Good afternoon, ladies and gentlemen, and welcome to the Fourth Quarter and Full Year 2017 Earnings Conference Call for Tactile Medical. [Operator Instructions] Please note that this conference call is being recorded, and that the recording will be available on the company's website for replay shortly.

Before we begin, I would like to remind everyone that our remarks and responses to your questions today may contain forward-looking statements that are based on the current expectations of management and involve inherent risks and uncertainties that could cause actual results to differ materially from those indicated, including those identified in the Risk Factors section of our most recent annual report on Form 10-K filed with the Securities and Exchange Commission, as well as our most recent 10-Q filing.

Such factors may be updated from time to time in our filings with the SEC, which are available on our website. We undertake no obligation to publicly update or revise our forward-looking statements as a result of new information, future events or otherwise.

This call will also include references to certain financial measures that are not calculated in accordance with generally accepted accounting principles, or GAAP. We generally refer to these as non-GAAP financial measures.

Reconciliations of those non-GAAP financial measures to the most comparable measures calculated and presented in accordance with GAAP are available in the earnings press release on the Investor Relations portion of our website. I would now like to turn the call over to Mr. Jerry Mattys, Tactile Medical's Chief Executive Officer. Please go ahead, sir..

Thank you, operator. Good afternoon and welcome, everyone to our fourth quarter and full year 2017 earnings call. I'm joined on the call today by Lynn Blake, our Chief Financial Officer. Let's get started with quick agenda of the items that we intend to cover today.

I'll first walk you through an overview of our full year and fourth quarter financial performance for 2017, followed by discussion of the primary drivers that underpinned our revenue growth during these periods and a review of our major operational accomplishments.

Lynn will then discuss our fourth quarter and full year 2017 financial results in greater detail, and review our financial guidance for 2018, which we introduced this afternoon in our earnings press release. Following Lynn's discussion, I'll share some concluding thoughts on our strategy and outlook for 2018 before opening the call to your questions.

For the full year of 2017, we reported total revenue of $109.3 million, representing 29% growth year-over-year.

These results exceeded both the 2017 revenue guidance range of $106 million to $108 million that we provided on our third quarter earnings call in November, as well as the preliminary estimate range of $108.5 million to $109 million, that we announced via press release in January.

Our exceptional revenue growth in 2017 was due to record sales of our Flexitouch systems, which grew 37% year-over-year to $100.3 million. This record performance in 2017 reflects our successful execution with respect to the 3 primary drivers that have contributed to our Flexitouch sales growth in recent years.

Field sales team expansion, focused account targeting and increased in-network coverage. These 3 elements of our commercial strategy have enabled us to achieve strong Flexitouch sales growth by increasing awareness in the market of lymphedema and of the clinically-validated benefits that our Flexitouch System provides.

Let me now take a minute to review each of these drivers in more detail. First, we remain focused in 2017 on investing in the expansion of our field sales team to improve our coverage of the U.S. market. In 2016, we expanded our direct sales force from 91 to over 125 full time sales representatives.

This past year, we successively grew our direct sales force to over 160 full-time sales representatives, up approximately 28% year-over-year.

Our sales reps, together with our reimbursement personnel and our network of in-home trainers are key components of our direct to patient and provider approach, a strategic area of differentiation for our company.

This approach allows us to rapidly expand our base of clinician and patient customers, by establishing direct relationships to educate them on the advantages of our products and provide quality service and support throughout the reimbursement and patient training processes.

Second, our sales growth during 2017 benefited from our efforts to enhance the productivity of our sales reps by focusing on those clinicians diagnosing the highest number of lymphedema patients. Recall that in 2016, we began a sales strategy to focus on clinicians that we identified through medical claims data analysis.

We focused our sales force on targeting the top 3 deciles of these clinicians in 2016 and 2017, and this prioritization was an important contributor to our growth in both years.

Notably, we made another important strategic decision in 2017 that enhanced the productivity and effectiveness of our selling organization, by adding specialized resources, focused on the Veterans Administration.

And finally, our sales growth during 2017 benefited from the progress that our payer relations group has made in recent years in expanding our contracted, in-network coverage with commercial payers to include over 270 million U.S.

lives, improving patient access to our products and further enhancing the potential productivity of our sales and reimbursement teams. In 2017, we complemented our impressive revenue performance with 73% gross margins and improved profitability.

For the full year, we generated adjusted EBITDA of $9.9 million or 9.1% of total revenue compared to $7 million or 8.2% of total revenue in 2016. 2017 was a year marked by strong operational progress as well. Let me take a moment to recap some of our most important achievements.

We obtained 510(k) clearance for the next product in our pipeline, Flexitouch Plus, and began to prepare for a full commercial launch in 2018. As a reminder, this next-generation system features important enhancements, based upon patient feedback, to facilitate ease of use, reduce treatment times and improve the user experience.

