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Edited Transcript of PODD earnings conference call or presentation 1-Nov-18 8:30pm GMT

Q3 2018 Insulet Corp Earnings Call

BEDFORD Aug 15, 2019 (Thomson StreetEvents) -- Edited Transcript of Insulet Corp earnings conference call or presentation Thursday, November 1, 2018 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Deborah R. Gordon

Insulet Corporation - VP of IR & Corporate Communications

* Michael L. Levitz

Insulet Corporation - Senior VP, CFO & Treasurer

* Patrick J. Sullivan

Insulet Corporation - Chairman & CEO

* Shacey Petrovic

Insulet Corporation - President, COO & Director

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Conference Call Participants

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* Christopher Thomas Pasquale

Guggenheim Securities, LLC, Research Division - Director and Senior Analyst

* Danielle Joy Antalffy

Leerink Partners LLC, Research Division - MD, Medical Supplies and Devices

* David Ryan Lewis

Morgan Stanley, Research Division - MD

* Jayson Tyler Bedford

Raymond James & Associates, Inc., Research Division - Senior Medical Supplies and Devices Analyst

* Jeffrey D. Johnson

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Joanne Karen Wuensch

BMO Capital Markets Equity Research - MD & Research Analyst

* Jonathan Preston McKim

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

* Kyle William Rose

Canaccord Genuity Limited, Research Division - Senior Analyst

* Malgorzata Maria Kaczor

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

* Rajbir Singh Denhoy

Jefferies LLC, Research Division - MD, Equity Research & Senior Equity Research Analyst

* Ravi Misra

Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

* Robert Justin Marcus

JP Morgan Chase & Co, Research Division - Analyst

* Ryan Blicker

Cowen and Company, LLC, Research Division - Associate

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Presentation

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Operator [1]

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Good afternoon, ladies and gentlemen, and welcome to the Insulet Corporation Third Quarter of 2018 Earnings Call. (Operator Instructions) As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Deborah Gordon, Vice President, Investor Relations and Corporate Communications.

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Deborah R. Gordon, Insulet Corporation - VP of IR & Corporate Communications [2]

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Thank you, Crystal. Good afternoon, and thank you for joining our third quarter 2018 earnings call. Joining me today are Patrick Sullivan, Chairman and Chief Executive Officer; Shacey Petrovic, President and Chief Operating Officer; and Michael Levitz, Chief Financial Officer. The replay of this call will be archived on our website and our press release discussing our third quarter 2018 results and fourth quarter and full year 2018 guidance is also available in the IR section of our website.

Before we begin, I'd like to inform you that certain statements made by Insulet during the course of this call may be forward-looking and involve known and unknown risks and uncertainties that may cause actual results to be materially different from any future results implied by such statements. Such factors include those referenced in our safe harbor statement in our third quarter earnings release and in the company's filings with the SEC. Unless otherwise stated, all financial commentary regarding dollar and percentage changes will be on a year-over-year basis.

And with that, I'll turn the call over to Pat.

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Patrick J. Sullivan, Insulet Corporation - Chairman & CEO [3]

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Thanks, Deb, and good afternoon, everyone. After my opening remarks, Mike will provide detail on our third quarter results and 2018 guidance. Shacey will follow with an update on our achievements and key milestones and then we'll open the call up for questions.

I am absolutely thrilled and impressed with the outstanding performance of the company in the third quarter. We achieved another record quarter revenue of just over $151 million, representing year-over-year growth of 24% and finishing at the top end of our guidance range.

We achieved another quarter of impressive gross margin expansion to 67%, a 700 basis point improvement from a year ago. We also delivered positive operating income of $7 million and are on track to deliver positive operating income for the full year for the very first time in Insulet's history.

In addition to our strong performance, we accomplished a great deal during the quarter on our key initiatives that will contribute to our long-term growth namely: the limited-market commercial release of our next-generation Omnipod DASH system; an exciting update on Horizon, our automated insulin delivery system; our direct commercial operations in Europe; and the buildout of our Massachusetts manufacturing headquarters. I'll provide a brief update on each of these initiatives, and Shacey will share additional color commentary in her remarks.

Our limited-market release of DASH is well underway and we are receiving valuable patient feedback with overwhelmingly positive reviews. We are very excited to have this new product in the hands of our customers. We're making great progress on our Omnipod Horizon development program. Based on compelling market research and terrific work by our development team, we are now thrilled to inform you that our Horizon automated insulin delivery system will be controlled by an app on the user's own mobile phone.

Since I joined Insulet 4 years ago, smartphone control of Omnipod has been the most desired feature expressed by people with insulin-dependent diabetes. In the last 4 years, advancements in BLE communications and cybersecurity, combined with the outstanding work of our technical team, have made phone control of Omnipod a reality. And because of the tubeless nature of Omnipod, we will be able to provide an outstanding customer experience, not possible by any other product on the market today. This development is a giant leap forward for the diabetes community and we are thrilled to finally make it possible.

Now turning to our direct operations in Europe. Our July 1 transition from distributor to direct operations marked a significant inflection point for our business. We expect to exit this year with an international business revenue run rate of more than $200 million and a long run rate for future growth.

The entire organization managed through this transition in Europe with great speed and extraordinary effectiveness. Now that we've had direct operations in Europe for the past 4 months, we are more confident than ever in the strength of the existing business, the sizable market and our opportunity to further accelerate growth.

Finally, I'd like to highlight the tremendous progress we've made in building our new state-of-the-art manufacturing facility and company headquarters in Massachusetts. The facility build-out is nearly complete and in a few weeks, we will begin installation of our first highly automated manufacturing line in the United States. We are on track to begin production early next year. Our U.S. facility will add the needed capacity and redundancy to support our growth. We are wicked excited and proud to bring Pod manufacturing and jobs to Massachusetts.

Since this is my 60th and last Wall Street earnings call, I'd like to make a few comments before I turn the call over to Mike. When I joined Insulet 4 years ago, I was attracted both by what I believe to be an amazing product and technology with enormous growth potential. Revenues were roughly $200 million, gross margins were less than 50%, market access was very limited and Insulet only had direct commercial operations in the United States and was losing money.

