Inogen Inc (INGN) 2016 Q3 法說會逐字稿

Welcome to the Inogen's 2016 third quarter financial results conference call. At this time, all participants are in a listen-only mode. Following management's prepared remarks, we'll hold a question and answer session. (Operator Instructions). As a reminder, this conference call is being recorded today, November 3, 2016. I would now like to turn the conference call over to Caroline Corner, Investor Relations. Please go ahead, ma'am.

Thank you for participating in today's call. Joining me from Inogen is CEO, Ray Huggenberger; President and COO, Scott Wilkinson; and CFO and Co-Founder, Ali Bauerlein. Earlier today, Inogen released financial results for the third quarter ended September 30, 2016. This earnings release and Inogen's corporate presentation are currently available in the Investor Relations section of the Company's website.

During the call and the subsequent Q&A session, we will be discussing plans and projections for our business, future financial results and market trends and opportunities including, among others, statements regarding our Inogen One G4 rollout, our expectation to establish a European presence in 2017, expectations for international sales and anticipated patient preference, market opportunities and increased use of portable oxygen concentrators, our ability to continue revenue growth and our expectations for our business-to-business and direct-to-consumer sales channels, our strategic focus and objectives, hiring expectations, estimates of patent defense expenses and bad debt charges, seasonality, our estimates of the Medicare and private-payer insurance reimbursement rate declines and the impact of such declines, our ability to offset reimbursement reductions, changes to the competitive bidding process, and 2016 and 2017 guidance including revenue, net income, adjusted EBITDA, adjusted net income, net cash flow, effective tax rates, and tax benefits and adjustments.

These statements are forward-looking and are subject to substantial risks and uncertainties that may cause actual events or results to differ materially from currently anticipated events or results. Information on these and additional risks, uncertainties, and other information affecting Inogen's business operating results are contained in Inogen's annual report on Form 10-K for the year ended December 31, 2015 and in Inogen's subsequent reports on Form 10-Q and Form 8-K filed with the Securities and Exchange Commission, including Inogen's quarterly report on Form 10-Q for the period ended September 30, 2016 to be filed with the Securities Exchange Commission.

We advise investors to review these risk factors carefully. The forward-looking statements in this call are based on information available to us as of today's date, November 3, 2016, and we disclaim any obligation to update any forward-looking statements except as required by law.

During the call we will also present certain financial information on a non-GAAP basis. Management believes that non-GAAP financial measures, taken in conjunction with U.S. GAAP financial measures, provide useful information for both management and investors by excluding certain non-cash and other expenses that are not indicative of Inogen's core operating results. Management uses non-GAAP measures to compare Inogen's performance relative to forecasts and strategic plans, to benchmark Inogen's performance externally against competitors, and for certain compensation decisions. Reconciliations between U.S. GAAP and non-GAAP results are presented in tables accompanying our earnings release, which can be found in the Investor Relations section of our website.

For future periods, we have not reconciled our non-GAAP guidance to the most directly comparable GAAP measures because the timing and amount of material items that impact these measures are inherently unpredictable or out of our control. Accordingly, we cannot provide a quantitative reconciliation of these non-GAAP measures without unreasonable effort.

I will now turn the call over to Ray Huggenberger. Ray?

Thank you, Caroline. Good afternoon, everyone, and thank you for joining our third quarter 2016 conference call. On our call today I will start with the financial and business highlights, then Scott will cover our recent operational developments, and, finally, Ali will review the financials and provide updated 2016 guidance and also introduce our 2017 guidance. At that point, we will open the call up for your questions.

Our solid performance in 2016 continued in the third quarter with quarterly revenues of $54.4 million, which represented 33.5% growth over the same period last year, despite the continued headwinds we are facing in our rental business. We continued to see the trend of rental revenues declining, but this was more than offset by successes with our direct-to-consumer and business-to-business sales channels.

Demand for our portfolio of innovative oxygen concentrators remained very strong across all of our sales channels and sales revenue grew 61.3% in the third quarter of 2016 when compared to the comparative period in 2015 and represented 86.7% of our total revenue in the third quarter of 2016, up from 71.7% in the comparative period in 2015.

International business-to-business sales were our strongest growth channel in the quarter, increasing 90% in the third quarter of 2016 compared to the third quarter of 2015 primarily due to strength in Europe with our distribution partners and key accounts. Sales in Europe represented the majority of international sales at 90.8% of international sales in the third quarter of 2016.

