Outset Medical, Inc. (OM) Earnings Call Transcript & Summary

Thank you, everyone, for joining us this afternoon. I'm Drew Ranieri, one of the medical device analysts here. It's my pleasure today to have Outset Medical with us. And from the company, we have CEO, Leslie Trigg, and CFO, Nabeel Ahmed. Before we get started, quick disclosure, but for important disclosures, please see the Morgan Stanley research disclosure website. If you have any questions, please reach out to your sales rep.

With that, let's kind of dig in here. To start maybe on the GLP-1 kind of debate, it's been kind of an inbound that we've been getting more frequently in med tech and even more so in dialysis. So there's a building view out there that kidney failure and dialysis could even be disrupted from some of the derivative effects of GLP-1s. But it would be great to kind of hear the house view from Outset on how you're thinking about maybe potential disruptions nearer term, longer term or how you're thinking about it, maybe even affecting the home market opportunity?

Sure. I'm happy to. We've spent -- so first of all, nice to see you all. We have spent a lot of time sort of studying this and also looking back at the history of the GLP-1 predecessor, the SGLT2, which have been out since 2013. And -- so we've had a nice kind of 10-year period to look at, hey, was the incidence of CKD affected? Was the ESRD new starts affected? Both CKD diagnoses and ESRD new starts have gone nothing but up year-over-year since the introduction, and that was about 5 of those, I think out. So there's no evidence to suggest at least as a starting point that the predecessor to the GLP-1, the SGLT2, has had any impact on the progression of CKD or ESRD. I think it is second important to talk about the 2 populations separately. The ESRD population is roughly 600,000 people in the U.S. That is irreversible kidney loss. And so ESRD patient can take all the Ozempic that they want, it will not affect or reverse their loss of kidney function. However, it may affect their cardiovascular health. And so what we predict in the ESRD population, again, those are patients who are already on dialysis. We actually predict as a prevalent population, will get larger. The mortality rate in the ESRD population, unfortunately, is about 20% per year. 40% to 50% of that mortality is actually driven by cardiovascular disease. And so if we do see a sustained and broader effect of the GLP-1s on cardiovascular health, we will see a reduction in mortality amongst the prevalent ESRD population. So what that would mean actually is net higher growth in the prevalent population over time. Now you talk about the CKD, chronic kidney disease population, there are 3.4 million patients just in the U.S. alone that have diagnosed CKD. Important to note, there are about 135,000 people who start dialysis every year. Most of those do not have to diagnosed CKD, most people never know that they have kidney -- any sort of progressive kidney loss until they are -- boom, they are an acute kidney failure, and they start on dialysis. But amongst the 3.4 million who are diagnosed with CKD roughly 50% to 60% is called nondiabetic CKD. That CKD is driven by other factors, cancers, acquired diseases, hypertension, et cetera, that is not related to diabetes. And so again, we don't expect any kind of impact from GLP-1s on 50% to 60% of the CKD population. So even if you assume that maybe the 40% to 50% that are related to diabetes, they all go on the drug, they all lose weight, they all have less progressive disease, we still would have 1.8 million to 2 million people, fortunately or unfortunately, progressing toward kidney failure. If our CMO was sitting up here, he would tell you that he would expect actually an expansion of the incident population as well for the same reason because cardiovascular mortality is expected to go down. He said the number one reason why most patients don't progress to dialysis is because they die beforehand of cardiovascular disease. So we would, in summary, start to give you a lecture on it, but we'd expect to actually see an expansion in the incident and the prevalent population as a result of the cardiovascular benefits of the drugs.

So potentially bigger population is what you're thinking.

Correct. Yes.

Actually, kind of thinking about 12 months ago when you were here, I think the AHA or AMA guidelines came out about cardiovascular health. Do you think that could kind of further play into some of the home dialysis opportunity? And with just dialysis care being a little constrained in the center, the shift to home, do you think it's a bigger opportunity with GLP-1s? How are you kind of thinking about the home opportunity and maybe an acceleration in type of -- in that growth rate there?

Well, I do. I mean the American Heart Association did come out about a year ago with a statement of recommendation just for more home dialysis because it's long been reported in the literature that home dialysis leads to lower hospitalization rates and lower rates of mortality, quite frankly, from comorbidities. That's separate apart from GLP-1. That's just for everybody else's background. Yes, I do think -- I think the biggest driver will be, again, a more rapidly expanding prevalent population and a more rapidly expanding incident population will, ultimately, it's kind of a rising tide lifts all boats story with regard to home. More than I think it's specific GLP-1 to home, I just think the patient population overall will grow.

