Good day, and thank you for standing-by. Welcome to Outset Medical Q2 2023 Earnings Conference Call. At this time, all participants are in listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advice that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Jim Mazzola. Please go ahead. Jim, if you could go ahead and unmute yourself please.

Okay. Good afternoon, everyone, and welcome to our second quarter 2023 earnings call. Here with me today are Leslie Trigg, Chair and Chief Executive Officer; and Nabeel Ahmed, Chief Financial Officer. During the call, we will discuss our second quarter 2023 operational and financial results and host a question-and-answer session. We issued a news release after the close of market today and updated our investor presentation, both of which can be found on the Investor Relations pages of outsetmedical.com. This call is being recorded and will be archived in the Investors section of our website. It is our intent that all forward-looking statements made during today's call will be protected under the Private Securities Litigation Reform Act of 1995. These statements relate to expectations or predictions of future events, are based on our current estimates and various assumptions and involve material risks and uncertainties that could cause actual results or events to materially differ from those anticipated or implied. Outset assumes no obligation to update these statements. For a list and description of the risks and uncertainties associated with our business, please refer to the Risk Factors section about the public filings with the Securities and Exchange Commission, including our latest annual and quarterly reports. With that, I will now turn the call over to Leslie.

Thanks, Jim. Good afternoon, everyone, and thank you for joining us. We are pleased to share our second quarter 2023 results, which were marked by accelerating quarter-over-quarter revenue growth, further margin expansion and continued commercial traction across our business. On the acute side, we've been encouraged to see more customers recognizing Tablo's strong economic value proposition and makes the decision to in-source inpatient dialysis with Tablo. We also continue to see improvement in the broader macro selling environment with both current and prospective customers. On the home front, we achieved our goal to sign agreements with the majority of large midsized dialysis providers and initiated the first Tablo Home program with one of the country's largest health systems with plans to expand to multiple US sites. With the first half of 2023 now behind us, we retain our strong conviction in the fundamentals of our business with confidence grounded particularly by a healthy pipeline and backlog with interest in and demand for Tablo's strong and growing. Before I go through the details of the quarter, I'd like to begin by providing an update regarding the warning letter we received from FDA in early July. As many of you are aware, we previously disclosed that our San Jose facility was inspected for the first time in the company's history by FDA in late January of this year. We were pleased overall with the inspection process, which concluded in February, and resulted in four observations that were communicated to us via Form 43. Each of those observations related to internal process improvements with none related to safety or efficacy concerns. We responded rapidly to FDA with a comprehensive work plan, and our team remediated all four observations internally at the end of the second quarter. The July warning letter noted two additional…

Thanks, Leslie. Hello, everyone. Our second quarter revenue increased 7.7% sequentially and 43.8% year-over-year to $36 million. The year-over-year change was driven primarily by higher console placements and the associated pull-through of consumables used for each Tablo treatment. Product revenue was up 5.6% from the prior quarter and increased 49.5% year-over-year to $29.3 million. Console revenue grew 4.4% from the first quarter and increased by 48.8% year-over-year to $19.7 million. We had strong console placements in both our acute and home end markets. As Leslie indicated, ASP remained high during the quarter, driven by mix, disciplined pricing and the substantial majority of acute console shipping with our Tablo Pros+ [ph] software. We believe that these three factors mix pricing and software sales will continue to be the primary drivers for ASP during the second half and for the longer term. Consumable revenue was $9.6 million, up 8.2% from the prior quarter and an increase of 50.9% versus the prior year as our installed base grows. Treatment revenue and cartridge utilization performed well and in line with our expectations. We saw invoice treatments in the acute setting between four and five treatments per week and just above three in the home setting. Service and other revenue of $6.7 million was up 17.9% from the prior quarter and higher by 23.4% compared to the prior year, driven by the growth of our installed base and offset by the planned expiry of the HHS agreement. As a reminder, the third quarter of 2022 saw the expiry of the final components of our HHS agreements. Moving to gross margin and operating expenses. I will highlight our non-GAAP results. I encourage you to review the reconciliation of GAAP to non-GAAP measures, which can be found in today's earnings release. Our second quarter gross margin was…

Thanks, Nabeel. We remain well positioned to execute against our full year strategic goals across both the acute and home segments and look forward to advancing our commercial and regulatory initiatives and lock staff in the months ahead. Recent trends, combined with our expectation for ongoing stability in the broader macro environment, give us greater confidence in our near-and longer-term growth opportunities, particularly given Tablo's differentiated value proposition, our large and growing end-markets and the positive macro tailwinds, which continue to fuel our business. So with that, I think we are ready for Q&A. Operator, please open the line.

