.3% sequentially and 37% over the same period last year. With regard to reimbursement, we believe the outcomes and benefits of home hemodialysis therapy with the System One are well aligned with the objectives of CMS’ expanded bundle, which is going into effect on January 1, 2011, and even broader, the overall health care reform goals.

Although we continue to work on improving the predictability and appropriateness of reimbursement, we don’t really have any new updates until we see the final rule on bundling, which we expect soon. We continue to gain meaningful traction with our go deep strategy. Centers greater than 10 grew 27% year-over-year and 7% sequentially. Centers greater than 20 grew 37% year-over-year and were flat sequentially.

Geographies with greater than 5% penetration increased by 18% year-over-year and 5% sequentially. In addition, we are excited about growth in previously underserved areas. Overall, we had good success developing deeper relationships to drive patient adoption in the second quarter. We also continued to create awareness and gain support for our therapy by promoting statistically significant clinical data from our FREEDOM study, such as a 30% reduction in depressive symptoms as measured by the Beck Depression Inventory, greater than 85% reduction in recovery time.

Given our patient’s (inaudible) waking day per week or over seven weeks a year, 6% to 17% improvement in a range of quality of life measures, we reduced any hypertensive medications, including a doubling of the number of patients that don’t need any our therapy. We made significant improvement in overall sleep quality as measured by a validated sleep index. We made marked improvement in restless leg syndrome and we showed a 40% reduction in mortality. We are very proud and excited about these results.

For Q2, new prescribing nephrologists were up 29% versus one year ago, and up 8% sequentially. That is continuing the strength we saw last quarter. Based on this success, we are looking forward to FREEDOM’s interim analysis on hospitalization and total cost of care. Also of note, our first results paper on depression and sleep quality has been accepted in a peer review journal. As you know, we followed our nocturnal indication with the FDA in February. Since then we have received our first round of questions, and are focused on providing a thorough response to move that clearance forward.

Patient generated new stories are continuing to drive demand and improve awareness. This past January, we had a group of patients take their System One with them on a cruise in the Bahamas. It was really a great success. This quarter, you will hear about another group of patients, who just this week embarked on a four-day road, river, whitewater rafting adventure with their System Ones.

It is remarkable how our product is going with these patients on their adventures, but it is even more meaningful to know that due in part to our therapy, these patients have energy and are healthy enough to live active lives by any measure. In conjunction with the AAKP, we provided materials that help patients to put plans in place for potential disaster. This is especially important for those patients affected by the hurricane season. In the past, we have talked a lot about the advantages of the System One in terms of safety, ease of use, therapeutic flexibility, and product design. These advantages were very evident in the second quarter, where an increasing majority of customers purchased rather than rented the System One.

In addition to validating our therapy and market opportunity, this trend helps us generate cash flow. We are making good progress in the international for the home. NxStage is a value partner to 4 distributors in international regions that represent a market opportunity of 60 million for NxStage in home alone. We’re beginning to see more interest and ultimately expect it will be material to our sequential growth rate in home. In the near term, we expect it will continue to represent less than 10% of home’s sequential growth rate.

All of this positive activity resulted in our third straight quarter of record sequential growth in the home, and we are working hard to continue this positive momentum. Last quarter we raised guidance for sequential home growth to be in the range of 1 million to 1.4 million a quarter. Given our outlook and the level of progress that we have achieved, we are raising our projections again for sequential growth in the range of $1.2 million to $1.6 million going forward.

Let us now turn to critical care, where we succeeded in setting a new record for the highest number of machines sold in the first half of the year. This achievement highlights both the strength of the System One in our competitive positioning. Based on our market estimates, we believe we place the majority of systems sold during the quarter. For Q2, strong machine sales again drove the majority of the 10% sequential revenue increase over the previous quarter, expanded with existing customers and had some good competitive wins with leading hospitals.

Underpinning our performance on machine sales is the strong recurring disposable revenue we generate from our growing installed base. This continues to amount for approximately 80% of the critical care revenue in the quarterly basis. Looking ahead, we feel we have got a strong growing pipeline of opportunities with a number of potential new customers evaluating our systems. All of this is encouraging, so we remain confident in our ability to grow our leadership position in the critical care market.

In the near term, we expect to benefit from the large installed base with good disposable revenue. Despite good success, we are going to remain cautious on the timing of equipment sales. Finally In-Center had a great quarter with revenues up 4% year-over-year and 8% sequentially. We had good end customer demand and expanded a bit with additional business to generate low single digit growth in the second quarter, which accounted for about half of the sequential increase. The balance can be attributed to viability in customer ordering patterns and the timing of shipments, two factors we continue to highlight as having the ability to affect revenues on a quarterly basis.

