Flexion Therapeutics' (FLXN) CEO Michael Clayman on Q3 2018 Results - Earnings Call Transcript

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About: Flexion Therapeutics, Inc. (FLXN)
by: SA Transcripts

Flexion Therapeutics Inc. (NASDAQ:FLXN) Q3 2018 Earnings Conference Call November 7, 2018 4:30 PM ET

Executives

Scott Young – Vice President-Corporate Communications and Investor Relations

Michael Clayman – Chief Executive Officer

Dan Deardorf – Senior Vice President-Commercial Operations

David Arkowitz – Chief Financial Officer

Mike Clayman – Chief Executive Officer

Analysts

David Maris – Wells Fargo

Randall Stanicky – RBC Capital Markets

Gary Nachman – BMO Capital Markets

Elliot Wilbur – Raymond James

Patrick Trucchio – Berenberg Capital Markets

Serge Belanger – Needham & Company

Bruce Jackson – Benchmark

Ken Trbovich – Janney

Operator

Good afternoon, ladies and gentlemen, and welcome to the Flexion Therapeutics Third Quarter Financial Results Conference Call. My name is Daniel and I will be your coordinator today. [Operator Instructions] I will now turn the call over to the company.

Scott Young

Thanks Daniel. Good afternoon. This is Scott Young, Vice President for Corporate Communications and Investor Relations. Both the earnings release we issued this afternoon and an archive of this call can be found on the company's website at flexiontherapeutics.com.

Today's call will be led by Flexion's Chief Executive Officer, Dr. Michael Clayman; and he is joined by Dan Deardorf, Senior Vice President of Commercial Operations; and David Arkowitz, Flexion's Chief Financial Officer.

On today’s teleconference we will be making forward-looking statements that include commercial, financial, clinical and regulatory projections. Statements relating to future financial or business performance, conditions or strategies and other business matters, including expectations regarding net sales, operating expenses, cash utilization, clinical, regulatory and commercial developments and anticipated milestones are forward-looking statements within the meaning of the Private Securities Litigation Reform Act.

Flexion cautions that these forward-looking statements are subject to various assumptions, risks and uncertainties, which change over time. Additional information on the factors and risks that could affect Flexion's business, financial conditions and results of operations are contained in Flexion's quarterly report on Form 10-Q for the quarter ended September 30, 2018, filed with the SEC today, and other filings with the SEC, which are available at www.sec.gov, as well as Flexion's website. These forward-looking statements speak only as of the date of this call, and Flexion assumes no duty to update such statements.

I will now turn the call over to Flexion's CEO, Mike Clayman.

Michael Clayman

Thanks, Scott, and thank you all for joining third quarter earnings call. Today we’ll provide an update on ZILRETTA's launch, review the progress of our clinical programs and discuss our third quarter financial performance. Following that we will open the call for Q&A.

To begin we remain very pleased with ZILRETTA's performance in the market and it’s continued growth momentum. In the third quarter we recorded net ZILRETTA of $7 million which is an 84% increase in sales over Q2. To provide some additional perspective, our Q3 sales have more than tripled as compared to sales we recorded in Q1, and while we have consistently stated that 2018 is a foundational year, everything we are seeing at this stage of the launch aligns with the our expectations for the full year and it further bolsters our confidence in ZILRETTA’s near and long-term potential.

One of the key drivers for ZILRETTA’s adoption will be the introduction of product-specific J code. And as we announced earlier this week we are very pleased that CMS issued J3304 for ZILRETTA. This dedicated reimbursement code will take effect on January 1, 2019 and it will supersede the current Q code. While Q9993 has provided more consistent and predictable reimbursement for ZILRETTA, than the miscellaneous J code we had for the first half of the year, J3304 is the most meaningful reimbursement code for our prescriber base. They have great familiarity and comfort with product-specific J codes and we believe that J3304 will serve as an important catalyst for increased uptake of ZILRETTA in the years ahead.

Dan will provide more color on the excellent progress our commercial team is making, but I can say that my personal interactions with physicians at the recent meetings of the American Association of Hip and Knee Surgeons and the American College of Rheumatology were tremendously gratifying. As I had the opportunity to hear directly from treating orthopedic surgeons and rheumatologists about how beneficial ZILRETTA has been for their patients. While anecdotal, spontaneous feedback from physicians and patients continues to grow mirroring the clinical adoption that we are seeing in the field and further bolstering our confidence in the future prospects for ZILRETTA.

