Insulet Corporation, Q2 2008 Earnings Call Transcript

Aug.12.08 | About: Insulet Corporation (PODD)

Insulet Corporation (NASDAQ:PODD)

Q2 2008 Earnings Call Transcript

August 12, 2008 5:00 pm ET

Executives

Duane DeSisto - President and CEO

Carsten Boess - CFO

Analysts

Kim - J.P.Morgan

Mimi Pham - JMP Securities

Paul Choi - Merrill Lynch

Shawn Fitz - Stephens, Inc.

Philip Legendy - Thomas Weisel Partners

Ben Andrew - William Blair

Bruce Cranna - Leerink Swann

Anup Mehta - Canaccord Adams

Derek Leckow - Barrington Research

John Green - Smith Barney

Operator

Good day, ladies and gentlemen, and welcome to the second-quarter 2008 Insulet Corporation earnings conference call. My name is Emity, and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will facilitate a question-and-answer session towards the end of today's conference. (Operator Instructions).

I would now like to turn the presentation over to your host for today's conference, Mr. Duane DeSisto, President and Chief Executive Officer of Insulet Corp. Please proceed.

Duane DeSisto

Thank you, operator. Good afternoon, everyone, and welcome. With me today is Carsten Boess, Insulet's Chief Financial Officer. Thanks for joining us to discuss our results from the second quarter of '08, another strong quarter for Insulet.

We will be making forward-looking statements about various aspects of our business, so please refer to our most recent 10-Q for a full discussion of our risk factors.

I am pleased to report that in the second quarter, we continued to make impressive progress in expanding Insulet's commercial footprint. We have more than doubled our manufacturing capacity since our last earnings call and already surpassed the production goal that we set for the end of the year.

In the second quarter, we also strengthened our sales and marketing infrastructure, achieving nationwide salesforce coverage to respond to the growing demand we continue to see for the OmniPod System. Our increased sales reflect the success we're having across the board in expanding our commercial operations.

In the second quarter, new patient shipments grew more than 35% sequentially, with the addition of approximately 1650 new customers. And in the first half of 2008, we generated more revenue than in all of 2007.

Several years ago, when we finalized the design of the OmniPod System, we were confident that the product's customer-friendly form factor would appeal to people with diabetes and their physicians and that our pay-as-you-go model would appeal to third-party payors.

We were sure that if we could deliver an insulin pump therapy that overcame the challenges of conventional pumps, we could eliminate the obstacles preventing so many people from choosing the best possible treatment for Type 1 diabetes.

As I've said before, we knew the tough part was going to be building the manufacturing capacity to meet the market's eventual demand for such an innovative product. I'm proud to say that we have made a dramatic jump on the production front and reached a manufacturing output of approximately 200,000 pods per month at the ended June.

Expanding manufacturing capacity inherently reduces per-unit production costs, and we will further drive down costs by both continuing to increase volumes and transition manufacturing to China.

The majority of the 200,000 pods we produced in June were manufactured in Bedford, Mass. Going forward, we expect that the majority of pods will be produced in China. We see a continued strong buildup in China over the next six months and think there is a possibility of significantly increasing throughput per line beyond our estimates of 200,000 pods per month.

In the second quarter, we broke through a major milestone by producing our millionth pod. To put that in context, that is approximately four times the total number of conventional pumps in the U.S. market today. When you produce anything at this scale, the ongoing challenge is going to be staying on the alert for manufacturing supply issues.

As we indicated on our last quarterly call, we did encounter a quality challenge related to the plating of a component. This issue manifested itself in the field in Q2 and caused a 2-point to 3-point increase in our out-of-box failures. We addressed it in the second quarter and saw a significant drop-off in complaints in July, and no key institution has stopped prescribing OmniPod as a result of the issue.

We have seen the manufacturing issue impact our P&L primarily in two ways, increased product testing and a slightly higher attrition level, which reached approximately 10% in Q2 compared to approximately 8% in the prior quarter.

Turning to the build out of our sales and marketing infrastructure, with our national sales force in place, in Q2 we were able to implement an increase in direct-to-consumer marketing programs. These DTC programs include magazine and Internet banner advertising, direct mail, as well as ads on dLife, a television program targeting the diabetes community.

Our DTC campaign has dedicated links and 800 numbers to order our unique trial tool, the OmniPod Product Demonstration Kit, or PDK.

Earlier this year, we broadened the sampling program by introducing a non-inserting PDK so patients can experience using OmniPod without waiting to visit their doctor. We dropped our first direct mail marketing piece to people with Type 1 diabetes, over 100,000 pieces in Q2, featuring a call to action to order the non-inserting PDKs. We're extremely pleased with the response to these programs so far. These activities have driven a 51% increase in traffic to our website.

Despite all the positive traction on leads generated through our DTC campaigns and sampling program, our sales growth has been slowed by our ability to process referrals. Our infrastructure build out for reimbursement processing is lagging the demand we see in the marketplace.

Currently, our conversion rate is about 5% to 10% lower than we would like it to be. We're working on addressing this challenge by increasing our spending on reimbursement processing and are in the midst of outsourcing some of our reimbursement support system.

We continue to invest in demonstrating OmniPod's clinical efficacy relative to other insulin delivery options. Last week, at the 2008 annual meeting of the American Association of Diabetes Educators, The Endocrine Group in the Albany College of Pharmacy of Albany, New York, presented results on a retrospective review titled Clinical Experience with the Tubeless Insulin Pump System. The study concluded that the OmniPod Insulin Management System was safe and effective in improving mean A1C values.

Now, I will turn the call over to Carsten to discuss our financial results in more detail.

Carsten Boess

Thank you, Duane. In the second quarter of 2008, we recorded sales of $7.4 million compared to $3.2 million in the second quarter of 2007. During the second quarter of 2008, approximately 1650 new patients began using the OmniPod System, a sequential increase of more than 35%.