These enhancements include a redesigned garment set, that are easier to put on and take off, a modified controller, that allows patients to treat two limbs at the same time, and an interactive color display, that allows for the creation of customized, preset therapy programs.

I'll discuss our recent progress and outlook for Flexitouch Plus in 2018 later in my remarks. In 2017, we also launched our Flexitouch System for the treatment of lymphedema of the head and neck in the middle of the year. Flexitouch head and neck represents an important, long-term opportunity for our organization for 3 primary reasons.

First, consider that over 400,000 people in the U.S. have been diagnosed with head and neck cancer according to the American Cancer Society. Over 75% of head and neck cancer patients will develop lymphedema, requiring treatment according to a 2016 study, published in the Journal of Lymphatic Research and Biology.

Against this backdrop, lymphedema of the head and neck represents a sizable opportunity for Tactile Medical. Second, lymphedema of the head and neck is a debilitating condition, with a clear clinical need for treatment options that patients can use at home. Head and neck lymphedema is progressive and chronic, and patients can experience swelling.

It may also result in difficulty breathing, swallowing and speaking. And third, Flexitouch head and neck is the only pneumatic compression device with FDA 510(k) clearance and a specific indication to treat this condition.

We've been pleased with the pace of our progress in the months following the commercial launch of Flexitouch Head and Neck within two of our traditional call points, lymphedema clinics and the VA. We also published our initial clinical support for the efficacy of our Flexitouch head and neck system in the medical journal Head and Neck, in November.

The study found that a single 32-minute treatment session with Flexitouch resulted in statistically significant reductions in patient face and neck edema. Moreover, 93% of the studies participants reported that they would likely be -- to use the Flexitouch head and neck at home.

As our commercial strategy and clinical portfolio for the system continue to evolve, we expect the product to become a more meaningful contributor to our growth in 2018 and the years to follow. In addition to our progress in bringing our new products to market, we strengthened our senior management team, with the addition of Dr.

Thomas O'Donnell as our Chief Medical Officer, and added two highly-qualified Directors to our Board, Dr. Cheryl Pegus and Ray Huggenberger. Lastly, we were able to broaden our shareholder base with the successful pricing of a follow-on offering in September, comprised entirely of secondary shares.

With that, I'll turn to a brief review of our fourth quarter performance. Due to the seasonality of our business, the fourth quarter represents our largest quarter of the year in terms of revenue contribution. I'm pleased to report that we brought 2017 to a strong close with total revenue of $34.9 million, representing 23% growth year-over-year.

Our growth was driven by sales of our Flexitouch System, which grew 28% year-over-year to $32.4 million in the fourth quarter. In addition to the three primary drivers that I outlined earlier in my prepared remarks, the performance of our Flexitouch product line in the fourth quarter also benefited from two additional factors.

Our performance during the fourth quarter was especially impressive given that our direct representatives in the Houston and the Gulf Coast regions were challenged with navigating the disruption to their patient pipeline caused by the hurricanes.

Due to the resourcefulness of this group, this ultimately had less of an impact on our Q4 performance compared to our $0.5 million to $1 million range that we anticipated on our third quarter earnings call.

We also saw a strong sales of Flexitouch into the Veterans Administration hospitals during the fourth quarter, reflecting the continued success of our efforts to penetrate this segment of the market by leveraging the dedicated VA specialists that we added to our field sales team earlier in the year.

Looking back, our performance in the fourth quarter and full year 2017 speaks to the success of our organization in continuing to increase the awareness of lymphedema among healthcare providers and insurers, and delivering our clinically-effective, at home therapies to patients suffering from chronic swelling.

I'll now turn the call over to Lynn Blake for some additional detail on our financial performance during the fourth quarter and the full year.

Lynn?.

Thanks, Jerry. Tactile Medical's total revenue for the fourth quarter increased $6.4 million or 23% year-over-year to $34.9 million. Our revenue performance was driven by sales of Flexitouch System, which increased $7 million or 28% year-over-year to $32.4 million.

The Flexitouch sales growth was primarily driven by the expansion of our sales force, along with increased physician and patient awareness of the lymphedema condition and its treatment options, as well as increased contractual coverage with national and regional insurance payers.

Flexitouch sales accounted for 93% of our revenue in the fourth quarter of 2017 compared to 89% of our revenue in the fourth quarter of 2016. Flexitouch revenue growth in the quarter was partially offset by sales of our Entre and ACTitouch System, which decreased by approximately $600,000 or 19% year-over-year to $2.5 million.

Gross profit increased $5.1 million or 24% year-over-year to $26.1 million for the fourth quarter of 2017. Our gross margin rate increased 111 basis points year-over-year to 74.7%.

Fourth quarter gross margin performance was primarily due to favorable product mix, as sales of Flexitouch represented a larger share of total company sales this year compared to the fourth quarter of 2016. Operating expenses increased $3.5 million or 20% year-over-year to $21.1 million.