I was very fortunate to assemble an extraordinarily talented team to help me turn the company around. When I retire at the end of this year, we will have more than doubled revenue, gross margins are closing in on 70%, Medicare and Medicaid coverage is established, we are direct in Europe and we have a very rich and exciting product pipeline. And the most significant accomplishment is that Insulet has finally made the pivot to profitability.

To say that we've come a long way in the last 4 years is an understatement. Today, the entire team is focused on driving Insulet forward and significantly improving the lives of people with diabetes. As amazing as the ride has been so far, there are so many more exciting opportunities to seize and patients to serve. I'm highly confident in the extraordinary potential that this company has and the amazing capability of this fantastic team. I look forward to watching all that Insulet will do with this dedicated team and what they will accomplish in the future.

For me, it has been a great privilege and honor to lead Insulet over the past 4 years. The future of Insulet is very bright and the best years lie ahead. Shacey has been a great Chief Operating Officer and will be an outstanding CEO. She is, without reservation, the right person to lead Insulet's next phase of explosive growth and I have full faith and the utmost confidence in her leadership.

Finally, I'd like to thank all the Insulet employees for their dedication and strong performance, the Board of Directors for their support, our partner community for their loyalty and our shareholders for your confidence and trust in the team. Thank you for the opportunity to lead this exceptional company.

With that, I'll turn the call over to Mike. Mike?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [4]

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Thank you, Pat. We continue to make excellent progress and deliver strong growth and I'm pleased to walk you through our third quarter financial results and fourth quarter guidance.

Our third quarter revenue growth of 24% was at the high end of our guidance range. U.S. Omnipod grew 17%, reaching $82 million. International Omnipod grew 55%, totaling $50.2 million. And Drug Delivery was $18.9 million, down 2%. We once again drove significant gross margin expansion, reaching 67.5%, up 700 basis points, exceeding our expectations.

The considerable productivity and cost improvements we've realized in our purchasing, manufacturing and supply chain continue to drive this expansion as well as an incremental benefit of approximately 400 basis points from our successful transition to direct operations in Europe.

Our operating expenses totaled $95.1 million, up from $71.6 million. This included spending in Europe, which was in line with our expected annual run rate of $45 million to $50 million and included a nonrecurring charge of $12.6 million for severance-related benefits due to our announced CEO transition, most of which is noncash. Operating expenses were favorable to our expectations due primarily to timing, which we now expect to occur in the fourth quarter.

As a result of our significant revenue growth and the gross margin expansion, we successfully made the pivot to profitability, delivering a positive operating margin of 4.5% with operating profit totaling $6.9 million. As Pat noted, we expect to achieve full year operating profit for the first time in Insulet's history, consistent with our stated objective. We also reached net income for the first time in Insulet's history and are on a strong trajectory for both growth and profitability, on track for our multiyear objectives.

We ended the quarter with over $435 million in cash and investments compared to $566 million at the end of last year, due primarily to capital expenditures as we invest in U.S. manufacturing and supply chain operations in line with our plans.

I will now update you on our fourth quarter and full year 2018 outlook. For the fourth quarter, we expect total company revenue of $159 million to $164 million, representing growth of 22% to 26%. This includes U.S. Omnipod of $89.5 million to $91 million, representing growth of 17% to 19%. International Omnipod of $52.5 million to $55 million, representing growth of 47% to 54% and Drug Delivery of $17 million to $18 million, down 2% to 7%.

For the full year, we have raised our revenue outlook to a range of $558 million to $563 million, representing growth of 20% to 21%. This compares to our previous expectation of $547 million to $562 million.

For full year revenue by product line, we expect U.S. Omnipod in the range of $320 million to $321.5 million, representing growth of 18%. This reflects our continued confidence in the growth of our customer base, given this year's market access wins and strong commercial momentum overall. We also expect international Omnipod in the range of $169.5 million to $172 million, representing growth of 41% to 44%. For Drug Delivery, we expect revenue of $68.5 million to $69.5 million, representing a decline of 4% to 5%.

Moving down the P&L. We now expect that 2018 full year gross margin will be 65% to 66%, a year-over-year increase of between 500 and 600 basis points. We are thrilled with the tremendous progress we have made in margin expansion. And while we expect the ramp of our U.S. manufacturing next year to present a near-term headwind, we are well positioned to achieve our longer-term gross margin objective of 70% in 2021.

Finally, as I mentioned earlier, we are incredibly excited to deliver operating profitability this year and are reaffirming our expectation of full year 2018 operating margin in the low-single-digit percentage range. Our successful pivot to operating profitability, even while investing significantly to continue to drive 20% or higher annual revenue growth, is a tremendous milestone for Insulet.

In summary, 2018 has been another year of high growth and successful execution for our business. As Pat mentioned, we have accomplished many operational, commercial and financial milestones this year, and at the same time, we remain laser-focused on the future.

Given the positive fundamentals and catalysts for growth across our business and our current growth trajectory, we are well positioned to continue delivering significant top line growth and operating income, and we are confident in our ability to achieve our 2021 financial target.

I will now turn the call over to Shacey.

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Shacey Petrovic, Insulet Corporation - President, COO & Director [5]

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Thanks, Mike. I echo Pat and Mike's enthusiasm about our team's incredible progress. We're pleased with what we've delivered and we're just getting started.

We believe our accomplishments today are building a strong foundation for future growth and I'm excited to share some of our key developments with you. Our global customer base continues to rapidly expand and in the United States, Q3 was another quarter of record new patient starts. We are reaffirming our expected U.S. Omnipod customer base growth of 18% to 20% and expect to finish at the high end of that range. And we are reaffirming expected international customer base growth of 20% to 25%.

The first full quarter selling direct in Europe has confirmed our view that there is tremendous opportunity within our existing markets in the near term plus a longer-term opportunity to expand into new markets across Europe and the rest of the world. We have completed a successful transition to Insulet Europe and are achieving our customer support and satisfaction goals.