Thank you. We will now conduct a question-and-answer session. [Operator Instructions] Our first question is from Travis Steed with Bank of America Securities.

Hi. Thanks for taking the question. I guess I just, wanted to follow-up on the decision to say, the lower end of the guidance range given you guys beat by $1 million this quarter, its only low single-digit millions you have embedded in the guidance. Just curious, why there was a reason that you can't kind of offset that within the guidance range and also understand like why would Tablo orders actually be deferred here when they can probably upgrade to get the Cart, post the approval?

Yeah. Maybe I'll just take Travis. I'll start with the second part of your question. So we originally developed TabloCart for customers that are in areas of the country with truly bad like anomalously bad water, where they found themselves replacing the filters inside the Tablo consoles more frequently than desired. And so we designed TabloCart as an optional accessory that, they could use to extend the life of the filters inside Tablo. So as we look at the second half, we're just thinking about, hey, if there are any new customers in these really bad water areas, they might choose to push back their console purchase until TabloCart is available and so for that reason, we contemplated that in the guidance that we talked about today.

Hey Travis, just a couple of other things on guidance, so first of all, when we think about the pause on TabloCart with Prefiltration, we did defer the revenue in the low single-digit million dollar revenue associated with TabloCart with Prefiltration itself. And then we also contemplated the potential deferral of some of these Tablo console sales that Leslie talked about. Importantly, based on the visibility we have as we enter the second half, we believe that the low end of our guidance range is our floor, and we're going to work hard to work our way up from that. But again, based on the visibility we have, we do believe we'll be

I will add -- oh, sorry, go ahead, Travis.

No, no, go ahead, Leslie.

I was just going to say that I will add that we -- I mean, we really did a fantastic quarter in Q2 and a really, really strong first half. I think we all feel very bullish about our ability to execute in the second half. And the entire team here is very focused and motivated to kind of work our way up through that range. as we move through time here between now and year-end.

And just to confirm, just saying that the only thing that's really changed here versus 3 months ago is the Tableau cart. And I don't know if there's a way to kind of parse out how much of this was the actual delays that you're factoring in, if that's like half of the guide to the lower end of the guidance range? And the build, can you kind of go over the Q3 commentary as well. I just want to make sure we got the message on Q3 modeling -- and I'll jump back in queue.

Yes, Travis. So guidance for us is always based on a couple of things. One, it's based on the visibility, right? And as I mentioned, we took the low single-digit million associated with Cart and sort of deferred that out of 2023. And then we took an estimate for Tableau deferrals, again, for the reasons that Leslie talked about. That is the only thing. As we were entering the quarter, Leslie talked about the strong performance. We saw console placements do exactly what we want -- we saw treatments behave the way we expect, right in line with our expectations. Service renewals remain high. So we had all of the ingredients, if you will, Travis, to have a really strong print and give really, really good commentary with respect to the back half of the year falls notwithstanding. So hopefully, that helps, again, we do -- we are guiding to the low end of our range as the floor. Now with respect to the quarters, given the recency of this event, we believe that the third quarter will be more disproportionately impacted. We have to now go out and work with our customers on alternate plans. Those customers in bad water jurisdictions. We have to go work on alternate plans and help them with how we can work with them. So we believe the third quarter will be more impacted and that it will be roughly flat to the second quarter. And then that we will grow in 4Q as again, we get some of the momentum out of 3Q and then some of the deals from 3Q that may be deferred land in 4Q

I'll just punctuate what Nabeel said at the beginning of your question, Travis, is that nothing else has changed and nothing -- I think importantly, nothing structural has changed here. Yes, this is an unforeseen curveball and we will be able to manage it within the current guidance range. But all of the other leading indicators in acute and home are performing exactly as I hoped they would. So I think with regard to the performance of the business at large, both near term and long term, our bullishness has remained unchanged.

Very helpful color. Thanks a lot.

Sure.

One moment for our next question. Your next question comes from Rick Wise with Stifel.

Good afternoon, everybody. Leslie, I don't want to dwell on Tableau. I mean it's clear the business is in excellent shape, and you're making a lot of positive progress. But -- just to make sure I'm understanding everything. It didn't seem like -- and maybe I'm wrong in remembering, but it didn't seem like you were going to -- or you felt the necessity to file a 510(k) how was the decision made in conjunction with the FDA? Was this your initiative? And maybe just help us think about a potential time line to resolution? I know there's no perfect answer, but can you just add to some more clarity around that point?

