Inogen's (INGN) CEO Ray Huggenberger on Q2 2016 Results - Earnings Call Transcript

| About: Inogen, Inc (INGN)

Inogen, Inc (NASDAQ:INGN)

Q2 2016 Earnings Conference Call

August 4, 2016 4:30 P.M. ET

Executives

Caroline Corner - IR, Westwicke Partners

Ray Huggenberger - Chief Executive Officer

Scott Wilkinson - President and Chief Operating Officer

Ali Bauerlein - Chief Financial Officer and Co-Founder

Analysts

Margaret Kaczor - William Blair

Robbie Marcus - JPMorgan

Danielle Antalffy - Leerink Partners

Mike Matson - Needham & Company

Matthew O'Brien - Piper Jaffray

Operator

Good day, ladies and gentlemen. And welcome to the Inogen 2016 Second Quarter Financial Results Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder this conference call is being recorded.

I would now like to introduce your host for today’s conference Ms. Caroline Corner, Westwicke Partners. Ms. Corner you may begin.

Caroline Corner

Thank you for participating in today’s call. Joining me from Inogen is CEO, Ray Huggenberger; President and COO, Scott Wilkinson; and CFO and Co-founder, Ali Bauerlein.

Earlier today, Inogen released financial results for the second quarter ended June 30, 2016. This earnings release and Inogen's corporate presentation are currently available in the Investor Relations section of the company’s website.

During the call and the subsequent Q&A session, we will be discussing plans and projections for our business, future financial results, and market trends and opportunities, including among others, statements regarding our Inogen One G4 rollout, including pricing studies, commencement of international sales and anticipated patient preference, market opportunities, and increased use of portable oxygen concentrators, our strategic focus and objectives, hiring expectations, seasonality, our estimates of the impact of reductions in Medicare and insurance reimbursement rates, and our ability to offset those reductions, changes to the competitive bidding process, cost reduction expectations, expectations for profitability improvement and 2016 guidance, including revenue, net income, adjusted EBITDA, adjusted net income, net cash flow, effective tax rates, and tax benefits, and adjustments. These statements are forward-looking and are subject to substantial risks and uncertainties that may cause actual events or results to differ materially from currently anticipated events or results.

Information on these and additional risks, uncertainties, and other information affecting Inogen's business operating results are contained in Inogen's annual report on Form 10-K for the year ended December 31, 2015 and in Inogen's subsequent reports on Form 10-Q and Form 8-K filed with the Securities and Exchange Commission, including Inogen's quarterly report on Form 10-Q for the period ended June 30, 2016 to be filed with the Securities and Exchange Commission.

We advise investors to review these risk factors carefully. The forward-looking statements in this call are based on information available to us as of today’s date August 04, 2016, and we disclaim any obligation to update any forward-looking statements except as required by law. During the call, we will also present certain financial information on a non-GAAP basis.

Management believes that non-GAAP financial measures taken in conjunction with U.S. GAAP financial measures provide useful information for both management and investors by excluding certain non-cash and other expenses that are not indicative of Inogen's core operating results.

Management uses non-GAAP measures to compare Inogen's performance relative to forecast and strategic plans to benchmark Inogen's performance externally against competitors and for certain compensation decisions. Reconciliations between U.S. GAAP and non-GAAP results are presented in the tables accompanying our earnings release, which can be found in the Investor Relations section of our website.

We have not reconciled our non-GAAP guidance for adjusted EBITDA, and adjusted net income to the most directly comparable GAAP measures because the timing and amount of material items that impact these measures are inherently unpredictable or out of our control. Accordingly, we cannot provide a quantitative reconciliation of these non-GAAP measures without unreasonable effort.

I will now turn the call over to Ray Huggenberger. Ray?

Ray Huggenberger

Thank you, Caroline. Good afternoon, everyone and thanks for joining our second quarter 2016 conference call. On our call today, I will start with the financial and business highlights. And then Scott will cover our recent operational developments and finally Ali will review the financials and provide update for 2016 guidance. At that point, we will open the call up for any questions.

Our solid start to 2016 continued in the second quarter with quarterly revenues of $54.6 million, which represented 23.9% growth over the same period last year, despite the headwinds we are facing in our rental business. Our rental revenue continues to represent a decreasing percentage of our total revenues. Demand for our portfolio of innovative oxygen concentrators remain very strong across all of our sales channels, as sales revenue grew 40.7% in the second quarter of 2016 versus the comparative period in 2015 and represented 83.5% of total revenue.

As anticipated, we also saw the benefit of seasonality from the warmer month when patients are more likely to travel and therefore see the advantages of our portable oxygen concentrators. Domestic business-to-business sales were again our strongest growth channel, increasing 61.3% over the second quarter of 2015, primarily due to purchases from traditional home, medical equipment providers and strong private label demand.

