Q1 2023 Eargo Inc Earnings Call

Participants

Adam Laponis; CFO; Eargo, Inc.

Christian Gormsen; CEO, President & Director; Eargo, Inc.

Nicholas S. Laudico; Chief Retail Officer; Eargo, Inc.

Malgorzata Maria Kaczor Andrew; Partner & Research Analyst; William Blair & Company L.L.C., Research Division

Presentation

Operator

Ladies and gentlemen, good afternoon. My name is Abby, and I will be your conference operator today. At this time, I would like to welcome everyone to the Eargo First Quarter 2023 Earnings Conference Call. Today's conference is being recorded (Operator Instructions)
And I will now turn the conference over to Nick Laudico, Chief Retail Officer. You may begin.

Nicholas S. Laudico

Thanks, operator. Good afternoon, everyone, and welcome to the Eargo First Quarter 2023 Earnings Conference Call. As a reminder, this call is being broadcast live and a digital replay will be available on our IR website. Joining me on today's call are Christian Gormsen, President and Chief Executive Officer; and Adam Laponis, Chief Financial Officer.
Before we begin, I'd like to remind you that some of the matters discussed in the conference call will contain forward-looking statements regarding future events as outlined in our press release today. We wish to caution you that such statements are based on management's current expectations and beliefs, are forward-looking in nature and are subject to risks and uncertainties, and actual events or results may differ materially. The factors that could cause actual results or events to differ include, but are not limited to, factors referenced in our press release today as well as our filings with the SEC.
Before turning the call over to Christian, I want to make note that we have posted a historical GAAP to non-GAAP reconciliation table on our IR website in the Events & Presentations section.
With that said, I will now turn the call over to Christian.

Christian Gormsen

Thank you, Nick, and thank you, everyone, for joining us today. Through the first quarter of 2023, we continued to make progress on evolving Eargo into a true omnichannel business. Retail once again led the way in our efforts to diversify our business growth with our direct-to-consumer cash-pay business seeing increased efficiency as we continue to refine our media spend. While still early, we also continue to pursue opportunities to expand our presence in the insurance market.
Our first quarter volume growth, combined with our continued capital efficiency initiatives, led to increased gross margins, reduced operating expenses and a lower net operating loss. We believe the worst of the uncertainty impacting our business is behind us, enabling us to make incremental steps in the right direction each quarter. As such, we believe that quarterly net operating cash burn will continue to see modest sequential improvements in the remaining quarters of 2023.
Moving to a summary of our first quarter business performance. First quarter net revenue was $11.8 million, up approximately 29% year-over-year and slightly down on a sequential basis. As a reminder, Q1 is typically a sequentially down quarter following the end of heightened holiday promotional activity in Q4.
First quarter gross shipment growth was primarily driven by sales to Victra, our largest retail partner. In the first quarter, Victra submitted an initial stocking order of Eargo 7 hearing aid devices in addition to subsequent replenishment orders. Since announcing our nationwide partnership with Victra last fall, we have been pleased with the early progress in this new channel. Importantly, Victra reports that Eargo devices continue to sell through Victra's approximately 1,500 retail locations. This positive trend gives us confidence in the future growth potential of the partnership.
We continue to support our retail partners by training and educating their sales staff on how to communicate with consumers about key differentiators of Eargo devices. With respect to our partnership with Victra, our focus for the remainder of 2023 is the continued training and education of the Victra sales force, gathering customer feedback and improving the overall customer experience.
From a direct-to-consumer cash-pay perspective, our focus has been on media spend efficiency. And we continue to make incremental improvements to the cost of acquiring a customer as we refine our strategy and continue to optimize our media channel spend.
Turning to a brief update on insurance access. As we shared on our last call, we're currently accepting both FEHB and non-FEHB insurance as a method of direct payment in certain limited circumstances, in particular when customers have undergone additional testing by a licensed health care provider to establish medical necessity with supporting clinical documentation. In the meantime, we expect to continue to operate at low insurance volumes and believe meaningful volume lift will take some time.
Before turning it to Adam, let me touch on Eargo 7, our seventh generation device and an example of our long-standing commitment to innovation. We were thrilled to announce Eargo 7 earlier this year at CES, followed by a full commercial launch in mid-February. Since then, the device has been available for purchase across all channels. We have been pleased with both the initial device uptake so far, which has tracked well to our expectations and the customer -- positive customer feedback. Specifically, Eargo 7 has received better overall customer reviews and reduced connectivity complaints versus prior Eargo devices.
Following received -- receipt of 510(k) clearance from the FDA last quarter, Eargo 5, Eargo 6 and Eargo 7 can each be marketed as self-fitting hearing aids with the use of Sound Match via our mobile app, and each is currently marketed as over-the-counter pursuant to the FDA's new OTC regulatory requirements.
With our self-fit technology, Eargo 7 does not require traditional in-office visits for fitting or adjustments like other hearing aids. This benefit has really resonated with customers so far in our retail and direct-to-consumer settings as they are able to get set up and personalize their devices at home quickly and easily.
We're incredibly proud of our first quarter results, especially in the context of an evolving hearing aid industry. We believe that the distribution of hearing aids in the U.S. through the physical retail channel will continue to grow and believe we are one of the leaders in this market evolution.
Let me now turn it over to Adam for a more detailed summary of our first quarter financial and operating results.

