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Edited Transcript of INGN earnings conference call or presentation 7-May-19 8:30pm GMT

Q1 2019 Inogen Inc Earnings Call

GOLETA May 14, 2019 (Thomson StreetEvents) -- Edited Transcript of Inogen Inc earnings conference call or presentation Tuesday, May 7, 2019 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alison Perry Bauerlein

Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer

* Matthew James Bacso

Inogen, Inc. - IR & Corporate Development Manager

* Scott Wilkinson

Inogen, Inc. - CEO, President & Director

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Conference Call Participants

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* Christian Diarmud Moore

JP Morgan Chase & Co, Research Division - Analyst

* Danielle Joy Antalffy

SVB Leerink LLC, Research Division - MD of Medical Supplies & Devices and Senior Analyst

* Jonathan Preston McKim

Piper Jaffray Companies, Research Division - VP & Senior Research Analyst

* Malgorzata Maria Kaczor

William Blair & Company L.L.C., Research Division - Research Analyst

* Mathew Justin Blackman

Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst

* Matthew Ian Mishan

KeyBanc Capital Markets Inc., Research Division - VP and Senior Equity Research Analyst

* Michael Stephen Matson

Needham & Company, LLC, Research Division - Senior Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the Inogen 2019 First Quarter Financial Results Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Matt Bacso, Investor Relations Manager. Please go ahead.

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Matthew James Bacso, Inogen, Inc. - IR & Corporate Development Manager [2]

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Thank you for participating in today's call. Joining me from Inogen is CEO, Scott Wilkinson; and CFO and Co-Founder, Ali Bauerlein.

Earlier today, Inogen released financial results for the first quarter of 2019. This earnings release and Inogen's corporate presentation are currently available in the Investor Relations section of the company's website.

As a reminder, the information presented today will include forward-looking statements, including statements about our growth prospects and strategy for 2019 and beyond, sales personnel strategy changes, rental strategy changes and the timing of an impact of such changes, hiring expectations, expectations for all sales channels including international tender activity, marketing expectations, the rollout of Inogen One G5, expectations regarding the impact of Chinese tariffs, competitive bidding, HME strategy and expectations and financial guidance for 2019.

The forward-looking statements in this call are based information currently available to us. These forward-looking statements are only predictions and involve risks and uncertainties that are set forth in more detail in our most recent periodic reports filed with the Securities and Exchange Commission. Actual results may vary, and we disclaim any obligation to update these forward-looking statements, except as may be required by law.

We have posted historical financial statements in our first quarter investor presentation in the Investor Relations section of the company's website. Please refer to these files for more detailed information.

During the call, we will also present certain financial information on a non-GAAP basis. Management believes that non-GAAP financial measures taken in conjunction with U.S. GAAP financial measures provide useful information for both management and investors by excluding certain noncash items and other expenses that are not indicative of Inogen's core operating results. Management uses non-GAAP measures internally to understand, manage and evaluate our business and make operating decisions. Reconciliations between U.S. GAAP and non-GAAP results are presented in tables within our earnings release.

For future periods, we are unable to provide a reconciliation of our non-GAAP guidance to the most directly comparable GAAP measures without unreasonable effort as discussed in more detail in our earnings release.

With that, I'll turn the call over to Inogen's President and CEO, Scott Wilkinson. Scott?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [3]

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Thanks, Matt. Good afternoon, and thank you for joining our first quarter 2019 conference call.

Looking at the first quarter of 2019, we generated total revenue of $90.2 million, reflecting growth of 14.1% over the first quarter of 2018.

Direct-to-consumer sales of $39 million in the first quarter of 2019 increased 35.9% over the first quarter of 2018 primarily due to increased sales representative headcount and associated consumer advertising. However, the sales reps we hired in the second half of 2018, on average, took longer to come up the productivity curve than our historical target and were not at their full potential in the first quarter.

Moving forward, we plan to slow down the addition of new sales representative hires and focus on improving the productivity of our sales team. Over the last 2 quarters, we have also applied with it a separate rental team that will focus exclusively on new rental additions to drive overall sales productivity. And we plan to roll this out across our entire group in the coming quarters.

As we've continued to grow our sales staff and the associated number of required leads has grown, we have seen the cost per generated lead trend higher than historical averages. We believe we will see increased productivity of our sales reps throughout 2019, which should reduce our overall cost per sale despite expected increased marketing spend.

First quarter 2019 domestic business-to-business sales of $26.1 million decreased 7% from the first quarter of 2018 primarily due to a decline in sales to our private label partner. These sales declines were a partner due to one large national home care provider who significantly reduced orders in the first quarter of 2019 as compared to the same period in 2018.

Specifically, this provider who we discussed in our last earnings call accounted for revenue of $700,000 in the first quarter of 2019, down from $9.3 million in the first quarter of 2018.

Excluding this provider, we continue to see strong demand from traditional HME customers. We expect domestic business-to-business sales in the remainder of 2019 to be negatively impacted by significantly lower order activity from this provider, who slowed their purchases beginning in September of 2018.

Due to the ongoing restructure challenges some HME providers faced, we continue to look for ways to partner with providers to drive POC adoption. We do plan to slightly change our rental intake criteria to accept more new rental patient additions to increase access to patients who otherwise could not obtain a POC from their current home care provider.

Since rental reimbursement revenue is recognized monthly compared to the mostly immediate revenue recognition of direct-to-consumer sales, we don't expect a meaningful rental revenue benefit from increasing new rental setups until next year and beyond.

While we expect rental revenue to take time to ramp, we believe we can improve our close rate and lead usage by slightly altering our intake criteria for rental patients. Historically, our remaining billable months threshold was high, which limited the number of patients we accepted through Medicare.

