(EDGAR Online via COMTEX) -- Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes to those statements included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Some of the numbers included herein have been rounded for the convenience of presentation. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under Part I., "Item 1A. Risk Factors" and elsewhere in this Annual Report on Form 10-K.
We are a global medical technology company focused on the development and commercialization of our proprietary Hi-VNI Technology products that are used to treat patients of all ages suffering from respiratory distress. Our Hi-VNI Technology delivers non-invasive ventilatory support by providing heated, humidified and oxygenated air at a high velocity to patients through a comfortable small-bore nasal interface. Our Precision Flow systems, which use Hi-VNI Technology, are clinically validated alternatives to, and address many limitations of, the current standard of care for the treatment of respiratory distress in a hospital setting. As of December 31, 2019, more than 2.1 million patients have been treated with our Precision Flow systems, and we have a global installed base of over 16,000 capital units.
We currently offer four versions of our Precision Flow systems: Precision Flow Hi-VNI, Precision Flow Plus, Precision Flow Classic and Precision Flow Heliox. We also initiated a limited release of our Oxygen Assist Module to certain United Kingdom accounts in February 2020 and we may expand that limited release to certain European accounts in the second quarter of 2020. The Oxygen Assist Module can be used with all versions of our Precision Flow systems except for the Precision Flow Heliox. Our Oxygen Assist Module helps clinicians maintain the pulse oxygen saturation, or SpO2, within the target SpO2 range over a significantly greater proportion of time while requiring significantly fewer manual adjustments to the equipment. Maintenance of the prescribed oxygen saturation range may reduce the health risks associated with dosing too much, or too little, oxygen, such as visual or developmental impairment and mortality in neonates. We intend to fully launch the Oxygen Assist Module commercially throughout the United Kingdom and Europe by the end of 2020, at which time we believe we will begin generating revenue from the product.
We generate revenue primarily from sales of the disposable products utilized with our proprietary Precision Flow systems. We also generate revenue from the capital units themselves. We offer different options to our hospital customers for acquiring Precision Flow capital units, ranging from the purchase of the Precision Flow capital units with payment in full at the time of purchase, to financed purchases of the Precision Flow capital units, to bundled discounts involving the placement of Precision Flow capital units for use by the customer at no upfront charge in connection with the customer's ongoing purchase of disposable products.
We sell our Precision Flow systems to hospitals through a direct sales organization in the United States and in the United Kingdom and through distributors in other select countries outside of the United States and United Kingdom. We intend to fully launch our Oxygen Assist Module commercially throughout the United Kingdom and Europe by the end of 2020 through a direct sales organization in the United Kingdom and through distributors in other select countries in Europe. In addition, we have clinical educators who are experienced users of Hi-VNI Technology and who focus on our medical education efforts to facilitate adoption and increase utilization. We focus on physicians, respiratory therapists and nurses who work in acute hospital settings, including the ED and adult, pediatric and neonatal ICUs. Our relationship with these clinicians is particularly important, as it enables our products to follow patients through the care continuum. We have sold our Precision Flow systems to over 1,500 hospitals across the United States, where they have been primarily deployed in the ICU setting.
We assemble our Precision Flow systems in our facility in New Hampshire and we rely on third-party suppliers for a majority of the components of our products, including many single source suppliers. We maintain higher levels of inventory to protect ourselves from supply interruptions, and, as a result, we are subject to the risk of inventory obsolescence and expiration, which could lead to inventory impairment charges. We currently ship our Precision Flow systems from our facility in New Hampshire directly to our United States customers and many of our international distributors on a purchase order basis. Warehousing and shipping operations for some of our international distributors are handled by a third-party vendor with facilities located in the Netherlands. While our customers have the right to return purchased products subject to a restocking fee, our historical return experience has been immaterial.