On a sequential basis, reported revenue increased 11% compared to the first quarter of 2008. Beginning in the first quarter of 2008, the Company changed its estimate of deferred revenue, resulting in a positive impact in the first quarter of 2008. If we adjust for this impact on revenue, the sequential increase from the first quarter of 2008 to second quarter of 2008 was 38%, which is a far better representation of the growth of the underlying business.

Deferred revenue at the end of the second quarter reached $1.7 million. The increase in deferred revenue is due to difficulty collecting from a few managed care institutions. We're working hard on solving this issue. And if we adjust for this, underlying revenue in the quarter would have been approximately $7.9 million.

Gross loss for the second quarter was $2.4 million or negative 32%, representing an improvement of 18 percentage points from the first quarter to the second quarter of 2008. We achieved this improvement despite the fact that we spent more heavily than we anticipated in the second quarter on testing product coming off the line following the quality challenge that Duane mentioned earlier.

A key initiative for Insulet is to drive down our production costs for OmniPod. We have significant leverage in our financial model, as higher volumes drive economies of scale. Reflecting this leverage, from the second quarter of 2007 to the second quarter of 2008, revenue increased 131%, while in the same period our cost of revenue increased only 42%.

Operating expenses were $19.8 million in the second quarter of 2008, up from $8.7 million in the second quarter of 2007. The majority of this increase was related to increased sales and marketing expenses.

Operating expenses were up 18% from $16.7 million in the first quarter of 2008, as we significantly ramped up our sales and marketing efforts, particularly our sampling programs. We spent approximately $5 million in sampling in the first half of the year. This is a discretionary expense we can increase or decrease as we need to.

We reported a net loss of $23.9 million for the second quarter of 2008 compared with a net loss of $12.7 million for the second quarter of 2007 and a net loss of $19.9 million for the first quarter of this year.

In June, we completed a private offering of convertible notes amounting to $85 million. The notes will pay interest at a rate of 5.4% per annum and mature in 2013. The notes will have a conversion price of approximately $21.35 per share of common stock. We used approximately $23.2 million of the net proceeds from the offering to terminate our outstanding term loan and intend to use the balance for continued investing in the business opportunity we have in front of us.

We recorded $1.5 million in interest expense as a result of the repayment and termination of the term loan in the second quarter of 2008. As of June 2008, Insulet's cash and cash equivalents totaled $99.1 million compared to $94.6 million at December 31, 2007.

Moving on to guidance, we are revising our expectation for full-year 2008 revenue by approximately 10% and are now expecting it to be in the range of $36 million to $41 million compared to our previous expectation of $40 million to $45 million. The Company's 2008 revenue has been adversely affected primarily by the Company's slower than anticipated conversion of referrals to patient shipments and, to a lesser extent, the up tick in attrition associated with the plating issues.

We also are revising our guidance for full-year net operating loss in excess of $70 million compared to our previous expectation of a loss of $55 million to $60 million. Net operating losses have been adversely affected by accelerated sales and marketing spending, in particular our sampling program, which is a deliberate investment in response to the success of our DTC campaigns.

Net operating losses have also been adversely impacted by higher than expected cost of goods sold, particularly higher costs for batteries resulting from increasing silver prices and higher costs for warranty and product testing as a result of the plating issue.

Now that we have reached the 200,000-pod production level, we are going to transition as much manufacturing to China as possible. We have already slowed down production in Bedford and, depending on our progress, we may substantially reduce manufacturing here by the end of 2008.

Depending on the progress of that transition, we may incur onetime asset write-downs on the equipment in Bedford in 2008. These potential write-downs could impact our net operating loss for the year.

As I indicated before, we have substantially improved our gross loss and expect to achieve even more upside from incremental manufacturing output in 2008. As a result, we continue to expect to breakeven on a gross margin basis sometime during the third quarter and achieve positive quarterly gross margins for the full fourth quarter of 2008.

Now, I will turn the call back to Duane.

Duane DeSisto

Thanks, Carsten. I would like to close the call by putting our guidance into the context of our achievements. We've made dramatic progress in scaling up our manufacturing capacity, which has more than tripled since the beginning of the year. Insulet now manufactures more insulin pumps in one month than all other conventional insulin pump producers in the world combined manufacture in a year.

At the same time, we have reduced our per-unit production costs, thereby reducing our gross loss percent by approximately 40%, and we expect to break through to positive gross margins later this year.

We've tripled our sales force, driven 171% sales growth year-over-year and more than a 35% sequential revenue growth. Of course, these sales provide us with a strong source of recurring revenue looking into 2009 and beyond.

We have experienced some growing pains recently from scaling so rapidly. I remain confident in our market opportunity and believe we are uniquely positioned to significantly expand the use of insulin pump therapy.

Looking ahead, with our expanded commercial footprint, our pipeline of future products and our growing base of clinical work, Insulet is poised to capture the growing demand of the OmniPod System and advance our mission to improve the lives of people with diabetes.

And with that, operator, I'd like to open up the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Michael Weinstein with JPMorgan. Please proceed.

Kim - J.P.Morgan

Hi guys, it is Kim here for Mike. Can you hear me?

Duane DeSisto

Yes Kim.

Kim - J.P.Morgan

Great. It sounds like we have got a couple of different things going on here potentially reducing the guidance for the remainder of '08. I think what we are maybe not getting a great picture of here is what really the end-user demand picture is like out there. I was wondering if maybe you could talk to us, give us a couple of data points just to help people better understand what the demand picture looks like, aside from the patient capture issues that you are having, then maybe detail a little bit better what those reimbursement issues are exactly and kind of the timing of resolution?

Duane DeSisto

Sure. So, I think the best way to kind of break this down, Kim, is let's break it down in two things. In our definition, there's three pieces. First, there's leads. And leads are interest that comes into the Company that is generated from this DTC. We have seen a significant increase in the amount of leads coming into the Company. So, there's a great deal of interest in seeing the product, and by the way, actually getting one of these non-firing PDKs. So, that is up dramatically.