Turning to our clinical development activities, our teams have made outstanding progress advancing our key trials including the Phase 3b repeat dose study of ZILRETTA. In the press release we issued today, we reported that the final data indicate repeat use of ZILRETTA was safe, well tolerated and had no deleterious effect on cartilage or joint structure. Further the data from exploratory efficacy endpoints are highly encouraging. For background this was an open label trial where 205 patients received ZILRETTA and as we have previously reported, 95% experienced clinical benefit as determined by both patient and physician assessment. 92% of these patients received a second injection between weeks 12 and 24 with a median interval of 16.6 weeks. Those patients saw similarly marked improvements from their baseline pain scores after each injection which was maintained throughout each injection period.

A critical component of this trial was an analysis of X-rays taken at baseline and again at week-52. The results from these radiographs show already ZILRETTA had no deleterious effects on cartilage as there were no observations of chondrolysis, osteonecrosis, insufficiency fractures or clinically significant subchondral bone changes. In addition, ZILRETTA was well tolerated with an adverse event profile comparable to that seen in our Phase 3 study, which was indistinguishable from placebo.

We have submitted the full results for our publication in a peer-reviewed journal and we will of course keep you posted once it is published. Further based on these positive results, we intend to file a supplemental NDA before year end with the aim of having the repeat dose limitation of use statement completely removed from the label. We believe it is likely that the FDA will conduct a 10-month review. So we anticipate a PDUFA date in the second half of next year.

Additionally, following a face-to-face meeting with FDA in July, we filed a labeling supplement with the agency as an interim step to address the LOU. We requested, they revised the LOU and specifically removed the words not intended for repeat administration from the label. As we have stated since approval, we have vigorously disagreed with this language as we believe it is not supported by any relevant data and it is inappropriate and confusing. While the FDA is not bound to a specific review period, based on precedence, we believe they may return to us with a decision in the first half of 2019, although we cannot exclude the possibility that the FDA will elect to focus on the supplemental NDA review to the exclusion of the labeling supplement.

With respect to recent publications and presentations, in September the full results from our double blind randomized Phase 2 study evaluating blood glucose levels in patients with osteoarthritis knee pain and controlled Type 2 diabetes were published in the online edition of the peer-reviewed journal, Rheumatology. The paper shows that the study met its primary endpoint, demonstrating that the change in blood glucose levels was significantly lower following ZILRETTA injection, than immediate-release triamcinolone acetonide or TA injection in people with OA knee pain and controlled Type 2 diabetes.

The primary endpoint compared the change in average glucose values over 72 hours before to 72 hours after injection for ZILRETTA versus immediate release TA. Additionally on October 22, at the American College of Rheumatology Annual Meeting, we presented positive results from our Phase 2 clinical trial evaluating the safety and pharmacokinetics or PK of bilateral injections of ZILRETTA compared to immediate-release TA. The data showed that systemic exposure to triamcinolone acetonide was significantly lower in patients given ZILRETTA, compared to those given immediate release TA, with maximum plasma concentrations nearly 10-fold lower. Safety profiles were similar for ZILRETTA in immediate release TA groups.

Regarding our Phase 2 open label study evaluating the safety and PK of ZILRETTA in patients with OA of the shoulder or hip, known as the SHIP study, it remains on track. As we reported last quarter, the study completed enrollment and due to the 24 weeks of follow-up results are anticipated by year end and we will keep you apprised of the findings once they are available.

Finally, in October, we initiated GLP toxicology studies for FX201, our intra-articular gene therapy product candidate for the treatment of OA. FX201 is designed to produce human interleukin-1 receptor antagonist or IL-1Ra, whenever inflammation is present within the joint. As previously described, we believe that the available data support the potential for FX201 to provide prolonged inflammation-dependent IL-1Ra production in the joint to confer persistent and meaningful pain relief and to modify disease progression. We look forward to the prospect of initiating trials in patients to begin generating defining clinical data, which, of course, would follow filing the IND in the second half of 2019, pending supportive GLP tox data.