Adam Laponis

Thanks, Christian. Given Christian's summary of net revenues, I will begin my commentary at the gross shipment line. First quarter gross systems shipped were 8,705, up approximately 51% year-over-year and roughly flat sequentially. The year-over-year increase in gross systems shipped was primarily driven by sales to Victra.
As Christian noted, first quarter net revenue was $11.8 million, up approximately 29% year-over-year and slightly down on a sequential basis. We derived approximately 22% of our net revenue in Q1 2023 from sales to Victra. It is important to note that our shipment volume in both the fourth quarter of 2022 and the first quarter of 2023 were impacted by large stocking orders through Victra as they made significant purchase to build and maintain inventory levels at their approximately 1,500 retail locations.
Going forward, we may not be able to accurately predict the timing or size of any future Victra orders, which may impact our net revenue and the consistency of our results on a sequential basis.
The first quarter 2023 sales return rate was 37.4%, up 3.5 percentage points year-over-year and 2.5 percentage points sequentially. The increase in the sales return rate was primarily driven by a sales channel mix shift given the larger percentage of sales attributed to our retail partner, Victra, where we have only recently implemented sales return-reduction initiatives.
These initiatives are similar to those implemented in our direct-to-consumer cash-pay channel years ago, which ultimately reduced and stabilized our sales return rate into the mid-30s. We hope to achieve similar benefits from these initiatives in the retail channel over the coming quarters and therefore believe the higher actual sales return rate experienced in the first quarter is transient.
Moving to non-GAAP gross margin and non-GAAP operating expenses. Our discussion of financial metrics in the gross margin line below will be on a non-GAAP basis, which excludes stock-based compensation expense. Please refer to our GAAP to non-GAAP reconciliation included in today's earnings release and the historical GAAP to non-GAAP reconciliation table on our IR website in the Events & Presentations section.
First quarter non-GAAP gross margin was 43.8% compared to 40.5% in the first quarter of 2022. We are pleased with our ability to expand gross margins consistently as we continue to scale volumes.
Moving to operating expenses. While we continue to refine our op cost structure, we have invested selectively in areas we believe will be the future drivers of our business, including insurance and retail as well as the supporting compliance infrastructure. First quarter non-GAAP sales and marketing expenses were $12.5 million or 100.5% of net revenues compared to $12.6 million or 137.9% of revenues in the first quarter of 2022.
Non-GAAP research and development expenses were $3.9 million or 33.5% of net revenues compared to $4.9 million or 53% of net revenues in the first quarter of 2022. The decrease is primarily due to lower personnel-related costs and lower third-party costs.
Non-GAAP general and administrative expenses were $8.1 million or 68.5% of net revenues compared to $13.6 million or 148.1% of net revenues in the first quarter of 2022. This decrease was primarily due to a reduction in professional fees, partially offset by an increase in personnel and personnel-related costs. Non-GAAP net operating loss for the first quarter of 2023 was $19.4 million compared to a non-GAAP net operating loss of $27.4 million for the first quarter of 2022.
Moving to the balance sheet. We had cash and cash equivalents of $79.8 million at March 31, 2023. This compares to $101.2 million as of December 31, 2022. Our net operating cash burn, which we define as cash used in operating and investment activities, in the first quarter of 2023 was approximately $21.5 million.
Now turning to cash burn guidance. The company expects modest sequential improvement to net operating cash burn in the remaining quarters of 2023. We are not providing any further financial guidance at this time.
I will now turn it back to Christian for closing commentary.