As expected, in the phase of re-imbursement reductions more HME businesses are turning to portable oxygen concentrators and specifically to Inogen as the leader in the space to improve their cost position when providing oxygen therapy. Internationally, we saw strong sales growth of 23.9% in the second quarter of 2016, compared to the second quarter of 2015, primarily due to strength in Europe with our distribution partners and key accounts.

Sales in Europe represented the majority of international sales at 92.1% of international sales in the second quarter of 2016. Direct-to-consumer sales continued to be solid in the second quarter of 2016 increasing 38.5% over the second quarter of 2015. Growth was primarily driven by increased sales headcount and marketing spend to drive consumer awareness.

With the Inogen One G4 launching on the last day of May, our sales force is now selling what we believe will be the most patient preferred portable oxygen concentrator on the market and we remain very excited about the market opportunity ahead. In the second quarter of 2016, we delivered a record setting net income of $5.1 million and adjusted EBITDA of $13.6 million, once again demonstrating that we can deliver solid bottom line results and leverage even in the face of rental reimbursement challenges.

I am thrilled to report that we are aiming to deliver on our strategic objectives for 2016. On the first quarter call, we said that we were planning to launch the innovated Inogen One G4 before the end May and we did that. In the second quarter, we continue to add sales staff and we are continuing to develop additional innovative products.

We have been able to offset the declines in our rental business with strength in our sales channels. Notably, we have increased the revenue share of our direct-to-consumer sales and business-to-business sales. We have also made marked improvements in our ongoing efforts to decrease the cost of goods sold per unit and improve operating efficiencies to further increase profitability with the goal of offsetting most of the effects of the expected rental reimbursement reductions on an adjusted net income margin basis.

With that I’d now like to turn the call over to Scott Wilkinson to cover our operational highlight. Scott?

Scott Wilkinson

Thank you, Ray. We achieved a significant milestone in the second quarter with the launch of the Inogen One G4 portable oxygen concentrator, which has been very well received. As we’ve mentioned before, the Inogen One G4 is not only smaller and lighter than our current Inogen One G2 and G3 products, but it is also less expensive to manufacturer. Shipments of the Inogen One G4 and our direct-to-consumer sales channel began at the end of May and we expect to expand shipments to our domestic business-to-business channel in the third quarter of 2016.

Remember that as part of our sales strategy, we do not plan to make the Inogen One G4 available for rental and will use the Inogen One G3 product as the primary ambulatory solution deployed in our rental fleet at this time. Our international channel remains focused on the Inogen One G3 and we expect a minimal of any sales of the Inogen One G4 in that channel in 2016.

We expect that international sales of the Inogen One G4 may begin in the fourth quarter of 2016 or early 2017 depending on the timing of product regulatory and reimbursement approvals and ramp-up in 2017. We are currently pricing the Inogen One G4 at par with the Inogen One G3 in the direct-to-consumer channel. We expect to initiate a pricing study starting in the third quarter of 2016 to determine our longer term pricing strategy and should be able to provide an update on our next quarterly call.

In the second quarter of 2016, we added sales representatives to increase our sales capacity and we plan to continue to with our sales rep additions and infrastructure building activities throughout the remainder of the year. On the Medicare reimbursement front, we have not received any update on the results of the round one re-compete bidding process for contracts that begin in January 2017.

As we mentioned on our last call, bids have been submitted and we expect to receive the results by the end of the third quarter of 2016. We estimate that these competitive bid areas cover less than 10% of the Medicare oxygen market. As a reminder, additional cuts to certain Medicare regions were effective July 1, 2016. In the round two competitive bidding areas, the average single payment amounts are approximately 14% than the round two average rates for oxygen therapy from the previous round.

The average amount billed under the E1390 Healthcare Common Procedure Coding System code or HCPCS code for stationary oxygen declined 17.4% from $93.07 per month to $76.84. The average amount billed under the E1390 HCPCS code for oxygen generating portable equipment, which is the add-on code used for portable oxygen concentrator, declined 11.3% from $42.72 to $37.90.

Therefore, Inogen’s average gross reimbursement for the typical ambulatory Medicare patient receiving a portable oxygen concentrator in areas covered by round 2 re-compete would be $114.74 per month, versus $135.79 per month previously or a reduction of 15.5%. These rates are all averages, and as such are estimates that could vary widely when applied to our specific patient population. We estimate that approximately 50% of the Medicare patient population is in the round 2 re-compete area.

We maintain solid market access in these regions as we were awarded and accepted respiratory contracts in 93 of the 117 competitive bidding areas. In addition, the second phase of cuts to Medicare areas not subject to the competitive bidding process, which we estimate is approximately 40% of the Medicare oxygen market was also effective July 1, 2106. We saw the first phase of these cuts on January 1, 2016.

While there were significant effort by the industry to delay the additional reimbursement reductions to these areas effective July 1, 2016 and there were bills passed both in the house of representatives and senate that would have delayed these cuts in order to study the impact in rural areas, these efforts stalled and the delayed bills did not become law. The industry is still hopeful that there will be a long-term rural relief bill passed in September when Congress resumes. And we at Inogen are supportive of such efforts.