Our team of almost 120 very talented and experienced people is fully deployed across Europe and our focus now turns to growth. I was with our team at last month's European Association for the Society of Diabetes (sic) [European Association for the Study of Diabetes] meeting in Berlin. This marked Insulet's first European conference since taking our operations direct. And it was clear that we are already benefiting from our move to establish Insulet Europe. Over the course of the week, we were able to meet with hundreds of European key opinion leaders, and we completed substantial market research, which will shape our innovation and expansion plans. Our success at the conference was a strong indication of the tremendous support and opportunity we have throughout Europe and other international markets.

Moving on to our market access efforts in the United States. Our team is very effectively expanding Omnipod coverage. This year, we had 3 market access objectives: first, to secure and pull through Medicare Part D coverage for Omnipod; second, to expand Medicaid access; and third, to establish pharmacy coverage for our next-gen system, Omnipod DASH. I am pleased to say we are accomplishing each of these objectives. As of the end of September, we secured almost 1/3 of Medicare Part D covered lives for both Omnipod and Omnipod DASH, including large Part D providers like Optum, Express Scripts and Magellan.

We've also had more than 1,000 Medicare beneficiaries gain Medicare coverage through the exception process, where applicants are averaging a greater than 80% success rate. Medicare beneficiaries can select a Part D plan that covers Omnipod or pursue Omnipod coverage through the exception process and will now have Omnipod covered. I am incredibly pleased with where we are today and confident our coverage will continue to grow for our Podder community.

We also continue to strengthen our Medicaid coverage position, and as of today, have an Omnipod coverage for approximately 33.5 million or about 45% of all Medicaid covered lives. We expect this number to continue to grow during Q4 and throughout 2019.

I am delighted with the progress we have made establishing coverage for our next-generation platform, Omnipod DASH. By the end of Q3, we had approximately 75 million covered lives for DASH. We are thrilled that a growing number of people will now have access to Omnipod DASH to help manage their diabetes.

The work we are doing to develop pharmacy access and migrate more customers through this channel is strategically important because it provides several competitive advantages. For the patient, pharmacy provides a better customer experience with lower out-of-pocket costs and no upfront fee to get started on DASH. For the physician, Omnipod can be prescribed with a simple e-prescription and less burdensome paperwork and documentation. For the payer, a pharmacy channel is a true pay-as-you-go risk-sharing model. And for Insulet, this approach offers a lower cost to serve. This shift in business model presents a short-term revenue headwind but neutralizes over a full year and has the potential to dramatically reduce barriers to pump therapy adoption.

Moving on to our innovation efforts, I have several updates to provide in terms of our progress, developments and time lines. Starting with DASH. We began our limited market release in July following FDA clearance in June. We expect to engage 1,000 users and 100 prescribers during our limited market release. User and clinician feedback has been incredibly positive, particularly around DASH's ease of use, intuitive design and the system's modern touchscreen interface. We know that our current and future Podders are anxiously awaiting DASH and we are working to deliver a terrific experience for the full market release in early 2019.

In addition to strong user feedback, 2 recent publications in the Journal of Diabetes Science and Technology highlighted DASH's innovative design, features and functionality and Insulet's commitment to a user-focused development process. The publications also reviewed the strong real-world clinical data and outstanding early feasibility results for our Omnipod Horizon automated insulin delivery system.

We are making great progress on our Omnipod Horizon development program. And as Pat noted, we have some exciting news to share. As many of you know, Omnipod DASH, which was designed as an app on a locked-down Android phone, was Insulet's first step towards full control of Omnipod from a user's personal smartphone. Because it is the #1 innovation request, we have been working hard to address the technical, regulatory and security hurdles and make smartphone control of Omnipod a reality.

As Pat mentioned in his opening remarks, we are thrilled to announce that, following remarkable work from our technical and cybersecurity teams and productive meetings with the FDA, we now plan to launch Omnipod Horizon and future generations of Omnipod DASH with personal smartphone control. Like automated insulin delivery, phone control is a feature that is easily discussed but very hard to implement in a way that provides a secure excellent customer experience.

Omnipod Horizon builds on the ease of use and security of DASH, and by allowing users to manage therapy from their mobile phone while wearing just a smart Pod and a Dexcom G6 sensor, the system will provide a level of freedom, discretion and ease of use that is unmatched.

While this adds scope and some time to the development process, we are pleased to announce that Omnipod Horizon was recently granted designation in the FDA's Breakthrough Devices program. This program is intended to help patients have more timely access to devices by expediting the development, assessment and review process. It offers an accelerated review and approval pathway for Omnipod Horizon.

Now with the Breakthrough Device designation and the exciting addition of phone control, we plan to complete a fourth IDE and estimate Horizon with phone control will be on the market in the second half of 2020. Phone control is a significant differentiator for Horizon and a great win for our customers.

Paramount to our ability to deliver phone control is our commitment to cybersecurity. Just recently, Omnipod DASH was the first pump to receive DTSec certification from the Diabetes Technology Society. This certification is a cybersecurity standard with the goal of raising confidence in the security of network-connected medical devices through independent expert evaluation.

This is a testament to the strength of our cybersecurity approach with Omnipod DASH, which is the foundation for our innovation pipeline, including Omnipod Horizon, which brings me to our next update. As many of you are aware, one of the more interesting movements in the diabetes device space today is interoperability. Interoperability is intended to enable pumps, CGMs and algorithms to be interchangeable components of automated insulin delivery systems. This has been strongly supported by advocacy groups, by industry and by the FDA.

Omnipod DASH was always designed to be interoperable, and we're thrilled to support this initiative by enabling the simplicity of Omnipod to work with other algorithms and CGMs. As a first step in our support of interoperability, we are pleased to share that Insulet is the first pump partner for Tidepool's Loop program. For those of you who aren't familiar, Tidepool is a nonprofit organization that is working to get an open-source, iOS-based Loop app and algorithm approved by the FDA.