Since inception, we have financed our operations primarily through public offerings of our common stock, private placements of our convertible preferred stock, sales of our Precision Flow systems and amounts borrowed under our credit facilities. We have devoted the majority of our resources to research and development activities related to our Precision Flow systems including regulatory initiatives and sales and marketing activities. We have invested heavily in our sales and marketing function by increasing the number of sales representatives and clinical educators to facilitate adoption and increase utilization of our Hi-VNI Technology products and expanded our digital marketing initiatives and medical education programs. For the year ended December 31, 2019, we generated revenue of $48.1 million and had a net loss of $51.1 million compared to revenue of $42.4 million and a net loss of $42.5 million for the year ended December 31, 2018. Our accumulated deficit as of December 31, 2019 was $265.4 million. In 2019, 76.0% of our revenue was derived in the United States and 24.0% was derived outside the United States. No single customer accounted for more than 10% of our revenue.
We intend to continue to make significant investments in our sales and marketing organization by increasing the number of U.S. sales representatives, expanding our international marketing programs and expanding direct to clinician digital marketing efforts to help facilitate further adoption among existing hospital accounts as well as broaden awareness of our products to new hospitals. We also expect to continue to make investments in research and development, regulatory affairs and clinical studies to develop future generations of our Hi-VNI Technology products, support regulatory submissions and demonstrate the clinical efficacy of our new products. Because of these and other factors, we expect to continue to incur net losses for the next several years and we expect to require additional funding, which may include future equity and debt financings.
Components of Our Results of Operations
Our revenue consists primarily of the sale of products, leases and services.
We primarily derive our revenue from the sale of our products to hospitals in the United States and United Kingdom and through distributors in select countries outside of the United States. Product sales consist of the following:
Our capital revenue is derived from the sale of our capital equipment, which consists of the Precision Flow Hi-VNI, Precision Flow Plus, Precision Flow Classic, Precision Flow Heliox, Vapotherm Transfer Unit 2.0 and Q50 compressor. Capital equipment sales include a one-year warranty.
Our disposable revenue is derived from the sale of single-use disposables, nasal interfaces, or cannulas, and adaptors used in conjunction with the Precision Flow capital units.
We enter into agreements to lease our capital equipment. We assess and classify these transactions as sales-type or operating leases based on whether the lease transfers ownership of the equipment to the lessee. Equipment included in arrangements which provide for the transfer of title at, or shortly after, the end of the lease term in exchange for the payment of a nominal fee are accounted for as a sales-type lease. We record the current value of future lease payments as a component of prepaid expenses and other current assets in our consolidated balance sheets. Equipment included in arrangements that do not transfer title are accounted for as operating leases and we recognize revenue on a straight-line basis as it becomes due over the lease term.
This revenue consists of service, component part and freight revenue offset by rebates and fees payable to GPOs, Integrated Delivery Networks, or IDNs and distributor partners. Service revenue consists of fees associated with routine service of capital units and the sale of extended service contracts and preventative maintenance plans. In addition, we sell small quantities of component parts in the United States, United Kingdom, and to third-party international service centers who service Precision Flow capital units outside of the United States. Freight revenue is based upon actual freight costs plus a percentage markup of these costs associated with the shipment of products domestically, and to a lesser extent, internationally.
Recent revenue growth has been driven by, and we expect continued growth as a result of, increasing revenue from product sales due to our growing installed base of Precision Flow systems and related disposables sales. Our revenue has fluctuated, and we expect our revenue to continue to fluctuate, from quarter to quarter due to a variety of factors including seasonality. We have historically experienced seasonality in our first quarter due to the impact of the flu season in the Northern Hemisphere and in our fourth quarter, which coincides with our customers' fiscal year-end and often drives higher purchases of capital equipment as previously approved but unspent capital budgets typically expire at year-end.
Cost of Revenue and Gross Margin
Cost of revenue consists primarily of costs incurred in the production process, including costs of component materials, assembly labor and overhead, warranty, provisions for slow-moving and obsolete inventory, facilities-related expenses, depreciation and freight costs for items sold. Within the overhead costs we include personnel-related expenses, including salaries, bonuses, benefits and stock-based compensation for our procurement, quality control and operations personnel. We provide a one-year warranty on capital equipment, and we establish a reserve for warranty repairs based on historical warranty repair costs incurred. Provisions for warranty obligations, which are included in cost of revenue, are provided for at the time of shipment. Cost of revenue in absolute dollars will increase as our sales volume increases.