However, our guidance assumes that there will not be any improvements or delays to the second phase of rate cuts that took effect in these areas on July 1, 2016. We expect the average single payment amounts for our services to decline to approximately $120 to $125 per month, or a decline of 45% to 50% as of July 2016 compared to the average rates we received in 2015 in the Medicare and non-CBA areas. This decline includes both the second reimbursement reduction for these regions, as well as the lower rates of the competitive bidding round 2 areas.

We have also seen some private insurance payers reduce their rates for auction services in the second quarter of 2016 in response to the lower Medicare reimbursement rates. We do expect these private payer rates to continue to decline in alignment with the new Medicare round 2 re-compete competitive bidding pricing. Looking ahead, in spite of these significant reimbursement changes, we believe we are well positioned to continue our total revenue growth in the auction therapy market with best-in-class and patient preferred products and services with the competitive total cost of ownership.

We have continued to execute our strategy and we believe we are seeing portable auction concentrators become more widely used throughout the auction therapy industry.

I will now turn the call over to Ali to cover our financial performance and guidance. Ali?

Ali Bauerlein

Thanks Scott and good afternoon everyone. During my prepared remarks, I will review the details of our second quarter financial performance and then I will review our updated guidance for 2016. As Ray noted, total revenue for the second quarter of 2016 was $54.6 million, representing 23.9% growth over the second quarter of 2015.

Looking at each of our revenue streams and turning first to our sales revenue, total sales revenue was $45.6 million, reflecting 40.7% growth over the same quarter of the prior year and representing 83.5% of total revenue. Total units sold increased to 25,100 in the second quarter of 2016, up 53% from the 16,400 in the second quarter of 2015. Domestic business to business sales of $60 million in the second quarter of 2016 exceeded our expectations with 61.3% growth over the same period in the prior year, reflecting significantly stronger demand from our traditional HME providers and our private label partner.

Traditional HME provider growth even outpaced the solid performance of private label and resale channels. And then in the second quarter of 2016, we saw traditional HME providers as the fastest growing portion within the domestic business-to-business channel. These sales represented the majority of the increase over the second quarter of 2015 within the domestic business to business channel.

For the first time revenue from resellers represented less than half of the domestic business to business channels total sales revenue in the second quarter of 2016. International business to business sales were $ 13.1 million in the second quarter of 2016, representing 23.9% growth versus the same period in the prior year, primarily due to strong demand from our European partners. Business to business average selling prices in the second quarter of 2016 declined over the same period in the prior year, primarily due to a shift in the sales towards tradition HME providers and sales private label sales, and additional discounts associated with the increased sales volumes worldwide.

Direct to consumer sales for the second quarter of 2016 were $16.5 million, representing 38.5% growth over the second quarter of 2015, primarily due to the increased internal sales headcount and increased marketing spend for media and advertising to drive consumer awareness. The Inogen One G3 represented the majority of the concentrators sold in the second quarter of 2016, due to the timing and ramp of the Inogen One G4 product launch in me.

Turning to rental revenue, direct to consumer rental revenue in the second quarter was $9 million, representing a decline of 22.8% from the same period in the prior year, primarily due to the anticipated Medicare rental reimbursement cuts that took effect in the first quarter of 2016 and reductions in private-payer rates as they followed the decrease in Medicare rates and higher rental revenue adjustments.

Rental revenue represented 16.5% of total revenue in the second quarter of 2016 versus 26.4% in the second quarter of 2015. At the end of the second quarter of 2016, we had 33,600 rental patients on service. A 1:2% increase over the 33,200 patients on service as of March 31, 2016, and 6.3% increase over the number of patients on service as of June 30, 2015.

Turning to gross margin, for the second quarter of 2016 total gross margin was 48%, compared to 47.3% in the second quarter of 2015, up approximately 70 basis points. Our sales gross margin was 49.4% in the second quarter of 2016 versus 44.8% in the second quarter of 2015, up approximately 460 basis points.

The improvement in sales gross margin percentage was primarily related to lower cost of goods sold per unit due to lower materials, labor and overhead costs associated with the upgraded Inogen One G3, and higher volume of units sold first, partially offset by a higher sales mix of domestic business to business sales, which have lower average selling prices.

Rental gross margin was 41% in the second quarter of 2016, versus 54.1% in the second quarter of 2015. The decline in rental gross margin was primarily due to lower net revenue per rental patient, primarily driven by the previously discussed reimbursement rate reductions and an increase in provision for rental adjustments in the second quarter of 2016, partially offset by lower cost of rental revenues associated with lower depreciation and servicing costs per patient.

As for operating expense, we continue to make strategic investments in additional sales force headcount and support personnel, as well as in the launch of the Inogen One G4. As a result, total operating expense increased to $18.2 million in the second quarter of 2016, versus $15.5 million in the second quarter of 2015. However, operating expense as a percent of total revenue decreased to 33.3% in the second quarter of 2016, down from 35.2% in the second quarter of 2015.

