Caroline Corner - IR Ray Huggenberger - CEO Scott Wilkinson - COO Ali Bauerlein - CFO.

Margaret Kaczor - William Blair & Company Robbie Marcus - JPMorgan Danielle Antalffy - Leerink Partners Mike Matson - Needham & Company.

Welcome to the Inogen 2016 Fourth Quarter Financial Results Conference Call. [Operator Instructions]. As a reminder this conference call is being recorded. I would now like to introduce your host for today's conference, Miss Caroline Corner. Ma'am, you may begin. .

Thank you for participating in today's call. Joining me from Inogen, is CEO, Ray Huggenberger; President and COO, Scott Wilkinson; and CFO and Co-Founder, Ali Bauerlein. Earlier today, Inogen released financial results for the fourth quarter and full year ended December 31, 2016.

This earnings release and Inogen's corporate presentation are currently available in the investor relations section of the Company's website.

During the call and the subsequent Q&A session, we will be discussing plans and projections for our Business; future financial results and market trends and opportunities, including among others, statements regarding our Inogen One G4 rollout, the timing and expectations for our pricing studies, expected changes in product pricing, expectations for international sales and anticipated patient preference; market opportunities and increased use of portable oxygen concentrators, our ability to continue revenue growth and our expectations for our business-to-business and direct-to-consumer sales channel; our strategic focus and objectives, higher expectations, estimates of patent defense expenses, the impact of Medicare and private payer insurance reimbursement [indiscernible] defined and our ability to offset those reductions, changes to the competitive bidding process, reimbursement expectations, expectations to establish a physical presence in Europe and open a new facility in Cleveland, Ohio, in 2017.

Implementation of a new customer relationship management system in the first half of 2017, the effect of ASU 2016-09 and 2017 guidance, including revenue, net income, adjusted EBITDA, adjusted net income, net cash flow, effective tax rates and tax benefits and adjustments.

These statements are forward looking and are subject to substantial risks and uncertainties that may cause actual events or results to differ materially from currently anticipated events or results.

Information on these and additional risks, uncertainties and other information affecting Inogen's business operating results are contained in Inogen's quarterly report on Form 10-Q for the quarter, ended September 30, 2016 and in other filings with the Securities and Exchange Commission.

Additional information will also be set forth in Inogen's annual report on Form 10-K for the year ended December 31, 2016, to be filed with the Securities and Exchange Commission. We advise investors to review these risk factors carefully.

The forward-looking statements in this call are based on information available to us as of today's date, February 28, 2017 and we disclaim any obligation to update any forward-looking statements, except as required by law. During the call, we'll also present certain financial information on a non-GAAP basis.

Management believes that non-GAAP financial measures, taken in conjunction with U.S. GAAP financial measures, provide useful information for both Management and investors by excluding certain non-cash and other expenses that are not indicative of Inogen's core operating results.

Management uses non-GAAP measures to compare Inogen's performance relative to forecast and strategic plans, to benchmark Inogen's performance externally against competitors and for certain compensation decisions. Reconciliations between U.S.

GAAP and non-GAAP results are presented in tables accompanying our earnings release which can be found in the investor relations section of our website. For future periods, we have not reconciled our non-GAAP guidance to the most directly comparable U.S.

GAAP measures, because the timing and amount of material items that impact these measures are inherently unpredictable or out of our control. Accordingly, we cannot provide a quantitative reconciliation of these non-GAAP measures without unreasonable effort. I will now turn the call over to Ray Huggenberger.

Ray?.

Thank you, Caroline. Good afternoon, everyone and thank you for joining our fourth quarter and full-year 2016 conference call. As you know, today is my last day as the CEO of Inogen and Scott Wilkinson will be taking over as President and CEO, effective tomorrow.

I will continue to be involved with the Company on our Board of Directors and I have high confidence in Scott's ability to continue to drive profitable growth at Inogen.

I would like to relay what a pleasure it has been to serve as the CEO of Inogen through these last nine years, growing from $10.7 million in revenues in 2009 to over $200 million in revenues in 2016. We have changed the lives of thousands of oxygen patients worldwide and I'm proud to have been the leader of this great organization.

I also believe that this is only the beginning for Inogen, as we're still only at approximately 8% penetration in the Medicare markets in the U.S.. I would also like to express my thanks to the 600-plus Inogen employees, who have been so critical to our success in taking our vision and making it a reality.

On our call today, Scott will start with the financial and Business highlights and cover our recent operational developments. And Ali will review the financials and provide updated 2017 guidance. At that point, we will open the call up for your questions. And with that, I would like to turn it over to Scott Wilkinson.

