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NxStage Medical Inc. (NASDAQ:NXTM)

Q1 2008 Earnings Conference Call

May 12, 2008 5:00PM ET

Executives

Jeffrey H. Burbank President - Chief Executive Officer

Robert Brown - Chief Financial Officer

Analysts

Anthony Ostrea - JMP Securities

Taylor Harris - J.P. Morgan

Bill Plovanic - Canaccord Adams

Philip Legendy - Thomas Weisel

Ben Andrew - William Blair

Operator

Good day ladies, and gentlemen, and welcome to the First Quarter 2008 NxStage Medical Incorporated Earnings Conference Call. My name is Makida and I’ll be your coordinator for today.

At this time all participants are in a listen-only mode. We will be facilitating a question answer session towards the end of this conference. [Operator Instructions]. As a reminder this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today’s call Jeffrey Burbank, President and CEO of NxStage Medical. Please proceed sir.

Jeffrey H. Burbank

Thank you all for joining us today. With me today is Robert Brown, our Chief Financial Officer of NxStage.

Let me start out by covering the Safe Harbor. This presentation contains certain forward-looking statements. These statements are based on the current estimates and assumptions of the management of NxStage Medical, Inc. as of the date of this presentation and are naturally subject to uncertainty and changes in circumstances.

Given these uncertainties, you should not place undue reliance on these forward-looking statements. Actual results may vary materially from the expectations contained herein. When used herein, the words "may", "will", "should", "could", "would", "plan", "anticipate", "believe", "estimate", "intend", "project", "potential" and "expect" and similar expressions are intended to identify such forward-looking statements. Such forward-looking statements are subject to risks, uncertainties, assumptions and other factors that may cause the actual results of NxStage to be materially different from those reflected in such forward-looking statements.

Important factors that could cause actual results to differ materially from these indicated by such forward-looking statements include among others, those set forth under the headings "Cautionary Note Regarding Forward-Looking Statements", "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations". In our Annual Report on Form 10-K for the year-ended December 31st, 2007 and our Quarterly Report on Form 10-Q for the three months ended March 31st, 2008.

Except to the extent required by applicable securities laws, NxStage is not under any obligation to and expressly disclaims any such obligation to update its forward- looking statements, whether as a result of new information, future events, or otherwise. All statements contained in this presentation are made only as of the date of this presentation.

We will be making forward-looking statements during the course of our presentation today, so please take a look at this and review our Safe Harbor.

You may be interested and why we chose this new format for our earnings. Let me explain, NxStage is a very different company today that we were 6 months ago when we acquired Medisystems. It’s important to understand how this transaction in the growth of our three markets has changed us as a company. So in addition to Q1 results, we will walk you through how we think about our markets and our strategy of building a successful company.

I’ll start with Robert reviewing highlights of our Q1 financial results. I’ll then provide an overview of our three markets and how we see them. This will clarify how we are building a company that has multiple growth vehicles that leverage each other. Afterwards, we'll open up the line to take your questions.

My high-level summary for the first quarter is as follows. Our integration of Medisystems, which was a very large acquisition for us as progressed very well. We had good revenue performance in all three markets. We achieved our plans for gross margin improvement and continued to have confidence in our targets for the rest of the year. We also did better than expected in the area of distribution costs and continued to see opportunities to reduce this going forward. We were unable to achieve our guidance for net patients added, our inability to predict this in the short term is a really frustrating aspect of pioneering a market. But our diversity to cross three markets allowed us to achieve very solid financial performance for the quarter.

We are focusing on smart growth to ensure our viability of the long haul, while delivering quarter on quarter financial progress.

Now I’ll turn it over to Robert for more detailed description of the quarter and beyond.

Robert S. Brown

Thanks Jeff. Let me start by covering non-GAAP disclosures. During this call we will be referring to non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principals. A reconciliation of the non-GAAP financial measures in the most directly comparable GAAP measures is available in our press release announcing our financial results for the first quarter of 2008. This releases, as well as our SEC filings, are available in the investor information section of our website at www.nxstage.com. Beginning this quarter we will be reporting the business as two segments, the system one segment which consists of the home and critical care market and the In-center segment which includes the product acquired in the Medisystems acquisition. We will also began focusing investor attention on adjusted EBITDA, which we define as EBITDA adjusted for stock based compensation and deferred revenue recognized. We believe it is an important non-GAAP number for understanding our business.

In the first quarter total revenue increased 270% year-over-year and 4% sequentially. Growth in the system-one segment in the first quarter compared to the same quarter last year was 78%. We continued to demonstrate progress in operations, we have a three point sequential gross margin improvement and reduction in distribution expenses,. Although our growth in home hemodialysis patients was below our expectations, we still delivered solid financial performance in the first quarter.

So typically when comparing our actual results to guidance, you can see that we hit the high end of our revenue projection and beat our expectations for net loss. Again being able to deliver this steady performance underscores how different we now are as a company. In addition, adjusted EBITDA for the first quarter 2008 was a loss of $8.3 million compared to a $10.7 million loss from the first quarter of 2007. We consider this as an important financial measure for the management of profitability and cash use and will provide us information going forward.

We continued to see improvement in gross margin on year-over-year and sequential basis and we are now starting to see a reduction in distribution expense in the system one segment. Improvements in gross margin can be attributable primarily to the product cost reductions and the acquisition of Medisystems.

We believe our manufacturing transitions are on target and will deliver the gross margin improvements that are expected. Beginning in the second quarter we are manufacturing all of our system one cyclers in Mexico and by the end of the second quarter we will no longer be purchasing Pureflow hardware from outside contract manufacture. Distribution expense in the system one segment experienced significant improvement in the first quarter as a distribution team began to gain traction.