Going forward, we plan to lower this threshold to improve sales representative productivity and lead usage. In changing our rental intake criteria, our guidance assumes an adverse impact on near-term sales revenue in the U.S. But we believe it will lead to increased conversion rates and increased POC adoption.

First quarter of 2019 rental revenue of $5.4 million decreased 1.5% compared to the first quarter of 2018 primarily due to an 11.5% decrease of patients on service partially offset by higher rental revenue per patient.

We had approximately 26,200 patients on service as of the end of the first quarter of 2019. And while we expect it will take some time to change the intake criteria and scale the separate rental teams, we do expect that rental patient count to start increasing in the back half of 2019. First quarter of 2019 international business-to-business sales were strong at $19.8 million, representing as reported growth of 17.1% and 22.3% on a constant currency basis.

Despite no meaningful tender activity in the quarter, underlying European demand trends remain healthy. We still expect European tenders in 2019. Although, we do not include any revenues associated with these potential tenders in guidance. We also saw a strong growth in Canada, Australia and South America. Although, these markets are much smaller than the European market.

Moving to product development. We are proud to say that we officially launched the Inogen One G5 in our direct-to-consumer channel in April. And only 4.7 pounds and 6 flow settings, the Inogen One G5 represents a step forward in innovation as we believe it is the highest oxygen output per pound of weight of any portable oxygen concentrator currently available in the United States.

With 1,260 milliliters of oxygen production capacity per minute and Inogen's standard Intelligent Delivery Technology, the Inogen One G5 was designed to meet the clinical needs of approximately 95% of the ambulatory long-term oxygen therapy patients who contact us.

Other patient-preferred features include a long battery life of up to 13 hours with the optional double battery, access to Inogen Connect, a large LCD screen and very quiet operation. Given these favorable product features and limited manufacturing capacity at launch, we initially priced the Inogen One G5 at a premium relative to the Inogen One G3 and G4 systems. We plan to reduce retail pricing to parity with the other Inogen One products, once manufacturing can support the volume demand.

Once volume has increased and pricing has been optimized, we still expect the Inogen One G5 to obsolete the Inogen One G3 over the intermediate term in all sales channels. We expect to roll out Inogen One G5 to the domestic business-to-business channel over the summer. And then to the international business-to-business channel by the end of the year pending standard regulatory clearances in each market.

On the topic of competitive bidding around 2021, we expect the bidding process to begin in July 2019. It has been announced that oxygen equipment and supplies will be separate from CPAP equipment and supplies and respiratory assist devices, which we had expected. All of the other previously announced changes to the competitive bidding program appear to be incorporated, including lead item pricing, surety bond requirements and setting the bid amounts at the maximum bid amount instead of the medium bid amount. The program has been structured to have the oxygen lead item the HCPCS code E1390, which is the billing code for stationary oxygen.

While the other oxygen codes are established by applying a factor by the ratio of that code to E1390 based on the 2015 Medicare fee schedule. However, due to the lead item pricing methodology being dependent on the 2015 standard Medicare fee schedule, portable add-on code reimbursement rates would be reduced even if E1390 reimbursement rates do not change.

We do plan on bidding in 129 out of the 130 regions covered under the program. Although, we cannot discuss our pricing strategy publicly. We don't expect winners or new pricing to be announced until 2020 based on the timing of these announcements in prior rounds.

As a reminder, in the last round of competitive bidding, we won 103 of the 130 regions. So we had access to most regions covered under the Medicare competitive bidding program.

Lastly, as a reminder, excluding annual inflation and budget neutrality adjustments, the 2021 competitive bidding round pricing is expected to be in effect for 3 years.

Looking at 2019, we are reducing full year 2019 total revenue guidance to $405 million to $415 million, down from $430 million to $440 million, representing growth of 13.1% to 15.9% versus 2018 full year results. This revenue range takes into account the difficult growth comparisons we face in the domestic business-to-business channel, restructuring challenges some HME providers are facing, the decreased planned direct-to-consumer hiring as well as our plan to increase rental setups. We plan to increase rentals in a balanced fashion to not alienate the great relationships we've already created with our home care provider customers across the United States.

For those providers who are adopting Inogen technology and converting their businesses, we plan to continue to support them to help fulfill that mission. And we will continue to drive patient awareness. We believe that the market for POCs remains under-penetrated. And we continue to see significant demand for our product given the number of leads we are able to generate on a monthly basis.

To prevent us from being beholden to the provider's ability to adopt POCs, we plan to take full advantage of our unique vertically integrated business model to increase access of our technology through our rental platform. We believe the patient demand is still very high for affordable oxygen concentrators. And it is our mission to fill this need for our home care provider partners or from Inogen through a purchase or an insurance rental.

With that, I will now turn the call over to our CFO, Ali Bauerlein. Ali?

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Alison Perry Bauerlein, Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer [4]

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Thanks, Scott, and good afternoon, everyone.

During my prepared remarks, I will review our first quarter of 2019 financial performance and then provide more details on our updated 2019 guidance.

As Scott noted, total revenue for the first quarter of 2019 was $90.2 million, representing 14.1% growth over the first quarter of 2018.

Turning to gross margin. For the first quarter of 2019, total gross margin was 49.2% compared to 47.7% in the first quarter of 2018.

Our sales gross margin was 50.4% in the first quarter of 2019 versus 49.8% in the first quarter of 2018. The sales gross margin increase was primarily due to a favorable mix shift towards higher gross margin direct-to-consumer sales versus business-to-business sales and a reduction in cost of goods sold per unit compared to Q1 2018.