Operating expense included a patent litigation settlement benefit of $1 million in the second quarter of 2016. Non-GAAP operating expense, excluding the settlement was $19.2 million in the second quarter of 2016, compared to $14.6 million in the second quarter of 2015, which excludes $0.9 million in audit committee investigation and related class action lawsuits costs.

Excluding the costs outlined above, non-GAAP operating expense was 35.2% of revenue in the second quarter of 2016, compared to 33.2% in the second of 2015. Research and development expense was $1.4 million in the second quarter of 2016 versus $1 million in the second quarter of 2015. The increase was primarily associated with additional personnel related expenses for engineering projects.

Sales and marketing expense was $9.6 million in the second quarter of 2016 versus $7.6 million in the comparative period in 2015, primarily due to the increased sales force additions and media expense. General and administrative expense was $7.2 million in the second quarter of 2016 versus $6.9 million in the second quarter of 2015, primarily due to increased personal related expenses.

These increases were partially offset by lower general, legal and accounting expenses, primarily due to the costs of $0.9 million for the audit committee investigation that was incurred in the second quarter of 2015 and a $1 million pattern litigation settlement benefit that was recognized in the second quarter of 2016.

In the second quarter of 2016, our effective tax rate was 36.1%, compared to 34.9% in the second quarter of 2015. This increase was primarily due to an increase in stock compensation expense and an increase in the blended state tax rates, partially offset by research and development credits allowed in the second quarter of 2016, but not in the comparative period in 2015.

Our net income in the second quarter of 2016 was $5.1 million, compared to $3.5 million in the second quarter of 2015, a year-over-year increase of 48.7% and a return on revenue of 9.4%. Earnings per diluted common share was $0.25 in the second quarter of 2016 versus $0.17 in the second quarter of 2015, an increase of 47.1%. In addition, I’d like to cover some key non-GAAP financial measures.

Adjusted EBITDA for the second quarter of 2016 was $13.6 million, which was a 24.9% return on revenues. Adjusted EBITDA increased 42.1% in the second quarter of 2016, versus the second quarter of 2015 were adjusted EBITDA was $9.6 million. Since there were no tax adjustments in either period, adjusted net income in the second quarter of 2016 and the second quarter of 2015 were the same as net income in their respective period and increased 48.7% to $5.1 million in the second quarter of 2016 from $3.5 million in the second quarter of 2015.

Moving to our balance sheet, cash, cash equivalents and short-term investments were $98.1 million as of June 30, 2016, an increase of $12 million, compared to $86.1 million from March 31, 2016. As of the end of the second quarter of 2016, we had no bank debt outstanding and our entire $15 million credit facility was available.

Turning to guidance, we are increasing our 2016 revenue guidance to a range of $190 million to $194 million, which represents year-over-year growth of 19.5% to 22%. This compares to the previous revenue expectation of $187 million to $191 million. We continue to expect total revenue headwind from competitive bidding rate reductions to be 3.5% to 4% in full-year 2016.

However, we expect additional rental revenue headwinds, due to the additional private insurance rate reductions, higher provisions for rental revenue adjustments, and lower net patient additions as we focus on sales versus new rental. We currently expect total rental revenue to decline as a percent of total revenue and decreased approximately 25% in 2016, as compared to 2015.

We expect strong second half growth for our business to business channels, versus the second half of 2015, which we expect will offset the additional rental revenue headwinds. Net income guidance for 2016 is now expected to be in the range of $12.5 million to $14.5 million, representing an increase of 7.9% to 25.2% growth over the 2015, up from the prior range of $12 million to $14 million.

We're also increasing our 2016 adjusted EBITDA estimate to a range of $37.5 million to $39.5 million, representing an increase of 16.1% to 22.3% over 2015. This is updated from prior guidance range of $37 million to $39 million. Adjusted net income is now expected to be in the range of $12.5 million to $14.5 million, representing 24.8% to 44.8% growth over 2015. This is updated from our prior range of $12 million to $14 million.

We continue to expect an effective tax rate in 2016 of approximately 35%, compared to 32% in 2015, excluding the tax benefit adjustments of $1.6 million experienced in 2015 that are not expected to recur in 2016. We expect a higher effective tax rate, primarily due to lower tax deductions for equity compensations, as a percentage of pretax income, which is expected to have a smaller percentage impact on the 2016 effective tax rate than it did on the 2015 effective tax rate. Finally, we still expect net positive cash flow for 2016 with no additional equity capital required to meet our current operating plan.

With that Ray, Scott, and I would be happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Margaret Kaczor from William Blair. Your line is open.

Margaret Kaczor

Good afternoon everyone.

Ray Huggenberger

Hi, Margaret.

Scott Wilkinson

Hi there.

