Inspire Medical Systems, Inc.: Form 10-Q for the period ended Sep 30, 2023

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to those statements included elsewhere in this Quarterly Report on Form 10-Q, as well as the audited financial statements and the related notes thereto, and the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” sections included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022. Some of the information contained in this discussion and analysis or set forth elsewhere in this Quarterly Report on Form 10-Q, such as information with respect to our plans and strategy for our business and the impact of macroeconomic factors on our business, financial results and financial condition includes forward-looking statements that involve risks and uncertainties. As a result of many important factors, including those set forth in the "Risk Factors" section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022, our actual results could differ materially from the results described in, or implied by, these forward-looking statements.

Overview

We are a medical technology company focused on the development and commercialization of innovative, minimally invasive solutions for patients with OSA. Our proprietary Inspire system is the first and only FDA-approved neurostimulation technology that provides a safe and effective treatment for moderate to severe OSA. We have developed a novel, closed-loop solution that continuously monitors a patient’s breathing and delivers mild hypoglossal nerve stimulation to maintain an open airway. Inspire therapy is indicated for patients with moderate to severe OSA who do not have significant central sleep apnea and do not have a complete concentric collapse of the airway at the soft palate level. In addition, patients in the U.S., Japan, Singapore, and Hong Kong must have been confirmed to fail or be unable to tolerate positive airway pressure treatments, such as CPAP, and be 18 years of age or older, though there are no similar requirements for patients in Europe.

We sell our Inspire system to hospitals and ambulatory surgery centers ("ASCs") in the U.S. and in select countries in Europe and Japan through a direct sales organization and we sell our Inspire system in Singapore and Hong Kong through distributors. Our direct sales force engages in sales efforts and promotional activities focused on ENT physicians and sleep centers. In addition, we highlight our compelling clinical data and value proposition to increase awareness and adoption amongst referring physicians. We build upon this top-down approach with strong direct-to-consumer marketing initiatives to create awareness of the benefits of our Inspire system and drive interest through patient empowerment. This outreach helps to educate thousands of patients on our Inspire therapy.

Although our sales and marketing efforts are directed at patients and physicians because they are the primary users of our technology, we consider the hospitals and ASCs where the procedure is performed to be our customers, as they are the purchasing agents of our Inspire system. Our customers are reimbursed the cost required to treat each patient through various third-party payors, such as commercial payors and government agencies. Our Inspire system is currently reimbursed primarily on a per-patient prior authorization basis for patients covered by commercial payors, under Local Coverage Determinations for patients covered by Medicare, and under U.S. government contract for patients who are treated by the Veterans Health Administration. As of November 7, 2023, we have secured positive coverage policies with many U.S. commercial payors, including virtually all large national commercial insurers, covering approximately 260 million lives in the U.S. In addition, all seven Medicare Administrative Contractors published final policies in 2020 that provide coverage of Inspire therapy when certain coverage criteria are met. Reimbursement in other countries can often be established through a combination of private (commercial insurance) and public funding sources, or at the hospital level through innovation budgets.

In November 2023, the final 2024 Medicare reimbursement payments were announced. The 2024 rate for our hospital customers is $29,617 per implantation of a hypoglossal nerve stimulator, an increase of 1% over the 2023 rate. The ASC reimbursement for 2024 is $24,870 per implantation, a decrease of 1% over the 2023 rate. The 2024 physician payment is $823 for implantation, a 6% decrease over the 2023 payment. The 2024 national average drug-induced sleep endoscopy ("DISE") procedure reimbursement to ASCs increased 714% to $757 per procedure over the 2023 rate, while the reimbursement to hospitals for the DISE procedure increased by 806% to $1,619.

For the nine months ended September 30, 2023, 96.4% of our revenue was derived in the U.S. and 3.6% was derived outside of the U.S. No single customer accounted for more than 10% of our revenue during the nine months ended September 30, 2023.