The favorable mix was partially offset by lower average selling prices in both the international business-to-business and direct-to-consumer channels, while domestic business-to-business average selling prices were flat.

Rental gross margin was 30.8% in the first quarter of 2019 versus 20% in the first quarter of 2018. The increase in rental gross margin was primarily due to increased rental revenue per patient on service and lower depreciation expense.

As for operating expense, total operating expense increased to $39.6 million in the first quarter of 2019 or 43.8% of revenue versus $29 million or 36.7% of revenue in the first quarter of 2018.

Research and development expense increased to $1.7 million in the first quarter of 2019 compared to $1.4 million recorded in the first quarter of 2018 primarily due to increased product development expenses.

Sales and marketing expense increased to $28.2 million in the first quarter of 2019 versus $18 million in the comparative period in 2018 primarily due to increased advertising expenditures and increased personnel-related expenses primarily at our Cleveland facility.

In the first quarter of 2019, we spent $10.2 million in advertising as compared to $4.8 million in Q1 2018. We saw an improved efficiency on a sequential basis in advertising expenditures as a percent of direct-to-consumer sales at 26.2% in Q1 2019 versus 29.4% in Q4 2018.

General and administrative expense increased to $9.7 million in the first quarter of 2019 versus $9.6 million in the first quarter of 2018 primarily due to increased personnel-related expenses and partially offset by decreased bad debt expense resulting from the adoption of ASU 2018-19 that requires reclassification of rental bad debt expense to be charged to rental revenue.

Operating income for the first quarter of 2019 was $4.9 million, which represented a 5.4% return on revenue. Operating income declined 44.2% in the first quarter of 2019 versus the first quarter of 2018, where operating income was $8.7 million or an 11% return on revenue.

The reduction in first quarter 2019 operating margin compared to first quarter of 2018 was primarily due to higher sales and marketing expense. In the first quarter of 2019, we reported an income tax expense of $0.8 million compared to a $1.1 million income tax benefit in the first quarter of 2018.

Our income tax expense in the first quarter of 2019 included a $0.6 million decrease in provision for income taxes related to excess tax benefits recognized from stock-based compensation compared to a $3.3 million decrease in the first quarter of 2018.

Excluding the stock-based compensation benefit, our non-GAAP effective tax rate was 23.1% in the first quarter of 2019 versus 22.5% in the first quarter of 2018. In the first quarter of 2019, we reported GAAP net income of $5.3 million compared to GAAP net income of $10.8 million in the first quarter of 2018. Earnings per diluted common share was $0.24 in the first quarter of 2019 versus $0.48 in the first quarter of 2018.

Now turning to guidance. As Scott mentioned, we are reducing full year 2019 total revenue guidance to $405 million to $415 million, down from $430 million to $440 million, representing growth of 13.1% to 15.9% versus 2018 full year results.

While we still expect direct-to-consumer sales to be our fastest-growing channel, we expect we will be slowing the pace of hiring in 2019, and primarily focusing on sales representative productivity. We continued to expect international business-to-business sales to have a solid growth rate but now expect domestic business-to-business sales to have a slightly negative growth rate. Given the difficult growth comparisons we faced in the domestic business-to-business channel, the restructuring challenges of some providers and our rental plans, we expect negative growth in the domestic business-to-business channel in Q2 2019 compared to Q2 2018, with modest growth in the back half of 2019 compared to the back half of 2018.

Despite planned increased net new rental additions, we continued to expect rental revenue to grow modestly in 2019. We are reducing our full year 2019 GAAP net income guidance range to $36 million to $38 million, down from $40 million to $44 million compared to 2018 GAAP net income of $51.8 million. This decrease in GAAP net income guidance range is primarily due to the estimated reduction in revenue and a decrease in estimated benefit in provision for income taxes related to excess tax benefits recognized from stock-based compensation from $4 million to $1 million due to our current stock price and fewer expected option exercises in 2019.

When excluding the benefit from the estimated $1 million decrease in provision for income taxes expected in 2019 from stock-based compensation deductions, we still expect a non-GAAP effective tax rate of approximately 24% in 2019.

Assumed in guidance is that tariffs associated with imported Chinese materials and products stay at a cost of 10% for full year 2019. If these tariffs are increased from 10% to 25%, we estimate the additional cost to be approximately $400,000 per quarter at the revenue guidance range listed.

Going forward, we plan to continue to monitor any new tariff proposals and economic policy changes and take the necessary steps to protect our financial interests and reduce our standard material cost risks. We are also reducing our full year 2019 operating income guidance range to $42 million to $44 million, down from $46 million to $50 million, representing growth of 10.8% to 16.1% versus 2018 full year results.

And we are also reducing our full year 2019 adjusted EBITDA guidance range to $66 million to $68 million, down from $67 million to $71 million, representing growth of 7.7% to 11% versus 2018 full year results.

We still expect net positive cash flow in 2019 with no additional capital required to meet our current operating plan, in spite of an additional investment in rental assets. However, we expect lower cash flow than in 2019 as we increase rental investments and expect lower cash provided by stock option exercises.

With that, Scott and I will be happy to take your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Margaret Kaczor of William Blair.

