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NxStage Medical Inc. (NASDAQ:NXTM)

Q2 2008 Earnings Call Transcript

August 5, 2008 9:00 am ET

Executives

Kristen Sheppard – VP of IR

Jeff Burbank – President and CEO

Robert Brown – CFO

Analysts

Ben Andrew – William Blair

Philip Legendy – Thomas Weisel Partners

Bill Plovanic – Canaccord Adams

Suraj Kalia – Sanders Morris Harris Capital

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2008 NxStage Medical Inc. earnings conference call. My name is Erica and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question and answer session towards the end of this conference. (Operator instructions)

I would now like to turn the presentation over to your host for today’s call, Mrs. Kristen Sheppard. Please proceed.

Kristen Sheppard

Thank you, and good morning. Welcome to NxStage Medical second quarter 2008 financial results conference call. My name is Kristen Sheppard, Vice President of Investor Relations. With me today are Jeff Burbank, NxStage’s CEO and Robert Brown, our CFO.

A replay of this call will be available shortly after the conclusion of this call for two weeks. In addition, the press release for the second quarter and the webcast for this call will be archived on our website under the Investor Information section.

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

These forward-looking statements may include topics such as the results of our operations, growth of the home and more frequent hemodialysis market in general, market adoption and demand for our product, the roll out of the PureFlow SL, anticipated benefits of the Medisystems acquisition, anticipated improvement in the operating efficiencies, gross margins, product quality and financial guidance for the future.

Because such statements deal with future events, they are subject to various risks and uncertainties and actual results may differ materially from these forward-looking statements. Important factors that could cause actual results to differ materially from those forward-looking statements are discussed in our SEC filings, including our quarterly report on Form 10-Q for the period ended March 31, 2008. In addition, any forward-looking statements made on this call represent the company's views only as of today and should not be relied upon as representing our views as of subsequent dates.

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

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

Jeff Burbank

Thank you, Kristen; and let me take a moment to officially thank you and welcome you to your first quarterly conference call at NxStage, sure we are all glad to have you here.

I will begin with an update on the business. Following my comments, Robert will review the financials and our guidance for the third quarter. At that point, we will open up the call for your questions.

Q2 was a good quarter for NxStage. We executed on the strategic initiatives outlined last quarter, further solidifying the business model focused on three target markets and delivering improved underlying operations and financial results. Total revenue for Q2 was $31.6 million. That is up 2% from Q1 and over 216% from last year. Our revenue performance was primarily driven by growth in the home market, which grew to $11.8 million; that is a 12.4% increase compared to the first quarter, and a 76% increase over the second quarter of 2007. We were encouraged by this growth and continue performance across all three markets.

Gross margins improved to 14%; that is a 100 basis point increase over the first quarter. This improvement can be attributed almost exclusively to the continued execution against our manufacturing cost improvements within the System One segment.

Our reported net loss for Q2 was $12.5 million. Included in these results was $2.1 million of non-cash gain related to the accounting treatment of the product placement, which Robert will discuss shortly. Our adjusted EBITDA for Q2 was $7.7 million, reflected our continued focus on lowering our cash burn rate.

Last quarter, we outlined four key areas where we are focused on driving results growth and expansion, by this I mean going deep strategy; clinical data; product development; and finally, reimbursement. All these with a goal of building momentum, creating meaningful barriers to entry, and delivering improved operating and financial performance for all of our stakeholders. We said we would continue to be pragmatic in our approach, take one step at a time, expecting challenges and not expecting quick fixes and that is exactly how Q2 played out for us. Executing against these objectives, we made good progress in strengthening and expanding our market presence.

Now let me turn to the home market. We continued to focus intensely on building patient density. By doing so, we believe we can make the geographic areas more robust, as centers respond with more training resources, while we gain and tail deficiency. Disciplined execution against this go-deep strategy allowed us to grow our total patients, and more importantly, increased the number of centers with greater than 10 patients to a total of 67, representing a 22% increase over the first quarter and a 91% increase when compared to Q2 of last year. This is validation that we are on the right track with our growth strategy and what can be achieved with good NxStage programs with our partners. We now believe accesses and plays with approximately 92% of U.S. patients located within 60 miles of the center that offers NxStage therapy.

