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NxStage Medical, Inc. (NASDAQ:NXTM)

Q3 2007 Earnings Call

November 2, 2007, 10:00 am ET

Executives

Robert Brown - Chief Financial Officer

Jeff Burbank - President and Chief Executive Officer

Analysts

Ben Andrew - William Blair

Robert Faulkner - Thomas Weisel Partners

Taylor Harris - JPMorgan

Suraj Kalia - Piper Jaffray

Anthony Ostrea - JPM Securities

Bill Plovanic - Canaccord Adams

Vivian Wohl - Federated Kaufman Funds

Andrew Morey - Tartan Partners

Operator

Good day and welcome to the third quarter 2007 NxStageMedical Incorporated Earnings Conference Call. My name is Candice and I'll beyour coordinator for today (Operator Instructions).

I would now like to turn the presentation over to your hostfor today's conference, Mr. Robert Brown, Chief Financial Officer. Pleaseproceed sir.

Robert Brown

Thank you, Operator. Good morning, everyone, and welcome.Before I turn the call over to Jeff Burbank, I would like to review ourforward-looking statement with you. Hopefully by now, you have seen our thirdquarter press release.

For your convenience, a replay of this call will beavailable beginning tomorrow for one week by dialing 1-888-286-8010 withpasscode 30934295. In addition, the press release for the third quarter resultsand a recording of this call will be archived on our website under the InvestorRelations section.

I would like to remind you that statements we may make onthis call, which are not purely historical, regarding the company's or ourintentions, beliefs, expectations and strategies for the future areforward-looking statements for purposes of the Safe Harbor provisions under thePrivate Securities Litigation Reform Act of 1995.

These forward-looking statements may include topics such asresults of our operations, growth of the home and more frequent hemodialysismarket in general, market adoption and demand for the System One, the roll outof the PureFlow SL, anticipated benefits of the Medisystems acquisition,anticipated improvement in product quality and financial guidance for thefuture.

Because such statements deal with future events, they aresubject to various risks and uncertainties and actual results may differmaterially from these forward-looking statements. Important factors that couldcause actual results to differ materially from those in the forward-lookingstatements are discussed in our SEC filings, including our quarterly report onForm 10-Q for the period ended June 30, 2007. In addition, any forward-lookingstatements made on this call represent the company's views only as of today andshould not be relied upon as representing our views as of subsequent dates.

Future events and developments may cause these expectationsto change and, while we may elect to update forward-looking statements at somepoint in the future, the company disclaims any obligation to do so. Andtherefore, you should not rely on these forward-looking statements asrepresenting our views on any date subsequent to today.

Now, I would like to turn the call over to Jeff Burbank, ourCEO.

Jeff Burbank

Thanks, Robert. Welcome everyone and thank you for joiningus. We're here to discuss the third quarter financial results, but I alsowanted to spend some time-sharing my thoughts on the transformation occurringat NxStage.

Since our inception, we've been a company seeking tovalidate our innovative technology and prove that it could meet the demand formore frequent home hemodialysis. We've been striving to put all the piecestogether to prove that the opportunity is as great as we've always thought,create high-quality innovative products and build a future for NxStage as aprofitable competitive company that makes a real difference in renal care.

Today, we're at the beginning of a new era at NxStage. Withthe acquisition of Medisystems complete, we've become a much larger company anda leading player in the dialysis industry. We now have five manufacturinglocations in four countries. We have over 1,200 employees and an annual revenuerun rate of over $100 million.

Our products are used in the delivery of therapy to over120,000 patients. Home patients on the NxStage System One are doing about50,000 treatments a month now. With our strong Medisystems brands for theclinic space product, our customers are using millions of our tubing sets andfistula needles each month.

This effect is based on proving quality products that arevaluable to our customers and their patients. In addition to our System Onebeing used in the critical care and home setting, we can now bring valuablesolutions to our partners' challenges with in-center dialysis.

We now think of our business in terms of three markets, thehome market, the critical care market and the clinic market, which is where weuse the Medisystems brand. So, let me update you on these three businesses.

First, the home hemodialysis market, the third quarter wasanother record-breaking one for patient additions with 342 new patientsreceiving home hemodialysis on the NxStage System One. That's a 21% increase inchronic patients since the end of Q2 of '07. You may have seen our pressrelease earlier this week announcing that in early October, we exceeded 2,000patients in 2007.

This is a milestone that we're celebrating here at theAmerican Society of Nephrology Meetings that started yesterday right here inSan Francisco. With this level of adoption I'm confident that home hemodialysisis a therapy that is here to stay and going to continue to grow.

In short, this is a market that has now been validated. It isa lasting opportunity, which is just starting to draw attention and we're theclear leader. As an organization, we now have what we need to turn from ourfocus on defining the opportunity to the business of educating on its benefitsand leading its evolution in maturation.

I believe we're positioned well for these tasks. Last month,the Journal of American Medical Association published a clinical studyconducted out of the University of Calgary. This demonstrated the clinicalbenefits of more frequent nocturnal hemodialysis.

