Insulet Corporation (PODD) Q2 2015 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Insulet Corporation's Second Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference call over to your host, Deborah Gordon, Vice President, Investor Relations and Corporate Communications.

Thank you, Jonathan. Good afternoon and thank you for joining us for our second quarter 2015 earnings call. Joining me today are Patrick Sullivan, our President and Chief Executive Officer; Michael Levitz, Chief Financial Officer; Dan Levangie, President, Insulet Drug Delivery; and Shacey Petrovic, Chief Commercial Officer. The replay of this call will be archived on our website. Our press release discussing our second quarter results and third quarter and full year 2015 guidance, as well as a document that provides our quarterly revenue composition, are also available in the IR section of our website. Before we begin, I would like to inform you that certain statements made by Insulet during the course of this call may be forward-looking and involve known and unknown risks and uncertainties that may cause actual results to be materially different from any future results implied by such statements. Such factors include those referenced in our Safe Harbor Statement, in our second quarter earnings release, and in the company's filings with the SEC. With that, let me turn the call over to Pat.

Thanks, Deb. Good afternoon, everyone, and thank you for joining us today. During today's call, I'll first provide commentary regarding our second quarter performance, including a brief overview of the state of the business and why we are so excited about the many opportunities that exist today and that lie ahead. Next, Michael will review our second quarter financial performance in more detail, and then this third quarter guidance, and discuss our full year 2015 outlook. I'll then discuss the progress we're making on some of our key initiatives, then we'll open the call up for questions. First, I want to briefly touch on the circumstances that resulted in a delay in issuing our [indiscernible] earnings and filing of our 10-Q. As outlined in our preliminary revenue results announcement on July 29, the company initiated a review related to certain revenue recognized in 2014. Since then, we have completed our work looking at these and some similar transactions. The review was scoped and conducted with the assistance of outside accounting and legal professionals. Ultimately, we did not identify any material errors. With that, I'd like to say just how pleased we are by our second quarter performance. As I predicted, our new leadership team has hit the ground running. The initiatives put in place, the changes made within the respective organizations, and renewed sense of urgency, focus and accountability are really beginning to show results. Q2 revenue was $75.6 million, up 5% year-over-year and approximately $7 million higher than the midpoint of our guidance range. While Mike will provide you the detail of our second quarter financial performance, let me share with you some of the highlights of our revenue performance. We have our four products outperformed expectations and our international revenue was as expected based on the forecast provided by our international distributors. Our Q2 of 2015 U.S. OmniPod revenue was $44.7 million, while roughly flat to Q2 of 2014 represented over half of our second quarter revenue [indiscernible]. Since Shacey joined us in February, she has quickly put resources and initiatives in place to strengthen ourselves and marketing efforts. We are very pleased to report that our U.S. new patient starts were up approximately 20% from the prior year and in fact the third highest in the company's history surpassed only by Q2 and Q3 of 2013 when the company completed the full launch of the new OmniPod system. Additionally, we saw more than a 20% increase in U.S. new patient starts from the pediatric population during the quarter, representing an all-time record. In addition to strong new patient starts in the quarter, our higher-than-expected U.S. results were driven by the growing patient base of OmniPod users. We're excited by the early returns from our U.S. team, and while still in the early stages, we believe this momentum will continue and grow in the second half of the year. The results from our emerging Drug Delivery business were terrific. With Q2 revenues of $7.5 million, this will be a significant growth driver for us in the future. In addition to our existing relationships with Amgen and Ferring Pharmaceuticals, we signed additional agreements with pharmaceutical partners during the second quarter. The first step in our proactive efforts was the placement of business development executives in the U.S. and Europe during the second quarter. We're very focused on nurturing our existing relationships with Ferring and Amgen while cultivating new relationships and business with other pharmaceutical and biotechnology partners. Our Neighborhood Diabetes business generated revenue of $15.7 million during the second quarter, also ahead of expectations. As most of you are aware, this business tends to fluctuate from quarter-to-quarter, and we expect revenue to be roughly flat to the prior year. Lastly, we recognized international revenues of $7.7 million in the second quarter, which was in line with our expectations. As we discussed on last quarter's call, we worked with Ypsomed at the end of March to reduce their days on hand inventory, and this effort is now complete. Ypsomed continues to forecast a more than 40% growth in the U.S. OmniPod patient installed base in 2015, based on direct end user demand. With our production capacity, inventory levels and balance, we remain confident about prospects internationally, and our international business will return to year-over-year growth in the second half of the year. Before I return the call over to Mike, I would also like to briefly discuss the FDA warning letter we received during the second quarter and the steps we have taken in response. As we've reported previously, we received a warning letter relating to observations noted during the FDA's March 2015 inspection in our facilities in Billerica. The issue noted in the warning letter related to company's release of certain products of the new-generation OmniPod in mid-2013 and the first of – first half of 2014 which had been identified during the March audit as non-conformant to final acceptance criteria. We responded to FDA within the required timeline and in abundance of caution, we have taken our corrective actions one step further by voluntarily initiating a product replacement of 12 lots in the U.S. and 7 lots in the European market. While the product in these lots were manufactured in compliance with our standard operating procedures and met the final acceptance criteria in place at the time, we have since implemented procedures that have set the product quality bar even higher. We initiated this product replacement proactively and we believe the vast majority of the product is no longer in the field. Through a focused effort of our Insulet manufacturing team, our product quality is now at the highest level on the company's history and we want to make sure that the product in the market today conforms to our current more stringent final quality acceptance criteria. We believe that is what our customers deserve and that's what the company needs to deliver. We are pleased to have received a letter from the FDA last month communicating that they reviewed our written response and the correction action we put in place, and they have identified that the response, our response, appears to be adequate. We also continue to believe that this matter will not have any adverse impact on our ongoing business and operations. To support our continued vigilance in ensuring the highest level of product quality, we have made an addition to our management team appointing Michael Spears to head our Quality, Regulatory and Clinical Affairs Organization. Michael started a couple of weeks ago and reports directly to me. We are thrilled to have him joined the executive team. Overall, I am strongly encouraged by the early results we're generating from initiatives we put in place since the start of the year. I am even more confident our team's ability to build momentum and generate strong results in the second half of the year as well as the 2016 and beyond. With that, I'll turn the call over to Mike, our CFO. Mike?