In our home market, DaVita continues to be our largest partner, representing over 40% of our home patients. We are pleased to have their support and are encouraged by their new marketing initiatives that promote home hemodialysis. For example, their new website offers patients compelling information and support of the daily home therapy and provides a comprehensive tool to help the patients locate a home program near them. In addition, their newly-appointed Chief Medical Officer, Allen Nissenson has been a public supporter of increasing patient access to home therapy.

Coupled with our go-deep strategy, we continue to invest in efforts to promote our clinical data and build momentum. With the launch of our new online registry, we are providing patients and providers with unprecedented access to NxStage patient outcomes. If you review our outcomes data, which is based on more than 1,000 patient years of experience and more than a million treatments, you get a good snapshot view of our patient base. Obviously we are most pleased that even when adjusted for age and gender, NxStage patients experience a better than 50% reduction in expected mortality compared to (inaudible) in the overall U.S. RDS patient population.

We are committed to updating this information and look forward to sharing the results from two other important clinical trials, the FREEDOM study, which is currently enrolled at 202 patients and our Nocturnal study, which is already nearing the halfway enrollment point. Near-term milestones for us include the interim quality of life analysis for the FREEDOM study expected in early November, interim analysis on the economic endpoints for FREEDOM early to mid 2009, and completing enrollment for our Nocturnal study by the end of 2008; this leading us to estimate FDA for Nocturnal home indication by the end of 2009.

I think the only way to top the effectiveness of clinical data validating our story are our patients telling you themselves. A NxStage patient named Harvey Wells visited us recently and told me, these are his words

‘I believe that I have been given an opportunity to help other kidney failure patients by demonstrating how liberating the NxStage System One can be’. Harvey is a 56 year old man whose in-center treatments left him so fatigued that he had to stop work and couldn’t travel. Since he started daily home therapy on the NxStage System One in 2007, he feels much better. He has experienced more energy, no longer needs his blood pressure medication, he has been able to return to work and is travelling more than he ever dreamed of – and again, that is in his words.

So here is the real exciting part

Harvey recently contested us with a plan to travel around the country in a motor home, speaking on the benefits he has gained through using our therapy. He has now visited over 20 dialysis clinics, all made possible because he dialyses in his motor home, oftentimes while demonstrating how easy the process is to interested patients. Harvey’s experience is remarkable, but it is not uncommon with NxStage patients. Their passion and support is a testament to the impact of our technology, the quality of our people, and the long-standing nature of patient relationships.

We continue to affirm our commitment to our patients with ongoing efforts to further improve on the quality, ease of use, and reliability of our product. For example, over the last quarter, we have been actively engaged in the rollout of our water-testing solution kits, in response to the new testing requirements imposed by CMS in the fourth quarter of 2007. Our solutions include both easy-to-understand user prompts on the user interface and easy-to-use septic [ph] kits. To ensure the effectiveness of the rollout, we enhanced patient education, outreach, and materials. Through these efforts we believe that we are beginning to see some early indication that our retention rate, which declined slightly in the first quarter, maybe stabilizing back at higher levels. We have more work to accomplish here, but I am pleased with the progress. These events, while frustrating for all of us, ultimately deepen our customer relationship and further define us as a leader in the home market.

Now turning to reimbursement. In June, Congress passed into law requirements for an expanded Medicare bundle, which changes how dialysis therapy will be reimbursed for Medicare beneficiaries. We believe this action can be favorable for home hemodialysis. First, clarity around reimbursement can be beneficial as it removes a level of uncertainty for patients, physicians, and providers. Second, the bundle could help remove current drug payment based centers to home dialysis. Finally, we believe the structure which maintains separate home training reimbursement may provide a stronger basis on which to grow our programs. We are now focused on working with CMS to ensure that the elements we perceived as being beneficial to home hemodialysis are implemented to expand Medicare reimbursement to predictably cover more frequent therapy with less administrative burden on our customers.