Scott?.

Thanks, Ray. On behalf of Inogen's Board of Directors, our employees, our investors and our business partners, I would like to thank you for your service at Inogen. Your leadership has been both beneficial to the Company and to me personally, as we have worked so closely together throughout your tenure here.

I too am excited about Inogen's future and I look forward to leading this organization through its next growth phase. Looking at the fourth quarter of 2016, we continued to build on our success in prior quarters and we saw solid performance with revenues of $50.9 million.

This represents 25.7% growth over the same period last year, reflecting great results in our business-to-business sales channels, both domestically and internationally and solid results in our direct-to-consumer sales channel.

The expected decline in rental revenue was more than offset by the increases in revenue from our direct-to-consumer and business-to-business sales channels which continued to show strong growth.

In the fourth quarter of 2016, we delivered net income of $5.3 million and adjusted EBITDA of $10.9 million, demonstrating that we can deliver solid bottom-line results, while scaling the sales of our new product, the Inogen one G4 and despite the expected rental reimbursement headwinds.

For the full-year 2016, we delivered net income of $20.5 million, reflecting 77.1% growth year over year. And adjusted EBITDA of $43.4 million, reflecting 34.3% growth over 2015.

Turning to revenue, the continued growth of sales revenue demonstrates the demand for our portfolio of innovative oxygen concentrators remains very strong across all of our sales channels. For the full-year 2016, total revenue was $202.8 million, up 27.6% compared to 2015.

Domestic business-to-business sales were our strongest growth channel in the fourth quarter of 2016, increasing 69%, compared to the fourth quarter of 2015. Growth here was primarily due to purchases from traditional home medical equipment providers and continued strong private label demand.

We continue to see more traditional HME providers turning to portable oxygen concentrators to lower their operating costs in the face of reimbursement reductions and specifically, they are turning to Inogen as the leader in this space.

For the third quarter in a row, revenue from our private label partner and traditional HMEs providers represented more than half of the domestic business-to-business channel's total sales revenue in the fourth quarter of 2016.

International business-to-business sales were also strong in the quarter, reflecting 42.2% growth which was primarily due to the strength in Europe of our distribution partners and key accounts, as well as the addition of a new customer in South Korea.

We're quite pleased with this result, given the strong third quarter of 2016, we did not expect international sales in the fourth quarter of 2016 to be as robust as they were. We're also pleased to have already seen more orders from the South Korean region in the first quarter of 2017.

While we're very pleased with our international sales results, we're mindful that international sales can be lumpy over time to the timing -- due to the timing of tender contracts and customer buying patterns.

Our plan to establish a physical presence in Europe in 2017 is on track and we continue to be excited about this opportunity to deepen our customer relationships and increase market penetration.

The European location is expected offer multilingual customer service, repair services and basic distribution, with the goal of improving our European customer support at lower costs. Direct-to-consumer sales were solid in the fourth quarter of 2016, increasing 34.2% over the fourth quarter of 2015.

With the Inogen One G4, our sales force is now selling what we believe is the most patient-preferred portable oxygen concentrator on the market. We ended 2016 with 177 inside sales representatives and we're pleased with our sales team's successes in the fourth quarter of 2016.

We're planning to hire additional sales employees in 2017, as this is still our largest bottleneck to growth in direct-to-consumer sales and rentals. We have continued to hire inside sales employees in 2017 and we believe that we can attract and retain the inside sales employees necessary to achieve our plan for 2017.

In order to ensure we have adequate space to support our future sales and support team's growth, we're planning to open a new facility in the Cleveland, Ohio, area, in 2017. We believe that having a sales and service support location, based in Eastern time zone, will allow us to better serve our customers.

We're planning on adding additional headcount of approximately 240 people in the Cleveland area location over the next three years.

While the new facility will require an investment in tenant improvements, we're expecting additional tax credits and incentives from the state and local governments of up to $1.9 million, based on our forecasted headcount additions and facility tenant improvement costs.

We plan to continue to operate our other current facilities at their functioning today. In addition, we're investing in a new customer relationship management or CRM system, in the first half of 2017.

We have already begun execution of this project and we believe this will help improve productivity of our sales, customer service and billing departments. Looking ahead, we would like to provide an update on the next expected Medicare competitive bidding process. The Medicare rates under competitive bidding contracts are known for 2017 and 2018.

With the new potential round of competitive bidding contracts, effective January 1, 2019. CMS did announce details on the 2019 round of competitive bidding, but pulled back those comments in early February 2017 to await feedback from the new administration on the next round of competitive bidding.