The increase in operating expenses was primarily driven by a combination of increased sales and marketing expense, and to a lesser extent, by higher reimbursement, G&A and R&D expenses as compared to the prior year.

Sales and marketing expenses increased by $2.7 million or 28% year-over-year, due to continued investment in the expansion of our field sales team, increased variable sales expense, including sales commissions, and incremental marketing expenses.

Reimbursement, general and administrative expenses increased approximately $500,000 or 8% year-over-year, primarily driven by increased professional fees and facilities expenses.

R&D expenses increased approximately $200,000 or 17% year-over-year due to increased clinical study and product development costs, including costs related to the development of our next-generation Flexitouch System. Operating income increased by $1.6 million or 50% year-over-year to $4.9 million for the fourth quarter of 2017.

Fourth quarter operating margin increased 250 basis points year-over-year to 14.1% of sales. Income tax expense for the fourth quarter of 2017 was $2.8 million compared to income tax expense of approximately $900,000 for the fourth quarter of 2016.

Fourth quarter 2017 income tax expense was impacted by approximately $1.2 million of incremental tax expense associated with revaluation of our deferred tax assets and liabilities, resulting from the enactment of the Tax Cuts and Jobs Act in December 2017.

Adjusted EBITDA for the quarter increased by $2.4 million, or 53% year-over-year, to $6.8 million. Fourth quarter adjusted EBITDA margin increased 390 basis points year-over-year to 19.5% of sales. As a reminder, we have provided a reconciliation of GAAP net income to our adjusted EBITDA in today's earnings press release.

Net income for the fourth quarter decreased approximately $100,000 or 6% to $2.2 million or $0.12 per diluted share compared to $2.4 million for the fourth quarter of 2016 or $0.13 per diluted share. Weighted average shares used to compute diluted EPS were $19.1 million and $18.7 million for the fourth quarters of 2017 and 2016, respectively.

Turning to a brief summary of our financial performance for the full year 2017. Total revenue increased $24.7 million or 29% year-over-year to $109.3 million.

Full year 2017 gross margin was 73.4% compared to 72.9% last year, driven primarily by products mix shift to our Flexitouch System, which represented approximately 92% of total revenue this year compared to 87% of total revenue last year.

Full year 2017 operating margin was 3.6% compared to 5.1% last year, driven primarily by the incremental public company costs for the full 12 months of 2017, as compared to 2016 when the company was public for only 5 months of the year. Full year 2017 pretax income decreased $100,000, or 3% year-over-year, to $4.2 million.

While our full year 2017 net income increased $3 million or 103% year-over-year to $5.9 million. The increase in net income this year was driven by an income tax benefit of $1.7 million that benefited our 2017 results, compared to an income tax expense of $1.4 million for the prior year.

The current year tax benefit was primarily due to a significant increase in tax-deductible, share-based compensation activity as compared to the previous year. Full year 2017 adjusted EBITDA increased $2.9 million, or 42% year-over-year, to $9.9 million. Our adjusted EBITDA margin was 9.1% of sales, up 83 basis points year-over-year.

Finally, at December 31, 2017, our cash, cash equivalents and marketable securities totaled $43.9 million compared to $41.7 million at the end of last year. The company had no debt outstanding at December 31, 2017. I'll now turn to a review of our 2018 revenue guidance, which we introduced in our earnings release this afternoon.

For the full year ending December 31, 2018, we expect revenue in the range of $131 million to $133 million, representing a growth of 20% to 22% year-over-year, compared to revenue of $109.3 million in 2017.

For the full year 2018, we expect total company revenue growth to be driven primarily by continued growth in sales of our Flexitouch products, which we expect to increase approximately 22% to 23% year-over-year in 2018. We expect sales of our Entré and ACTitouch products to grow in the low single digits in 2018.

We continue to expect our gross margin rate to remain in the low 70s, and we expect to deliver adjusted EBITDA margins of approximately 10% for the full year 2018 period, which includes non-cash stock compensation of approximately $6 million. We expect our GAAP tax rate for the full year to be in the 20% range.

And lastly, for the purpose of calculating earnings per share, we expect fully diluted weighted average share count for the year to be approximately 20 million shares.

Finally, I'd like to remind investors that our business experiences significant quarter seasonality each year as we move into the new year, with Q1 and Q4 representing our smallest and largest revenue volume quarters, respectively, each year.

Historically, over the last 4 years, our first quarter revenues have ranged from approximately 14% to 18% of total annual revenue. For Q1 '18, we would expect revenue to be at the higher end of that range of full year revenue, given some moderation in our seasonality.

Importantly, while we expect to deliver adjusted EBITDA margins of approximately 10% for the full year 2018 period, up approximately 100 basis points year-over-year, we do anticipate reporting an operating loss in first quarter, as in prior years, given the lower percentage of sales in our first quarter.

With that, I'll turn the call back to Jerry for some additional closing remarks.