While we are very pleased with our European sales results, we are mindful that international sales can be lumpy over time and due to the timing of tender contracts and customer buying patterns. We plan to build upon our recent momentum in the European markets by establishing a physical presence in Europe in 2017. We are excited about this opportunity to deepen our customer relationships and increase our market penetration.

Domestic business-to-business sales were again a strong growth channel for us in the third quarter of 2016, increasing 65.1% over the third quarter of 2015 primarily due to purchases from traditional home medical equipment providers and continued strong private label demand. As we detailed before, in the face of reimbursement reductions, more HME businesses are turning to portable oxygen concentrators and specifically to Inogen as the leader in this space to improve their cost position when providing oxygen therapy. We introduced our Inogen One G4 product to some of our partners in this channel in the quarter and we are pleased with the uptake although we know that the Inogen One G4 still accounts for a small contribution in the third quarter of 2016 in this channel overall.

Direct-to-consumer sales were solid in the third quarter of 2016, increasing 38.6% over the third quarter of 2015. With the Inogen One G4, our sales force is now selling what we believe is the most patient-preferred portable oxygen concentrator on the market. In the third quarter of 2016, about one-third of the system volume in the direct-to-consumer sales channel was the Inogen One G4 product, which is still ramping up. So, the majority of systems sold were still the Inogen One G3.

Rental revenues were impacted by the reimbursement headwinds, as we had expected, and rental revenue was $7.2 million in the third quarter of 2016 compared to $11.5 million in the third quarter of 2015.

In the third quarter of 2016, we delivered net income of $3.5 million and adjusted EBITDA of $10.8 million, demonstrating that we can deliver solid bottom-line results while launching a new product into multiple markets and despite the expected rental reimbursement headwinds.

We continue to deliver against our strategic objectives for 2016. We have now introduced the Inogen One G4 into all of our domestic sales channels. On the last call we said we'd be introducing a new battery for the Inogen One G3 that lasts about 10% longer, increasing the battery life of our Inogen One G3 system up to 10 hours, which would bring it to parity with the battery life of the Inogen One G2 product. We have now launched this new battery and will be rolling it out across all sales channels in the fourth quarter of 2016.

So, with that, I would now like to turn the call over to Scott Wilkinson to cover our operational highlights. Scott?

Thank you, Ray. We have moved forward with the continued launch of the Inogen One G4 portable oxygen concentrator in the third quarter, which has been very well-received since we first started initial sales in May. As we have mentioned before, the Inogen One G4 is smaller and lighter than our current Inogen One G2 and G3 products and feedback, thus far, is that patients are pleased with the new offering. We are steadily expanding shipments of the Inogen One G4 to our domestic business-to-business channel as planned. Remember that, as part of our sales strategy, we do not plan to make the Inogen One G4 available for rental and we'll use the upgraded Inogen One G3 product as the primary ambulatory solution deployed in our rental fleet at this time.

Our international sales channel remains focused on the upgraded Inogen One G3 and we expect minimal, if any, sales of the Inogen One G4 in that channel in 2016. We expect the international sales of the Inogen One G4 will begin in the first half of 2017, depending on the timing of product regulatory and reimbursement approvals, and ramp up in the second half of 2017.

We also initiated the direct-to-consumer pricing trial in the third quarter of 2016 and completed it in the fourth quarter of 2016. The results indicate that, to maximize our overall direct-to-consumer operating margin, we should sell our portable oxygen concentrators at price parity and maintain the current retail prices across all configurations.

On the Medicare reimbursement front, recall that on September 8, 2016 we received notification that we won contracts in 10 of the 13 competitive bidding areas by CMS as part of the competitive bidding round 1 2017 re-compete. These new contracts and rates are effective from January 1, 2017 through December 31, 2018. Currently, we hold respiratory equipment competitive bidding contracts for three of the nine competitive bidding areas under the last round 1 re-compete effective from January 1, 2014 through December 31, 2016.

The additional cuts in the round 1 2017 re-compete areas were in-line with our expectations and, on average, are at parity with the reimbursement rates in the round 2 areas. Our average gross reimbursement for the typical ambulatory Medicare patient receiving a portable oxygen concentrator in areas covered by round 1 2017 re-compete is expected to average $114.03 per month versus $133.82 per month currently, or a reduction of approximately 14.8%. These rates are averages and, as such, our estimates could vary when applied to our specific patient population. We estimate that approximately 9% of the Medicare oxygen market is in the round 1 2017 re-compete areas.