Got it. Okay. Maybe let's change gears to some of the growth drivers of the business. Maybe start with the acute care setting first. Maybe this is a compounded question here. But related to the TabloCart's shipment hold, maybe give us an update on expectations for submission or returning to market? And then second there is just, Leslie or Nabeel, if you want to answer this part, is just I think the expectation was you're going to see potential delays in customer purchasing in the acute care setting. Has that kind of manifested into the third quarter? Any indication of what that could look like for the back half of the year?

That is a compound question. So you're [indiscernible] is flying from California, just as a reminder, last night. So I'm going to have to work hard to remember all the parts. Let me maybe get...

We'll I take the warning letter first...

Yes, I got it. I got it. That's where I was going to start. So we have filed. And so the submission is in. As I say, it's in God's hands now. But I think the team did an exceptional job at a very thorough, very comprehensive and thoughtful submission. That's part one. We also have responded to the warning letter itself. We did that a while back. And our response effectively was strategically yes and. So we -- I don't foresee that there's anything controversial in our response, which we are choosing to take a very, very collaborative approach. They had some commentary about some customer testimonials on our website. Those have been long removed, and then we did choose to take the step of filing on TabloCart and then voluntarily said, "Hey, you know what, we'll just push the pause button on the Cart to continue to be a good corporate citizen and a good partner to FDA." So all of that is now behind us. Going to acute demand, I think I am -- and I'll just say, separate -- apart from TabloCart for a second, the acute demand continues to be really, really high. And it is because Tablo continues to deliver on its promises around cost reduction, around operational efficiencies. We actually have some data coming out at the ASN in November, one hospital and there are more that are now starting to publish on their data. But this is a Midwestern regional health system that published. I'll give you some for -- examples, a 57% reduction in the cost of treatment, of almost a 5-day reduction in length of stay in the ICU. They looked at a pre-Tablo period with other machines in a post-Tablo period. That was the comparison set and over $1 million in savings in the first 12 months using the system. So I think as white papers and customer experiences get shared both in writing and peer to peer, I think that is contributing to kind of this flywheel effect in the acute. So demand remains strong. The last part of your question was about, hey, you expected some impact from TabloCart. How is it going? We did -- let me back up, as background on our last earnings call in early August, and that was just a couple of days after we had submitted or made the decision to file. So it was very early. We hadn't talked to any customers yet, we were speculating that maybe there could be some deferrals, some delay, particularly in Q3, maybe even administratively, as we had to rewrite order agreements or rewrite POs. That is playing out the way we expected it to. So we have had to go back and rewrite agreements with customers that had OAs or POs in the pipeline. That won't take months and years, but it does take time. And so that is playing out as we expected it. In the third quarter, we had maybe shared with investors in August, hey, we'd expect more growth in Q4 as we look out at the back half of the year, maybe a flatter Q3 as a result of some of the administrative and other delays or deferrals that customers may choose. But this is all under the heading of timing. We have not seen any customers pull out. We have not seen any orders removed out of our pipeline. This is all about timing. And I think in the history book of Outset, this will be a footnote, a little bit of a painful one, but there is nothing structurally different about our business or certainly about my confidence in the outlook for the rest of the year and certainly not for 2024.

So some of the orders that have been pushed out a bit, I mean, it's dependent on TabloCart coming back to the market. Is -- do you have a sense of what you're expecting or any clarity on FDA approval timelines? I mean Tablo, the actual system itself, I thought it was like a 6- to 9-month 510(k) kind of clearance. TabloCart, these are my words, it seems a little less complex than the console, but just how should we be thinking about maybe the approval timeline?

It is a lot less complex than Tablo, that's for sure. I have long since stopped trying to speculate about how long the FDA is going to take. But what I will say is back in early August, we just went ahead and assumed that it would be under review through the end of the year. So we have -- so is it possible that it could come early? Yes. Are we counting on it? No.

Got it. So there's the deferral piece of some of the contracts that were already written, but you're also still seeing high underlying demand for even new customers.

Absolutely. Yes. I mean we are seeing expansion in existing customers. We are seeing new customers come into our order books and our pipeline. I remarked, I think in August that our pipeline actually has never been bigger. That is still true today. So again, I would -- I don't want to trivialize it. But over the long term, I would characterize this as a speed bump, an unwelcome one, but it is one that we will get over in the relatively short term here.