Of course, absolutely. Happy to. So first and foremost, we are doing at the run volition. As we talked about, I think, in early July, the warning letter did not require or request that we stopped selling or distributing Tableau or the Tableau system. Our goal -- I mean, job number one is to fully remediate the warning letter as quickly and smoothly as possible. And so as we had more time on the clock, I mean, we've received the warning letter in July 6th I think and we disclosed on July 7th. So with the benefit of more assessment and analysis time we determined that the fastest path towards kind of a smooth and expeditious resolution was to file and pause. I just think it's the right thing to do. Again, in the spirit of job number one is resolve the warning letter as quickly and smoothly as possible. Related to the 510(k) itself, taking a step back, the decision-making around Tableau Card's this regulatory approach obviously occurred some time ago. While this recent action may not reflect it externally, we really have substantially deepened our expertise and capabilities in this area and I do feel we are well positioned moving forward to scale quality and regulatory at the pace that our high growth rate is requiring. We have taken a lot of time, both internally and also with external experts to develop an and implement a multitude of initiatives to continue to scale and bolster quality regulatory from people to senior leadership to process these procedures. We have upgraded and expanded the breadth and depth of our talent. And at this point, we have examined every facet of our quality and regulatory management systems strengthening along the way. So I feel that moving forward. And let me add…

Great. That's a -- very appreciate the thorough answer. Two last questions. I’m going to answer -- ask them rather together. I think I'm correct in saying it that I was intrigued to see that despite moving to the lower end of your sales range guide unchanged, but the low end and thinking about losing revenue or possible revenue from TabloCart accessory sales, which I imagine must be higher margin, highly accretive margins to the overall company. I mean how does gross margin stay intact when you move to the low end? And the second question there is just talking about all these -- your significant progress in landing the midsized accounts and you hinted at one very large account and another one to come. When -- how do we imagine that starts to get factored into the sales sort of your thinking on sales is -- is it -- it's going to potentially benefit fourth quarter, or no, it's going to take three to six months for some reason? I'd just like to know how that all plays out? Thanks so much for both.

Sure. Nabeel, do you want to hit the margin question first?

Yes, for sure. So Rick, TabloCart with prefiltration was and when it gets back, it expected to be margin accretive to us. Having said that, we only launched the product late last year. And again, Rick, this is a product that is really only serving customers and jurisdictions where the water is really bad. So we never expected it to be in all of our console sales or even the majority of console sales. The drivers for us of margin expansion really are unchanged. It's continued cost down on the console. It’s continued pull-through of our consumables, it’s service leverage. And then just to double-click on ASP, while TabloCart with prefiltration certainly was a component, the other drivers of ASP strength have been number one, our disciplined pricing, which really hasn't changed since we've been commercial. And number two, it's been our sale of Tablo Pros, the 24-hour software which in the second quarter was in the substantial majority of our acute consoles. And so we have a lot of other margin drivers right that continue to give us conviction in our gross margin objectives both through the back half of this year and then to our ramp up to that 50% milestone.

I'll pick up on the home piece, Rick. So we started the year here in January, or planning for the year, last December, we had those two goals in mind as we thought about our forecast and our expectations for where we wanted to land the plan on home by the end of 2023. And so we assumed -- we are prone to assuming victory and reaching it, no matter what obstacles in our way. So we had assumed victory on, hey, we are going to get contracts with the majority of these midsized MDOs by the end of the year. And we will have, through the largest health systems, our contracted to set up home program. So I -- while it would be difficult to say, hey, we're going to start to see impact in this quarter versus that quarter, we certainly planned for some benefit in 2023, which we're already starting to see.

Thank you so much.

Of course.

One moment for our next question. Our next question comes from Shagun Singh with RBC Capital Markets.

Hey, thank you for taking question. I was just wondering that with Q3 sequential growth is flat, what is driving your confidence in the significant step-up that you're modeling for Q4?

Shagun, it's really just the visibility that we have into the business. Remember, we've always run a high-visibility business just under half of our revenues, our recurring revenues, these from consumables and service, and then with our strong pipeline and backlog, we have a good forward visibility into console placements. So again, it's really just visibility, which is what we always anchor guidance on that tells us both that we will achieve the low end, at least the low end of our guidance range and that we believe 3Q will be roughly flat to 2Q

I would also add everything to do that. I would only add from my vantage point and probably more editorial than anything. I mean, we have never had a bigger pipeline than we have today. And I think we've really been aided with the benefit of some time as more and more and more health systems have adopted Tableau for in-sourcing and seeing the cost reduction benefits and the clinical care benefits and the operating benefits there's a network effect that starts to emerge. And so I've been present myself for a number of conversations between health system executives sort of sharing and swapping success stories. And so I think that I can sincerely say that the flywheel, particularly in acute is firmly underway. And so those are some of the factors that give me the confidence more editorially about the back half of this year.