As a reminder, additional cuts to certain Medicare regions were effective July 1, 2016. Our average gross reimbursement for the typical ambulatory Medicare patient receiving a portable oxygen concentrator in areas covered by round 2 re-compete would be $114.74 per month versus $135.79 per month previously, or a reduction of 15.5%. We estimate that approximately 50% of the Medicare patient population is in the round 2 re-compete area.

We maintain solid market access in these regions, as we were awarded and accepted respiratory contracts in 93 of the 117 competitive bidding areas.

In addition, the third phase of cuts to Medicare areas not subject to the competitive bidding process, which we estimate is approximately 40% of the Medicare oxygen market, was also effective July 1, 2016. There are still ongoing efforts by the industry to delay the additional reimbursement reductions to these areas. However, they have not been successful thus far. We, at Inogen, are supportive of such efforts however our guidance assumes there will not be any improvements for the third phase of rate cuts that took effect in these areas on July 1, 2016.

We continued to see more private insurance payers reduce their rates for oxygen services in the third quarter of 2016, as seen in the second quarter of 2016, in response to the lower Medicare reimbursement rates. We do expect these private-payer rates to continue to decline in alignment with the new Medicare competitive bidding pricing.

I'd like to comment on the recently-released Medicare market data from CMS for the full year 2015. While the information provided has some limitations when used to assemble a picture of the oxygen therapy market, such as the absence of brand or manufacturer information, we believe that the information can serve as a proxy for the entire oxygen therapy market.

Based on the data set, we estimate that the share of portable oxygen concentrators in the Medicare oxygen therapy market grew from 6.9% in 2014 to 8.0% in 2015. However, this estimate does not include direct-to-consumer cash sales or private insurance transactions. Our direct-to-consumer cash sales in 2015 grew faster than rentals so we believe that is data from CMS may represent a conservative estimate of actual portable oxygen concentrator market penetration. Inogen is still the market leader of portable oxygen concentrators in the U.S., based on 2015 Medicare billing data.

Moving to the international markets, we have continued to see solid POC revenue growth in Europe over the last several quarters. We are planning to invest in a European customer support site in 2017 to ensure we have the proper infrastructure necessary to support our current and future business. The new site will include multilingual customer service, repair services, and basic distribution with a goal of improving our direct-to-consumer support at lower total cost going forward.

Looking ahead, we believe we are well-positioned to continue our total revenue growth in the oxygen therapy market with best-in-class and patient-preferred products and services with a competitive total cost of ownership. We have continued to execute our strategy and we believe we are now seeing traction that demonstrates that portable oxygen concentrators are becoming increasingly adopted in the oxygen therapy industry.

I will now turn the call over to Ali to cover our financial performance and guidance. Ali?

Thanks, Scott, and good afternoon, everyone. During my prepared remarks, I will review the details of our third quarter financial performance and then I will review our updated guidance for 2016 and provide our guidance for 2017.

As Ray noted, total revenue for the third quarter of 2016 was $54.4 million, representing 33.5% growth over the third quarter of 2015. Looking at each of our revenue streams and turning first to our sales revenue, total sales revenue was $47.2 million, reflecting 61.3% growth over the same quarter of the prior year and representing 86.7% of total revenue. Total units sold increased to 26,600 in the third quarter of 2016, up 81% from 14,700 in the third quarter of 2015.

We achieved record domestic business-to-business sales of $16.2 million in the third quarter of 2016, which exceeded our expectations with 65.1% growth over the same period in the prior year, reflecting continued strong demand from our traditional HME providers and our private label partner. For the second quarter in a row, revenue from our private label partner and traditional HME providers again represented more than half of the domestic business-to-business channel's total sales revenue in the third quarter of 2016.

We also achieved record international business-to-business sales of $15 million in third quarter of 2016, which exceeded our expectations with 90% growth versus the same period in the prior year primarily driven by strong demand from our European partners and due to a weak quarter in the third quarter of 2015 for international sales.

With record business-to-business sales, business-to-business average selling prices in the third quarter of 2016 declined over the same period in the prior year primarily due to the continued shift in sales towards traditional HME providers and private label sales and additional discounts associated with the increased sales volumes worldwide.

Direct-to-consumer sales for the third quarter of 2016 were $16.1 million, representing 38.6% growth over the third quarter of 2015 primarily due to the increased internal sales headcount and increased marketing spend for media and advertising to drive consumer awareness.