And maybe just kind of sticking in the acute care setting for a second. But with sub-acute, I mean, this feels like a newer opportunity for the company, and you've had a lot of progress to date with agreements from the top 10 providers. But how significant really kind of is this opportunity for Tablo? And you had one of the providers on a call. But do we think about the general opportunity similarly across the top 10 and kind of that rollout process?

By and large, I do, so we're talking about sub-acute, rehabs and LTACs and skilled nursing facilities. Our entry point -- our chosen entry point into this sub-acute market, which is a couple of hundred million dollars in size just -- even just in the console TAM alone. Our chosen entry point was LTACs and rehabs. Those operate very similar to inpatient dialysis actually in a hospital. So it's the same sales force, it's the same field service organization. There's a lot of operating leverage that we get from this, same value proposition, cost reduction. And we -- the team has been very successful there. The top 10 largest LTACs and rehabs are all contracted with Tablo. The next segment of the market that I think is in our future is skilled nursing facilities. There -- even if you take a very targeted approach, and I don't want -- it's premature to kind of size the TAM, but it would be larger than the TAM we've already discussed for LTACs and rehabs. There are about 15,000 skilled nursing facilities in the United States. Not all of them have sizable dialysis populations, but a very large percentage do. So I'd expect us to be talking about that more in the future as we start to get a little bit further into that market. But the value proposition for Tablo is a little bit different, but quite strong and it is simply the opportunity to do dialysis on-site in the SNF. Right now, the SNFs have to transport patients at their own expense to a dialysis clinic, back and forth 3 times a week. That typically will wipe out most of the day for the SNF to be able to not -- they won't be able to offer any other types of services, really hard on patients. And so we know that a lot of SNFs are looking at this also as an incremental revenue opportunity, their reimbursement is being affected quite severely by CMS. And so I think the interest level and the desire, I'm sort of seeing a market rise in the SNF community, but more to come on that.

Got it. And with sub-acute, I mean some of these providers, to your point, are offering transitional care. And we were talking about the ESRD population is obviously irreversible damage. So when they transition out of sub-acute, they're going to go home or maybe to an in-center. So as you're talking to some of these customers, kind of help us kind of bridge the gap of like what's going to get a patient from a center into the home with the Tablo system?

Yes. So there's I would call it kind of top of the funnel and bottom of the funnel. Our long-term goal is to get to the top of the patient funnel. By the time somebody is kind of in a dialysis clinic, you're operating more at the bottom of the funnel and the dialysis clinic provider will decide along with the nephrologist who's going home and who's not going home. We have -- and that's where these midsized providers come in. So we are now contracted with the majority of the midsized providers. They control about 1/3 of the patient population today. So that's a nice -- I'll call it, a nice entry point. That entry point made a lot of sense. We could access it right away, and we're enjoying really good growth there. That's kind of low altitude. Higher altitude simultaneously, we want to get to the top of the funnel. We're going to do that by partnering with health systems to open up their own home programs because they're receiving the majority of the incident patients. They are also increasingly frustrated the hospitals by their inability to discharge patients into a dialysis clinic because some of the LDOs have announced several hundred clinics closing between last year and this year. And that creates a length of stay problem for a lot of hospitals. And so hospitals are -- have another incentive now to set up their own health programs to control their own destiny on cost. And the second channel of access are the sub-acute players, LTACs, rehabs. They now have a competitive advantage that they can offer to their customers, the hospitals, hey, we're happy to receive dialysis patients, and we can train them while they're here to go directly home. And so I think the incentives at play here, again, are cost reduction for the hospitals and the sub-acute providers and now a new incremental revenue stream for hospitals and sub-acute providers as well through home. The last channel I'll mention of the 4 channels, home, are new entrants, and I think this is the most interesting. There are some health care providers that are already offering other types of services. They just happen to have a very large percentage of CKD and ESRD patients. And there are now several that are entering the home dialysis space for the first time. And what's really kind of cool and interesting about that, they're sort of unshackled from the way it's done. So we have one provider who stood up a number of new home programs across the country. They're training patients in their home. If you approached a conventional dialysis provider about that and some, not all, would probably take 1 to 3 years to talk about that idea and make the change. But people who are entering home dialysis, our observation, they're doing so with a much more creative mindset really driven by the financial incentives, particularly Medicare Advantage, to get as many patients' home as quickly as possible. And they're doing it in novel ways.

Got it. And some of the center closures that you're talking about from some of the larger providers, it sounds like new providers have the opportunity to kind of come in there. Does this open up maybe some geographic opportunities that you might not have had access to because of the provider competition in that space before or concentration, I should say.