We calculate gross margin as gross profit divided by revenue. Our gross margin has been, and we expect it will continue to be, affected by a variety of factors, including manufacturing costs, the average selling price of our Precision Flow systems, the implementation of disposable cost-reduction initiatives, sales volume and inventory obsolescence costs. Sales mix also impacts our gross margins as our average selling price in the United States is typically higher than for our international sales given our distribution model. In addition, sales of our single-use disposables carry a higher margin than that of our capital equipment sales. Our gross margin may increase over the long-term to the extent our production volumes increase, we launch new products and we continue to experience cost savings derived from supply chain and manufacturing efficiencies. However, our gross margin may fluctuate from quarter to quarter due to seasonality.
Research and Development
Research and development expenses consist primarily of product development, engineering, regulatory expenses, testing, laboratory supplies, consulting services and other costs associated with future generations of products using our Hi-VNI Technology. These expenses include personnel-related expenses, including salaries, bonuses, benefits and stock-based compensation for employees in our research and development, regulatory, quality assurance and innovation functions. We expect research and development expenses to increase in the future as we develop future generations of products using our Hi-VNI Technology and companion products. We expect research and development expenses as a percentage of revenue to vary over time depending on the level and timing of new product development initiatives.
Sales and Marketing
Our sales and marketing expenses consist primarily of personnel-related expenses, including salaries, commissions and bonuses, travel expenses, benefits and stock-based compensation for employees in our sales and marketing, customer service and medical education functions. Other sales and marketing expenses include consulting services, education, training, tradeshows, digital marketing, medical education and clinical studies. We expect sales and marketing expenses to continue to increase in absolute dollars as we continue to expand our sales and marketing organization to both drive and support our planned growth in revenue. We expect sales and marketing expenses to continue to decrease as a percentage of revenue primarily as, and to the extent, our revenue grows.
General and Administrative
General and administrative expenses consist primarily of personnel-related expenses, including salaries, bonuses, benefits, and stock-based compensation, for employees in our finance, administration, human resources, information technology, and legal functions. Other general and administrative expenses include professional services fees, audit fees, travel expenses, insurance costs and general corporate expenses including facilities-related expenses. We expect our general and administrative expenses will increase in absolute dollars as we expand our headcount to support our growth and operations as a public company, upgrade our director and officer insurance coverage to be commensurate with other publicly listed companies and incur additional expenses related to audit, legal, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements. Over time, we expect general and administrative expenses to decrease as a percentage of revenue primarily as, and to the extent, our revenue grows.
(Gain) Loss on Disposal of Property and Equipment
The (gain) loss on disposal of property and equipment is calculated by comparing the net proceeds received for the disposed property and equipment against the net book value of the disposed property and equipment on the date of disposal with the difference being recorded as a (gain) loss as a component of operating expenses. We expect (gain) loss on disposal of property and equipment to vary over time.
Other Expense, Net
Other expense, net consists primarily of interest expense related to our credit facilities offset by interest income driven by the interest accruing on cash and cash equivalents. Other expense, net also includes the gain on litigation settlement, loss on the extinguishment of debt, the fair value adjustment of our previously outstanding convertible preferred stock warrants, which were accounted for as a liability and marked to market at each reporting period and foreign currency gains or losses arising from transactions denominated in foreign currencies.
Immediately prior to the closing of our initial public offering, our outstanding convertible preferred stock warrants automatically converted into warrants to purchase shares of our common stock.
Benefit for Income Taxes
The benefit for income taxes represents a benefit for net deferred income tax assets deemed more likely than not to be realized by our foreign subsidiary. We have not recorded any federal or state income tax benefits related to domestic operating losses due to uncertainty about future taxable income.