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Malgorzata Maria Kaczor, William Blair & Company L.L.C., Research Division - Research Analyst [2]

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Maybe to start. You can walk us through why you think now is the right time to change that rental intake criteria you describe earlier? And it seems that underlying growth outside of that one large provider, we're still up over 30% based on a rough math. But it seems relatively good so maybe walk us through that? And then if not for that change in intake criteria with that growth of over 30% continue? Or is something else has changed in the market as you guys look at it?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [3]

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Yes. Margaret, it's a good question. This is Scott. I'll take that one. And you're right, if you peel back the purchases from a national provider, that slowed down their purchases. The rest of the domestic B2B channel is growing nicely in the mid-30s. And we're very pleased with that. But when we assess the overall situation, there's a couple of things that really go into this. One, you do have a slowdown of the larger player and they do represent a fair piece of the market. Now while the rest of the channel is growing nicely, they just aren't able to completely absorbed all the demand that the other provider that was taking. So there's an access issue and, frankly, I call it an opportunity, if you want to look at it that way. That's certainly the way we're looking at it. Now let's also couple that with some other comments that I made that we've increased our advertising spend, but we just aren't satisfied yet with the productivity of our sales team. So we've got some opportunities there to improve that productivity. We already are paying for literally tens of thousands of leads every month and when you're focused primarily on retail sales, you're leaving a lot of money on that tree by not taking in more rentals. So when we coupled our goals to improve our sales team productivity, also to address the issues in the market regarding access. The result of that, our assessment was us relaxing our intake criteria and taking on some more rentals satisfied both of those issues, or I guess, all 3 of those issues, if you will. So that's how we've landed at that point of we're going to accept some more rentals, drive productivity in the sales team, harvest more of the leads that we have already paid for. And we don't have to increase our marketing spend to have access to those leads, we just have to use them. And then create better access for the patients which is consistent with our mission and vision.

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Malgorzata Maria Kaczor, William Blair & Company L.L.C., Research Division - Research Analyst [4]

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Okay. So just to follow up on that intake criteria then. It sounds like the changes you're making are maybe more minor. Obviously, you can go out more aggressive on that. But what are the steps you're looking for to push this out into the field? Are you looking at improvements in close rates? What other metrics are you looking at? And how should we look at that long-term profitability within rental given the lower gross margin profile of rental today?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [5]

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Yes. It's another good question, Margaret. And you are right on target in that. This is a subtle shift. It's not a wholesale change of what I would call a dramatic shift over rentals. But we are going to relax the last criteria upfront. When we talk about that criteria, we've got a minimum number of billable months remaining for a rental patient or an insurance patient that we require to consider bringing them on service and deploying a POC. So we can relax that criteria and it creates more a bigger portion of the leads that come in every month to become rental candidates. So that's what we'll be doing. But it's not a massive shift. It is a subtle change. Now in order to execute that, I had mentioned that we had piloted this rental intake team. They are much more efficient going forward because you drive more of the volume through a narrower group of people that are experts in this area as opposed to our wholesale sales team that they may do a rental or 2 here and there a month, and they're just not as proficient at it. So the results of these trials have been very positive. It improved our efficiency, but it will take, I'll say, the rest of this year to kind of roll that out. And we'll scale as we go. But it will be a slow shift but a steady shift, and that should drive efficiency. Now you mentioned close rates. Yes, it should, a, improve our close rates with some of the trainings, rescripting, focusing on leveraging the benefits of the G5 with the sales team, more training for the management that is responsible to help bring the reps up to speed. All of that should improve our close rate. Another thing that we have piloted that is a best practice in other industries is we've actually started letting the better performing reps, and better performing reps generally have higher close rates, they can earn more leads. So once you get to a base level of leads, that everybody gets the higher close rate people as a higher performer, we can give you more leads. And so if you give a bias of more leads to the higher closures, your de facto close rate ultimately improves. So it becomes even better utilization of the marketing spend in the leads. Now you mentioned the rental gross margin. Yes, we've made some great progress in the past year there. We've got a lot of opportunities to continue to improve that. And we do need to do that. You got to remember that right when you look at the gross margin associated with the entire rental pool, there's a pretty substantial number of folks there in the cap in there that you subsidized. So out of the gate as we start to take on a higher level of newer patients, none of them are in the cap to start. Now ultimately, they'll hit that cap. But it certainly gives us some runway to continue to focus on driving up our utilization of assets, reducing denials further, optimizing our business and improving that gross margin, which is something that is at the top of our list of things that we need to do if we're going to do more rentals in the future. Ali, do you have anything to add on that?

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Alison Perry Bauerlein, Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer [6]

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I think mostly you covered it from a rental gross margin side. I do want to note, though, just with the sequential decline in rental gross margin. There were a few drivers of that associated with the additional rate cuts that was effective January 1 of 3.9%. But we also had an accounting change associated with the new lease standards where we needed to move bad debt expense from a G&A expense up to a top line expense. So that does impact gross margin but it doesn't impact the net margin of the rental business. We also tend to see higher servicing costs in the first quarter of the year versus other quarters of the year that winter tends to have a higher death rate in the pool as well as you also have insurance changes in that period. So we are very focused on improving the gross margin over time. But as Scott said, what's really great about the rental side is that you don't need to spend more on sales and marketing to drive the interest or the leads associated with that. You can leverage the leads that you're already getting. So on an incremental cost basis, there's very little additional operating expenses. It's just using the operating expenses you already have to drive incremental revenue in the business. But obviously, the rental gross margin is lower than our overall corporate gross margin. We do have multiple initiatives in play to drive improvements in that over time, and we do expect to see sequential increases in rental gross margin throughout 2019.

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Malgorzata Maria Kaczor, William Blair & Company L.L.C., Research Division - Research Analyst [7]

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Just to kind of wrap it up, I guess. If your rental intake criteria changes, they are going to be minor. It's going to take a little bit of time to input those into your numbers. You guys took a pretty big hit to guidance assuming you will see that impact on the HME side that's adverse. So walk us through why is that is the right assumption versus something above or below that? And maybe very bluntly, how confident are you in overall guidance at this point?