Together, we are developing an interoperable automated insulin delivery system that allows Omnipod DASH to be controlled by the Tidepool Loop algorithm from an iPhone. This partnership is additive to our internal Omnipod Horizon program and offers a potentially faster route to market, an automated insulin delivery system with iPhone control for our Podders and a terrific way for us to support the DIY diabetes community.

So as you can see, we've made great progress on the innovation front with many exciting developments this quarter, and we look forward to providing you updates on our progress.

Before we jump into the Q&A, I'd like to take a moment to thank Pat for his kind words earlier in the call and for his friendship and mentorship over the past few years. With Pat at the helm, Insulet has driven considerable operational improvements, developed an exciting innovation road map, established a global footprint and delivered outstanding shareholder value.

Pat, you've been an incredible leader for the company and on behalf of all of us at Insulet, we wish you the very best in your retirement. I'm honored and excited to take on the CEO role. We have great momentum towards achieving our long-term strategic and financial objectives. And I look forward to continuing to work with the entire Insulet team as we advance our mission.

With that, operator, let's open the call for 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 Joanne Wuensch from BMO Capital Markets.

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Joanne Karen Wuensch, BMO Capital Markets Equity Research - MD & Research Analyst [2]

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I wanted to circle in on a couple of things. Clarification, the international number that you just printed, does that include the $11 million you were talking about as a transactional or not transactional, translational fee or fill in the right word there associated with you changing your distributor in Europe?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [3]

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This is Mike. No, so there is a termination fee in our agreement with our former distributor and that fee is not in those numbers. That fee will be determined over the successive 12 months following the takeover that we did on July 1. And that fee will be capitalized as an asset on our balance sheet and will be spread over a number of years. So that fee, we do not expect that fee to be material to our P&L in any period.

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Joanne Karen Wuensch, BMO Capital Markets Equity Research - MD & Research Analyst [4]

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Okay, it's probably my fault because I sort of rambled along there. But what I wanted to really understand is, is this a clean quarter without distributor impact associated with the transition? Or was there still a negative headwind in the quarter?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [5]

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So what we said on the last call is we said that we expect the fourth quarter to be representative of the ongoing run rate of the business. And the guidance that we just gave on this quarter was consistent with what we gave on the last quarter, apart from a small foreign currency headwind. In terms of this quarter, we were very pleased that we successfully transitioned the business and had less disruption than we expected could be possible. So that was very encouraging. And now the disruption is behind us and we're right on track for a $200 million run rate international business coming out of this year.

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Patrick J. Sullivan, Insulet Corporation - Chairman & CEO [6]

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Clean as a whistle.

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Joanne Karen Wuensch, BMO Capital Markets Equity Research - MD & Research Analyst [7]

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Clean as a whistle in the fourth quarter?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [8]

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Yes.

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Joanne Karen Wuensch, BMO Capital Markets Equity Research - MD & Research Analyst [9]

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All right. And then if I may sneak one more in here. In the United States, how are you thinking about Medicare and Medicaid ramping into 2019?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [10]

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Yes. Thanks, Joanne. So we expect Medicaid to continue to ramp in 2019 and less so for Medicare because as we mentioned on previous calls, the negotiation and kind of establishment of coverage happens really between August and October of the previous year for the upcoming year. So we think we're in a great shape in terms of broad coverage because patients can select the Medicare plan that works for them, and we've got some great broad-based plans covering it now so we're in good shape.

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Operator [11]

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Our next question comes from David Lewis from Morgan Stanley.

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David Ryan Lewis, Morgan Stanley, Research Division - MD [12]

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So Shacey, I'll start with you. Maybe Shacey and Mike. Just thinking about the U.S. business this particular quarter, so momentum wise it was a little lower than the prior quarters. But your guidance implies actually a significant step-up in momentum into the fourth quarter. So Can you just talk about third quarter to fourth quarter trends? And is there anything in that number that we should be aware of heading into 19?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [13]

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Sure, I'll just stay at a high-level and Mike can talk about the guidance. But at a high-level, we don't see any diminishment of momentum. We had some timing issues in terms of orders in Q3 heading into Q4. But both quarters very strong and consistent momentum with earlier in the year and as we look forward.

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [14]

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Yes, David, I would just echo that. There was some timing that moved from the third quarter into the fourth quarter. And also there was some mix in the quarter that impacted the numbers. But no we were very pleased with the trajectory. And as Shacey said, we're trending towards the upper end of the range on the installed base. The business is growing very nicely.

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David Ryan Lewis, Morgan Stanley, Research Division - MD [15]

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Okay and just maybe 2, one to follow-up. I'll just ask 2 and I'll ask them both together. Just to confirm on the ex-U. S., Mike, based on your commentary, the thought was that you would exit the year, obviously, in that 20%-plus run rate. But my math, I thought the third quarter actually did better than I expected and the fourth quarter looks pretty stable with the third quarter. So do you think underlying, the fourth quarter numbers are actually getting better than the third? It's one question for you. And then Shacey, you've talked about pharmacy benefit now the last 2 times you spoken publicly, what is the process for getting the penetration of pharmacy benefit? What is a realistic way for us to think about the penetration in the pharmacy benefits channel in the next 18 months? And what does that mean to the profitability for the company?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [16]

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David, it's Mike I'll take your first question. So yes, as we said in our last call, we believe the fourth quarter to be indicative of more the run rate of the business. And given the significant disruption that there was in the second quarter, we really -- we knew that we had successfully transitioned the business when we gave our guidance on the last call 1 month in. But it remained to be seen, how much channel was in the market and so on. We were very pleased to see that our decision in the second quarter to buy back the excess inventory that our foreign distributor had really did mitigate disruption in the market. And so yes, we did do better and finished at the high end of our guidance in the third quarter and are right on track with the natural business growth into the fourth quarter. One of the things that we did identify as we looked into it is it appeared that the amount of inventory that Insumed had built up, that we talked about in our last call, had been built up in the second half of last year and probably, after the announcement that we were going direct. So that second half of last year and beginning of this year. So that created a bit of a tougher comp for us here in the second half of this year. But there really was much less disruption, again, I think, the actions that we took really made that happen.

