Inogen, Inc. (INGN) Q3 2018 Earnings Report, Transcript and Summary

Hello and welcome to the Inogen 2018 Third Quarter Financial Results Conference Call and Webcast. All participants are in listen-only mode. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Mr. Matt Bacso Investor Relations Manager, please go ahead.

Thank you for participating in today's call. Joining me from Inogen is CEO, Scott Wilkinson; and CFO and Co-founder, Ali Bauerlein. Earlier today, Inogen released financial results for the third quarter of 2018. This earnings release and Inogen's corporate presentation are currently available in the Investor Relations section of the company's website. As a reminder, the information presented today will include forward-looking statements, including statements about our growth prospects and the strategy for 2018 and beyond, including plans to enter the Chinese market, hiring expectations and related productivity expectations, marketing expectations, international growth and tenders, product development and our planned financing program, CMS rate adjustments and the impact of recent CMS announcements, expectations regarding the impact of Chinese tariffs and financial guidance for 2018 and 2019. Forward-looking statements in this call are based on information currently available to us. These forward-looking statements are only predictions and involve risks and uncertainties that are set forth in more detail in our most recent periodic reports filed with the Securities and Exchange Commission. Actual results may vary and we disclaim any obligation to update these forward-looking statements except as maybe required by law. We have posted historical financial statements and our third quarter investor presentation in the Investor Relations section of the company's website. Please refer to these files for more detailed information. 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 US GAAP financial measures provide useful information for both management and investors by excluding certain non-cash items and other expenses that are not indicative of Inogen's core operating results. Management uses non-GAAP measures internally to understand, manage and evaluate our business and make operating decisions. Reconciliations between US GAAP and non-GAAP results are presented in tables within our earnings release. For future periods, we are unable to provide a reconciliation of our non-GAAP guidance to the most directly comparable GAAP measures without unreasonable effort as discussed in more detail in our earnings release. With that, I'll turn the call over to Inogen's President and CEO, Scott Wilkinson. Scott?

Thanks, Matt. Good afternoon and thank you for joining our third quarter 2018 conference call. Looking at the third quarter of 2018. We generated total revenue of $95.3 million, reflecting solid results in all three of our sales channels. Direct-to-consumer sales of $38.3 million in the third quarter of 2018 exceeded our expectations primarily due to increased sales representative headcount and associated consumer advertising. Given our recent success, our strategy is to continue to hire additional sales representatives and invest in advertising activities to increase consumer awareness as we believe this is still our most effective means to drive growth of direct-to-consumer sales. As stated on our second quarter call, we still expect to have 500 Cleveland-based employees by year end 2020 with at least two-thirds of these employees plan to be sales representative. Third quarter 2018 domestic business-to-business sales were $30.3 million. Business-to-business sales were driven primarily by continued adoption by traditional home medical equipment providers and internet resellers. As we have always said, it is important to remember that domestic business-to-business sales can be lumpy quarter-to-quarter due to the inherent challenges facing providers, both from an infrastructure and financial perspective. Given these natural barriers, we continue to believe the conversion to non-delivery technology will take seven to ten years. Third quarter 2018 international business-to-business sales of $21.1 million was a record for us with growth primarily due to continued adoption from our European partners. Once again, there were no meaningful tenders in the third quarter. Expected Spanish tenders were postponed to a later date. Transitioning to the subject of Chinese tariffs, the US federal government appears set to increase its import tax from 10% to 25% on January 1, 2019 on $200 billion of imported Chinese materials and products. With these incremental changes, we estimate a low-single-digit percentage increase to our cost of goods sold per unit in 2019. This increase was factored into our 2019 guidance. Going forward, we will continue to monitor any new tariff proposals and economic policy changes and take the necessary steps to protect our financial interests and reduce our standard material cost risks. I would also like to comment on the recently released Medicare data from CMS for the full year 2017. While the CMS information 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 9.1% in 2016 to 10.8% in 2017. However, this estimate does not include patient cash sales or private insurance transactions. Our direct-to-consumer cash sales in 2017 grew significantly, while our direct rental patients on service declined. So we believe that this data from CMS may represent a conservative estimate of actual portable oxygen concentrator market penetration. POCs were still the fastest growing modality in oxygen therapy based on the CMS data and we believe this category has a significant growth opportunity ahead. Specifically POC beneficiary claims increased 12% above 2016 levels. When excluding Inogen from this data set, given our declining rental base, POC beneficiary claims increased 17% above adjusted 2016 levels. By comparison, HCPCS Code: K0738 for home transfill devices and HCPCS Code: E0431 for oxygen tanks declined 3.4% and 2.1% respectively. As the POC market leader, we are pleased to see the transition to POCs supporting our vision that portable oxygen concentrators will be the standard of care for long-term oxygen therapy patients. On November 1, 2018, CMS released the DME final rule, which is very similar to the proposed rule that was released in July. Effective January 1, 2019, beneficiaries may receive DME equipment from any Medicare enrolled supplier until new contracts are in effect under the next round of competitive bidding, which is not expected until January 1, 2021. Reimbursement rates will be set at the current pricing level throughout the United States for all Medicare patients, subject to CPI and budget-neutrality adjustments. Pricing in competitive bidding areas will be subject to an annual CPI adjustment beginning in 2019 until the next bidding round takes place. However, CMS is also changing the calculation on budget neutrality adjustments to apply these to all oxygen and oxygen equipment classes beginning January 1, 2019, instead of previously only applying these adjustments to the stationary oxygen code E1390. It is not yet clear whether the reimbursement rate increase associated with the CPI adjustment or the decrease in reimbursement rates associated with the budget-neutrality provision will have a bigger impact on our 2019 Medicare reimbursement rates, but we expect clarity on this before year-end. In addition, this final rule extends the present 50-50 blended reimbursement rates in rural and non-contiguous areas that were set to expire on December 31, 2018, until December 31, 2020. This rule also establishes new payment classes for liquid oxygen equipment and high flow portable liquid oxygen content. This rule also finalizes revisions to the DMEPOS competitive bidding program for rounds bid in the future. These revisions include implementing lead item pricing and setting reimbursement at the maximum winning bid rate, instead of the median winning bid rate. Overall, we are glad to see these changes and we believe they will result in increased access for patients who will now be able to receive portable oxygen concentrators from any supplier, not just bid winners. Transitioning to product development, I briefly want to discuss our next generation oxygen concentrator, the Inogen One G5, which we expect to launch in the first half of 2019. Similar to the Inogen One G4 launch, we expect to first rollout the G5 through our direct-to-consumer channel, followed by the domestic business-to-business channel and then the international business-to-business channel. While we are not ready to talk specifics, we can say that we expect that the G5 will produce a higher oxygen capacity output than the G3, will be smaller in size than the G3 and will have a higher oxygen output per pound than the G3. Thus we expect the G5 to obsolete the G3 over the intermediate term. As we get closer to launch, we will comment on other features. Further, I would like to discuss Inogen Connect, our new connectivity platform for the Inogen One G4 and G5 devices. Specifically, we expect to launch Inogen Connect with the G4 through the direct-to-consumer channel by year-end 2018, followed by the domestic business-to-business channel for G4 and OxyGo FIT by the end of the first quarter of 2019. Inogen Connect is compatible with Apple and Android platforms, and includes patient features such as oxygen purity status, battery run-time, product support functions, notification alerts, and remote software updates. We believe home oxygen providers will also find features such as remote troubleshooting, equipment health checks, and a location tracker will drive operational efficiencies when transitioning away from the oxygen tank delivery model. We also plan to launch Inogen Capital, an HME-focused financing program that we believe will support HME providers in securing financing to help convert their business to a non-delivery POC model. Inogen Capital will be financed through a third-party to provide direct lease financing between the third-party and our HME customer with no recourse obligations to us for events of default under the contracts. We believe Inogen Capital will be a valuable tool for smaller home care providers that have historically been capital constrained. Looking ahead to 2019, we expect to remain a high growth company and to continue to invest heavily in our sales force, advertising efforts and operations in order to drive portable oxygen concentrator adoption worldwide. We also expect to open new international markets such as China by year-end 2020, and we plan to continue to invest in regulatory approval and business infrastructure in 2019 to support this initiative. We believe the launch of the Inogen One G5, Inogen Connect, and Inogen Capital will keep us at the forefront of patient and provider preference. With that, I will now turn the call over to our CFO, Ali Bauerlein. Ali?