Margaret Kaczor

So, first question from me is on the G4 and you guys, I know it is early days and you just started selling, but have you seen any change in the ability of closed patients with that launch, whether it is seeing more patients maybe calling in, now that that marketing campaign has started or maybe [indiscernible] after trailing it, and really how is that compared to some of the historical product launches you’ve had?

Ray Huggenberger

Yes, in part you’ve started to answer the question yourself Margaret and we haven't had a lot of time in the [indiscernible] yet. As you recall, we started selling at the very end of me. So we had about a month of sales traction in the second quarter, but we did not do any G4 focused advertising in May, June. We just started to launch our G4 focused advertising in the third quarter and we will continue to scale that up throughout the third quarter. So, what that means is the sales that you see in the second quarter, they are really based on our individual reps talking about that product to patients that initially responded to a G3.

So in the past, where we’ve really seen an uptick when we launched G2 over G1 and G3 versus G2, it’s really when we got the message out and lead with the message on that new product and people responded to that advanced product and the increased performance that we launched into the market. So that’s kind of a long winded way of saying it's still a little too early to tell in the sample side it is too small and we are still a rollout in scale up phase that’s going to take some more time for us to really know where we stand.

Margaret Kaczor

Okay that’s fair and I mean Ray and Scott, another kind of big picture question, I know it’s early days again, but what reaction are you guys saying for the market if any due to competitive bidding cuts, are you seeing the DMEs cut back on a number of deliveries, are you seeing DMEs exit the market or are they consolidating or obviously it would be good for you guys, if there was more interest in wanting to adopt POCs.

Scott Wilkinson

I think, again you know way too much about this market because you are kind of already taking my answers someway. I think it spans the spectrum. We've seen a good indication that HME's are beginning to consider non-delivery options with the success we had in the B2B channel domestically in the second quarter. I’ve always said that this shift when it happens in an event, it’s more of a process that will likely take quite some time possibly years, but it does seem that more and more HME's are considering POCs, as a way to reduce our overall operating cost, along with all the other things that you have mentioned like cutting back on service or dropping Medicare altogether, but again what we’re looking at right now in terms of data is one quarter that suggests all that and one quarter does not make a trend, but it certainly marks say departure from what we’ve seen in previous quarters.

Margaret Kaczor

And so just following on that logic, as well as the increase in guidance in both revenue and adjusted EBITDA on the quarter and that’s even as competitive bidding is impacting the market you talked about private-payers coming in a little bit stronger, but is it really B2B and more specifically your white label demand by the DMEs that is driving that increase, or is it something else? Thanks.

Ali Bauerlein

Yes, so as we said the domestic B2B strength that we saw in the second quarter is a combination of both traditional HME purchases, as well as the success of the private label product. So, both of those together were part of the very strong Q2 results that we saw in that channel. So, when we look at going forward and guidance and the increase in guidance and continuing to increase guidance in-spite of seeing those additional rental revenue reimbursement reductions and declines year-over-year, it really is because the domestic B2B side continues to perform very nicely for the company and we continue to expect strength in those channels as more providers do switch towards non-delivery solutions like POCs and particularly our POC. And for the first time, in the second quarter in that domestic business to business segment of $16 million, over half of that was the private label plus traditional HMEs versus the resellers. So, we are seeing a lot of strength in that channel.

Margaret Kaczor

Great and just last one from me, I just want to clarify Ali, if I do that math that’s $8 million being sold into the DMEs this quarter and for context what was that maybe last quarter?

Ali Bauerlein

So, last quarter we didn’t provide it, but we did say that resellers were the majority of the Q1 2016 volumes, so it was the majority and it’s $9.5 million you are looking at, at least $5 million was the resellers last quarter.

Margaret Kaczor

Thank you.

Operator

Thank you. And our next question comes from Robbie Marcus from JPMorgan. Your line is open.

Robbie Marcus

Great, and congrats on the good quarter guys.

Ray Huggenberger

Thanks a lot.

Scott Wilkinson

Thank you.

Robbie Marcus

You know, maybe I could just start with guidance and looking at sales guidance, it looks like just versus where the Street was, you know that rental revenue has to come down a couple of million and looks like B2B and DTC is going to be moving up a few million versus what the Street had, so is kind of $7. 5 million the right level for rental revenue per quarter in the back half for the year? And then are you still expecting DTC to be the fastest growth channel of the year, assuming maybe that G4 sales pickup with more advertising focus in the third and fourth quarter?

Ali Bauerlein

Yes, sure. I’ll take that one Robbie. So, starting first with the rental side, you quickly picked up on the key message there. So, last year we had about $45.4 million of rental revenues and we said we expect rental revenues to decline now in 2016, 25% down off of that. So that would be approximately $34 million in total rental revenue. For the year, it would be our current expectation and given what we’ve done year-to-date that would put the next two quarters at approximately $7.5 million per quarter in rental revenues.

