Insulet Corp (PODD) 2012 Q4 法說會逐字稿

Good afternoon. My name is Stephanie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Q4 2012 Insulet Corporation earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.

(Operator Instructions)

Thank you. I would now like to turn the conference over to Brian Roberts. Please go ahead, sir.

Thank you. Good afternoon, everyone. Thank you for joining us for our fourth-quarter and year-end 2012 conference call. I am Brian Roberts, Chief Financial Officer of Insulet. Joining me on the call today is Duane DeSisto, our Chief Executive Officer.

Before we get started, I'd like to remind everyone that our discussion today may include forward-looking statements as defined under the securities laws. We intend these forward-looking statements to be covered by the Safe Harbor provisions for forward-looking statements contained in Section 27A of the Securities Act and Section 21E of the Securities Exchange Act and are making this statement for purposes of complying with those Safe Harbor provisions. These forward-looking statements reflect our current views about our plans, intentions, expectations, strategies, and prospects, which are based on the information currently available to us and on assumptions we have made. There are risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. Information concerning the Company's potential risks and uncertainties is highlighted in the Company's press release, issued earlier today, and in the risk factors section of the Company's SEC filings, including the Company's annual report on Form 10-K for the year ended December 31, 2011, and the Company's quarterly reports on Form 10-Q for the quarters ended March 31, June 30, and September 30, 2012.

These risk factors apply to our oral and written comments. We assume no obligation to update publicly any forward-looking statements whether as a result of new information, future events, or otherwise. I'd also like to remind you that the guidance we are offering today represents a point in time estimate of our future performance. You'll find a link to the webcast to this call as well as to today's press release at MyOmniPod.com in the Investor section. And now, I'll turn the call over to Duane.

Thanks, Brian. Good afternoon, everyone. 2012 was an extremely successful year across all fronts for Insulet, with strong revenue growth and expanded gross margins driving us to operating cash profitability in the fourth quarter. The year culminated with our most exciting accomplishment -- 510(k) clearance of the new OmniPod system. We have pioneered a new market, evidenced by the 45,000 plus people who use the OmniPod to better control their diabetes. People continue to choose OmniPod in greater numbers for its ease of use, discretion, and freedom from multiple daily injections, or the freedom from nearly three feet of tubing required with a conventional insulin pump.

Revenue grew nearly 40% in 2012 to $211.4 million. Our core OmniPod business continued to perform exceptionally well, with a third consecutive quarter of nearly 30% year-over-year revenue growth. This growth has propelled us to a double-digit share of the insulin pump market here in the US. With [over] 70% of our new customers having never before used an insulin pump, we are expanding the market of those taking advantage of continuous insulin infusion therapy. However, with just 3% share of the overall type I market in the US, it is clear that we have an enormous opportunity in front of us as we continue to increase our sales reach.

To improve that reach, in 2012, we invested in sales and marketing in the US. We added approximately 20 new members to the commercial team in the first half of the year, including a new inside sales capability which launched in May. Almost immediately, we saw a return of these investments as growth accelerated in the second quarter and was sustained throughout the back half of the year. I am extremely proud of the efforts of our sales team. They were able to effectively communicate to both healthcare professionals and customers that there was no reason to wait until the new OmniPod was available to start therapy.

While we know that some customers decided to wait, the team established new records for both referrals and initial shipments in the fourth quarter, and we entered 2013 with a referral backlog of potential new customers. After an extensive review process with the Food and Drug Administration, we were pleased to receive 510(k) clearance of our new OmniPod in December. The new OmniPod maintains all the same features and benefits as the original OmniPod, but does so in a package that is over a third smaller and a quarter lighter. We are confident that the new OmniPod will significantly address any size concerns of potential customers.

Since approval, we have been aggressively moving forward with the initial phase of our product launch to ensure a smooth introduction in the United States. At our national sales meeting in January, we focused primarily on training our commercial team. Our goal is to ensure a clear and consistent message to make sure that all healthcare providers and customers, both new and existing, are as excited as we are as we introduce the new product. The field team has spent the last 45 days educating healthcare providers to make sure they have had a chance to see, touch, and try the new product. Our customer support teams are prepared for the launch. They have been trained and have the resources to make the transition as seamless as possible to our customers. The result of these efforts is that we are now shipping the new OmniPod to new customers here in the United States.

For our existing customers, we will begin the transition from the original product to the new OmniPod in the next few weeks. To make this conversion as seamless as possible, we have taken several steps to make the change straightforward and easy. For example, we've created a What's New information card that will be included in re-orders, and we developed proprietary online training for customers to better understand the improvements in the new OmniPod. Additionally, we have ramped up our 24 by 7 technical customer support team to assist customers who need additional help with the transition. With a start in March, we expect that the majority of our customers will be enjoying the benefits of the new OmniPod over the next few months. As we commence the transition of the customer base in the US, our international partner Ypsomed is nearing the completion of the conversion in Europe. Feedback on the new product has been excellent and has led to an overall increase in Ypsomed's growth rate. We expect growth in Europe to accelerate over the coming months and our international business to more than double in 2013.

On the operational side, we have also made significant strides towards a smooth changeover to the new OmniPod. Our operations team, our partner Flextronics, and our many suppliers have worked closely together since approval to commence the manufacturing move from one product to the other. At this point, the supply chain has effectively transitioned to the new OmniPod. At Flextronics, we're in the final production runs of the original product, which will provide us enough supply to implement the transition plan of the customer base. Production of the new OmniPod continues to increase across two manufacturing lines, as resources that were producing the original OmniPod switched to producing the new OmniPod.