We saw nice reduction in our freight rates, partially offset by rising fuel surcharges along with internal process improvements. As you can see we have also narrowed our adjusted EBITDA loss year-over-year which under scores the benefit of Medisystems acquisition. As Jeff said earlier, we are at different company following our Medisystems acquisition, we are larger, compete in more markets, and have a more diversified product portfolio. In response to this different reality, we plan to change the type of financial guidance we provide on a quarterly and year end basis. For comparative reasons and due to the unpredictability of home patient numbers on a quarter to quarter basis, we are moving away from providing patient guidance on a quarterly basis. At the same time we will be providing greater ability by providing adjusted EBITDA and segment information as key financial metrics. Going forward we will provide quarterly and full year guidance on our expectations for revenue, net loss, and adjusted EBITDA.

For the same quarter 2008 we expect revenue to be in the range of $30.5 million to $32.5 million. We expect a net loss in the range $13.5 million to $14.5 million or $0.37 to $0.40 per share based on current shares outstanding. We expect an adjusted EBITDA loss in the range $7.4 million to $8.2 million for second quarter of 2008. As you saw in our press release, based on the home patient growth in the first quarter we had reduced our expectations for a number of patients on system one at the end of 2008. We now project that we’ll have between 3100 and 3500 home patient at year end.

For the full year 2008, NxStage expects revenue to be in the range of a $130 million to $135 million, the company also continues to expect a net loss in the range of $52 million to $56 million or a $41 to $52 per share for the full year 2008 based on current shares outstanding. The company expect adjusted EBITDA in a range of $28 million to $31 million for the full year of 2008. Cash used in the first quarter 2008 was $23 million, higher than the average for the past 4 quarters primarily as result of remaining inventory bills in our contract manufactures as we transition to manufacturing our cycler and Pureflow hardware in house.

We project that we will have adequate cash and availability from our revolving credit facility to the end of 2008 based on our projections of adjusted EBITDA loss and our projections of equipment requirements for the remainder of the year. As we discussed on our last call, we planned to raise additional capital this year to meet our capital requirements beyond 2008 and we are confident that we will secure the additional capital we need. Now let me turn the call back to Jeff

Jeffrey H. Burbank

Thanks Robert. Now it’s my turn to discuss how we are building a company that’s beyond just a leader in home homedialysis and how this improves our growth opportunities as well as reduces the risk of the achieving our financial goals. We embarked on a strategy that we hope will allow us the opportunity to develop and lead the growth of home homedialysis and further leverage our capabilities into additional markets. We did this by developing and combining three complimentary markets, In-center, home and critical care. Iit allows us to deliver the required financial performance while we pursue multiple significant growth opportunities. We’re therefore less dependent on the growth rate of any single one of these

Additionally I believe that we are now at a point due to the improvement in our cost of goods that our cash needs are relatively insensitive to our growth rate In-center and critical market growth doesn’t consume cash due to their profitability. Cash needs are relatively insensitive in the whole market relative to our growth there. Said another way, in the home market there are really three key drivers of cash needs, the cash for buying machines, the cash generated from running these machines, and the rate of our growth. Over a broad range of assumptions, cash needed to grow the business is within a relatively tight range. I believe that were now positioned with multiple opportunities for growth such as new products, growing market share, market expansion, and new geographies. The combination of our three markets represent an estimated $1.6 billion US market opportunity. Today our largest business is in In-center market. We estimate the US in-center for hemodialysis disposable products like our Medisystems branded products to be approximately $500 million per year.

We see our greatest opportunity to grow this is our ability to leverage our technology leadership and introduce new products. In-center targets to grow our revenue to a run rate of around $120 million by the end of 2011. We believe our home market potential for growth is as exciting as ever, even though predicting how it will grow is challenging. We estimate that the US market hemodialysis for equipments and supplies is conservatively cited to the billion dollars. Our continued work in this market provides us confidence in the belief that it will be a very large market in a relatively short period time.

Last year our sales in the home hemodialysis market were $30 million and we expect to expand that market and grow to 4 to 6 times that by 2011. We believe the critical care market for CRRT equipment and supplies is approximately $100 million. This market has provided consistent growth for the company. And although that market size is not as large as the other markets, we see a nice opportunity for market convertion as a result of NxStage’s system-one user fairly technology that’s valued by customers.

We are projecting that the 2011 will bring a doubling of that market from 2007 sales of $14 million. Although we are beginning to think about international opportunities we've not put any of these into our financial plans. We are seeing a lot of progress in market like Canada, Australia and the UK that seem to be worry for more home hemodialysis and we think our innovation in disposables and critical care products will be valued around the world.

Let me discuss the In-center market in a little more detail, we acquired Medisystems because it brought us infrastructure that is comparable to some of our largest competitors. NxStage can use this to provide scaled operations supporting all three of our markets well in advance of them maturing to these levels.

At the time of our acquisition last October, Medisystems was already a leader in this market with reputation for high quality products. But we saw the potential to unlock even more value from the In-center market by leveraging some of the NxStage’s core strengths in technology innovation. We expect that the key growth driver for the In-center market is the product pipeline we’ve put in place. Combined with NxStages customer relationship and ability to demonstrate value to them, we think this is an exciting combination.

We’ve already launched Streamline, our airless blood tubing set. That’s been shown to improve clinical results while saving costs. Synergies in Streamline have been able to increase the patient dialysis dose delivery and achieve minimum Kt/V of 1.2 for virtually all their patients,even while reducing dialysis by 25%. As our team helps more and more customers appreciate the clinical and economic advantage of the Streamline we expect market adoption to grow.

Another high value product in the pipeline is new Buttonhole needle with steripik. This is an other great product in the Medisystems line up. There is a trend to using the Buttonhole technique for cannulation which reduces the pain for the patients and improves ease of cannulation. We have added the future to our needle that eliminates the need to use sterile tweezers. Like Streamline, this product advancement reduces complexity and cost for clinics.

This one is another great example of our propriety product innovation. We now discuss our plan for future products but we look forward to adding additional products that create value. Innovative products require solid sales and marking support for customers to realize their value. This is been a strength of us and we’ve built NxStage on relationships with customers who expect us to bring these types of products to market. And they listen to us when we do. We’ve have a history of being able to backup our claims to customers which helps us when it comes to launching the next innovative product into the market.