Thank you, Pat. Let me start by saying that I'm very excited to be part of Insulet's leadership team and to have an opportunity to partner with Pat and the rest of the senior team to support our efforts to drive growth and profitability. And to make a difference in delivering such an important medical advance to patients living with diabetes and other diseases. This is a truly remarkable company with many opportunities ahead, given the strength of our differentiated technology, a significant room from market share expansion, and the wealth of experience and talent of our team. As I review our second quarter 2015 results unless otherwise stated, all the commentary regarding changes will be on a year-over-year basis. Our revenue increased 5% to $75.6 million and that compares to $72 million same period last year. And that's driven by growth in the U.S. OmniPod revenue as well as growth in drug delivery revenue as Pat mentioned earlier. Our consolidated gross margin decreased in the period to 45.5% and that's compared to 49.7% reflect shifts in geographic and business line product mix. But more significantly, it reflects additional scrap and warranty charges that occurred during the quarter. As Pat mentioned, we recently implemented procedures with more stringent file acceptance criteria and product quality is now at the highest level. As a result, certain product and inventory did not meet the more stringent acceptance criteria that's now in place. We believe approximately $2.5 million if the incremental scrap and warranty charges in the second quarter were non-recurring in nature. These charges negatively impacted our second quarter gross margins by approximately 4 points. Our operating expenses increased 14% to $46.7 million from $41 million. The largest increase was within sales and marketing where we have been investing to expand sales coverage, customer support and marketing to improve access, customer experience and retention. And that's followed by an increase in research and development, where we have been making increased investments to drive market-oriented innovation. Our G&A expense was lower in the period due to a charge last year of $7 million related to a legal settlement. Our net loss was $15.4 million, and that's compared to a net loss of $29.1 million in the same period last year. And that includes $3 million in net interest expense, primarily related to interest on our 2% convertible note, and $1.9 million of that was non-cash. Our cash balance at the end of the quarter was $145.1 million, and that's compared to $151.2 million at the end of the last calendar year. Now, turning to third quarter revenue guidance. As Pat mentioned, we are confident in our ability to build on the momentum from the second quarter and generate stronger results in the second half of the year, and our third quarter revenue guidance reflects this. We anticipate our revenue will be in the range of $82 million to $85 million. That's up 11% at the midpoint compared to Q3 of last year. We expect this growth, on a percentage basis, will be driven by mid to upper single-digit growth in our U.S. OmniPod business, growth in the mid to upper teens in our international business, revenue in our drug delivery business of between $5 million to $7 million and revenue of approximately $15 million in our neighborhood diabetes business. For the full year, we are reaffirming our full-year guidance range of $305 million to $320 million and we feel good about the second half of the year, while also appreciating it does represent a significant year-over-year increase in our U.S. and international OmniPod sales. As Pat stated, we are very excited about the early wins we are seeing in each area of our business and we believe the positive momentum as we exit the second quarter will continue to grow in the back half of the year. While we believe there are still risks to the guidance which we walked you through previously, there is also upside, specifically within drug delivery. As a result of our second quarter revenue and our forecast for the remainder of 2015, we are increasing our drug delivery guidance to a midpoint of $25 million from our previous expectations of $15 million to $20 million. The high end of our total company guidance of $320 million assumes even more upside should revenue from the drug delivery product line continue to outpace our expectation. However, that is too early to predict. For the second half of 2015, we expect year-over-year OmniPod revenue growth on a percentage basis will be in the low teens in the United States and to midteens internationally and that's based on continued growth in new patient starts and improvement in customer reorders. To be clear in terms of what this means for international business, we continue to expect the international business to approximate $40 million revenue for the year, which is down on a year-over-year basis due to the destocking of inventory that took place in the first half of 2015 which we previously discussed. And finally, we expect neighborhood diabetes revenue to remain steady at approximately $15 million in each of Q3 and Q4. Since joining Insulet three months ago, I've spent considerable time focusing on the company's near and longer term financial plan to drive growth, profitability and margin expansion. We have a truly differentiated product in a large and growing market. We believe the best way to drive growth and profitability is to increase new patient starts and reorders through improved market access and our focus on a quality customer experience. This year, the company has made significant changes in the management team, bringing on a number of very experienced leaders with a history of success. We have expanded our direct sales force and customer support infrastructure, and we've also increased research and development efforts to drive product improvements and technology innovation. In addition, with the initial success of our drug delivery product line, we are making thoughtful investments to further leverage our tubeless pump technology, the delivery of drugs in areas beyond diabetes. Reflecting all of the organizational changes and these incremental investments, we are currently expecting our operating expenses for the full year 2015 to total approximately $200 million. We are making these investments to support our plans for sustained growth and profitability. Our leadership team is now actively focused on a multi-year strategic planning process. Once this process is complete, we look forward to sharing with you our longer-term vision, our goals, our opportunities and outlook. We believe the company is well positioned to make a significant positive impact for our investors, for our patients and our employees. In summary, we believe the second quarter revenue results are a positive signal that we are succeeding with our transition planning, and we also realize there is work ahead of us to achieve our goals. We look forward to continuing to execute and drive improved results, creating increased value for all of our stakeholders. With that, I'll turn the call back over to Pat.