With two manufacturing lines active, we have capacity to produce approximately 600,000 new OmniPods per month or about 20% excess capacity over current demand. While resources have been focused on the initial two lines, as well as dealing with the shutdown for the Chinese New Year, we have made progress on the third manufacturing line as well. We anticipate that the third line will be qualified this summer, increasing our overall capacity to nearly 1 million pods per month. While we are not at optimal production levels today, we expect to be at those quantities in the second quarter, which will drive the cost per new OmniPod down under $12, allowing us to achieve 60% plus US OmniPod margins by the end of the year.

With the approval of the new OmniPod completed, we now turn our attention within our R&D team to other areas of development that will drive future growth. First, we expect to file in the coming months a submission requesting 510(k) clearance for our PDM integrated with the LifeScan Verio blood glucose meter. We are hopeful that this new PDM will be commercially available in 2013. Second, we continue to make progress towards leveraging the OmniPod technology for use with other pharmaceuticals outside of the diabetes space. The closest of these initiatives, an approved oncology drug, is in clinical trial now and could be on the market as early as 2014. Third, we continue to look towards opportunities within the type 2 diabetes market to assist the growing population of insulin-dependent type 2 patients.

Finally, in January, we signed an agreement with a new, continuous glucose-monitoring partner. The agreement calls for both parties to continue development work already underway towards the ultimate goal of an OmniPod integrated with a CGM sensor. The benefits of combining the OmniPod and the CGM sensor in the same system are numerous. For example, a person no longer has to wear two things on the body, giving the customer more freedom and eliminating CGM-type holidays. Market data has always suggested that, while people living with diabetes are willing to wear one device on the body, much fewer are willing to wear two devices. Additionally, both products share many similar components, allowing the sensor to be added to the product at a significantly reduced cost as compared to standalone sensors.

As we've seen with the latest round of competitive bidding, the reimbursement environment is only going to become more challenging. By developing a more cost-effective all-in-one product, we are well positioned to address this changing reimbursement landscape. We believe a truly integrated OmniPod/CGM system has the potential to become standard care and are excited about its prospects. Early returns on our progress have been very positive, and we are confident that sensor accuracy will be comparable to those currently on the market. Clearly, our pipeline is robust and will allow Insulet to remain an innovative leader in diabetes for years to come.

While the OmniPod business demonstrated strong growth throughout 2012, our Neighborhood business did lag behind our expectations. In the fourth quarter, Neighborhood Diabetes generated just under $13 million in revenue, or about 4% year-over-year growth. When we acquired Neighborhood Diabetes in June of 2011, we did so to achieve three strategic goals. The first was to solidify and strengthen our reimbursement, billing, and distribution infrastructure. With more than two-thirds of our patients receiving their OmniPods every quarter directly from Insulet, we needed to make sure that our services arm was capable of handling an ever-increasing number of customers. Second, we needed to add a national pharmacy capability as trends continue to push diabetes supplies to be adjudicated as pharmacy benefits. Third, we wanted to be able to [bride] customers at both entities with cross-selling opportunities.

As we reflect on our progress today, we are especially pleased with the results of our integrated infrastructure and pharmacy capability. In 2012, we completed the integration and the support functions and saw improvement in key metrics such as better conversion, lower day sales outstanding, and a reduced cost per shipment. These improvements helped drive the improved gross margin seen over the last couple of quarters. On the top line, however, 2013 will be a challenging year for our Neighborhood Diabetes business. In late January, CMS announced results of the second round of competitive bidding for the distribution of certain diabetes products such as blood glucose test strips for Medicare customers.

CMS has decreased the overall reimbursement rate for these products by an average of 72%, including a decrease in the reimbursement rate for blood glucose test strips from more than $33 per box of 50 strips to $10.41. The new rate is expected to become effective on July 1. At this new reimbursement rate, it is likely the Neighborhood Diabetes will cease selling these products to Medicare patients after the effective date. The potential impact of competitive bidding on the business is expected to be $10 million to $15 million in revenue in 2013, with the majority of the impact in the second half of the year.

In summary, we had a great 2012, and we're very excited about 2013. The team has worked tremendously hard on making the new OmniPod a reality for our customers. The launch in the new OmniPod here in the US will transform our business operationally and financially as we bring an improved product to the market with a much better margin profile for the Company. We are confident that the new OmniPod will also accelerate the top line of the business, and we are seeing early signs of that in our forecast in new customer starts. In fact, as we look at the first quarter, which is historically a very challenging period for new patient starts, we are forecasting a year-over-year increase of nearly 30%.

For the full-year 2013, we believe initial shipments will increase by over 40% as compared to 2012. We do expect some disruption in the first quarter in terms of reorders, as we have seen many patients delaying shipments to utilize any remaining supply they may have on hand. As a result, we do expect some percentage of our reorder customers to not reorder in Q1 but wait until the second quarter. Taking into consideration our forecast for increased OmniPod initial shipments, potential of a loss reorder for some percentage of our customers, and the impact of competitive bidding, we are setting our initial revenue guidance at $240 million to $255 million for 2013. We expect that the OmniPod business will continue to grow for the full year at approximately 30% at the midpoint of the range, with the top end achievable of growth that accelerates to higher levels. With that, I'll turn the call over to Brian to provide additional details about the fourth quarter, the full-year 2012, and our expectations for 2013.

Thank you, Duane. First, let me summarize our fourth-quarter results. Revenue increased overall by 23%, to $57.8 million in the fourth quarter of 2012 compared to $47.2 million in the fourth quarter of 2011. Despite some patients choosing to wait for the launch of our new OmniPod, the core business continued to perform exceptionally well, with approximately 30% year-over-year growth for the third consecutive quarter, coupled with record levels of initial shipments and referrals. Gross profit for the quarter improved by over 25% to $25.3 million compared to gross profit of $20.1 million in the fourth quarter of last year. Gross margin was 44%, a slight decrease from the third quarter. This decrease was a result of higher international sales of the new OmniPod, which, given the current inefficiency of production, produced the decline.