As I mentioned before our targets are to grow this business to around a $120 million run rate by the end of 2011. Now lets turn to the home market where we have gone a long way to validating the opportunity in our technology. People often ask us what percentage of the overall ESRD market would be suitable for home hemodialysis. We’ve always thought that it would be the right therapy for about 10-15% of patients based on surveys and demographics.

I’m excited with now point to geographies that we’ve have actually achieved this level of penetration, not just centers but rather whole geographies. We have greater than 5% penetration in nineteen geographies and four geographies that reached penetration in the range of 10 to 17%. This is an exiting validation of what can be achieved with good programs and partnership with NxStage. The delivery of this therapy is technically challenging and the reliability of the equipment is essential. We’ve made consistent progress in the few years we’ve had patients doing daily home dialysis with the NxStage system one. We estimate now that there have been over 1 million treatments done by home hemodialysis patients with the NxStage system one so far.

This is a really big milestone for us, over a million treatments. In addition, we had come a long way with the Pureflow SL since its launch. I’m struck by the fact we actually have more of these systems being used in house across America then the leading dialysis provider has clinics. We’re operating safely every day in approximately 1800 patient’s homes. The significant is not just our scale, but also that it is being done by lay people rather than trained technicians. We read about water failures in this industry all the time. And I am especially proud of our safety track record with this product.

Our focus on cost of goods continues. I'm sure you've noticed the addition of Tom Shea Senior Vice President of Operations. I believe he’ll add additional skills to transform us into this strong manufacturing company we must be to compete. We continue to weed out the efficiencies and work with our vendors to lower our cost. I’m pleased with our progress and our future plans. We continue to believe our largest market opportunity is expanding the home market. I am sure I’m repeating myself, but I think it’s important to understand how we are developing this market. It’s critically important to develop successful programs that have ability to grow and support a large number of patients.

NxStage and partners are learning a lot as we achieve this goal. In fact this is the key element of why we didn’t achieve our expected patient growth. We have centers that are performing quite well and others that have not achieved the same level of training and low patient drop out. The job at hand is to continue to transfer this experience through best practices and built a market capability and capacity for the long haul. We believe it is essential to take time to do this right. Even though it has led to near term reduction in our growth rate, we believe these efforts will build a more sustainable business in the long term and that’s what we’re here to do. Last week was a very exiting week for a clinical validation of more frequent in-home dialysis. A paper was published which added another peer review study to the growing body of evidence that shows the significant survival benefit for patients receiving home and daily dialysis. We are also on the virge sharing our experience on survival. And as promised the instrument analysis of the freedom trial focuses on quality of life. We have 182 patients to enrolled in freedom study and have reached our targets for this QL analysis or Quality of Life analysis.

We expect that clinical data will be very key to market expansion and like the good progress we are making with this work.

The third area of focus for expanding the market is reimbursement. We continue believe that private payers are supporting the therapy, as are many medicare contractors by paying for more than three treatments per week, through the medical justification process. However the process is not yet predictable and still some what burdensome for customers.

We would like to see two things happen in the future. First, we support reimbursement policies make this therapy more available to all patients by improving predictability and reducing the burden on our customers.

Second the reinvestment per training of patient is not even close to the investment a center makes, which also limits adoption by imposing financial risks for the providers. We are generally optimistic that these limitations can be dealt with over time. And we are working hard to communicate these issues to the key decision makers in Washington in order to bring about the needed changes.

Finally, we continue to believe product capability is key to expanding this market. We began enrolling patients in our nocternal trial for the goal of having a specific indication for this important treatment. We are also rolling out products and product enhancers that help the a clinic implement the recent CMS conditions of coverage. Many provisions of the new conditions were positive for us. Among these is strong language requiring education of all patients regarding home hemodialysis as a treatment alternative

At the same time, the conditions also imposed additional water testing requirements on our patients using PureFflow SL. This is another area that limited our success due to the burden of implementing these additional water testing requirements.

We believe we can minimize the burden of these additional requirements moving forward. But any effort that takes time away from training patients or makes home therapy more burdensome slows our growth. We believe that they are all obstacles we can overcome, but this is the challenge of leading the creation and expansion of a new market opportunity.

All that said, we believe our revenues will grow four to six times over our 2007 rate by the end of 2011. It’s certainly conceivable that if we add improvements and reimbursements or outstanding clinical data, there might be some upside on that target.

Finally lets turn to critical care market, which is not really not enjoyed the limelight like Home Hemodialysis. In just a few years we converted approximately 25% of the installed base of machines used in the ICUs and CCUs across the country. We saw a significant increase, 31% on machines placed in the first quarter over last year, despite Gambro being back in the market.

Leading hospitals continued to recognize our easy-of-use benefits due to our platform strategy by which I mean using similar technology for both home and clinical care segments. I believe we enjoy a very strong cost position that allows us to invest in market conversion to NxStage. Hospitals have chosen to convert to NxStage before the existing equipment has aged, which in my mind is a strong validation of our value proposition.

To grow our clinical care revenues over the next few years, we focused on two things.

First with just 25% of market today, we still can achieve market share growth through conversion. Second, we think we have opportunities which will bring additional products and line extensions to this market, and with it come additional revenues. Our target is to be at two to three times the 2007 revenue by the end of 2011.

Now let me conclude my discussion by bringing this all together. NxStage was focused on and will continue to succeed with technology leadership. The breadth required for success in this industry is impressive and I believe we have done a very good job of not only delivering this breadth of products, but also innovating and what has been done in the past. We’ve gained valuable business model experience and product performance experience while growing our position in these three markets. This is hard fought and especially valuable for the home market. I also believe competing in these three markets helps us to create innovation to costs of all three. They really are synergistic.

Finally we’ve demonstrate our ability to bring proprietary technology that can improve clinical outcomes in every market that we participate in. Not only are we proud of this, but we believe it’s essential to our success.

There are three legs on the stool that we believe will deliver the financial performance we all are looking for, technology, experience and clinical value. I hope you find this discussion informative.

We’ll now turn it open to questions. Operator, please open the line.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Taylor Harris of JP Morgan. Please proceed.

