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NXTM > SEC Filings for NXTM > Form 10-K on 28-Feb-2013All Recent SEC Filings

Show all filings for NXSTAGE MEDICAL, INC.

Form 10-K for NXSTAGE MEDICAL, INC.


28-Feb-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation

Overview

The results of our operations are included in two separately reportable segments, System One and In-Center. Other business activities relate 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 products in the home and critical care markets. The home market is devoted to the treatment of ESRD patients within a homelike setting, 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.

Financial Performance

During 2012, we grew our revenues 11% from $217.3 million during 2011 to $242.1 million during 2012, with growth occurring in each market: home, critical care and in-center. Home revenues continue to drive the growth increasing $15.1 million, or 14%, during 2012 compared to 2011, driven by an increase in the number of patients prescribed to use and centers offering the System One. We have continued to increase both the average number of patients at existing centers and centers offering the System One, primarily through existing relationships with service providers, including DaVita and Fresenius. Critical care market revenues increased $4.5 million, or 13%, during 2012 compared to 2011, primarily due to increased sales of disposables from our growing installed base of System One equipment. In 2013, we expect to see continued growth in our System One revenues, primarily driven by the annuity nature of our business, as well as the life-sustaining, non-elective nature of dialysis therapy. Our two largest customers in the home market, DaVita and Fresenius, will be important to that growth. If the purchasing patterns of either of these customers adversely change, our business will be adversely affected, at least in the near term. In-center revenues increased $3.2 million, or 4%, during 2012 compared to 2011 driven by increased sales of needle products due to increased end user demand. We expect future demand 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.

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 32% during 2010 to 36% during 2011 to 38% during 2012. The improvement in gross profit as a percentage of revenues was mainly attributable to higher relative sales of higher margin products, lower product costs and favorable changes in foreign exchange rates versus the U.S. Dollar, partially offset by costs incurred by manufacturing transition costs related to the startup of the new Dialyzer manufacturing plant in Germany and costs related to the earthquakes in the second quarter of 2012 affecting our manufacturing facility in northern Italy. While we expect to continue to improve gross profit as a percentage of revenues as a result of various initiatives, including the expansion and rationalization of our manufacturing network, these improvements will


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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. Improvements to our operating margins 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 operating margins 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.

Statement of Comprehensive Loss Components

Revenues

In the System One segment we derive our revenues from the sale and rental of equipment and the sale of disposable products in the home and critical care markets. In the home market, customers purchase or rent the System One equipment, including cycler and PureFlow SL, and then purchase the related disposable products based on a specific patient prescription. In the critical care market, we sell or rent the System One and related disposables to hospital customers. In the In-Center segment, we derive our revenues from the sale of needles and blood tubing sets. Nearly all of our sales in the In-Center segment are through supply and distribution contracts with distributors.

In the home market the majority of our revenue is derived from recurring sales of disposable products. For customers that purchase the System One, we recognize revenue from the equipment sale ratably over the expected service obligation period. For customers that rent the System One, we recognize revenue on a monthly basis. We recognize revenues related to the disposable products upon delivery. Over time, as more home patients are treated with the System One and more systems are placed in patient homes, we expect to derive a growing recurring revenue stream from the sale of related disposables.

Our contracts with dialysis centers in the home market for ESRD home dialysis patients generally include terms providing for the sale of disposable products to accommodate up to the number of prescribed treatments per month per patient and the purchase or monthly rental of System One cyclers and, in most instances, our PureFlow SL hardware. These contracts typically have a term of one to seven years, and may be renewed on a month-to-month basis thereafter, subject to a 30-day termination notice. Under these contracts, if home hemodialysis is prescribed, supplies are shipped directly to patient homes and paid for by the treating dialysis center. We also include vacation delivery terms, providing for the shipment of products to a designated vacation destination for a specified number of vacation days. We derive a small amount of revenues from the sale of supplementary products and services such as ancillaries, reserve inventory and special deliveries.

In the critical care market we recognize revenues from direct product sales at the time of shipment or, if applicable, delivery in accordance with contract terms. Our contracts with hospitals generally include terms providing for the sale of our System One hardware and disposables, although we also provide a hardware rental option. These contracts typically have a term of one year. We derive a small amount of revenues from the sale of one-and two-year service contracts following the expiration of our standard one-year warranty period for System One hardware. To further support service in the critical care market, we have a bio-medical training program, whereby we train bio-medical engineers on how to service and repair certain aspects of the System One in the critical care setting. Bio-medical training is typically provided under a two-year contract following the expiration of our standard one-year warranty period for System One hardware. As more System One equipment is placed within hospitals, we expect to continue to derive a growing recurring revenue stream from the sale of disposable


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cartridges and fluids as well as, to a much lesser degree, from the sale of service and bio-medical training contracts.

In the In-Center segment nearly all sales to end users are structured through supply and distribution contracts with several significant distributors; however, in many instances we have direct contractual relationships with our end user customers. These contracts typically contain minimum volume commitments with negotiated pricing triggers at different volume tiers.