We had some good competitive wins during the quarter, including Atlantic Dialysis Management Services. Atlantic chose to implement our next generation blood tubing set, Streamline, across all their dialysis centers, citing the need for and I quote, “continued clinical improvement and significant operational savings.” Wins like these speak volumes about the volume of Streamline versus traditional bloodlines. Year-to-date our initiatives to convert customers to Streamline translated to a 61% increase in treatments using Streamline versus the same period last year.

Finally an update on our Asahi collaboration. In June, our Asahi branded dialyser was presented to customers for the first time in the European market at EDTA or the European Dialysis and Transplant Association meeting. That is the largest industry meeting in Europe.

Another area of success is regulatory compliance. This seems to be an area that is proving very challenging with our industry. I wanted to take a moment to thank all of our employees for their efforts in successfully completing our recent audits and inspections. Four of our facilities received ISO audits with no non-conformities identified. That is a great achievement. We also received a full FDA multi-day QSIT inspection with no 483 items issue. We are very pleased with our ability to continue to improve our regulatory systems and maintain our compliance as we grow.

In closing, Q2 was another great quarter in all respects. We delivered record revenues with solid performance across all three markets. We achieved positive cash flow, and we continued operational execution. Given the strong first-half of 2010, we are raising our revenue guidance for the year to a range between 170 million and 175 million. Like me say that again, $170 million and $175 million is our new revenue guidance for the year.

Now I will turn the call over to Robert for his financial review. Robert.

Robert Brown

Thank you Jeff. I will review revenue for the second quarter of 2010, including details of our two reporting segments, discuss the company’s operating performance, balance sheet, and cash flow results and then finish with a discussion regarding our outlook for the third quarter. I will discuss the numbers on both a GAAP and non-GAAP basis. Please refer to the reconciliation table in our press release for further information in this regard.

We are very pleased with both, our operating and financial performance for the second quarter of 2010, which we believe reflects solid performance against our strategy to deliver consistent and predictable results. NxStage had record revenue of $44 million, which represents a 21% increase over the second quarter of 2009. This performance exceeded our guidance for second quarter revenues between a range of $40 million to $42 million. This has been a strong first half of the year.

Solid performance across all three of our markets drove the year-over-year growth. Home had the strongest growth with revenue of $20.8 million, which represents a 37% increase over the second quarter of 2009. Critical care delivered revenue of $6.7 million, representing a 27% increase over the second quarter of 2009. As Geoff mentioned, solid machine sales and strong recurring revenue accounted for the year-over-year growth.

In-Center revenue increase to 16.5 million, a 1.2 million increase over the first quarter of 2010. An increase in end-user demand accounted for approximately half of the sequential increase, while changes in customer ordering patterns and inventory accounted for the balance. Consistent with what we discussed in prior calls, In-Center revenue will continue to be susceptible to these factors. Gross margin was 31% in the second quarter of 2010, up 200 basis points from the first quarter, and compared favorably with gross margins of 24% in the second quarter of 2009.

The sequential improvement is consistent with our goal of making one percentage point to 3 percentage point improvement quarter-on-quarter. NxStage had a net loss of $8.3 million for the second quarter of 2010 compared with a loss of $12.5 million for the second quarter of 2009. This improvement was the result of higher revenue and improved gross margin, partially offset by higher operating expenses as we continue to invest in both research and development and sales and marketing.

A substantial portion of the year-over-year sequential increase in operating expenses was the result of an increase in stock compensation expense as a result of annual grants late in the first quarter, a higher stock price versus last year and achievement against company performance metrics. NxStage generated $1 million in cash for the first time during the second quarter as a result of strong operating performance and higher than expected home machine sales in the quarter. The strong machine sales in the quarter were a positive for our business and cash flow. For the next couple of quarters cash flows should range between plus or minus $2m, based on the level of machine sales and inventory to support machine build plans in the corresponding quarters.

For the year we expect cash to be between zero and negative $5 million. On our non-GAAP basis, our second quarter adjusted EBITDA loss adjusted for stock based compensation, deferred revenue recognized and other non-cash and non-recurring expenses narrowed to a loss of $200,000, compared with an adjusted EBITDA loss of $3.4 million in the second quarter of 2009. Although just slightly below our breakeven target as a result of the higher than expected number of machines sold versus rented, the improvement in our adjusted EBITDA loss was a meaningful component in the generation of 1 million in cash during the quarter. We are very pleased with this result.

Turning to the balance sheet, we ended the second quarter [ph] with $20 million in cash and cash equivalents. Moving forward, we will remain focused on our four key financial metrics revenue, gross margin, adjusted EBITDA, and cash.