Thanks, Scott, and good afternoon everyone. During my prepared remarks, I will review our third quarter of 2018 financial performance and then provide details on our updated 2018 guidance and initial 2019 guidance. As Scott noted, total revenue for the third quarter of 2018 was $95.3 million, representing 38% growth over the third quarter of 2017. Looking at each of our revenue streams, and turning first to our sales revenue, total sales revenue of $89.7 million in the third quarter of 2018, reflected 42.1% growth over the same quarter of the prior year. Total units sold increased to 52,400 in Q3 2018, up 45.6% from 36,000 in Q3 2017. Direct-to-consumer sales for the third quarter of 2018 were $38.3 million, representing 66.3% growth over the third quarter of 2017, primarily due to increased sales representative headcount and increased advertising expenditures. Domestic business-to-business sales of $30.3 million in Q3 2018 reflected 32% growth over Q3 2017, primarily due to strong demand from traditional HME providers as more providers are adopting portable oxygen concentrators instead of tanks to service their oxygen patients. Record international business-to-business, sales of $21.1 million in Q3 2018 increased 23% from Q3 2017 and was driven mostly by strong European volume and a 1.4% benefit from favorable currency exchange rates. On a dollar basis, third quarter 2017, international revenue of $17.2 million was our toughest comparable to quarterly 2018 results. Sales in Europe represented 87.6% of international sales in the third quarter of 2018, down from 90.1% in the third quarter of 2017. Sales revenue per unit sold declined over the same period in the prior year by 2.4%, primarily due to the lowering of retail pricing effective June 1, 2018, lower business-to-business pricing due to increased volumes worldwide and partially offset by increased mix of direct-to-consumer sales, which have a higher average selling price. Rental revenue represented 5.9% of total revenue in the third quarter of 2018 versus 8.5% in the third quarter of 2017. Rental revenue in the third quarter of 2018 was $5.6 million compared to $5.9 million in the third quarter of 2017, representing a decline of 5.3% from the same period in the prior year, primarily due to a decrease in net rental patients on service of 13% compared to the third quarter of 2017, partially offset by higher revenue per patient on service. Turning to gross margin, for the third quarter of 2018 total gross margin was 51.2% compared to 48.1% in the third quarter of 2017. Our sales gross margin was 52.3% in the third quarter of 2018 versus 50.3% in the third quarter of 2017. The sales gross margin increase was primarily due to a favorable mix shift towards direct-to-consumer sales versus business-to-business sales and lower average cost of goods sold per unit. The favorable mix was partially offset by lower average selling prices in both business-to-business channels, due to increased volumes and lower direct-to-consumer pricing effective June 1, 2018. Rental gross margin was 34.3% in the third quarter of 2018 versus 24.3% in the third quarter of 2017. The increase in rental gross margin was primarily due to increased rental revenue per patient on service and lower depreciation expense. As for operating expense, total operating expense increased to $38.4 million in the third quarter of 2018 or 40.3% of revenue versus $24.8 million or 36% of revenue in the third quarter of 2017 as we invested in sales infrastructure and related advertising to support planned growth. Research and development expense was $2.1 million in the third quarter of 2018 compared to $1.4 million recorded in the third quarter of 2017, primarily due to increased personnel-related expenses. Sales and marketing expense increased to $26.3 million in the third quarter of 2018 versus $13.1 million in the comparative period in 2017, primarily due to increased personnel-related expenses as we continued to hire inside sales representatives at our Cleveland facility and increased advertising expenditures. In the third quarter of 2018, we spent $8.8 million in advertising as compared to $3.4 million in Q3 2017. General and administrative expense decreased to $10 million in the third quarter of 2018 versus $10.4 million in the third quarter of 2017, primarily due to a $1.5 million reduction in patent defense costs and $0.9 million reduction in bad debt expense, which was partially offset by increased personnel-related expenses. In the third quarter of 2018, we reported an income tax benefit of $5.1 million compared to $1.5 million income tax expense in the third quarter of 2017. Our income tax benefit in the third quarter of 2018 included an $8.1 million decrease in provision for income taxes related to excess tax benefits recognized from stock-based compensation compared to $1.7 million in the third quarter of 2017. Excluding the stock-based compensation benefit, our non-GAAP effective tax rate in the third quarter of 2018 was 26.4% versus 36.5% in the third quarter of 2017, primarily due to the impact of US federal tax reform. In the third quarter of 2018, we reported net income of $16.4 million compared to net income of $7.3 million in the third quarter of 2017. Earnings per diluted common share was $0.73 in the third quarter of 2018, versus $0.33 in the third quarter of 2017, an increase of 121.2%. Adjusted EBITDA for the third quarter of 2018 was $16.3 million, which represented a 17.1% return on revenue. Adjusted EBITDA increased 16.2% in the third quarter of 2018 versus the third quarter of 2017 where adjusted EBITDA was $14.1 million, which