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NXTM > SEC Filings for NXTM > Form 10-Q on 8-Nov-2012All Recent SEC Filings

Show all filings for NXSTAGE MEDICAL, INC.

Form 10-Q for NXSTAGE MEDICAL, INC.


8-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Special Note Regarding Forward Looking Statements

The following discussion should be read with our unaudited condensed consolidated financial statements and notes included in Part I, Item 1 of this Quarterly Report for the three and nine months ended September 30, 2012, as well as the audited financial statements and notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" for the year ended December 31, 2011, included in our Annual Report on Form 10-K filed with the SEC.

This Quarterly Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 concerning our business, operations and financial condition, including statements with respect to: the market adoption of our products in the U.S. and internationally; the growth of the home, critical care and in-center dialysis markets in general and the home hemodialysis market in particular; the development and commercialization of our products; changes in the historical purchasing patterns and preferences of our key customers, including DaVita Inc. and Fresenius Medical Care; the adequacy of our funding; our ability to achieve and sustain positive cash flows; expectations with respect to future demand for our products and revenue growth; the timing and success of our initiatives to improve our gross profit as a percentage of revenues; expectations with respect to our operating expenses and achieving our business plan; expectations with respect to achieving profitable operations; expectations with respect to achieving improvements in product reliability; the timing and success of the submission, acceptance and approval of regulatory filings and the impact of any changes in the regulatory environment with respect to our products or business; the scope of patent protection with respect to our products; expectations with respect to the findings of our FREEDOM study and other ongoing clinical studies evaluating home and/or more frequent hemodialysis; expectations as to the continued availability of raw materials, components, and finished goods, including from key single source suppliers; expectations with respect to our ability to supply on a timely and uninterrupted basis all products ordered by our customers; expectations with respect to the Gambro litigation; the impact of any new business development initiatives on our business, such as centers of excellence, and any potentially negative response from customers to such new initiatives; and the impact of new and future changes to reimbursement for chronic dialysis treatments. All statements other than statements of historical facts included in this report regarding our strategies, prospects, financial condition, costs, plans and objectives are forward-looking statements. When used in this report, the words "expect", "anticipate", "intend", "plan", "believe", "seek", "estimate", "potential", "continue", "predict", "may", and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. Because these forward-looking statements involve risks and uncertainties, actual results could differ materially from those expressed or implied by these forward-looking statements.

Among the important factors that could cause actual results to differ materially from those indicated by our forward-looking statements are those discussed under the heading "Risk Factors" in Item 1A of Part II. We undertake no obligation to revise or update publicly any forward-looking statement for any reason. Readers should carefully review the factors described under the heading "Risk Factors" in Item 1A of Part II of this Quarterly Report and in "Management's Discussion and Analysis of Financial Condition and Results of Operations", as well as in other documents filed by us with the SEC, as they may be amended from time to time, including our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q.

Introduction

We are a medical device company that develops, manufactures and markets innovative products for the treatment of kidney failure, fluid overload and related blood treatments and procedures. Our primary product, the NxStage System One, or System One, was designed to satisfy an unmet clinical need for a system that can deliver the therapeutic flexibility and clinical benefits associated with traditional dialysis machines in a smaller, portable, easy-to-use form that can be used by healthcare professionals and trained lay users alike in a variety of settings, including patient homes, as well as more traditional care settings such as hospitals and dialysis clinics. Given its design, the System One is particularly well-suited for home hemodialysis and a range of dialysis therapies including more frequent dialysis, which clinical literature suggests provides patients better clinical outcomes and improved quality of life. The System One is cleared or approved for commercial sale in the U.S., Europe, Canada and certain other markets for the treatment of acute and chronic kidney failure and fluid overload. The System One is cleared specifically by the U.S. Food and Drug Administration, or FDA, for home hemodialysis as well as therapeutic plasma exchange, or TPE, in a clinical environment. We also sell needles and blood tubing sets primarily to dialysis clinics for the treatment of end-stage renal disease, or ESRD. These products are cleared or approved for commercial sale in the U.S., Europe, Canada and certain other markets. We believe our largest product market opportunity is for our System One used in the home hemodialysis market for the treatment of ESRD.