Operating expenses for the fourth quarter were $31.4 million, less than a 3% increase from $30.6 million in the fourth quarter of 2011. Operating expenses declined 5% sequentially, from $32.9 million in the third quarter of 2012, as we incurred higher costs related to our new OmniPod approval and commercial launch activities in Q3. We reported an operating loss for the fourth quarter of 2012 of $6.1 million compared to an operating loss of $10.5 million for the fourth quarter of 2011 and $8.5 million for the third quarter of 2012. Our fourth-quarter 2012 operating loss includes over $6 million of non-cash operating expenses, comprised primarily of depreciation, amortization, and stock-based compensation. We achieved operating cash profitability back in September and maintained it throughout the fourth quarter. Net interest expense was $4.1 million in the fourth quarter of 2012 compared to $3.8 million last year. Of the $4.1 million in interest expense, approximately $2.6 million was non-cash. Finally, we reported a net loss for the fourth quarter of 2012 of $10.2 million, or $0.21 per share, compared to a net loss of $14.3 million, or $0.30 per share, for the fourth quarter of last year.

Now, let me summarize our full-year 2012 results. Revenue increased by 39% year over year to $211.4 million from $152.3 million in 2011. For the year, our core OmniPod business performed well, growing nearly 30% and accounting for over 75% of our overall revenue. Gross profit increased by nearly 40% to $92.3 million as compared to $66.7 million in 2011. Gross margin remained consistent at 44% each year, a significant achievement given that our 2012 results included a full year of Neighborhood Diabetes as compared to a partial year in 2011. Full-year 2012 operating expenses were $128.3 million as compared to $109.2 million for 2011. The year-over-year change is primarily related to our acquisition of Neighborhood Diabetes in June of 2011, coupled with unplanned incremental costs related to the approval process for the new OmniPod this year.

For the full year, we reported an operating loss of $36 million compared to $42.5 million in 2011. For 2012, we reported a net loss of $51.9 million, or $1.08 per share, compared to a net loss of $45.8 million, or $0.98 per share, for the full year of '11. As of December 31, 2012, cash and cash equivalents totaled $57.3 million. In early January 2013, we sold 4.7 million shares of our common stock at a price of $20.75. We received net proceeds after underwriting discounts and issuance costs of $92.8 million. At the end of 2012, we had approximately 48.4 million common shares outstanding; however, after the sale of common stock, we currently have approximately 53.2 million shares outstanding.

Finally, let me turn towards providing some color for 2013. As we plan for 2013, we've taken several factors including the 510(k) approval of our new product, our launch strategy, and customer transition plan, as well as the potential impact of the competitive bidding program into consideration. As Duane noted, the OmniPod business continues to perform exceptionally well, and we are confident that we will see initial shipments accelerate with the launch of new product. In Q1, however, we have seen existing customers delay reorder shipments to utilize any remaining supply on hand, resulting in some expected reorder disruption for the business in the first quarter. Additionally, we know that, historically, the first quarter is always our most challenging time of the year, due primarily to seasonality and deductible resets. As a result, we're projecting first-quarter revenue in the range of $56 million to $59 million.

For the full year, we expect revenue to be between $240 million and $255 million. This implies 30% year-over-year growth for the core OmniPod business at the midpoint of the range. In regards to gross margins, as we've indicated in the past, we will provide our in-warranty customers with a new PDM at the time of transition at no additional cost. The payback to Insulet is effectively three to four months of savings from the new lower cost OmniPods. Thus, with the conversion of the customer base expected over the next three to six months, we would expect gross margins to remain relatively flat with Q4 for both the first and second quarters of 2013.

We would expect to see an uptick of approximately 3 percentage points in Q3 and further increase of an additional 3 to 4 percentage points in Q4. The full effect of the new pod will come to play in Q1 of 2014. Operating expenses are likely to remain in the range of $32 million to $34 million per quarter throughout 2013 as we continue to invest in our sales and marketing function to support our growth and the launch of the new OmniPod. We do not expect significant increases in R&D or G&A, with any uptick in G&A costs primarily a result of non-cash charges such as stock-based compensation. We are confident that we will be cash operating profitable for the full year and have set a goal to be operating profitable as defined as earnings before interest in taxes in the fourth quarter. With that, let me turn the call back over to Duane.

Thanks, Brian. In summary, 2012 was a year of very strong execution for Insulet, and we expect 2013 will be even more exciting. The OmniPod launched in Europe to a strong early response, and we have now commenced the launch in the US. We are on track with our transition plans for our 45,000 plus customers who are now confident that the feedback in the US will be just as positive. We are always focused on innovation at Insulet. In 2013, we will continue work towards expanding our product portfolio with the LifeScan PDM, new entries in the type 2 market, and integrated CGM-enabled OmniPod. We will do all of this with our shareholders in mind. With the robust demand we expect for our new OmniPod, we expect to be able to continue delivering strong year-over-year top-line growth while expanding our gross margins even further to become operating profitable by year end. With that, operator, please open the call for questions.

(Operator Instructions)

Kim Gailun, JPMorgan.

First question is on the new product launch, and maybe talk about the ability to get into new accounts with the new OmniPod, how those conversations are going and why you think the new product is going to get you the ear of some of the endos that have not been using your product before?