The details announced on the 2019 round were consistent with our expectations, including the new surety bond requirements. Tom Price, the new head of Health and Human Services, has been a proponent of repealing competitive bidding in the past, so we look forward to seeing what changes this administration considers for the competitive bidding program.

The 21st Century Cures Act also included a provision, calling for a study on the impact of the application of competitive bidding rates in the unbid areas. However, we have not seen the specifics of this study yet.

We continue the launch of the Inogen One G4 portable oxygen concentrator in the fourth quarter which has been very well-received since we first started initial sales in May of 2016.

As we have mentioned before, the Inogen One G4 is smaller and lighter than our current Inogen One G2 and G3 products and we continue to hear that patients are pleased with the new offering. In the fourth quarter of 2016, almost half of the portable oxygen concentrator volume in and the direct-to-consumer sales channel was the Inogen One G4 product.

Which was solid progress from approximately one-third of our direct-to-consumer sales in the third quarter of 2016. Remember that as part of our sales strategy, we're not currently making the Inogen One G4 available for rental. We're using the upgraded Inogen One G3 product as the primary ambulatory solution deployed in our rental fleet at this time.

We're continuing to expand shipments of the Inogen One G4 to our domestic business-to-business channel, as planned. Our international channel remains focused on the upgraded Inogen One G3.

We expect that international sales of the Inogen One G4 will begin by mid-2017 and ramp up in the second half of 2017, depending on the timing of product regulatory and reimbursement approvals.

Looking ahead, we believe we're well-positioned to continue our total revenue growth in the oxygen therapy market, with best in class and patient-preferred products and services, with a competitive total cost of ownership.

We have continued to execute our strategy and we believe we're now seeing traction that demonstrates that portable oxygen concentrators are becoming increasingly adopted in the oxygen therapy industry. I will now turn the call over to Ali.

Ali?.

Thanks, Scott and good afternoon, everyone. During my prepared remarks, I will review the details of our fourth quarter and full-year 2016 financial performance and then I will review our updated guidance for 2017. As Scott noted, total revenue for the fourth quarter of 2016 was $50.9 million, representing 25.7% growth over the fourth quarter of 2015.

Total revenue for 2016 was $202.8 million, representing 27.6% growth over full-year 2015. Looking at each of our revenue streams and turning first to our sales revenue, total sales revenue was $42.6 million, representing 83.8% of total revenue in the fourth quarter of 2016 and reflected 47.2% growth over the same quarter of the prior year.

Total units sold increased to 23,300 in Q4 2016, up 60.7% from 14,500 in Q4 2015. Total sales revenue for 2016 was $168.2 million, up 48% over 2015. Strong domestic business-to-business sales of $15 million in Q4 2016 reflected 69% growth over Q4 2015. And continued strong demand from our traditional HME providers and our private label partner.

We also demonstrated strong international business-to-business sales of $12.1 million in Q4 2016, primarily driven by continued strong demand from our European partners. Sales in Europe represented the majority of international sales at 83.3% of international sales in the fourth quarter of 2016.

With strong business-to-business sales again in the fourth quarter of 2016, average selling prices declined over the same period in the prior year, primarily due to the continued shift in sales towards traditional home medical equipment providers and private label sales and additional discounts associated with the increased sales volume worldwide.

However, compared to the third quarter of 2016, average selling prices increased in the fourth quarter of 2016, associated with increased sales mix towards direct-to-consumer sales.

Direct-to-consumer sales for the fourth quarter of 2016 were $15.6 million, representing 34.2% growth over the fourth quarter of 2015, primarily due to increased consumer awareness from our ongoing sales and marketing efforts. Rental revenue represented 16.2% of total revenue in the fourth quarter of 2016, versus 28.4% in the fourth quarter of 2015.

We continued to see the expected trend of rental revenues declining in the fourth quarter of 2016, versus the fourth quarter of 2015. Primarily due to the reimbursement changes which were partially offset by the non-recurring benefit of $2 million associated with the 21st Century Cures Act.

This retroactively increases the reimbursement rates in certain Medicare regions for the second half of 2016. Rental revenue in the fourth quarter of 2016 was $8.2 million, representing a decline of 28.3% from the same period in the prior year.

Primarily due to the anticipated Medicare rental reimbursement cuts and reduction in private payer rates, as they followed the decreases in Medicare rates and partially offset by the non-recurring $2 million 21st Century Cures Act benefit.