Now let's turn to our guidance, consistent with what we told you on prior calls, we are being conservative and cautious in how we forecast and run our business. For the third quarter of 2010, we expect revenues to be in the range of $43 million to $45 million and net loss in the range of $7.5 million to $8.5 million or $0.15 to $0.18 per share and break even to positive $500,000 adjusted EBITDA.

Given the strength of the first half of 2010 and our performance, we are increasing our projections for sequential growth in the home and raising our revenue guidance for the 2010 fiscal year to be in the range of 170 million to 175 million versus our previous guidance of revenue to be in a range of 163 million to 170 million. We are maintaining our guidance for net loss in the range of 28 million to 33 million or $0.60 to $0.71 per share, and for adjusted EBITDA to be in the range of positive $1 million to a loss of $3 million.

We expect to achieve consolidated gross margins of between 33% to 37% in the fourth quarter of 2010, and remain committed to achieving our gross margin target of 50% over the longer term.

Now, I would like to open the call to questions. Operator, we are ready for the first question.

Question-and-Answer Session

Operator

(Operator instructions) Our first quarter comes from the line of Ben Andrew of William Blair.

Ben Andrew – William Blair

Good morning Jeff.

Jeff Burbank

Good morning Ben.

Ben Andrew – William Blair

Good morning to everybody I guess. The question I guess to start with is on the gross margin side, you know, you were a little bit below my target this quarter. Maybe talk about some of the pushes and pulls on projects and didn’t come through, and you are leaving us with a pretty broad range for Q4, and maybe give us some insights into what will move that around, if you would?

Jeff Burbank

Sure. I mean, gross margin as we talked in the past is based on projects, about two thirds projects, about one third leverage. So, we continue on track with our projects. We have very well identified – we have more identified today than we have ever had them identified at this point. So, we feel really good about where we are moving with that.

As we move forward though, mix actually plays a little bit more into gross margin. So, the rate of growth of the different businesses actually have some impact on the overall consolidated gross margin. But we feel very comfortable with the gross margin individual business units.

Ben Andrew – William Blair

Okay.

Jeff Burbank

And we’re still solidly within the range that we projected for Q4.

Ben Andrew – William Blair

Okay. So, in terms of the breath of the range in Q4 then, what puts you at the very bottom of that range and what puts you at the very top. Is it the mix of system sales, is it the mix of In-Center, what are the major contributors, and are there a couple of key projects in particular that you are waiting to see if they come through then for the fourth quarter in terms of their contribution?

Robert Brown

Yes. Actually, I would say probably the biggest factor is probably mix. And the home business is becoming such a large part of our businesses, the gross margin in that business are pretty much close to our average gross margins for the company. As we have talked in the past, the critical care business is higher gross margins and the In-Center business is slightly lower gross margin, especially in the tubing set area. So, the mix of growth of those businesses probably has some of the biggest factors on where gross margins end up in the fourth quarter.

Jeff Burbank

Hi Ben, because we have got such great programs in place on gross margin improvement, focusing on revenue growth is really valuable in creating long-term value, because as we make improvement on those gross margins that will drop through to the bottom line. So, having a focus on growing those businesses and then translating them to good value over the long haul is really where we are going.

Ben Andrew – William Blair

Okay, great. Thanks. That is helpful, and then Jeff the DaVita relationship, are there going to be any further details disclosed on that in filings or should we just sort of wait to see what sort of targets they would hit and then we would hear announcements of warrants issued or how will that play out publicly?

Jeff Burbank

So, first, make sure you know what is available to you. The 8-K filed this morning. So there is some details in that. That contract will get filed as well in retracted [ph] form. There are some confidential treatment elements within that agreement. So until we see what that final negotiation on confidential treatment is I don’t want to get ahead of that process. So I wouldn’t want to speculate on what gets treated that way. Certainly as they earn those targets from significant growth, then you will see the issuance of those warrants.

So you will see it at some point along the course of the contract term. So that will be a flag as well. But let us see what gets covered in confidential treatment, and then we will come back and add in the details.

Ben Andrew – William Blair

Okay. Aside from the specific numbers or metrics qualitatively does it tie your hands with other competitors in any way or is this sort of a non-exclusive incentive-based contract if you can describe it that way?

Jeff Burbank

Yes, that is a great question. You know, we said as of the end of December we didn’t have any restrictions in markets. That is true, we can do business with any provider in markets. There are some markets where because of investments that our partners have made, we hold to certain conditions like purchasing the majority of machines, or a certain number of machines they need to purchase, but there are no limitations to where we could go.

Ben Andrew – William Blair

Okay, thank you.

Operator

We have a question from the line of Bill Plovanic from Canaccord Adams [ph].

Bill Plovanic – Canaccord Adams

Great. Thank you. Good morning and congratulations.