Taylor Harris - JP Morgan

Thanks a lot. Two questions I want to start with just focusing in on the home market. Number one is, Jeff you talked about how it is difficult to predict patient enrollment on a quarterly or even yearly basis. So, maybe give us your perspective on why that is. And then secondly, in most of your guidance range now for patients at the end of the year that would imply fewer patients added this year than last year. So just give us your big picture perspective on why that would be the case.

Jeffrey Burbank

Yes. We're obviously very enthusiastic about where we're going in the long haul and we've got to make sure we get this business built right, which means getting the right programs built the right way so that that are successful economically and clinically for themselves as well as for NxStage. That's proving to take a little bit more time and we want to make sure that we make that investment now, versus chasing growth for growth sake. So your conclusion is right, its lower patients than we would have thought in the last call. But we think it's the right way to build the business.

Taylor Harris - JP Morgan

Okay. So let me just understand, I guess are you saying that you're trimming back certain programs or centers where you didn't think the program was being built correctly?

Jeffrey Burbank

We are still growing. Obviously, we are still adding patients. And I think it takes some time for the system to learn how to best do that. So it just takes time to adjust. So some programs may find that they can't thrive for various reasons, because they may not have the right infrastructure in place. They may not have the right training nurse or the right referral process, those types of things. Those are all things that are well worked out in traditional dialysis. They're not as well known, so we've got to understand those with our partners so we can build a meaningful programs that has staying power and economic liability.

Taylor Harris - JP Morgan

Okay. So, you had a couple of statistics to show your view on the in-market opportunity is really unchanged; it's just the pace at which you can access that.

Jeffrey Burbank

Yeah I think if anything my confidence in what the market can be has grown because we've now done something that we hadn't done a while ago, which is going geographies and get to the kind of penetration rates that validate what it can be. As I mentioned our largest was 17% penetrated in geography, and four over 10% and 19 over 5%. So we're really seeing when you get these right, you can really penetrate to the levels that we all hope for.

Taylor Harris - JP Morgan

Okay. But maybe specifically with the lower expectation now versus a quarter ago, are you still seeing in the same numbers centers? Are their some centers that doing great and just a few that aren't ramping, or is it a higher churn rate perhaps? Or are their other factors that are coming into play more specifically?

Jeffrey Burbank

Two factors that we didn't fully characterize or understand in the last call, and the first is; getting this infrastructure in place and how long it takes? And the second is, the burden of the conditions of coverage, the balance is making it easy. Anything we can do to make it easier for patients, makes training quicker and makes dropout lower. So, there was a new burden put in place through the release in the conditions of coverage and we need to work through that. It's something that we can absolutely work through. We think we know how to make that less burdensome to both of those parties there, the clinic and the patient. But it takes a little time to implement that

Taylor Harris - JP Morgan

Okay, great. And then just one more question. I believe you are indicating that we are not from a profitability cash flow perspective, we are not as reliant on the home business ramping as you might think. Is that what you were saying? I just want to make sure we got it right? And as any way you can describe for us the level of sensitivity there? In other words, how much of your margin profitability enhancing programs are or aren't dependent on the home business growing?

Jeffrey Burbank

I’ll give an overview and then maybe Robert wants to add to it. We changed the patient numbers quite a bit and we didn’t change our end-year financial targets that much at all. And net loss not at all and we just trimed the revenue slightly. So that is one way of saying, they are not very dependent. The beauty of the integration of the three markets and Medisystems is that Medisystems is at scale manufacturing environment. So the rate at which home grows is not as important to our cost reduction as the projects of getting those products into that infrastructure. So the vast majority of our cost reduction comes from moving products to the right place and working with our vendors, not necessarily from the scale that we drive from the growing home business. So that’s why the financial performance is relatively insensitive to that growth rate. And we are pretty proud of that, the ability to have robust financials and be here for the long haul to make the right investment in the near term of building this home opportunity and not making investors suffer for that is something we are pretty proud of

Robert Brown

Yes, just to add on that, I think Jeff hit it right on. Just to quantify that a little bit, the gross margin project improvements we see for this year and going into next year, about 75% of them are actually project based and only probably about 20% to 25% are actually leverage based. So even with trimming the patient back, number back, we'll still continue to see gross margin improvement and we still believe that can get to our 22% to 24% gross margin target by the end of the year.

Taylor Harris - JP Morgan

Okay. Great. And me sneak one more in. Would you care to give us your gross margin target for 2011 that corresponds to that revenue? Are you at that point and close to the 50% gross margin range that you've talked about?

Robert Brown

I think we still view that as the long-term target. We'll leave something for the next call.

Taylor Harris - JP Morgan

Okay, thanks a lot, guys.

Operator:

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

Ben Andrew - William Blair

Hi Good afternoon, Jeff, Robert. I just wanted to touch on a couple things, following up a bit but also going a couple of different directions. The strategic shift, is this a shift in your thinking, Jeff, in terms of the comprehensiveness in the business or has this been an evolution for some time kind of in your head.

Jeffrey Burbank

That the two things that I brought to the table in this call relative to the home market are new insights. The concept of the four things that drive the expansion to the home market are not at all new, because you've been hearing me talk about going deep, reimbursement, clinical data and product for, I don’t know how many years now? So the basic strategy has not changed at all. And what we have is some near-term information that we are adjusting to and doing the best job we can with it and the, I guess to put the bow around, it is the good news is that this isn’t something that’s going to drive our financials negatively. It’s just how we build this business. And the good news is we're here for the long haul. We have the ability to manage through this and create the long-term opportunity of home.

Ben Andrew - William Blair

Okay so I understand kind of -- the three piecese all coming together. Just couple of nuts and bolts questions; what was going on with inventory in the quarter? Can you break down Robert some of the components of that increase?

Robert Brown

Yes, most of it is related to closing of our manufacturing contracts with our outside vendors for equipment. So, as I mentioned earlier, as of the end of Q1, our outiside contract manufacturer is not building anymore cyclers. As of mid or late Q2, we will be receiving no more PureFlow hardware from our outside manufacturers. So really it's that kind of bolus that you transition from external manufacturing to internal manufacturing. So what will happen is we have more equipment inventory on hand here in Q1 and will burn it off during Q2, Q3 and Q4. So we get back to our normal levels.