Without the 21st Century Cures Act benefit, rental revenue would've been $6.2 million which was in line with our expectations. As a reminder, the 21St Century Cures Act only provided reimbursement rate relief to the portion of the Medicare markets that were unbid, from July 1, 2016 to December 31, 2016.

Effective January 1, 2017, in the unbid areas that saw the benefit in the fourth quarter of 2016, due to the 21St Century Cures Act, rates revert to the rate seen in the third quarter of 2016, before the retroactive adjustment went into place.

We expect Medicare to re-process the claims associated with the 21st Century Cures Act in May through July 2017. Turning to gross margin, for the fourth quarter of 2016, total gross margin was 48.5%, compared to 49.5% in the fourth quarter of 2015. For the full-year 2016, gross margin was 48%, compared with 48% in the prior year.

We maintained our overall gross margin despite the rental reimbursement declines in shifts in revenue towards business-to-business sales, primarily due to lower cost to manufacture the upgraded Inogen One G3 product, launched in the fourth quarter of 2015 and the Inogen One G4 product, launched in the second quarter of 2016.

Our sales gross margin was 49.9% in the fourth quarter of 2016, versus 48% in the fourth quarter of 2015.

Sales gross margin percentage improved, primarily associated with lower cost of goods sold per unit, due to lower materials, labor and overhead costs associated with an upgraded Inogen One G3 and G4 products, partially offset by the higher sales mix of domestic business-to-business sales which have lower average selling prices.

Rental gross margin was 41.4% in the fourth quarter of 2016, versus 53.4% in the fourth quarter of 2015.

The decline in rental gross margin was primarily due to lower net revenue per rental patient, driven by the previously discussed reimbursement rate reductions experienced throughout 2016 and partially offset by the non-recurring $2 million benefit from the 21st Century Cures Act and lower costs of rental revenues associated with lower depreciation and servicing costs per patient.

As for operating expense, total operating expense increased to $18.5 million in the fourth quarter of 2016, versus $16.6 million in the fourth quarter of 2015. However, operating expense as a percent of total revenue decreased to 36.4% in the fourth quarter of 2016, down from 41% in the fourth quarter of 2015.

Research and development expense was $1.2 million in Q4 2016, in line with the $1.2 million reported in Q4 2015. Sales and marketing expense was $9.3 million in the fourth quarter of 2016, versus $8.7 million in the comparative period in 2015, primarily due to increased media expense and sales force personnel-related expenses.

General and administrative expense was $8 million in the fourth quarter of 2016, versus $6.6 million in Q4 2015. Primarily due to increased personnel-related expenses and patent defense legal costs.

Additionally, we previously qualified as an emerging growth company or EGC, under the JOBS Act and availed ourselves of an exemption from the requirement that our independent registered public accounting firm attest to the effectiveness of our internal controls over financial reporting, under Section 404(b) of the Sarbanes-Oxley Act of 2002.

However, we no longer qualify as an EGC and this exemption is no longer available to us.

Our independent registered public accounting firm is therefore required to undertake an assessment of our internal control over financial reporting, beginning with our 2016 annual report on Form 10-K and the cost of our compliance with Section 404(b) has increased.

Before we discuss our tax rate and net income, I want let you know that during the fourth quarter of 2016, the Company elected to early adopt accounting standards update or ASU 2016-09, ahead of the mandatory 2017 effective date for all U.S. public companies.

For those of you who are not familiar with this issue, on March 30 of 2016, the Financial Accounting Standards Board issued ASU 2016-09 improvements for employees share-based payment accounting which simplifies the accounting for share-based payment transactions, including the income tax consequences.

The impact of the adoption is favorable for full-year 2016. The adoption led to a decrease in provisions for income taxes of $6 million in the full-year 2016. We reported a retrospective adjustments to previous reported three quarters of 2016 provision for income taxes with our annual report on Form 10-K, including fourth quarter 2016 results.

The change to the accounting treatment of stock-based compensation also increases the number of shares outstanding on a fully-diluted basis which has a small impact on earnings per share. In the fourth quarter of 2016, our effective tax rate was 9.8%, compared to negative-16.3% in Q4 2015.

Excluding the $1.7 million decrease in provision for income taxes associated with the adoption of ASU 2016-09, our fourth quarter 2016 effective tax rate would have been 39.7%.

As a reminder, in the fourth quarter 2015, our effective tax rate was negative-16.3%, primarily due to the tax benefit adjustments of $1 million which were mainly related to a decrease in the valuation allowance related to California net operating losses and an increase in equity compensation deductions and benefits associated with the federal research and development tax credit and the timing of stock dispositions in the fourth quarter of 2015.