Jeff Burbank

Thanks Bill.

Robert Brown

Good morning.

Bill Plovanic – Canaccord Adams

Just, you know, Ben already asked, but are there any other major differences with the new contract versus the old contract with DaVita that we should be aware of?

Jeff Burbank

Yes, again, I want to make sure we stress, no exclusivity going on that. They certainly are the differences that are enumerated in the 8-K, the warrant structure, there is a little slight pricing increase on the base business, some things like that. But, you know, I think it is pretty clear in the 8-K.

Bill Plovanic – Canaccord Adams

Okay. And then, does the new contracts impact the P&L in any way. I think previously DaVita could rent machines, I don’t know if they did. And if so, did that change?

Jeff Burbank

Now, one of the great things about that relationship is that they are required and do buy the majority of the machines. They have and they will continue to do that. So, we don’t see any changes in P&L, you know, we hope that they achieve the highest levels of performance on that because it will create tremendous value for all of us. We will see about that as we move forward, get into this a little bit farther. But no quarter-on-quarter changes to the P&L.

Bill Plovanic – Canaccord Adams

Okay. That is helpful. And then, just kind of more from a – I think we had talked about potentially the FX impact to GMs, I was wondering if there was an impact this quarter, and then Robert if that is going up or down as we go into Q3 or Q4. And then, I don’t think you provided Q3 gross margin guidance, you know, because you did give us a range for Q4, but you know we expect the 1% to 3% increases like we have seen sequentially in the past.

Robert Brown

Yes, we’re sticking with the 1% to 3%. Two year comment on FX, we saw a little bit of impact in Q2 because of our supply lengths, actually it takes a little bit of time for that impact to roll through. So the euro has improved for us over the last couple of months, but it takes normally 3 to 6 months for that to roll through the P&L. What is kind of interesting is actually the peso has gone against us a little bit, and that actually rolls through the P&L basically almost immediately. So, we are beginning to have changes in FX. We don’t see the impact of the euro that great right now. But we will see more impact in the second half of the year.

Jeff Burbank

And I will say in general, we do consider FX when we put together our guidance. So, that is part of what goes into that range of guidance, which we are sticking [ph] to what we were sticking. And I think as we move forward, I will reiterate kind of what Robert was saying, it gets a little more complex because we have got euro, peso and baht that we deal with, and now with our business starting in Europe, we’re going to have sales in costs in Europe. So, we will educate you a little bit more as it becomes meaningful moving forward, but we do consider those things in our guidance.

Bill Plovanic – Canaccord Adams

Okay. And then just, you know, lastly, can you remind us as you said you turned positive cash flow in the quarter. I think a lot of people asked questions, how can you lose 7.3 million on an operating basis and be cash flow positive. Can you simply just balance that out for us, what makes that happen?

Jeff Burbank

Sure. I mean, there are two main drivers to that. The first one is stock compensation, which is in the P&L. So that is about $3.5 million in the P&L. The others, most companies have, the second one is the machines that we purchased in previous quarters, and actually have up on our balance sheet. And we are amortizing the P&L and we amortize those over 5 to 7 years. So, there is a lot of expense related to depreciation and amortization in our P&L.

And those are the two big factors when you adjust them, that get us from basically a loss to you know cash flow positive.

Bill Plovanic – Canaccord Adams

And then, is it fair to say going forward it sounds like more and more customers are purchasing the machines, then we should see that spread shrink over time, especially as kind of the amortization rolls on?

Jeff Burbank

Well, the amortization does roll off, but we are always constantly putting more amortization onto the balance sheet. So, if you look at our deferred revenue and deferred costs in Q2, they actually both grew in Q2. So, we’re actually adding more than we are actually taking off at this point in time. If the business continues to grow, and we’re replacing more machines down to the field.

Robert Brown

That is what you actually want to see. That means the business is growing.

Bill Plovanic – Canaccord Adams

Thanks. That is helpful. Thank you very much, and again congratulations.

Jeff Burbank

Thank you.

Robert Brown

Thank you.

Operator

And we have a question from the line of Joshua Zable from Natixis.

Joshua Zable – Natixis

Hi, good morning everyone. Congrats on a really strong quarter. Thanks for taking my questions.

Jeff Burbank

Thank you.

Robert Brown

Thanks.

Joshua Zable – Natixis

Just, most of my questions have been answered, just kind of a follow up here, I know a couple of people have asked on the gross margin and the guidance and what not, and I guess, currency obviously is in there and you know, I know you obviously were halfway through 2010, but as we think of sort of 2011 and going on, before we kind of get ahead of ourselves, I guess, it is a pretty big jump from where we started the year to where we look to end the year, which is great. But I know there is a lot of moving parts. I guess, historically you guys have said instead of looking for some sort of sequential move every quarter, you have done that obviously in a very big way here, or you are looking to do that.