I think Kim, so the early returns, and keep in mind they are early, but the early returns, people are intrigued by this next step in our evolution. And I think from our standpoint, there is both patient excitement, and like I said, many of these physicians -- one of the blocking things that was out there was our whole insulin on-board calculation, and not to bore everybody with the kind of arcane way we did it, but we thought we had a better mousetrap. It was not the way the market leader did it, so this product basically put it in line with the way the market leader did it, which was blocking us in several institutions.

They did not want to be treating their patients, training their patients on multiple ways to calculate this depending on the product. We know for a fact there's a whole list of people that told us as soon as we fixed that, come back in. Even if in the original product we just wanted to fix that, that would have been a whole new 510(k), so we coupled that in there. We know there's places, we know why a lot of people were blocking, and like I said, there is a lot of interest so gives us the opportunity to go back into all of these guys. Like I said, that one in and of itself is significant.

Okay, great. A follow up on the gross margin side, it sounds like you guys are doing all the right things on the manufacturing side, but how do you get visibility into that second half of gross margin ramp, because it sounds like you're still looking to exit the year at that 60% plus gross margin level?

No problem Kim, it's Brian. We have certainly talked with our partner Flextronics on a daily basis, and Charlie has been leading the charge for us and making sure that we're hitting all of the milestones that we need to hit around our overall pod cost, making sure the components cost coming in as planned, and so far, we are right on track. With all of those discussions with Flex, as we get to full capacity here, as we said in the prepared remarks, as the original pod ramps down its final runs of production and all of our resources can then be focused on generating the new pod we are very confident that we're going to see the cost come in where we need it to be.

I still feel extremely confident that we're going to end this year with a US OmniPod margin in the low 60%s, which will translate on a consolidated basis -- our Q4 gross margin on a consolidated basis is probably somewhere around 50%, 51%, and then you get the full effect of it probably a few more points in Q1 of '14 once all of the inefficiencies of the transition are now over.

Great, thanks guys.

Danielle Antalffy, Leerink Swann.

Wanted to, Duane, follow up on your comment about patients deferring for the new OmniPod. How do we think about the impact of those patients coming online versus the reorder disruption that you expect to see in Q1? How did they offset each other? If you could walk us through that, that would be helpful.

Sure, Danielle, it is Brian. As you guys know, in any given quarter, the majority of our revenue in a given quarter comes from our reorder base. As our patients come on-board, they typically order every 90 days, and a lot of that is dictated by guidelines that come from the managed care plans of how we can bill. So no surprise, typical effect is your sales in the third month of the quarter tend to pick up a little bit, so you are always a little bit back ended.

On average, we see and hear from patients that they may have around a month's worth of supply maybe sitting around in the closet that they have accumulated over time for whatever those reasons may be. Some would like to be able to leverage and use that supply before going onto the next-gen product, and a lot of that couples with the fact that it is Q1 and everybody's deductibles have reset, so there is more cash out of pocket in Q1 then as compared to Q2 or Q3.

What we are planning for, just given what we have been hearing from customers through the first two months, is that some of our reorder customers who would ship in the month of March normally may not wind up shipping until the beginning part of April. The impact of that just becomes, depending on the managed care plan that those reorders, you may have a group of patients who have three reorders in the course of 2013 versus four. That is what we have effectively baked into that Q1 number, and then our overall guidance is that phenomenon. Any disruption from the reorder base around this area we think is completely resolved as we get into the Q2. This is really almost just a March, April effect, and it is just a timing issue of exactly when the quarter cuts off.

Certainly new shipments, and one of the things that we're pretty enthusiastic about is coming out of the gates with a strong new shipment number in the first quarter of the year. It means that those patients are going to have three reorders over the course of the year as compared to if they start in Q2, then they have two reorders. There is a compounding effect there by getting more people on board with the product earlier. It certainly is why we put a lot of effort to making sure that we were ready to go with the launch here and that all of our customers in the US are now getting the new pod. That will offset some of that effect, but really it is a timing phenomenon between March and April.

Great, that's great color. Then on Neighborhood Diabetes, obviously the business is turning out a little bit different than you had hoped and dreamed when you purchased it. Can you talk about how you're thinking about Neighborhood Diabetes going forward from a strategic perspective, what might happen to that business or does it still make sense within the total Insulet business from a potential sales synergies perspective?

This is Duane, that is a great question, Danielle. Look, I think from our standpoint, it wasn't lost on us or anyone else in the industry that competitive bidding was going to come out. I think the entire industry in terms of the glucose monitoring business was stunned at $10.41. I think I would tell you flat out, our proposal, we thought that was still profitable business for us in the $13 per 50 box range, at $10.41 it really isn't.

I think the pluses that we saw and we described there, we are seeing the benefit of all of that. I think from our standpoint, we are -- we obviously have to modify the spending to take into account the business that will go away with this Medicare piece. There is subsets of people out there that are thinking that they can make a lot of money at $10.41, so there's some interesting customer names there, so there's a lot of activity swirling around.

I think our overall concept continues to be, and I think when you fast-forward whether it's two years from now or five years from now, patient driven outcomes are going to be the real key to this whole thing, and we still see Neighborhood playing a huge part in where we want to be, their high touch service model. We are still very excited about it, and in my mind, we didn't buy it for the Medicare strip business. That came along for the ride and was nice and it was accretive business at the time.

But $10.41, you just scratch your head and say -- it is the only real Medicare business that we have, it is easier to get out from under that than it is to be involved, and all that goes with being involved with the government at that price, a very tough business model for all those guys. We're still excited, we still see -- nothing has changed from our standpoint, but obviously we have to readjust a little bit.

All right, that makes sense. Thanks guys.

Bill Plovanic, Canaccord.