The results of our operations are included in two separately reportable segments, System One and In-Center. Other business activities relates primarily to the manufacturing of dialyzers for sale to Asahi, certain business development activities, including our early work on establishing centers of excellence which are dialysis clinics focused on the provision of home therapies, including home hemodialysis, and certain corporate expenses, specifically research and development and general and administrative expenses, which are excluded from the segment operating performance measures. In the System One segment we derive our revenues from the sale and rental of the System One and PureFlow SL equipment and the sale of disposable


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products in the home and critical care markets. The home market is devoted to the treatment of ESRD patients in the home, while the critical care market is devoted to the treatment of hospital-based patients with acute kidney failure or fluid overload. In the In-Center segment, we derive our revenues from the sale of blood tubing sets and needles for hemodialysis primarily for the treatment of ESRD patients at dialysis centers and needles for apheresis, which is referred to as the in-center market.

Segment and Market Highlights

Our customers in the System One segment are highly consolidated. DaVita Inc., or DaVita, and Fresenius Medical Care, or Fresenius, own and operate the two largest chains of dialysis clinics in the U.S. and collectively provide treatment to over two-thirds of U.S. dialysis patients. DaVita and Fresenius are our two largest and most significant customers in the System One segment. Direct sales to DaVita represented 30% and 31% of our System One segment revenues for the three months ended September 30, 2012 and 2011, respectively, and 30% and 31% of our System One segment revenues for the nine months ended September 30, 2012 and 2011, respectively. Further, DaVita is our largest customer in the home market, constituting over 40% of our home hemodialysis patients. Direct sales to Fresenius represented 17% of our System One segment revenues for both the three and nine months ended September 30, 2012. Increased sales to DaVita and Fresenius have driven a large portion of our historical revenue growth and will be important to future growth. If the purchasing patterns of either of these customers adversely change, our business could be negatively affected.

Our In-Center segment revenues are highly concentrated in several significant purchasers. Our two largest distributors are Gambro Renal Products, Inc., or Gambro, and Henry Schein, Inc., or Henry Schein. Revenues from Gambro represented 34% and 41% of our In-Center segment revenues for the three months ended September 30, 2012 and 2011, respectively, and 38% and 40% of our In-Center segment revenues for the nine month periods ended September 30, 2012 and 2011, respectively. Revenues from Henry Schein represented 35% and 38% of our In-Center segment revenues for the three months ended September 30, 2012 and 2011, respectively, and 33% and 38% of our In-Center segment revenues for the nine months ended September 30, 2012 and 2011, respectively.

DaVita is also a significant customer in the in-center market. Sales of our products through distributors to DaVita accounted for approximately half of In-Center segment revenues for both the three and nine months ended September 30, 2012 and 2011. DaVita has contractual purchase commitments under two agreements: one with us for needles and one with Gambro for blood tubing sets. DaVita's purchase obligations with respect to needles will expire under an agreement with us at the end of March 2013. Gambro's long term product supply agreement with DaVita, entered into in connection with the sale of Gambro's United States dialysis clinic business to DaVita, obligates DaVita to purchase a significant majority of its blood tubing set requirements from Gambro. Our distribution agreement with Gambro, which expires in June 2014, contractually obligates Gambro to exclusively supply our blood tubing sets to DaVita.

We offer certain customers rebates based on sales to specific end users and discounts for early payment. Our revenues are presented net of these rebates and discounts. As of September 30, 2012, we had $1.9 million and $1.1 million reserved against trade accounts receivable for future rebates and discounts for customers in our In-Center and System One segments, respectively. We recorded $1.7 million and $1.8 million during the three months ended September 30, 2012 and 2011, respectively, and $4.9 million and $4.8 million during the nine months ended September 30, 2012 and 2011, respectively, as a reduction of In-Center segment revenues in connection with rebates and discounts. For the System One segment, we recorded $1.1 million and $0.9 million during the three months ended September 30, 2012 and 2011, respectively, and $3.7 million and $1.9 million during the nine months ended September 30, 2012 and 2011, respectively, in connection with rebates and discounts.