This week, at the American Society of Nephrology Meetings,numerous presentations are being given on the benefits of home, more frequenttherapy and specifically, the NxStage System One. The evidence continues tobuild nicely. Consistently, each study concludes the vast majority of patientsprefer the overall well being of more frequent therapy.

Within our patients, 15% treat themselves five times perweek, 83% treat themselves six times a week, so that's over 98% of our patientsthat are treating five or more times a week.

PureFlow SL adoption continues to be strong with 65% of ourhome patients using PureFlow SL at the end of the third quarter. We're pleasedwith this continued uptick as PureFlow is an important element of our effortsto expand the NxStage System One's capability, improve its ease of use andimprove the company's gross margins.

As we've discussed in the past, PureFlow SL's launch has hadchallenges. I'm pleased to say that there are no new issues, only good progress.Reliability continues to grow steadily. With these improvements in the systemand water purification pack quality, we had a 25% gain in purification packlife from Q2 to Q3.

We've now completed the transition of bulk PureFlow SLdisposables into our manufacturing facility in Mexico. Not only has our costimproved, but our quality is improved with this transition as well. We expectto see the benefits of these improvements in reduced premix fluid usage andlower costs to continue.

We now estimate that we've done over a quarter millionPureFlow SL treatments in the relatively brief time since it's been on themarket. Our user surveys continue to indicate that the vast majority of ourpatients prefer PureFlow SL to the alternative. So, we're confident we're onthe right track with this product. In general, I feel really good about theprogress we're making in the home market.

Now turning to the critical care business, this is where ourpartners use the NxStage System One primarily to treat ICU CPU patients. Thisis a business that continues to perform extremely well for us. A demonstrationof our success is that seven of the top ten renal hospitals in the country, asreported by U.S. News and World Report, are using NxStage System One as theirtherapy system.

We not only want to have the easiest system, but we want tobe the easiest company to work with. We continue to expand our training andsupport services to ensure that all of our partners are getting the supportthey expect from a leader in this business. Although Gambro announced they wereoff of the FDA import hold for their machine, they're still waiting for an FDAclearance before they reenter the critical care market.

We expect to see them in the market before the end of theyear. This will increase competition in the business. However, we continue toadd large institutions of customers, winning with our product features andsimplicity, ease of training and ease of use. The advantages of our design,which eliminates scales and all of their limitations, is really gainingtraction in this market.

We expect that customers will continue to appreciate ouradvantages. Let's move to a discussion about the clinic business, our newestmarket as a result of the Medisystems acquisition. We closed the transaction onOctober 1, so the entire fourth quarter will include this business.

The integration is progressing on track. We'll be workingover the next few quarters to integrate all the systems and people. We'repacing ourselves to ensure that we remain focused on our rapid growth with theSystem One. From the announcement of Medisystems acquisitions, it was easy forinvestors to understand the strategic and operational advantages of thistransaction for NxStage.

What was not as apparent was our belief that productopportunities exist that could improve growth in the Medisystems product line.We have just unveiled the first of these, the Streamline Airless Blood TubingSystem. I'm excited about what this does for our customers. Streamline usesinnovative tubing set technology that can play a significant role helping toachieve clinical targets while reducing waste and resources.

In a recent clinical study, Streamline was demonstrated toincrease the delivered hemodialysis dose at lower cost while being simpler forusers. Streamline is also more environmentally friendly than conventionaltubing sets with 40% less plastic and using significantly less dialyses eachtreatment. We really look forward to helping our partners benefit from thisinnovative product.

You'll hear more from me over the next few quarters as wemake progress towards introductions of additional offerings that take advantageof the combination of NxStage and Medisystems businesses. I believe the mostimportant driver of our business in all products is quality.

Quality is a critical aspect of our growing business,whether this is the quality of our products, the quality of our therapy or thequality of life for our patients. This is our number one obligation and ourdecisions have been and will continue to be guided by quality as our firstpriority.

As we discussed on our last call, we announced the voluntaryrecall of certain System One cartridges that had higher than average leakrates. We take customer satisfaction very seriously and initiated thisvoluntary recall to maintain that commitment. Although it means a short-termhit of gross margins, we're confident that our customer relationships are worthit.

We're back on-track and believe we've dealt with this issueeffectively. In another demonstration of our commitment to quality, in thethird quarter, we elevated the lead quality assurance position at NxStage andpromoted Mike Webb to the newly created role of Senior Vice President ofQuality, Regulatory and Clinical Affairs. I've worked with Mike for a number ofyears and I'm pleased for him to be playing this really important role.

With regard to the quality of our therapy, we continue tosee encouraging data, much of which is being presented right now at theAmerican Society of Nephrology Meetings, which we're obviously attending. Inaddition, we continue to enroll patients in our Freedom trial and now enrolled145 patients at 26 sites.

I have more confidence than ever that NxStage has all thecomponents we need to reach our potential as a leading player in the dialysismarket. Our acquisition of Medisystems positions us to lead and grow thesignificant home hemodialysis opportunity as well as bring more value to ourcustomers.

We're transitioning from a start-up company built on hope toan industry leader focused on execution. The execution won't be easy, but wenow have the pieces to build an innovative profitable company that istransforming renal care.

Now, I'll turn the call over to Robert to review ourfinancial results.