Just a couple of questions here. First, on the Q1 guide, is Jan, February, you talked about it but, from a utilization rate, it is going to drop down, it comes back in April-ish. How do you know that that's not a competitive issue?

Bill, this is Duane. I think we're talking to the customers, right? What we have is, when we've talked to people, we explain to them the transition plan, it's not like people are coming back to us saying -- we don't want the product, they're trying to use this, what a lot of people are hoping is if they use the supplies, then the next reorder they get will be the new product. There is a bunch of that going on. I think one of the benefits that we have in this business, we actually talk to the customers.

I think from our standpoint, the kind of insight and guidance we are giving you is the feedback that we are receiving from our intake group. We're really not, I would tell you, we're not sitting here with initial starts going up and the other positive things, we really don't see those as competitive things But we are, and like I said, the nice part about the good news and the bad news depending on the given day is we talked directly to the customer.

To parlay that, 40% new patient gross sounds -- doesn't sound like competition is really having an impact on you, because it is I think the best growth you've all had. Is that US or is that worldwide, just a little granularity?

That 40% number is factored on the US.

Then one more if I may, just as you look at CGM, you've talked about it, you signed the partnership still with an unnamed company, a name would be helpful, one. Two, time frame and cost to develop this, and that is all I had, thanks.

Bill, just to make it clear, the agreement we have with the Company until we get to the point where we think we have a final version, a commercial version, we agreed not to get involved in disclosing that. If the company wants to disclose it at some point in time, we said it is fine with us. But they asked us not to disclose it, and like I said, it is not material to anything we are doing at the moment. In terms of the cost, it really fits within the guidelines of R&D because once again, just to reset everyone, we're not developing a sensor. We are taking a sensor that is developed by a company that has been in the blood glucose monitoring business, and we are trying to integrate that into our product so we have an existing product.

If you think about what is involved in terms of the new R&D type stuff, it is a, they've got to make sure the sensor's competitive with everything that is out there. And like I have said, we have tested on pigs, so far so good. Sometime next year, we would like to be doing it on people. We would like to be doing it on people not as a stand-alone sensor, but in our integrated format.

So the big engineering hurdles /opportunities for us is how do we insert this within the framework of product we have, and how close can it be to the insulin delivery, and the third one is, and we've tested this a lot now, but we still have to go through and test it in final form is, can the sensor withstand ETO sterilization. From an engineering standpoint, those are three big things that we have. So I would tell you it's not outside the scope of our ongoing engineering, it's not some huge increase, because once again, we are not developing a continuous sensor.

Ben Andrew, William Blair and Company.

Can you talk maybe about two or three topics. One is, if you can't at this time, I apologize, but the Ypsomed experience with both patient satisfaction and patient add rates as you've rolled off Gen II, how has that gone?

We have seen an uptick, Ypsomed has worked over the course of the last five months or so on transitioning their customer base from one to the next. I think our last shipments of the original OmniPod to them were probably back somewhere in the August, September time frame, all of Q4 was the new pot. The response has been really positive from that. We've seen it in a couple of ways.

One is, their growth rate, the number of patients they have been adding every single month has started to accelerate, and that has been happening in a period of time, so for example January and February within their business, which aren't the strongest of months either. Second, we've also been able to get some early response back from them around their initial feedback, what we're hearing from customers, and one of the things that we've focused on is these idea of auto box failures from a quality perspective.

One of the things that we know is that customers don't like the fact that the pod comes out of the box and for whatever reason we have a communication failure with a handheld and it does not work. Historically we have seen a 2% to 3% rate or so of those here in the United States. We made a lot of changes to the product, including why we're giving people a new handheld to be able to improve that overall communication protocol. To date, we are seeing that overall rate overseas now drop from the 2% to 3% range to less than 0.5%. We think that is a significant improvement overall from where we were. It has been a big positive for us and something they have commented back on.

It sounds like the gross margin is trending consistent with what you would expect. Are the yields flowing in the same trajectory?

Yes, absolutely. There certainly -- as Charlie's been working through the process with our various suppliers, there have been a couple of components that the yields are a little bit lower on than you'd like. The good news is except the parts that are $0.10 a part versus the point where you're getting to a fully developed OmniPod. I'd call that just a normal course growing pains as these suppliers ramp up their production from tens of thousands per month to hundreds of thousands per month, and then obviously the next step would be as we get through the year to 1 million pods per month.

Okay, and then turning to see CGM products for a second, can you, Duane, maybe give us a timeframe for when we could hear an update either public presentation of some data about the performance of the sensor, and have you been able to determine if you can use the same cannula, or is it going to need a fundamental redesign of the pod? Obviously R&D -- and then I've got a follow-up for that.

Ben, great question. From our standpoint, we want to fit it in the same form factor. We are still going around that process to see if we can do that. The last thing in the world who want to be doing is buying new tools, new base tools and doing all of that. Right now, we believe, but we still have to prove it that we can use the same form factor.

I think in terms of -- I think for us, I think the first real milestone other than the normal R&D and the pig data and the other stuff that we have done, we have gone through this [generations], we would like to begin in the next year to start getting it on people. And if we can get it on people, then I think -- if you start looking at the convention and see between the ADA, the ATTD, the AAD, hopefully at that point in time, we will have enough that we can start sharing that information with people.

Like I said, right now, we've got some real promise. We will see if we get where we want. We are excited about it, we obviously wouldn't have signed it, we wouldn't have been putting the effort into it if we hadn't seen enough to really take the next step up. To me, that is -- that would be the time period there. I think we would start having data in the meaningful enough format that it would be worth sharing with clinicians and the general market.

That is just the sensor itself, not embodied within the pod we would be seeing --?