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Shacey Petrovic, Insulet Corporation - President, COO & Director [17]

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So in terms of pharmacy, David, to that question, so we see pharmacy as very attractive because it's a growth driver in terms of reducing the barriers for people to adopt pump therapy and as I mentioned, it's a lower cost channel for us to serve. So I'm not sure, maybe Mike can comment on specific contribution to margin. But I will say, as we look to 2019, most of DASH coverage is going to happen in the pharmacy. That's where the team is focused. So the DASH ramp is commensurate with the pharmacy channel ramp. And that's a lower cost to serve for us but does present a little bit of a revenue headwind because we won't be charging for the PDM. That removes a significant barrier in a given year that's neutral. And longer term, we believe, it will be a nice growth driver and nice contributor in terms of efficiencies in the organization.

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [18]

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Yes, this is Mike, I would just add on to Shacey's point on the margin. We feel very comfortable with our 2021 target of 70% gross margins. The largest contributor to that really is the improvement in operations and the successful launch of U.S. manufacturing where we're making great progress. There are other commercial initiatives. Pharmacy is a very good initiative to drive growth in the business. We don't expect that, that's going to be a material contributor to margin at this point. We are new in that space, but we don't expect it to be a detriment at all. So we're very excited about that opportunity.

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Operator [19]

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Our next question comes from Margaret Kaczor with William Blair.

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Malgorzata Maria Kaczor, William Blair & Company L.L.C., Research Division - Research Analyst [20]

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First to just follow up a little bit more on DASH. So I guess to ask the question more poignantly, you're about 75 million patients under coverage. Is there any reason that you wouldn't sell that patient DASH going into next year? Within that, at least that 75 million patient base and then as we kind of look at our models, should we start to maybe take that as a 350 -- sorry, the surrogate costs out of our models for at least some portion of the patients throughout the year?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [21]

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Yes, Margaret, that's exactly how I'd look at it. As we look ahead and ramp DASH, it will become a bigger portion of our new patient starts. And in that patient population, we will not charge for the PDM. So -- and I think you're right when we think about coverage that's where we will focus in terms of new patient starts on DASH and maybe even conversions to DASH. The limiting factor -- we know patients are responding really with a tremendous amount of enthusiasm for the products that we -- the limiting factor is going to be how quickly can we establish coverage for DASH. And what I am excited about is, we are right where we expected to be if not slightly ahead. We're going to launch with a great established coverage, probably 100 million covered lives. That's a great spot. That's about where we were in 2015 with Omnipod, and that will continue to grow as we look forward. So I think we're in a really good spot and it's going to get better but that is the limiting factor, I think, for DASH as we look forward.

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Malgorzata Maria Kaczor, William Blair & Company L.L.C., Research Division - Research Analyst [22]

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And I know you guys aren't commenting on 2019 guidance or anything of the sort but I think it was at one of the conferences where maybe Pat had suggested that you expect U.S. to grow probably faster in 2019 than in 2018. So maybe if you guys can elaborate, is that on patient adds? Is that on revenues? Any color would be great.

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Shacey Petrovic, Insulet Corporation - President, COO & Director [23]

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Sure, I'll say we feel great about 2019. I think we've got a lot of momentum heading into the year. We are making a change in the business model and moving to pharmacy so that does present some potential headwinds but we don't expect growth to decelerate. And so we feel really strong and we'll give more color, obviously, on the February call.

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Patrick J. Sullivan, Insulet Corporation - Chairman & CEO [24]

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Yes, we've had significant -- we've had quarter-over-quarter record new patient starts this year so I would expect that to continue.

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Malgorzata Maria Kaczor, William Blair & Company L.L.C., Research Division - Research Analyst [25]

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Noted.

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Patrick J. Sullivan, Insulet Corporation - Chairman & CEO [26]

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Noted. I'll be watching.

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Operator [27]

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Thank you. Our next question comes from Jeff Johnson from Baird.

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Jeffrey D. Johnson, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [28]

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Want to start -- let's see where to start, I guess, on the pharmacy side. Shacey, I guess, my question is as you get more and more pharmacy coverage and as it scales throughout 2018 and 2019, are you seeing any payors kind of tier preference towards Omnipod? Obviously, it's going to be much easier for the docs to prescribe Omnipod over some of the tubed pumps. But there's also that lower start-up cost, obviously, rather than committing to a pump where we know a lot of patients do drop out in the early part of wearing a pump. So are you starting to see any pharmacy payors -- sorry, any payors tier preference or move preference towards Omnipod over the tubed pumps?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [29]

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Well, I tell you that -- so I appreciate, I think that's exactly how we're thinking about it, Jeff. We haven't had preference by payors yet. But it is definitely what's driving the step function change in access and why we've been able to establish so much access for DASH in such a short period of time. When you think about it we were just approved in June and now here we are in early November and we've established 85 million covered lives. That's a great position to be in and just a testament to the strength of the model of eliminating the upfront costs and sort of sharing that ongoing risk as the patient goes forward. So we're going to look to continue to build on that value proposition with payors as we look to the future. But I think it's, to me, it's working just given where we are today with covered lives.

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Jeffrey D. Johnson, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [30]

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Okay, and then on phone control and the interoperability that you talk about as well. Am I hearing you correctly then by 2H '20 when Horizon would be ready to launch, that will also have that Ipump designation or whatever we're going to end up calling that? And then on the phone control, will it go from Pod to DASH to phone? And you can just control from phone or Pod straight to a phone and you can take the DASH handheld out of the equation?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [31]

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So it'll go Pod to phone and you can take the DASH handheld out of the equation. And that's what Pat was referring to in his opening remarks that nobody can really quite match this value proposition because we really are going to eliminate a device that the patient is carrying around and really only Omnipod is positioned to do that super well. So we are thrilled with that configuration. We know it's going to be a winner and we're working very hard to get it out there as quickly as possible. And Jeff, I completely blanked on your first question -- oh Ipump. So we are not really telegraphing our regulatory strategy. However, we do see that the system today, DASH, is an interoperable system. And so we fully expect to take advantage of all regulatory pathways for both Horizon and then, of course, Tidepool as well.