As an alternative to a cash-based rebate, we issued to DaVita a warrant that may vest and become exercisable to purchase up to 5.5 million shares of our common stock based upon the achievement of certain System One home patient growth targets at June 30, 2011, 2012 and 2013. This warrant-based rebate structure preserves our cash, and provides for the issuance of shares upon the exercise of any warrants earned only if patient access to home hemodialysis with the System One is materially expanded. The warrants have an exercise price of $14.22 per share, expire during 2013, are non-transferable and must be exercised in cash. The accounting for these warrants is similar to the accounting for cash-based rebates. Specifically, the warrants are measured at fair value through their date of vesting and recognized as a reduction of revenues, based on the number of warrants expected to vest over the same expected period as the related expected product revenues, which is 7 to 10 years. Estimates of the number of warrants expected to vest and the fair value of the warrants will be revised each reporting period through the date of vesting. Approximately 5% of the 5.5 million warrant shares were earned based on the achievement of certain performance targets at June 30, 2011 and no warrants were earned during the performance period ended June 30, 2012. As of September 30, 2012, 30% of the warrants have expired, unearned. While our business with DaVita continues to grow, we believe it is unlikely they will achieve the level of performance needed to earn the remaining outstanding warrants. The reduction of revenues recorded in connection with these warrants has not been significant.

Financial Performance

During the three months ended September 30, 2012 we grew our revenues by 9% to $61.2 million and during the nine months ended September 30, 2012 we grew our revenues by 11% to $177.1 million. Home revenues drove the growth, increasing $4.7 million, or 17%, and $11.9 million, or 15%, for the three and nine months ended September 30, 2012,


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respectively, versus the prior year comparable periods, driven by the increase in the number of patients prescribed to use and centers offering the System One. We expect to see continued growth in our System One segment revenues, primarily driven by the annuity nature of our business, as well as the life-sustaining, non-elective nature of dialysis therapy.

We continue to see improvements in our financial performance below the revenue line. We have not yet achieved profitable operating margins, but we continue to improve gross profit as a percentage of revenues from 35% during the three and nine months ended September 30, 2011 to 39% and 38% during the three and nine months ended September 30, 2012, respectively. The improvement in gross profit as a percentage of revenues was mainly attributable to favorable product mix with higher relative sales of higher margin products and lower product costs, partially offset by costs incurred by our In-Center segment related to the earthquakes in the second quarter of 2012 affecting our manufacturing facility in northern Italy, and the transition of manufacturing of certain blood tubing sets from a contract manufacturer to our own manufacturing facility in Mexico beginning in the second quarter of 2011. While we expect to continue to improve gross profit as a percentage of revenues as a result of various initiatives, including the consolidation of our manufacturing network, these improvements will continue to be offset in the short-term by associated costs and will be impacted favorably and unfavorably by fluctuations in foreign exchange rates versus the U.S. dollar.

We are encouraged by the improvements to our operating margins and are continuing to work toward our long-term goal of achieving profitable operating margins. However, there can be no assurance that we will be able to continue to improve our operating margins or achieve positive operating margins. Our ability to become profitable and the timing and sustainability, depend principally upon continued improvements in gross margins, growing revenues, and the leverage of our operating infrastructure including after taking into account the effects of any investment in selling and marketing or research and development activities or investment in new business development, including with respect to centers of excellence. Additionally, our profitability will be negatively impacted beginning in 2013 due to the 2.3% medical device excise tax which will be assessed on nearly all of our products sold in the U.S.

Comparison of the Three and Nine Months Ended September 30, 2012 and 2011

Revenues

Our revenues for the three and nine months ended September 30, 2012 and 2011
were as follows (in thousands, except percentages):



                                          Three Months Ended September 30,                   Nine Months Ended September 30,
                                            2012                      2011                    2012                     2011
System One segment
Home                                $   31,925         52 %    $ 27,218        49 %    $  92,171        52 %    $  80,276        50 %
Critical Care                            9,099         15 %       9,170        16 %       28,257        16 %       25,199        16 %

Total System One segment                41,024         67 %      36,388        65 %      120,428        68 %      105,475        66 %
In-Center segment                       19,637         32 %      19,515        35 %       55,477        31 %       54,760        34 %
Other                                      491          1 %          -         -           1,207         1 %           -         -

Total                               $   61,152        100 %    $ 55,903       100 %    $ 177,112       100 %    $ 160,235       100 %