The actual referrals that our sales force is putting together and sending into the building is also up dramatically. Our issue today, and the only reason, like I said, if you kind of think about the guidance we originally had, it was 40 to 45, and we're down slightly from that, is, we thought, it would be easier to move those referrals into, basically, finished business, in other words, billable business, that we could get it through the managed care.

And we had a couple of different ways of doing that. I would tell you that the referrals and the sales force has scaled much faster than we anticipated, so the bottleneck lies not so much with the managed care company, but within this building. And while we continue to battle through that, there's a significant amount of paperwork. You have to go through the process. You have to go through those steps. And that is what we're struggling with.

I would've told you at the beginning of the year, we thought we could outsource some of this to take the pressure, so we really didn't scale up quickly. And we thought the process of outsourcing that would be in terms of a few weeks, we could get these outside resources to get onto our contracts.

It now appears, unfortunately, that it takes more like months than weeks for that to happen. So, we underestimated the time that we could bring up some of these outside resources, so what it has forced us to do is go back in, and we're starting to build out the internal department.

So, from a demand standpoint, kind of give you some sense, I mean, we're converting, kind of number in, percentage wise, has a 6 in front of it, and we were hoping more like a 7 or 8 in front of it. Okay? So, that will give you some sense of how big the demand is and that the problem basically lies in here.

And like I said, based on our experience today, it really kind of came to fruition in the second quarter because we really thought we had a solution only to find out that what we thought would take weeks is probably going to take three or four months to get some of this stuff offloaded. We just didn't think it would be prudent to go forward without taking it down slightly.

Kim - J.P.Morgan

Okay, and that is very helpful. And in terms of working through this process, is this something we should think about, kind of in the fourth quarter, we're working our way back toward 70% to 80% capture rates, just as we think about the ramp for the remainder of the year?

Duane DeSisto

Yes, our reaction is, the third quarter is going to be, the third quarter is a tipping point for us, but we really see it kind of in the fourth quarter, is where we're hoping to be. And then just to put it back in perspective, if you go back to last year, when we had a handful of sales reps that had been on board for a significant amount of time and we knew how to gauge the back office to that, that was the basis in which we were thinking 70 and 80 type percent, and like I said, we haven't been able to achieve that yet.

Kim - J.P.Morgan

Okay. One quick one on housekeeping for Carsten, and I will drop. Carsten, did you give a number for what you had spent on the sampling program to date?

Carsten Boess

Yes, we actually did. In the first half year of '08, we have spent approximately $5 million on samples. So, out of the total spend in sales and marketing, by the half year was $19.5 million, approximately $5 million of that is associated with sampling, which is a unique tool that we have compared to a conventional pump company, that we can actually allow the patient to try the product on, as the cost is only in the magnitude of $29 as opposed to a several-thousand-dollar conventional pump. So, that is the reason we see the opportunity here.

Duane DeSisto

The other reason that number is that big is we tripled the sales force. When you triple the sales force, obviously part of what goes in their bag is this whole sampling program from office-to-office.

Kim - J.P.Morgan

Sure. Okay, thanks guys.

Duane DeSisto

Okay.

Operator

Your next question comes from the line of Mimi Pham with JMP Securities.

Mimi Pham - JMP Securities

Hi good afternoon.

Duane DeSisto

Hi Mimi.

Mimi Pham - JMP Securities

Can you just clarify, so again, the lower sales guidance has nothing to do with what you're seeing in terms of how your new sales force are ramping up starting in the third quarter?

Duane DeSisto

No. It is pretty simple, like I said, that the referrals are what we hoped they would be. Our ability to get those and turn them into shippable orders is lagging behind. I would tell you we're probably a quarter behind where we thought we would be. But we still, our concern is, I would've told you at the beginning of the year I thought it all was well within our control.

We went, trying to outsource some of this, only to find out instead of this being a few weeks to get it done, it is really becoming more like months to get it done, streamlined, get new names on contracts and the other stuff that is associated with that. So, it really is our ability to process that. That is what is driving the guidance on the sales line.

Mimi Pham - JMP Securities

And then on your manufacturing capacity, can you just clarify, are you at 200,000 in Bedford alone, and then are you also producing full pods in China, I guess as…

Duane DeSisto

Yeah, I think it is about 80% Bedford and about 20% out of China. So, China has started up. I was over there a few weeks ago. The factory is up, working. We are pleased, very pleased with what we're seeing. But I would tell you in the month of June, where we hit that number, it was probably 80/20 Bedford and China.

Mimi Pham - JMP Securities

And can you perhaps give us maybe a tighter range of where you think the cost per pod could be during the fourth quarter? I know you talk about positive gross margins, but are we talking…

Duane DeSisto

Mimi, I think the best way to think about it is, when we described it, we're on a FIFO basis. We're running with about three and a half months of inventory. And so you've got to start thinking in terms of the bulk of the stuff running through the P&L in the fourth quarter. It would look much more similar to the product produced in Bedford than in China. So, you are talking, you know, it has a two in front of the number.

Mimi Pham - JMP Securities

Okay. And then last question, on your sales and marketing spend, is that something that we should model leveling off in third quarter and fourth quarter relative to second quarter or…?

Carsten Boess

Well, again, that actually, because a significant element of the cost, 25% of the cost in second quarter, was related to sampling, it all depends on what decisions we are making in terms of the sampling for the remainder of the year in order to continuously boost our referral rates that comes in the door. My recommendation would be to take the level second quarter and then move that through third and fourth quarter as well.

Mimi Pham - JMP Securities

Okay, thanks very much.

Operator

Your next question comes from the line of Paul Choi with Merrill Lynch. Please proceed.

Paul Choi - Merrill Lynch

Hi guys, can you hear me?

Duane DeSisto

Hi Paul.

Paul Choi - Merrill Lynch

Hi guys, just a couple of questions on respect to the incremental testing expenses that you guys mentioned, as well as the battery costs that could affect the gross margin. Do you feel comfortable at this point, having switched out that component back, that this testing expense can be reduced going forward, or do you feel that this will need to be something you will need to keep doing for a couple more quarters here?