Robert Brown

Thank you, Jeff. Revenues for the third quarter of 2007totaled $11.6 million compared to $5.5 million in the third quarter of 2006.This represents a 111% year-over-year increase and a 16% sequential increasecompared to the second quarter of 2007. In the chronic market, revenues were$8.3 million in the third quarter of 2007 compared with $3.6 million in thethird quarter of 2006, representing a 128% year-over-year increase and a 23%increase compared to second quarter of 2007.

In the critical care market, revenues were $3.3 million inthe third quarter of 2007 compared to $1.9 million in the third quarter of2006, representing an increase of 77% year over year. We added 342 patientsduring the third quarter and at the end of September, the number of patients onthe System One in the chronic care market totaled 1,957, an increase of 21%compared to the end of Q2. We added 41 centers in the third quarter, reaching atotal of 306 at the end of the third quarter.

The gross margin deficit in the third quarter of 2007 was30% compared to a 15% deficit in the second quarter of 2006. The increaseddeficit in gross margin was due to $2.3 million in charges related to theCompany's voluntary recall of certain System One cartridges that Jeffreferenced earlier.

Excluding the impact of the recall, gross margin deficit inthe third quarter was 10%, an improvement of five points over the secondquarter of 2007. This improvement was due to product cost reductions as aresult of contractual price commitments and the move of PureFlow disposables toMexico, along with an improvement in PureFlow reliability. We expect to reachgross margin break even during the fourth quarter of this year before theimpact of the Medisystems acquisition.

Operating expenses for the third quarter were $13 millioncompared with $9.4 million in the third quarter of 2006. The increase inoperating expenses reflects increased sales and marketing expenses as we expandour sales force and increase our marketing activities and distribution expensesfor a growing number of patients.

Non-cash stock-based compensation totaled $800,000 in thequarter. We reported a net loss of $16.1 million for the third quarter of 2007,including the $2.3 million impact of the voluntary inventory recall, or a lossof $0.54 per share compared to a loss of $9.6 million in the third quarter of2006 or a loss of $0.34 per share. We ended the quarter with $33 million incash, cash equivalents and short-term investments.

Turning to guidance, we expect revenue to be in the range of$27 million to $29 million for the fourth quarter or $57 million to $59 millionfor the full year 2007, including the consolidation of Medisystems for theentire fourth quarter.

The company expects a net loss, including Medisystems, in therange of $12 million to $13 million or $0.33 to $0.36 per share for the fourthquarter, including estimated non-cash stock-based stock compensation charges of$850,000 and amortization of acquisition intangibles of $750,000.

For the full year 2007, the company expects a net loss,including Medisystems, in the fourth quarter to be in the range of $53 millionto $54 million or $1.69 to $1.72 per share. This includes estimated non-cashstock-based stock compensation charges of $3.2 million and amortization ofacquisition intangibles of $750,000. The Company expects to end the year with2,200 to 2,300 patients at approximately 320 to 340 centers offering therapywith the NxStage System One.

Operator, that concludes our prepared remarks. Please openup the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come fromthe line of Ben Andrew of William Blair. Please proceed.

Ben Andrew - William Blair

Hi. Good morning, gentlemen.

Jeff Burbank

Good morning, Ben.

Ben Andrew - William Blair

I just wanted to catch up on a couple of things. The clinicadds have been really good the last couple of quarters, I think by my countyou've added 60 some clinics here pretty quickly, I'm sorry more than thatactually. Jeff, maybe talk about the dynamic of patient adds in those centersas distinct from maybe some of the early adopters.

Does it take a month or two or three to get one or twopatients, or longer? And then, when do you get those newer centers up to fiveor maybe ten patients each?

Jeff Burbank

As you can imagine, there is variability. On average, acenter will start a few patients, they tend to want to see how they do andthen, they tend to put additional patients on. And a typical patient will getto somewhere between seven and nine patients over the first 12 months.

Ben Andrew - William Blair

Okay. And this group, and it's actually 106 clinics the lasttwo quarters, are these clinics kind of similar in that dynamic so far?

Jeff Burbank

Our averages haven't changed.

Ben Andrew - William Blair

Okay. And as you think about the impact of nocturnal, haveyou seen any greater push by clinics themselves? Or where are you all on theclinical side to push that towards a regulatory approval?

Jeff Burbank

Yes, Its an area we're interested in, we're working with theFDA to understand what the requirements for that will be. And as soon as wehave clarity on that, well, we'll come back to you and share that. But it's anarea that NxStage is interested in. And we think it's important to have a rangeof therapies, you've seen us systematically grow our capabilities over the lastyear or two.

We are now with the PureFlow SL much better prepared to givehigher dose and longer therapies, including also less frequent therapies,which, as I mentioned, very few do because they tend to prefer the well beingof the more frequent therapies. But, we want to be a system that allows aclinician to do any of the types of prescriptions he's interested in doing. So,we see nocturnal as being one of those pieces.

Ben Andrew - William Blair

Okay. And the Freedom trial continues to plug along, it'smaybe a little bit slower on the enrollment side than we expected, maybe talkabout the dynamic there and when we should be looking for a first traunch ofdata.