Thanks, Mike. We believe OmniPod is the most innovative and differentiated insulin delivery system on the market and has significant growth potential in other drug delivery applications. I'm even more confident today that we are driving toward accelerated growth and global adoption. With our full leadership team now in place and our strengthened focus on execution, growth and accountability, I strongly believe we are well positioned to win. I would like now to take a few minutes to recap the progress made during the quarter in executing our initiatives and to share with you some of the exciting recent developments. Our U.S. commercial restructuring and expansion efforts are just about complete and we continue to strengthen our capabilities through our expanded sales organization and focus on marketing activities. Our new sales incentive and training programs along with rigorous performance measures to drive greater accountability are delivering positive results on new patient starts, leads and revenue generation, which position us well for accelerated growth in the second half of the year. We had a very successful presence in the American Diabetes Association Trade Show on Boston in June and hosted [indiscernible] to showcase our OmniPod, our next-generation PDM and our data integration partnerships. We generated a record number of leads at the show and we conducted viable market research with overwhelming positive feedback. We hosted an exciting and well-attended symposium which included a panel discussion by three individuals involved with the artificial pancreas initiative and we had very positive partnership, scientific advisory board and investor meetings. So, overall, ADA was big success for us this year. We continue to work on our next-generation PDM with the ultimate goal of developing artificial pancreas. In addition to the many benefits of our new PDM will provide, we are focused on integrated CGM and ultimately fast tracking in artificial pancreas solution. In addition, given the significant improvements we have made over the past six to nine months to refine and improve our standard operating procedures within the quality and regulatory organizations, we want to be very carefully and thoughtfully ensure all these improvements are fully integrated within our new PDM. With that said, our management team and I have been focused on driving a culture of continuous improvement and accountability across all functions including product development. And in an effort to incorporate viable customer feedback from our ADA market research and our more recently implemented quality and reliability improvements, we're delaying the submission of our next-generation PDM by a few months. We still anticipate a 2016 launch and launched into the market just a few months later, a little bit later in the year. On the market access front, Medicare and Medicaid coverage remains my highest priority and we continue to make multiple – to pursue multiple parallel paths to secure coverage as quickly as possible. Since my last update last quarter, we've had several very productive meetings with CMS and we've been reading with legislators and efficacy groups as well. With that, operator, I'd like now to open the call for questions.