The full-year 2016 effective tax rate was 9.7%, compared to 21.3% in 2015. Excluding the $6 million decrease in provisions for income taxes associated with the adoption of ASU 2016-09, our full-year 2016 effective tax rate would've been 36.3%.

Our net income in the fourth quarter of 2016 was $5.3 million, compared to $3.9 million in Q4 2015, an increase of 36.3%, versus the compared period in the prior year and a return on revenue of 10.3%. Earnings per diluted common share were $0.25 in the fourth quarter of 2016, versus $0.19 in the fourth quarter of 2015, an increase of 31.6%.

Our net income for full-year 2016 was $20.5 million, compared to $11.6 million in 2015, an increase of 77.1%. Adjusted net income in the fourth quarter of 2016 increased 85% to $5.3 million, from $2.8 million in the fourth quarter of 2015. Adjusted EBITDA for the fourth quarter of 2016 was $10.9 million which was a 21.5% return on revenue.

Adjusted EBITDA increased 34.4% in the fourth quarter of 2016, versus fourth quarter of 2015 adjusted EBITDA of $8.1 million. Moving to our balance sheet, cash, cash equivalents and marketable securities, were $113.9 million, as of December 31, 2016. An increase of $5.5 million, compared to $108.3 million, as of September 30, 2016.

This compares to $82.9 million of cash, cash equivalents and marketable securities, as of December 31, 2015. An increase of $31 million in full-year 2016. As of the end of fourth quarter 2016, we have no bank debt outstanding and our entire $15 million credit facility was available.

Turning to guidance, we're increasing our 2017 revenue guidance to a range of $233 million to $239 million which represents year-over-year growth of 14.9% to 17.8%. This compares to the previous revenue expectation of $230 million to $236 million.

Remember that the $2 million from the 21st Century Cures Act rental revenue increase in the fourth quarter of 2016 is not expected to recur in 2017.

We expect direct-to-consumer sales to be our fastest growing channel and domestic business-to-business sales to have a solid growth rate and international business-to-business sales to have a modest growth rate, with a strategy we will continue to be heavily focused on our European market.

We expect rental revenues to continue to decline in 2017 compared to 2016, based on lower average rental revenue per patient, primarily due to the known cuts for Medicare competitive bidding, continued reductions of private insurance and Medicaid rates and continued focus on sales versus rentals.

We're increasing our 2017 net income and adjusted net income estimate to $21 million to $23 million, representing 2.3% to 12.1% growth over 2016 full-year actuals. This compares to the previous guidance range of $16 million to $18 million.

We estimate that the adoption of ASU 2016-09 will lead to a decrease in provisions for income taxes of approximately $5 million in 2017, based on forecasted stock activity which will lower our effective tax rate. This compares to $6 million decrease in provision for income taxes associated with the adoption of ASU 2016-09 experienced in 2016.

Excluding the $5 million decrease in our provision for income taxes expected in 2017, we expect an effective tax rate of approximately 37%.

After giving it back to ASU 2016-09, we expect our effective tax rate, including stock compensation deductions, to vary quarter to quarter, depending on the amount of pretax net income and on the timing and size of stock option exercises.

We're increasing our guidance range for the full-year 2017 adjusted EBITDA to $46 million to $50 million, representing 6% to 15.2% growth over 2016 full-year actuals. This compares to the previous guidance range of $45 million to $49 million.

We expect patent defense legal expense within general and administrative expense to significantly increase in 2017 from 2016, associated with the two pending suits. We're confirming our expectation for net positive cash flow for 2017, with no additional equity capital required to meet our current operating plans.

With that, Ray, Scott and I will be happy to take your questions. .

[Operator Instructions]. Our first question comes from the line of Margaret Kaczor with William Blair. Your line is open..

First off, Ray, congratulations, obviously, on the success you've headed at Inogen, it's been a great ride. Scott, congrats on the promotion, as well, obviously well deserved, hopefully you can add the same amount of success.

The first question for me, you guys had some really great direct B2B sales and we're actually at the annual Medtrade meeting right now. The feedback here seems to be very positive, even more so than what we saw at the fall show.

How would you guys describe the atmosphere of the traditional DME market today, relative to six months ago? And where can we get to six months from now and just because I like to do the math, what would it mean in terms of units and penetration of POCs if your sales to DMEs were to increase by 50% to 100%. .

It's a good question. Margaret, it's one that in one form or another we've actually fielded throughout the last year or so, because we've continued to see growth in the B2B channel. As I've said in the past, this is a process, not an event, for the DME industry to change their business model and I think it will continue to be that way.