Jeffrey Burbank

And then I was an advocate for accelerating us moving forward and getting out of those contracts, because it obviously takes more effort to manage two sites of manufacture than one. So just getting us as fast as we could to the other side raised our inventory machines a little bit.

Robert Brown

And our Mexican plant has come up fantastically. It's really the productivity down there has been great. So we're ready to make the shirt

Jeffrey Burbank

As well as quality. Yes, we are pleased with productivity and quality out of our facility in Mexico.

Ben Andrew - William Blair

Okay so that number should normalize, so that the inventory should be source of cash for next to three quarters?

Robert Brown

It should b source of cash, there will be little bit more taking of hardware in Q2 on the PureFlow SL, But not a lot. And we should start to see it as a source of cash in Q2, Q3 and in the Q4.

Ben Andrew - William Blair

Okay and talk a little bit about the cash raise for this year. And you talked about cash through the end of the year, if I heard the correctly. And in the last call I think you’ve said you’d need to raise $20 to $40 million. You haven’t changed guidance here but the mix is somewhat different from what we were thinking. Has that raise target changed or the timing changed or the potential source, or are they strategic or equity?

Robert Brown

The amount has not changed, the timing has not changed and we never commented on source and we won’t.

Ben Andrew - William Blair

Can’t blame me for trying. Okay so just one last kind of bigger picture question and I’ll jump off. As you think about day-to-day what the reps were sending their time in the field during in the first quarter and the productivity that that engendered with the patient adds that you delivered, whats literally different about what they were doing in that quarter versus in Q3. Because the patient adds some slowed down pretty meaningfully and I think we’re 60 to 75 under-target this quarter. So what changed and what kind of caught you by surprise.

Jeffrey Burbank

Yes, I’ll keep sounding like I’m repeating myself but this is the good way that try to dissect it a little bit third quarter last year and maybe second, third quarter in that time frame, we are on a very large centre expansion. And if we go back and look in the numbers, we added lot of centers pretty quickly. So the focus of the sales group was to expand our training capabilities so to speak, the coverage of training capability. Now, when you do that, they come on, they train a patient, they train another patient and what happens is the system starts to learn and learn how to optimize, and it takes a little bit of time to do that. And we saw that in first quarter. Fourth quarter is very hard to judge what’s going on because of vacations and holidays. So, its not a pure quarter. Nobody kept doing what they were doing from third quarter or fourth quarter. So first quarter was really where we became aware of providers saying, “hey this is working; that doesn’t seem to work so well; lets modify and move”. And isn’t that they stopped, its just that it reduced their rate of growth slightly.

So that’s the first thing, and then the second thing is the conditions of coverage were discussed and started to implement in the fourth quarter. And first quarter was when they really started to get widely implemented and were released. So that was the new one which, both of these are. The good news is that both of these are the things we can deal with and we can move fast even though they slowed us down than in near term. We are not seeing any of our partners backing off. They're making huge investment in staff, in facilities, in advertising, in promotion. I'm really pleased with the efforts that I'm seeing. So I'm not worried about the long-term prospects. It just slowed us down a little bit as we deal with these things creating this market. And it's part of the challenge of being the front runner here.

Ben Andrew - William Blair

Okay, but the partners are still very active and pushing hard to put the pieces in place and add patients over time.

Jeffrey Burbank

That's my sense. And I know you guys do calls too. I'm not seeing anybody back off. We're seeing a lot of passion about the clinical data here and we've got tremendous patient advocates. And so really, I feel pretty good about that. I just want to make sure we get this right because you can push too far, too fast and have frustration or failures. And we want to make sure we're not doing that. And is that not an outcome any of us want.

Ben Andrew - William Blair

Okay thank you.

Operator: Your next question comes from the line of Anthony Ostrea JMP Securities.

Anthony Ostrea - JMP Securities

Hi guys, thanks for taking the question. One, Jeff maybe if I can ask the patient number deceleration another way. If you look back at your, may be earlier 2007, in terms of the number of patient progression for a new center. .Are you saying now that for every new center that patient enrolment or progression is decelerating, what are you saying for those centers?

Jeffrey Burbank

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What we are saying is some centers are doing probably better than what we would talk about on average and some are doing not as well. And the system wants to make sure that they have efficiency at the high side of that. So, there is an adjustment to try to spend the time to get it right. So yes there are some patients underneath that, excuse me, not patients but providers, centers, locations, training centers that are not achieving that. And the effort is to make sure that they can either get back on track and get a process to success, which I think is entirely likely that they can, or whether there are certain metrics where you invest in some areas and maybe its not a appropriate in some areas. That, we haven’t seen in this case. We’ve seen where you get it right, where you get the staff in place, where you get the word out, and detailing of doctors, the demands there, and when those pieces come together its very successful. But it’s the matter of getting those pieces in place and figuring out how to replicate them.

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Anthony Ostrea - JMP Securities

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Got it. And then also last quarter or in your last conference call, you made mention of maybe just refocusing your sales effort to a -- but its more concentrated effort rather than that before. Was that also part of maybe what was playing on and maybe you underestimated that impact?

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Jeffrey Burbank

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You know hindsight is 2020. We were doing it for slightly different reasons but it was the right thing to do. It was always part of our core strategy. So I think I can’t tie in that tightly, but looking back at it, its certainly kind of looks that way. And maybe some of what we were seeing that was making us adjust to that was broader than we thought at the time.

Anthony Ostrea - JMP Securities

Okay and then just two last question from me. Jeff you also mentioned the conditions of coverage, maybe just spend a few minutes talking about may be some other areas where you need to do a lot of work, or maybe just broadly characterize what work need to be done and if there are areas which need a lot of work? Can you mention those?