Certainly. [Operator Instructions] Our first question comes from the line of Tao Levy from Wedbush. Your question, please.

Great. Thank you. Good afternoon.

Hi, Tao.

Hi, Tao.

So maybe we can first start with the drug delivery, which I mean, obviously was really strong in the quarter and then you up the guidance. Is that all through your Amgen partnership?

Yeah. This is Dan. We've said in the past that Amgen represents the lion share of our revenues in drug delivery. We're not going to give any further visibility into the breakout of revenues. But I would say we're very enthusiastic about what we're seeing with our relationship with Amgen and we're very bullish about our prospects for the year.

Got you. And I mean, do these sales involve stocking type of orders for now and at some point, is it going to slow down, or you're putting out the doors as much as you can manufacture, and then the same thing is happening on the patient side?

We don't have access to end user information. I think our partners, either Ferring or Amgen or both, would be the best source of that information. We get a forecast from me to those companies. We build to that forecast and ship product.

Thank you. Our next question comes from the line of Mike Weinstein from J.P. Morgan. Your question, please.

Hi. This is Robbie Marcus in for Mike. So, thanks for giving me 20% new patient growth number. We also know that Animas grew 32%, Tandem grew 53%, Medtronic grew 9% in the U.S. this past quarter, while your total revenues were up 1%, so not everyone can gain share. So can you help us reconcile that 20% new patient growth number with what's going on in the installed base? And I know, Pat, at ADA, we were talking. You were going through an overhaul of what is your installed base. Are you in a position now where you're able to qualify that and what your true attrition rate is?

Robert, I guess I would say there's no change from what I provided a the J.P. Morgan conference back in January. On a worldwide basis, it was 75,000 patients at the end of last year. It was about 75% U.S., 25% outside U.S. split, and the attrition rate remains about 9%.

Okay. So can you help us reconcile that 20% new patient growth with 1% overall OmniPod growth?

I suppose I'm not in a position at this point in time to give you any more color on that.

Thank you. Our next question comes from the line of Brooks West from Piper Jaffray. Your question, please.

Hi, guys. Thanks for taking the question. Pat and Mike, I wanted to just circle back to make sure I understood the guidance. So, it sounds like international, you're holding the same with $40 million Neighborhood Diabetes flat, taking drug delivery up, you said at the midpoint of $25 million. So I'm wondering what the range is there. And that leaves us with kind of $180 million to $195 million in U.S. OmniPod. So, I'm wondering, I guess what is the range of drug delivery that would imply that midpoint? And then has your thinking changed on your guidance around the U.S. OmniPod business since you last gave guidance?

Well, just in terms of the drug delivery business, so we said at midpoint of $25 million. So, I think you could view a range of between $23 million and $27 million, to be at that midpoint. I think that there is a potential for upside which, as I said, would support the upper end of our range but it's still early to tell. We're pleased with the results so far. In terms of the U.S. OmniPod business, I think our view there is around $180 million to $185 million.

Okay. Thanks. And then, Dan, while we've got you on the phone, you guys are talking about some new drug delivery partnerships. Any details or kind of timelines that you could give us on what we might hear there?

Yeah. We can't give a lot of detail. These agreements are with earlier stage development projects, agreements are confidential. I will just remind everyone that the timelines associated with these development projects are in terms of years, not months. So in the three- to seven-year timeframe is when you would expect to see revenue from any of these agreements.

Thank you. Our next question comes from the line of Anthony Petrone from Jefferies. Your question, please?

Hi. Great. Thanks for taking the questions. Maybe just to stay on Drug Delivery for a moment, just wondering how the Amgen agreement sort of tracks over time, I think if we go back to the initial language around Amgen, it was certainly for one drug which I think is Neulasta at the moment. But potentially, there was a path full with other drugs. So I'm just wondering, is this just Neulasta or eventually do we see multiple drugs out of the Amgen agreement? And then I have a follow-up.

The agreement that we – the commercial agreement we have in place today is related to Neulasta with Amgen.

Right. And I think...

And your...

Go ahead.

The other commercial agreement we have is with Ferring. All other agreements that we have in hand, as I've said earlier, are early-stage confidential agreements with pharmaceutical companies.

Got it. Maybe just switching gears a little bit to international orders that wasn't touched on here, if we sort of model out the $40 million target for the year, I guess, we're getting third and fourth quarter in the $15 million to $17 million range. So I'm just wondering for modeling purposes going forward, do you sort of see that quarterly range as the go-forward sort of run rate with Ypsomed? Thanks.