Got it. And just as my second question, in the acute care setting, you called out strong demand from hospitals due to cost savings. I think you also referred to some data out there. That seems pretty positive. Just in that setting, I guess a two-part question. Are there any economic or outcomes analysis that you're focused on presenting data from? And then in the acute care setting, how are you thinking about utilization versus continuing to and so within our land and expand strategy? Thank you.

Yes. Maybe I'll start, Nabeel you can. On utilization, I'll just touch on that. It's not an or, it's an and. And our -- we have a commercial team that is very focused both on expanding the number of customers, expanding the number of facilities inside those customer networks through console sales. And then we have a large percentage of our team in the commercial organization focused on expanding utilization as the tenure of the Tableaus and those accounts mature. So it will never be in work for us. It will always be in hand. In terms of the economic analysis, some of that actually will be presented in greater length at the -- or more detail, I should say, at the ASN Annual Meeting here in early November. And in addition to that, we continue to see customers publishing white papers sharing their own experiences. There are a number of other conferences, et cetera, that will take place into early 2024 and it will be in my expectation. I think that we'll continue to see more of this economic data being shared in those venues as well over time as more and more of it is recognized and accumulated.

Thank you.

Next question.

One more for next question. Our next question comes from Suraj Kalia with Oppenheimer & Company.

Can you hear me all right?

Yes.

Perfect. So Leslie, I remember last year in your comments, there was this notion of home being approximately 15% contribution in FY 2023, at least I vaguely recall that number and it was triangulating to like $20-plus million in contribution. I appreciate the qualitative commentary, Leslie, maybe can you give us some guidepost on where home hemo is currently relative to your expectations, relative to patients?

Yeah. Hey, Suraj, it's Nabeel. Our comments were with respect to 2022, we had expected for the full year 2022 to drive home revenue to roughly 15% of our total revenue, and we surpassed that. We actually got home revenues to be roughly 20% of our 2022 revenues for the full year last year. And we will update you with our installed base annually. We do consultations annually that break out home and acute, and we'll update that when we print our 4Q results.

One moment for our next question. And our next question comes from Josh Jennings with TD Cowen.

Hi, great. Thanks for taking the questions. I was hoping, Leslie and Nabeel, you could just help us think about drivers for 2042 drivers that will be sustaining the revenue growth you're delivering in 2023 or accelerating, some soft-ish comps from the recovery earlier in the year for the ship hold and then now with TabloCart and just a very, very minor, I guess, disruption here in the second half of 2023. But outside of soft comps sounds like the pipeline is plus, any other drivers you would have a think-through as forecasting after post 2Q results?

Yeah, Josh, hi. It's Nabeel. So look, for 2024, as Leslie pointed out earlier, structurally, nothing has changed for us. Tablo demand for both our acute and home-end markets remains and we entered the second half with a lot of momentum in both of those end markets, and we're really setting up -- we had a good print and we're still setting up for a strong back half of the year. Now none of the hiccup that we're facing here, none of that demand goes away. As we've talked about our expectation is that sales of both TabloCart with prefiltration will resume once we get our clearance and that any Tablo orders that may defer will also come back once we get our 510(k) clearance. So as we think about 2024, nothing has structurally changed. Now we're in the middle of 2023 here, and it's -- in any year, it would be early for us to give any specific commentary on 2024. Our focus is now really executing to get to the low end of our guidance range for 2023 and then to work hard to get above that, and we'll come back and update you on 2024 as we get more visibility as we normally would.

I agree with all that. I'd only add maybe at a more qualitative level, the drivers of demand, which will underpin, obviously, our performance in 2024, the drivers of demand on the acute side are strong and only getting stronger. Hospitals need to, want to, must reduce costs, hospitals want to need to must provide the best possible clinical care that they can for their patient community. And increasingly, hospitals are facing challenges with discharge. Their inability to find a dialysis chair in the outpatient, dialysis clinic continuity is causing some really significant headaches and cost pain points with length of stay. The hospitals cannot find a chair in that community to discharge a patient who, they must continue to dialyze that patient in the inpatient setting for which they are not reimbursed. And so we are seeing a pretty material uptick in traction, interest, activation amongst both smaller hospitals and large health systems in standing up their own home programs. And I do anticipate that to be a major driver in 2024 as well.