Also in June, we added Jeff Smith to our team as a new VP and General Manager of the home market. He is fully engaged in the business and working on programs to create momentum and deepen our penetration. His appointment rounds out our team, giving us leaders with strong track records for growth in each of our target markets.

And moving to critical care, we are steadily expanding our presence in this market, gaining stature as a clinical care system of choice, now at 7 of the top 10 institutions in the U.S. Here, customers are leveraging the System One for its ability to meet their real-world clinical and operation needs, including enhanced quality of care, lowering their cost, and reducing the burden on critical care staff. Our unique technology advantages with that volumetric balancing is delivering these results. With System One, higher dose continuous therapies can be achieved without overburdening those things with fluid management. (inaudible) therapies can be delivered without staffing changes.

Additionally, we continued to compete well against Gambro both in terms of machine placements and machine utilization. Overall, we are very encouraged by our performance here and see further opportunity for market conversion.

Finally, the in-center market. We saw strong customer demand within the Medisystems business in Q2. While sales to distributors declined from Q4 and Q1, notably those were high stocking levels, sales to end customers remained strong. Here, customers continued to invest in our products because of their ability to deliver superior operational, economic, and clinical benefits. For example, as of Q2, our new blood tubing set, the Streamline is approaching 1 million treatments. This performance is particularly encouraging as the product was only launched in Q4. Streamline’s rapid adoption can be attributed to its ability to enable centers to increase their patient dialysis dose delivery and increase minimum Kt/V of 1.2, the target to 98% of their in-center patients, clearly exceeding the industry standards that tell Kt/V of 1.2 for just 93% of patients. This is a key measure for in-center therapy.

In addition, as Streamline is an arrowless, lighter, lower-volume set, it delivers significant operational benefits to customers through savings in dialyses, water, heparin, smaller dialyzer size, supplies, and waste disposal. We continue to be excited about Streamline as well as our other products including the ButtonHole needle with steripik. We are optimistic regarding our ability to convert customers to these products.

As you know, blood tubing supply agreement with DaVita; well, it is firing September this year. We are currently in negotiations with them to establish this new agreement. Our guidance for the company is predicated on us maintaining this contract. Overall, I'm cautiously optimistic here, so I believe we have a product which delivers the best clinical performance available in the market today. In the interim, until our distributors have visibility to the results of our contract negotiations with DaVita, we are taking a cautious position on tubing set inventory levels. This is putting pressure on our in-center revenue in the near term. This uncertainty regarding future blood line orders for DaVita is also delaying implementation of our long-term plans for achieving blood line manufacturing efficiencies. This is putting a near term pressure on our gross margin.

Given this, we are adjusting our gross margin expectations for 2008. I think it is important to note that we believe there will be a minimal impact in dollar terms. Therefore, we do not see a need to adjust our current projections for both net income and adjusted EBITDA. If our assumptions change due to our negotiations with DaVita, we will come back to you.

Expected gross margin improvements for the System One segment remain on track. We are making solid progress and continue to aggressively execute against initiatives to reduce cost of goods and improve distribution costs. In Q2, we took important steps to develop manufacturing efficiencies of scale. We completed the plant transition of local manufacturing and service capabilities to lower cost manufacturing facilities in Mexico. Following this, we created centers of excellence, aligning all our production to areas of expertise. We continue to work towards reducing product cost with process and product design changes.

In summary, we believe the strategic course we set will make NxStage a stronger company, and a more formidable competitor. And with a balance sheet recently strengthened with the successful closing of our 43 million private placements, we remain confident and optimistic about our growth prospects. While Robert will address our financial guidance more specifically in a moment, we expect to grow our patient and centers numbers steadily, improve the underlying operations of the business, and further reduce cash burn from operations. We expect that gains will be made incrementally, quarter-over-quarter, by consistently executing within our four focused areas.

Thank you. I will now turn the call over to Robert.