I think what we described is mid to upper teens in terms of our expectations for international growth. Ypsomed has been talking about growth north of 40%. And so there's – I think that's where the real demand is coming from. As you know, last year, there were some challenges coming after the EROS launch. And so we had certain distributors that were taking on more product to make sure they had product to meet the demand. And so that impacts the year-over-year comparisons, but now that we have – they've taken down their inventory levels quite considerably, I think that as we move forward in future periods beyond this year that we're going to be seeing straight demand based growth in line with what Ypsomed has been talking about.

Thank you. Our next question comes from the line of Jeff Johnson from Robert W. Baird. Your question, please.

Thank you. Good afternoon, guys. I just wanted to touch on the R&D line, obviously, up quite a bit on a year-over-year basis. And Pat, I know you talked about some of the increased investments there. But is this kind of a run rate we should be thinking about on a quarterly basis? And maybe what, from a high level, have you seen now over the last 6 to 12 months or so in your role where you need to step up the investments on the R&D so aggressively?

Yeah. I think as I – I guess I'm in month 11 since joining back in last September. I think one of the things that has become clear to me is that we need to step up our innovation. I think the company had some challenges with the new generation of the OmniPod launch. In 2013 or 2014, we've talked a lot about – but now focusing engineering resources on the next generation PDM that we've talked about coming to market next year. And also initiatives in the artificial pancreas that we need to put some resources in that initiative, and I think there's other opportunities for us to continue to grow out the drug delivery capabilities that we have, increase our investments there to provide for what we think is a spectacular opportunity in that particular market space.

All right. And so, again, just not to push it too hard, but $45 million, $50 million, somewhere in there kind of a run rate going forward on R&D on an annualized basis, and then any update you can provide on the G5 integration will be helpful. Thank you.

This is Mike. I would say that I think that we expect our R&D to be north of 10% for the next – this year and for the next probably a couple of years, and then we expect that to start to move down. So, I think that's a reasonable range, but I'm not prepared to give a specific range on OpEx. But I think the key story there is we do believe there are some very exciting opportunities for investment. We think that it will pay off quite nicely in terms of our opportunities in the OmniPod area and drug delivery as well. And so we do expect some increased investment.

Thank you. Our next question comes from the line of Danielle Antalffy from Leerink Partners. Your question, please.

Hey. Good afternoon, guys. Thanks so much for taking the question. Patrick, I was hoping you could elaborate a little bit on the sales force add. So you've clearly been adding some sales folks. Wondering how to think about the really great growth that we saw on new patients adds coming from new sales people ramping versus just sort of organic growth and how to think about that going forward as far as the cadence of rep adds over the next few quarters.

Since I have Shacey on the call today, I think I'll let Shacey answer the question.

Thanks, Pat.

Shacey.

Yeah. I mean I think the initial start, the new patient performance is a direct result of the sales force expansion. We have more feet on the street and that increased footprint allows us to better serve our targeted account. So that's clearly driving results and we're excited about what that means for this quarter and what that means for the future.

Okay. And can you give any color on rep adds over the next few quarters or...

We've completely completed our sales force expansion. We're at about 150 people in the field right now and have no plans at the moment for future sales force expansion. I would say that the other thing Shacey has done since she came back, she came in February, was I think really focus the sales organization, focusing them in targeted accounts where really the high prescribing offices identifying those through some marketing research that we did as well as, I think, providing for increased execution against bonus and incentives and all those other elements of sales force execution.

Thank you. Our next question comes from the line of Jayson Bedford from Raymond James. Your question please.

Good afternoon and thanks for taking my questions. Just a couple of follow-ups. On the international guidance, the $40 million which I think is a little lower than what we had, but when we factor in your mid-teens guides for 3Q, it looks like the implied fourth quarter guidance calls for deceleration. I'm just wondering why you wouldn't feel a little bit more growth in the fourth quarter internationally?

This is Mike. I think the guidance, as I see it, to get the $40 million given where we are halfway through the year, in the mid teens, I don't see deceleration. I see it being fairly consistent through the second half of the year.

Okay. So the third quarter guidance is mid to high teen’s international growth. Isn't it?

Right. That's right.

And the full-year is 40. Okay. I'll go back to my model there. And then just one on drug delivery. You mentioned you signed the additional agreements. Is there up-front revenue associated with those agreements?

Usually not.

Okay. Thanks, Dan.

Thank you. Our next question comes from the line of Bill Plovanic from Canaccord. Your question, please.

Great. This is actually Kyle, on for Bill. Can you hear me all right?