In addition to contractually determined volume discounts, 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 December 31, 2012, we had $2.1 million and $1.0 million reserved against trade accounts receivable for future rebates and discounts for customers in our In-Center and System One segments, respectively. We recorded $6.4 million, $6.7 million, and $5.5 million during 2012, 2011 and 2010, respectively, as a reduction of In-Center segment revenues and $5.5 million, $3.0 million and $2.3 million during 2012, 2011 and 2010, respectively, as a reduction of System One segment revenues in connection with rebates and discounts.

The majority of our revenues have been generated from sales to customers in the U.S. We sell our System One and certain of our other products internationally, primarily through distributors. For sales to our international distributors that occurred prior to January 1, 2011, we recognize revenues from the equipment sale ratably over the expected term of our remaining service obligation, which is five years. For sales occurring on or after January 1, 2011, we recognize revenues from equipment sales at the time of shipment or, if applicable, delivery in accordance with contract terms. Disposable product revenues has continually been recognized upon delivery. We also manufacture and sell dialyzers to Asahi and recognize revenues at time of shipment in accordance with contract terms.

Cost of Revenues

Cost of revenues consists primarily of direct product costs, material and labor required to manufacture our products, service of System One equipment that we sell or rent to customers and manufacturing overhead. It also includes the cost of inspecting, servicing and repairing System One equipment prior to sale or during the warranty period and stock-based compensation for certain personnel. The cost of our products depends on several factors, including the efficiency of our manufacturing operations, the cost at which we can obtain labor and products from third-party suppliers, product reliability and related servicing costs and the design of our products.

Operating Expenses

Selling and Marketing. Selling and marketing expenses consist primarily of salary, benefits and stock-based compensation for sales and marketing personnel, travel, promotional and marketing materials and other expenses associated with providing clinical training to our customers. Included in selling and marketing are the costs of clinical educators, usually nurses, we employ to teach our customers about our products and prepare our customers to instruct their patients and their partners in the operation of our products and customer service and technical support personnel.

Research and Development. Research and development expenses consist primarily of salary, benefits and stock-based compensation for research and development personnel, supplies, materials and expenses associated with product design and development, clinical studies, regulatory submissions, reporting and compliance and expenses incurred for outside consultants or firms who furnish services related to these activities.

Distribution. Distribution expenses include the freight costs of delivering our products to our customers or our customers' patients, depending on the market and the specific agreements with our customers, salary, benefits and stock-based compensation for distribution personnel and the cost of any equipment lost or damaged in the distribution process. We use common carriers and freight companies to deliver our products and do not


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operate our own delivery service. Also included in this category are the expenses of shipping products under warranty from customers back to our service center for repair and the related expense of shipping a replacement product to our customers or their patients.

General and Administrative. General and administrative expenses consist primarily of salary, benefits and stock-based compensation for our executive management, legal and finance and accounting staff, fees of outside legal counsel, fees for our annual audit and tax services, and general expenses to operate the business, including insurance and other corporate-related expenses. Also included in general and administrative expenses beginning in 2013 will be tax expenses incurred related to the medical device excise tax.

Comparison of Years Ended December 31, 2012 and 2011

Revenues

Our revenues for 2012 and 2011 were as follows (in thousands, except
percentages):



                                                Years Ended December 31,
                                             2012                     2011
           System One segment
           Home                       $ 123,589        51 %    $ 108,489        50 %
           Critical Care                 39,540        16 %       34,991        16 %

           Total System One segment     163,129        67 %      143,480        66 %
           In-Center segment             76,927        32 %       73,776        34 %
           Other                          2,076         1 %            -         -

           Total                      $ 242,132       100 %    $ 217,256       100 %

In the home market, revenues increased $15.1 million, or 14%, during 2012 compared to 2011, driven by the increase in the number of patients prescribed to use and centers offering the System One. During 2012, we 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 increased $4.5 million, or 13%, during 2012 compared to 2011, primarily due to increased sales of disposables from our growing number of System One equipment placed within hospitals, partially offset by lower 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 approximately 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 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 DaVita or Fresenius adversely change, our business would be negatively affected, at least in the near term. Additionally, our System One revenue will continue to be susceptible to fluctuations in international equipment sales and changes in inventory levels at our international distributors.

In-Center segment revenues increased $3.2 million, or 4%, during 2012 compared to 2011. The increase in revenues was driven by higher sales of needles due to increased end user demand. While revenues continue to be susceptible to fluctuations in inventory levels at our distributors, end user demand of both our blood tubing sets


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and our needle products continues to grow at a rate equal to or greater than the growth in the ESRD population. However, 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 in April 2013.

Other revenues relate to dialyzers sold to Asahi pursuant to our Dialyzer Production Agreement.

Gross Profit

Our gross profit and gross profit as a percentage of revenues for 2012 and 2011
were as follows (in thousands, except percentages):



                                             Years Ended December 31,
                                          2012                      2011
              System One segment   $ 74,402         46 %     $ 60,847        42 %
              In-Center segment      19,153         25 %       16,761        23 %

              Subtotal               93,555         39 %       77,608        36 %
              Other                    (747 )      (36 )%           -       n/a

              Gross Profit         $ 92,808         38 %     $ 77,608        36 %

Gross profit increased $15.2 million, or 20%, and increased as an overall percentage of revenue during 2012 compared to 2011 driven in large part by the System One segment. Gross profit for the System One segment increased $13.6 million, or 22%, during 2012 compared to 2011. In addition to the impact of increased revenues, the improvement in gross profit and gross profit as a percentage of revenue in the System One segment 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 and increased relative sales of higher margin products.