I guess, as we think kind of going forward, how much of that is sustainable in terms of that high-end level, or should we sort of think about you are getting some short-term benefits and kind of back to the lower stair step effect?

Jeff Burbank

Well, certainly their gains will be made early on. You just can’t stay in that forever, though it will be a business model we would all love, but it will continue to make good progress towards our ultimate goal of getting to 50%. The majority of that will come on the nearside versus the other side, it does get a bit (inaudible) towards that goal. So, I think your point is valid, however, we still got a number of good quarters ahead of us that are pretty significant in the 1 to 3 gross margin sequential growth or improvement. So, we feel really good about that and feel like we’re on track for delivering that kind of performance.

Joshua Zable – Natixis

Okay, great. And then on the critical care side, obviously really strong again. I know you guys are being conservative with the kind of back half of the year. I know you guys are traditionally conservative with this business, because it is lumpy. I guess maybe you can just kind of talk about the environment you are seeing, you are obviously winning a lot of competitive business, I’m sure that some of it is confusing to tell, but it seems like we have heard other things, spending is okay. It is not great. You know, you guys are obviously doing great. So, I guess any color around there – any more color will be helpful, thanks.

Jeff Burbank

I think a couple of things on that one. First of all, we have a great product and a great team there. And they have really established themselves in this community. And now, I think at a point of really having a strong lead position and have won a lot of competitive situations. So, we are doing great execution in that business. I think relative to kind of the overall capital markets, we tend to be in the small capital category, these systems aren’t hugely expensive. So that is probably why we are able to get these through in what is maybe a mediocre to average type of capital market.

So I think that helps this along. The other thing is that we have taken and build the pipeline significantly over the last number of quarters. So, the statistics of having a bigger pipeline has helped us to achieve the success that we have seen in the last few quarters on bringing these home. But with all that said, it is amazing how quickly these things can turn on you. We experienced a very dramatic turn at the beginning of last year and we are still may be a little scarred from that. So, we’re going to stay conservative on our projections, but focus on the execution to bring these numbers home.

Joshua Zable – Natixis

Okay, great. And then just on the guidance, obviously you got a really strong outlook on the revenue side. You did maintain bottom-line EBITDA kind of guidance, can you just kind of talk about why the top is going up or the bottom is, is it more spending. I know you touched upon it, is it more investments in the programs that you can see that is worth driving this growth, or just any color on that?

Jeff Burbank

Yes. So we’re really excited about the revenue growth, and as Robert was mentioning on the gross margin, mix has a factor on that. So a lot of this is real successful progress in the home market. So as we look at that it doesn’t drop to quite as much at this time, as we continue to make improvements in that business model, we will capitalize on that and have that flow through to the bottom in the future.

So we really want to build the business, and grow it as fast as we can, which we are doing a great job, and that will translate that into a win as we move forward and continue to make the progress we are talking about on gross margins. So we feel really good about it. The other for the net income and things like that we do have stock-based compensation, we’re hitting performance targets. So we’ve got a bit of a chunk there that we’re working with.

So we just want to see how all this plays out. But mix is playing a big role and we’re growing the business, which is a fantastic indication of where we are going and will drop that to the bottom line. And obviously we made some good decisions in selling equipment, had the opportunity, executed on it well and brought a lot of cash in too. So you know, in our hierarchy of needs we’re going to focus on cash and growth, and we’re going to have the ability to capitalize on that as we make the improvements in gross margin. So it will just get richer as we move forward.

Joshua Zable – Natixis

Great. And then the question Jeff, I know you tend to be cautious about talking about the international markets until they get meaningful, you guys seem to be doing a lot of things out there. Can you just touch on where you are at or what markets you are in actually versus the ones you are looking to get into, or maybe just a little bit. I know you don’t want to talk about the numbers yet, until they get more meaningful, but just sort of, you know, we see agreements come out, just sort of if you can give us some sense of how quickly they go from sort of agreement to execution, or to actually getting in those markets. Thanks. Thanks for taking the questions.

Jeff Burbank

Sure. So, yes, we’ve seen a lot of activity. I think there is another place where we’re starting to build a good team that’s got a good execution record. We’ve now four distributors, five geographies. New geographies are UK and Ireland, Scandinavia, the Netherlands, and Italy, and we do have some presence in Middle East as well. So those are where we are. I won’t speculate on future territories, but we do have a pipeline of opportunities that we’re betting and working through.