Turning to rental revenue, direct-to-consumer rental revenue in the third quarter of 2016 was $7.2 million, representing a decline of 37.2% from the same period in the prior year primarily due to the anticipated Medicare rental reimbursement cuts, reductions in private-payer rates as they followed the decrease in Medicare rates, and higher rental revenue adjustments. Rental revenue represented 13.3% of total revenue in the third quarter of 2016 versus 28.3% in the third quarter of 2015.

Turning to gross margin, for the third quarter of 2016, total gross margin was 46.2% compared to 47.5% in the third quarter of 2015. Our sales gross margin was 48.6% in the third quarter of 2016 versus 45.1% in the third quarter of 2015, up approximately 350 basis points. Sales gross margin percentage improved primarily associated with lower cost of goods sold per unit due to lower materials, labor, and overhead costs associated with the upgraded Inogen One G3 and G4 products partially offset by a higher sales mix of domestic business-to-business sales, which have lower average selling prices.

Rental gross margin was 30.7% in the third quarter of 2016 versus 53.5% in the third quarter of 2015. The decline in rental gross margin was primarily due to lower net revenue per rental patient driven by the previously-discussed reimbursement rate reduction and an increase in provision for rental adjustments in the third quarter of 2016 and partially offset by lower cost of rental revenues associated with lower depreciation and servicing costs per patient.

As for operating expense, we continued to make strategic investments in additional sales force headcount and support personnel. As a result, total operating expense increased to $19.7 million in the third quarter of 2016 versus $15.7 million in the third quarter of 2015. However, operating expense as a percent of total revenue decreased to 36.3% in the third quarter of 2016, down from 38.4% in the third quarter of 2015.

Research and development expense was $1.4 million in the third quarter of 2016 versus $1.1 million in the third quarter of 2015. The increase was primarily associated with additional personnel-related expenses and product development costs for engineering projects. Sales and marketing expense was $9.7 million in the third quarter of 2016 versus $8.1 million in the comparative period in 2015 primarily due to increased sales force personnel-related expenses and media expense. General and administrative expense was $8.7 million in the third quarter of 2016 versus $6.4 million in the third quarter of 2015 primarily due to increased personnel-related expenses, patent defense legal costs, and allowance for bad debt provision.

In the third quarter of 2016, our effective tax rate was 36.6% compared to 26.7% in the third quarter of 2015. This increase was primarily due to the $0.6 million tax benefit adjustment that occurred in the third quarter of 2015 partially offset by research and development credits allowed in the third quarter of 2016, but not in the comparative period in 2015.

Our net income in the third quarter of 2016 was $3.5 million compared to $2.7 million in the third quarter of 2015, an increase of 28.2% versus the comparative period in the prior year and a return on revenue of 6.3%. Earnings per diluted common share were $0.16 in the third quarter of 2016 versus $0.13 in the third quarter of 2015, an increase of 23.1%.

Adjusted EBITDA for the third quarter of 2016 was $10.8 million, which was a 19.8% return on revenues. Adjusted EBITDA increased 30.7% in the third quarter of 2016 versus the third quarter of 2015 where adjusted EBITDA was $8.2 million.

Adjusted net income in the third quarter of 2016 increased 61.4% to $3.5 million from $2.1 million in the third quarter of 2015. Adjusted net income in the third quarter of 2016 did not include any tax benefit adjustments compared to $0.6 million in tax benefit adjustments in the third quarter of 2015.

Moving to our balance sheet, cash, cash equivalents, and marketable securities were $108.3 million as of September 30th of 2016, an increase of $10.2 million compared to $98.1 million from June 30th of 2016. As of the end of the third quarter of 2016, we had no bank debt outstanding and our entire $15 million credit facility was available.

Turning to guidance, we are increasing our 2016 revenue guidance to a range of $194 million to $198 million, which represents year-over-year growth of 22% to 24.5%. This compares to the previous revenue expectation of $190 million to $194 million.

Revenue guidance includes our expectation that total rental revenue will continue to decline as a percent of total revenue and decrease approximately 25% to 30% in 2016 as compared to 2015. We expect strong growth from our business-to-business channels in the fourth quarter, which we expect will offset the additional rental revenue headwinds.