Jeff Burbank

Yes, I'd agree with you on the a little bit slower than weall hoped for. I think the events of the third quarter didn't help us there.When you're dealing with some of the issues that we dealt with, customers tendto hunker down a little bit versus doing some of those things.

So, I think we saw some of those affects in those numbers.We'll watch. Fourth quarter is never an exciting new enrollment, whether it'sfor patients or patients in Freedom trials, so it's going to be a hard quarterto judge against, but we should see some progress there over the next twoquarters.

What was the second part of the question? Sorry, Ben.

Ben Andrew - William Blair

No, it's all right. The other piece I was going to ask aboutwas actually for Robert on the cash side. With $33 million, I know you'vetalked about putting in place some debt, where are you in that process? Andwhen might we hear something on that?

Robert Brown

Yes, we're in final discussions with a number of financialinstitutions at this point, and I think we're still on our time line to getsomething done this year.

Ben Andrew - William Blair

Okay. And you still think you can fund through cash flowpositive with that debt?

Robert Brown

Yes. That's what our model shows us right now.

Ben Andrew - William Blair

Okay, thank you.

Operator

Our next question will come from the line of Robert Faulknerof Thomas Weisel. Please proceed.

Robert Faulkner - Thomas Weisel Partners

Sorry, good morning.

Jeff Burbank

Good morning.

Robert Faulkner - Thomas Weisel Partners

A few things, I wondered if you could just comment on whatyou think the impact of your constraints on the cycler, because some of thewarranty issues associated that came as a result of the leaks in thecartridges, so what was the impact of that on patient enrollment? What do youthink it might have been?

Jeff Burbank

That's speculation, there was an impact I can assure youthat it's probably somewhere between zero and 100, but probably towards themiddle of that. We have really no precise way of knowing, but that's a gut feelI think from the NxStage team, we feel it's about that.

Robert Faulkner - Thomas Weisel Partners

Okay. And what was the dynamic that would have determinedwhether someone was or wasn't added because of a constraint? Did you just nothave cyclers for a while to send out?

Jeff Burbank

Yes, when we did our 8-K on the leaks and the consequence ofthose, some of the leaks caused service events for the machines, so there was ahigher demand on machines than we anticipated. So we had to manage demand ofthat, we just couldn't meet all those needs given the growth rate combined withsome cyclers requiring a higher rate of service.

Robert Faulkner - Thomas Weisel Partners

Okay. And that was handled at the sales person level or indiscussion with people at the clinic saying, hold off on this?

Jeff Burbank

It was a management of timing of put ons, yes.

Robert Faulkner - Thomas Weisel Partners

Okay. And you gave us a margin update, I wonder if you couldtalk, Robert, about the distribution line next quarter and going forward?

Robert Brown

Yes, the distribution line is a little higher than weactually want at this point, but we're actually putting some processes in placeto drive that back down and kind of manage that. I think we still feel verycomfortable with our long-term distribution goal of getting it down to 10%, andwe're now taking a look at it and putting some resources in place to manage itdown to that level over a period of three to four years.

It will start to trend down a couple of points per quarteras we go forward, that's what we're looking at.

Robert Faulkner - Thomas Weisel Partners

Okay. And for either of you, can you talk about the natureof Medisystems sales with respect to volatility? Are they volatile quarter toquarter or are they very consistent? How should we think about that?

Jeff Burbank

Yes, I think that's probably a good point. There is somechunkiness and there is some potential for rationalization as we get our handsaround the business. We're going to be focused on selling the right value,creating nietotic (ph) lines over time. So, there is a potential for that. Andas you all know from our relationships and our contracts, there are somesignificant customers there.

I think we have really solid product offerings that will dovery well in the market, but there is a potential for a little of that movingforward so, we've got to walk our way through that. But the products arestrong, we're launching an additional product, which I think strengthens ourposition there and we're learning as we go a little bit, but have the solidMedisystems team that came over with us.

So, I think we've got to get our hands around that a littlebit, but it feels good from where we're are.

Robert Faulkner - Thomas Weisel Partners

Can you give us an example or quantification of thehistorical quarter-to-quarter volatility?

Jeff Burbank

Most of the volatility in that product has been due toconsolidation in the industry, if I look back and look for some generic bucketsfor you guys. For instance, when somebody like an RCG gets purchased byFresenius, they tend to get converted from whatever they were using toFresenius products. So, a lot of the chunkiness historically has been due tothose strategic moves.

There is a potential for those going forward, I don't thinkthey're quite as large as what they were in the past because we now haveconsolidation to two significant vendors, DaVita and Drasinia (ph). But that'sreally been the only case of Medisystems losing business in the market, it'sbeen they lost a customer due to acquisition.

Robert Faulkner - Thomas Weisel Partners

And just in terms of at the micro level quarter to quarter,should we think of this as being very even quarter to quarter, Robert? Or isthere a seasonality to it?

Robert Brown

It is fairly even. I will make one comment about that isthat the products do go through distributors. So, depending how the supplychain, you may actually have something go between quarters because somethinggot dropped on the first day of the month versus the last day of the month.That's really the only choppiness we see from a financial impact.