Duane DeSisto

No, on a go-forward basis, Paul on go-forward basis, our initial reaction, to kind of reset the stage once again, was we have a final test machine that originally we thought would capture every possible, we've never seen anything out in the field that we didn't see at that final test machine.

So, given what happened to us with this plating, which really was kind of an aging environmental random type thing, it surprised us. We probably over tested every lot to really get to the bottom of it. So, we are very comfortable that we now understand the parameters of that and that testing will go back.

But our initial reaction was to increase our sampling size. And then, given that this was an aging process, we're taking a significantly larger part of the lot and we're sampling, just to make sure once we put that fix in that we did in fact actually have it. So, that will go back to a much more normalized number.

With regards to the batteries, given the price of silver, and we had some long-term contracts in place that unfortunately expired in the first half year, and so we are now buying closer to a monthly, we are now buying closer on POs month to month to try to take advantage of the silver. But to give you some context, it hits the cost of goods sold at about $2 per pod, to kind of give you some -- it hits the building material about $2 per pod.

Now, we're working on several different solutions that we have. We're working with the battery supplier that currently supplies us with the batteries. And the interesting thing is the batteries we currently have, have a significant quantity of silver. They have given us a version that a lot of companies use in the medical device field, which has probably about half as much silver.

So, we are diligently testing those. So, if that is the case, we're hoping here that by the fourth quarter, worst case first quarter, that that number comes back in line to what we originally estimated it to be. But that is $2 for every pod above and beyond what we ever estimated.

Paul Choi - Merrill Lynch

Great, thank you for that. And then, maybe my last question here will be on the demand side, and also a bit on attrition. Can you maybe just give us a little color in terms of where the referrals are coming from with respect to your geographic expansion? Is it coming more from deeper penetration of the accounts where you guys have been in historically on the coasts, or are you finding that more of the growth is coming from some of the newer geographies that you guys are entering here in Middle America?

And then, with respect to attrition, can you just maybe give a little insight as to what your potential plans are to perhaps go after these patients and potentially recapture them again in the future?

Duane DeSisto

Sure. I think with regards to the growth, obviously the fastest-growing territories in terms of percentage quarter-over-quarter are the new ones, because they started with next to nothing. I would tell you the growth is coming from throughout the country. The productivity, we have divided, I believe, we have divided seven territories that we're monitoring very closely.

If you look at those geographic territories here if there was still a single person in it. There is significant growth coming out of those territories. Obviously, the new territories are growing rapidly.

So, we're very, very pleased. If I laid it out, if I laid out all 50 sales guys for you, I think, other than looking at the percentage step-up, because a lot of these guys were starting with such a low base, you start looking at productivity, we are very happy with where the sales force is. So, it is across the board.

We just came back from the AADE, which was down in Washington, DC. And I would tell you, and this is kind of a ballpark guess of all the people that were in the booth, but most of those people said there's 30% to 35% of the nurses who came there to this day had not see the product yet. So, the opportunity is still enormous. There's still a million places for us to go. And we are still very, very much excited about that.

Carsten Boess

Second question.

Duane DeSisto

On the attrition side, look, the direct correlation to what happened with the symptom that happens out in the field with the product, the plating issue they have, which I believe we've described several times, but what happens is the pod would fail out of the box. The switch wouldn't make contact and would fail out of the box. So, we directly saw a jump-up in the attrition with new patients. So, if we had a new patient and they had three of them in a row fail and they were coming off shots, those people got a little nervous and they moved away.

So, our plan is, we know who they are. We're going to give it a little time, and we're going to circle back with those people. But that really was the good news in all of this, obviously, it wasn't a safety-related issue. It failed right at the startup, so you never were able to put the product on you.

I think the customer service, we got a lot of compliments at the AADE. I've now personally traveled to several institutions, talked to the physicians. They're very pleased with how we handle this. We're not the first company to go out there and have a problem out of the box.

So, we're very happy with our reputation. We believe it has come out in very good shape. But there is no doubt that if you were a first-time user of this product and the first three you went to try on failed that your confidence was shaken. So, we know who they are, we know where to go to go back and get them. We're going to give it a little time and circle back, like I said. And that impacted us, there's no doubt it impacted us a couple of points.

Like I said, it wasn't institutionalized. We have not seen any of that. But we have seen specific people where their confidence was shaken. And especially given that about 75% of our people are coming from shots, that clearly shook some of the confidence of some of those people, and we lost some, unfortunately.

Paul Choi - Merrill Lynch

Thank you for that. I will jump back in queue.

Operator

Your next question comes from the line of Shawn Fitz with Stephens, Inc. Please proceed.

Shawn Fitz - Stephens, Inc.

Hi Duane and Carsten, thanks for taking my questions. This is the first question. You all have obviously done a great job ramping up manufacturing. You were at 200,000 units at the end of June. Just in terms of, as we think about manufacturing capacity at the end of this year, could you provide us maybe kind of a benchmark that you all expect to be, given your plans in terms of shifting manufacturing?

Duane DeSisto

Yes. I think the best way to look at this is our next goal is to have 200,000 coming out of China and then start ramping that up. So, we are going to go through a transition phase here over the next few months, where we are moving more and more of that activity to China to really get it up, take advantage of the cost savings that are associated with there.

We believe the equipment coming out of China is the same equipment they have here. We believe that they can generate 50% to 75% more than we, one line, had originally thought. So that would be the next step to really start ramping that up. But first, what we want to do is make that transition to Asia, take full advantage of all the cost savings associated with that. And the way we are going to buffer that whole transition is we are going to buffer it with inventory over the next few months here as we make the transition.

Shawn Fitz - Stephens, Inc.

So, I guess what you’re saying is that by year end, manufacturing capacity is probably still going to be 200,000 units, but most of it coming out of China? Is that the right way to look at that?

Duane DeSisto

Yes, the vast majority of it should be coming out of Asia by the end of the year, correct.

Shawn Fitz - Stephens, Inc.