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Operator [32]

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Our next question comes from Jayson Bedford with Raymond James.

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Jayson Tyler Bedford, Raymond James & Associates, Inc., Research Division - Senior Medical Supplies and Devices Analyst [33]

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I wanted to follow on the last question on Horizon and congrats on the breakthrough designation. So timing on Horizon is second half of '20, will you be able to launch a smartphone-controlled DASH before the second half of 2020?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [34]

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No. I think they're going to come around the same time. We're working as fast as we can to get phone control in and so we're lucky to be able to include it into the Horizon program. But I think second half of 2020 is when it's coming.

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Jayson Tyler Bedford, Raymond James & Associates, Inc., Research Division - Senior Medical Supplies and Devices Analyst [35]

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Okay, and just to be clear on the change in business model. The goal here and the expectation is, revenue to Insulet per customer on an annual basis is the same under pharmacy versus the current structure?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [36]

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Jayson, this is Mike. So just to be clear, what we're saying is that it is going to be revenue neutral to the company on an annual basis. So that's what we're saying. So what we were trying to speak to there was we think that pharmacy is a tremendous opportunity. It does, by offering a no-charge PDM, that does present a headwind in the period where you have a new patient start. But we're charging a little bit more for the Pod and as you spread that across that, that covers for the lost PDM revenue. And we believe it provides a benefit for everybody involved, payor, physician, patient and for us.

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Jayson Tyler Bedford, Raymond James & Associates, Inc., Research Division - Senior Medical Supplies and Devices Analyst [37]

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Very clear. And just one quick one here, Mike. The non-recurring expense of $12 million, that was all included in G&A? And then just a quick follow-up, how does the cost structure change in the fourth quarter versus the third quarter if we take out that non-recurring cost?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [38]

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So in answer to your first question, the $12.6 million is all included in G&A. And in terms of the cost structure of the company and what we're guiding to, we do expect OpEx to increase. As I said, the reason we were more favorable in the third quarter was really a matter of timing between the third and fourth quarter and so we do expect OpEx to increase in the fourth quarter. That said, we reiterated our guidance for the operating margin for the year. And honestly, we are thrilled to be delivering on our commitment to be EBIT positive for the year and now net income positive as well on our trajectory. So really pleased with that, and I think it positions us very well going into 2019.

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Operator [39]

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Our next question comes from Robbie Marcus from JPMorgan.

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Robert Justin Marcus, JP Morgan Chase & Co, Research Division - Analyst [40]

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I don't want to minimize the U.S. results, because they're really good in the quarter but I went back through the model and this is the first time since we kept track, at least in early 2015, where you didn't deliver U.S. results above the top end of your guidance range. Maybe just help us understand some of the one-time items in the quarter or maybe what happened versus when you were setting guidance versus what played out?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [41]

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Robbie, I will speak to it because I think it's -- Shacey can speak to installed base but our installed base is growing faster than what we expected, so it really is a matter of mix and it's also a matter of, well, first of all, it was timing, as I said, between Q3 and Q4. But it was also a matter of mix, and we're really seeing the start of acceleration of our pay-as-you-go model, as we described in the pharmacy. And so what that does is even preceding DASH, we've been moving more and more business to the pharmacy and you get less upfront revenue. So we're having record new patient starts but we're getting less contribution from those in the quarter. And so we are doing better than we had expected in terms of the actual installed base growth. But the mix of where that growth is coming from, honestly, the pickup in this pay-as-you-go model is faster than what we expected.

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Patrick J. Sullivan, Insulet Corporation - Chairman & CEO [42]

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It's a good thing.

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [43]

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It's a very good thing.

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Robert Justin Marcus, JP Morgan Chase & Co, Research Division - Analyst [44]

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So can you help us frame maybe what percentage is in pharmacy or what the pricing is versus pharmacy versus the prior business? Or maybe if you don't want to do that just frame if you had the business on the former platform, what the dollar headwind in third quarter was? And maybe what it will be in fourth quarter as well?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [45]

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If we didn't have the timing issues, we didn't have the mix, we would have been at the top end or above. So -- which makes sense given what we said on the installed base growth. The installed base growth is at the high end of what we expected. And so really is a matter of what I just described.

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Robert Justin Marcus, JP Morgan Chase & Co, Research Division - Analyst [46]

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Okay, great. Maybe just one quick follow-up on Horizon. That's really great news that it'll be controlled by the phone. But you do have 2 other competitors out there with hybrid closed-loop pumps. Medtronic potentially out early 2020 with their NexGen in Tandem, other products. So how do we think about Omnipod over the next 2 years competing against some of the competitors?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [47]

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Well, I'll take that one, Robbie. I guess, I make the point which I always make is that we are not competing directly with Tandem or Medtronic. And their innovation that has occurred to date has certainly not slowed us down. I think, as everyone has mentioned, this has been another record quarter for us despite innovation in the marketplace. And it's a really large, fast-growing market with significant unmet need. And I've never really believed that anybody has to lose for us to win. We are focused in the United States, 1 million MDI users, and in this segment, we know that Omnipod is incredibly attractive and it's a preferred product. So certainly, the market's going to get more dynamic. It has over the last few years and we are growing just fine and excited to continue that trend.

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Operator [48]

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Our next question comes from Danielle Antalffy from Leerink Partners.

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Danielle Joy Antalffy, Leerink Partners LLC, Research Division - MD, Medical Supplies and Devices [49]

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Just wanted to, I know it's very early days but you guys did get CE Mark approval for the Type 2 pump with Lilly. Just curious sort of anecdotally what you're seeing, how -- sort of, what patients are -- how patients are using it? If patients are staying on it, things like that? Any sort of color you can give on the Type 2 launch in Europe?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [50]

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So, Danielle, you are very well researched but a slight mistake. So we's did get CE Mark for DASH, actually -- CE Mark for DASH in Europe. So we're still just -- in fact, we haven't even publicized that because we are still working through our launch plans and we do have some work to do in translations, et cetera. So that's what that was. We are still working with Lilly to get U-500 over the finish line in terms of the submission there and making good progress on U-200. so I think, obviously, we are still focused on the insulin-intensive Type 2 patients and capturing insulins can help us address that patient segment but actually what we are seeing, which is to me really interesting, is that DASH is testing extraordinarily well with that segment. It's actually a pretty fast-growing segment of our user base in the United States. And phone control might be arguably just as, if not more, meaningful in terms of unlocking the Type 2 population. So we feel really good. Even while we wait for concentrate insulins in Lilly to get done, we feel really good about our ability to unlock growth in the Type 2 population.