In the home market, revenues increased $4.7 million, or 17%, and $11.9 million, or 15% for the three and nine months ended September 30, 2012, respectively, versus the prior year comparable periods, driven by the increase in the number of patients prescribed to use and centers offering the System One. We have increased both the number of patients at existing centers and centers offering the System One, primarily through our existing relationships with service providers, including DaVita and Fresenius. Critical care market revenues decreased slightly during the three months ended September 30, 2012 versus the prior year comparable period but increased $3.1 million, or 12%, during the nine months ended September 30, 2012 versus the prior year comparable period. Sales of disposables to our growing number of System One equipment placed within hospitals increased during both the three and nine months ended September 30, 2012 versus the prior year comparable period; however, these increases were offset by decreased sales of our System One equipment. Sales of our System One equipment in the critical care market are subject to fluctuation due to timing of sales and the overall capital spending environment. We expect future demand for our products and revenue growth in both the home and critical care markets to be strong as we further penetrate these markets, expand internationally, and leverage the annuity nature of our business. However, this revenue growth will be slightly offset on an ongoing basis by lower deferred revenue recognized on previously sold System One equipment in the U.S. home market as a result of equipment reaching the end of its relative revenue amortization period. Further, the U.S. dialysis market is highly consolidated with DaVita and Fresenius providing treatment to over two-thirds of U.S. dialysis patients. Our customers in the U.S. home market have a range of treatment options available, including traditional in-center dialysis and peritoneal dialysis. Convincing our customers, in particular DaVita and Fresenius, to make investments in their


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training infrastructure to expand their offering of home hemodialysis using our System One will be important to our continued revenue growth in the future. If the purchasing patterns of either of DaVita and Fresenius adversely change, our business would be negatively affected, at least in the near term. Additionally, as our international business grows, our System One revenue will be susceptible to fluctuations in international equipment sales and changes in inventory levels at our international distributors.

In-Center segment revenues increased $0.1 million, or 1%, and $0.7 million, or 1%, for the three and nine months ended September 30, 2012, respectively, versus the prior year comparable periods. The increase in revenues during both periods was driven by higher sales of needles due to increased end user demand partially offset by decreased sales of blood tubing sets driven by fluctuations in inventory levels at our distributors. While revenues continue to be susceptible to fluctuations in inventory levels at our distributors, end user demand of both our blood tubing sets and our needle products continues to grow. We expect future revenues will continue to be susceptible to fluctuation as a result of increased competition and variations in inventory management policies with both our distributors and end users. In-Center revenues will also be negatively impacted, at least in the near term, if we are unable to negotiate an extension of DaVita's needle purchase agreement with us which is scheduled to terminate at the end of March 2013.

Other revenues for the three months ended September 30, 2012 relates to dialyzers sold to Asahi pursuant to our Dialyzer Production Agreement.

Gross Profit (Loss)

Our gross profit (loss) and gross profit (loss) as a percentage of revenues for
the three and nine months ended September 30, 2012 and 2011 were as follows (in
thousands, except percentages):



                                          Three Months Ended September 30,                   Nine Months Ended September 30,
                                            2012                      2011                     2012                     2011
System One segment                  $   18,810         46 %     $ 15,412       42 %    $   54,772        45 %     $ 44,351       42 %
In-Center segment                        4,978         25 %        4,128       21 %        12,739        23 %       12,087       22 %
Other                                      (40 )       (8 )%          -        -              (62 )      (5 )%          -        -

Gross profit                        $   23,748         39 %     $ 19,540       35 %    $   67,449        38 %     $ 56,438       35 %

Gross profit increased $4.2 million, or 22%, and $11.0 million, or 20%, and increased as an overall percentage of revenue for both the three and nine months ended September 30, 2012, respectively, versus the prior year comparable periods, driven in large part by the System One Segment. Gross profit for the System One segment increased $3.4 million, or 22%, and $10.4 million, or 23%, for the three and nine months ended September 30, 2012, respectively, versus the prior year comparable periods, due to increased revenues and improvement in gross profit as a percentage of revenues. The improvement in gross profit as a percentage of revenues for the three and nine months ended September 30, 2012 was attributable to several factors, including lower product costs driven by certain cost savings initiatives, improvement in product design and reliability and continued leveraging of our manufacturing infrastructure, favorable impact of foreign exchange rate fluctuations versus the U.S. dollar, increased relative sales of higher margin products and lower depreciation expense on our field equipment assets resulting from the change in the useful life of certain of these assets from five to seven years.