We rely on third-party suppliers to manufacture our Inspire system and its components. Many of these suppliers are currently single source suppliers. We have experienced and continue to experience supply disruptions that began during the COVID-19 pandemic, but to date we have managed to avoid any delay in implant procedures due to those issues. During the third quarter of 2023, we began experiencing an inventory supply issue related to our polyurethane-based stimulation leads, one component of the Inspire system currently used only in the European market. In 2022, the FDA approved our silicone-based stimulation and sensing leads in the U.S., which replaced the polyurethane versions of the leads, and we stopped manufacturing polyurethane leads. We applied for European Union ("EU") Medical Devices Regulation ("MDR") in December 2021, which we expect to obtain in the first quarter of 2024, following delays in the process. In the interim, we received a derogation from the Dutch national competent authority allowing us to place the silicone-based leads on the market until April 1, 2024 or until we receive certification under the EU MDR, whichever occurs first. We are also pursuing derogation in several other EU member states. However, such derogations are granted at the national level only and we cannot be certain that national competent authorities of the other EU member states will grant a derogation similar to the Dutch authority. Until we obtain certification under the EU MDR or these derogations are received, we may only sell our polyurethane-based leads in the EU, where the stimulation lead is in low supply. During the fourth quarter of 2023 and possibly extending into early 2024, we expect that the delay in certification and the shortage of polyurethane-based stimulation leads may cause delays to implant procedures which may adversely affect our business in the EU, including a reduction in our European revenue, and thereby our consolidated revenue, of up to $4 million during the fourth quarter of 2023.

We typically seek to maintain higher levels of inventory to protect ourselves from supply interruptions, and, as a result, we are subject to the risk of inventory obsolescence and expiration, which could lead to inventory impairment charges. For example, during the three months ended September 30, 2022, we recorded a charge of $2.8 million for obsolete inventory and component parts related to product introductions which were completed in October 2022, including the new silicone leads and the Bluetooth®-enabled patient remote.

In the U.S., our products are shipped directly to our U.S. customers and are shipped to our Singapore and Hong Kong distributors on a purchase order basis, primarily by a third-party vendor with a facility in Tennessee, although we do ship some products from our facility in Minnesota. Warehousing and shipping operations for our European customers are handled by a third-party vendor with a facility located in the Netherlands, and warehousing and shipping operations for our Japanese customers are handled by a third-party with a facility in Japan. Customers do not have the right to return a non-defective product, nor do we place product on consignment. Our sales representatives do not maintain trunk stock.

Since our inception in 2007, we have financed our operations primarily through sales of our Inspire system, private placements of our convertible preferred securities, amounts borrowed under our former credit facility, and equity offerings of our common stock. We have devoted significant resources to research and development activities related to our Inspire system, including clinical and regulatory initiatives to obtain marketing approval, and sales and marketing activities. For the three months ended September 30, 2023, we generated revenue of $153.3 million with a gross margin of 84.1% and had a net loss of $8.5 million compared to revenue of $109.2 million with a gross margin of 81.9% and a net loss of $16.8 million for the three months ended September 30, 2022. For the nine months ended September 30, 2023, we generated revenue of $432.3 million with a gross margin of 84.1% and had a net loss of $35.9 million compared to revenue of $270.0 million with a gross margin of 83.7% and a net loss of $48.0 million for the nine months ended September 30, 2022. Our accumulated deficit as of September 30, 2023 was $360.2 million.

We have invested heavily in product development. Our research and development activities have been centered on driving continuous improvements to our Inspire therapy. We have also made significant investments in clinical studies to demonstrate the safety and efficacy of our Inspire therapy and to support regulatory submissions. We continue to make investments in research and development efforts to develop our next generation Inspire systems and support our future regulatory submissions for expanded indications and for new markets such as additional

European countries and the Asia Pacific region. For example, in June 2023, we submitted a premarket approval ("PMA") supplement to the FDA for our next generation Inspire system. Also in June 2023, we received approval from the FDA on an expanded indication which includes an increase on the upper limit of the Apnea Hypopnea Index to 100 events per hour from 65, and raises the Body Mass Index ("BMI") warning in the labeling to 40 from 32, and we also received FDA approval of our new physician programmer, called the SleepSync™ programmer, which we expect to formally launch in the U.S. in early 2024. In March 2023, we received FDA approval to offer Inspire therapy to certain pediatric patients with Down syndrome, and in 2022, we received FDA approval for additional magnetic resonance imaging ("MRI") scan conditions for use with Inspire therapy. This full-body MRI approval expands the Inspire use labeling that previously allowed only head, neck, and extremity MRI scans. Also in 2022, the FDA approved silicone-based stimulation and sensing leads, which provides improved manufacturability, easier system implantation, increased long-term performance, and enhanced reliability.

Our direct-to-consumer marketing includes the use of social media platforms such as Facebook, Google ad placements, and radio and television commercials. In January 2022, we purchased our first national television advertising spots and began airing new TV commercials, and in March 2023, we began airing additional new television commercials. The objective of this outreach is to bring patients to our website, where they can find educational materials and videos on sleep apnea and the use and benefits of our Inspire therapy, contact information for physicians and clinical sites, and information regarding community awareness events. Further, our team leverages the Inspire Sleep app for patient education. We expect to maintain or increase our level of direct-to-consumer activities.