Jeff Burbank

And Rob, I want to be clear because the information is outthere. We have a needle contract with DaVita that comes up in December forrenewal, that's an important piece of business for us. And we have a tubing setcontract coming up with DaVita for renewal towards the end of third quarter,beginning of fourth quarter next year.

So, those are important dates for us. DaVita and even itsprecursor has used Medisystems products for over 20 years now, so it's been aconsistent high-value relationship on both sides, we've been good partners onboth sides. And we're going into that with more value than I think we've evergone into it, but nothing's for sure in this business.

Robert Faulkner - Thomas Weisel Partners

Okay, great. And finally, if I may, any other Renal Weekhighlights, anything you think is going to be a core message of Renal Week withrespect to NxStage Home?

Jeff Burbank

A lot of good, solid progress. Today is my big day for that,I was mostly preparing for this call, so I haven't had a chance to poke intothat. But, I've reviewed the abstracts. A lot of good work that I think willcontinue to move the ball forward, much more experience and data with theNxStage system.

Historically, it's been more with other systems, so I'm veryencouraged by that and even more encouraged that the data looks as good orbetter, that kind of thing. So, it looks pretty solid, but a little too earlyfor me to call because I've got to get out of this conference room and go talkto customers.

Robert Faulkner - Thomas WeiselPartners37

Right. Okay, thanks, I'll hop back in the queue.

Operator

Our next question will come from the line of Taylor Harrisof JPMorgan. Please proceed.

Taylor Harris - JPMorgan

Thanks. Jeff, I'll try to be brief so you can get on to thecustomers there. So, going into the fourth quarter last year, we ended upseeing more seasonality than we thought and I'd just love for you to comment onwhat the gives and takes are this year, what you think may be different thisyear.

Jeff Burbank

Yes, I think our planning assumptions are it's going to beabout like last year in terms of what the individual centers are doing. There'sa few more centers out there, so we have the benefit of that. And you can seeby the numbers, we expect to add more in this fourth quarter than last fourthquarter just because of the growth of our base.

But, we're predicting similar behavior, having no knowledgeof anything significantly different, so that's our planning assumption at thispoint, Taylor.

Taylor Harris - JPMorgan

Okay. But at the top end of the range, you would have to addthe same number of patients in the fourth quarter that you did in the thirdquarter, which didn't seem to be the pattern last year. But, it also seemed tome that you were capacity constrained this third quarter and you've opened up aton of new centers, so I thought that might change the dynamic this year.

Jeff Burbank

There is a little bit of that dynamic in there, yes.

Taylor Harris - JPMorgan

Okay. And then, Robert, on the fourth quarter gross margincomment that you made, I just want to clarify. Do you think you will be breakeven for the full fourth quarter without the Medisystems business? Or do youreach that by the end of the fourth quarter?

Robert Brown

Yes, right now, we feel very comfortable that we'll reach itwithin the quarter and I think we'll be somewhere between breakeven and minus2% or minus 3%.

It's a little tough to call right now depending on wheresome of the projects are coming in, in the quarter, but we've got six or sevenpoints that we feel very good about and there's about two or three points thatreally depend on when they actually hit in the quarter.

If they hit it more towards the beginning of the quarter,we'll tend to break even, if they hit towards the end of the quarter, thenwe'll probably be a negative 2% or 3%.

Taylor Harris - JPMorgan

Okay and then just a few questions on Medisystems to help uswith our model there. The Medisystems business looks like gross margin of 23%,24%, that includes the revenue to you guys. Once we strip that out, are youstill at about the same gross margin level on the residual sales?

Robert Brown

Right, we're about 22%, 23%.

Taylor Harris - JPMorgan

Okay, 22%, 23%. And then, the Medisystems businesshistorically had been pretty close to break even on an operating basis. For'08, should we make the same assumption? Or can it be more profitable combinedwith you?

Robert Brown

Yes, it was actually break even, but in there was a $5.8 millionroyalty paid to another David Utterberg entity. That royalty actually goes awayand they historically, once you take that royalty out, they've been about 9% or10% on the bottom line.

Taylor Harris - JPMorgan

Okay, great. So, that whole royalty expense line goes away.

Robert Brown

Right.

Taylor Harris - JPMorgan

Okay, very good. And then growth in the Medisystemsbusiness, it seems like most of it has been generated by sales to NxStage, isthat fair? And should we assume flat sales in Medisystems next year or could itbe better than that?

Robert Brown

I think in this call, what we’ve say is that growth rate isabout market growth rate for those products, which is somewhere between 4% and6%, right in that range.

We'd like to come back to you and say how we're going toimprove that, we think there is opportunity, but we'll get more specific, Ithink, as the next two quarters come and we get some experience under our belt.

But we didn't buy it for 5% growth rate. We bought it,because we thought the synergy could enhance that.

Taylor Harris - JPMorgan

Great. And then last question, Jeff, strategically, you'vehad a lot of activity this year between the contract with DaVita, Medisystems,anything that you're thinking about considering as we go into '08? Or do youfeel like you're moving more towards a phase of all right, we have thefootprint that we want, let's go out and execute?