So, you know, we expect to grow that over time. In terms of – kind of that rate now represents about $60 million of market opportunity that we are going after. So, we’re pleased about that and in terms of timelines, our experience is it takes really a year before you start to get into the window of opportunity. You know, you’ll set up. We do extensive training with them to make sure they know how to maintain the equipment, training in how to sell the therapy, all kinds of elements of that get their infrastructure in place. They put a few patients on, see how that goes, work the reimbursement cycles. So it typically takes a year before we feel like we’re on some sort of systematic growth trajectory.

Joshua Zable – Natixis

Great.

Operator

And we have a question from the line of Kim Gailun from JP Morgan.

Kim Gailun – JP Morgan

Hi everybody. Congratulations on a good quarter.

Jeff Burbank

Thank you.

Robert Brown

Thanks Kim.

Kim Gailun – JP Morgan

A couple of questions, I guess the first is on just looking for any update on the progress with the nocturnal filing, I know you had just commented that you had received another round of FDA questions, anything surprising in that series of questions, anything that makes you think that the process is going to move faster or slower perhaps than previous expectations?

Jeff Burbank

Yes, I always loved these questions of predicting the future with the FDA. It is very difficult to do. You know, we got our first round of questions. There isn’t anything in there that we don’t think we can do a good job of answering. So I feel good about it. You know, I mentioned in the past but I’ll say it again, I really was pleased with the results of the trial. It was a solidly executed trial, and the results were good to us. So we feel like we’re on a pretty solid base, but just really difficult to predict timelines and outcomes there. So, we’ll leave it there I guess at this time.

Kim Gailun – JP Morgan

Okay, thank you. (inaudible) questioning we have heard feedback from other companies in the space [ph] that FDA is going to come back with some questions that have been a little more detailed than in the past. I just wanted to know if there was anything surprising there.

Jeff Burbank

Yes, I will collaborate that as well. I think, you know, we have multiple products under review at any given time and the FDA is changing. It’s a very different environment than it was, maybe a year or year and a half ago. So the nature of the questions, the details they’re asking are significantly different than they used to. With that said, we understood all the questions and we think we understand how to prepare responses to them. So we’re in the process of putting all that together in a very thorough manner, and we’ll do the best job we know how and I think we’ve got what we need to do to do a good job to respond to the questions, but they are significantly more detailed than you might have expected a year or two ago.

Kim Gailun – JP Morgan

Okay, that is helpful. And then a quick question, probably for Robert on the stock based compensation, it did come in a little higher than we had expected in the quarter, the reasons for that make sense, just wondering if you could then share an estimate for the year, of what you think stock based comp might come in as?

Robert Brown

You know, I expected to see you know, as we did our grants at the end of Q1, it should more trend towards the Q2 rate. So, it will carry through more to Q2. So it’s you know, it’s not going to be quite double, but a little bit less than double the first half of the year.

Kim Gailun – JP Morgan

Okay, all right, great. That’s helpful. Thanks so much, guys.

Jeff Burbank

Yes.

Operator

And our next question comes from the line of Brian Zimmerman from Deutsche Bank.

Darren Lehrich – Deutsche Bank

Thanks. Good morning everybody. It is actually Darren Lehrich from Deutsche Bank. I have a couple of questions. The first is just related to the proposed rule on the whole rule-making process, can you confirm how many times you are able to meet with CMS during the common period. I know you provided comment, but I will be curious just to get some colour on whether you met face to face with them. And then, could you confirm if you participated in any of the industry meetings with OMB, I know there were three during the common period, if you had a table at any of those?

Jeff Burbank

So, CMS has done a really good job of listening to stakeholders in providing access to CMS, and we were able to take advantage of that. We also are active participants in KCP and some of the other organizations. So, yes, we have been actively involved in those processes.

Darren Lehrich – Deutsche Bank

Okay, and so you wouldn’t comment on how many meetings you have had specifically?

Jeff Burbank

No. That’s a little more detail than I feel comfortable with. We feel like we have the kind of access that we want from them, and I think they’ve been respectful and responsive to the issues that we’re raising, which are largely around training. When we saw the proposed rule, we thought that they did a good job on unit [ph] of payment meaning per treatment. Their handling of additional treatments provided with medical justification in that they said they would continue to pay for those. And so where we thought they kind of let everyone down a bit was in the area of training for home hemodialysis, where they put those funds into the general pool so that in a sense disincentivize home adoption based on that.

We bought a lot of attention to that. That was an area where patients had some strong feelings and some of the societies you know, National Kidney Foundation, AAKP, and others stepped up and expressed their concerns about that. So I think it ended up being the second most commented on element of the proposed rule behind probably the oral medications. So I think we brought a lot of attention to what the issue was, and if the process is what it is supposed to be, they will listen to that and hopefully respond. It will probably take some time to get it right. We don’t expect, you know, a big win here, but we expect some progress made on that topic. We’re hoping for that.