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Danielle Joy Antalffy, Leerink Partners LLC, Research Division - MD, Medical Supplies and Devices [51]

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Okay. Sorry, about that mistake there. And just one quick follow-up for me. Just in general, as you look at your installed base in the U.S, I mean one of the potential needle movers longer term to growth was possibly attrition. And you guys have done a great job of stabilizing that and now with DASH. Do you think you can really start to move the needle on the attrition rate because that could be very incremental to installed -- I'm sorry, to sales growth?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [52]

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Yes, I think the real challenge we have in terms of understanding what is making an impact on attrition, we've got good visibility to attrition of new patient starts but as the base grows and more customers go through various different channels, we have less visibility. The great thing that DASH will give us is visibility to what's happening in those patient groups. And then a better assessment of what we can do to move the needle on attrition. But the great news is, patient retention is very solid, has not moved. We are in real good shape there. But I do think DASH presents an opportunity as we look over the next few years.

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Operator [53]

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Our next question comes from Chris Pasquale from Guggenheim.

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Christopher Thomas Pasquale, Guggenheim Securities, LLC, Research Division - Director and Senior Analyst [54]

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Couple of questions. I want to start with follow-up on the DASH economics to make sure we're thinking about this correctly. When you say it's revenue neutral in year 1, that suggests to me that the higher price of years' worth of Pods is making up for the loss of that upfront PDM revenue. But that would imply that revenue per patient in years 2 and 3 should actually be higher since you are still going to be getting that higher Pod price. Is that right?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [55]

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It's right. It's right, except for I just want to, I guess, moderate the value. Because what we are also seeing is patients that are going to be migrating over, who we wouldn't normally have sold the PDM to. So when we think about it being revenue neutral in the year, we're thinking about all of that activity being revenue neutral for Insulet in a given year. So I don't want you to go attach too high of a premium to pricing in the pharmacy.

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Christopher Thomas Pasquale, Guggenheim Securities, LLC, Research Division - Director and Senior Analyst [56]

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Okay, that's helpful. And then just on the Drug Delivery business, that's actually been more resilient this year than we thought so far, but The Street is expecting Neulasta sales to be under pressure from here. It also look like OnPro penetration might be starting to flatten out a bit. Can you share any preliminary thoughts on how you're thinking about that business in 2019?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [57]

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Well, I think, I guess, the short answer is, we don't expect Drug Delivery to be any more of a headwind in 2019 as it is in 2018. It's just becoming sort of a smaller part of our business. And because of the rapid growth on the diabetes side, it just becomes a little less meaningful.

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Operator [58]

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Our next question comes from Doug Schenkel from Cowen.

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Ryan Blicker, Cowen and Company, LLC, Research Division - Associate [59]

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This is Ryan on for Doug. You discussed that the ramping of your new manufacturing facility is expected to represent a headwind to gross margin next year. Can you quantify at all how we should be thinking about that? Is this new 67% to 68% a good baseline for the company moving forward? Or could there be some pressure earlier in the year?

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [60]

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This is Mike. Yes, there will be pressure. Just purely because of the accounting as you ramp up a plant. And so you have to put your period costs into the P&L and they're just normal ramp-up costs. So we do not expect that our gross margin is going to improve on a full year basis in next year than it is at this point. And that's really not because of the ongoing run rate, it's really a matter of the inefficiencies in ramping up a new plant.

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Ryan Blicker, Cowen and Company, LLC, Research Division - Associate [61]

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Got it. And then, Shacey, you noted that the Tidepool Loop algorithm could offer a potentially faster path to market than Horizon. I was under the impression that the Loop approval would take a bit longer given how early stage that seems, at least from the FDA process. When do you think that could reasonably get approved?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [62]

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You're welcome. I really don't want to comment on specifics because it is technically Tidepool's program and so I'll let them do that as they make progress. The reason why we predict it could be potentially an accelerated pathway and that's just a potential, is that the Loop product is an existing product that's being used by a few thousand people. So it's already gathering data. They may have faster pathways to actually use real world data to support their approval and the product is also already a working product. And so those things potentially offer some acceleration.

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Operator [63]

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Our next question comes from Ravi Misra from Berenberg Capital.

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Ravi Misra, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [64]

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So just one on the P&L and regarding your gross margin long-term targets, you said, I guess, it's going to be led by improvement in operations and U.S. manufacturing. How do we think of how to layer in Horizon when that does come? I mean, it sounds like you'd be getting rid of the DASH device completely. So what kind of tailwind would that represent to margins? And then I have a follow-up.

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [65]

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This is Mike. So we were really pleased this quarter to be able to deliver out of our existing operations over 67% gross margins, which was really unheard of not that long ago. So that positions us very well for our target of 70% in 2021 and we expect opportunities to expand our gross margins following that. In terms of a particular product launch, it's definitely going to be helpful to not have a PDM cost in the mix with phone control. But there are a lot of drivers, U.S. manufacturing is a driver, leverage is a driver. So there are a number of drivers for the gross margin expansion. And I wouldn't single out any one particular product as being overly meaningful to that.

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Ravi Misra, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [66]

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Great. And just my follow-up is, I just wanted to probe a little bit deeper on that noncash severance charges. Was that of a one-time event in the quarter or was that a pull forward? I'm just trying to think of what will be the new base here.