In summary, our medical regulatory, manufacturing, clinical development and early research teams have done outstanding work to potentially enhance the label and expand the indications for ZILRETTA and to strengthen our pipeline by advancing an exciting preclinical program, which we believe has the potential to be truly game changing. Coupled with the growing commercial success of ZILRETTA, we very much like where we are and where we're headed as a company.

I'll now turn it over to Dan.

Dan Deardorf

Thanks, Mike. To begin, I'd like to underline the sentiment that Mike expressed in his opening comments. This launch is squarely on track, and we remain bullish about ZILRETTA's potential to provide rapid, substantial and extended pain relief from millions of patients who confront OA of the knee.

As we've discussed, third quarter was marked by significant sales growth, which reflects the increasing adoption and expanding clinical interest in ZILRETTA. Our teams have done an excellent job executing our plan, and that's clearly reflected in the commercial launch metrics we are sharing today. As a reminder, we report these metrics to give our investors and analysts a better sense of how this launch is advancing across several dimensions. And the encouraging numbers we are reporting today reflect that progress. But I'd also like to provide some additional color that further illustrates the depth, breadth and overall impact our teams are having in the marketplace.

By the end of the third quarter, our musculoskeletal business managers and field access managers have conducted product preparation training or held in-depth reimbursement discussions at 80% of our approximate 3,700 target accounts. This is a leading indicator since generally speaking accounts do not participate in these types of deep interactions unless they have a strong clinical interest in using the product. Tracking very closely with this metric, is the number of target accounts that have purchased or received samples of ZILRETTA. As of September 30, roughly 78% of accounts had experience with the product, whereas that number was approximately 60% at the end of Q2.

Looking at the number of ordering accounts that are placed at least one reorder for additional product, again, we see a very strong quarter-over-quarter increase. By the end of Q3, 64% of our target accounts had reordered versus 56% at the end of the previous quarter.

With respect to reimbursement, we have now had interactions with commercial payers covering the vast majority of patients in the country. In total, our market access team has engaged with 48 key commercial insurers who represent approximately 225 million people or 75% of all commercially covered lives in the U.S. This team continues to engage with payers based on customized plans to educate them on the clinical utility and value of the product and to influence their policies. In addition, commercial insurance coverage for ZILRETTA remain strong throughout the third quarter, with more than 95% of benefits verifications process with FlexForward indicating coverage of ZILRETTA.

With respect to our marketing efforts, we have a comprehensive multipronged direct-to-patient, or DTP campaign, under way. And we will continue to ramp up those activities in anticipation of the J code. We're also in the final stages of unveiling a targeted television ad pilot, and we intend to run these test ads in select markets during the first half of next year. We will closely monitor and analyze the impact of those spots and use that information to decide on a broader television campaign.

Regarding our physician peer-to-peer educational programs, we have more 55 physicians now fully engaged in our Speaker's Bureau and have conducted hundreds of programs; as well we have increased our presence at Regional Medical Society meetings. Additionally, we continue to build our presence at major medical congresses and we recently had significant activities at both the ACR and Hip and Knee Society meetings in October and November, respectively.

To close, we remain pleased with the progress of ZILRETTA's launch. The important place of ZILRETTA is establishing the treatment paradigm for patients with OA knee pain and the effectiveness of our commercial team of extraordinary and committed professionals.

With that, I'll turn it over to David.

David Arkowitz

Thanks, Dan. I will briefly review the financial highlights for the third quarter of 2018. We reported a net loss of $43.6 million for the third quarter of 2018 compared to a net loss of $34.2 million for the third quarter of 2017. Net sales of ZILRETTA for the third quarter of 2018 totaled $7 million and the cost of sales was $1.6 million for this period.

The third quarter net sales reflects a gross to net reduction of 9%, which is consistent with our gross to net percentage reduction in both the first and second quarters of this year. The gross to net reduction is primarily comprised of distributor fees, returns reserve and mandatory government discounts and rebates, such as Medicaid 340B institutions, VA and DoD. As we don't provide and we don't have plans to provide end customer rebates or discounts, we expect our gross to net percentage reduction to be in the low teens over the ensuing quarters.