We got you, Kyle.

Great. So, just wanted to kind of circle back on the U.S. business. I guess just two questions. Appreciate the color on the new patient starts. Wondered if you could talk about – are you still seeing any destocking in the U.S. business? And then, when we're working with our models, I appreciate the color on the attrition, but how should we think about utilization from the existing base patients? Is that still about 10 pods a month? Is it more like eight or nine? Or are there any additional insight into what the recurring base looks like there?

I don't have any additional insight on the recurring base. I would say it's probably similar to what you've probably seen before.

I would just say also that our retention rates have remained fairly consistent across the last several periods. We do see an opportunity there because small improvements in patient retention could drive a lot of value for us. So, we do have strategies and focus in that area. But it's been pretty consistent for the last several years.

Great. And then just any commentary regarding – is there still ongoing destocking that you're seeing with some of your distributors?

No. The destocking issue, domestically and internationally, is done.

Thank you. Our next question comes from the line of Ben Andrew from William Blair. Your question, please.

Good afternoon. Thank you. And I guess first question from me is on the gross margin. About half of the sequential decline was you said one time and you're working on the quality. Can you talk to what it's going to take to get that gross margin just back to where it was on an overall basis, normalized in Q1? And how do you – are you permanently impaired, if you will, from getting back to kind of the 60%, 65% long-term target?

This is Mike. I think there are a couple of things. First of all, as I said, I think we had about 4 points of drag because of with what we believe to be non-recurring scrap or warranty costs related to the improved product quality and I think, as Pat said, we're in the midst of the voluntary recall and those other things. So I think that there are going to be some costs as we go into the third quarter. In terms of the year-over-year gross margin, I think that was around 50% last year in the second quarter, rounding-wise, and we are about 4 points shy of that year-over-year. In terms of the first quarter, I think one of the things that impacts our business is mix. And our strongest product mix from a gross margin standpoint comes from our U.S. OmniPod sales and our drug delivery sales, to the extent that we have a higher growth in other areas. Then, that is not as positive to our gross margin. So I think mix will have an impact as we go forward. In terms of the longer-term goals and expectations for gross margin, honestly, I'm really excited about our opportunities there. I think that we have some real opportunities to have it fixed in front of the number there, as we go forward in future period. But there is work to do to get there.

Okay. And I guess two other questions, one following on that. I mean, your revenues from Amgen are extremely high margin and arguably would have been steady with Q1. So I'm not sure the year-ago comparison is the same because of that. So I'm just curious where that gross margin goes because we've been consistently looking for that to head higher over time. And then second, Pat, kind of a big picture question for you, what would it take for you to put a Bluetooth transmitter in the OmniPod? Thank you.

Well, I speak to the gross margin question first. I would say that our direct business is where we have the highest gross margin and our distributor less so. And our distributor business in the U.S. is stronger than our distributor business internationally. So to the extent that our mix changes, it can have a real impact on the gross margin numbers. So our international distributor business is, as I said, on the lower end and that impacts us in a particular period.

I would say on your second question, we have the capability of putting a Bluetooth capability in the pod.

Thank you. [Operator Instructions] Our next question comes from the line of Suraj Kalia from Northland Securities. Your question please.

Good afternoon, everyone. So Patrick, first and foremost, congrats on the progress. A lot of things going on behind the curtain. So I didn't want to diminish what you guys have accomplished in six months. Let me belabor a point, Patrick, if I could. I know this has been asked twice before, at least forgive me if I don't understand this correctly. If attrition rates are the same, utilization the same, again, you have added new reps and the patient starts are up 20%. I'm somehow not – I wanted to ask the same question about reconciling with revenues, and I'm also trying to understand did the ASPs changed, any directional color would be helpful so that we can model it appropriately moving forward.

The ASPs have not changed. The attrition rate remains at 9%. And new patient starts were up 20%. I can't – I can't reconcile your model at this point, but perhaps we can take it offline.

Fair enough. And Patrick, in terms of the quality issues you mentioned that were – that's a corrective recently, what specifically were the quality issues and would this impact gross margins moving forward? Thank you.

Could you repeat that? I'm sorry. I missed the first part of that question.

So at least what I heard on the call, Patrick, was there were some quality issues that were remediated because of some initiatives you all have taken. I'm just trying to understand what specific quality issues were remediated, and at the same time, does this cost add an additional cost to your cost line item? Thank you.