Robert Brown

Thank you, Jeff. I will review the revenue for the second quarter of 2008, including details of our two reporting segments, discuss the company’s operating performance, balance sheet and cash flow results, and then finish with a discussion regarding the outlook for the third quarter. I will discuss the numbers on both a GAAP and non-GAAP basis. Please refer to the reconciliation table in our press release for further information in this regard.

Second quarter revenues were $31.6 million within our guidance of $30.5 million to $32.5 million. Q2’s net loss was $12.5 million or $0.32 per share. The Q2 net loss includes the impact of stock-based compensation expense of $1.8 million, amortization and depreciation of $4.9 million, and other income of $2.1 million. This $2.1 million non-cash gain reflects the liability accounting treatment for the recently-completed 43 million private equity financing, which included both common stock and warrants. $900,000 of the gain arises from the treatment and (inaudible) evaluations of the stock and warrants from the second crunch as a put option from May 28, 2008 through June 30, 2008, as the put was effectively exercised on July 31, 2008 when the shareholders approved the second crunch of the agreement. There will be no further impact beyond Q3.

In Q3, there will be a corresponding non-cash loss of approximately $1.5 million that will offset Q2’s gains. Additionally, the warrants were considered a liability for accounting purposes, because of the potential reset feature on the slight [ph] price and therefore must be valued to the markets, resulting in a gain of approximately $1.2 million in the second quarter. The warrants will be revalued to market at the end of each quarter at least until December 31, 2008.

On a non-GAAP basis, our adjusted EBITDA loss adjusted for stock-based compensation, deferred revenue recognized and the liability accounting on the private equity financing that I just mentioned was $7.7 million. While we still have some (inaudible) work ahead of us, I believe that this number is a good indication of the progress we are making against our goal of reducing cash burn and achieving profitability in the longer term.

The System One segment, which consists primarily of our home and critical care business, had revenues of $16.2 million, up 9% when compared with Q1 and up 62% versus Q2 of 2007. As Jeff mentioned, the quarterly increase was driven by growth in the home business.

The in-center segment had revenues of $15.4 million, a 4% decrease from Q1’s level. The decline reflects lower purchases by our largest distributor after two strong quarters to bring inventory levels up to normalized stocking levels. We continue to see strong end user demand.

As a result of our progress in reducing cost of goods sold, we continue to improve overall gross margin, reaching 14% in Q2 compared with 13% in Q1 and a negative 15% in Q2 of 2007. As Jeff indicated, we are seeing near term pressure on incentive revenues and gross margins due to our ongoing DaVita negotiations on blood tubing sets, which are delaying implementation of our related cost reduction initiatives. For this reason, we are adjusting our 2008 gross margin target to 18% to 21% from 22% to 24%. Our efforts to drive further improvements in gross margin and lower distribution cost for the System One segment remain on track. Consistent with our plans, the System One is now fully manufactured in our Mexico facility, and we no longer purchase Pureflow hardware from outside contract manufacturers. We expect to realize a benefit of these other actions throughout the next few years. As of Q2, System One distribution expenses decreased to 19% of System One revenue, compared to our year end target of 20%. While we continue to see opportunity in distribution expense, we are aware of rising fuel costs, and based on that, we are maintaining our 20% target for the end of the year.

Moving to the balance sheet and cash flow statement, cash, cash equivalents and marketable securities at June 30, 2008 totaled $26.4 million. This balance includes $25 million of the first transfer of private equity financing but does not reflect the additional $18 million from the gross proceeds for the second crunch, which closed on August 1, 2008. This amount will be included moving forward. Cash used in the second quarter was $14.7 million. We believe based on current projections that the company has the required resources to fund projected operating requirement, which assume that we will restructure the repainted schedule under current GE credit facility. We believe we will complete this restructuring before the end of 2009.

Turning to our guidance for the third quarter, the company expects revenues to be in the range of $30 million to $32 million, driven by growth in the System One segment, offset by a reduction in the in-center segment as we go about the reduction in distributor inventory levels on blood tubing sets tied to our contract negotiations with DaVita.

The company also expects a net loss in the range of $13.5 million to $14.5 million or $0.30 to $0.32 per share, excluding any accounting impact of its private equity financing and an adjusted EBITDA loss in the range of $7 million to $8 million for the third quarter of 2008.