Jeff Burbank

It's a fair question. I couldn't tell you, if we were workingon something really big and strategic, but the reality is that's what themessage I was trying to convey in our talk track was that we really feel likewe've got what we need, we've got the platform or the foundation to now goexecute.

I'm really excited that we got all that we got done thisyear, so we can focus on execution fourth quarter and beyond.

Taylor Harris - JPMorgan

Great. Enjoy San Francisco.

Jeff Burbank

Thank you.

Robert Brown

Thank you.

Operator

Our next question will come from the line of Suraj Kalia ofPiper Jaffray. Please proceed.

Suraj Kalia - Piper Jaffray

Good morning, gentlemen, congratulations.

Jeff Burbank

Good morning, thank you.

Suraj Kalia - Piper Jaffray

Jeff, in terms of synergies from integration, I think so wehave the Medisystems P&L and if we back everything out, can you shed somecolor on what are the key components you'll expect to derive synergies from inFY '08?

Jeff Burbank

Yes, it's not the synergies you get in traditional forms ofacquisitions, where you see overhead synergies.

We don't see synergies in headcount and overhead, where wesee it is some of the products and capabilities we have, and some of those aretechnologies and some of those are pure marketing capabilities and sales andmarketing and customer relationships and those kinds of things. And then, wedid not take advantage of Medisystem’s full complement of technology in theNxStage products.

So, for instance, we didn't use all their components in oursystems. You know, we were in a negotiation, so I wanted to retain some of thatvalue for us. So, it's more in new products, ability to grow products in themarketplace and integration of similar components and technologies.

Suraj Kalia - Piper Jaffray

So, if I heard you correctly, Jeff, that the 700 or soemployees of Medisystems, that is not going to be a core focus. Can you shedsome color on in terms of R&D, SG&A? Will everything pretty much remainintact? How should we break out those line items for the combined business?

Jeff Burbank

Yes, you can't see our heads shaking, but Robert and I tellyou know, it tracks straight across, we don't expect any significant changes inthose investment rates.

Suraj Kalia - Piper Jaffray

Okay. Any color from your competitive intelligence onBaxter's efforts in home hemo?

Jeff Burbank

Not really anything more than you all know. They announced adevelopment deal with DEKA and Dean Kamen’s team. We take them seriously, wethink it's great for the industry, it's been a validation on the segment or thebusiness and we won't stand still, we're going to lead the market.

Suraj Kalia - Piper Jaffray

One final question and I'll hop back in the queue, Jeff, andit might be a little convoluted question, but do you guys have any insight orcan you share your intelligence on the percent of patients on PD that are beingconverted to home hemo?

Jeff Burbank

Yeah, that's a number that is kind of tough to get at becauseof the way it happens. Typically, when PD patients fail with therapy, theytypically don't plan the failure, meaning they don't predict that they're goingto be needing to come off of PD in two or three months, therefore they'retraining on home hemo.

They typically fail PD, end up in a center and then get putin the queue to learn how to do home hemodialysis and go back. And part of thatis they tend to be missing their clinical targets towards the end of PD, sothey're not as well as, you'd like them to be. So, there's that stabilization.

So, when we look at our survey numbers of patients that gofrom PD to NxStage, it's very, very low. However, when we've had just kind ofconversations of how many of our patients have been on PD, it's a pretty significantnumber.

I'd like to try to get that data, we haven't made thateffort, but it's kind of our general belief that the majority of our patientshave been on PD at one time or another.

Suraj Kalia - Piper Jaffray

Okay. So and if I were to make a broad brush, Jeff, if Iwere to draw a pie chart and say these are the absolute new patients that arecoming on to home hemo or these are converts from, let's say, a Fresenius, andthey're coming over to NxStage's System One and maybe a third category of PD,which obviously like I heard you is unknown.

How would the pie chart look like? I mean, is there a bigskew towards one element?

Jeff Burbank

It would be 80% or 90% converted.

Suraj Kalia - Piper Jaffray

Converted. Okay, gentlemen, nice quarter, thanks.

Operator

Our next question will come from the line of Anthony Ostreaof JPM Securities. Please proceed.

Anthony Ostrea - JPM Securities

Hey Jeff, Robert, how are you?

Jeff Burbank

Good.

Robert Brown

Good.

Anthony Ostrea - JPM Securities

Few questions, I actually wanted to get a better handle onyour costs. First, would it be possible for you to strip out just theMedisystems contribution in Q4 to operating income?

Robert Brown

Contribution to operating income, if you look at it as we goforward, we're looking at being right around break-even on the gross margin,spending up on our side won't be up significantly.

So, our operating loss will be generally what our SG&Aspending is for the quarter, so it was $13 million in Q3 it'll be maybeslightly higher than that in Q4 and then, the rest will be related toMedisystems and there is also $750,000 in there related to the amortization ofthe acquisition intangibles.

Anthony Ostrea - JPM Securities

Okay. So, $13 million being flat quarter on quarter so therest of it is really differences with Medisystems?

Robert Brown

Right. And intangibles from the acquisition.

Anthony Ostrea - JPM Securities

Okay. And are you still essentially doubling up on the bagson certain PureFlow patients? Or has that stopped?