Yeah. I think the quality issues that I was referring to relate to the product issues associated primarily with the launch of the new OmniPod insulin delivery system back in 2013 and 2014. Those issues remained. They were product performance issues during – into 2013 and 2014. Those issues have largely been remediated. But I would say there's always, in any disposable product, or any product, for that matter, there's always sustaining engineering efforts that companies undertake to continuously improve the performance of the product in the field. And that's where we're in right now, the sustaining engineering portion of supporting that product in the field, and we'll always be making improvements.

Thank you. Our next question comes from the line of Ben Haynor from Feltl & Company. Your question, please.

Good afternoon. Thanks for taking the questions. Can you just remind us when the destocking impact was done with in the U.S. OmniPod business?

Sure. Most of that occurred in Q1 and some – the remaining occurred in Q2. So, it's now behind us as we look towards the second half of the year.

Okay. Great. And then what level of the new patient starts do you believe would be required to return to double-digit growth in the U.S. OmniPod business, and what else – what other factors go into that?

I couldn't give you an exact number of what the new patient starts need to be to drive that. But I would say that the combination of increasing new patient starts and increased utilization or reduction in attrition by the existing base I think could clearly get us into that realm.

Okay. Great. Thank you very much.

Thank you. Our next question is a follow-up question from the line of Tao Levy from Wedbush. Your question, please.

Great. Thanks. So maybe I'll start with a quick clarification on some of the expenses. In the press release, there's the $3 million charge, and that, I assume, is different than the gross margin impact that you were talking about?

This is Mike. I'm just trying to look in the press release. The $3 million charge in the press release, are you referring to consisting primarily of severance related to recent management change.

Yes, exactly.

Yes. And you're saying that was different than the $2.5 million?

Oh, no, no. That's not my question. So that's different than the gross margin that you're talking about...

Yes.

...the $2.5 million.

That is correct.

Okay. So there's $5.5 million of really onetime charges, I guess, in the quarter. Is that right?

Yeah. $2.5 million was [indiscernible] warranty charges, we believe, are non-recurring and the $3 million was related to the severance. There was a good amount of management transition, as Pat described.

And that $3 million, where is that in the OpEx? Is that in G&A?

Yeah. The majority of that would be in G&A.

Okay. And then just – so when I look at the $200 million that you're talking about in terms of OpEx guidance for the year, are you taking any of those – are you taking that $3 million out or does that include that?

I've had to include all of the different charges I described. It would be kept. The $200 million, as I said, was OpEx, so it would not include the [ph] scrap and warranty because those are in the gross margin line obviously. But in terms of OpEx, it includes all of the severance and related things that would be within our operating expense category.

Thank you. Our next question comes from the line – is a follow-up from Mike Weinstein from JPMorgan. Your question, please?

Hi. Thanks for the follow-up. This is Robbie Marcus again. Maybe just touching on the OpEx again, Pat, when you started you said you were going to do an incremental $15 million spend and now we're at $200 million versus $155 million at 2014. And in this quarter, it was the biggest loss since second quarter 2011. So, maybe help us understand exactly where is this significant increase in spend going to and is it onetime in nature or is this going to continue to grow in 2016 and beyond?

This is Mike, I'll answer and Pat can obviously add any color to it. I think the – our view is we really want to build for a sustained growth and profitability in the future. And what we're finding is that there are opportunities for investments that are, in our view, very straightforward in terms of the value proposition. Those are in – and I think what Pat described earlier is describing expense growth in sales and marketing specifically because that was the initial area of focus. And I think we're seeing the fruit of some of those investments that Shacey described. But what we're also seeing now is that there are opportunities from an innovation standpoint. Whether that's related to the new PDM or whether that's related to artificial pancreas solutions or other areas in drug delivery. Where we believe there is going to be a real payoff, we want to make those investments. So, we are not in this for the short term, we believe that there are some really exciting opportunities.

Yeah, Robbie. I would just add to that. We did add $15 million, as I described at the JPMorgan Conference back in January, to the sales and marketing line item budget. But I think as going through the year here, it's – I came to the realization that we really need to continue to build the infrastructure to support $1 billion business opportunity that we see five to six years from now. And I think that the level of spend that you described back in 2011 and 2012 or earlier in the company's history did not provide for that foundation to be put in place across the organization, in engineering, manufacturing, R&D, quality regulatory, et cetera. And we're building that foundation, our expense profile will – shows that, but it's upward getting to $1 billion in revenue five or six years from now. And there's a very clear path to get there.

And I would also – this is Mike again. I would just add that we're not just focused on the revenue. I think that, as I say, there are a number of opportunities in margin expansion and operating leverage. So, I think that – I look forward to the opportunity to be able to speak with you, our investors, about our longer-term views. And that's something that we want to get on the schedule here after we've wrapped up our strategic planning efforts. So that, you can better understand where we see the opportunities going forward.