No, that is another great question. We're trying to put it in, we're not doing the sensor. What I'm talking about is we are trying to embody it into the pod and put it on people come the beginning of next year. We have a couple of variations of that, depending on where the insulin is going to be delivered in relationship to the sensor. We're going to try, we are trying a couple of different things here, and we've done a lot of work understanding the impact of insulin delivery in the proximity to the sensor so we think we understand.

We think we understand, but as you know, until you start putting it on people, you really don't. We think we understand, but we're going to find out what we don't know in doing this. We are talking about, when I talk about putting it on people, it's not a standalone sensor. I'm talking about putting it on in the embodiment that we believe will approximate what the product should look like.

Has that CGM sensor been used on actual patients, as opposed to given controlled testing as opposed to diabetics and patients that have got other comorbidities and all kinds of other stuff going on?

It has been used, the technology has been used on patients, but not in this particular format, no. We have been through the steps, we have been through blood, we've been through the pig test thing, but we've still got a ways to go. I don't want to paint any pictures that this thing is around the corner. Like I said, I think our view is simple.

I think if you look at the pressure being put on blood glucose monitoring, and you look at where this is all going, you look at our internal studies on how many things people are willing to wear on the body, we are focused on insulin dependant patients, but I think it is pretty clear to us that the right format is to get it all in one person. Get it all on the insulin dependent people, and we think over time that will drive some interesting outcomes, and we think that is the format, we think we have a cost structure that we can accomplish that. So hang on, we will keep you informed as we go forward, but that is how we are approaching it.

Just to be crystal clear, you're talking about the embodiment of the CGM within the pod that the CGM sensor itself has been used on diabetics and patients and people with all different kinds of drugs on board and you're comfortable with the performance of the sensor?

The technology has, the embodiment of the sensor has not. It may have been used on the -- on a few patients I don't know, but not in any meaningful way, but the technology itself has been tested on patients.

Mimi Pham, ABR Healthco.

Did you get the installed OmniPod base at the end of 2012?

Yes, we mentioned that we are at this point slightly over 45,000 patients.

I guess doing the math, would that be fair that to use a ballpark number of 15,000 new patient adds last year when talking about initial shipments increasing by 40%?

Yes, I'll let you guys go through that part, but I'll just leave it -- we are over 45,000 patients, and we've talked about that in our overall annualized attrition rate, continues to be hovering in that a 8.5% to 9% range. I will leave it there.

In terms of the delay in the CGM integration timeline, how important is CGM integration to your current customer base? Do you have any sense of that installed 45,000, what percent are using CGM?

We do an independent survey, and I think about 20% of our installed base is used in CGM. If you look back at the beginning of the year, about 20% of our installed base was using CGM. In our particular -- in that 45,000 number, granted we have an independent company do a survey, they have lots of different questions for CGM usage is one of it. So about 20% of that installed base is using it, and we're predominantly they're using the [Dexcom] sensor because if people want CGM, that is where we direct them. Not to the market leader.

The last question, just to clarify, will you stop shipping first gen pods by year end?

By year end 2013?

Yes.

Absolutely. Hopefully sooner.

Tom Gunderson, Piper Jaffray.

Just to be clear, I didn't catch this at the beginning, you're going to start shipping to existing customers of gen II, or next gen in the next several weeks. Are new customers getting this right away?

New customers, we've moved all of our new customer shipments to the new pod, and we will start to transition our existing customer base here within the next couple of weeks, correct.

Duane, you said last quarter that you might start when you got the approval, prior to getting approval, when you got approval that you might go out to some of the big centers that you could get a lot of bang for your buck. Did that in fact happen?

Yes it did, and Tom the kind of insulin on board calculation like I said is a bit of an arcane calculation, but obviously it is critical to diabetes patients. Some of the bigger centers were concerned about how our older product did this, and not that there was anything wrong with it, it was just different, so that meant they had to train on it, and some of them were worried about confusing patients.

The fact that we are now in line with how the general market does it, we've already been back to those guys, and a couple of them have already given us a couple of patients because they want to see it live themselves. It is one thing to give them a demo, but they want to put a couple of patients on, and they want to start seeing it. We're pretty excited. Like I said, time will tell here, but we're pretty excited about what the opportunity is.

Just a larger concept on type I, there has been reports now for the last couple of years that there is a new type of type I which some are calling late onset, adult onset, but type I. I would think that OmniPod would be well-suited for that. Have you seen any differential uptake by those older new type ones?

There has been a little -- Tom, that's a great question -- there has been a little bit, but the sweet spot for us still remains that 18 and under. What people gravitate to with this product and will gravitate even faster to with the smaller product is, obviously, this whole freedom not interfering in their lifestyle, basically having diabetes but in their mind they don't have diabetes for that period of time.

There has been an uptick, it is interesting, there has been a little bit of uptick. While it is not meaningful yet in terms of installed base, there has been an uptick in the type II, insulin-dependent type II for the product. We are seeing some of these numbers start to move a little bit. But it is still, like I said, the sweet spot for the Company is still that young active, whatever you want to define that as are the people that gravitate immediately toward this product.

Got it thanks. One for you Brian, I think in the script it said operating profitable by year-end was a goal. Could you talk a little bit about cash flow from operations since you've had a good run here in the last part of '12, what you expect that to be maybe by quarter in '13?

I don't think I have the quarterly detail to go through, but overall, we were operating cash profitable over the last four months, and again, the definition that we used for everybody just to be clear is, effectively EBITDA plus an add back for basically stock comp expense, so we have been able to achieve that now for the last four months. The trick now is as we continue to grow the overall top line, as we continue to expand the gross margin through the transition to the new product, is that we are then able to cover those non-cash expenses, as well to get to overall operating profitability.