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Michael L. Levitz, Insulet Corporation - Senior VP, CFO & Treasurer [67]

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So the majority of that was a noncash charge of acceleration of stock comp. And then the rest of it was a cash severance charge in our normal severance policy. So it was -- so, I guess, arguably the noncash charge for the stock comp acceleration is somewhat of a pull forward. But yes, it's all contained in the third quarter in the G&A.

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Operator [68]

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Our next question comes from JP McKim from Piper Jaffray.

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Jonathan Preston McKim, Piper Jaffray Companies, Research Division - VP & Senior Research Analyst [69]

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I wanted to ask on Medicare Part D or getting coverage. If I hear it correctly, you're at 1/3 as of today. And I was just trying to figure out what's your kind of goal is internally by the end of this year? And how should -- how do you view the ramp in Medicare next year? And whether getting the full, the other 2/3 on there, how important that is to accelerating that?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [70]

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Sure, JP. Ultimately, our goal was to establish broad Medicare access and so while we may have gone about it in a slightly different way, we now have broad Medicare access. And I think what may be, just to give some context around that, I think, there's always this natural tension between maintaining price integrity and expanding market access. And so because we had seen just really good success with the exception process and because we know that Omnipod users each year can select a plan that provides them the best coverage, we opted not to compromise more on price than we thought absolutely necessary. So actually on balance, we are extremely pleased with where we landed. I wouldn't expect, actually, coverage to ramp materially in 2019. But we don't believe we're going to be materially limited for Omnipod users, Medicare beneficiaries to adopt Omnipod. So that's kind of where we landed. And we actually are really -- I think the team did a real smart job executing the strategy and we're in a really good spot.

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Jonathan Preston McKim, Piper Jaffray Companies, Research Division - VP & Senior Research Analyst [71]

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Okay, so you're saying they can just use the exception instead of getting the full coverage. And then do you have any ...

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Shacey Petrovic, Insulet Corporation - President, COO & Director [72]

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Actually just to clarify that, right now, every year a user signs up for a new Medicare plan. So the first thing Medicare user can do is just go select a plan that covers Omnipod. And that's probably the first avenue. If for some reason they don't want to do that, they can pursue the exception process.

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Operator [73]

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Our next question comes from Kyle Rose from Canaccord.

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Kyle William Rose, Canaccord Genuity Limited, Research Division - Senior Analyst [74]

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I wanted to talk about Horizon, Shacey, you mentioned a fourth IDE trial, can you just walk us through what that trial looks like? Is there anything different in the trial design? Or is that just simply you're actually going to be using the phone control before you move to the pivotal?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [75]

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Yes, so we opted to do IDE 4 to get really just more real world data under kind of real world conditions across all ages with specific challenges like exercise, like large meals or skipped meals. So that's really the goal there. And then because we had that time, we are pursuing phone control. And then we will -- for phone control, specifically, we have human factors requirement. But IDE 4 is about 20 to 30 people looking specifically at those real world kind of more challenging scenarios.

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Kyle William Rose, Canaccord Genuity Limited, Research Division - Senior Analyst [76]

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Great. And then just one follow-up on the Tidepool announcement. Obviously, very interesting. Just wondered if you -- why is that the right partner to go with right now? And, I guess, is it fair to think that we'll see future partners emerge in the future? I guess, I am just -- TypeZero's a big player in the space. I'm just wondering why, if you're going to go with a partner why not go with someone you already have an established relationship with, you know Dexcom, already?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [77]

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Yes, and I think that, that's the benefit of interoperability, and frankly, the benefit of our DASH platform is that we can be interoperable with multiple algorithms and multiple sensors. So TypeZero is certainly a good possibility for that. We like Tidepool because it's a community that's already using the system, right? There is about 1,000 -- I guess, almost 2,000 people out there that are using a hacked Medtronic pump and a Dexcom sensor and downloading this app. And so we thought it was a great opportunity to be able to work with them to get the Pods studied and cleared in the system that is already being used out there. And because it was iPhone control and just a great way to support the DIY community. So that's why we are doing that. It's a great little program but it is primarily Tidepool's program that we're integrating into.

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Operator [78]

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Our next question comes from Raj Denhoy from Jefferies.

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Rajbir Singh Denhoy, Jefferies LLC, Research Division - MD, Equity Research & Senior Equity Research Analyst [79]

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Maybe it's a bit of a follow-on to that last question, but I'm curious to know on DASH in its current form, it doesn't have -- it doesn't seem to have the capability to have CGM data displayed. And I'm curious how long it would take or if that's part of the plan over the near term to be able to get CGM onto that display?

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Shacey Petrovic, Insulet Corporation - President, COO & Director [80]

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Yes, Raj, we made a distinct choice to do integration on a users iPhone. So we don't plan to integrate CGM data on DASH. And we did that because -- well, mainly because users told us that's what they wanted, but also because users can use whatever sensor on their iPhone and kind of see that data. We have a great, I think, mechanism with Dexcom where we use the Today widget screen so that they can get their data both for their Dexcom and their Omnipod right from their iPhone. And so that's where the integration is taking place as opposed to on the device. And we always had planned to migrate everything to the phone and so that was sort of along with the step of secondary display on the iPhone. We wanted to get the CGM data and the Pod data there in 1 snapshot as well.

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Operator [81]

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And that does conclude our question-and-answer session for today's conference. I'd now like to turn the conference back over to Patrick Sullivan for any closing remarks.

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Patrick J. Sullivan, Insulet Corporation - Chairman & CEO [82]

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Thank you, Operator. We had a terrific Q3. We had solid revenue record results of over $151 million, continued our momentum of impressive growth with gross margin expansion to 67%, we remain on track to deliver Insulet's first year of positive operating income and this was probably my best conference call out of 60. I'm confident and excited about Insulet's future and the significant contributions the company will make for people living with diabetes. As we close, I'd like to congratulate Shacey on her well-deserved promotion as CEO at the end of this year. With her at the helm, the company will be in great hands with an extremely bright future ahead of it. It's been a great run at Insulet and I look forward to a lot of fun in retirement. My very best wishes to all of you. Operator, I'll drop the mic and you can drop the curtain. Thank you for joining today's call.

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Operator [83]

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Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.