Jerry?.

Thank you, Lynn. As we look ahead to 2018, Tactile Medical remains dedicated to growing our organization into a globally recognized provider of clinically-effective solutions for chronic diseases, helping people improve their quality of life by caring for themselves at home.

With this overarching goal in mind, we've committed again to delivering revenue growth of at least 20% this year, by continuing to execute with respect to our primary drivers of growth. Specifically, in 2018, we aim to expand our sales team by approximately 20%, consistent with our annual target over the past few years.

Expanding our selling resources remains the most important driver of our long-term success in penetrating our addressable market opportunity, which as a reminder, we estimate at more than $4 billion in the U.S. alone. We will continue to focus on maximizing the productivity of our sales team, by targeting the highest diagnosing clinicians in the U.S.

lymphedema market and by dedicating specialized resources to the VA channel. As discussed on our Q3 call, we performed another data analysis of medical claims for the 12 months ending June 30, 2017.

The data were extremely compelling and revealed that the awareness and diagnosis of lymphedema was increasing dramatically, with more than 1 million diagnoses in the 12-month period, a 23% increase over the number of diagnoses during the 12 months ended December 31, 2015, the last time we performed this analysis.

Importantly, the new data analysis showed an increase in the total number of diagnosing clinicians and a number -- an increase in the number of high-diagnosing clinicians. Simply stated, as we look at the U.S.

lymphedema market today, we believe there are approximately 10,000 high-diagnosing clinicians that work at more than 4,500 facilities around the United States.

While we're proud of the strong growth that we've reported in recent years and the mounting evidence that the awareness of lymphedema is indeed growing, we remain in the early stages of penetrating the large addressable market opportunity in the U.S.

Specifically, as of the end of 2017, a little more than 40% of the estimated 4,500 high-diagnosing facilities have at least one clinician that does business with Tactile Medical. We're intently focused on introducing our differentiated, at-home lymphedema treatment option to all of these high-diagnosing facilities in the coming years.

And finally, we will continue to leverage our widespread in-network coverage with commercial insurers. In addition to these primary drivers, our 2018 growth will also be fueled by the addition of our new products, Flexitouch Plus and Flexitouch head and neck.

We've been conducting a limited market release of our next generation Flexitouch System, the Flexitouch Plus, and I'm pleased to report that the feedback to-date has been very promising.

Most importantly, our customers are very pleased that the Flexitouch Plus garments are easier to put on and take off and provide better coverage compared to prior generations. The system's ability to reduce treatment times, by treating two limbs simultaneously, has also received strong praise from both, clinicians and patients.

Likewise, our in-home trainers have reported that the Flexitouch Plus controller is more intuitive and easier to train patients on. And lastly, a surprising finding from our limited market release has been the extent to which therapists are pleased with the improved pressure controls of the Flexitouch Plus.

The Flexitouch Plus controller can adjust the pressure of the garment's individual chambers, allowing patients with wounds or sensitive areas to perform treatment by applying lower pressures to these affected areas. In summary, this is an important new product introduction for the company.

The Flexitouch Plus offers significant enhancements versus the prior generation, and we are extremely pleased with the response from patients and clinicians during our limited market release.

We plan to begin the full commercial launch of Flexitouch Plus at the end of Q1, and expect this new product introduction to be a significant contributor to our growth in 2018 and beyond.

With respect to Flexitouch head and neck, we are focused on driving increased account penetration in our existing markets, while establishing the commercial and clinical support to enhance our future growth.

On the commercial side, we will refine our strategy to target call points outside of our existing areas of focus, and expect to hire a dedicated sales resource to assist in this effort in the first half of 2018.

On the clinical support side, we aim to follow our initial Flexitouch head and neck study, with the publication of additional studies, with the next one expected in the second half of 2018.

In conclusion, with a large market opportunity in front of us, multiple growth tailwinds in our business and a strategy that's demonstrated impressive results in recent years, we're very confident in our ability to continue to drive growth of 20% -- plus and remain committed to improving our profitability again in 2018.

I'd like to end my remarks this afternoon by thanking our employees, directors, investors and everyone on tonight's call, for their support this past year. Thank you, and congratulations on a very successful 2017. That concludes our prepared remarks. Operator, we'll now open the call for questions..

Thank you [Operator Instructions] Our first question comes from Malgorzata Kaczor with William Blair. Your line is open..

Hey, good afternoon, guys. Thanks for taking the question. The first one for me is just kind of big picture. As we think about guidance and drivers of growth throughout 2018, what should we think about for head and neck? You mentioned it's going to be meaningful.

But can you give us some color over that? And a similar comment for Flexitouch Plus, which you said, will have a significant impact.

But maybe talk about how significant or how quickly that can be realized?.

Hey, Margaret. Jerry and Lynn here. Thank you, for the question. Around 2018 growth drivers. I think the single biggest driver to our growth in 2018 is going to be the expansion of our field organization. The number of specialists that we're planning to add, I think, will be the thing that contributes most to our growth in '18.