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Alison Perry Bauerlein, Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer [8]

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Yes. So I want to highlight that the change in guidance is not just associated with B2B. It's also on the direct-to-consumer side. So remember when we're talking about this rental shift. If you have a patient that previously would have bought for cash that you're now -- they're now going to be able to use the rental benefits, you're going to recognize that revenue monthly over time versus the mostly immediate revenue recognition that you have on the D2C side. So that's certainly a component that whatever portion of the sales that you would have driven on these incremental changes that you do lose on the direct-to-consumer immediate revenue recognition. We also have a slowing of the D2C hiring that is a part of that lowering of the guidance range. And that's really associated with slower hiring and focusing on that productivity improvements and making sure that we get the return on the investments that we made last year. We do expect on the B2B side that there is some impact associated with our change in rental intake criteria. But we believe the major challenges for the HMEs is still, overall, are just restructuring their business. Obviously, this is a large change to guidance. But we do still feel good that these numbers -- that we can achieve these revised numbers. And that we have taken into account what we're currently seeing from the market forces across the entire business.

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Operator [9]

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Our next question comes from Robbie Marcus of JPMorgan.

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Christian Diarmud Moore, JP Morgan Chase & Co, Research Division - Analyst [10]

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This is actually Christian on for Robbie. I wanted to start out may be on the D2C side. I think that was more of an unknown issue going into the quarter. It sounds like the incremental return on hires, isn't that high as you viewed it towards the end of 2018, when you had a large spend in hiring? Is that just what the market getting too saturated? And how can you drive better rep productivity from here? Just any color on your view the productivity of what changed, and that bolus of hiring at the end of 2018 to now leading to the revision in guidance and lower outlook for hiring?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [11]

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Yes. Let me back up to probably the first half of '18 is kind of a benchmark. We started to hire at a heavier rate than historical in the first half of the year. And things, I'll say, that even exceeded our expectations. As we continued and actually cranked up hiring to an even higher rate as we went into the third quarter, that's where things didn't meet our expectations. And as I said in my prepared remarks, when we look at productivity of reps, they no longer were matching what we have seen from a historical productivity standpoint. We got a little bit ahead of ourselves on management. I think we mentioned that in the previous call that we had to shore up our management but we found that we still need to invest in further training on management so that there are even better resource for the new reps that we have. If you look at most of the incremental hiring is in our Cleveland facility. That's where we have space. So that's why most of the hiring is there. But the folks are not surrounded by 5-year veteran reps there. It's a relatively new facility. So we need to make an even bigger investment into training and support of those new reps to drive that productivity. As I said, yes, it's falling short of our expectations in the second half, with a little traffic going into the first quarter because the first quarter is always seasonally slow. So you kind of want to assess things and you're trying to assess it through what's traditionally a seasonally slow period, but we come to the conclusion in analyzing rates and looking at the classes and historical first that were just not where we should be in or where we're convinced that we can be. So it's going to take some time to do that. As you can imagine when you're hiring at a higher rate that does take a lot of your resources just to execute that. We think where we are right now and some of the opportunities that we see, we should redeploy those resources into investing in the team that we have rather than adding more folks to that pool. That could potentially continue to be below our expectations from a productivity standpoint. So that's the plan as we're going to reinvest our resources into training and other programs. I don't want to share every initiative that we have. As you guys know there's some other folks in the space that are also trialing direct-to-consumer initiatives. So we're not going to throw out every detail of every improvement idea or things that we're trialing. But suffice it to say, we see an opportunity to dramatically improve our efficiency going forward if we invest in that way, and that's the decision that we make.

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Christian Diarmud Moore, JP Morgan Chase & Co, Research Division - Analyst [12]

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Got it. So I guess just taking the fact that D2C is seasonally slow in the first quarter, I still think the numbers that you guys put up in the quarter is relatively in line with expectations and in line with first quarters in the past. And that the guidance reduction actually implies D2C to decelerate over the course of the year. So what's changing between the results in 1Q? And the adjustment to guidance going forward that has gotten incrementally worse?

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Alison Perry Bauerlein, Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer [13]

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Yes. So we're not expecting in guidance that there is a significant slowdown versus the growth rates that we saw in Q1 in the D2C channel. So however, we also aren't assuming in guidance that there is a significant acceleration of those growth rates which is what the models were showing previously. So that's really the differences that we essentially are focusing on productivity and not focusing on repetitions. We are instead kind of leveling off of that growth rate for this year.

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Operator [14]

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Our next question comes from Danielle Antalffy of SVB Leerink.

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Danielle Joy Antalffy, SVB Leerink LLC, Research Division - MD of Medical Supplies & Devices and Senior Analyst [15]

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Just to follow up on the D2C business. I'm just curious if you could give a little bit more color on how this works from a rep productivity perspective and the lease? Because the reps are at a call center and they're taking incoming calls, like how do you ensure from a D2C advertising spend perspective that the leads that are coming in are good leads? Like how do you target advertising, I guess, is the first question. And the second question is where did rep productivity start to take a step down? Is it because they weren't able to convert what could have been good leads? Was that the leads coming in were not good? Can you give a little bit more color there? And I have one follow-up.