I guess one thing we are trying to grapple with as we look at these numbers and then try to juxtapose your demand and manufacturing capacity, I guess at 200,000 units per month, it looks to us that maybe you need to have 20,000 patients to support that level of manufacturing. So, I guess my question is, are you a bit ahead of your demand at 200,000 units per month, where you stand now?

Duane DeSisto

Okay. So first of all, I think the best way to do it is don’t divide by 10, divided by 15, because that takes into account samples. That takes into account some people have to change it out every two days. So if you do that math, you’re somewhere between 12,000 and 13,000 patients. And vis-à-vis the demand, the other nuance that we have in here is, like I said, I think we have a planned shutdown at the end of the year, both in Asia to make sure, to basically clean up all the equipment once again, to do any maintenance we have. And then we have the Chinese New Year that is coming in February, I believe, which is typically in Asia a two-week shutdown. And given that the manufacturing, the vast majority of the manufacturing will be over there. So some of that, some of the inventory we have to use to buffer that.

Having said that, like I said, I think in terms of 200,000, you want to think more like 12,000, 13,000 patients. So, that’s kind of how we are looking at it, and that’s what we’re trying to drive to.

Shawn Fitz - Stephens, Inc.

Okay, great. Thanks Duane. Just back to the attrition rate very quickly. I think the number that you all provided was 10%. Is that a 10% number compared to the end of the first quarter, or is that just kind of an annualized number?

Duane DeSisto

The 10%, the way you compare it to the first quarter, it went up a couple of points. So, it’s 10% versus an 8% number. That is the best way to look at it.

Shawn Fitz - Stephens, Inc.

Okay. And then maybe a couple of just more housekeeping questions. Carsten, do you have your inventory levels in terms of number of units at the end of the quarter?

Carsten Boess

It is not something we have disclosed and are not intending to disclose. Having said that, there is no doubt that, as Duane alluded to two and a half to three and a half months on inventory given the significant ramp-up in manufacturing we saw in June is what you will see when our 10-Q comes out in terms of the reported inventory number.

Shawn Fitz - Stephens, Inc.

Okay, great. And then last question, just on the revised guidance on the operating loss, I think you all provided a number in excess of $70 million. Can you help us maybe think about where the cap on that might be for this year?

Duane DeSisto

So, instead of bracketing the operating loss guidance, we simply decided to keep it open. And the reason is, as Duane has talked about several times, is that we actually see over the next six months the strong manufacturing up-tick in China. And as a result, we will commence negotiations on what has to happen with the fixed asset base we have here in Bedford. And that might from an accounting point of view lead to some asset write-downs, and as such, that will impact potentially our operating loss in the second half of the year. And that is the reason we have kept it open ended, because we are only embarking upon those negotiations in the coming weeks/months.

Shawn Fitz - Stephens, Inc.

Okay. Duane and Carsten, thanks for your time.

Carsten Boess

Welcome.

Operator

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

Philip Legendy - Thomas Weisel Partners

Hi. Good afternoon, gentlemen.

Duane DeSisto

Hi, Phil

Philip Legendy - Thomas Weisel Partners

Wondering if you could give us an idea, now that you are starting to get some visibility on what is coming out of China, can you give us an idea of where you think gross margins might end up by year end? I know you’ve said you think they will be positive, but if you could put a tighter bead on it, that would be great.

Duane DeSisto

Yes, I think you have to assume that, as, given that we’re on a FIFO basis and as the inventory flows through the P&L, you’re looking at more of a blend that is heavily weighted towards being manufactured in Bedford, which, that will kind of put a 2 in front of the cost of goods sold number.

Philip Legendy - Thomas Weisel Partners

Okay. That’s helpful. And then just another question related to China. I assume quality control is going to be a key issue on the product that comes out of there. I wonder if you guys have an estimate yet of how much it might cost on a per-pod basis to do the quality testing you’re going to need to do on that product?

Duane DeSisto

Phil, I think back when we talked about, at various levels, that included, I mean, we’re looking at cost of goods sold coming out of Asia, depending on the actual level, we are talking in teens. That is all baked into that number. We are very comfortable on the quality side. We once again think we have a very good handle on it. And the thing I want to stress is all the components continue to be manufactured in the US. Over time, we may start finding Asian manufacturers. But it is all our same suppliers. Instead of shipping to Bedford, they are shipping directly to Asia.

The quality of the systems are the same. The equality department is headed by a US citizen who was one of the engineers integral in designing the product here who is living in Asia. So he is our employee. And the guy overseeing the manufacturing is an Asian national who is our employee living in Asia. So I don’t think there is anything -- I mean, that was built into the kind of numbers we’re thinking about from day one.

Philip Legendy - Thomas Weisel Partners

Okay, fair enough. And then I just wanted to clarify, on the outsourcing of the back office functions that appear to have been the bottleneck, it sounds like you are pursuing a dual strategy there, because on the one hand you’re building out internal capacity. On the other hand, it sounds like you’re still looking at outsourcing. How do you think about how you are going to balance those two initiatives?

Duane DeSisto

I think we are building internal capacity, because we thought the outsourcing would be effective, efficient and relatively inexpensive. And what we found is it is significantly more complicated than we had anticipated. So we’re building out the internal. We haven’t lost sight of the outsourcing. I think over time, it will make a lot of sense. The trick with all of this is, what you have to do is you have to transfer, basically you have to add names and suppliers to the various contracts that were out there. And I would have told you, from the little bit of feedback we originally had when we partook of this and the first couple that we did, that that would take weeks.

What we are finding is that process to add other people to your contracts that are managing stuff is more like months. It is almost like getting new contracts. So it turned out to be much more bureaucratic, I guess, than we had imagined. So look, at the end of the day, we have a number to hit. We are driving to the number. We’re going to build the internal infrastructure. That we clearly control. I think over time, though, we continue to look at that strategy, which is outsourcing.

Philip Legendy - Thomas Weisel Partners

Okay. And then a just final housekeeping question, and I apologize if I missed it. But did you give the number of sales reps that you have on board in the quarter?