Uses of cash in 2013, we will still use some cash mainly around capital expenditures and will have to cover the interest expense in our debt. From an operational perspective, using the P&L as a guide, I think we're going to be in really good shape and we will be effectively operating cash profitable for the entire year. There could be a little bit of timing change from a working capital side as we build inventory, as we go through receivables and those things. That piece will be tricky to be able to nail for you right now.

Got it. Thanks, that's good for me.

Jayson Bedford, Raymond James.

I realize the benefits of the new device, and you mentioned 8.5% to 9% attrition rate on gen I. Just wondering internally are you expecting a lower attrition rate with the new pod?

I would tell you we are hoping for a lower attrition rate from the standpoint, one, if you take about half that attrition rate being economic in that people are impacted in their jobs or whatever, take that off the table. The other big piece of that attrition rate was given that 70% of our customers have never been on an insulin pump before, and if you couple that with what Brian said, one of the failures we struggled with on and off was the whole out of box failure. If Europe is any indication, we are cautiously optimistic that we put that one in a good spot.

That is the one that gets people pretty irritated. The whole idea that they put it on and all of a sudden they had a problem with it. That we feel based on the European experience so far we feel pretty good about, we specifically went after that one in design.

The second piece, if you look at the second cause, if you get out of that -- if you look in the first 45 to 90 days where a bunch of these people would drop off, the second reason was, some of put on -- it was a bigger than -- I know I tried it, but it is a little bit bigger than I thought, so we think the size will help impact that again. Let's put it this way, if size was an issue, there will probably not in any foreseeable future be a smaller insulin pump than this. I think that will knock down the second one.

The hope is that we impact that number. Like I said, I think on the economic side, about half the number has always been related to people's jobs, their health care benefits. There is a school of thought internally that with Obamacare kicking in, maybe we get a benefit from that. We will see. I will readily admit I'm not smart enough to dial in the impact of what that all means.

There may be a positive from that, but right now like I said, if you look at the two major things that we think we went after and hopefully knocked out here, size is obvious, and then these out of box failures, we feel pretty good about. You put those two together, we think there will be a positive impact.

That's helpful. The financial structure of the CGM partnership, is this a royalty type arrangement, is there cash outlay from you guys expected upon some sort of milestone?

Ultimately the plan would be simply think of them as Intel inside. They will effectively sell sensors to us at an agreed-upon price and we will work it into our bill of materials and the go forward. No different than how we buy semiconductor chips from Freescale, same type of approach.

Maybe Brian on the OpEx a guidance just curious as to the mix? Looks like it will stay fairly constant in '13 here. Wondering if you are able to take some of the cost out of the Neighborhood business given competitive bidding. And then maybe backfilling that with increased spend on the launch. Is that a fair way to look at it?

Yes, absolutely. Certainly as we continue to figure out, obviously there are still some moving parts of the competitive bidding, and the July date move and some of the other stuff we're just watching it closely. Certainly there's an opportunity to be able to reallocate some resources from that area to other initiatives likely within the commercial team. If it all comes to pass.

Last one for me if I may, you mentioned you expect international sales to more than double in '13. What were international sales in '12?

We haven't disclosed specifically what the number is. I have said to folks that it is somewhere in the mid single digits, but we haven't gotten more specific than that.

Ben Haynor, Feltl and Company.

On the gross margin guidance, you talked about the 2% to 3% out of the box failures here in the US and about 0.5% in Europe. Does the gross margin guidance factor in any improvement in the out of box failure rate?

Yes, we certainly -- again, as we've given you the gross margin expectations for the next four quarters at least, it's again roughly flat for the first and second quarter of '13 from where we are today. Probably a 300 bp or so improvement in Q3. Another similar improvement, maybe a little bit more than that in Q4.

We are taking into consideration where we're seeing a little bit so far, and hopefully being able to drop down, if you will, our implied warranty on pods, because certainly when people experience the out of box failures, we are able to, we turn around and replace those. We haven't really factored into that impact customer support costs or any of those things at this point. It is just too early.

That's helpful. On the CGM side of things, is the plan for it to insert the cannula on the OmniPod? And then also is it a glucose oxidase-type sensor, or is it something really new and different?

The technology is -- the technology while different isn't based on the glucose oxidized sensor, and the idea is what we are working on is automatic insertion, so it will be, I can say it will be on the same general concept as the com product.

One more quick one, I didn't quite catch this, did you say 10% to 15% impact versus 2012 revenue on Neighborhood or $10 million to $15 million?

Million, dollars. We anticipate that it will be $10 million to $15 million of revenue impact in the Neighborhood in 2013, the majority of that in the back half of the year. But realistically, our expectation is it will start to see some attrition in the second quarter as we would expect some of the folks are going to aggressively go after this business will try to do a land grab.

So $35 million to $40 million type range.

No, you mean for the Neighborhood in total?

Correct. Yes. $10 million to $15 million decrease.

Robert Goldman, CL King.

Just two little things, with Neighborhood Diabetes in the quarter, was it about the same revenue in 2012 fourth quarter as compared to third? That's what I thought I was hearing, but just wanted to check that detail.

Yes, it's pretty accurate. It was up slightly sequentially, we were a little under $13 million in Q4 but that is correct.

Also Brian, you mentioned some reference to 40% growth with US OmniPod, and I didn't catch exactly what metric you were referring to with that 40% growth.

Yes, sure. What Duane said is we are projecting -- when we look at our new patient starts in 2013, we are forecasting that we should -- we're forecasting a 40% uptick in the number of new patient starts from 2012.

On the international OmniPod, you mentioned that mid single digits was what you've been suggesting to folks for 2012 sales. Did you see any, or what sort of progression did you see in the fourth quarter versus the third?