Great, thanks for that detailed answer. I also wanted to just ask about, I mean, I guess, a potential headwind would be in the acute channel just the competitors having a stronger response. And our anecdotal check suggests that some of the dialysis providers that provide that outsourced inpatient dialysis are rolling over and it's been giving up. I have -- is there -- have you seen anything on the -- in the marketplace with a stronger competitive response from those dialysis providers, or do you expect one going forward? Thanks.

Yes, sure, Josh. Short answer, no. We haven't really seen a significant change. What has been happening and continues to happen. And this is just giving you some color on what we hear from health system executives is that they are continuing to receive higher pricing and lower service levels on those outsourced contracts. And so yes, I mean, that activity does continue to be a tailwind for us is that obviously provides additional ammunition and motivation to in-source and sort of take back control of that service line. kick out of controlling their own destiny, both on cost and also clinical care. So that does continue to be a tailwind for us.

Understood. Thank you.

[Operator Instructions] Our next question comes from Drew Ranieri with Morgan Stanley

Hi, Leslie and Nabil. Thanks for taking the questions. Maybe just to piggyback off Josh's last question there -- or first question, but I know that we like previously talked about home being more of a gradual type of adoption curve versus like an inflection point, but maybe just to build on your answer to Josh, but is there anything in the environment and home from a provider or maybe even a patient standpoint, that's getting easier in terms of your ability to drive Tableau home adoption or just even shifting care to the home from the clinic. I mean you're just talking about the discharge issues. But is there a point where you think you just kind of hit critical mass, where mean adoption just because it becomes much more easier and maybe doesn't flaunt?

Yes. I'm happy to talk about that. That has homes my favorite topic as everybody at out that note. I do think that the -- the what's new, again, in the last kind of couple of quarters, so what's new are these discharge issues. What remains a strong tailwind in on the financial side, are the one, the availability of Medicare Advantage for dialysis patients, which is new since 2021. And the estimates that we've heard from providers is that already at least 40%, if not a bit more, of their dialysis patient census is already on Medicare Advantage. That's a tailwind because that does have an associated higher reimbursement rate than pure Medicare. So that's helping a lot. And then the second thing is the ETC program. And that has got a long runway running through 2027. Those carats and those decks are starting to get deeper as we move into 2024 through 2027. So we do continue to see that as a motivator probably more so with sort of the midsized operators than the health system because the health systems just have a completely different cost structure. So I think all of those financial headwinds -- or excuse me, tailwinds remain. If there's anything new, I think the Tablo economic value proposition has become more and more clear to providers as they understand that whether it's a Medicare patient or Medicare Advantage or commercial patient, the economics of Tablo on a per treatment basis make a lot of sense. And so I think we've had greater success through in sort of what's new I think we've been more successful in our ability to show people that through financial ROIs and walk people through that story. And I think as the providers gain more and more experience in supporting patients at home, that's the last piece. I think that continues to change in a positive way. As they say, seeing is believing and every time a new customer starts seeing patients preferentially choose Tablo start seeing patients actually really train inside of 10 days regardless of their age, education or skill level and as they see their own patients stay on home for a much longer period of time than their experience has led them to believe with other devices in the past, that, that word is getting out. And yes, it will not be overnight. And yes, we still anticipate a gradual climb. But in those respects that again, I'll use the flywheel analogy, the flywheel is beginning to turn here.

Got it. I appreciate the color there. And maybe one for Nabeel. Just as we look at your gross margins, versus the prior year period, a significant step-up in product revenue margins step down in service and others. You just talk about maybe some of the factors there for service. Was it just the leasing agreement coming off, but anything that we should be focusing on as we think about a build up in our gross margin lines?

Yes. Drew, on the service margin line, you are spot on. It's really just the expiry of the HHS agreement. So Q3 of 2022 was the last quarter of that deal. And it will be behind us here in a quarter even from a comp perspective. Now if you look at our progress Q1 of this year to Q2 of this year, you'll see kind of a linear step up. And that linear step-up in service margins will continue into the future. Every once in a while, we'll have to make investments in people and programs, but again, over time, you will absolutely see a linear step up in service margins. And the product margin is really our cost down efforts as well as, again more consumables shift -- more consumables revenue as the mix shifts from growth in the installed base.

Thanks for taking the questions.

I'm showing no further questions at this time. I would now like to turn the conference back to Leslie for closing remarks.

Great. Thank you. Well, I'd just like to thank everybody for attending and wish everybody a very good evening. I do want to close by thanking the entire Outset team I see every day a relentless determination and a really deep belief in restoring agency and autonomy to patients and providers. And for that, I and others here are deeply grateful. So thank you again to the team, and thank you all for joining today, and have a great evening.

This concludes today's conference call. Thank you for participating. You may now disconnect.