There continues to be barriers that prohibit people from just turning their business over to a new model overnight. So, that is going to, I believe, prevent what a lot of folks would like to see in a hockey stick effect. This is going to be a transition that goes on for several years.

We do seem to see momentum, we've seen it in our own business-to-business sales, a we hear the same buzz that you are hearing, so we're bullish on that, but we're also cautious that we don't get expectations ahead of what the market can actually bear. All of the traditional barriers for conversion are still there.

The smaller DMEs tend to be undercapitalized, so they can turn their business overnight. The larger DMEs, while they tend have more access to capital, they've got a bigger restructure challenge, so it's just not that simple.

We've talked in the past about people trialing the product and I've said at various conferences and I think on this quarterly call, that one man's trial can migrate into a slow conversion.

We haven't seen anybody trialing product and backing off or anybody walking away and saying, well, I tried it and it was a failure and I'm going to go back to focusing on more efficient tank delivery. We've never seen that. We've just seen people continue, if they, say they're in a trial phase, they've continued to repeat their purchases.

They may be expanding their trials, expanding into different regions. And again, I think that flurries into a market conversion, but that conversion is going to take several years.

If you listen to Ali's comments on guidance, we tend to be a little more bullish in the area where we have more control which is direct-to-patient, that's also the core part of our strategy and some of direct-to-patient also drives B2B sales, just from a cultural effect.

But we have been a little more bullish in our expectations for the 2017 plan with regard to B2b than we have in the past and I think that's a signal that we think the market is going to continue to build in that area, but I will continue to caution that it's not going to be a short term event, it is going to be a long term process. .

I think the question really relates to when you guys talk about being 8% penetrated, we're not expecting the market to flip to 100%, but can you get that 8% to go to 15%, what would that mean for you guys, without requiring the market to flip?.

Let's look at some of the growth rates that we have posted in the last year that have been pretty impressive. And tied to those growth rates are market penetrations of the one 1% to 1.5% annually. So, to go from a 8% to 15% and double is probably more than the market could swallow in a year.

That would take quite an aggressive conversion and again, remember, you've got all of those other capital barriers. I would be surprised if it moved that fast.

I wouldn't be surprised if we started seeing penetration change from 1% to 1.5% a year to maybe 2% to 2.5%, it might pick up a little bit, but it's not going to double the penetration in one year. .

On the D2C side, [indiscernible] despite the fact that you slowed down hiring in D2C in Q4 and I think you even have sales reps down, so maybe talk to how efficient your sales staff was, why were they so efficient this quarter? Was it the G4, was it the CRM system? Why shouldn't we assume that same level of productivity over even increases from here as the G4 maybe fully rolls out.

Thank you. .

That's another good question. The one is really easy. There's nothing in our results in 2016 attributed to the new CRM system. While we started the project, a lot of the time and effort that's gone into it has been a planning phase. It will actually go live in the middle of this year.

There's nothing from that, in fact, if anything, that just kind of curved our focus a little bit and it's one of the reasons that we did slow down in hiring, because you have the same people focused on planning for that system. You hit on the other one that's a success, is the G4.

We spent a lot of time in the fourth quarter focusing on improving our scripting, honing that sales process. One of the successes that came out of that is we drove our mix from about a third to about 50% by the end of the year. We will continue that focus throughout this year.

If you recall, we said we think our sea level point is at about 60%, 65% penetration, so, we're not there yet, that we made great progress in the fourth quarter. Why can't it continue in the future? Well, there's always puts and calls. We're going to continue to hire this year.

In fact, you noted that we're going to -- we're running out of space in Texas, so we have got to open a facility. That's evidence of our commitment to continue to hire and grow our sales team and drive market penetration. I think we can continue to get some leverage out of the G4.

Long term, we will get some leverage out of the new CRM system, but in the short term you'll actually take a step back. If anybody's been through a software conversion, they tend to be a headache. There's always some bugs that you have to work out and we expect that will happen.

We've done software upgrades and changes in the past and you have to fight through some things. Like any year, there's going to be some puts and calls and that's all reflected in the guidance that Ali has noted. .

Just to expand on that a bit, headcount on a year-over-year basis was up less than 10%, but revenue on the direct-to-consumer side was up 40%. We don't want to imply or have the takeaway be that the difference is productivity.

There was incremental productivity improvements in the D2C team, both from the scripting side, as well as the launch of the G4 product, but that was more incremental in size of productivity increases and the rest was more around the timing of hires, when they happened, how many fully productive and seasoned reps we had out of the total pool, because that has a dramatic impact on the overall success of the direct-to-consumer organization.