Results of Operations Year Ended December 31, 2019 2018 (in thousands) Net revenue $ 48,104 $ 42,377 Cost of revenue 26,793 25,605 Gross profit 21,311 16,772 Operating expenses Research and development 13,376 8,771 Sales and marketing 37,689 33,927 General and administrative 18,410 11,186 Loss on disposal of property and equipment - 121 Total operating expenses 69,475 54,005 Loss from operations (48,164 ) (37,233 ) Other expense, net (3,041 ) (5,235 ) Net loss before income taxes (51,205 ) (42,468 ) Benefit for income taxes (146 ) - Net loss $ (51,059 ) $ (42,468 )
Fiscal Years Ended December 31, 2019 and 2018 Revenue Year Ended December 31, 2019 2018 Change (in thousands, except percentages) Amount % of Revenue Amount % of Revenue $ % Product Revenue Capital $ 9,324 19.4 % $ 10,780 25.4 % $ (1,456 ) -13.5 % Disposable 35,055 72.9 % 28,453 67.1 % 6,602 23.2 % Subtotal Product Revenue 44,379 92.3 % 39,233 92.5 % 5,146 13.1 % Lease Revenue 1,721 3.5 % 1,334 3.2 % 387 29.0 % Service Revenue 2,004 4.2 % 1,810 4.3 % 194 10.7 % Total Revenue $ 48,104 100.0 % $ 42,377 100.0 % $ 5,727 13.5 %
Revenue increased $5.7 million, or 13.5%, to $48.1 million for the year ended December 31, 2019 compared to $42.4 million for the year ended December 31, 2018. The increase in revenue was primarily attributable to a $6.6 million increase in disposable revenue as a result of an increase in the installed base of Precision Flow capital units world-wide offset by a decrease in capital product revenue due to a decrease in sales volume of Precision Flow capital units. The $0.4 million increase in lease revenue was primarily attributable to a higher volume of lease contracts, as a higher percentage of Precision Flow capital units were leased versus sold for the year ended December 31, 2019 compared to the year ended December 31, 2018.
Revenue information by geography is summarized as follows:
Year Ended December 31, 2019 2018 Change (in thousands, except percentages) Amount % of Revenue Amount % of Revenue $ % United States $ 36,583 76.0 % $ 33,010 77.9 % $ 3,573 10.8 % International 11,521 24.0 % 9,367 22.1 % 2,154 23.0 % Total Revenue $ 48,104 100.0 % $ 42,377 100.0 % $ 5,727 13.5 %
Revenue generated in the United States increased $3.6 million, or 10.8%, to $36.6 million for the year ended December 31, 2019, compared to $33.0 million for the year ended December 31, 2018. Revenue growth in the United States was primarily due to increased disposable sales resulting from a larger installed base, higher average selling prices and increased utilization of Precision Flow units, and to a lesser extent, an increase in lease revenue, partially offset by a decrease in the sale of Precision Flow units.
Revenue generated in our international markets increased $2.2 million, or 23.0%, to $11.5 million for the year ended December 31, 2019 compared to $9.4 million for the year ended December 31, 2018. Revenue growth outside the United States was primarily due to increased disposable sales resulting from a larger installed base of Precision Flow units and increased average selling prices.
Cost of Revenue and Gross Margin
Cost of revenue increased $1.2 million, or 4.6%, to $26.8 million in fiscal year 2019 compared to $25.6 million in fiscal year 2018. The increase was primarily due to increased product costs, primarily due to higher sales volumes of our disposables.
Gross margin increased to 44.3% in fiscal year 2019 compared to 39.6% in fiscal year 2018. The increase in gross margin was driven by a decrease in disposable component costs, increased average selling prices on disposables and a favorable sales mix of disposables. Additionally, we improved operating efficiency by holding operating overhead constant while increasing throughput in our manufacturing facility to support continued sales growth.
Research and Development Expenses
Research and development expenses increased $4.6 million, or 52.5%, to $13.4 million in fiscal year 2019 compared to $8.8 million in fiscal year 2018. As a percentage of revenue, research and development expenses increased to 27.8% in fiscal year 2019 compared to 20.7% in fiscal year 2018. The increase in research and development expenses was due to new product development costs and increases in research and development employee-related expenses and stock-based compensation.