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

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from the line of Ben Andrew with William Blair. Please proceed.

Ben Andrew – William Blair

Hi, good morning, Jeff. Just wanted a follow up of the few things relative to the home business; can you give us a sense what patient you were doing this quarter and are you going to keep giving guidance or at least kind of reporting on where that is coming through?

Jeff Burbank

No, we are making good progress towards our year end goals. So we are pleased with the progress. We focus more on the things that drive the progress than the actual number because as you know that is bounced around a bit and we believe we are in a better competitive position by not disclosing it. So we are not going to give you the actual number, but we are going to focus a lot on the things that drive it, and it is the go-deep strategy. You know, the numbers that we talked about – 67 centers with 10 or more patients, a big growth in that number and types of activities like the improvement in sample taking with the Pureflow system.

Ben Andrew – William Blair

So is it fair to say you are in the range of 900 to 1300 that targets the warrants?

Jeff Burbank

As I said, we are making good progress towards our goals for year end.

Ben Andrew – William Blair

Okay. And talking about the DaVita renegotiations and sort of when we might expect a resolution of that and kind of what some of the alternatives are there?

Jeff Burbank

Sure. You know, we have had a good – you have watched us for a lot of years. We have proven capable of having these negotiations. So it is around the tubing set contract, because as you know, we have got our home contract in place and we did our needle contract towards the end of last year. So the contract goes through basically the end of September. I mean specifically I make it September 21 or something like that. As you saw probably from the needle contract, not always does everything get tied up in a bow by that date, sometimes we go past that date. So, don’t expect there is an announcement on that date necessarily. So sometime between now and sometime after that, we will come back to you. It is a material contract, so as soon as we know, you will know, but we are just in the process of working that out with them.

Ben Andrew – William Blair

Okay, and then the home and the needle set contract, when do those run through?

Jeff Burbank

Needle set was a 5 year agreement from – basically December last year I believe and the home as you knew I think was a 3 year with 6 months renewables – or 6 month renewables. So up to a 5 year from about at year and a quarter ago.

Ben Andrew – William Blair

Okay, great. And can you talk about kind of the progress in the home market on the gross margin side, because the overall gross margin is not materially different with some of the issues around in the tubing subcontracts, but how are you doing on that, because the EBITDA numbers certainly look better but are we seeing that on the gross margin side in the home as well?

Jeff Burbank

It is actually almost all coming from the home; so we are very pleased with the progress in gross margins from what we call the System One segment. Made a lot of progress and continue to see good progress moving into the future. We have been a little bit more cautious there just due to some timing of implementation of strategy around tubing sets until we get this DaVita contract out of the way.

Ben Andrew – William Blair

So can we still think gross margin positive in that business by the end of the year, in the home business?

Jeff Burbank

Here is the good news, Ben. We are gross margin positive on home now.

Ben Andrew – William Blair

Okay, then I guess maybe I'm going to forget that. Okay, then the other question is, Robert, can you kind of project where your cash balance is going to be at the end of the year before the warrant exercise I assume which is an ’09 event?

Robert Brown

Let me take the cash question. I think you can – as we look at cash, we look at adjusted EBITDA for the cash burn on the P&L and we have seen good downward trend on that number and we expect to continue to see that in Q3 and Q4. Equipment for the most part – won’t be making many equipment purchases in the second half of the year. We are now manufacturing that in our own facility down in Fresnillo, Mexico; so that will be a relatively small number. We will have a little bit of change in working capital on – a little bit of negative working capital change but that should not be that impactful.

Ben Andrew – William Blair

Okay, so from a cash standpoint at the end of the year – I mean, where do you think the balance will settle?

Robert Brown

You know, right now we are not ready to give that out, but I think you can work through it with the adjusted EBITDA and what – the items in our cash flow statement.

Ben Andrew – William Blair

Okay, thanks.

Operator

Our nest question –

Kristen Sheppard

Operator, can we move to the next question please?