Research and development expenses were $13.6 million for the third quarter of 2018 compared to $12.8 million for the same period in 2017. The $0.8 million increase in R&D expenses was primarily due to an increase in salary and other employee-related costs associated with additional headcount and increased stock-based compensation expense and an increase in preclinical expenses related to portfolio expansion and other program costs, partially offset by a decrease in ZILRETTA clinical development expenses.

Selling, general and administrative expenses were $32.8 million and $18.4 million for the third quarters of 2018 and 2017, respectively. Selling expenses were $23.7 million and $9.7 million for the third quarters of 2018 and 2017, respectively. The $14 million increase in selling expenses was primarily due to salary and other employee-related costs associated with additional headcount and cost to establish commercial, marketing and sales capabilities.

General and administrative expenses increased by $0.4 million in the third quarter 2018 compared to the same period in 2017. Interest expense was $3.9 million and $3.8 million for the third quarters of 2018 and 2017, respectively.

As of September 30, 2018, the company had $302.9 million of cash, cash equivalents and marketable securities compared with $423.9 million as of December 31, 2017. Our net cash burn for the third quarter, which is the change in our cash balance from the beginning to the end of the quarter, was approximately $38 million. We believe that our current cash balance with expected future sales of ZILRETTA will bring us to profitability.

We do expect our operating expenses to increase over the next several years primarily driven by commercial activities in support of ZILRETTA, line extension clinical trials for ZILRETTA in OA of the hip and shoulder, continued development of FX201 and development activities associated with future additions to the pipeline.

At this point, I would ask the operator to please open the line for questions.

Question-and-Answer Session

Operator

Thank you. That concludes our prepared remarks. We will now open the all for questions. [Operator Instructions] Our first question comes from David Maris with Wells Fargo. Your line is now open.

David Maris

Good afternoon and congratulations on the great ramp up. So a lot of questions during the quarter had to deal with some competitor noise out there. And even though they are years away, Mike, maybe you could just address what you would say to an investor that raised the concern about these competitors, and specifically Centrexion and TLC. Even though I know you don't like to talk about competitors because ZILRETTA is really the focus, but just from the delivery of Centrexion, that drug, as well as the potential, what does it say to you about hyperglycemia event risk for TLC's drug? From a doctor's perspective what do you think the pushback would be if those drugs are approved knowing that they are several years away anyway? Thank you.

Dan Deardorf

Thanks David. In general we spend 99.9% of our time focused on ZILRETTA and its success. We certainly don't turn a blind eye to potential competition. We're deeply familiar with Centrexion compound and the approach what we've learned we believe is that it requires a fair amount of preparation before it can be administered. And we think that that's a challenge that we’ll have to get worked through. As it relates to hyperglycemia with a different competitor product all we know is that there were several reports with that product sustained release steroid from TLC and it does beg the question, what are the release kinetics in the joint and do you do achieve plasma concentrations that might induce hyperglycemia?

At the end of the day David it’s all about the data. And we will continue to follow with great interest, but I want to stress that our clear and consistent focus is on ZILRETTA and its success.

David Maris

Great, thank you.

Michael Clayman

Thanks David.

Operator

Thank you. And our next question comes from Randall Stanicky with RBC Capital Markets. Your line is now open.

Randall Stanicky

Great, thanks guys. Mike or Dan as you guys have looked at past analogs for companies that have gotten, their products have gotten new J codes, turn on Jan 1, how are you thinking about, just to set expectations, how are you thinking about that ramp? I mean there's a number of things going on right, the new J code coming on January 1. I suspect the seasonality aspect to the early year timeframe and then the fact that ZILRETTA is clearly ramping as evidenced by the 3Q result that you reported this afternoon. So just to set expectations, how should we think about that ramp as the J code turns on?

Michael Clayman

Yes I think we are going to be in a position to remove mystery from that Randall. We will provide guidance in the first quarter of next year when we report our fourth quarter and full year results for 2018. So we want to be sure that there is no misunderstanding about where we stand on projected sales in 2019. So it simply says stay tuned there. As you point out, there are a lot of moving parts we will integrate those into our estimate.