Jeffrey Burbank

There are some good things about Conditions of Coverage, because they would now require more patient education and awareness for the therapy options for patients. We think that’s really good because that’s one of the challenges, making sure that patients known what their options are. So that’s great. The challenge that we're dealing is some more specific requirements of water testing, and more specifically water testing of home water treatment systems. So, it's making those samples easy to take for patients and just facilitating that process. So, it's as simple and automatic as everything else we do. We designed a system and had a system that was cleared by the FDA that didn't require that, but CMS felt more comfortable putting those requirements in place. So we'll take hold of those and make them as easy to do as the rest of the NxStage therapy, but it will just take a little bit to get those pieces in place.

Anthony Ostrea - JMP Securities

Great, and just a last question on the gross margins. Can you talk about may be the activities that I know you have mentioned some, but it just seems like your gross margin, the actual number came in probably, if not at least what we expected but higher than we expected. May be you could talk about the pace of activities that went on in the quarter what you actually did, what got done, and maybe what your plans for finishing in Q2 and Q3?

Robert Brown

Yeah I will take that one. I think we are pretty much on track and I think we see our projects that we've lined up for the year pretty much on track. We saw some benefit from beginning our cycler builds down in Mexico, so those lower-cost cyclers are now starting to get into the system. We're seeing benefits from leveraging both the Medisystems and NxStage infrastructure.

There's a lot of projects though that are in the works right now that actually have not hit the P&L yet and we expect them to hit probably late Q2, Q3, and Q4. So there is probably at least a half dozen projects that are in various stages of their progress and they're tracking well. And we still expect to get to 22-24% gross margin by the end of the year.

Unidentified Speaker

And other one that was contributed in Q1 was inbound freight. We renegotiated some contracts there and consolidated some things, so we picked up some there too as well.

Operator

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

Philip Legendy - Thomas Weisel Partners

Hi guys, good afternoon. First I wanted to ask, your distribution costs were down pretty nicely, sequentially even. You mentioned you have a new team in place. I wondered if you could expand a little bit on what it is specifically that they are doing and how sustainable that benefit you saw in this quarter is going to be throughout the rest of the year.

Robert Brown

Sure. You know we have been talking about the team over the last couple of calls. We actually put a Vice President of Customer Fulfillment in place in Q2 last year and she has now built her team around distribution with those individuals coming in Q3, and they are now starting to get traction. As we see the cost improvements in Q1, there's a very good impact from renegotiating our rates in Q1, a little bit offset by fuel surcharges as fuel prices raise. Those rates will carry through for rest of the year. We have to see how oil prices go and then they are also working on process improvements, they got quite a few done in Q1 but we’ve added few more lined up for Q2 and Q3. So we continue to see good progress in that area. And the distribution costs and rate of distribution in Q1, we expect most of that to carry through for the rest of the year and we see some more improvements further along in the year.

Philip Legendy - Thomas Weisel

So hypothetically here it, and I realize this is an unlikely hypothetical, but if the cost of fuel were to remain constant from here, would you be expecting continued sequential reductions going forward? In other words, you've renegotiated rates, that's perminent, you are implementing new process improvements that should continue to get better, so or we kind of seeing the base rate that you pay come down here?

Robert Brown

You know, I expect to see some more improvement in Q2. What I want to make sure that the process improvements we made in Q1 really stick. So its like whenever you do process improvement we have quite a few lined up in distribution area. They get to a few in Q1. We want to make sure those actually stick before we start adding on a lot of process improvement. What you don’t want to do is continually add process improvements and not get the first ones to actually stick. I expect to see improvement as we go through the year. Our target for the end of the year was actually 20% and we actually hit 21% in Q1. So we're very pleased about that. We need to go back and reassess and make sure that the process improvements we had in Q1 stick and reassess what kind of benefit we're going to get off the process improvements for the rest of the year.

Jeffrey Burbank

Let me say hat in a high level way We had a target for 20% at the end of the year, we're not yet ready to move that target. But obviously we are really pleased with the progress we have made towards that, we will come back to you. I think one quarter we don’t want to start moving our target based on that, make sure it sticks and see how that progresses. But obviously the 20% doesn't look like it's going to be that hard to achieve by fourth quarter at this point.

Philip Legendy - Thomas Weisel

Okay, got it. And then I wanted to ask you to give us a little more color on the manufacturing transition going down to Mexico. I think that was one of the factors that you had mentioned on the last call that was delaying the gross margin or delaying your reaching your targets. Where are we? What’s been done and what left to be done in terms of that piece of the puzzle.

Robert Brown

Yes, there are hardware pieces and disposable pieces. The hardware pieces are effectively done. The transition of the cycler into our own manufacturing is done. And the transition of the PureFlow into our own manufacturing will be done this quarter. So those two are pretty much wired and done. The disposables were largely integration from us into Medisystems and a number of those got delayed because of some of the quality issues in the third quarter last year. Those are on track and look good and those are ina a couple of components, One is transitioning now and so that’s right on track for what we want it and we have another one that is transitioning from another vendor actually, and that’s on track as well. So all the key ones, we feel like we're in a good position there. But it's never over until it's over, so we're working hard, got good team doing it, but it looks very encouraging at this point.

Philip Legendy - Thomas Weisel

Okay. And then last question, Gambro is now, they have 10-K clearance to or they have been able to launch in critical care again. And just wanted to see what impacts you’re seeing in the market from then now and how you feel about your numbers going forward?

Robert Brown

Yeah. They were there first quarter. So we’ve lived with them in the market now and as I mentioned we were 31% up last year over last year to this year on machines placed in that quarter. So that was really encouraging that in the, if you call it the new competitive market with Gambro, we still grew our machine placements against the quarter where they were in the market. So that’s encouraging. There is clearly is more activity, meaning more discussion in potential customers but we also see the advantages of NxStage being widely recognized. Whe big difference is that we have a pretty nice install base, and most centers that have converted in the last couple of years that have converted to NxStage. So the trend is in the momentum is a little bit in our direction. We are very strong team, we have been in that market for a while now and a very strong product. So we’re having fun competing against a good competitor and taking our share.