represented a 20.4% return on revenue. The reduction in third quarter 2018 adjusted EBITDA margin compared to third quarter of 2017 was primarily due to investments in sales infrastructure and related advertising, lower rental depreciation expense, and our continued shift in revenue mix towards sales revenue. As our business continues to move in favor of sales revenue, we will be placing more emphasis on reporting operating income as we believe it is more relevant when analyzing profitability trends of the business. Specifically, operating income margin in the nine-month ended September 30, 2018 is roughly flat at 12.2% versus 12.1% in the comparative period in 2017. By comparison, adjusted EBITDA margin in the nine months ended September 30 of 2018 is down 250 basis points to 18.7% versus 21.2% in the comparative period in 2017. Cash, cash equivalents and marketable securities were $223.9 million, an increase of $15.4 million compared to $208.4 million as of June 30, 2018. Turning to guidance, we are increasing our full-year 2018 guidance range for total revenue to $345 million to $355 million, up from $340 million to $350 million, representing growth of 38.3% to 42.3% versus 2017 full-year results. We still expect direct-to-consumer sales to be our fastest growing channel, domestic business-to-business sales to have a significant growth rate and international business-to-business sales to have a solid growth rate where the strategy will still be focused on the European markets. We still expect rental revenue to be down approximately 10% in 2018 compared to 2017 due to our continued focus on sales versus rental. Additionally, we are narrowing the range of our full year 2018 GAAP net income and non-GAAP net income guidance range to $46 million to $48 million from $45 million to $48 million, representing growth of 119% to 128.5% compared to 2017 GAAP net income of $21 million and growth of 61% to 67.9% compared to 2017 non-GAAP net income of $28.6 million, primarily due to continued sales and marketing investments expected in the fourth quarter of 2018, offset by a lower effective tax rate. We estimate that the decrease in provision for income taxes related to excess tax benefits recognized from stock-based compensation will lead to a reduction in provision for income taxes of approximately $18 million in 2018 based on forecasted stock activity, which would further lower our effective tax rate as compared to the US statutory rate. This is an increase from our previous estimate of a $12 million benefit. Going forward, we expect our effective tax rate, including stock compensation deductions to vary quarter-to-quarter depending on the amount of pre-tax net income, share price, and on the timing and size of stock option exercises. When excluding the benefit from the estimated $18 million decrease in provision for income taxes expected in 2018 from stock-based compensation deductions, we now expect the non-GAAP effective tax rate of approximately 24% compared to our previous expectation of 25%. We are reducing our guidance range for full year 2018 adjusted EBITDA to $60 million to $62 million down from $65 million to $69 million, representing growth of 18% to 22% versus our 2017 full year results due to our continued sales and marketing investments expected in the fourth quarter of 2018. Further, we expect full-year 2018 operating income to be $35 million to $37 million, representing growth of 26.9% to 34.1% versus 2017 full year results. We are also providing an initial full year 2019 guidance range for total revenue of $430 million to $440 million, representing 22.9% to 25.7% growth over the 2018 guidance midpoint of $350 million. We expect direct-to-consumer sales to be our fastest-growing channel and domestic business-to-business sales and international business-to-business sales to have a solid growth rate. Internationally, we expect we will be primarily focused on the European markets in 2019. Lastly, we expect rental revenue to grow modestly in 2019 compared to 2018. Due to the forecasted decline in stock-based compensation tax benefits, we are providing a full year 2019 GAAP net income estimate of $48 million to $52 million, representing 2.1% to 10.6% growth over the 2018 guidance midpoint of $47 million. Please keep in mind, net income may be significantly impacted by our stock price and associated tax benefits in 2019. We estimate that the decrease in provision for income taxes related to excess tax benefits recognized from stock-based compensation will lead to a reduction in provision for income taxes of approximately $12 million in 2019 compared to $18 million expected in 2018 based on forecasted stock activity, which would further lower our effective tax rate as compared to the US statutory rate. When excluding the benefit from the estimated $12 million decrease in provision for income taxes expected in 2019 from stock-based compensation deductions, we expect a non-GAAP effective tax rate of approximately 24% in 2019, compared to 24% expected in 2018. We are providing a guidance range for the full year 2019 adjusted EBITDA of $67 million to $71 million, representing 9.8% to 16.4% growth over the 2018 guidance midpoint of $61 million. We expect full year 2019 operating income to be $46 million to $50 million, representing 27.8% to 38.9% growth over the 2018 guidance midpoint of $36 million, primarily due to continued sales and marketing investments expected in 2019. We still expect net positive cash flow for 2018 and 2019 with no additional capital required to meet our current operating plans. With that, Scott and I will be happy to take your questions.