Specific to the new products. We actually put head and -- sorry, we actually put Flexitouch Plus as having a bigger impact in 2018. You should think of it as a replacement product. So it is actually going to eventually replace the Flexitouch System.

I say eventually only because we need to get the Flexitouch Plus onto the federal supply schedule so that we can make it available to our veterans, as well as to our commercial patients. So that, we expect to have a -- kind of the next biggest impact. Head and neck has been a big success from our point of view.

But even as such, ended up in the low-single digits percentage of Flexitouch revenue in 2017. So while we expect that to increase substantially, it's from a very, very low base. So our expectation is it will continue to be a contributor in 2018.

I think it'll be more so in '19, as we sort out the commercial aspect of trying to reach those patients beyond our traditional call points of the lymphedema clinic and the Veterans Administrations hospitals..

Helpful. So, to follow up, maybe on your commentary on the expansion of the field organization being the largest driver. I think you guys had referenced a 20% percent increase in the sales organization. But then you also referenced potential increases in the head and neck, specialized head and neck organization. So there's two points to the question.

Number 1, is the specialized head and neck sales organization included in the up 20%? And number 2, you guys seem like it picked up in terms of the amount of sales reps that were increased in the fourth quarter of '17.

So do those impact '18 as well as the new reps that'll come online?.

So, you're right. At the end of Q3, we had reached our objective of sales adds for 2017. And also mentioned that we are going to be opportunistic in following up the number of leads that we had, to see if we could add even further to the sales organization.

And as you heard today, we were successful in that endeavor and actually brought on a much larger number of reps than we had at the end of Q3. The 20% number is based on our year-end number. So we intend to add another 32 to the organization, coming off of 2017. So that's the total number.

The head and neck resource we're talking about is included in those numbers. And we're -- what we're really talking about is trying to find some help in determining how to go after those patients that are outside of our traditional call points.

So I don't want to leave the impression that, that's going to be a large number of these hires because it's not. We're going to start with one, like we did with the VA specialists. We were able to determine -- start with one and determine how they were able to help our current sales organization go beyond their current call points.

We're going to take that same approach with the head and neck product and hire our first in the first half of 2018..

Great. And last one for me. For Flexitouch Plus, since you referenced that was going to be another big driver for you guys going into '18, it seems like it'll be a pretty easy sale going deeper into maybe your existing accounts.

So maybe talk to us about what you've seen? Is it new patients that previously weren't getting products that are now getting products of those accounts? Is it a big piece of those patients that maybe weren't and now are? Any additional color would be helpful..

You bet. So I think, during the limited market release, what we've seen so far has been a willingness to try the product on more patients. So for those patients that, where they didn't think the patient had the ability to put the garments on and off easily, with our Flexitouch Plus, they're willing to do that.

And for those patients that they didn't think would use the product for two hours, those of their patients with bilateral disease, the ability of the Flexitouch Plus to be able to provide the same treatment in one hour.

So a much reduced timeframe is appealing and has our clinicians looking at using that -- our Flexitouch Plus product for that part of the population that they didn't necessarily think of Flexitouch Plus -- Flexitouch for before..

Got it. Thanks, Jerry..

Your next question comes from Jason Mills with Canaccord. Your line is open..

Thanks. Hi, Jerry. Congrats on a great quarter.

Can you hear me okay?.

Yes..

Yes, Jason..

So, Jerry, just want to go to your statistics on the high diagnosing docs. Thanks, for giving us an update on that. And you clearly made great progress. 40%, you're doing business 40% of those facilities.

That said, as the biggest player in this market, it begs the question, what are the other 60% doing? And presumably, that's why you're adding to your sales force to the extent that you are in a fairly robust fashion.

But I am wondering just if you could give us a sense for whether or not the remaining 60% are low-hanging fruit or what percentage of that 60% you would consider to be sort of in those three deciles that you mentioned that you're targeting? And how we should think about that remaining piece of the market and how it can contribute to your future growth?.

You bet. So good questions, Jason. First of all, the 4,500 facilities that we referenced are all in the top three deciles. So that's -- there are more facilities beyond that aren't seeing as many patients as these facilities are seeing. So we see this as the most lucrative call point, if you will.

The other 60% of these facilities are doing one of three things with these patients. They're either sending them home with compression stockings or basically giving them minimal care. They're sending them to a lymphedema therapist, where we may or may not have a relationship with, most likely, do have a relationship with.

Or they're sending them to a competitor. And while we certainly see some of these facilities using competitors, that's not the typical profile of the facility. So we see this as the primary call point for us.

This and the VA as our two primary call points, if you will, in 2018 to be able to deliver on this 20% to 22% revenue increase that we've projected..

Okay, that's helpful. Just a follow up on that, Jerry.