So that is a correct way of interpreting what we gave from a guidance perspective on rental revenue. In terms of the fastest growing segment and what we expect on the back half of the year, we’ve already seen such strong growth on the domestic business-to-business side, compared to where we were last year and we do expect that to continue. So, the increase on the guidance, as well as making up for the additional rental shortfall, it really falls into that domestic business to business channels more than the direct to consumer side because we are still early in the G4 launch, we are not yet to a point where we would want to look at that direct to consumer guidance and increase associated with either different seasonality associated with G4 or looking at the productivity of the sales force. So, but we have seen very strong domestic business to business success and we do expect that to continue for the next two quarters to round out 2016.

Robbie Marcus

All right, maybe just to follow up on that a bit. With the B2B channel with more of the HMEs starting to use POCs, how should we be thinking about, is it different coverage areas of the country that maybe you are just not strong in, how should we view the B2B channels picking up some of the customers that I imagine you would like to get in the DTC channel?

Ray Huggenberger

I’ll take that on Robbie. I’m going to start with our coverage and our strategy on DTC and that is national coverage, okay. So, from a DTC standpoint we’ve got a national presence, we’ve got - our competitive bidding contracts gives us pretty much access all across the country. Our advertising drives awareness and demand all across the country, but from a DTC standpoint we’ve always kind of played ball with the HME providers, but they just really weren’t ready to look at POC seriously in the past.

The reimbursement cuts seem to be driving at least some thinking that we’ve got to do something different and we’ve covered our results here and talked about what we think is driving those results, but on the B2B side, it is really the same thing, it’s across the whole county. The rates are now completely national, you know with the rural areas going into play this year that took up the remaining 40% that was not under the competitive bid umbrella. You know the round 2 cuts hit half the country with another reimbursement reduction. So, what we’re seeing in terms of existing B2B customers that have bought a little bit more product, as well as new customers that we brought on board in the second quarter it is really all across the country. Because the reimbursement cut, it hits everybody and it is going to drive everybody.

Robbie Marcus

Okay and then maybe I will slip one last question and the InNova Patent settlement. Can you talk about what the study is that you are doing together to explore POCs and then with the win here do you feel confident that some of your pan technology can block or generate royalty revenue from other competitors out there? Thanks

Scott Wilkinson

Okay, I’ll answer the second one first. And you know we’ve always said that we feel we have a solid patent portfolio that covers our technology and our ability to come up with patient preferred products. We’ve also always said that you can make a POC, you just can’t make that POC.

And that is a very important distinction. At the end of the day this settlement is a testament that our patent portfolio is alive and well. As far as the - can it be used as a revenue generating tool? Well that would require somebody infringing first. And I can’t comment on whether or not there will be any future or potential future activity on that front. What we’ve always done in the past is to defend our patent portfolio if it is to be in the [indiscernible]. The first question was, what is that study? All I can tell you at this point is that we are collaborating on a study that involves the use of POCs. I can’t really say anything more than that at this point, not only because we don’t want to, but because we really can’t. There’s still a lot of work to be done.

Robbie Marcus

Okay great, thanks a lot.

Operator

Thank you. And our next question comes from Danielle Antalffy from Leerink. Your line is open.

Danielle Antalffy

Hi, good afternoon guys thanks so much for taking the question and congrats on yet another great quarter. I wanted to touch on the private label portion of the business, you know you are anniversarying that and just wondering how we should think about the long term growth trajectory there and whether that will continue to be a significant growth driver in your mind or how we should think about that?

Scott Wilkinson

Yes, I mean Danielle it’s really woven into the comments that we just made about business to business growth. I mean that both the HME folks that buy directly from Inogen, as well as the folks that decide to purchase the private label product we see those both being strong in the second half of the year and it’s reflected in our guidance. So, both.

Ali Bauerlein

And just adding to that Danielle, we’ve had a great relationship with the private label partner, they continue to invest in sales and marketing and continue to drive the conversion of POCs. So we do see them as a critical partner for us and somebody who is performing very well for us. So we would continue to expect nice growth in that area of the business.

Danielle Antalffy

Okay.

Ali Bauerlein

Remember, still POCs as a category have very little penetration and so we still have a large market that is tanks that has the potential to convert to POCs over time. And so our private label partner has been great at showing people how they can make POCs work for their business in spite of the lower rental reimbursement rates.

Danielle Antalffy

Okay. Got it. And then the question came out earlier about changing behavior amongst some of the DMEs and I’m just wondering obviously you guys are benefitting from that on your B2B side of things that – are you seeing some of the DMEs get more aggressive with any of the competitive POC devices? Or are you seeing any change in activity there that’s notable?

Ray Huggenberger

No, not really, Danielle. I mean we haven’t seen anything markedly new on the competitive front. As the homecare folks coping with these reimbursement cuts and trying to decide what they are going to do differently, certainly, a lot are looking to us. They are familiar with our model, we are a public company, so they can see our results, we seem to be coping pretty well overall with the cuts and so a lot look to us because we have experience in that channel. We’ve got a patient preferred product, so most people have some experience with patients at least enquiring within their own DME company about our product. So we’ve haven’t seen anybody that’s migrating another path. We are pretty pleased with that they are looking to us to help them with the solution. So far, you see the results in the second quarter and again for the guidance that Ali shared, we are hopeful that will continue.