Randall Stanicky

Okay. And let me ask a follow-up Dan. You talked about physicians and the reorders and some of the traction you had there in the quarter. If I was to flip it around and say of the physicians who haven't ordered ZILRETTA yet or perhaps who haven't reordered, what's the rationale or the pushback or feedback that you've gotten from some of those folks?

Dan Deardorf

Yes I think that that dovetails out of your first question which is those physicians, those practices that we haven't seen start using the product yet, it's a reimbursement question, either from the physician or from their office. So the J code will go a long way into opening up those accounts for us. So that's the predominant issue. With respect to reorders it is likely that physicians who particularly are on the J code, if they were not in the game so to speak, because of the miscellaneous J code and started to get some experience with the Q code, they likely went slow and they're waiting to get their clinical feedback in due time in three, four months, however long it takes for their patients to come back.

So I would say for those that have ordered and not reorder again it's a matter of being a little later to the game and still needing to see the clinical feedback.

Randall Stanicky

Okay. Great thanks guys.

Michael Clayman

Sure.

Operator

Thank you. And our next question comes from Gary Nachman with BMO Capital Markets .Your line is now open.

Gary Nachman

Hi, good afternoon. First how does the diabetic benefit the resonating because in recent physician conversations we've had, it seems to matter a lot. And then how concentrated are the orders in your targeted account? Is it sort of like the 80-20 rule? And then if the shift data are positive, what are the next steps there?

Dan Deardorf

Okay, I'll take the first one first Gary. As we're out there with clinicians we see them in general migrating to three primary patient types as their first patients to treat are the ones that make the most obvious sense to them. The first is the diabetic patient for obvious reasons. And a lot of times that's the first patient type that a physician will treat. The other patient type that we hear getting a lot of usage, patients who have failed therapies, or multiple other therapies and therefore are trying ZILRETTA and we're hearing lots of anecdotes of the product working very well in the patients for which other things had not worked well.

And the last is patients that are non-surgical candidates. So those are three primary and each of them large buckets of patients that rise to the top with physicians. I would say the diabetic patient if there was one of those that was more likely to rise to the top to be the first patient to treat, it is going to be the diabetic patient. We hear that from physicians anecdotally, we see that some of the surveys that we've conducted as there is an additional reason to treat those patients.

So certainly is resonating as a viable product. We have a hard time tracking patient data, so we can't quantify that, but by every stretch that we're hearing, I would expect that we're seeing disproportionate use in the diabetic patient at this point in time.

Michael Clayman

As it relates to the hip and shoulder study Gary that will set the stage for additional studies for label expansion. Specifically we will initiate the hip registration trial before the end of the year. And we will initiate additional work in shoulder in 2019 We’re particularly interested in not only osteoarthritis, but we're actively considering initiating a trial next year in adhesive capsulitis or so-called frozen shoulder, an incredibly painful condition in which diabetics are disproportionately represented. 20% of the injected OA population has diabetes almost 40% of the adhesive capsulitis or froze shoulder population is diabetes. And it's a place where steroids are currently being injected.

So I'd say stay tuned, but we are proceeding aggressively and with the highest levels of rigor around understanding exactly how our product might get expanded into other joints.

Gary Nachman

Okay. One other question I had that Dan you didn't get to is just how concentrated are the orders in your targeted accounts? I want to get a sense if it's like 20% of the accounts are responsible for 80% of the orders. And then one last one just in the repeat dose study, the X-ray data like in how many of the 205 patients do you have X-ray data? Thanks.

Dan Deardorf

Gary that in excess of 150 patients, that we have X-ray data in. And we think that's a very healthy database that from our perspective provides a reassuring dataset to demonstrate the absence of deleterious effect on join architecture.

Michael Clayman

Yes, with respect to the concentration within ordering accounts, we have not got into specifics around that. I will just say that we – there in many cases seems to be a bit of a tipping point with practices where once they start to get rolling, they really start to get rolling, but we have not been specific about the breakout there.

Gary Nachman

Okay. Thank you.

Dan Deardorf

Thanks Gary.

Operator

Thank you. And our next question comes from Elliot Wilbur with Raymond James. Your line is now open.

Elliot Wilbur

Thanks. Good afternoon. First question for Mike, I appreciate the fact that we're going to get a more detailed outlook from the company in the first quarter of 2019. But previously you had talked about comfort with the then existing consensus estimates for 2018 and 2019 which have come down a little bit since that point of time. Just sort of wondering kind of how you're thinking about those metrics? I guess the specifically 4Q estimate?