Duane DeSisto

I mean I think we have either 50 or 51. I’m not sure. So, I [don’t prepare] that I will give you some -- that’s the number.

Philip Legendy - Thomas Weisel Partners

And do you still look at a range of 50 to 55 as an appropriate target for the year end?

Duane DeSisto

Absolutely. I think what is very, very important for us is to fully to understand the capability, now that we will have -- by the end of this year, we will have most of these reps on for almost a year. We’ll have a very good understanding of productivity. We will have a good understanding of what dividing territories. I mean to kind of put this in context, to step back, we are tripling the business. And we had to do that off of a platform, I think we had weighted average, I don’t know, nine or 10 sales reps last year. So while we thought we understood it and we feel good about where we are, there was some significant guesswork. I think at the end of this year we’re going to have a real solid platform going forward.

Philip Legendy - Thomas Weisel Partners

Fair enough. Thanks gentlemen.

Duane DeSisto

Thank you.

Operator

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

Ben Andrew - William Blair

Good afternoon. I just was wanting to follow up a little bit about the infrastructure stuff. Talk about specifically what functions you thought you were going to outsourcing easily. Is this the reimbursement side? Is this training, because I know that’s typically one of –

Duane DeSisto

Yes, Ben, let me put it to you very clear. It is the processing of the orders as they come in, and then basically, it’s not the actual billing, but it is basically taking the information from the physician’s office, from the patient, and putting that through the process to get it reimbursed. That is where we have kind of run into a little bit more complication than we had anticipated.

Ben Andrew - William Blair

How is the training process going? Have you found you have adequate capacity to handle these patients?

Duane DeSisto

Yes, on the training side, it is going phenomenally well. It really has gone phenomenally well. Most of the major institutions don’t require any of -- they do all their own training. It is simple, easy to use. It is as advertised for the physician’s office. So we are in very, very good shape there. It is something that we are favorable to budget, we have been favorable to budget. Every budget estimate I think we’ve had in the history of the company we have beaten. So that has gone very, very well.

Ben Andrew - William Blair

What’s the holdup on the managed care reimbursement side, because we’ve got a large number of covered lives. We’ve got coverage policies. It is just a function that they are requiring multiple turns on the paperwork? Is this a one-month process, three-month process to kind of get a patient from referral to actually reimbursed before they can be trained?

Duane DeSisto

It is the – kind of give you some sense about it’s about half the paperwork that can go out in the same month. And then there is always, inevitably, there’s always pieces of paper missing. And one of the things that has happened is, if I go pick, in Massachusetts, that paperwork typically comes in complete, because we’ve been doing business there for a significant period of time.

Now what happens is I am in Iowa, let’s say. It’s the first time I’m in the doctor’s office. The sales rep, we give all the patients, we give the doctor the paperwork. They decide to put the patient on. And maybe two out of the three pieces come in. Maybe the paperwork comes in, it is not signed. Then you start that process, going back and forth and back and forth. And if the patient has to get involved, getting hold of the patient, you have to contact them at night, at home. Sometimes to return the call, sometimes it takes a week.

So really, the paperwork, I would tell you, the stuff coming from an office that we’ve been there for a year or two is pretty much complete. They know the routine. A lot of parts of the country, now, this is the first time they’ve seen the paperwork, and it comes in okay. And oh, by the way, if the paperwork is not pluperfect, managed care doesn’t process it. They kick it back to us.

So, it just takes on, as hard as it may seem to believe, this thing takes on a life of its own. And it’s the same thing. If it goes in perfect the first time, it usually works. If anything is wrong, you can start adding weeks, not days, to the turnaround process for this.

Ben Andrew - William Blair

So, is that dynamic the bulk of the change in the revenue guidance?

Duane DeSisto

That dynamic is what is driving the change in the revenue guidance. I can sit here and tell you that we got X number of referrals. If I can’t turn it into revenue, you don’t care, right? So, it’s pretty simple. And our window internally is, the way it works typically with the patient, I think we’ve kind of given this guidance from the very first day we stepped in the public forum. You have about 90 days to get the patient through that window, or then it really drops off. So if you start taking a look at how we process the paperwork, we have 90 days from the time the patient signs the paperwork, we may not get it that same day, but from the time he signs the paperwork to the time he gets the product in the hand, you have a 90-day window in which the patient is very receptive. Once you get beyond that, the patient starts losing interest. They go back to what they’re doing.

So, that’s really the trick. It’s turned out, I mean, it’s pretty straightforward. It’s pretty clerical. But it’s not all on our demand. You need the cooperation of the patient. You need the cooperation of the physician’s office. You need the cooperation of the managed care provider in order to do all that.

Ben Andrew - William Blair

Okay. And then last question, when you think about retention rates from here, we have gone from [to extent]. Some of that’s the quality issue, some of that may be as some of these reimbursement challenges you’ve got on the front end. But do you see that stabilizing, or do you think that goes back up or goes back down or goes higher?

Duane DeSisto

I don’t believe it will go higher. And to be conservative, I will say stabilizing. I won’t be happy with that number, and we’re going to drive to reduce it. But there is no doubt, because if you remember, we were kind of going along a couple of points below that for a significant period of time. And we ran into this speed bump here with the product quality and the out-of-box failures. So, stabilizing or better is our goal.

Ben Andrew - William Blair

Okay. Thank you.

Operator

Your next question comes from the line of Bruce Cranna with Leerink Swann. Please proceed.

Bruce Cranna - Leerink Swann

Hi. Good afternoon.

Duane DeSisto

Hi, Bruce.

Bruce Cranna - Leerink Swann

So, it sounds like you really just need to have more people doing the reimbursement paperwork, I guess. But in the meantime, can you give us a little help in terms of what kind of discussions are you having with these patients? What are they being told? It sounds like maybe they are waiting 90 days after signing an agreement. But I guess what I am wondering is what are they being told? Who is communicating their situation? And how do you make sure that, I guess, the hot lead doesn’t go cold?