Yes. I mean, broadly speaking, what we're after is just channel access, the broadest possible channel access for patients to be able to access Tablo. So as these other tributaries -- again, top of the funnel tributaries, health system, subacute and I'll call it, new entrants, are populating across the country, it's just creating more and more channel access to Tablo. Yes.

And with home growth, I know you don't want to give a number today or an installed base. But can you just talk about maybe like year-to-date, where the growth has been coming from a bit more? Is it new provider growth? Is it just same-center providers pushing more patients towards the home? Just kind of what's that new account versus kind of like just the utilization increase or push?

Yes. I know you're trying to force me to make a choice, but the truth is both. It really is both. We are continuing to add new locations. And we are seeing really good growth in each location. So the idea is depth. Look, I mean, each location is very, very valuable. So we are -- we still -- our team is very focused on, hey, if you've got 10 patients on, can you get 20 patients on, right? If you've got 20, it can push -- how high can we push the ceiling. And we also have started to do that to really maximize the depth in each location with some very targeted social media direct-to-consumer. That's specifically ring-fenced. You're not going to see us with the Super Bowl ads, the US Open ads. We're not -- that would be a waste of money at this point. But what's not a waste of money is generating direct-to-consumer interest in the locations where Tablo is being offered. And so we've actually really had some intriguing success. It has led me to conclude that patient demand will not be a challenge. And then we're able to actually feed those leads to the locations when I talk about depth, not only from the patients that they already have in that facility, but bringing new patients to their facility, which, of course, they also find quite valuable in the partnership without that.

Got it. maybe to give you a break and go to Nabeel for a moment, but it sounds like there has been some pushout in the orders or pushout on the timelines. But as you laid out like flat revenue, 2Q to 3Q, are you still comfortable with that? And is that dynamic actually still just playing out as you expected? Or has it been a little bit more challenging?

Yes. So Drew, as we talked about our guidance for 2023, a couple of things: one, we're really proud of the fact that our scale and diversity of customers and end markets means that we could absorb something like this within our guidance range, that's number one; and then number two, again, as Leslie mentioned, sort of the dynamic that we considered as we talked about the shape of the back half was that given the proximity to the announcement, we'd have more contracts to rewrite more customer conversations to have. So again, we said that 3Q would be flat to 2Q and that we'd expect acceleration as we exited the year, so in the fourth quarter. Yes.

Okay. And Nabeel, sticking on kind of the financials for a moment. But just with the progress that you made on gross margin initiatives, remind us kind of like what the playbook is for '23, given some of these headwinds and maybe what your expectations are or anything directionally that we should expect heading into '24?

Yes. So my -- we're very proud of our margin progress. So we printed 22.5% in 2Q. On our last call in August, we reiterated our conviction around getting to mid-20% exiting the year low 20s for the full year on our way in a linear fashion up to 50% in the not-too-distant future as our next mile marker. And Drew, the things that are going to get us to that 50% are the same things that we've sort of -- the same muscles we've used through today. It's console cost down, it's consumable pull-through as the installed base grows. And it's service leverage, both from natural installed base growth and from the investments we're making in remote diagnostics, remote repair, all of that stuff. And so it's the same things that will push us as we move forward. As we think about the Carts, the impact of Cart was relatively small or the expected impact of Cart in the back half was relatively small. It's really only a device used for jurisdictions with really bad water. The real benefit that we've had from ASP is disciplined pricing and then our PRO+ 24, our software feature. So we remain very much on track with a lot of conviction around our margin objectives for this year and then as we move to the next milestone.

Got it. And maybe on TabloCart, is there a non-0 potential that it does get approved by year-end?

A non-0? Yes.

Probably. So it's possible. And if it were to get approved by year-end, like what structurally what these contracts like kind of happen? I mean would you be immediately able to ship those consoles, put them in the hospitals or the home -- or put them in the hospitals, not the home? Just kind of trying to understand like what the speed could be...

It would depend, right? I mean is it December 31 at 5:00 p.m., is it Christmas Day? No, but kind of within some operating parameters, it would depend. I hate to speculate about -- and I don't -- I really don't want to set an expectation. I'll just end with, yes, there's non-0, but this branch does not have any demonstrated track record of clearing things at that pace. But it is non-0.

Got it. Okay. With 2024 Nabeel, I'm going to still ask, but just bear with me here, just anything that you can help us with from a quantitative or qualitative perspective? You were going into '23, guidance was about 25% growth. Just maybe just help us understand what the acceleration could look like for 2024? Consensus, I think, has you closer to 35% year-over-year growth. So just trying to understand if we should be thinking about it from a stable perspective or maybe even an acceleration for next year?