Christian Gormsen

Thanks, Adam. When we last spoke with you in March, we ended on a note of optimism with a belief that we were well positioned to capitalize on our recent progress in 2023 as we work to return Eargo to growth mode. Standing here today with the first quarter of 2023 now behind us, I'm pleased to report we have even greater confidence in our ability to transform our business and execute our omnichannel strategy. We believe that the first quarter demonstrated momentum in our business, laying the groundwork for further Eargo success.
While we clearly have work to do, we do believe the worst of the uncertainty impacting our business is behind us, enabling us to make incremental steps in the right direction each quarter. Most importantly, we remain steadfast in our belief that Eargo is driving a revolutionary change in the hearing industry, backed by innovative technology and robust remote customer care. There remains a very large and unpenetrated market opportunity for us to capitalize on, particular in direct-to-consumer, and we look forward to providing future updates on our progress over the course of 2023.
We I will now turn the call over to the operator for Q&A.

Question and Answer Session

Operator

(Operator Instructions) And we will take our first question from Margaret Kaczor with William Blair.

Malgorzata Maria Kaczor Andrew

I wanted to start with Victra. And I apologize, I've got a series of questions. But can you give us a sense of, I guess, how many Victra stores at this point have an Eargo device given the stocking dynamic? So is that largely behind us? And then you mentioned that most of the sales were stocking, but you're clearly seeing an increase in return rates, meaning that they seem to be selling some of these devices, and hopefully, replacing some of the sales. So I guess, can you give us a sense, at least based on the return rate, how much that may suggest for sell-through, either as a percentage or the number versus the sell-in?

Christian Gormsen

Thanks, Margaret. Let me start here, and I'll see if Adam has some more details that you're looking for. But at the highest level, we've sold into all Victra stores. All 1,500 have inventory of Eargo, so you can get Eargo 7 at any Victra Verizon store, assuming they haven't just recently sold out. But there is also a replenishment system set in place. So that is completely behind us in terms of getting that initial stocking there.
We've also seen -- in terms of development, we've clearly seen more sell-through in Q1 than what we saw in Q4. So we are seeing over to improvements in the sell-through. Obviously, it's being masked to that level about the actual sell-in of inventory, which is what we're reporting on financially.
Adam, anything -- any further color? I don't think we have further color to give, right?

Adam Laponis

No. I think Christian said it well, Margaret. We did see sequential improvement in the sell-in -- sell-through, but the sell-in still exceeded the sell-through even in Q1.

Christian Gormsen

Yes.

Malgorzata Maria Kaczor Andrew

And was that true in maybe March? Is that...