Michael Clayman

Yes let me be very clear Elliot. Thanks for the question. We are very comfortable with the 2018 full year consensus estimate. And we will provide guidance, as I said before, for 2019.

Elliot Wilbur

Okay thanks. And obviously there's been a lot of noise out there with respect to potential competitive agents in various stages of development but also been a lot of noise in terms of movement and the reimbursement environment, particularly changes in both Medicare Part D and obviously Part B, which impacts you a little bit more.

So just doesn't seem like anything that has been proposed from the administration necessarily is going to impact or intersect with Flexion's will, but just want to get may be your perspective on some of the key macro developments on the reimbursement front that you guys are monitoring that we should be thinking about.

Dan Deardorf

Surely, it's Dan. I think the first thing with respect to part B reimbursement, for people to remember or to understand is that any broader sweeping changes to part B reimbursement requires legislation. So I think that's just an important backdrop for people to remember. That said, if we think about the proposals that are out there now, they're largely focused on high cost drugs and also around transparency with respect to pricing a discount. At a price point 570, ZILRETTA is not a high priced product. And frankly we've generated solid health economic data that supports the value of the product. So we don't see ourselves in that realm.

The other thing to consider is we don't provide discounts to providers. So in many respects we're already aligned with the transparency goals that many of these proposals are aimed at. So we feel good about feel good about that.

And lastly, ex-U.S. reference pricing is something that's been thrown out there. As you know ZILRETTA is not sold outside the U.S., so that would not be applicable to us as well in the realm of these proposals. So by and large and in summary, we don't see any were any impact of these proposals on ZILRETTA.

Elliot Wilbur

Okay. And one last question for you Dan as well. Based on your various payor engagement activities to date with respect to engagement on the commercial side as payors implement various coverage policies and the like, I mean what are you seeing with respect to ZILRETTA for the policies that have been established in terms of is it requiring step through theory may be through IRTCA? And just how is – how do these policies look versus what you had originally expected?

Dan Deardorf

Yes I think I’ll first start by saying we’re extremely pleased with the broad access that we've got now. We've got full and complete coverage of Medicare, which is half the market and that's open for initial, as well as repeat treatment. And as we said in our prepared remarks we're still seeing 95 plus percent successful coverage or benefits of investigations through FLEXFORWARD. So on the commercial front we've still got broad coverage there as well.

As there have only been a few policies that have been written, we've seen some step edits, not unexpected to us. In fact expected, given the fact that there is a $10 steroid out there. So we expected that it would be logical as it is with the HA categories for them to step us through.

So in the limited places where we've seen policies we have seen step-throughs there. And we have seen the limitation of use language come through. What that means in many of these policies is still unclear because we've seen some of these policy that have a limitation of use where we've seen paid repeat treatment claims. So that's it. That's frankly an area of confusion with the payers at this point in time, the limitation of use and one which we think the repeat treatment data that we announced here earlier today will go to great lengths to help educate and inform payers as they're creating their policies.

Elliot Wilbur

All right. Thank you.

Michael Clayman

Thanks, Elliot.

Operator

Thank you. And our next question comes from Patrick Trucchio with Berenberg Capital Markets. Your line is now open.

Patrick Trucchio

Great, thanks, and good afternoon, everyone. So regarding the limitation of use in the label, just a follow-up there and the supplemental NDA filing. Is this just going to be a standard 10-month review?

Michael Clayman

Yes.

Patrick Trucchio

And then, in terms of your anticipated guidance for 2019, how important is the label or vision ultimately the removal of this LOU entirely from the label for the uptake of ZILRETTA next year?

Michael Clayman

Yes. I will say this, Patrick that we've appropriately integrated a reasonable expectation about what the LOU going away will look like in next year. There is an assumption that it will at least be modified, ideally go away entirely. We’re going to speculate on specific timeframe, but it will – other than to say that we believe that the data that we're submitting supplemental NDA gives us a very strong foundation for a reasonable expectation.