Darren Lehrich – Deutsche Bank

And do you think there was receptivity to the notion that much of the training and retraining occurs outside of the first 120 days, I am just curious if that was something that CMS expressed surprise to industry comment with regard to that?

Jeff Burbank

Yes, well you know, the facts speak for themselves. Most of our patients are incident patients, and so they wouldn’t be within that first period of time.

Darren Lehrich – Deutsche Bank

Okay, my last question really just really kind of a fact question if you could provide an update on more frequent dialysis in terms of your provider partners being reimbursed, and the frequency of the reimbursement on a per week basis, where is that this year and can you comment on maybe either a spot number for the patient pool that you have and where that was maybe a year ago?

Jeff Burbank

Sure. So that’s an important thing to the adoption of our therapy, appropriate reimbursements for the therapy delivered. In general, there is, you know, it’s hard for us to get a lot of evidence because that’s our customers P&L, and there tend to be allowed to share that with us, but we have done some surveys and we have looked at the CMS database. I think at a highest level over time it’s gotten a little bit more routine in the sense that the process of providing medical justification and receiving reimbursement is more widely understood, and the process for doing that is maybe a bit more lockdown than it was a few years ago.

So generically, I think we’re making progress on that dimension. Our understanding is that most private pay, if not all private pay, reimburse what is prescribed and that was validated for us in some comments that Kent Thiry from DaVita made in one of his I think annual meetings or earnings call, I don’t remember exactly which.

Darren Lehrich – Deutsche Bank

A couple of more [ph] in 2008. Yes.

Jeff Burbank

Yes. So we have that validation. We also have some data from the USRDS that says on average, Medicare patients are receiving that that are receiving reimbursement for that medical justification, and they can receive for somewhat over for treatment for reimbursement on average. That was earlier days because that data trails. So I don’t know how it has changed over time, whether it has gone up or down, but there is some indication that on average they are receiving additional treatments.

Darren Lehrich – Deutsche Bank

So, do you think it is safe to say at this point just given your comments that somewhere between four and five is probably what is on average for your – the pool of patients within your provider partners facilities?

Jeff Burbank

I don’t know for sure because I don’t have full visibility to that, but I’d say on Medicare it is probably closer to the four side, and on private pay it is probably closer to the five.

Darren Lehrich – Deutsche Bank

Great, that’s very helpful. Thank you.

Operator

Thank you. And we have a question from the line of Suraj Kalia from Rodman & Renshaw.

Suraj Kalia – Rodman & Renshaw

Good morning gentlemen. Congrats on the quarter.

Jeff Burbank

Good morning, thank you.

Robert Brown

Thanks.

Suraj Kalia – Rodman & Renshaw

Jeff, two key questions, and I’m sure there are some things that might not be answered right now, but when I look at this amended DaVita agreement, I can’t help but think this is more of a financing mechanism rather than a growth mechanism unless my numbers are wrong. DaVita is already, and I looked at the 8-K, at least to the extent that information is present out there. Please correct me where I am wrong, DaVita is receiving warrants in lieu of cash, maybe with a modest pricing increase and from what I see 5.5 warrants at 14.22. So, let us say rounded of to $77 million on 20% growth rate from the current levels. At least those are the things that I gleaned as quickly as I could.

So, when I look at that I think the first thing that comes to my mind is, okay, you guys did a modest price increase, great. But you guys were paying some amount of rebate to DaVita, now that has really been moved down to the share count. So, the OpEx line and everything else, our margin lines might look good, it has just moved down to the EPS?

Jeff Burbank

Okay, can I jump in?

Suraj Kalia – Rodman & Renshaw

Sure.

Jeff Burbank

I’ve been patient long enough. First of all, this isn’t an equity race. We have the resources we need to execute our business model. We also have additional resources in our line of credit. So it has nothing to do with that. Secondly, they have to do significant extraordinary growth rate to achieve these. So, we think a deal that enhances our position for doing the same thing they’ve done and give them the benefit of doing more than what they’ve done is the structure that we wanted.

So that’s what this is. We’re assuming that we wouldn’t, that we’d use that use of proceeds if they end up achieving those high level of targets, and accept that dilution. I mean, we could just go right back out and buy those shares to minimize the dilution. That’s actually one way of calculating. It’s called treasury stock method, where you’d go out and minimize dilutions by using those proceeds to just buy shares back because this isn’t an equity race, because we don’t need those proceeds that would be one of our options that we go after.

So you know, they have to really grow significantly for the first part, and also the share price has to increase for them to be of any value. So this is a great way to protect and grow value for everybody, much in contrast to what traditionally is done with a cash kind of rebate or a discount based on superior growth rates. That in the cash goes, but no shareholder value is created. So I didn’t like that structure at all. We think this is really a very elegant rebate structure that has significant performance targets.