Net income guidance for 2016 continues to be in the range of $12.5 million to $14.5 million, representing an increase of 7.9% to 25.2% growth over 2015. We expect to continue to invest in sales force additions in the fourth quarter. We also expect to continue to have higher patent defense legal costs and provisions for bad debt expense.

We also expect to have a higher effective tax rate in the fourth quarter of 2016, as we expect a full-year effective tax rate in 2016 of approximately 36%, up from 35% previously expected in full-year 2016. This estimated 36% effective tax rate in 2016 compares to 32% in 2015 excluding the tax benefit adjustments of $1.6 million experienced in 2015 that are not expected to recur in 2016. We expect a higher effective tax rate primarily due to lower tax deductions for equity compensation as a percentage of pre-tax income, which is expected to have a smaller percentage impact on the 2016 effective tax rate than it did on the 2015 effective tax rate.

We are also maintaining our 2016 adjusted EBITDA estimate in a range of $37.5 million to $39.5 million, representing an increase of 16.1% to 22.3% over 2015. Adjusted net income guidance remains in the range of $12.5 million to $14.5 million, representing 24.8% to $44.8% growth over 2015. Finally, we still expect net positive cash flow for 2016 with no additional equity capital required to meet our current operating plan.

Turning to 2017 guidance, we expect full-year 2017 total revenue of $230 million to $236 million, representing 17.3% to 20.4% growth over the 2016 guidance midpoint of $196 million.

We expect direct-to-consumer sales to be our fastest-growing channel and domestic business-to-business sales to continue to have a solid growth rate and international business-to-business sales to have a modest growth rate where the strategy will continue to be heavily-focused on the European markets. We expect rental revenue to decline slightly in 2017 compared to 2016 associated with lower average rental revenue per patient primarily due to the known cuts from competitive bidding and the continued focus on sales versus rental.

We expect full-year 2017 net income of $16 million to $18 million, representing 18.5% to 33.3% growth over the 2016 guidance midpoint of $13.5 million. We expect full-year 2017 adjusted EBITDA of $45 million to $49 million, representing 16.9% to 27.3% growth over the 2016 guidance midpoint. We expect an effective tax rate of 36% in 2017. We also expect net positive cash flow for 2017 with no additional equity capital required to meet our current operating plan.

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

Thank you. (Operator Instructions). Margaret Kaczor, William Blair.

Good afternoon, guys.

Hi, Margaret.

Hey there.

So, the first question is on the B2B domestic side. It was good to see the growth accelerate this quarter. But can you give us a sense of which HMEs are adopting or trialing the POCs? Is it more the large nationals or is it regional mom-and-pop players? And are they buying in bulk or just more regular as they get new patients online?

Yes, Margaret, it's Scott. I'll take that one. And the answer is similar to what we saw and communicated in the second quarter. And, really, the trialing and interest of the HME community comes in all shapes and sizes at this point.

We don't discuss individual customers, but I think it's pretty clear that the HME community is struggling with the new reimbursement cuts and the rates. They're looking for new solutions in how they can provide adequate service and still achieve an attractive financial return at these new rates and certainly POCs are at the forefront of that solution set.

But it's really across the entire geography of the USA as well as all shapes and sizes. It's some of the same customers continuing to buy and trial. Some new ones have been added to mix. So, it's really kind of an all-of-the-above answer, if you will.

And so, given that demand that you're seeing at the at HME level, does it make you guys want to start investing more in driving sales from HMEs? And, if that's the case, how would you do that?

Yes. Our strategy is one of patient preference and a direct-to-consumer approach to the market. And that strategy hasn't changed. In fact, it's one of the reasons that I think we are a compelling solution for the HME community because we know a little bit about taking care of patients probably more so than the average manufacturer that hasn't gone down the path of a direct-to-consumer play and direct-to-consumer care. And, remember that we have an outstanding private label partner that helps us access that market without us diverting our attention away from our direct-to-consumer approach.

And so, to be clear, you guys have figured out how to show and share and educate the DMEs how they can make money and essentially make this; could it be as much or more profitable than the tanks that they are driving around? And, again, to the original question; is it for everyone of all shapes and sizes?

Yes. And our answer is; yes, we believe it is for everyone of all shapes and sizes in the home care channel. And, yes, we not only have been successful doing that and demonstrating it ourselves, but we're happy to share that with anyone in the HME community whether that be directly or through our outstanding private label partner.

Great. And then, just on the DTC side and G4 launch, you guys, I think, referenced some mix of what the G3 and G4 units were sold. Is there a reason why the G3 still remains over 50% of the sales? And how should we think about that going forward?