Patrick Trucchio

Okay. And then just on the hip and shoulder. If everything goes as expected with the clinical development for OA hip and shoulder, when is the earliest you believe you could submit supplemental applications for each indication there? And related to this, would you have to submit new and/or separate J code applications for those indications? And if so, when would be the earliest you could have dedicated J code for those indications? Thank you.

Michael Clayman

Yes. So thanks, Patrick. Let me -- let's turn it over to Dan to answer the second half of your question, and I'll answer the first half.

Dan Deardorf

Yes. Since ZILRETTA would be used at the same dosage in those indications, it would still have its own code that could be submitted for reimbursement. They would just need to specify the joint et cetera. And if it's approved for that indication, particularly in Medicare and the cross-commercial payers would be covered.

Michael Clayman

As it relates to timelines for hip and shoulder, Patrick, it would say stay tuned. We're finalizing those timelines and we have them locked down, we'll be in a position to share them.

Patrick Trucchio

Got it. Thanks guys.

Michael Clayman

Thank you.

Dan Deardorf

Sure.

Operator

Thank you. And our next question comes from Serge Belanger with Needham & Company. Your line is now open.

Serge Belanger

Hi, good afternoon. First a question on the sNDA that you'll be submitting in the fourth quarter. Clearly, the goal is to remove the LOU, but do you think you'll be able to update the label with the data that you generated in the repeat dose studies similar to the graphs that are currently included reflecting the results of the pivotal studies?

Michael Clayman

Yes, it’s – let me just say this, Serge, top of mind for us is moving the LOU. We certainly would expect and hope that these data are shown in the clinical trial section because they so importantly inform the prospective on this. But as we've said many times before, you predict exactly what the FDA will do with this data at your risk, so we can’t say with certainty. We're just saying as a statement of logic, they should be included. And I'll just stop there.

Serge Belanger

Okay. And then, in terms of the reimbursement codes, the J code will take effect on January 1, 2019. But I think earlier this year you were granted a C code for administration in the hospital outpatient setting. Will that now be covered by the J code? And I guess how important is that segment to current sales?

Dan Deardorf

Yes, it will – actually, the Q codes already sub planted the C code in the hospital outpatient settings and the J code will sub plant that, so it will be across the board.

Serge Belanger

Okay. And then one last one. As we think of the market in shoulders and hips, in the same market dynamics supply here in terms of 15% to 20% of diabetes patients as well as the corticosteroid and hyaluronic acid usage?

Dan Deardorf

Yes. They're comparable, particularly from a diabetes perspective the rates around 20% as well. And the use of steroids is equally, if not more, utilized there, as hyaluronic acids are not approved for that indication.

Michael Clayman

The vast majority of hyaluronic acid uses in knee, whereas steroids are more democratically attributed across joints.

Serge Belanger

All right. One last one for Dan. Can you just talk about ZILRETTA's inventory levels that are currently in the channel?

Dan Deardorf

Yes. I should turn that over to David.

David Arkowitz

Yes. Hey, Serg, it’s David. So I think, as you know, we sell to specialty distributors. We target inventory levels at one to three weeks with those specialty distributors. We closely manage and monitor the inventory levels at those customers. And in fact, the agreements we have with them mandate that they maintain inventory in the one- to three-week timeframe. And I'm happy to say that we ended the third quarter with our inventory levels squarely in that range.

Serge Belanger

And is that stable from the prior quarter?

David Arkowitz

Yes.

Serge Belanger

Okay. Thank you.

Michael Clayman

Thanks, Serg.

Operator

Thank you. [Operator Instructions] Our next question comes from Bruce Jackson with Benchmark. Your line is now open.

Bruce Jackson

Hi. I wanted to get back to the repeat administration study and the finding that there is no deleterious effect on cartilage or join structure. One of the knocks on immediate-release corticosteroid is the cartilage damage. And I was wondering if there is a way that you could use that for marketing purposes or if you're seeking any labeling for that?

Michael Clayman

Well, I'll just say this, Bruce. I think that the deleterious effects of steroids on immediate-release steroids on joint architecture is there is a range of view of the strength of the data on that, but there is certainly a sensitivity out there. We would hope, as a matter of informing the prescribing physician that the key elements, particularly the safety elements of the repeat dose study, including x-ray, would be included in some fashion in the label that's in front of us. We think that's important information and we would use it appropriately.