Thank you. [Operator Instructions] Our first question is from Margaret Kaczor of William Blair.

First of all, I just wanted to follow up on some of the commentary on market adoption at the HME level and how that's continuing. And the question is a little bit twofold, as I'm going to cheat on the one question and one follow-up. But in terms of the near-term, we've seen some pretty strong growth in the past but at least this quarter the sequential change seemed to drop off a bit. So can you guys provide a little bit of color around that, whether it's this new competitive bidding rule, internet resellers or just general lumpiness. And then kind of the second part of this question is on a long-term basis. So the 10.8% penetration suggest a pretty marked acceleration in adoption for POCs over the prior years, which I think we're closer to 110 basis points a year, whereas now we're seeing a 170 basis points a year. So as we go forward, why shouldn't we assume that you can at least maintain that rate, if not see potential further acceleration into '18 and '19 especially with some of the initiatives you're putting out with Inogen Connect and Inogen Capital?

On the growth, we've said this before and it's really -- it's the same old issue that it's lumpiness that we see in the HME channel. You have providers that will go kind of fast, there are starts and stops, I've told the story in past calls. We had a provider in Europe. One time I used this example that they were buying pretty heavy on POCs and then they had an issue on their C-pep segment and they had to divert capital over to replacing some C-peps. And so you're running down the line with somebody and things are growing and then due to business issues, capital constraints, then things start and stop. I think over the short-term, quarter-to-quarter, we expect that things will be lumpy. We saw this, if you go back about a year and a half ago, from first quarter to second quarter of 2017, we had really high growth in one quarter and then the next quarter it seemed like at least numerically it sequentially declined and then it picked back up again. It really just goes back to the lumpy nature, all the challenges that the homecare providers faced as they really fundamentally changing their business, they've got capital constraints, et cetera. Now you mentioned, our Inogen Capital program, I think that'll help some of the smaller providers certainly from a capital perspective. It helps them purchase from a cash flow standpoint, but it doesn't really help them fundamentally restructure their business. That's a challenge that they have to take on at their own pace. So, while I think that's probably putting a little grease into the gears. It's still going to be lumpy going forward. We don't expect any change in that. And frankly, it's kind of what we've said in the past and it's -- I don't want to say, we told you so. But this is just the nature of the HME channel. I've seen that, I've been in this market for about 20 years. Now on the growth from the Medicare data, you're absolutely right. And it depends on your time horizon, if you're looking at that seven to 10 year conversion cycle, then if you look at adding 1% or 1.1% a year and to go from 9%, 10% up the 60%, 65%, you won't convert in seven to 10 years if you don't see it pickup. So we absolutely over that timeframe we expect it to pick up and accelerate, it's hard to predict exactly at what rate -- there is an infinite number of curves, if you were to extrapolate from here in the next five, seven, 10 years out. So we're always pretty conservative about that. But in the big picture, we've said, yes, we expect POCs to be the standard of care. We expect the end of that curve, a full penetration to be in, say, the low-60s of total patients, 60s in terms of percent. And remember about 30% of the patients, I'm rounding, are stationary-only patients. So that's about 90% of the ambulatory patients would be on a portable of oxygen concentrator. We still expect that and mathematically to get there over that seven- to 10-year period, you would see acceleration. We just don't like to predict it in the next quarter or even the next year.