All right. And maybe just a follow-up on Ben's question before on gross margin. So we have 49.5% gross margin this quarter adjusted for the onetime items, Street models are kind of at 53%, 54% for the rest of the year, going to may be 55% next year. Is that too aggressive in your view given the new quality standards, or do you think you – are those still achievable?

Well, I guess I would just comment on where we see things as opposed to commenting on the Street's expectations. But as I say, I believe that we've got four points that are nonrecurring in nature, but given the mix profile and the opportunities here, I think, in the near term, I think that those numbers you described are higher than what we're expecting in terms of the – this year. As I look out forward, as I say, I expect us to be reaching about 60%, but that – that's going to take us some time to get there. And so – yeah. That's how I see the gross margin coming together at this point.

Thank you. Our next question is a follow-up from the line of Anthony Petrone from Jefferies. Your question please.

Great. Thanks. Maybe, Pat, just to drill down on $1 billion of revenues over time. Is there any maybe outlook as to how much of that comes from drug delivery over time and maybe how much is from maybe even the core type 1 market? And maybe another iteration to that second question there is, can you review for us where you see pump penetration broadly in the U.S. as it stands today and maybe where you think it can go over the next three years.

Well, I would say that the aspirational goal of hitting $1 billion in revenue five to six years now is one that we have as an organization and are more focused on. I don't think I'm prepared today to give you the breakout of where that could come from. I think that there are tremendous opportunities in drug delivery. There's tremendous opportunities increasing our international OmniPod business, as well as our domestic OmniPod business with the improvements in the product roadmap that we've outlined in front of us. So I think there's a – we see a clear path to get there and I think we hope to share that with you in a not too distant future.

I think the other part of the question was regarding the market for [indiscernible]?

Yeah. Pump penetration into type 1s in the U.S. Is there any update there where that is currently?

I mean there's a number of different sources then they all come out slightly differently but it's approximately 30% to 35% of current type 1 users use pump therapy. And we do see that growing over the horizon.

I would say from my perspective, everybody that has type 1 diabetes should be on insulin delivery system principally the OmniPod. I think we got the best drug insulin delivery system on the market. But I will tell you the impediments to that market adoption, that widespread market adoption, I believe are the lack of clinical benefits and economic benefits that have not been provided to the insurance carriers who were paying for these therapies. So I think that we have a – we've been working a lot on putting together clinical evidence as well as economic benefit and marketing that to the clinicians and to the insurance carriers. From my perspective, that's the largest obstacle to a very widespread adoption of the technology broadly as a marketplace. So I think we're working to fix that. And I think that given the benefits of pump therapy, everyone should be on pump therapy.

Thank you. Our next question comes from the line of Ben Andrew from William Blair. Your question, please.

Thank you. I got two. Let me just do it, a touch of math. So if the Amgen revenues are very high gross margin, so you sell it to them for $75 or $80 with volume. Your cost on those should be about the same, if that's correct. That would suggest the $25 million in guidance you would generate upwards of $20 million of gross margin from the Amgen partnership, is that even in the right zip code?

This is Dan. So I don't think we're going to confirm pricing to Amgen. You could imagine that's not something we would do, and the device is different than the insulin delivery device and you would expect it to cost a little bit more to make that device than our OmniPod device they're delivering.

Okay. That's fair. And then, I guess the other question is, Pat, coming back to my other one, do you need to redo manufacturing to put a Bluetooth transmitter in the OmniPod?

We have the capability to put a Bluetooth low-energy device in the OmniPod device itself. Yes, we can do that. Another question – you would have to make a manufacturing change obviously to do that to incorporate into product, but it's not difficult to do.

Thank you. I'm showing no further questions at this time. I'd like to turn the conference back over to Pat Sullivan.

Great. Thank you. Before the call ends today, I would really like to reiterate that we are very pleased to report second quarter revenue results coming in ahead of our expectations. Our focus on driving growth is beginning to yield positive results and validates the recent organization and operational changes we've made. While we've got work to do, we strongly believe our revenue results demonstrate our success in executing our key initiatives and our game-changing OmniPod technology can win in the market with a proper focus and execution. We are still in the early stages of a transition. Our senior leadership team is now having a very early and significant impact. I'm incredibly proud and energized by what I'm seeing from the new team and from all the employees at Insulet who work tirelessly every day to raise awareness about our product and to drive results. We're in a clear path to growth and with positive remaining – and with very positive momentum heading into the second half of the year. We look forward to sharing with you our further progress and reporting our results at future conference calls. Thanks.