Robert Brown

It's come down slightly. I think in the past we've said thatright now, PureFlow is costing us about 4 to 5 points of gross margin aroundthe reliability. I would say I'd put it around 3% to 4% right now. I think,we've picked up a point, point and a half in the Q3 time frame.

Anthony Ostrea - JPM Securities

But for your guidance though for Q4 assumes still some levelof…?

Robert Brown

Yes, we've got modeled in about 4 points.

Anthony Ostrea - JPM Securities

Okay. And then in your press release, I think, you hadmentioned something about increasing sales, marketing and distribution expensesin Q3. Jeff, maybe can you just talk about what the make up was of those costs,whether it was one-time, were there people? I'm just trying to understand thatmake up.

Jeff Burbank

Yes, that was actually our year-over-year growth rate inthere and it really comes down to your core sales and marketing. So, it'sputting more reps on the street and doing more marketing activities in general.

Anthony Ostrea - JPM Securities

Did you add new reps between Q2 and Q3?

Jeff Burbank

Yes, we did, we added approximately 4 reps in the chronicmarket.

Anthony Ostrea - JPM Securities

Four reps. And then, the last question from me, Robert, Ithink you had mentioned earlier on an earlier question on your distributionexpenses, you had mentioned that you are working on certain activities to bringthat number down. Two questions there, one, I think you said was it 2 pointsper year? And second question --

Robert Brown

No, I would look at it 1 or 2 points per quarter goingforward. We've actually in the last 90 to 120 days, we've really brought insome new individuals into that organization, their feet are on the ground now,they're actually starting to get some traction there. So, I'm expecting to get1 or 2 points per quarter as we move forward.

Anthony Ostrea - JPM Securities

And what kind of activities are these, essentially, to bringthat down? Are you maybe you can…

Robert Brown

Well, I mean they're taking it all the way down to lookingat our shipping lanes. So, taking a look at long haul shipping versus the lastmile. When you ship the last mile is pretty expensive, so you don't want tobasically have small loads going across the country from the distributioncenter. So, they're trying to balance that out of how do you take a semi loadto a certain point and then basically break it down there to actually deliverit to the home.

So, they're looking at the shipping lanes all the way fromdistribution center all the way to the end customer and then looking at thedifferent providers of freight that we use and looking at our contracts aroundthat and then also looking at our patient density. So, I mean they're basicallydoing a diagnostic on the whole infrastructure around that.

Anthony Ostrea - JPM Securities

Great. Thanks. I'll hop back into queue.

Robert Brown

Okay.

Operator

Our next question will come from the line of Bill Plovanicof Canaccord Adams. Please proceed.

Bill Plovanic - Canaccord Adams

Canaccord Adams, but that's close enough, good morning.

Jeff Burbank

Good morning, Bill.

Bill Plovanic - Canaccord Adams

I just actually have one housekeeping question. Did you giveus the number of hospitals that you added in the quarter?

Jeff Burbank

For clinical care?

Bill Plovanic - Canaccord Adams

Yes.

Jeff Burbank

No, we didn't. But thanks for caring.

Bill Plovanic - Canaccord Adams

Just trying to get my model up to date, that's actually allI have, thanks.

Jeff Burbank

All right.

Operator

Our next question will come from the line of Vivian Wohl ofFederated Kaufman Funds. Please proceed.

Vivian Wohl - Federated Kaufman Funds

Good morning, guys.

Robert Brown

Good morning.

Jeff Burbank

Good morning.

Vivian Wohl - Federated Kaufman Funds

Did you give us the number of patients or percent ofpatients that are on PureFlow now? And can you update us if the reliability isat the point where you really are starting all the patients out on PureFlow atthis point?

Jeff Burbank

Yes, the first part of the question, it's 65% at the end ofthe third quarter, so we continue to make progress there. The vast majority ofnew patients are going on to PureFlow. There are certain local issues to dowith local surveyors that we are working through. It hasn't been a significantimpact but, as with everything, nothing's universal, there are alwaysexceptions.

Vivian Wohl - Federated Kaufman Funds

And is that because of regulatory issues at the State levelor because of different water issues around the country?

Jeff Burbank

It's only the States' interpretations of the regulatoryissues.

Vivian Wohl - Federated Kaufman Funds

Okay. And given that it is at 65% then at the end of thequarter, I mean, I appreciate all the efforts on the distribution line, butmaybe you can help us understand what the distribution costs would have beenlike in the quarter if you didn't have the recall issues?

Robert Brown

Well, the distribution line in the quarter, actually we tookout the impact of the recall, or at least the direct impact of it. There weresome indirect impacts where, because we ran into a low point on the cyclers, wewere actually doing quite a bit of expediting on the cyclers to get patients upand running. So, there was a fairly what I'd say, to get the impact from that,that we're working out of right now. So, I don't have that number right infront of me how much that was.

Jeff Burbank

We probably would have added it to the write off if it waseasily quantifiable and that was the challenge we had. We know it's in there,but it's very hard to come to a specific number. So, we know there was anaffect, but tough to quantify.