Gross profit for the In-Center segment increased $0.9 million, or 21%, and as a percentage of revenues for the three months ended September 30, 2012 versus the prior year comparable period, due to lower costs of revenues driven in large part by lower product manufacturing costs including lower costs relating to the transition of certain blood tubing sets from a contract manufacturer to our own manufacturing facility in Mexico and the favorable impact of foreign exchange rate fluctuations versus the U.S. dollar. Gross profit for the In-Center segment increased $0.7 million, or 5%, and as a percentage of revenues for the nine months ended September 30, 2012 versus the prior year comparable period, due to favorable foreign exchange rate fluctuations versus the U.S. dollar partially offset by costs incurred related to the transition of certain blood tubing sets from a contract manufacturer to our own manufacturing facility in Mexico, which began in the second quarter of 2011, and costs incurred by our In-Center segment related to the earthquakes in the second quarter of 2012 affecting our manufacturing facility in northern Italy.

The Other category relates to the manufacturing of dialyzers for sale to Asahi, which should provide us with long term cost efficiencies through increased dialyzer production volumes.

We expect gross profit as a percentage of revenues will continue to improve in the long-term for three general reasons, all of which we expect will reduce costs in the future. First, we expect to introduce additional process improvements and product design changes that have inherently lower costs than the costs associated with our current products. Second, we anticipate that increased volume, rationalization and consolidation of our manufacturing operations, rationalization of our supply chain, and realization of economies of scale will lead to lower costs and better purchasing terms and prices. Finally, we expect to continue


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to improve product reliability, which would reduce unit service costs. However, there is no certainty that our expectations or the projected timing associated with our expectations will be achieved with respect to these cost reduction plans. Further, these improvements in gross profit as a percentage of revenues may be offset in the short-term for five general reasons, all of which could negatively impact gross profit. First, we manufacture a large majority of our products internationally and purchase products from foreign companies in other than U.S. dollars and, therefore, our product costs are subject to fluctuations due to changes in foreign currency exchange rates. Any unfavorable fluctuations in foreign exchange rates versus the U.S. dollar would negatively impact our gross profit as a percentage of revenues. Second, we expect that we will continue to incur higher transportation costs driven in large part by increased prices from carriers and changes in fuel prices. Third, we may see an increase in the cost of certain raw materials, due to increases in the cost of commodities, particularly resin. Fourth, we expect future demand for our products to continue to grow; however, higher relative sales of lower margin products, including the sale of dialyzers to Asahi, and certain pricing strategies would have a negative impact on gross profit as a percentage of revenues. Finally, rationalization and consolidation of our manufacturing operations, in an effort to drive long-term gross margin improvement, will require us to incur additional costs in the short-term.

Selling and Marketing

Our selling and marketing expenses and selling and marketing as a percent of
revenues for the three and nine months ended September 30, 2012 and 2011 were as
follows (in thousands, except percentages):



                                          Three Months Ended September 30,                   Nine Months Ended September 30,
                                             2012                     2011                     2012                     2011
System One segment                  $    8,414          21 %    $ 7,894        22 %    $   25,039        21 %    $ 23,560        22 %
In-Center segment                        1,408           7 %      1,361         7 %         4,063         7 %       3,937         7 %
Other                                      346         n/a          191       n/a             904       n/a           528       n/a

Total Selling and marketing         $   10,168          17 %    $ 9,446        17 %    $   30,006        17 %    $ 28,025        17 %

Selling and marketing expenses increased $0.7 million, or 8%, and $2.0 million, or 7%, for the three and nine months ended September 30, 2012, respectively, versus the prior year comparable periods. The increase in selling and marketing expense was primarily the result of increased personnel and personnel-related costs and increased marketing programs within both segments.

Selling and marketing expenses for the System One segment decreased as a percentage of revenues for the three and nine months ended September 30, 2012 versus the prior year comparable periods due to our initiative to continue to leverage our infrastructure. Selling and marketing expenses for the In-Center . . .

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