Just to add on to that a little bit. We really don't think that the DME ruling had any material impact on the quarter. So whether people were holding orders or that type of thing, waiting to see what the final ruling was, we didn't see any indication of it. It was more just the natural HME buying patterns kind of starting and stopping, as Scott mentioned. So that's more what we saw. We didn't see customers telling us that they were waiting to see what that final ruling would be or how that would impact their business. And of course the final ruling came out very close to the ruling that they had issued -- the proposal that they had issued in July. And I also just want to mention, of course, us giving 2019 guidance in November of 2018, particularly on the B2B side, the farther we are from the end consumer, the more cautious we are on guidance. So while we talk about a market conversion and that seven- to 10-year process, we still are cautious, particularly given that domestic business-to-business channel year-to-date through the end of September has grown over 48% year-over-year. We want to be cautious that we again don't get out ahead of that market conversion, so that's built into guidance. We want to see how that really continues to trend and the adoption of projects like Inogen Capital and the continued conversion of the providers from a tank-based system to a non-delivery model.

And then from a sales and marketing expense growth perspective, I wanted to hit on that for a second because it's obviously up quite a bit the last few quarters. It's still accelerating. If you take out, even that marketing expense that you guys are kind enough to provide, it still seems like the direct sales expense is growing at a pretty healthy level. So I assume that means more sales reps. Why is that right or wrong? And really, how should we think about that impact in Q4 and 2019 as the hires ramp?

So as we said on the last quarter call, we are ahead of our expectations on the hiring side. Cleveland has been a great market for us to expand our sales base and we are expanding that sales base and continue to do that in the third quarter. And really we do that because we know that there is a known return on those types of investments and we are still early in the stages of POC penetration. So we will continue to do that if we can find and train the right people, so that is really the plan. I know certainly the expense ratios are above what we've seen historically. But we think it's the right investments to set ourselves up for a nice 2019 and 2020 and going forward. This is really an infrastructure that we need to make sure that we can maintain that market leadership position and we know we have a product that had high consumer appeal, and we want to capitalize on that market opportunity.

The next question is from Mike Matson at Needham & Company.

I guess I just want to start with the tariff impact. So I was a little confused by your commentary around the impact and what you've included in the guidance. So does the guidance include the worst case, 25% tariffs, and does that equate to this low-single-digit hit to your gross margin that you're talking about?

Yes. So that does assume that the tariff impact is as scheduled right now 25% for the components that are impacted. So it's not obviously our product. It's sourced from many different countries. But for the components that directly come from China that we do not have an exemption code for, we have assumed that those rates would be applied. And then based on the mix of our product portfolio, we've made some assumptions there to get to that low-single-digit percentage COGS impact and all of that was built into our guidance. Obviously, we don't give guidance specifically to gross margin since it is heavily mix dependent, but it is factored into our bottom line guidance both -- net income, adjusted EBITDA and operating margin.

Okay. And then with regard to the connectivity feature, so I mean I assume that'll be available when you launch in every G4 that goes out the door and then it also be on the G5. Are there any fees for the customers associated with that? Is it free to them? And then is there any added cost to you? Will that impact the gross margins of these products at all?

Right now, Mike, there's no fees at the patient level, no plans right now for fees at the provider level. We just want to drive operational excellence at the provider level. And us being a provider ourselves and when we kind of look at this and how it could improve your efficiency when you're managing a rental fleet, so that's what's really been a driver behind our design. There shouldn't be any material impact to COGS. I mean, everything is already factored into guidance, any impacts that we have whether it's tariffs or new products or anything like that. Just to reiterate though as I said in my opening comments, we'll start with the G4 launch, it will be in every G4 in the direct-to-consumer channel, the launch will be before the end of this year, and then we'll roll out kind of channel by channel, it will go to business to business in the first quarter and then it will go to international markets down the road after that.

And then, just given the large expansion to the sales force -- DTC sales force, I'm just wondering, I know the markets under-penetrated when we look at the numbers, but in terms of tapping into that pool of patients willing to buy out of pocket, have you been -- I assume you're calculating your customer acquisition costs, I know you are not going to tell us what those are. But have those been going off, is it getting more costly to acquire incremental patients, and are you seeing any kind of signs of saturation of this pool of patients that are at least willing to buy out of pocket.

Yes, I mean we do monitor all of those metrics. And I mean, obviously, we're confident when we're making these investments that we're not at a point where you're at saturation and certainly the Medicare numbers bear that out. Our other metrics bear that out, otherwise we wouldn't make such an investment. Now I will say it's just a general comment in the past, we've shared some of the metrics around our direct-to-consumer go-to-market program. We are going to be a little more cautious about sharing those metrics going forward, because as you know, there are at least two other manufacturers out there in the POC space that have said that they are putting their toe in the water with that same go-to-market strategy. So, they're going to have to go learn on their own not learn from our earnings calls.

The next question is from Robbie Marcus with JPMorgan.

Ali, I was hoping you could kind of do a cross walk for us from guidance for operating expenses from the second quarter. What you learned since then how that impacted third quarter and then how we think about the headwinds on the operating expense and gross margin line, maybe if you could bucket them for us for 2018 and into 2019.