Yes. So Drew, we haven't guided to 2024 yet. We obviously will, in due course, but I'll say a couple of things. So first of all, we are in the early innings of 2 very, very large end markets, right, where our value proposition remains very much intact. On the acute, land and expand has worked well for us. We have built awareness. We're continuing to build awareness on the part of health systems. And we've got a large number of customers now that have had a positive experience. They have seen, as Leslie talked about earlier, the economic savings that Tablo generates. And so the combination of awareness and experience is a net positive as we think about '24 and beyond. On the home side, again, we are expanding our awareness with patients and with physicians. And we've also seen expansion of channel access, where as we sign more providers, both MDOs, health systems, these alternative sites of care that Leslie talked about, again, expanding channel access plus awareness should lead to growth over the long term. On top of that, we've now continued to expand our moat. If you think about from an innovation perspective, I'll point to Tablo Pro Plus as an example of innovation that is expanding Tablo's use case in the acute in that particular example. And then the final thing I'll say is, again, as we think forward, is that our business drives a lot of recurring revenues. In 2Q, Drew, 45% of our revenues were from consumables and service as we propel forward as the installed base grows, that number is only going to grow. And so it's the combination of those sort of 3 big vectors that I talked about that give us a lot of conviction in '24 and beyond. Again, I don't want to guide right now as much as we like you, but we do have a lot of conviction in our ability to grow.

And when I look at some of the models, we have you having about 4,300 Tablo systems in acute; 1,400 to 1,500 in the home. I mean I think the acute generates $20,000 per year, home is about $15,000. So that kind of looks like you have to do $85 million in incremental revenue to hit numbers for next year or consensus for next year. Can you give us a little bit more breakdown of like how you could actually do that? Or like is this going to be just nephrologists are coming online and prescribing home? Just anything more?

Yes. Let me maybe help you with the math, if that makes sense. So sort of if you think about our model and certainly the way we think about our model, you start with kind of the installed base entering a year. We look at the recurring revenue elements the way you talked about. And then we layer on our estimate of new consoles that we're going to sell and the service and consumables related to those, right? And if you just look at the first half, Drew, console sales were about $39 million, right, just in console sales. And so if you imagine that as kind of a run rate of what the business has done, you can kind of see the ability of the business to drive more revenue.

Okay. Maybe to shift gears to competition for a moment. But one of the early -- another early kind of home provider potentially recently announced that their home trial finished enrollment. So there's potential home competition coming. And I think Fresenius has like the Versi HD hitting the market at some point. But just any updated views on your expectations for competition in the home market as you are thinking about next year or 2025?

Yes, I'm happy to. I know we're running out of time. I would assume competition in both acute and home. I mean it is an $11 billion market just in the U.S. I've never participated -- well, I've never participated in $11 billion market in my career, number one; and number two, not one that has like 1 competitor in it. So I would expect it. I think one thing that is maybe a little bit underappreciated probably because we just haven't talked about it a lot is, I think, the moat, that we have the defensibility moat that we have in the software and the interoperability. We are now connected to Epic and Cerner, a whole panoply of custom dialysis center EMRs and custom hospital EMRs. Much like the infusion pump playbook of the past, that obviously makes it much, much more difficult for anybody in the future to try to break into, especially because Tablo has 2-way wireless data capabilities. So it's a pretty powerful engine. I think around that, we are also building, a little painfully, a regulatory moat around Tablo because we are filing often. We have gotten exquisitely good at human factors, at cybersecurity. We are the only device now that meets the very latest electrical safety standards, the home health safety standards because when you are filing frequently on your hardware, you have to represent to the FDA that you actually meet the latest standards. If you're not filing, you don't. So that is going to become more and more painful for competitors to catch up to over time. So I like the regulatory moat that's emerging, the interoperability moat that's already there. And of course, we're not done as we continue to develop and iterate particularly in the software and the data side. So I think we're very well positioned. And then lastly, I'll say on the home side, we are the only device that is a stand-alone single system for water purification and dialysis on-demand. Some of the -- I think, the coming competition requires a second separate machine to perform some of the functions that Tablo does all in one, and I think that's going to be -- continue to be pretty powerful.

I think we're going to have to schedule 45 minutes next year, but we're out of time right now, but great to have you both with us today. Thank you so much.

Yes. Thank you. Thanks for the opportunity. Thanks all of you.

Thanks, Drew.