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [16]

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Yes. So the way we distribute leads are we've got a computer algorithm that does that. And we measure the close rates and the cost per sale of all the different lead forces. And we have an internal marketing team that's always trying to optimize that. And part of that optimization is, yes, to keep things fresh. When you can't -- you can't advertise on the same ad, on the same channel or in the same print, periodical over and over. You've got to mix it up and keep it fresh. And you're always doing that by measuring your close rates, your results and making the necessary changes. So the team is always doing that. You're always looking for some new outlets to keep things fresh as well. So we kind of target it in the past that we'll spend 10% of our media mix. We said, "Let's try it and put that into new ideas or new things to test them out to try and keep things fresh." Again, that's driven by our marketing team. Now the leads, they're distributed by our CRM system. So everybody should get the base amount of leads. Everybody gets a mixture of leads from all the sources. So we don't give all the leads from one source to a certain group of reps. That's kind of randomly distributed. Some leads close better than others. Some leads cost more than others. Where the rubber really meets the road is the cost per sale. As you can imagine, it might be money well spent to pay more for a lead if it has a significantly higher close rate. So we always measure that in terms of the cost per sale. As I mentioned earlier, we are giving the higher-performing reps an opportunity to kind of earn more leads. So if you're a higher closer, we can give you more leads than the number of base leads. And that should ultimately when you look at mix, it should enhance our close rate, allow us to better use our media spend.

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Alison Perry Bauerlein, Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer [17]

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Yes, and just to add on to that, Danielle, before your second question. When we look at productivity, we look at both season reps and reps still coming up the productivity curve. So if it was broad-based where you saw productivity challenges across the whole sales team, that's when you would assume that there was some either challenge with the leads or competitive forces or something like that. But when it is primarily associated with just where the reps are in their productivity curve coming up to speed, then it's not usually going to be a lead issue or a market issue. It's going to be just training and getting those sales reps performing at the expected close rates.

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Danielle Joy Antalffy, SVB Leerink LLC, Research Division - MD of Medical Supplies & Devices and Senior Analyst [18]

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Okay. Got it. And then my second question is around the B2B business. I'm curious what you're seeing as B2B becomes a bigger piece of the business as they ramp adoption, are they redeploying -- just trying to get a sense of the longer-term market opportunity there? Are they redeploying devices back into the system once the patients expires? How do we think about how many patients 1 device can serve that's purchased by a [CME]?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [19]

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Yes. So on the rental side, Danielle, Inogen does the same thing, by the way, on our owner rental business but so do all of the other providers. That asset is owned by the provider and it is redeployed. So they may put a new unit out on a patient. Let's say that patient was -- for a couple of years. When the patient expires, that provider owns that asset. They'll bring it back in, disinfect it. They'll test it. It might get a new battery with it before it goes out to the next patient and it's redeployed. We look at these assets as a 5-year asset. For us, that's how we depreciate the devices. Other company might have their own depreciation schedules whatever they see fit. But we've always referred to these as a 5-year asset. And it could be on 1 to several patients through the asset life. The key to really drive the most out of an asset for a provider, and again, Inogen is in that same bucket. It becomes an asset utilization exercise. You want to keep this thing rented for as many months as possible. Realizing that it will probably be on the patients through the asset's life that's in the cap over 60 months. If you are able to keep an asset rented 50 out of 60 months, I think you've got some pretty darn good results. But that's kind of the game that they play. That's not a new game for them. It's the same with stationary concentrators and, frankly, tanks and everything else. They reuse those assets on people.

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Operator [20]

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Our next question comes from Mike Matson of Needham & Company.

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Michael Stephen Matson, Needham & Company, LLC, Research Division - Senior Analyst [21]

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I just wanted to start with the challenges that some of the HME companies are having, transitioning to the POC model. Have you seen customers that have been able to do that successfully? In other words, is there some kind of structural issue here that would prevent these companies from being able to completely make the transition? Or is it just a certain onetime kind of executing in the proper way?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [22]

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Yes. Mike, it's a good question. And let me answer it from 2 different ends of the spectrum. Maybe first I should answer your overall question. We haven't seen anybody that's fully converted yet. There is -- I mean Inogen is running a complete remote model. But we didn't have a restructured challenge. We started with a white sheet of paper and as we've grown our business, we've added assets. But we don't have trucks and drivers out there. But other than ourselves, people are, what I would call, in a transition state. Nobody has navigated all the way through that. At least, not that we know of. If there's somebody out there, they are pretty small player that's not on our radar screen. Now if you look at the challenges, again, two ends of the spectrum. If you're a larger player, it's a bigger restructure exercise because you de facto, you've got economies of scale on the delivery side that you probably got many branches in many trucks and many drivers and really make the model work if you're going to save money in 5 POCs, you also need to eliminate the cost associated with deliveries. So the challenge is to knock out that delivery infrastructure. We've seen some companies out there that have a good plan. They're executing along the plan. They're not done yet. It seems to be going pretty well. You do have to make some tough decisions on how you're going to reduce that structure. Are you going to redeploy it to other areas of your business or you're going to literally let people go and dispose of trucks. That's probably the bigger challenge that the larger players have. They tend to have more or less access to capital so that they can purchase the assets. It's the restructure that they kind of choke on. If you go to the other end of the spectrum, the smaller what we call mom-and-pop providers. Obviously, they don't usually have many, many branches that may have couple of branches, a couple of trucks. So the restructure exercise is not nearly as daunting. But their access to capital is a lot tougher than the big guys. So they tend to be constrained on just the credit of purchasing the assets. They've got other issues in their business. Sometimes the driver you want to restructure out might be your brother-in-law in a mom-and-pop business. So there are some other nuances there. A little bit of different challenges at both ends of the spectrum. It's why we've always said that this is a process not an event. Nobody can really bite this off in a year or 2, several years. In our last call, we have said in our view from where we are today, it's at least 5 more years. We really didn't put a cap on it. So it's going to take a while. It's an exercise. And I think the good news for us when we look at our business is we continue to see strong demand throughout the leads that we generate. We know there is demand for POCs out there. Probably, our challenge becomes -- because we have the best product and there's demand, it becomes a fulfillment exercise of how are you going to get the product in the end users' hand. What role does the current provider is going to play and how can we help them and support them and be their partner. And then in addition, how can we pick up some of the slack and harvest some of the opportunity without trampling on our good customers and partners.