Yes. So the level of investment clearly was higher than we had thought on the second quarter call because of the ramp that we've seen on the sales reps and the number of people we have in the facility and then the related media spend. So that has come in ahead of what we expected on the second quarter call, which of course leads to higher expenses in the near term, but we think that that's the right decision. So while we did lower our adjusted EBITDA, it's really for those sales and marketing expenses. So we expect those sales and marketing expenses to also be higher in the fourth quarter and they also were higher in the third quarter as well. So those two items combined really account for the changes that we're seeing in adjusted EBITDA. When we look at the gross margin side, Q3 was a fantastic result for us. It was a great expansion of gross margin to 52.3%, up 200 basis points from Q3 of last year. So we're really proud of that. And remember that's in spite of the lower pricing from that DTC pricing trial and the rollout of the $200 lower pricing there. So, we think that that was a really strong results and certainly strong compared to Q2 as well. So that's something that we certainly want to highlight. Looking into 2019 from a guidance perspective, obviously we don't give specific guidance on gross profit or operating expenses, but the key messages are we still expect 2019 to be an investment year on particularly the sales and marketing side, secondarily, R&D but sales and marketing is really where the dollar investment happens. Given that we expect direct-to-consumer to be our fastest growing channel next year, that actually should be a tailwind to gross margin expansion. Obviously you have a little bit of a headwind associated with the tariffs and then just general price pressures, but certainly, the mix shift also has a big impact on the gross margin percent. And of course, in that business, you see higher operating expenses and higher gross profit dollars versus the business-to-business channels. So all of that was factored in to guidance and the numbers that we put out there. Our approach to guidance is the same as it always has been. We think it's important to point out achievable guidance taking into account both the factors of what can go right and what we're planning to execute, but also the lumpiness on the B2B side of the business and making sure we don't get out ahead of that market conversion and that we also are making significant investments in the business, so all of that was factored in. Obviously the tax change for 2019 for the stock-based compensation benefit that is much lower, so that also has a dramatic impact on net income versus 2018 as well.

And maybe another question for you, Ali. I was hoping you could spend a minute on the Inogen Capital. This is the first I've heard you talk about it. I know that the industry itself has been capital constrained for a long time. This has been a crunch for a lot of the small mom and pop shops out there. So maybe help us understand why now, how this can help drive the business going forward. And then how we should think about this impacting your balance sheet and cash flow needs.

Yes, sure. So we're really excited about Inogen Capital. It's something that our HME customers have been asking for a long time and frankly something that our competition has used as a selling tool against us for many years as well that we didn't have a financing tool. So we're really excited about getting this out there and working with the industry to help them convert their businesses. We think we found the right partner that understands the HME business and can also provide the proper financing for these customers as they're going through this transition period. In terms of our balance sheet impact, this is no recourse to Inogen. So it actually is just a traditional sale of the product and that's then the lease payments would be owed to the third-party that's operating under the Inogen Capital brand. So it will operate as it's Inogen, but it is through a third-party with no recourse to us and no liabilities on our balance sheet associated with potential losses.

Okay. So to be clear, you sell it to the rental agency and they then finance it and sell it and rent it to the patient?

They then lease it to the HME. So we sell it to the HME, the HME pays us with the third-party financing and then they -- if there is a deal between the third-party financing company and the HME to make monthly payments over whatever payment term whether that's 12 months, 24 months or 36 months.

The next question is from Danielle Antalffy at Leerink Partners.

Just want to make sure that there was -- when we look at the B2B business and I understand there is lumpiness, was there any change in the competitive dynamic there? Maybe another way to ask the question is to ask, I mean, did you continue to sell to all your B2B customers or do you worry that maybe you lost some customers to competitors?

No, I mean we continue to sell to everybody. I wouldn't say what we saw from market dynamics is a change, but there is continued price pressure and there is price competition. So, but that's not new, it's more of the same. So we certainly saw that and we continue to make price concessions where appropriate to defend our share and our leadership position. But we didn't see any material new products or anything different from a financing or go-to-market strategy, it was really just more of the same. I mean the home care providers, a big part of their purchasing decision is on price. Now in POCs, it seems like we're still at a point where quality and reliability probably plays a larger part of their decision than maybe some other legacy products, obviously like tanks. I mean tank is a tank. If ever there were a commodity in this market, it would be tanks. But I think that we continue to enjoy what I call that reasonable premium for a high quality and high reliability product but really nothing different than in the past, Danielle.

Okay, got it. That makes sense. And then as we look out to 2019, appreciate the guidance you gave, and you are adding reps for DTC. So just wondering how you're thinking about that guidance and where the potential sources of upside could be. I know you're being very conservative on B2B, so that sounds like a potential source of upside. But could we see accelerated rep hires much like we saw in the first half of this year drive upside to that DTC, whatever is baked in for DTC next year?

Yes, certainly. I mean, if we can hire above our expectations that also leads to upside on the DTC side. So we still are cautious there of trying to again make sure we don't get ahead of how many people we can hire and effectively train. So that's built into our models is looking at how many we can hire, how many will leave, what is the ramp-up curve, all of that is factored into that guidance. And of course, always the goal is to put out something achievable, as I said. There certainly is on the business-to-business side built into the guidance is more cautiousness just because this year's results have been so strong and we know the B2B community has their inherent challenges in converting their businesses. So I'd say we still continue to be conservative there, both on the domestic side as well as the international side. So, certainly those are opportunities for upside if the market accelerates in the adoption and buys our product.

The next question comes from JP McKim with Piper Jaffray.

This is Kevin on for JP. I had two questions on G5. I'll ask the first one here. I was curious what the principal features do you think customers care about the most there? And then on the operating margin side for the products, what type of margin do you think you can get on the product versus the current average? Does the spend increase to grow that product such that it offset any gross margin benefit, if any, for that products. Would appreciate any type of breakdown you might have early on?