Operator

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

Philip Legendy – Thomas Weisel Partners

Hi, guys, good morning. I wanted to take another swing at the patient numbers here. It sounds like you no longer want to give those numbers out, but the previous guidance you gave was to new patients of 3,100 to 3,500 at the end of the year. Are you still confident in that range?

Jeff Burbank

Yes, we are making good progress towards that goal.

Philip Legendy – Thomas Weisel Partners

Okay, and can you maybe just directionally give us an idea of what the patient adds are doing, I mean, are they up, are they down?

Jeff Burbank

They are up.

Philip Legendy – Thomas Weisel Partners

Up sequentially or up year-on-year?

Jeff Burbank

Both. Yes, we are making good progress so you can kind of put a (inaudible) grand out there and we are making progress towards that, so –

Philip Legendy – Thomas Weisel Partners

Okay, so I guess maybe another question on the patient adds then – I wonder if you could give a little bit more detail on the attrition rate that you are seeing related to some of the Pureflow issues that you have had. It sounds like you are making progress but maybe give us a little more detail on what is driving your confidence there?

Jeff Burbank

Yes, I would say first off to parse out specific requirements to specific issue is always challenging. Over a broader period of time, we get better insight to it and we are only talking about a quarter’s information here. So, what we can know is we have taken some steps relative to the implementation of better practices for taking water samples and we believe that was leading to frustration. And frustration leads to lower retention or higher dropout. We have seen improvement in retention or a reduction in dropout from Q1 to Q2. I would like a little bit more time to see if that was specifically it, but there is always some other things going on in the background that – I want to point you to them, but there is always multiple things and it takes some time to sort it all out.

Philip Legendy – Thomas Weisel Partners

Okay. And maybe my last question is also on DaVita, I know that one of the issues that you talked about last quarter was that DaVita was still trying to sort out their own growth strategy for their home hemo program. Maybe give us a little bit of color on what you think they are struggling with and when you think they might come to a resolution or any kind of signs of progress that you see there?

Jeff Burbank

Yes, I would like to – when DaVita does anything because they are 40% of our patient base, it has a bigger effect, but it is the same process many of our customers go through. This is new therapy that they are trying to figure out the best operational way to implement it and execute it. So it is a learning curve and we have seen other customers go through it on varying timelines and DaVita has done a good job and it has been a great supporter and is making good progress and I think they are trying to figure out what is the most efficient way for them and effective way in terms of growth to implement this and I think they have some – not all centers are the same within DaVita, they have got some great examples of doing that, they have been making a lot of progress in that and they have some that have not been as successful; so they are working through that, and I think one thing that we talk a lot about is going deep and going deep benefits the center and it benefits the patients and it benefits NxStage and we are seeing a lot more of that, so we are focused on being successful there. So I think over time these things sort themselves out, but they can be a challenge on a quarter-by-quarter basis.

Philip Legendy – Thomas Weisel Partners

Just to push there for a sec – the go-deep strategy, is it specifically in the DaVita accounts that you are starting to see that progress or was that a comment that is more general for the business?

Jeff Burbank

More general, it is across the board.

Philip Legendy – Thomas Weisel Partners

Okay, thanks.

Operator

Your next question comes from the line of Bill Plovanic with Canaccord Adams. Please proceed.

Bill Plovanic – Canaccord Adams

Great, thank you. A couple of questions here. First, just clarity relative to the attrition rates that we have seen and kind of where we are in the cycle, you know, simply put, Jeff, have we bottomed yet?

Jeff Burbank

You know, these are multi-quarter kind of things, so I can’t say we have or we haven’t. We have seen improvement, but I don’t know if we have seen (inaudible) improvement yet; I need a little bit longer time. I'm sorry but that is kind of the reality of the situation.

Bill Plovanic – Canaccord Adams

Okay, that is fair. And then, with the FREEDOM trial, you had 202 patients, I didn’t understand the comment. I mean, you were supposed to enroll originally 500, are you just stopping at the 202, or are you still enrolling?