Yes. It takes a little while to turn things up. You've got to consider a few things. One, just the sales cycle with your average patient. It's not a one-day or a one-week cycle, as you might appreciate. If somebody is going to spend a considerable amount of money, they take their time and choose carefully.

In addition to that, if you recall, we scaled our advertising at the end of the second quarter and throughout the third quarter. So, we didn't start all-in. We've scaled kind of as we've gone. We ended the third quarter with a mix in G4 in the direct-to-consumer channel of about one-third of our sales. We've continued to make progress throughout the fourth quarter.

So, we're on a track that we're comfortable with and it's what we would have expected. I mean we saw the same thing when we launched G2 versus G1 and the G3 versus the G2. So, it's a progress. It's not an event. But we're making -- we're happy with our progress and the patients are clearly happy with that product offering.

Great. And last one for me. I think we were a little bit surprised that the sales and marketing maybe didn't grow as much as it did earlier this year despite the fact that you guys launched the G4. So, was that advertising or sales force hiring? And was it where you wanted it to be or did you pull it back for some reason? Thanks.

Yes. In the direct-to-consumer channel, again, we launched at the end of May. Now, keep in mind, we didn't start launching to the domestic B2B channel until the third quarter and that progressed even into the fourth quarter. So, today, we're selling across the domestic B2B channel, G4 across all customers.

But we've scaled that from the end of the second through the third. We've scaled up our manufacturing line to make sure that we keep up with demand in a controlled manner and make sure that we stay on top of quality on a new product. Again, it's a model that we've kind of been through before and we have a method to our madness of how we scale things up so that we don't go too fast and screw things up. So, we're right on track with where we expected and we're pleased.

Great, thank you.

Robbie Marcus, JPMorgan.

Great. And congrats on the quarter, guys. Nice job.

Thank you.

Ali, maybe starting with a question for you. Looking down the P&L, it was impressive to see the adjusted EBITDA and net income come in where it is. And I guess it speaks to that, you know you've been saying for some time and there's been confusion on the street, that the higher DTC sales -- DTC sales have the higher gross margin and, as B2B continues to improve, that that will have a slightly lower gross margin. But I think what we're seeing here is that it's coming equal on the operating line.

So, I guess my question is; can you affirm that's the view? And maybe talk about, in the fourth quarter it looks like adjusted EBITDA is coming in a bit low versus trend. Is that that SG&A spending and the legal costs that you're going to see in the fourth quarter?

Yes. So, starting first with the difference of business-to-business versus direct-to-consumer. As you noted, our direct-to-consumer business does have a higher gross margin profile than the business-to-business side. However, the direct-to-consumer side also has higher operating expenses associated with it; both the sales force cost as well as the media costs associated with those sales.

So, yes, on an operating margin basis, they are relatively close and that's why when we look at how we give guidance and how we look at opportunities, we really focus on revenue growth as well as net income growth. And we don't give gross margin guidance because it really does depend on the mix of business-to-business versus direct-to-consumer sales. So, we have done a nice job of being able to get to relatively similar operating margin profiles.

In terms of the fourth quarter; yes, we do expect lower adjusted EBITDA just given where the guidance midpoint comes out at. We are continuing to invest and we do expect that to continue in the fourth quarter. And we do expect higher legal costs. So, really, the increase in costs is in the SG&A line.

Okay. And then, looking out to next year, solid initial guidance for next year. It came in above the street both on the top and the bottom line. One area that's been some confusion, other than the gross margin, has been kind of the ASP in the mix. So, is there any way you can kind of give us your initial thoughts on what we might see on that ASP mix line for next year? And then, any just initial thoughts, maybe, on SG&A and R&D growth for next year so we can try and back into where you're thinking about cost of goods?

Sure. So, when you think about our growth rate for 2017, as we said, we do expect our highest growth rate of a channel to be direct-to-consumer sales. So, that is inherent in the guidance, that direct-to-consumer sales will be the fastest-growing. We do expect still very robust domestic business-to-business growth as we've continued to see more providers adopt POCs as a strategy. We expect that trend to continue into 2017. And we expect pretty moderate growth on the international side. We've had such a strong year in 2016 internationally through, primarily, Europe. And we do expect that we will continue to grow in those markets, but that is more of a moderate area. And we expect a slight decline in rentals.