Philip Legendy - Thomas Weisel

I am not sure exactly how the ordering process works, have you been head to head with the new and improved Gambro product and have you had any feed back specifically

Robert Brown

We have, the new improved is may be a software upgrade but it’s the same product they were selling before they went on import hold. So we’ve competed against this product quite well for a number of years. You know we compete very well. We're very differentiated from that product. We have a very easy to use, easy to learn system that delivers very high quality therapy and we’ve done very well with that and continue to. We haven’t seen anything significantly different than they had in the past. They are certainly trying to be more aggressive than they have. But we seem to be holding our own, we have a good product that’s really appreciated by customers in that market.

Philip Legendy - Thomas Weisel

Okay, thanks a lot. I will be back in queue.

Operator

[operator instructions] Your next question comes to the line of Bill Plovanic of Canaccord Adams. Please proceed.

Bill Plovanic - Canaccord Adams

Very thanks, good evening. Couple of questions here, just going through the conditions of Coverage, in regards to the water testing in regards to the home treatment systems, does this preclude you from adding new patients in certain territories. What exactly is the incremental step that patients must go through, or you must go through to gain CMS reimbursement?

Robert Brown

Let me put some structure around that. Conditions of Coverage are the regulation that a clinic adhere’s to ensure their licenser to be a Medicare Provider for ESRD. That’s my quick definition of it and they haven’t been updated for many-many years. It actually, as an industry guide, its great that there have been updated. There is a lot of things that are long over due. One other things that’s specific to water treatment is they've gotten much more prescriptive, which again in the long run is a good thing because it'll protect patients and bring more consistency to the market. So what they've asked is that testing be done of the Dialysate. So we designed a product that was validated and robust such that people wouldn’t have to do that. We tried to eliminate those types of steps and are clearance in our labeling didn’t require that, but that’s something that needs to added to meet those Conditions of the Coverage. So it could be done with our system, but its kind of cumbersome. So we are providing some tools that make that easier for patients to do and makes it more systematic. That’s the kind of thing that we are talking about here. So just talking samples. Some patients takes samples at home of a number of things, this is just one that we didn’t think we need to plan for, that we do

Bill Plovanic - Canaccord Adams

It’s basically an incremental kit that you are shipping right now to customers and then eventually you are going to have to build that back into the box?

Robert Brown

Yes it’s a not lot of economic effect, but you know centers have little cups that they've used for taking samples and those are kind of cumbersome. We're are going to provide a little sampling disposable that make that easier and you know some prompting in the software that helps them to do that more effectively.

Bill Plovanic - Canaccord Adams

So far that software upgrade, will you have to go back to all the boxes in the field and upgrade them? And if so, how would you accomplish that?

Robert Brown

That's a good question. We have varying approaches to doing that and we don't want to really talk about that. But we can do that without a large economic burden on the company..

Bill Plovanic - Canaccord Adams

And is this one of factors that is going to impact growth in the near term?

Robert Brown

It is one of the factors that has. First the centers have took get all their policies and procedures in place. And then when you add any burden to a therapy, it’s a balance of the benefit of the therapy versus the burden. And so it tends to have the affect, of in some cases, increasing the dropout rate. Patients just say; “I don’t understand that,” they don’t get it, it’s too hard, not a lot of that. But it’s enough that we see it in our numbers, and then the second part is just the time it takes staff to train the patients how to do this procedures, and the time that takes away from training new patients.

Bill Plovanic - Canaccord Adams

I mean the way you are explaining it, all they have to do is take some of the Dialysate that they make out of the PureFlow system and basically package it and ship it back in probably a prepackaged envelope or what am I missing here?.

Robert Brown

When you get it all down to that, it is that easy. But its not that easy today.

Bill Plovanic - Canaccord Adams

Okay couple other questions if I may, the freedom trial, how many centers do you have up in rolling at this point and when do you expect that data?

Robert Brown

We’ll do a interim analysis of QAL, that’s coming shortly. We are trying to find the right forum to present and finish the up the analysis, but we hit the number of patients required to do that analysis. So we are trying to follow the right procedures to make sure that an impactful clinical trial and report, so that’s coming.

I am sorry. Was there a another question there?

Bill Plovanic - Canaccord Adams

Number of centers that are currently enrolling.

Robert Brown

I don’t have that with me. I don’t know the exact numbers of centers, we’ve got 182 patients enrolled.

Bill Plovanic - Canaccord Adams

Okay. So the bottom line is the date is ready, you are just looking for the right venue.

Robert Brown

That’s right.

Bill Plovanic - Canaccord Adams

And then is your if you look at the…

Robert Brown

I’m sorry, Bill. There's another analysis that is forthcoming which is an update. We've done this in symposiums, our mortality rate, we're doing an update analysis on that now that we have significant number of patients. So that will be forthcoming as well.

Bill Plovanic - Canaccord Adams

Okay. And then just looking at the Medisystems’ deal. Are there any incremental integration operating expense savings up and above beyond which we already discussed? I mean is there any overlap that you gone deeper into it from an operational standpoint that you can eliminate?

Robert Brown

I am not sure as I step back and look at it not necessarily eliminating as much as leveraging their infrastructure. And I think a number our project improvement we have for this year actually do focus on that as we move items into the Medisystems’ facility. You know, the one thing we did do is at the end of the March we actually ended up closing the Seattle facility, which we've talked about in the past. So we've now closed that facility and don’t have any of those costs.

Bill Plovanic - Canaccord Adams

Okay, and what was that roughly savings per year for that?

Robert Brown

It was probably roughly a million dollars and we took some of that. And we talked about this early when we did the acquisition, we took that money actually put it into selling and marketing to beef up that area, about half of it. So, we brought in a general manager for the In-center products and built a team around him so that we can take some of those products that have value and get a them out into the market place.

Bill Plovanic - Canaccord Adams

Okay, and is there any seasonality to the Medisystems business which should be aware of?

Robert Brown

Not really seasonality.

Jeffrey Burbank

Every once in a while there is some inventory adjustments that go back and forth. When you launch a product, there is a little bit inventory built, but not seasonality that we have seen in looking at that over a last in our due diligence.