Do you -- is there a portion of that 60% that you would put in a bucket of having a philosophical -- some sort of a philosophical -- something against Flexitouch specifically or more generally pneumatic compression device therapy? Or do you think that ultimately, a relatively large chunk of that remaining 60% will be customers of Tactile Medical?.

I think the momentum we have in educating clinicians about, A, the problem, and B, our solution, is evidenced by our growth rate over the past few years. So I think we've been doing very good at getting to those clinicians. And once we get to them, actually convincing them that we're worth working with.

So we look at all 4,500, sorry, yes, all 4,500 of these facilities as candidates to be become customers of Tactile Medical, and see no reason that they shouldn't be..

Okay, that's helpful. Just a few follow-ups and I'll get back in queue, Jerry. The -- maybe, for you Lynn, sort of a combo product on ASPs and gross margin.

With the launch of Flexitouch Plus, how do you see that sort of impacting the average ASP for Flexitouch in general? And the gross margin ticked up every single quarter during 2017, and I think, beat our numbers every quarter as we were sort of modeling with some price compression, generally in the market for gross margins to tick down on a year-over-year basis.

You're still saying low 70s, which is a fairly broad range for 2018.

But given the recent trends and the launch of Flexitouch, can you put a finer point to gross margins? And maybe, give us more specificity with respect to average ASPs across the Flexitouch franchise for 2018?.

Yes. Thanks, Jason. I'll start first, then turn it over to Lynn. First and foremost, we don't expect to see any pricing difference between the Flexitouch and the Flexitouch Plus. They both use the same billing code. And we have contracts in place with most payers for that code.

So we don't see a difference between those two in terms of the price that we will charge. Regarding gross margin, I'll let Lynn respond to that one..

Sure. So gross margin, Jason, as you observed, was strong, both in the quarter and for the year. Biggest driver there, as we said, was really the mixed shift, depending on quarter or year, 300 basis points to 500 basis parts increase in Flexitouch versus the Entré and ACTitouch. So we don't expect that same shift this year.

However, we expect Flexitouch to remain high and contribute to a 70-plus percent gross margin profile.

As far as impact of Flexitouch Plus, until we get to full scale of the rollout of Flexitouch Plus and converting all our accounts over to the new product, there could be some headwind to the gross margin, from a cost of goods sold perspective, as we ramp our suppliers and get to full scale.

But we expect to be there certainly by fourth quarter this year. So are comfortable with that 70-plus percent gross margin rates for the year..

That’s clear. Thanks, Lynn. Thanks, Jerry..

Your next question comes from JP McKim from Piper Jaffray. Your line is open..

Hi. Thanks for taking the question. I had a couple here. I wanted to start first on the new Flexitouch Plus system.

And if you could remind us how often old patients are covered for kind of an upgrade? Like, is it every 4 years where you could go back and you got X amount of patients that you sold it four years ago, that you could call up and offer the Flexitouch Plus and the insurance would cover that? Trying to get an idea of who could upgrade into the system how quickly..

You bet. Hi, JP. Thanks for jumping on the call and appreciate the question. Yes, Flexitouch Plus or any change of product in the category of durable medical equipment only gets upgraded in the event of a new medical need for the patient.

So that medical need could be anything from the product has worn out after a five-year expected life, which is what most payers have for durable medical equipment or it could be that the patient has developed bilateral disease or they had unilateral disease before, and this is the way that their physician wants it to be treated.

Most health plans will not just automatically upgrade based upon any number of years. There really has to be a medical reason for them to pay for that equipment. Having said that, we're certainly anxious to have some of our existing users use our equipment.

So we're contemplating being able to offer some of them incentives that might get them to trade in their equipment, to step up to a new Flexitouch Plus. But this market is so under-penetrated right now that we really don't need to look backwards to get access to patients.

We are putting up very small numbers in terms of the one million patients that have been diagnosed with this condition over the last year, that, that's going to be our focus going forward..

Okay. So it's not like, you have X percent of your patients that are bilateral. And now that you have a system that can treat them both at the same time, you can go back to them.

It's still more about just hiring new reps and penetrating things further?.

That's the way we're looking at it. Yes..

Okay. And then on Flexitouch Plus, again, I thought it's interesting that each chamber can now be controlled by different pressures.

So I'm wondering if this is maybe a leading way into maybe a new indication beyond lymphedema, now that it can control each chamber at a different pressure? Or where you can take that technology now?.

I think we really designed the Flexitouch Plus based upon the feedback that we got from patients and clinicians. And one of those elements of feedback was the desire to kind of soften the pressure around wounds or around sensitive areas of a limb. So that's why we build the pressure-controlled mechanism in place.

It doesn't mean we can't use it for other things or that we haven't thought of other things to use it for. But that's what it was based upon. And we think just that feature alone, surprisingly, has -- to us, surprisingly, has impressed a lot of therapists, to think, again, to think of our product for use on more of their patients.