So, given those factors, that would lead to, with higher direct-to-consumer sales as a higher percentage of the business, all else equal, leads to expanding gross margin percent, but higher operating expenses associated with that portion of the business. So, our approach to guidance has been very consistent with previous years where we focus on where we have the most visibility in the business, which is really the direct-to-consumer side. And then, we look at the opportunities on the business-to-business side to continue to expand and maintain our market-leadership position.

Great. And if I could sneak one last one in, maybe for Scott. I think second quarter was nice to see the U.S. B2B sales increase like they did. You had a lot of enthusiasm about it. We had you on the road in September. Again, a lot of enthusiasm. And now, we see the data point in the third quarter. So, it's starting to look like two points is a trend more than a one-off.

You touched on it a bit, but do you think now, with the reality setting in that the rate cuts aren't going to go away in what used to be the standard allowable regions, do you think we'll start to see more of hockey stick adoption over to POCs in some of these regions, maybe in the rural areas where people are just giving up because it's unprofitable? Or how do you see that developing from here on out? Thanks.

Yes. It's a good question. And you're right; now we have a couple points. We're still pretty conscious, and I'd say two points are a line, not quite a trend. We are, I'll say, equally enthused this quarter as we were last quarter. But, really, we feel we need a little bit more time under our belt to say that there is a wholesale change afoot.

I think it is clear that people are struggling to cope with the new reimbursement rates. And they're certainly looking at all possible solutions to right the ship in their business with these new reimbursement levels. But it's going to take a little bit more time for us and more success and to see that continue to climb before we would say there is a hickey stick or we're in the middle of it. It's just too -- it's still too soon to call that at this point.

Danielle Antalffy, Leerink.

Great. Thanks so much for taking the question. And congrats on a really good quarter, you guys. I just, and I'm sorry if I missed this, I'm jumping on a few earnings calls at the same time. But based on guidance, you are assuming some deceleration on the top line in Q4. And I just wanted to better understand what might be driving that. Did you maybe see a (inaudible) of the G4 that might moderate a little bit in Q4? Or is there anything -- any color you can give there would be great.

Yes. There are a couple factors there. So, first of all, seasonality is important to remember in our business. Typically, in the warmer summer months that's when we tend to have stronger demand for our product versus the winter months where there is a weaker demand for our products.

On top of that, remember we also have the rental revenue headwinds. And we continue to expect those headwinds in the fourth quarter and expect those to increase slightly in the fourth quarter compared to where we were in the third quarter of 2016.

We also had a very strong international quarter, as you saw, in the third quarter of 2016. And, as we said, those sales can be very lumpy in nature. And it was a record quarter for international sales and we did see strong orders there from our customers. And so, we're a little cautious on the international side of how repeatable that is in the fourth quarter given those factors. So, those are the main drivers.

Yes. That's helpful. And then, my last question is just on the rental revenue. I mean I think I asked this last quarter as well, but just wondering if your thoughts have changed here. I mean at some point do you guys just exit the rental business? Or is there some reason that you guys should still be involved in the rental part of POC world? Thanks so much.

Yes, Danielle. The rental business is part of how oxygen therapy is being reimbursed. The issue is that what we're undergoing right now is, let's call it, growing pains. The entire reimbursement world, through competitive bidding, has changed significantly and the pendulum has probably swung a little bit from the left side all the way to the other side. That doesn't mean that it won't come back. You just got to give that a little time.

And there really is the question; will we be in the rental business forever? And the answer is I don't know. But will be we in the reimbursement business for as far as we can see? The answer is yes. Right? Because it does not always have to be rental. It is today, but it doesn't have to be. But, in reality, to kind of go and say, "Oh let's punt on the rental business because it provides us with a couple of difficult challenging quarters," would be throwing the baby out with the wash.

Yes. Let me add to that, Ray. I mean maintaining as broad market access as possible is part of our strategy. So, being able to use reimbursement as a vehicle to help patients acquire our product is something that we will continue to use as one of our tools to get product in patients' hands.

On the other front, I think, as we navigate through these challenges, I go back to something that I said earlier. Who better to help the other HME folks out there that have to navigate these same challenges than somebody that's walking in exactly the same shoes that they are? So, we can help them from a level of experience and we're all kind of tackling the same challenges together.

Thanks so much, guys.

Mike Matson, Needham & Company.

Sorry about that. Can you guys hear me?

Yes. Yes.