Jeff Burbank

No we are still enrolling and we are really encouraged. We have met the enrollment targets for doing the quality of life analysis. So, you will see some results for those and we will have a interim endpoint analysis that you will see in first half of ’09 – first or second quarter ’09. So we are really excited about having enough patients in that to start to get some – what we think will be convincing data, and we will continue to roll up to the limit.

Bill Plovanic – Canaccord Adams

And then how many centers are enrolling at this point?

Jeff Burbank

Don’t know if we have said that specifically, it is quite a few.

Bill Plovanic – Canaccord Adams

So when will we expect the quality of life analysis results?

Jeff Burbank

In November.

Bill Plovanic – Canaccord Adams

Okay, and then, relative to the sales and the distribution, the distributors in the in-center market – you know, you mentioned that their decreasing their inventories. Do you think you have seen (inaudible) we will see in the third quarter just prior to the timing of the DaVita contract and kind of once that is out of the way, you would expect inventories to go back up, and then is there any kind of granularity you can provide us with your end user sales or your direct sales and kind of what those growth rates have been so that we can get a feel for kind of what the trend of that business is?

Jeff Burbank

Sure. Let me take the first one. We were I think pretty open about the fact that Q4 and Q1, the sales in in-center were in excess of the end customer sales. So these is an inventory build there. Q2 was about the same. And customer sales and sales to the distributor were almost identical. So that is about the ongoing run rate. In Q3, we expect our sales to be less than end customer sales due to distributor adjustments in inventory just as you described. So that is a third quarter event. We haven’t seen that yet and then as you mentioned, we would expect with positive conclusion, a resolution with DaVita that those inventories would be built back to normal levels, so we would see in excess of end customer sales in the in-center sales. Your point about can you give us visibility, not prepared to do it today because we just didn’t think about that, we will take that into consideration in the future.

Bill Plovanic – Canaccord Adams

And how much impact would there be if the DaVita project was not resigned, I mean what is the overall impact to your company from a revenue or profitability standpoint?

Jeff Burbank

Bill, let us not go there yet. Let us go get the facts and we will come back to you with a complete fact set once we resolve it.

Bill Plovanic – Canaccord Adams

Okay, that is all I got, thanks.

Operator

(Operator instructions) Our next question comes from the line of Suraj Kalia with Sanders Morris Harris Capital. Please proceed.

Suraj Kalia – Sanders Morris Harris Capital

Good morning, Jeff, Robert. Jeff, given the inherent complexity in the business model, you know so many moving parts and the lack of a serious competitor as we know it in the home hemo market, can you shed some more coloring on the decision not to give out patient add-ons; if I remember correctly, you mentioned because of competitive reasons? What specific competitive rationale is being adopted because – muddy is the water in terms of trying to understand exact patient add ons.

Jeff Burbank

Well, you know it is our obligation to do what we think makes best sense for building value over time. So that wasn’t an easy decision for us, but we think our customers and our competitors knowing our exact patient numbers, especially as we are moving towards – someday, we will have competition, we fully expect that and I think you are all aware of that but it is a few years off. So we think giving ourselves a few years where nobody has visibility in the patient numbers is a good idea. So that is the rationale, don’t really want to go more deep than that because part of this is involving our business strategy and don’t want to disclose that.

Suraj Kalia – Sanders Morris Harris Capital

Okay, one last question and I will hop back in the queue. And Jeff, you know, when you look at the mod database, you come across a lot of issues in terms of lack of following protocol by patients, blood loss, venous air alarms, so to speak. Do you think that there is lack of proper training and/or ease of use as perceived by patients, which could be resulting in any retention issues. I guess fundamentally, given all the issues in the mod database that are reported with the System One, are they really affecting patient retention and/or attracting the marginal patient?

Jeff Burbank

(inaudible) though. The philosophy of NxStage is to be very, very conservative relative to disclosure of information with the FDA. I think we have built a very open and what I would say conservative to this and with – there is a program that calls it a blood loss policy that the FDA has, not all companies comply with it, we do. That greatly increases the number of disclosures. Anytime, a patient loses any blood, we call that an incident and report it. So, I think what you are seeing is a very conservative position that NxStage states from a regulatory perspective and (inaudible) to correlate them to what you just did. We don’t believe that is the issue. Does that say that we can’t make the system easier to use and better? We absolutely can and are focused on that. Well, I don’t think you tying that to dropout rates would be something that we would agree with.