Versus the prior comparative period. .

Our next question comes from the line of Robbie Marcus with JPMorgan. Your line is open..

I wanted to talk about the international market for a bit. You're going to have your first direct presence there. You had, I think it was off the radar for most of us, that South Korea came online.

Maybe you could help quantify the contribution there and maybe talk about what markets you could potentially still enter that have reimbursement on your radar screen and how that could play out over the next 12 to 24 months. .

Sure. Our focus, again, is primarily on direct-to-consumer. That's where we focus our resources, our growth. We've been very careful to not over-invest in B2B channels, whether it's domestic or international.

On the South Korean opportunity, that was one that came our way, it took a little bit of investment in time and effort to work with the South Korean team to secure the proper registration and reimbursement for product. But you have to remember, while it's a nice upside for us in the fourth quarter, South Korea is still a relatively small market.

It's not a market that we would have independently said, let's go after South Korea, that's a great opportunity. Again, when we're looking at what are we going to go after, set penetration in our own backyard, that's where our resources are.

As these opportunities continue to come our way and they do, we will continue to assess them and look at what kind of resource do we have to invest to harvest that and we will take advantage of them, but I don't want to lead you to the idea that we've got a bulletin board here with a bunch of South Korean opportunities that we're going after, because that's not the case.

It's about direct-to-consumer in the U.S.A. .

To answer the question a little bit more directly, Robbie. It was less than 5% of our international revenues of fourth quarter that came from that South Korea customer. It still is a small portion of the $12.1 million international bucket in the quarter. .

All right. Maybe to follow up on Margaret's question a bit and dive bit deeper. We've seen two quarters now of accelerated growth in U.S. B2B, a lot of that is or most of it is coming from the private label and the HME sales.

So, maybe you could just give us a little more clarity about how you're thinking about 2017, D2C is expected to be your fastest growth channel, followed by the U.S., but may be peel back the onion a bit there and help explain what you're baking into those estimates, in terms of private label and HME sales. .

As we said for guidance next year and kind of how we've always approached guidance, the closer we're to the end consumer, the more visibility we have on what we expect in revenue, in the areas that we're farther from the end consumer, we tend to be more cautious in our guidance.

Inherent in our guidance range is that we expect direct-to-consumer to be our fastest-growing channel. We also expected that going into 2016, however, what ended up happening was both B2B domestically and internationally grew faster than our direct-to-consumer sales segment.

So, that certainly is something that is just an approach in our guidance, because we're farther from the end consumer. On the domestic sales side, we do expect, when we say that we expect solid growth there, that that really is coming from the traditional HME side, either through our private label partner or through our own direct sales efforts.

The reseller business, the Internet reseller business, has been growing much more modestly than the 69% we saw on the domestic side in the fourth quarter of 2016. So, that growth we expect will continue to be driven by traditional HME purchases, going into 2017 as well. .

Okay. So, it's fair to say that there's a healthy dose of conservatism baked into your non-direct channel sales. .

What I would say is, we're cautious about how quickly the HME community will adopt. We certainly see the large market opportunity that eventually POCs should be the standard of care, but how the HME community will get from where we're today to that point and the timing of that, we still are very cautious on that.

While we've seen a great couple of years now of success of them really trialing POCs, we still feel like we're in the early stages the POC trials and as a result, we don't want to get out ahead of ourselves in terms of our guidance. .

Our next question comes from the line of Danielle Antalffy with Leerink Partners. Your line is open..

I was just wondering if you could talk a little bit, maybe this is for Ali, about margins and how they differ between the business, because clearly, your B2B businesses are growing much faster, but I was under the impression from a margin perspective those are not the margins there are lower, so, I guess just a little bit of color on the split of the Business and how margins come into play here, because you're raising your net income guidance, so clearly, I'm wrong.

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Overall, we see between business-to-business and direct-to-consumer relatively similar operating margins in those businesses. So, while the business-to-business side has a lower gross margin profile, it has lower operating expenses, as well.

So, where that revenue comes from specifically on an operating margin basis, we're relatively neutral on that from a margin perspective. You will notice in the fourth quarter, we've continued to make nice progress on our gross profit or gross margin on the sales side of the business that came in at almost 50%, 49.9%.

That's both an increase by increase and mix towards direct-to-consumer, but you also see that we're continuing to lower our cost to goods. On an average basis year over year, if you take our total sales cost to goods divided by our units sold, we're down about 15%.