Certainly there was an uptick in the fourth quarter revenue versus the third as we move them completely to the new OmniPod. That was a quarter where I don't want to call that they built inventory but they certainly added a little bit extra where beforehand they would pretty much hand them out.

Suraj Kalia, Northland Securities.

Duane, I know there has been a lot of discussion on the CGM part of the equation, hopefully forgive me, if this is too redundant or just beating down the same questions again. I heard you say this technology may have been used on patients, and I am just curious in terms of the strategic thought process to the extent that you can share, why go down the new technology given the challenges in terms of product launch and technology validation, so on and so forth to whatever extent you can share. I'm very curious why -- it looks like you are going to the new player, but probably some combination technology and I'm very curious why not go with some of the existing players.

Suraj, great question. There are two parts to it. First of all, these people do have experience in this, so when I say the technology, the sensor, the trick with all the existing sensor technology, any kind of oxidized sensor is they do not do well in heat and humidity. The way we sterilize our product involves heat and humidity. The real trick for us if we're going to integrate it into the pod is was there sensor technology out there that can withstand heat and humidity and still function at a comparable level to the technology that is out there. That was the real trick for us.

If we're going to put it in one pod, I think if you talk to any the existing players, they would tell you that heat and humidity is not a good thing for any of their sensors. We think we found one that has a sterility cycle that can be ETO sterilized, that can be comparable to everything that is out there, has a start up time within an hour and can work in our product at a cost that we think we can make money at.

That is really the trick for us. It is other than that, I would just tell a patient if that product doesn't exist, you would just tell the patient go with Dexcom sensors, that is the best one out there, go get it. That is the way we go about it.

If we are going to put it all in one product, that is a significant technological hurdle that the existing centers that would tell you think if you talk to any of the players out there, they would tell you their product doesn't like, and we think we have a product that we can do all that. All the animal testing we've done, all the testing in blood has all been through an ETO cycle, and like I said, while it's early, and I want to emphasize it's early, the data looks very intriguing to us, and the form factor can fit in our product so those are the biggies.

Duane, what percent of the Neighborhood Diabetes patient base has been converted to the OmniPods and I guess how are you looking at it from a fiscal '13 perspective?

This Brian, we purposely for a couple of different reasons have not aggressively gone after switching Neighborhood customers to the OmniPod at this point. A lot of that was really predicated around we wanted to do it with the next-gen product. Monday morning quarterbacking, we thought we would have been kicking that initiative off nine months ago, instead we're effectively kicking off that initiative now. As we talk about 2013 and new patient stats, certainly there's a group of folks within the Neighborhood business that we think we can get over to the OmniPod side that make up a piece of that number.

Brian, just to follow up on that question, if I strip out again in terms of units or new patient add-ons, 40% growth, let's say X percent you move, strip it out because of Neighborhood Diabetes, on a year-over-year basis, when I strip out Neighborhood, which you say would still be higher than what we have seen in 2012? I'm just trying to get a sense of the new OmniPod, what that is going to do to core patient growth stripping out Neighborhood Diabetes.

Absolutely. Neighborhood is not -- Neighborhood is a small piece of this overall. Again, look at the last three quarters. We have seen overall 30% year-over-year growth in the core OmniPod business and again, sans some reorder disruption that we need to go through between the next couple of months and then that will be behind us.

We are forecasting overall that our new shipment number here in Q1 can be as much as 30% higher than what we were last year and looking at an even acceleration beyond that. You get into Q2 and beyond. It will absolutely be higher, there is no doubt. [Schreud] does not have enough patients to not make it higher.

Finally, Brian in terms of Neighborhood, should we assume that when the sales come down say by $10 million or $15 million margins everything, at least anecdotally what we know about Neighborhood from a modeling perspective, we pretty much keep it in line or you anticipate some things to change on those line,s so that the weighted average gross margins from a modeling perspective any help would be great.

Again, the numbers that I tried to give you guys were basically consolidated gross margins for 2013, so to reiterate, I think again where looking at relatively flat gross margins in Q1 and Q2 of this year from where we are in Q4. As then, we start to see the benefit of the new smaller pod coming through and effectively the PDMs if you will are paid off, we should see some uptick in the third-quarter, my best guess at the moment is probably somewhere around 300 bps from where we are today. Then you will see another uptick of a similar number probably little bit higher as we get into the fourth quarter and that many more customers are now contributing with a, if you will, a fully paid off new PDM. The Neighborhood changes have been factored into that thinking.

Debbie Wang, MorningStar.

In the past you have mentioned that supply chain issues keep you up at night, and in particular, there's one component you are hoping to bring a second supplier on for. I'm just curious what is the situation now, is a still giving you sleepless nights?

That will always give -- five years from now that will be giving me sleepless nights. We have a second supplier, we're pretty happy with where we think we are at so -- and we continue to move through. I would tell you any kind of issues we're facing at the moment is more in the normal ramp up that we are going through, as opposed to a particular supplier. That I think in that particular case we were concerned that he really had the capability to be producing that kind of volume.

Now it is the normal stuff, you go from a two cavity tool to a 10 cavity tool. They're all 10 cavities working the way they should be, and it is normal ramp up stuff, but the thing that really scared us early on was like I said, we had a supplier that helped us, was instrumental in design, but when we started stepping on the gas, we came to the conclusion that we just didn't think they could handle the volume of business and we were way outside their comfort zone. That's behind us.

I would now like to turn it back over to management for closing remarks.

Thanks everyone for joining us and we look forward to updating you throughout 2013. It should be an interesting year. Thanks.

Thank you this concludes today's conference. You may now disconnect.