Yes, I'll start with some commentary just on the design rationale of G5 and then I'll turn it over to Ali for the second part of the question. So, we've said in past calls that when we launched every version of our POC, each version when we've gone to the market and talk to patients about what they would want to see improvement, they always said I wanted it smaller and lighter until we launched G4. And when we launched G4 little more than two years ago, what we heard is, for the first time, how can we improve it, we heard things like I'd like it quieter, I'd like a longer battery run-time. We didn't automatically here right out of their mouth that I wanted smaller and lighter. So that was all kind of factored into the G5 as our next generation product and it's a more balanced approach to look at some of the other parameters and not just roll out another smaller and lighter POC versus our last version. Now, as I said, we're not ready to talk about all of those specifics in the specification today. We're still going through some internal testing and things that can tweak a spec left or right by a couple of points. So we don't want to make any statements and then something changes, even if it's by a really small amount. But what we did say in this call is the G5 will have a higher output than even the G3, but it's going to be smaller than the G3. Those are things that we know, because we've already locked in the tooling and so we know what the size is and it will be smaller than the G3. It's more efficient, so it's going to have more output per pound than the G3. And it will be out of the gate a connected device, just like the G4 connectivity that we're going to launch before the end of this year. So until we refine a few of those other specs, I really don't want to talk specifics about them. But I think that you will find that this is a product that's going to be embraced not only by the patients out there, but also by the providers. And if you look back at the G4, the G4 is kind of been this retail product that's a premium for patients we did not included in our rental fleet. A lot of the other homecare providers have followed our lead and they have standardized on their fleet with a G3. And given our success is the market leader, I think you'll see that this product is not only embraced by the patients, but the providers as well.

And on the cost side, just from our prepared remarks, you saw we didn't specifically comment on costs. We really don't want to comment on the cost profile of the unit until we're at launch. So at launch, we'll talk a little bit more about the specs as well as the cost profile and the impact on our operating margin, but we have made assumptions built into our guidance around those impacts as well.

And I wanted to put, I know it was asked earlier, but as it relates to G5, I just wanted to put a finer point on the 2019 revenue guidance because this time last year, the company gave about 20% to 24% growth over 2017. And you're probably going to do at least $15 million ahead of that this year, so you are up to 24% next year at the midpoint and it's clearly you have the larger sales force in this new product. So how would you break down, how much -- even if you can't quantify it, just sort of in general, how much G4 accounts and gives you the confidence for that type of increase over this time last year?

Yes, I mean really, when we look at our guidance philosophy, it's the same. We do a bottoms-up approach to putting our numbers together. We look at all of the inputs on the direct-to-consumer side, how many reps and what are we going to spend and where are they in the ramp curve together prediction there and then we always want to make sure that we adjust for things not going exactly to plan, so that's built in from a direct-to-consumer side. When we look at the product mixes, that also a portion of our budgeting looking at G3 versus G4 versus G5. Now remember, on the ASP side, how we do pricing, they actually all come out at the same selling price to either the providers or the patients. So really the only margin difference is cost differences, it doesn't have a revenue difference. So when we look at it from that perspective, there isn't a material change. And remember, G4 is already the majority of the direct-to-consumer volume. So with the G5 coming online with eventually at replacing the G3 volume, that's a smaller impact on the direct-to-consumer side. It's really for patients that have a higher flow need or really want a more balanced unit in case they get sicker over time. So minimal impact G5 on the direct-to-consumer side for 2019. Now, we do expect the G5 to be adopted more widely on the provider side but of course that will phase in as the product is launched. Remember, we always launched in the direct-to-consumer side first and then we phase in domestic business-to-business and then international business-to-business. So launch in the first half of 2019 first direct-to-consumer. You're talking about pretty minimal impact in 2019, again depending on the timing of when we can actually get the product launch. But we do think that it will have strong provider preference, as Scott mentioned. But in terms of guidance, we're pretty cautious on taking that to the bank, especially this early when we haven't even finalized the exact launch date yet.

The next question is from Mathew Blackman with Stifel.

Scott, maybe to start with some bigger picture perspectives, how do you feel in general about the business here at the tail end of 2018 and with 2019 approaching versus the last several years. Do you feel like the business has more potential tailwinds than in recent years or more potential headwinds. And clearly with elevated spend expectations now for 2018, I would think you'd also feel very good about the outlook for durable growth and have good line of sight on incremental growth opportunities. Is that a fair characterization?

Yes, I mean I feel very good about where we sit in the market today. We have over the last one to two years, if you look at our growth rate versus the POC growth rate, it indicates that we have strengthened our market leadership position. So we're pleased and proud of that. We've also invested pretty heavily and increased our inside sales force, and we feel good about that. That gives us a launch pad to continue to grow in the future, not only with oxygen therapy products and we've talked about this a little bit in past calls, but we think this go-to-market strategy in the sales team and marketing team that we've built is conducive to drive growth with other innovative disruptive products. So while we've done great in oxygen therapy and the numbers indicate that we still have room to run from a growth perspective, our view and what we're trying to settle ourselves up for is to not be just an oxygen therapy company in the future, but rather, I'll call it a consumer healthcare company with a unique go-to-market strategy focused on the end-user instead of primarily on the homecare providers. Now having said that, we've had great success with the homecare provider community. We consider them our partners. We have common objectives in that. We want to take care of oxygen patients and we're all facing challenges with reimbursement rates, so we've got to drive down operational costs, while we continue to enhance the service offering to patients. So I think that we're aligned there, but I feel very good about the future. We've also continued to strengthen our balance sheet, I've mentioned in the past that we continue to review opportunities for new products that bar to add a new products are either partnership or acquisition remains very high. But when the right one comes along, I think we remain in a great position to take advantage of it, but we haven't pulled the trigger yet because the bar is still very high and that's a tribute to the success that we've had and how bullish, we are on our future in the auction therapy market.