Sales and Marketing Expenses
Sales and marketing expenses increased $3.8 million, or 11.1%, to $37.7 million in fiscal year 2019 compared to $33.9 million in fiscal year 2018. As a percentage of revenue, sales and marketing expenses decreased to 78.3% in fiscal year 2019 compared to 80.1% in fiscal year 2018. The increase in sales and marketing expenses was primarily due to increased sales headcount and employee-related expenses in our sales and marketing organizations, increased stock-based compensation and increased investments in sales and marketing initiatives in 2019 compared to 2018.
General and Administrative Expenses
General and administrative expenses increased $7.2 million, or 64.6%, to $18.4 million in fiscal year 2019 compared to $11.2 million in fiscal year 2018. As a percentage of revenue, general and administrative expenses increased to 38.3% in fiscal year 2019 compared to 26.4% in fiscal year 2018. The increase in general and administrative expenses was primarily due to increased public company costs including headcount and other employee-related expenses, including stock-based compensation, and legal, accounting, insurance and consulting fees.
Loss on Disposal of Property and Equipment
The loss on disposal of property and equipment for the year ended December 31, 2018 was attributable to the loss on the disposal of property and equipment associated with our facility consolidation. We expect loss on disposal of property and equipment to vary over time.
Other Expense, Net
Other expense, net decreased by $2.2 million, or 41.9%, to $3.0 million in fiscal year 2019 compared to $5.2 million in fiscal year 2018. The decrease in other expense, net was primarily due to one-time items recorded in each fiscal year. Other expense, net, in fiscal year 2019 included a $1.2 million gain on litigation settlement. Other expense, net, in fiscal year 2018 included a $2.8 million loss on extinguishment of debt partially offset by a $0.6 million gain recorded due to the change in the fair value adjustment of our outstanding convertible preferred stock warrants that had been outstanding prior to our initial public offering. Interest expense increased in 2019 due to additional borrowing under our credit facilities and was partially offset by increased interest income in 2019 due to higher cash balances resulting from proceeds received from our initial public offering of common stock in the fourth quarter of 2018 and the public offering of our common stock in the third quarter of 2019.
Benefit for Income Taxes
The benefit for income taxes for the year ended December 31, 2019 totaled $0.1 million and there was no income tax provision or benefit recorded for the year ended December 31, 2018. The amounts recorded in 2019 relate to a benefit for net deferred income tax assets deemed more likely than not to be realized by our foreign subsidiary. We have not recorded any federal or state income tax benefits related to domestic operating losses due to uncertainty about future taxable income.
Historically, we have experienced seasonality in our first and fourth quarters, and we expect this trend to continue. We have experienced and may in the future experience higher sales in the fourth quarter as a result of increased sales from hospitals nearing their fiscal year-end that have not fully utilized the funds allocated to purchases of our Precision Flow systems. In the first quarter of each year we have experienced and may in the future experience higher sales in direct correlation with the number of patients presenting with respiratory distress due to the severity of the flu season, especially in the Northern Hemisphere.
Liquidity and Capital Resources
As of December 31, 2019, we had cash, cash equivalents and restricted cash of $73.5 million and an accumulated deficit of $265.4 million. Our primary sources of capital to date have been from public offerings of our common stock, private placements of our convertible preferred stock, sales of our Precision Flow systems and amounts borrowed under credit facilities. Since inception, we have raised a total of $162.6 million in net proceeds from private placements of our convertible preferred stock. On November 16, 2018, we completed an initial public offering of 4,600,000 shares of common stock at a price of $14.00 per share, which raised net proceeds of $57.4 million after deducting the underwriting discount of $4.5 million and offering expenses of $2.5 million. In August 2019, we completed a public offering of 3,570,750 shares of common stock, which included the full exercise by the underwriters of their option to purchase 465,750 shares of common stock, at a price of $14.50 per share, which raised net proceeds of $48.3 million after deducting the underwriting discount of $3.1 million and offering expenses of $0.4 million.
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Mar 04, 2020
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