Vivian Wohl - Federated Kaufman Funds

Well, I guess I'm just trying to understand why thedistribution costs then haven't come down more as a percent, given that we'reat 65% conversion. Emancipation, we're looking for emancipation now. Is theresome other assumption in there that changed?

Robert Brown

No, because I think we're seeing on the individual shipmentsof a PureFlow patient versus a bag patient, we're seeing those costs comingwhere we want them to come to. But, I think the fact is that, when you get to apoint where you're low on cyclers, you end up starting to move cyclers around alittle bit where you don't really want to.

And you're also expediting some cyclers and there is cost inthere. It's related to the recalls, but it wasn't directly related to therecall. And so, as we work out of that, we'll get improvement there.

Vivian Wohl - Federated Kaufman Funds

So, do you have enough cyclers at this point on November 2that this quarter we don't need to be expediting as much?

Robert Brown

Yes, we do.

Vivian Wohl - Federated Kaufman Funds

Okay. And then, if I can just ask a different question onreimbursement, what are you hearing from the grass roots about the policiesmaybe being put into place, or contracts with private payers in with Medicareas far as how many times a week they're paying? Is there any standard evolvingin?

Jeff Burbank

We continue to hear encouraging things about our customers'ability to receive additional payments. I haven't heard standards, we've alwaysheard in the 4 to 4.5 range is where it tends to settle out and we haven't hadany real new input on that. We may learn some things, while we're talking tocustomers here at ASN, but nothing significantly different than what we'vealways heard.

There are a lot of on the horizon with bundling in a coupleyears and whether and when and those types of things, but not any big changeson the way and the frequency of reimbursement for our customers.

Vivian Wohl - Federated Kaufman Funds

Okay, great. Thanks very much, Jeff and Robert.

Operator

(Operator Instructions) Our next question will come from theline of Andrew Morey of Tartan Partners. Please proceed.

Andrew Morey - Tartan Partners

Yes, I guess, can you hear me?

Jeff Burbank

Yes.

Robert Brown

Yes.

Andrew Morey - Tartan Partners

Oh, thanks. One, just review on Medisystems quickly, remindme again, what was the price you paid as a multiple of sales, sorry, for thereview?

Robert Brown

As a multiple of sales, it was about 1.2.

Andrew Morey - Tartan Partners

1.2 times, great. And just going over to the balance sheetfor a sec, I think this earlier first quarter of '07 showed a little bump inreceivables. It was my impression that was due to some of the seasonality lastfourth quarter, so when someone was asking about seasonality this fourthquarter, do you think that's possible as well that maybe some of the sales comea little bit later and maybe the cash flow, there is a little bit of a stretchin the receivables?

Jeff Burbank

In Medisystems or in NxStage?

Andrew Morey - Tartan Partners

I guess overall from the seasonality.

Jeff Burbank

Ever so slightly.

Andrew Morey - Tartan Partners

Right.

Jeff Burbank

Everybody is trying to make the balance sheet look good atyear-end, so you may see a little bit late payment there, but ever so slightly.

Andrew Morey - Tartan Partners

Okay, great, great, thank you. And last question, is thereanything you think you can do in any of the changes to help with the capitalintensity of the business? Just the field equipment, just how that rises inrelation to your growing sales, obviously the patient growth is terrific, butI'm just curious if there's anything you can do there just with respect to thatfield equipment line?

Jeff Burbank

Well, I'll take part of it and Robert can add in. I mean,the two great things on that, the first one is our relationship and structureof that with DaVita, whereby DaVita and some of the other large providers arebuying versus renting. The second is that we believe debt facility can get putin place that would help us with that as well, so Robert's been working on thatand we have multiple interested parties. So, we think both of those things willhelp us nicely.

Robert Brown

And third point is that, we've moved a portion of our cyclerproduction down to Mexico. Getting lower cost cyclers out of Mexico willdefinitely help there and we've seen over the last year and a half, two years,the cost of the cycler come down on a steady state. So, it's coming in nicelywhere we think it should really come into long term.

Andrew Morey - Tartan Partners

And I missed the front part of the call, so perhaps youalready answered this, did you quantify, whether it’s centers or new patients,any impact from DaVita in the quarter?

Jeff Burbank

Don't know exactly the question.

Andrew Morey - Tartan Partners

Well, just from your relationship, you kind of formalizedearlier in the year just any additional color on how much DaVita kind ofcontributed to the number of new centers added, and the number of net newpatients?

Jeff Burbank

Yes, they continue to be a good partner to work with, theycontinue to grow how we expect them to grow. So, they're providing the centergrowth and the patient growth that we had hoped for.

Andrew Morey

Okay. Thanks.

Jeff Burbank

You're welcome.

Operator

Ladies and gentlemen, this concludes the question-and-answerportion of today's conference. I will turn the call back to management for anyclosing remarks.

Jeff Burbank

Well, thanks everyone for joining us today. If you'll beattending the ASN meeting, we'll invite you to visit our booth, otherwise welook forward to updating you on NxStage's progress in our next call. Have agreat weekend, bye-bye.

Operator

Thank you for your participation, you may now disconnect.Have a great day.

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Source: NxStage Medical Q3 2007 Earnings Call Transcript

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