Duane DeSisto

Sure. The process is the patient makes that commitment. We advise them when we receive the paperwork from the physician’s office. If we don’t receive all the paperwork from the physician’s office, they get contact in that regard. Then we also advise them when the paperwork is all complete, that we submitted it to managed care, so they know that it is in that process. Then what will happen is, if for some reason managed care kicks it back, they get advised of that.

So, we talk to them every major step of the way. And then obviously, when we ship it, they get the advice. Having said that, some people are just not going to sit around and say, well, yes, it’s nice. I’m glad you told me everything, but I want the product now or forget it. So, I mean, that’s what we have to battle through, but we do have a process that every major step of the way we do in fact advise the patient on where we are.

Bruce Cranna - Leerink Swann

And thinking about adds in the quarter, until you get the situation ramped up a little more, is this kind of where you are in terms of your capability of adding people or adding patients?

Duane DeSisto

No. We intend, I mean, we’re driving to grow the business. There is no question whatsoever. I do think, once again, I do think we found it harder to move that conversion number. I mean, we can put more people in here and there’s plenty of referrals coming in, and we will do it. But to drive that from a 6 in the front to a 7 in the front, that would be a twofold step-up for us. But that is where we are going with this.

Bruce Cranna - Leerink Swann

It sounds like you’ve probably had to pull the leash back on the sales force a little bit, haven’t you?

Duane DeSisto

It is tough to pull the leash back. What we have to do is we have to do some internal discussions. Obviously, the sales force is compensated based on shipments, not on referrals. So there is a management issue that Shawna has to face on a quarterly basis with these guys. But they are not compensated on referrals. So just sending stuff in the door is not going to get it done. So they are very interested in our ability to process this. They offer a lot of help, too, most of which is constructive.

Bruce Cranna - Leerink Swann

That’s good to hear. That’s where I was going with that in terms of their compensation. And then just one last thing for me, I guess, on the guidance, Carsten. And I know this came up before in a prior question. But if I just kind of straight-line OpEx today, I get more like an $80 million loss. And I know you don’t want to be penned into anything, but did your comment about being in excess of $70 million, just so I’m clear, was that inclusive of any potential charges for shutting down Bedford, if you will?

Carsten Boess

So, the reason that we keep it higher than $70 million is exactly for the reason you mentioned, that there might be elements come-in in the second half of the year that pertains to the asset write-downs. And then at all, the additional variable in the whole thing is our continued investment in the sampling.

Again, I want to stress that out of the first-half spend in sales and marketing, $5 million was in the sampling, which is an expense that we have discretional or as we move into the latter part of the year. We, however, have felt it right to keep on investing in samples as we speak because it is assisting us in driving the top line toward our revised guidance. So I hear what you are saying, and those are the two key variables in the whole second half of the year P&L.

Bruce Cranna - Leerink Swann

And just so I’m clear, if in fact you were to take a charge for the Bedford equipment in the second half of the year, what actually, I mean, I guess my question is why is there a charge, I would assume that that equipment is just going to get placed somewhere else.

Duane DeSisto

Yes, I think one of the things that we’re doing is we are negotiating with Flextronics on taking over possibly some of the equipment, the maintenance of the equipment, doing a lot of different things, which could render some of this equipment obsolete. So we are early in the discussions with them. We’re discussing various scenarios, various potential sites. We’re doing a lot of different things with them.

I just came back from China a couple of weeks ago. What I am convinced of, while I think we are an incredibly innovative company, I think taking something and mass-producing it is what they are very, very good at. So we are involved in those discussions. Where we end up with, hopefully we will have that buttoned down here by the end of the third quarter. And that will give us a much better determination of what we are doing.

Bruce Cranna - Leerink Swann

But there is a chance you are going to scrap all that equipment in Bedford?

Duane DeSisto

Yes, scratch probably the wrong word, but you know, from an accounting standpoint it may end up looking that way. But scratch is probably the wrong word.

Bruce Cranna - Leerink Swann

Okay. Thank you.

Operator

Your next question comes from the line of Anup Mehta with Canaccord Adams. Please proceed.

Anup Mehta - Canaccord Adams

Good afternoon, Just a few questions left. The patient adds in the quarter, was that a net new patients or was that a gross number?

Duane DeSisto

That’s gross.

Anup Mehta - Canaccord Adams

That’s gross., okay. Is there any way we can get a net number?

Duane DeSisto

If you just do the math, and assume a 10% attrition rate, I guess that would probably be – it’s not completely accurate, but it puts you in the ballpark.

Anup Mehta - Canaccord Adams

Okay. And then, for the gross margin, you’ve given a number for cost of product. But is that something that we could actually achieve -- you could achieve in the quarter, or is that something you’re looking to leave 2008 with?

Duane DeSisto

We believe we will break through positive margins in Q3 and the entire quarter for Q4. We haven’t changed our guidance on any of that. We believe we will be making money at the gross profit line for the entire quarter. Q3, we should break through. Q4, the entire quarter should have positive margins.

Anup Mehta - Canaccord Adams

Okay. And then the last question, as you start to recognize the fact that you had an infrastructure need to process these referrals, has there also been any move to improve the customer support, or have you recognized that customer support is absolute fine and it is not an issue going forward as you’re pushing more and more patients through the company?

Duane DeSisto

The customer support system we recognized early on to be a key to the image that we want to present and a key to patient satisfaction. So that we have put in place at the beginning of the year. That is working phenomenally well from our standpoint. Despite going through the issue we had to go through with the out-of-box failures related to the plating, the customer support, every institution I’ve been to, we just got unbelievable grades from physicians, nurse educators.

So the customer support is in place. We’re very, very happy with that. We’re very happy with the image that they are setting in the marketplace. So that is not it. It really is kind of a back-office processing the paperwork that we really struggled with.