Danielle Antalffy

All right. Thank you so much.

Operator

Thank you. And our next question comes from Mike Matson from Needham & Company. Your line is open.

Mike Matson

Hi, thanks for taking my questions. I apologize for any background noise. So I guess I just wanted to start with the provision for rental adjustments. I was wondering Ali if you could explain again what that is? And just how big of part of the decline in the rental sales was caused by that factor?

Ali Bauerlein

Yeah, so we are not going to breakout the specific impact, but it’s really the decline from Q1 of 2016 to Q2 of 2016 is a mix between those private payer rate changes as well as the provisions for rental revenue adjustments. On the provision, it’s – what that really is, is when we cannot procure the payment form the Medicare side or on the private insurance side for amounts that we billed in revenue. So that is the large driver of rental revenue adjustments that can be anything from a patient passing away and then having to write-off that amount or another provider being in the home or an issue with the certificate of medical necessity or timely filing of those claims, claims that enter their appeals process and/or not approved through the appeals process, there is quite a few factors that impacts that rental revenue adjustments line, but it really was a mix in the second quarter. On top of that, we also have continued to tighten our intake procedures to try and prove the collectability of those accounts receivable balances.

Mike Matson

All right. Thank you. And then just on the private haircuts that you’ve seen as a result of the bidding cuts. Can you just talk a little bit more about that? Is that in the round two areas? Is that in the national expansion areas? Is that in all the above? And where do you think you are at in that process? Do you think it’s going to take a few quarter to fully play out or have already most of the insurance companies adjusted their reimbursement?

Scott Wilkinson

Yeah, I will take that. What we’ve seen in the past and remember, we are several rounds into competitive bidding. So historically, we’ve seen the private instruments, they would follow the rate reductions driven by competitive bidding, but there was quite a lag in the past. I mean we’d see anywhere from six months to a year in a given area before private insurance starting following down that rate reduction path. What we saw this year is that private instruments companies started to follow the new rates basically a quarter after it, much quicker and much more aggressive in their timing of cost reduction or rate reduction I should say. So that was one of the things that was a bit of a surprise to us in the second quarter and it’s really all across the country. Again remember that the rate reductions that just swept through this year between the rural areas and the round two areas cover roughly 90% of the market. So you’ve got private insurance companies whether it’s national players or regional players, they are all taken a look at that as a cost savings opportunity to reduce the rates. No, we don’t think that it’s done yet. We’ve seen some people start earlier than in the past, but that doesn’t mean that they have finished earlier and we do expect as Ali mentioned in her comments that we will continue to see private insurance reductions throughout the rest of this year, that’s our expectation, even though the Medicare rates are stable for the rest of the year.

Mike Matson

All right. Thank you. That was very helpful. And then just on the – how does [indiscernible] PSCs to directly to HMEs? How does the pricing and margins on that business compared to the private label sales through private home healthcare, is it better, is it worse, is it the same?

Ali Bauerlein

It really depends on the volume. So we don’t breakout ASPs by that level, but it really depends on the size of the customer and how much they are buying, what their prices would be, I mean clearly the private label needs to be priced appropriately, so they can sell into the traditional HME channel as well. So, private label sales would need to be able to operate at a margin, which means that at those same volumes they can still have a portion of that margin.

Scott Wilkinson

Yeah, let me add to that. On the private label front, our partners done, as Ali already said, a great job of servicing the HME community providing in-person service and handholding for those that needed and there was a cost to that. And by us basically seeding that responsibility to them, it’s a cost that we avoid, but they get some margin for that. So if a provider comes to us versus looking at our private label partner, they are not going to see a difference in price between the two supplier, they would see a price from both suppliers as Ali said based on their volume. Sockets higher volume they are going to get a lower price, no matter who they buy from, but equal volume it really doesn’t matter.

Mike Matson

All right. That’s great. Thanks for taking my questions.

Operator

Thank you. And our next question comes from Matthew O'Brien from Piper Jaffray. Your line is open.

Matthew O'Brien

Good afternoon. Thank you for taking my questions. Just starting on the ASP side I think, when I look at your product revenue in the quarter versus how many units you sold, that ASP has come down pretty meaningfully, down about 6% sequentially, about 8% down year-over-year. Can you understand that PSCs [ph] domestically the bigger piece of the business, but it has been for a while as far as growth rate, can you help us understand why that ASP looks like it’s under pressure from the data delinquencies?