So, we have continued to take cost out where we can, based on higher volumes and design improvements that we've been able to implement that helps our overall margins and offset both the pressure we've seen on the average selling price side, as well as the reimbursement pressures that we've seen on the Medicare portion of the business. .

And maybe just a high-level strategic question for you, Scott.

You guys have quite a bit of cash on hand, note debt, can you talk about the Company's strategic priorities?.

It's no surprise that we're going to continue to drive penetration of POCs in the market and that's what our core strategy is built to do, so we will continue to hire reps, we will continue to develop patient-preferred products.

With a change in leadership, that's been our strategy for the last eight, nine years and that will continue to be our strategy going forward.

Now, with the cash that we do have in the bank, I think we're in an outstanding position to take advantage of an opportunity if something comes our way from an acquisition or partnership standpoint, where some type of strategic partnership or investment made sense. So, we're in a great spot to have that at our disposal.

But as far as what we're prospectively going after, it is executing the same strategy that we have over the last several years. .

Our next question comes from the line of Mike Matson with Needham & Company. Your line is open..

You said that the G4 made up about half of the D2C sales business, but I was wondering if you could give us similar number for the domestic B2B business? What's the penetration of that adds the G4 into that mix?.

It certainly is still pretty early in that launch. We really started ramping that up towards the end of the third quarter and then really into the fourth quarter, we didn't give a specific number there, but it is certainly well below 50%. .

And then just within the web channel, I was a little surprised, you said the growth there was not really strong, but do you feel like the G4, from a competitive standpoint, I know a lot of those sites tend to sell a lot of the various products that are out there, if that positions you better so that you're able to pick up some share within that channel?.

Within that channel, what's important to remember is that there are a certain number of resellers that sell our product and while they have seen improved productivity associated with the G4, just like we've seen on our internal side, they are also very much limited by the size of their sales force.

So, their growth rate there follow much more closely to how they're growing their internal teams and they tend to not grow as quickly as we try and grow and the overall traditional HMEs are growing at this point.

It's more having to do with their size of budgets of investments and headcount and media expense that drives their success on the direct-to-consumer internet cash buys, just like it does on our side. .

Let me add to that for a second. We look at capacity in the market and obviously, we're expanding our capacity. What we don't want to do is flood the market with a bunch of resellers, so that there's more capacity than there is demand. So, we kind of watch that pretty carefully.

If we get to a point where we think there's room to add another reseller, we will do that. It's got to be the right partner for us, too, not just anybody. But we're driving our capacity increase pretty hard, if you look at over the last five or six years at the expansion of our sales team, so we will keep an eye on that.

But Ali is right, not all of the other resellers are looking to invest and grow their business at the same level as Inogen. .

Okay. That's helpful in terms of explaining why the growth there is slower.

But I guess what I was getting at is within those companies, they sell multiple products from different ESC companies, so even with the given number of sales people at their disposal, teams like with the G4 just being leaps and bounds beyond any competing products, you should be able to pick up more, a greater share of their business, if you will.

Does that make sense? Have you seen any evidence of that?.

It does make sense and we have seen, we have seen growth there. I think what happens is because the growth in that overall B2B bucket is being dominated by the home care providers, that it looks like their internet reseller growth is, it's much lower than their growth, but there is decent growth there. And G4 helped them just like it helped us. .

Okay.

And then finally, just with regards to the private insurers following Medicare's lead in terms of cuts, has that all run its course now or are you still seeing private insurers coming in and cutting more?.

We're still seeing that, even into the first quarter of 2017. .

Our next question comes from the line of Matt O'Brien with Piper Jaffray. Your line is open. .

Thanks, guys, this is Matt, in for Matt today.

My first question is actually on rental gross margins, so I know you guys are going to benefit from the Cures Act in the fourth quarter, but what would have been -- I'm sorry, you may have already answered this, but what would have been the margins for rental revenue there in the quarter?.

In the quarter, excluding Cures, the gross margin would've been approximately 23%, excluding the $2 million benefit from Cures. .

And into 2017, how do you expect that to trend? You've sequentially come down throughout 2016, so just sort of flatten out around that maybe 25%, 23% range or how should we think about that?.

We haven't given specific guidance there, but the mass majority of the reimbursement cuts are now behind us. So, we don't expect to see large additional cuts to reimbursement rates, but you can tell they are already at pretty low rates from where they were a year ago.

So, we do expect that from there we would continue to look for ways to improve our gross margin profile on the rental side of the business, through cost productivity on the rental states. .

I'm showing no further questions at this time. Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a wonderful day..