Anup Mehta - Canaccord Adams

Okay. And then just one more. In terms of once you actually process the paperwork for the insurers, are you getting a very good response from the insurers to the point where you’re getting, like, 80% to 90% coverage. Once you process all the paperwork, there is an 80% to 90% chance that you’re going to actually get paid and be able to –?

Duane DeSisto

Yes, I think we are -- look, we qualify that ahead of time. So we will not ship a product unless we have a 99.9% -- I mean, stuff always happens, but let’s say we have a 99% chance of getting paid, that’s when we ship. We will not process the order if we don’t think we’re going to get shipped, if there’s any hesitancy.

The good news is as we continue to grow as a business, when you are a little company, you can look through rose-colored glasses. I think from a finance standpoint, we are looking at the orders. If we don’t think we’re going to get -- if there’s not a 99% chance we think we’re going to get paid.

Now, the flipside is the co-pay associated with the customer, that is a little bit tougher to judge until you really get into that. But with the managed care, it is pretty clear up front. I think we’re doing a good job of qualifying that. I think we have tightened that up dramatically over the last 12 months, and we continue to improve that. But we will not ship it if we don’t think we’re going to get paid.

Anup Mehta - Canaccord Adams

Okay. Thank you very much for your time.

Duane DeSisto

Thank you.

Operator

Your next question comes from the line of Derek Leckow with Barrington Research. Please proceed.

Derek Leckow - Barrington Research

Yes, thank you. Good afternoon.

Duane DeSisto

Good afternoon.

Derek Leckow - Barrington Research

Just a question here on the progression of revenue. As I look out at the next eight quarters or so, originally I think we had talked about sort of a step-function increase in revenue happening by around the fourth quarter. Given what you know now, will it take a little bit longer to get to that best practices level, where you can see that step-function increase, or do you think we should look at this more as a momentum increase on a quarterly basis?

Duane DeSisto

Yes, I think at the moment it’s still more of a momentum increase.

Derek Leckow - Barrington Research

So nothing like a step-function like we thought before. So that is one change, I guess. And that gets me to that lower level of revenue that you talked about. And are you guys assuming any revenue at all from the new relationship anytime in the next, let’s say, 12 months?

Duane DeSisto

You mean with Ferring?

Derek Leckow - Barrington Research

Yes.

Duane DeSisto

We think, and we really haven’t taken a hard look at 2009 yet, but that would be in the back half of 2009, if we get anything. It won’t be material in 2009 for sure, but we do think we will start seeing some of that in 2009, back half.

Derek Leckow - Barrington Research

And what drug are you guys talking about delivering with that?

Carsten Boess

It’s a fertility drug.

Derek Leckow - Barrington Research

And do you guys have a sense for the market size of that?

Duane DeSisto

It’s, by pharma standards, it’s relatively small. I think there is, I think in Europe, and I should be careful, but it’s in terms of thousands, not millions. It’s low thousands, is kind of the number of people that are using the drug, I believe.

Derek Leckow - Barrington Research

Okay. All right, that’s helpful. And is there another relationship that you’re working on that you might announce here in the next year, or is this really the only one that is currently –

Duane DeSisto

No. I mean, we have several that we continue to move forward with. We’re moving forward pretty much at the pace of the pharma companies, from our standpoint. We are engaged. We’re discussing it, various ones. We have a couple that are significantly closer than others. And they, once again, they range from being part of an actual drug submission to delivery device. So, they are all over the map, but we are still working with several, once again, at their pace. The pharma pace obviously is significantly different than what we are used to. So we are in fact pursuing several others.

Derek Leckow - Barrington Research

Okay. Let me get back to the current market, then. Competition within the pump market, have you seen any changes, anything to be concerned about as far as your ability to capture market share? Have you seen any changes in marketing behavior among your competitors?

Duane DeSisto

No. I think if you take a quick scan around the marketplace, there is the major competitor and the obviously dominant player in this thing is Medtronic MiniMed. And their marketing campaign and how they pitch the product is the closed-loop system and talking to continuous sensing. That is how they compete with us.

And after that, we have seen some press releases from J&J. They are a phenomenal company. But we haven’t really, on a head-to-head competition, our competition is Medtronic MiniMed, and they’ve been pitching it the same way for some period of time, which is really continuous sensing in conjunction with pumping.

We did not discuss it on the call, but we continue to work with both Abbott and DexCom. We hope to be into the agency at the end of this year, the beginning of next year. And at that point in time, I think that argument will become moot and we will see how we compete.

Derek Leckow - Barrington Research

As far as the turnaround time, once you do submit that, do you guys have an idea of what that might be?

Duane DeSisto

It’s a PMA supplement that’s submitted both by; one would be submitted by Abbott, one would be submitted by DexCom. And so the turnaround time is going to be a function of how much testing we do. I really don’t know at the moment. We will wait and see.

Derek Leckow - Barrington Research

Okay. Thanks for the answers. I appreciate it.

Operator

Your next question comes from the line of John Green with Smith Barney. Please proceed.

John Green - Smith Barney

Good afternoon, gentlemen.

Duane DeSisto

Good afternoon.

John Green - Smith Barney

My 19 year old son is one of the new 1,650 users in the last quarter. He was diagnosed as a type 1 diabetic earlier this year. And after being on shots for about one month, he switched over to the OmniPod. He has been on the pod for about 90 days now, and it’s been a real game-changer for him. He has been away from home at school for two months and managing his diabetes on his own very well. And I just wanted to say from the bottom of my heart, thank you very much.

Duane DeSisto

Listen, we appreciate that, and like I said, if there is anything we can do to just keep pushing the envelope and help make his life better, feel free to give me a call.

John Green - Smith Barney

Thank you.

Duane DeSisto

Like I said –

John Green - Smith Barney

In my mind and my family’s mind, you’re -- the Apple iPod was a really cool device, but your product is the product of the year, in our minds.

Duane DeSisto

Thank you very much.

Operator

And I am showing you have no further questions at this time.

Duane DeSisto

Thank you, everyone. And like I said, we look forward to updating you on our progress on the next call. Thanks a lot.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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