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Michael Stephen Matson, Needham & Company, LLC, Research Division - Senior Analyst [23]

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Okay. And then just back to the rep productivity issue. So can you maybe comment on the productivity of the new Cleveland-based reps versus your kind of your legacy or existing reps? I would assume based on what you're seeing that the productivity issues were really confined to these new reps and existing reps kind of saw stable productivity levels. So in other words, it's not going to be sort of a sign -- it's not a saturation issue or some other issue. It's really just confined to Cleveland with the training or whatnot?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [24]

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Yes. I mean, Mike, you're right and that is the newer reps and where we have lesser seasoned support structure to help them along. That's where we need to continue to make investment. And yes, that's primarily in Cleveland. As far as giving you actual numbers, we don't give that publicly. Again, there are some things I just -- I don't want to say what's a good number or a bad number when other people are trying to work through this curve potentially themselves. All I'll say is they're below our expectations and they're below historical what we have been able to post. Now you mentioned the term saturation. Our issue isn't a saturation issue. We wouldn't have the tens of thousands of leads that come in every month if there weren't many, many thousands of people still dragging the tank around the 1 POC. So saturation are -- full penetration of the market is not our challenge today.

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Michael Stephen Matson, Needham & Company, LLC, Research Division - Senior Analyst [25]

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Yes. Okay. I mean I wasn't looking for numbers. I guess I just wanted to know if the productivity of the existing reps has been more stable? Or this issue is really limited to kind of the newer reps you had hired more recently?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [26]

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Yes. And the answer to that is, yes, it's more of the rep -- a newer rep issue/opportunity.

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Michael Stephen Matson, Needham & Company, LLC, Research Division - Senior Analyst [27]

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Okay. All right. And then finally, I just wonder if you could comment on the pricing? It sounds like, I think I heard you say that the D2C channel saw some price decline as well as domestic B2B, which I think is normal, but D2C I thought had been more stable in the past.

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Alison Perry Bauerlein, Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer [28]

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Yes. So if you recall, remember we did a pricing trial last Q2. And then we put 8% pricing decline in place a couple of months after that trial. So we were still lapping the comps in Q1 associated with that pricing trial change.

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Operator [29]

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Our next question comes from JP McKim of Piper Jaffray.

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Jonathan Preston McKim, Piper Jaffray Companies, Research Division - VP & Senior Research Analyst [30]

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I just wanted to circle back on the D2C because I feel like the B2B softness was well telegraphed. But it sounds to me like it's not a lead-generation issue. It's a lead-close issue. And how confident are you and that just -- you need to train these folks better versus just the leads being weaker than before?

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Alison Perry Bauerlein, Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer [31]

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Yes. So if it would have just been the leads being weaker, as we said earlier, you would have seen that across the whole salesforce. Now obviously, we're still seeing higher lead-generation cost just looking at our marketing spend as a percent of the D2C revenue. Now that's a mix of both having the lower close rate as well as increased marketing spend. But we do believe we can get the D2C or direct-to-consumer sales cost to decline over time really associated with us being able to improve the productivity there. So that's our focused on, but we do believe the primary area that we are focused on improving in 2019 is the productivity of the sales force and driving incremental sales there. If you would just have a lead-quality issue, again, it would have just been more broad-based across the wholesale stream.

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Jonathan Preston McKim, Piper Jaffray Companies, Research Division - VP & Senior Research Analyst [32]

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Okay. That's helpful. And then one on the rental side. Is there anything around the competitive bidding outlook with all the changes that, Scott, you alluded to that, that make you want to make this move more to rentals? Or is it just purely an access issue? And then just -- can you just give us confidence around -- I mean it's a tight rope to tiptoe. And you don't want to anger any B2B customers and you don't want your sales reps just diverting all of the leads to rentals when we still sell those units outright. So how do you -- what's your confidence? And how do you make sure you can tiptoe on that line properly?

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Alison Perry Bauerlein, Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer [33]

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That's what you have to make that change gradually. You don't want a step change in your criteria. But I mean we do expect this to be important to the long-term strategy anyway and this is just a slight change in criteria now to drive more which does have some impact on D2C sales in the period, and also some potential blowback on B2B side. But we know that there are access issues to get to the patients getting POCs. So we think it's the right time to make that decision. Nothing specifically tied to competitive bidding in our strategy. Obviously, we think that the changes that they're making to the bidding program, overall, are positive changes that should lead to a better bidding approach than what we've seen in the past. But we won't know the outcome of the bidding or how people will bid until probably sometime mid to late next year. So it will be sometime before we really understand what that next round of competitive bidding will look like. But in that case, no matter what happens with rates we do think POCs are the future and the only way that people will be able to compete in this both reimbursement environment as well as patient preference side will be to convert the mass majority of their volumes to POCs. And as they struggle to do that, we want to make sure we just help patients access as much as possible. But for the partners that we have that are going to drive POC adoption, you're right. We absolutely want to maintain those relationships and work with those providers and make sure we minimize the overlap of our efforts versus their efforts in driving POC conversion.