So again, getting back to accessing more of the market, we think our Flexitouch Plus will allow us to do that more than our Flexitouch did..

Okay, very helpful and last one for me for Lynn on the EBIT margin, I appreciate the guidance for '18, but I'm really looking out over the next 3 to 5 years, how -- when do we see a lot more draw into the bottom line in terms of leverage, the reimbursement team and G&A guide in place.

I mean from my understanding you're going to continue to hire sales reps, 20% a year growth, but when should we really see some of that EBITDA margin expansion in the model that you guys have?.

Great question, JP. As we've talked about it, I think before, we don't have a formal target model for that out there. However, we absolutely anticipate seeing that leverage largely from the reimbursement and G&A lines on the P&L.

And I would say, in -- we're looking to expand that margin rate into the teens, certainly in the next one year to two in the high teens or 20% in the 3 to 4-year time frame, I would say, today..

Your next question comes from Chris Pasquale with Guggenheim..

Jerry, if I do some quick math, it looks like your reps are calling on about 11 sites a piece. So if I just take that 60%, or sorry, the 40% of 4,500, divided by the 160.

As we think about this business longer term, do you expect that to remain consistent? That would imply that at some point, you need a sales force approaching 400 individuals to serve the market.

Or do you start to get some more economies of scale as you ramp?.

Hey, Chris. Appreciate the question. Yes, I think from a -- from an expansion perspective, we do think we're going to have to continue to add sales reps. Having said that, there's kind of two dynamics about the number of facilities that have these high-diagnosing clinicians that we need to think about. The first is the number that we've penetrated.

We're 40% there and we've got 60% to go. That's terrific for continued growth. The other dynamic though is there is 10,000 clinicians, and the 4,500 facilities that we're in, we're not getting prescriptions from each clinician in that facility. So we have a ways to go, to get more depth within each facility, as well as breadth of facilities.

So there's kind of two dynamics about that penetration thing. As we increase awareness of our solution, these folks obviously know what the problem is, because they are the high-diagnosing clinicians.

But as we increase awareness of our solution and get more of these clinicians to prescribe, that's really where we'll see the leverage come from our field organization. If we can get 3 or 4 or 5 clinicians from each facility prescribing, we don't have to penetrate any more facilities for a long time because that will really drive productivity.

So there's two elements. I just want to make sure you're aware of both..

No, that's helpful.

But do you have a long-term sort of bogie in terms of we think the sales force will eventually need to be X in terms of full national coverage?.

We've been kind of plugging along with the idea that we could double the size of the sales organization, and still not reach them all. So that's why we picked the 20% a year pace. We think that's the right pace. We've shown we can recruit, bring on board, train and bring to productivity that number.

But we really do think we've got a lot of runway left, in terms of hiring and bringing these facilities on. So we do think we can double the size of our sales force..

Makes sense. And then, how long do you expect it to take for you to get plus on the federal supply schedule? And maybe, a sort of corollary to that for Lynn.

While you're producing both versions of the system, are you at a disadvantage from a margin perspective?.

I'll start with the federal supply schedule question. We're engaged with them now on trying to add or adding Flexitouch Plus to the federal supply schedule contract that we have. Our estimate is that it's going to take the rest of the year before we get that underway. So we'll be running with both products for the rest of 2018 in the current plan.

So I'll turn that back to Lynn on the margin question..

Sure. So, as I commented to Jason's question earlier, Chris, yes, until we get to full-scale I'll say, on the Flexitouch Plus volume of production as well as sales converted 100% to that new product. It does represent a bit of a headwind on the gross margin standpoint. That is contemplated in our guidance of 70% to 70-plus percent.

So as we're working through that transition midyear, we have anticipated some headwinds there, expect to be past that, as we get into Q4. As you know, we guide kind of to the full year rate. So, hope that helps..

[Operator Instructions] The next question comes from Suraj Kalia with Northland Securities..

So, Jerry, couple of questions from my side. And maybe I missed this in your prepared remarks.

Did you provide the contribution from your rental segment and the growth rates thereof?.

We did not, Suraj, talk specifically about the rentals. So I'll comment on it now. It continues to represent roughly a high single-digit percentage of our revenue. And we certainly haven't seen that change at all.

At least we haven't seen any material change in payers moving toward a rental model from the purchase of the product that we've enjoyed in the past..

Got it. And Jerry, you gave some very interesting commentary in terms of the broader market. And thank you, for the same. So the numbers I got, 10,000 clinics, roughly, 40% penetrated. At least one clinician in these high-diagnosing clinics that is, "a Tactile" -- they prescribe the Flexitouch.

I guess if I look at it a little differently, Jerry, if you did nothing else, how many patients is this specific clinician, who's already prescribing Flexitouch, using Flexitouch on -- let's say, 10 patients come through in a month, is he prescribing on 1, 2, 5 or what -- I guess, what I'm trying to head is, the same-store sales versus trying to go after the next clinician? And if you could help us reconcile that with your 20% increase in sales force.