Ali Bauerlein

Yeah, so I will take that one. And you are correct, it’s down about 8% on a sales revenue per unit sold compared to the second quarter of 2015. I do want to first of all point out that at the same time, our sales cost-of-goods average on a per unit sold again is down over 16% in that same comparative period. So we have been able to improve our gross margin on our sales side of the business in spite of those lower ASPs. And when you look at the ASP side, as we’ve continued to have success with the private label partner and traditional HMEs, those are in much higher volumes that what we saw in previous years as well. You will expect to give slightly on price associated with those higher volumes as well as you have the mix shift towards the business to business side compared to the direct-to-consumer side of the business

So if you look at last year’s domestic business-to-business as a percent of our total sales in the second quarter of 2015, it was about 30.6% compared to 35.1% in the second quarter of 2016. So as you have higher domestic business-to-business sales in that mix, it has direct impact on that ASP. Remember also that our direct-to-consumer business, the configurations they are buying tend to be have more components in them, they tend to buy extended warranties and batteries and those types of items, that also increases ASP and increases cost of goods associated with that. So as you shift to more business-to-business sales you have a lower level configuration being purchased versus the direct-to-consumer side of the business.

Matthew O'Brien

Okay, that’s very helpful, Ali. I guess, I didn’t notice that and that was another question that I had on the gross margin side, profit side of things with the COGS reduction that – is there an inflection point where we can start to see those to – start to see the benefits on the COG side continue to go lower where as the ASP pressured it via new volumes or increased volume will start to stabilize more, are we getting to that point or is that still a couple of years out? And then kind of buried within that question, did you see any bulk purchases this quarter, I know you can only make so much before of it, anything else along those lines here in Q2 that you should call out?

Ali Bauerlein

Yeah, so on the sales gross margin side, when you look at the margin of the product, the real driver of the year-over-year decrease in cost was upgraded G3 product that launched in December of 2015. So at – really the first quarter of 2017, you will start annualizing those large year-over-year decreases in cost of goods. Now at the same time, you have G4 ramping up, which will provide additional cost leverage. However, that cost leverage is a smaller amount on a per unit basis than what we saw on a G3 side and it also will enter the sales channels over time with starting direct to consumer, than moving to business-to-business as Scott laid out in his prepared remarks. So you will see that impact much slower than what you saw with upgraded G3 where we were able to convert all of the sales almost immediately to that new product.

Now where margin goes over time, that really depends on the mix of the business, how much is business-to-business, how much is direct-to-consumer and frankly that’s one of the reason why we don’t give a specific gross margin guidance. Because while the business-to-business side does have a lower sales gross margin profile, it also has lower operating expenses associated with it. So we really focus on how do we optimize the bottom line and where margin versus OpEx falls in between, it just depends where the business is coming from.

Matthew O'Brien

Got it. And last one if I may, just the change on the rental outlook, certainly not the worst thing in the world for the business, but pretty big headwind here in 2016, you able to offset that elsewhere in the business. Should we think about that business as a continual either mid to upper single-digit decline over the next several years? And then to offset that type of pressure is still fairly large piece of the business. Do you have to make alternations to your spending plans, you had new heads, your ETC spending, sort of offset some of that within the more purchase side of the business going forward?

Ray Huggenberger

Yeah, so you have a couple of things going on there. We will still see a little bit of headwind next year that just comes from the year-over-year because not all of the cuts of 2016 were effective in the first half of the year. So as you said have a little bit of an overhang there. It’s not as much as we are going to see in the second half of 2016, but there is a little bit of an overhang there. Then the rates will be stable for two years or so, then there is not going to be any [indiscernible] until the beginning of 2019 I believe for Medicare. So once we get through that overhang which would be around the middle of next year as far as the Medicare market is concerned, that’s going to be kind of the new reality, the new baseline. And I wouldn’t want to venture of predicting what pricing is going to look like 2019 and beyond, but what I know is that there is not going to be as many waves anymore because starting at the middle of 2017 even on a year-over-year comparison, it’s all even-steven, it’s all on an even keel. We are responding to that in two ways, right. One is that we put more emphasis on sales just to kind of drive through the transition. There will always be rentals because not everybody can afford pay $2,500 or $3,000 purchase and those that can’t we will take rentals assuming that all of the necessary requirements are fulfilled and what we are doing like many other providers I’m sure are doing these days is to be extra careful and double check and be a bit more rigorous when we take on rental patients simply because at these rates we can’t afford the effort of chasing out the paperwork and doctors orders and signatures. So we have to have that right from the GetGo and the same goes for co-pays right. We – at these rates, we can’t afford the administrative effort to chase co-pays. So that will for a while create a bubble in which rental intake slows down until it normalizes and everybody is doing it and it’s a new reality and then I think patient intake will return to normal levels, but in the meantime you have kind of a double-whammy right, on one hand, we are slowing down the intake because we are more rigorous on the requirements and two, relative to years passed, we are putting more emphasis and stronger emphasis on the sales side of things and less on the rental side of things. Did that answer your question?

Matthew O'Brien

Yeah, it’s perfect. Thank you.

Operator

Thank you. [Operator Instructions]

Operator

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

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