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [34]

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Years. Let me add to that for just a second. A lot of the key to success in this is just good communication with your customers. We have similar if not the same goals. They want to take care of patients. We want to take care of patients. We want to give them a product that's going to give them better freedom than dragging a tank around. And from what we've seen, for the most part, the majority of the HME community wants to do that as well. They are just struggling with how much they can bite off one step at a time. So our goals in helping patients are alive. But you got to sit down with them which we already had some discussions with some of our key customers before this call today to share with them, look, here's the conundrum we have. We've got thousands of leads coming in every month. These people want POCs. They're qualified for POCs. Somehow we got to figure out how to service them. Either you guys service them or we got to service them. But it doesn't serve anybody to deny these people the benefits of a POC. And that's how working hand-in-hand with the provider partners to make that happen. But will we play a little bit bigger role going forward on the rental side than we have in the last year or so? Yes. Is it a wholesale shift that we're just throwing out the provider community and we're going our own way? Absolutely not. That's not the plan at all.

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Operator [35]

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Our next question comes from Matthew Mishan of KeyBanc.

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Matthew Ian Mishan, KeyBanc Capital Markets Inc., Research Division - VP and Senior Equity Research Analyst [36]

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POCs are typically kind of rented or reimbursed in tandem with stationary oxygen concentrators. I guess can you guys manufacture and ship your stationary concentrator to receive an adequate return to current reimbursement? And how does the work -- how would it work where somebody else would be reimbursed for maybe a stationary oxygen concentrator, and you would be potentially reimbursed for the POC?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [37]

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Yes. So to be clear, POC is our dual coded for both E1390 and E1392 reimbursements. So that means as long as the physician has written a prescription for both stationary and ambulatory oxygen, you can deploy a POC and receive the full reimbursement for both codes. So you do not need to deploy a stationary concentrator. Now some providers have chosen to continue to deploy a stationary concentrator as well, and then it's up to them to decide if they are going to dual code and bill the POC for both codes or bill them separately. But the reimbursement, you can't get incremental reimbursement if you deploy a stationary concentrator on top of the POC. So when we bill as a provider, we bill both codes for the POC reimbursement. We do deploy our stationary concentrator as well, but that product is really designed for the retail sales. From a cost perspective, it is higher than the typical stationary concentrators. So it doesn't make it a natural fit for the price-sensitive HME community as a product standpoint.

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Matthew Ian Mishan, KeyBanc Capital Markets Inc., Research Division - VP and Senior Equity Research Analyst [38]

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And then is 30% of business-to-business sales a good proxy for what that DME, the problem DME was throughout 2018?

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Alison Perry Bauerlein, Inogen, Inc. - Co-founder, Executive VP of Finance, CFO, Corporate Secretary & Treasurer [39]

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So the dollar headwind is was the highest in Q1 versus the rest of the year. Q2 was also very high. So similar to Q1 in size but slightly smaller. And then it takes a step down in Q3 and then the easiest comp for us will be Q4 of 2019. So it does step down throughout the year, and particularly much lower in the back half of 2019 from a comp perspective.

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Operator [40]

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Our next question comes from Mathew Blackman of Stifel.

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Mathew Justin Blackman, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [41]

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I just wanted to ask it directly. Although your comments about the rep productivity issues are being isolated, too. Newer reps would seem to answer it. But Scott, you did bring up competition in D2C. And I just want to understand why do you think you're also seeing the competitive pressures in that channel?

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [42]

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Yes. It is nothing that I would say is why we're revising anything. I mean you always hear somebody's got a new program out there. We haven't really seen any significant new products. I mean we've been the one that launch new product recently. So we took the best product and made it better. So we feel we're in a very strong position from a competitive standpoint. We haven't seen anything wild on the pricing side. And I appreciate you asking it directly, Mat, to give us a chance to address that. But no, right now, we're in a stronger position, as I think we've been in from a competitive standpoint with the launch of the G5 and then pairing that with the G4, that's a sub-3 con product.

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Mathew Justin Blackman, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [43]

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Okay. I appreciate that. And maybe to end on a more positive note, we did have another really strong international performance. So I'm hoping you could talk about how sustainable this type of growth is? And more broadly, what inning you think Europe is in terms of a runway for growth? And that's all I have.

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [44]

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Yes. And thanks for the comment on international. It oftentimes gets lost in the shuffle. If you look at Europe, they don't have the downward pressure on reimbursement. So we don't see this struggle to make the delivery model work. But we also on the opposite side of that. It seems like in Europe, people tend to have more bias for a product that is what patients want; whereas in the U.S. with the fixed reimbursement, there's a lot of focus on price first. In Europe, it's not quite that dramatic. So we had some good success in Europe. We had a strong growth over the last 10, even 12-year period when we first broke into Europe. I think if you look at it year-to-year, we kind of expect it's going to trend about as it's trending. I don't think you're going to see a big change in the adoption unless you see reimbursement changes that drives some change there. It's going to take, I think it will lag the U.S. in terms of conversion, but we also think in Europe that ultimately the endgame is POCs. Again, it just doesn't make sense to deliver tanks when you have a POC that can -- that's patient preferred and is a better cost model. Now as you know, we tend to be more conservative on our international guidance because we're even further away from the customers. And we're delighted with the demand that we saw in the first quarter. We continue to think it would be a great market for us. As I said, an [unsung] market, and then we're looking, as we said, in the past calls opportunities in emerging markets for even higher growth when you look at just the sheer population and say a market like China. But that's beyond Europe, and we will probably talk about that a little or talk about that in 2020 when we expect to enter China.

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Operator [45]

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This concludes our question-and-answer session. I would like to turn the conference back over to Scott Wilkinson for any closing remarks.

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Scott Wilkinson, Inogen, Inc. - CEO, President & Director [46]

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Thank you. Yes, we believe the market for POCs remain under-penetrated, and we believe there's strong patient demand for our products. Given our unique vertically integrated business model to drive patient access, it is our mission to fill this need, either through our home care provider partners or from us directly. Thank you for your time today.

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Operator [47]

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The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.