I really appreciate that and then I just have a couple of follow-ups for you that all lumped together. I may have missed this, but if I didn't -- could I ask about the 4Q sales deceleration implied in the guidance is there anything we need to be sensitive to outside of just potentially lumpy B2B segment growth and then going back to the higher spend on reps and advertising, how quickly could we see positive returns on those investments? That's all I had. Thanks.

Yes. So when we look at the Q4 expectation, obviously, it does assume a deceleration there of the growth rate, now remember Q4 also last year was strong for us on the direct to consumer side against the typical seasonality where we see typically the stronger months are actually Q2 and then followed by Q3, so the comps get tougher on the direct to consumer side going into Q4 because of that. So I want to make sure people understand that obviously as we've continued to hire that also help offset that, but it is a toughest comp for us is Q4 on the direct to consumer side, it also was very strong for us on the domestic B2B side last year in Q4. International actually is an easier comp for us and the easiest comp for us of the year in Q4, so that area is an area that should see an acceleration of the growth rate -- else being equal. So when we look at it, it is just overall wanting to make sure that we put out achievable guidance and that we kind of don't lose sight of the challenges that's the provider has, there isn't one individual factor that we would say would be driving that Q4 results. And the second question again was.

How quickly do you typically see returns on investments in reps and advertising?

Yes, typically it's a quarter or two before we see return on the reps now obviously the better up kind of quicker than have been some of the reps that don't perform as strongly, but it's in that same range of a couple of quarters and you're seeing results from those reps.

Okay, thank you.

The next question comes from Matthew Mishan at KeyBanc.

Great and thank you for squeezing me in. Just a quick follow-up on the G5, what percentage of the market could a higher oxygen flow allow you to go after and does it help providers with potential for dual reimbursement product?

Well, remember that POC is right now are already dual coated and you get reimbursed for both the stationery auction code and the portable oxygen code with one asset. So all of our POCs in the past have been coated that way G5 will continue to be coated that way, as well as all of the other POC offerings in the market. So there's no change there. When you look at the incremental output of a G5, it will help you pick up a few percentage points in the market, the G3 already serves 80% to 85% maybe even up to 90% of all the patients. So our products already serve the majority, but what it does is sometimes when you have a patient that's on the POC, and they get a little -- and the doctor increases their flow rate. It will help avoid that switching cost that you see if you've got to go put them on to higher flow product a lot of times those higher flow products also are not necessarily a non-delivery products. So you've got to go back to a liquid or a tank and that's why we've always said that we think POCs will be appropriate for 90% of the market not 100% -- still a small percentage that are really high flow and that will remain, but it will help, it will help pick up a few percentage points in markets coverage and what it really does for the provider is reduce the switching costs to other assets.

And then you used to have a group, our -- I'm pretty sure you still have a group that's targeting physician practices. Can you give an update on where you're at with that sales force and then the question is being with hospital systems consolidating physician practices consolidating, do you have corporate sales group or a corporate push that works with larger hospital systems to demand change to portable oxygen concentrators for their patients versus delivery oxygen.

Yes. So we do still have our field referral sales force. We have invested much more heavily on the inside group over the past two to three years. And remember, we've said we've focused more on cash sales and rentals. The field sales force primarily drives rentals, although it's kind of interesting is they have, they've actually had some retail sales success that has surprised us a little bit, but we've added nominally to that group. We'll continue to add to them at a lesser investment rate is even on a percentage basis, then the inside group right now but they're very effective at going out and spreading the gospel in the clinical community and driving referrals and rentals. So we'll continue to invest there, now as far as our team that would call on hospitals right now, that falls in our business to business area. So we do make some of those calls what we and you have to remember that most of the insurance companies out there and payers, they already covering portable oxygen concentrator. So we're not going out and lobbying for coverage, but we have started to look for ways to actually change the reimbursement structure for POCs, portable oxygen is currently reimbursed on a monthly basis because the predominant modality for taking care of patients is administered on a weekly or monthly basis, so that's tanks are used to be liquid oxygen. So the reimbursement kind of match the costs you make your deliveries this month, you get your revenue this month, you have your cost this month. With POCs it kind of blows up that whole model. So we think that it's frankly kind of silly to have a monthly reimbursement for an asset that's put in the home and you don't have an ongoing delivery costs associated with it and if we could get reimbursement change such that insurance companies or Medicare would cover acquisition of that asset upfront that could dramatically break down the barriers of adoption for the homecare provider community because they would no longer be as cash flow constrained, as they are right now. They buy an asset and they've got to figure out how to pay for it with reimbursement month by month. So most of our efforts are focused primarily on what do we need to do to change reimbursement, but I will tell you that doesn't change easy and that is a long-term play.

All right. Thank you very much.

This concludes our question-and-answer session. I would now like to turn the conference back over to Scott Wilkinson for closing remarks.

Thanks. I'd like to close with a few comments. As we look ahead to 2019, we're excited about the future of oxygen therapy, and we still expect portable oxygen concentrators to become the standard of care for ambulatory oxygen patients worldwide in this large and growing market. Lastly, I'd like to thank those who participated on today's call and all of the Inogen employees who have been instrumental to our success. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.