Gross profit for the In-Center segment increased $2.4 million, or 14%. In addition to the impact of increased revenues, the improvement of gross profits and gross profit as a percentage of revenues in the In Center segment was attributable to favorable foreign exchange rate fluctuations versus the U.S. dollar, favorable pricing for certain products and lower manufacturing costs partially offset by costs 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 and includes related start-up production costs for the new manufacturing plant in Germany. We expect that this relationship 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, expansion and improved leverage of our manufacturing operations and rationalization of our supply chain will lead to lower costs and better purchasing terms and prices. Finally, we expect to continue 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


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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 by increased prices from carriers and changes in fuel prices. Third, we may see an increase in service costs as the existing System One equipment ages and increases in the cost of certain raw materials. We may not be able to pass these costs along to our customers through higher prices for our products. 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 expenses as a
percentage of revenues for 2012 and 2011 were as follows (in thousands, except
percentages):



                                                 Years Ended December 31,
                                               2012                    2011
          System One segment            $ 33,728        21 %    $ 31,619        22 %
          In-Center segment                5,539         7 %       5,215         7 %
          Other                            1,218       n/a           716       n/a

          Total Selling and marketing   $ 40,485        17 %    $ 37,550        17 %

Selling and marketing expenses increased $2.9 million, or 8%, during 2012 compared to 2011. The increase in selling and marketing expense was primarily the result of increased personnel and personnel-related costs and increased spending due to expanded marketing programs within both segments.

Selling and marketing expenses for the System One segment decreased as a percentage of revenues during 2012 compared to 2011 due to our initiative to continue to leverage our infrastructure. Selling and marketing expenses for the In-Center segment remained consistent as a percentage of revenues during 2012 compared to 2011 due to our efforts to continue to broaden our marketing programs while still leveraging our existing infrastructure. Selling and marketing expenses for our Other category relates primarily to personnel and personnel related costs related to business development activities, including our centers of excellence initiative. We anticipate that selling and marketing expenses will continue to increase as we increase public awareness of the System One in the home market, broaden our marketing and business development initiatives, and support growth in international markets.

Research and Development

Our research and development expenses and research and development expenses as a percentage of revenues for 2012 and 2011 were as follows (in thousands, except percentages):

Years Ended December 31, 2012 2011 Research and development $ 17,111 7 % $ 14,437 7 %

Research and development expenses increased $2.7 million, or 19%, during 2012 compared to 2011 but remained consistent as a percentage of revenues. The increase was primarily due to increased personnel and personnel-related costs and increased project related spending. For the near term, we expect research and development expenses will increase as we seek to further develop and enhance our System One, invest in our peritoneal dialysis product development program and expand our product portfolio.


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Distribution

Our distribution expenses and distribution expenses as a percentage of revenues
for 2012 and 2011 were as follows (in thousands, except percentages):



                                             Years Ended December 31,
                                           2012                   2011
                System One segment   $ 16,325       10 %    $ 14,892       10 %
                In-Center segment       2,563        3 %       3,024        4 %

                Total Distribution   $ 18,888        8 %    $ 17,916        8 %

Distribution expenses increased $1.0 million, or 5%, during 2012 compared to 2011 due to increased business volumes but remained consistent as a percentage of revenues. Distribution expenses for the System One segment remained consistent as a percentage of revenues. Distribution network efficiencies were offset by higher carrier rates. Distribution expenses for the In-Center segment decreased in absolute dollars and as a percentage of revenues primarily due to decreased costs associated with shipping certain of our products from our international manufacturing locations to our customers. We expect that distribution expenses over the long term will increase at a lower rate than revenues due to expected efficiencies gained from increased business volume and improved reliability of System One equipment. However, these favorable impacts may be offset by overall increases in fuel costs and enhanced distribution services.

General and Administrative

Our general and administrative expenses and general and administrative expenses as a percentage of revenues for 2012 and 2011 were as follows (in thousands, except percentages):

Years Ended December 31, 2012 2011 General and administrative $ 27,530 11 % $ 23,206 11 %

General and administrative expenses increased $4.3 million, or 19%, during 2012 compared to 2011 but remained constant as a percentage of revenues. The increase in general and administrative expenses was primarily the result of increased professional services, personnel and personnel-related costs and other related infrastructure costs. We expect general and administrative expenses to increase beginning in 2013 due to the medical device excise tax which will be assessed on nearly all of our products sold in the U.S. However, over time we expect general and administrative expenses will decrease as a percentage of revenues as we continue to leverage our existing infrastructure.

Other Expense

Interest expense decreased $1.9 million during 2012 compared to 2011. In May 2012, we repaid our term loan with Asahi through the issuance of shares of our common stock. Interest expense ceased upon repayment; however, the repayment resulted in the early recognition of approximately $1.0 million of unamortized . . .

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