Adam Laponis

I'd say -- well, again, the orders don't come in on a week to week. They came in, in pretty big months, so it's kind of lumpy in that regard. But I'd say the average orders in March and the total sell-in -- the average order of sell-in in Q3, we're getting closer, but we're still not there yet. But we're -- so we're still in that dynamic of building up inventory in Q1.
But to your question of, is it done, at this point, we're at a steady state now, where we've got inventory in every store and we are seeing continued momentum in sell-through.
In terms of RFC dynamics, yes, we are seeing a increase in RFC. So we are seeing that sell-through, but we're also now implementing the trainings across the country that -- and the other actions that we think we did back in the 2018, 2019 that can positively impact that RFC rate over time.

Malgorzata Maria Kaczor Andrew

Okay. So moving to that return rate, can you give us a sense of how quickly those initiatives maybe did help the DTC business? Was it a matter of quarters or years? And if you could remind us as well the current generation of Eargo devices. I believe that despite the high return rate, you can still reuse those devices, so the impact on gross margins maybe a little bit less than in the past. Is that true?

Adam Laponis

Yes. So let me give you kind of 2 parts there, Margaret. So the first part is when we did this back in 2018 to 2019 over the course of 4 quarters, we saw a 10-point reduction in return rates, in the mid-40s to the mid-30s, in that time range. So I think that's probably a decent proxy for the kind of time we're expecting things to move here. So it will take quarters, but it won't take years.
In terms of the, we call it refurbishment capabilities of our products, we are able to refurbish all of the Eargo 5, 6 and 7 lines that get returned to us. So it does minimize that impact to gross margin when there is a higher return. But we're still sensitive to it from both the customer experience as well as there is still some costs associated with that rework.

Malgorzata Maria Kaczor Andrew

Okay. Yes. Two more questions. So number one, on the Victra experience, obviously, you're seeing some success there. So does that suggest you may want to expand these types of partnerships? And so if so, why? And then if not, what metrics do you need to see to want to expand any further?

Christian Gormsen

Yes. No, let me grab that. Clearly, we believe that the best way to grow hearing penetration, which is the overall goal and the mission of Eargo, helping more people hear better, is to meet people where they are. And I think we're getting strong feedback that those people are in locations like Victra Verizon stores. So that basically is the whole strategy that we're building on.
It's also clear that it's a new location. People are not walking into a Verizon store expecting to buy a hearing aid. So it is that journey of educating consumers that you can actually now get a health product in such a location. And I think that's part of driving, obviously, the sell-through, not the sell-in, and also managing the return rate and managing people's expectations.
So as we've always said, this is a long-term initiative. It's a long-term strategy for us. But it's something we are as committed to. As Adam also mentioned, it's an area that we are actively investing in our organization's capability to support into. And then we've continued investing through the quarter here, and we'll continue to do so through the rest of the year.
So absolutely -- and the KPIs we'll be looking for is ultimately not the sell-in, it's the sell-throughs combined with the return rates. And ultimately, the most important is the customer experience. And so far, what we're learning is customers did not expect it, but they appreciate that opportunity. So it's a journey that we have literally just embarked on but we're excited about for the future.

Malgorzata Maria Kaczor Andrew

Okay. Last question. You mentioned most of the increase in sales seems to be from Victra, but can you give us a sense around DTC growth on a year-over-year basis and then how that might change with the latest Eargo 7 launch? And any potential marketing expense you may have?

Adam Laponis

Yes. So Margaret, when you look at the 20% of revenue coming from retail, you can kind of back into it if that -- year-on-year, we're essentially between the repeat business and our existing DTC business. We're roughly flat, even slightly down, depending on how you cut it. So to me, there's -- we are focused on optimizing it, and that's really where we're seeing the improvement in sales and marketing and driving that first and then building off on the growth from there.
We are seeing, though, that there is cross-pollination effect. A customer goes into Victra and creates a lead that they can convert online or the phone and vice versa. A customer that goes on the phone can then go into Victra. So the 2 are commingling each other as well. And that's a phenomena we want to see, but we expect to see more of that as we go forward.

Operator

And ladies and gentlemen, this concludes today's conference call, and we thank you for your participation. You may now disconnect.