Robert Brown

It is a distributive business so its usually timing with distributors is more what you see with them. So, based on their stocking and selling their products and in between quarters you see some bouncing between the quarters. And we talked about this past, but as you smooth out the quarters, the number really run pretty evenly.

Bill Plovanic - Canaccord Adams

Okay, I mean there is been a lot of talk on this call about projects in order to improve your cost structure in terms of manufacturing. You’ve talked about a lot of projects and historically, if I remember back to the fourth quarter call, that was one of the problems that there were too many on the plate. What is changed between last quarter and this quarter because it seems like you are talking about the same number, if not more, things you are working on to help them improve the margins and profitability of the company?

Robert Brown

We’re always looking ahead and the list is; one, that we are not trying to get our 22 to 24% gross margin, we are trying to get to our 50% gross margin. So the list is robust enough to make sure that we’ve got projects that take us to that, so you may be hearing that. We do have a good team that has the capability of doing more than thing at a time and we have checked of some of the things that we talked about. So there is a lot of that list that is now position of being complete, soI don’t mix kind of what’s been completed, what in process, with what’s in the future. When you break it down that way maybe its not as onerous as it may come across to you.

Jeffrey Burbank

Yeah, just to add on that a little bit. The list itself, fundamental list hasn’t changed and our outlook on that list hasn’t changed. I think what we’ve done is we done a better job of phasing them over the period time. As a project winds down, we start up another project. We are not trying to start up all the projects and run them on the same pase.We’ve ranked the projects, we’ve looked at what benefits they actually achieve, we took the best projects and are running at those hard. We know what the next projects are, so as those projects near completion we actually start pulling other projects onto the list and start working those on.

Bill Plovanic - Canaccord Adams

Then lastly, to me the pink elephant in the room here is, you are talking about Medisystems and now we are talking about doubling the business over 4 years on a business it was I believe a single digit growth business. What has changed in the last 90 days that makes you really believe you can take something growing from mid single digits, to have significantly in the double digits, to double that business over the time frame you are talking about.

Robert Brown

It’s now two quarters into the acquisition, we a little more than over a quarter to quarter and a half into the launch of Streamline, we are into the next launch which is the buttonhole needle, so we now have two product launches under our belt with some experienced in visibility of those and we have had the time to build that product pipeline and understand it more deeply and broadly. So the combination of those gives us the kind of confidence we need to be able to put those numbers up

Bill Plovanic - Canaccord Adams

That’s all I have thanks.

Robert Brown

Any additional calls operator anybody in queue.

Operator

Next we have a follow up question from the line of Taylor Harris J.P. Morgan, please proceed .

Taylor Harris -- J.P. Morgan

Thanks Jeff. I have got one follow up, thats the same question for the tenth time, but let me try one more time, and then one easier follow up after that. So I guess the question is, you had in early adoption phase where you had a number of academic not for profits centers and then after that you gone more head long into the for profit world. I just want to make sure that when you make comments about reaching 10 to 15% penetration levels, what we are not really seeing is that you can get there in circumstances, but then in the more real world you cant.

Jeffrey Burbank

I am actually really glad you asked that question Taylor, because if you look at those centers where we penetrated, it’s a nice distribution between what you would call commercial and academic. So we have not seen that’s its limited to centers that are only driven by clinical matrix and don’t pay attention to operational and economic, that’s not the case

Taylor Harris -- J.P. Morgan

Okay

Jeffrey Burbank

I mean actually I wish I would have thought about that to put it in the script because that is concern that I’m glad I got to deal with.

Taylor Harris -- J.P. Morgan

Okay and then last question, the revenue per patient and I know that we are calculate this differently. Just strictly looking at what is reported, it is a little under $1500 a month now for the last couple of quarters. Before that, it may have been higher than that, maybe $1550. Is right up at $1500 the right place where to keep it in our models.

Jeffrey Burbank

Yes

Taylor Harris -- J.P. Morgan

Okay alright thank you.

Jeffrey Burbank

Thank you Taylor.

Operator

Final we have a follow up question from the line of Anthony Ostrea, of JMP Securities please proceed.

Anthony Ostrea, - JMP Securities

Thanks for taking the follow up. If I may ask about the cash levels again for in home and that not being to dependent on growth. If I ask that the question another way, you did see a probably a better ramp in margins in the quarter versus what you outlined at least for this year with the target numbers that you mentioned for by year end. Is the cash, or the lack of fluctuation in the cash portion of your in home business, is that really only a function of your getting better margins then you anticipated and not necessary that cash doesn’t fluctuate as much with growth.

Jeffrey Burbank

We are both looking at each other, this is aconcept that I think has been challenging. We have been challenged in communicating in a way that people really understand it. You are right to some extent, obviously the less the machines cost, the less cash that it uses to buy them . So that is absolutely true the better our cost of goods are, the more gross margin we generate by each machine in the field. And our growth rate determines how many machines we have to buy. So there are those three things that are in play that if you grow really fast you got to buy lot of machines, which uses cash. But they throw off cash because we are now at a point where the gross margin is favorable so it starts the fund the box. So on a fast growth, it kind of self funds, not fully but pretty close. On a slow growth, you are not buying boxes, so you are not using cash for that. And however, you don’t have the revenues thrown off, however you have gross margins thrown off. So it turns out that given where we are with those factors, what a machine cost to build, what the gross margins are, that across a wide range of growth rates, it consumes about the same amount of cash in a very tight range of cash. That’s what we are trying to say, so that gives us some robustness to the business model because we don’t have to huge swings of cash required to build the business.

Anthony Ostrea - JMP Securities

That’s helpful. Thanks

Operator: It apprears there are no further questions, I will now turn the call back over to Mr. Jeffrey Burbank for closing remarks.

Jeffrey Burbank

Thank you everyone, thanks for the time this evening. We really are excited about building all three of our markets, including the home market, and appreciate your support in helping us do that. Thank you and good evening

Operator

Thank you for your participation in today’s conference. This concludes the presentation, you may now disconnect. Have a great day.

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Source: NxStage Medical Inc. Q1 2008 Earnings Call Transcript

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