Okay. So, you called out some patent litigation costs. And I think there is some patent suit going on. So, I was wondering if you could just give us an update on where things stand with that and what are the potential implications.

Yes. So, you know the problem with that is that we can't comment on ongoing procedures. All we can say is what we have been saying all along; is that we don't really see no basis for these cases that have been brought and that they have absolutely no merit and that we do plan to defend ourselves in the most rigorous way possible. We have, at this point, not accrued any contingencies in our financials because we are very much convinced that there's no basis and no merit to these cases.

So, the cost is really the defense cost.

The cost is really the defense cost, the ongoing legal expense. And I mean that's pretty much all I can say about ongoing litigation.

Okay, I understand. And then, I was just curious; the rental decline was pretty large and I know you obviously cited the Medicare cuts. But I was wondering if the fact that you guys are requiring patients that want the G4 to buy it out of pocket is kind of helping to steer people to the DTC purchases rather than using insurance. So did that factor into that decline at all?

It certainly factors in at a very small level. So, when you look at our net patient additions for the quarter, we added 100 net patients. So, the fact that we had a very low net addition on the rental side of the business that would be a natural reason is that for those patients that did want the G4 their only option to get the G4 was to purchase it outright from us. So, that certainly can have an impact.

The largest impact was, of course, the actual cuts from competitive bidding from Medicare, both the application of applying the national rates across the board to that large portion of the market, as well the new competitive bidding rates for round 2 areas, and then the fact that we have continued to see private insurance payers follow Medicare and reduce their rates. So, those were the large factors because each individual patient you add in the quarter does not have a material impact on the rental revenue for that quarter.

Okay, thanks. And then just as the G4 goes up as a percentage of the mix, does that have any positive or negative impact on the gross margins? And that's my last question. Thank you.

It has a positive impact on the gross margin, but is a small impact. So, when you look at the improvement that we had from the Inogen One G3 to the upgraded version that we did late December of 2015, that was a large change. Here, this is smaller change than that impact. And, because it's only hitting a portion of the mix and it's rolling over time, it's smaller incremental steps over the quarters instead of, with the G3, when we rolled it out very quickly across all of our channels, you saw that impact very quickly in the first quarter of 2016.

Thanks.

(Operator Instructions). Matt O'Brien, Piper Jaffray.

Thanks. This is Matt in for Matt. Can you guys hear me okay?

Yes, we can hear you fine.

Great. So, I'm going to ask a question I think that might have been asked earlier, but slightly different. Have you guys noticed in any CBAs where DMEs are actually pulling out of oxygen altogether, given the lack of profitability? And, as a result, have you benefitted from this trend within your DTC sales segment?

I wouldn't say that we've seen anything material in any specific geography. We've maintained market access, broad market access with our success in the CBAs ourselves. Most of what we've seen from competitive bidding is more, I'll say, inquiries for help or assistance in how you run a non-delivery business, because that's exactly what we're doing, as opposed to picking up big chunks of business.

Okay. And then, also, is there anything that anything you guys can compare the international opportunities to, just really to the U.S.? And do you guys have any estimates on what penetration rates are there?

Yes. It's a real tough question and let me tell you why it's tough. First of all, from an oxygen or healthcare standpoint, there is no Europe. There is a collection of countries that all have different healthcare systems. Some are somewhat similar to the U.S. Some are very dissimilar. The only thing that's consistent in Europe is the EU and the currency. And we have some multinational customers that cover various countries. But, other than that, you've got to slug it out country by country.

There are some areas where we have much higher penetration than others. We know that our penetration, for example, in Spain is higher than some of the other countries. It's one of the countries that we had early success in, if you go back seven, eight years ago. It's driven by tenders, which tend to be blocks of business. So, when you win a block of business you may get 10% of the country in one fell swoop. A country like France is just the opposite. There's no tenders. It's a government healthcare system. And you win it one patient at a time through the providers and distributors that you have in place.

I will say that the penetration of POCs seems to be lesser in Europe than in the USA although it's much more difficult to get hard data around that. So, I'll say that's kind of a feel from what we've got in sales and what we see in the market. But they face the same challenges that we do, in that their reimbursement, while generally a little richer than ours, it still is trending downward. And you've got the same dynamics of people looking at POCs as a future solution. But they're not under the gun like we are here, given the rather dramatic rate declines that we've seen across the U.S.

Great. Thanks.

That concludes our question and answer session. Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a wonderful day.