So we’re very pleased about that. If you think this is a bad deal then I’m doing a very bad job of explaining it because this is great for shareholders and a good opportunity for DaVita. You’ve also mentioned that they get the warrants of 20%. That’s only the threshold. They have to grow at a sequential growth rate of 20% just to get those thresholds, which is a significant growth rate on the base pf patients that they have built up.

Suraj Kalia – Rodman & Renshaw

So, if DaVita – sorry, if DaVita raises whatever growth rates and they hit their bogey straight, subsequently for whatever reason market or some idiosyncrasy next stage of stock is down, they essentially are not realizing anything.

Jeff Burbank

That is right.

Suraj Kalia – Rodman & Renshaw

And they wouldn’t exercise the warrants, I’m just trying to understand the incentives for each party here. The linear assumption would be that this stock would go up, and I’m just trying to understand the incentives for DaVita, rather than having the certainty of cash, in this case there would be a backend loaded assumption that the stock would go up, and in all good fairness it would. I’m just trying to understand, the NPV creation for each party through these transactions.

Jeff Burbank

The vast majority of value creation would go to our shareholders, and DaVita would receive some benefit from achieving those extraordinary growth rates. So it aligns I think the strategic partners very well. So we’re in the same page on value creation. It works for them and it works for us. Those were the best deals I’ve seen where it’s based on a carrot not on a stick. It’s based on opportunity and value creation, not on taking things away. So I’m very excited about this deal.

Suraj Kalia – Rodman & Renshaw

Fair enough. Last one, Jeff, have you’ll seen any or can you’ll quantify the impact of available freedom data on acceptance in home care?

Jeff Burbank

Yes, most definitely. I mean, we see a broadening in the number of clinicians that are prescribing, I think just over the last quarter we were up 8% sequentially, it was 27% year-over-year. So that’s partly due to that data that we’re generating from FREEDOM, and we are doing a much better job of marketing that into the industry. So we are seeing a broadening of that and that’s one of the lifters on our ability to increase our sequential growth rate guidance.

Suraj Kalia – Rodman & Renshaw

Great, thanks guys.

Jeff Burbank

Yes.

Operator

(Operator instructions) We have a follow-up question from the line of Bill Plovanic with Canaccord Adams.

Bill Plovanic – Canaccord Adams

Great, thanks. I am just looking for a little more clarity, you know, as we kind of walk through guidance and what is expected are that the home market, the trends we are seeing in critical care, I think the one thing I’m trying to get my hands around, it seems like the In-Center is – you made comment that there are some issues with timing of revenues and what have you, I mean, do you basically believe that that could be flat to down in the back half of 2010 versus the first half of 2010?

Jeff Burbank

Now, let me be real clear on that. So what we said is we had about an 8% sequential growth rate. 4% of that was strong customer demand and bringing on some additional business. So that’s great. So that’s kind of our new baselines. That would put you to about 15.6, 15.8 somewhere in there.

Bill Plovanic – Canaccord Adams

Correct.

Jeff Burbank

So that’s kind of our new base demand rate. On top of that in any quarter we can see plus or minus half to a million based on shipments and timing. It’s a chunky business. We deliver in container loads. So depending on, you know, customs and all kinds of things, we can see it just fall one day or another and that can have that kind of quarter-to-quarter chunkiness. So we’ve always tried to be really clear on saying here’s about where end-customer demand was and here is the effect of inventories for those shipments.

So moving forward to be specific on your question, well we see a flat to down in the third and fourth quarter. The only way that would happen is that we have that chunkiness. That typically doesn’t happen two quarters in a row, but we’d update you if the end customer demand moves, but we’re seeing good trends there. It’s moving in the right direction. So we don’t expect your disaster scenario there.

Bill Plovanic – Canaccord Adams

So (inaudible), the way to think about it is the base business is between 15.6 to 15.8 and kind of that – that’s how we should look at it?

Jeff Burbank

Yes, and then float around that because it will go up and down. So when we build guidance, you know, we take that into consideration that we could miss a container or two. And so that’s what we used to establish our range, but the good news is that base rate was up 4% sequentially.

Bill Plovanic – Canaccord Adams

Got you. Okay, that’s very helpful. Thank you very much.

Jeff Burbank

Yes.

Operator

And ladies and gentlemen we have no more questions in the queue, I like to turn the call over to Mr. Jeff Burbank for closing remarks.

Jeff Burbank

Thank you everybody. We appreciate your attention. Enjoy your summer and we’ll look forward to talking to you again on the next call.

Operator

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

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Source: NxStage Medical, Inc. Q2 2010 Earnings Call Transcript
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