Bruce Jackson

Okay, great. And then my other question is about repeat order rate and the increase in incremental revenues. In addition to having more reorders and a higher rate of reorders, are doctors at all increasing the size of their orders as they gain familiarity with the product?

David Arkowitz

Yes. On average, we're seeing increase in size every order.

Bruce Jackson

All right. That’s it from me. Thank you.

Michael Clayman

Thanks, Bruce.

Operator

Thank you. And our next question comes from Ken Trbovich from Janney. Your line is now open.

Ken Trbovich

Hey, guys. Congratulations on the nice sequential increase. I guess, I’d like to start maybe with a question for David around how the gross margins – the sequential growth certainly seemed helped margin a little bit. I just wanted to make sure we all sort of understand how much volume matters when it starts to relate to margins for example in 2019 and out years when volumes should be significantly higher obviously than what we just saw?

David Arkowitz

Yes. Sure, Ken. So this is David. So as you can appreciate it is early days from a manufacturing standpoint. And there's inherent variability in our costs to sales as sales are ramping up at this point in time. As we get to steady state, and as we are manufacturing significantly more in terms of volume, then we think we will get to about 90% gross margin. We haven't given any – actually, it’d be premature to give any specific guidance on when that will happen, but that's what we're targeting in the future.

Ken Trbovich

Okay. And in terms of steady state and I think one of the major initiatives that was undertaken during the preparation for filing the NDA was actually switching manufacturing from Evonik to Patheon. Can you help us understand what sort of implications that had for total capacity or capability? Not that we're going to hit that now, but just longer term so that we have comfort with the sort of current statuses as it exists now?

Michael Clayman

Yes, Ken, this is Mike. The switch from Evonik to Patheon went incredibly well and it was driven by the kinds of capacity that Patheon can offer us in a condo model. So this condo model is we take possession of a suite, we populate it with our own equipment. We're furnished with excellent operator from Patheon who run the process for us. We have the latitude to run that process as often as we like. So it gives us tremendous capacity, flexibility, and that was one of the drivers. Let me just say that even on – under the most optimistic expectations for this product, we feel very good about the inventory that Patheon can provide.

Ken Trbovich

Okay. And then just last question. Mike, I think you mentioned in the prepared comments an effort with a labeling supplement to perhaps get the limitation of use removed. Can you explain that a little bit more? And is there a historical precedent that your regulatory attorneys perhaps have identified it as the recent approach?

Michael Clayman

Yes. So, we – Ken, it's a little complicated. I'll try to keep it as simple as possible. We filed a labeling supplement attacking the basis for the language that was embedded in the LOU, as lacking regulatory precedent in consistent with previous regulation and guidance. We thought it was inappropriate to have that language in there based on the available data. And so we filed a labeling supplement. We met with the agency, we explored the filing of such a labeling supplement and they opened the door for us to do so.

So that path – you can think of that path is not necessarily being the path to removing the LOU but path to removing the language not intended for repeat administration. Unfortunately, a labeling supplement is not under a PDUFA clock. Then it becomes open ended. And in a division that is working as hard as app is, that kind of application can be put to the side. We originally hope and expected they would rule on that by the end this year. They indicated to us that they would not be in a position to rule on it before well into next year.

And the original strategy of filing the supplemental NDA with the repeat dose data, which has a 10-month PDUFA clock on it to remove the LOU, was predicated on the assumption of a speedy labeling supplement review, which is not happening and as a result we took a step back and said, let's go ahead. File the supplemental NDI with the new data, accept the 10 months clock and take a more definitive and assertive approach to that undesirable element in the label.

Ken Trbovich

Makes complete sense. Thanks for the explanation.

Michael Clayman

Thank you, Ken. Yes, Daniel.

Operator

Thank you. There are no additional questions at this time. I would now like to turn the call back over to Mike Clayman for any further remarks.

Michael Clayman

Simply to say, thank you all for attending, and leave you with the perspective that we have going forward. There's never been a more exciting time to be at this company. We couldn't be more bullish about our prospects or more excited about the difference that ZILRETTA is making for so many patients in the marketplace. And with, we'll close.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program, and you may all disconnect. Everyone, have a wonderful day.