What would be better? Going deep with the existing clinicians? Or you think that is pretty much saturated? You have to find the next clinician and the next clinician within this clinic..

It's an interesting observation, Suraj. Let me make sure we're talking about the same numbers though. Because I don't think you captured exactly what I said. So the data analysis we did, that ended June 30 this year, showed one million patients diagnosed over the previous 12-month period.

And that was up substantially from the last time we did this analysis. That's -- not only do we see the number of patients. We also see who diagnoses them. So we understand the total number of clinicians that have seen these million patients. We then stratify those clinicians into high-diagnosing or top 3 deciles of diagnosers.

And there were 10,000 clinicians that were in the top 3 deciles of the -- of finding those one million patients. Those 10,000 clinicians worked in 4,500 facilities. So not 10,000 facilities, 4,500 facilities. So that -- so about 40% of those facilities have ordered at least -- we have at least one clinician ordering product from Tactile.

So for those facilities that are ordering from us, we want to continue to service that account and that same-store to use your vernacular, can we can get order from that clinician or another clinician within that facility, that's the same-store we're talking about.

And our objective this year is to not only penetrate more of those, 4500 facilities, but also to get more clinicians in each of those facilities to order from us. The real key here though is, we basically put 24,000 units on patients last year, one million of them have lymphedema.

So whether we get it from a new clinician, an existing clinician or anyone else, what's important is we are so under-penetrated in this market that it will lead to a long pathway of growth for the company..

Fair enough. And sorry for the screw up in the numbers. And, Jerry, this might be -- and I'll keep this as my last question. Forgive me, this is a dumb question, I found your comments on Flexitouch also interesting, just like one of the other analysts. Different pressures in different chambers.

Jerry, does that mean that the pressure gradient that is created, is there is a change in the gradient in one of the intermittent chambers? I guess what I'm trying to understand is, for fluid drainage or movement, could there be a change in the gradient? And what happens to fluid movement? Forgive me if I heard it wrong, but any color would be great..

You bet, Suraj. So understood question, we have built into the Flexitouch the ability to maintain that gradient throughout the limb. So if you lower the pressure, if you lower the pressure at a distal chamber, it will adjust the pressure in the other chambers so that a gradient is maintained.

We think that's one of the reasons that we're able to get our clinicians to enjoy this change and not be concerned about it.

And again, I think, this added flexibility, is what some of our clinicians were looking for when they gave us feedback that, that would make it a more appealing product for them to use, with patients that had not the usual type of concerns or not the usual type of disease. So I think we've given that flexibility to our customers.

And that's what they asked for..

Your next question comes from the line of Mitra Ramgopal with Citigroup..

Jerry, with the introduction of the Flexitouch Plus this year, as you look to expand your product offering, are you more inclined to continue to focus on internal development? Or given the tremendous balance sheet you have, maybe if you're more inclined to look at some external opportunities, if there are any out there for you?.

Hey, Mitra. Appreciate the question. Yes, in fact, we have been looking and continue to look at opportunities to bring other products to market, whether they are developed here or outside. We've been looking at both. So I think it's important to know that we put some resources behind business development in early 2016.

And have been looking for other products that might fit into our channel to leverage the platform that we've built to get products into the home and get those products paid for. We do have a product pipeline. We expect the next product that we are developing to come out late in 2018. It's our ACTitouch next-generation product.

So we expect to not only -- that's the one we can control, is the one in our own pipeline. Unfortunately, the business development side has to match, both a market attractiveness as well as a price that we're willing to pay. And those, as you can appreciate, don't always come together.

So we're continuing to look and continue to work on opportunities external. But also, we believe it's important for us to continue our internal development as well..

Okay, that's great. And Lynn, quickly, if you can just give us a sense of what we should expect in terms of CapEx for 2018? I know it ticked up a little last year. And maybe, also on cash flow..

Sure. So CapEx, you're correct. For 2017, was definitely at a higher level than we've seen historically. A function of a few different items. Our 10-K should be filed shortly and there is some additional discussion in there. But we did make pretty significant investments in IT infrastructure as well as the facility expansion.

We moved our operations group to a new facility this year. A couple of other items in there as well that are a bit unique this year that I don't expect to repeat next year. So I would say, a lower level in 2018. Probably in the range of 1/2 of what we saw in 2017. For cash flow. We expect to continue to be operating cash flow positive.

We don't guide to that more specifically. I would say, for us, the adjusted EBITDA is a fairly close proxy for cash flow. But again, more discussion in the 10-K on the 2017 results you can reference as well..

There are no further questions at this time. I'll turn the call back over to the presenters..

Well, listen, everyone, thanks very much for the questions. And we certainly appreciate your interest in Tactile Medical. Operator, that'll conclude the call. Thank you..

That does conclude our conference for today. Thank you for your participation..