Suraj Kalia – Sanders Morris Harris Capital

Fair enough. Gentlemen, thank you.

Operator

The next question is a follow up question from the line of Ben Andrew with William Blair. Please proceed.

Ben Andrew – William Blair

Hi, good morning. I was just checking my sanity. Is this the first quarter you guys have made a gross profit in the home?

Robert Brown

No.

Ben Andrew – William Blair

We were checking our gross margin model and we had you losing money in sales. So, where did you kind of flip over?

Robert Brown

You know, on a total allocated basis, beginning this year, on incremental patients, it was over a year ago.

Ben Andrew – William Blair

Right, well that I remember, but the – okay, so earlier this year, so you did get that. In terms of the progress with the switch in manufacturing down to Mexico, I mean, where are we in terms of that dynamic, is that something that is going to accelerate in terms of the benefit to the gross margin line after you get rid of those external sourcing or is this going to be sort of a slower grind to push that gross margin higher in ’09?

Jeff Burbank

There is two parts to it. There is product gross margin and that happens pretty quickly as you go through the inventory. You know, you implement it and go through the inventories. So you will see that quarter on quarter in that, the majority of the improvement just this last quarter and the quarter before. And then there is the equipment benefit and you see that not as much in the gross margin line as you see it in cash used to buy equipment. Over time, it will impact the gross margin line, but it doesn’t have as immediate an effect because you are diluting it against the entire machine base that is depreciating. That make sense?

Ben Andrew – William Blair

Yes, that does. Is there any change driver to the average selling price per patient in the home this quarter versus others?

Robert Brown

Little bit higher, with some of our contracts that renewed in the second quarter. We actually increased the price on patients that were using premixed fluids.

Ben Andrew – William Blair

How big a step is that?

Robert Brown

It is not that substantial.

Jeff Burbank

It is directionally higher but not –

Robert Brown

It is not a huge change.

Ben Andrew – William Blair

Okay, and any change –

Jeff Burbank

That is not where the gross margin positive came from.

Ben Andrew – William Blair

No, that is not where I'm going. Okay, and then in terms of just changing gears, the international market, Jeff, we still haven’t done anything or you haven’t done anything there with either distribution deal or kind of committing some resources. I know you have been real careful with cash but is there a thought process to targeting that in the next six months or twelve months?

Jeff Burbank

Yes, not ready to really talk about it – you know, I continue to do a lot of work to try to understand it and look at our opportunities and options, but we are in the analysis mode. So we will come back to you when we think we have a strategy that is workable.

Ben Andrew – William Blair

Okay, great, thank you.

Operator

(Operator instructions) Our next question is a follow up question from the line of Bill Plovanic with Canaccord Adams. Please proceed.

Bill Plovanic – Canaccord Adams

Thanks. I don’t know if you provided this or not, but just the update on the penetration of Pureflow at this point?

Jeff Burbank

Yes, it is up presently over last quarter, so you know, we are about 70% of patients on Pureflow now.

Bill Plovanic – Canaccord Adams

So it was up sequentially despite the challenges you are facing kind of – to get the CMS reimbursement.

Jeff Burbank

The CMS testing, yes; yes, it continues to grow.

Bill Plovanic – Canaccord Adams

Perfect. Thank you.

Jeff Burbank

Okay, thanks Bill.

Operator

There are no further questions on the line. I would now like to turn the call back over to Jeffrey Burbank for closing remarks.

Jeff Burbank

Great, well thank you all for your support and attention this morning. We still feel very strong about our home market growth and end customer demand in-center. Both of those are working quite well for us. Very pleased about gross margin improvement in the System One segment and our sequential progress and EBITDA. So we will keep working hard and make the progress we intend. Look forward to talking to you next quarter. Bye.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. Everyone have a great day.

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