We have a call center which we refer to as the Inspire Advisor Care Program ("ACP"). The primary purpose of this program is to assist patients with making a connection with a qualified healthcare provider based on their specific needs. In 2022, we initiated a digital scheduling pilot program to facilitate and streamline patient access to care. We plan to continue to expand this scheduling capability during the remainder of 2023 and 2024.

We also continue to make significant investments to build our sales and marketing organization by increasing the number of U.S. and European sales representatives and continuing our direct-to-consumer marketing efforts in existing and new markets throughout the U.S. and in Europe. During the three months ended September 30, 2023, we created 13 new U.S. sales territories, bringing the total to 274 U.S. territories as of September 30, 2023. During that same period, we activated 62 new centers, bringing the total to 1,107 U.S. medical centers implanting Inspire therapy as of September 30, 2023. At both of September 30, 2023 and December 31, 2022, ASCs made up 23% of our total U.S. implanting centers.

During 2023, glucagon-like peptide 1 ("GLP-1s"), a class of drug indicated for diabetes and obesity, continued to gain popularity as a weight-loss drug. OSA is a multifactorial disease with many independent factors including age, gender, weight, and neck circumference. Inspire is designed to address anteroposterior airway collapse, also known as tongue-based collapse. Patients with a higher BMI are subject to a larger neck circumference and present predominantly with lateral-wall collapse. A combination of tongue-based collapse and lateral-wall collapse is identified as a complete concentric collapse of the upper airway which is detected during a DISE procedure. Inspire is contraindicated for complete concentric collapse. While weight loss may help reduce a patient’s Apnea-Hypopnea Index and other OSA symptoms, we have seen from numerous studies that weight loss alone will not resolve OSA for the vast majority of patients. We expect GLP-1s will help patients address their lateral wall collapse, potentially bringing them into our indication. As shown in our ongoing ADHERE patient registry, the average BMI of patients treated with Inspire therapy is 29 and the American Academy of Sleep Medicine guidelines recommend weight loss prior to surgery for patients with BMI over 35 and nonsurgical solutions for patients with BMI over 40. Therefore, there is not a significant overlap in in the Inspire patient population with the GLP-1s today. While we cannot quantify the impact, we believe that there could be a benefit to our business as a result of the GLP-1s, although there can be no assurance of such benefit.

Because of these and other factors, we may incur net losses for the next several years and require substantial additional funding, which may include future equity and debt financings.

Macroeconomic Environment

The global economy is experiencing increased inflationary pressures in part due to global supply chain disruptions, labor shortages, and other impacts from COVID-19 and the current macroeconomic environment which we anticipate will continue. Higher interest rates and capital costs, higher shipping costs, increased costs of labor, international conflicts and terrorism, and weakening foreign currency exchange rates are creating additional economic challenges. These conditions may cause our customers to decrease or delay orders for our products.

Our operations have been adversely impacted by the inflationary pressures primarily related to labor, raw materials, and component parts. Our inventory on-hand has been constrained by the continuing supply chain challenges and component shortages, although the supply chain constraints eased somewhat throughout 2023. As mentioned above, the delay on EU MDR approval of our silicone-based leads and the shortage of polyurethane-based stimulation leads may cause delays to implant procedures and a reduction in our European revenue.

COVID-19 Update

Our business, operations, and financial condition and results have been and may continue to be impacted by COVID-19. During the first quarter of 2022, resurgences of COVID-19 in various U.S. and international regions impacted our revenue slightly, although surgical volumes had generally returned to pre-pandemic levels by the end of the first quarter, and therefore the impact on the remainder of 2022 was less significant. As discussed above, we have also experienced, and continue to experience, COVID-19-related supply chain issues which has negatively impacted our inventory levels. The extent to which COVID-19 continues to impact our results of operations and financial condition will depend on future developments that are highly uncertain and cannot be predicted, including new information that may emerge concerning the severity and longevity of COVID-19 and its variants, the resurgence of COVID-19 in regions that have begun to recover from the initial impact of the pandemic, the impact of COVID-19 on economic activity, and the actions to contain its impact on public health and the global economy.

Components of Our Results of Operations

Revenue

We derive primarily all of our revenue from the sale of our Inspire system to hospitals and ASCs in the U.S., select countries in Europe, Japan, Singapore, and Hong Kong. We recognize revenues from sales of our Inspire system when the customer obtains control of the product, which occurs at a point in time, either upon shipment of the product or receipt of the product, depending on shipment terms.

Our revenue has fluctuated, and may continue to fluctuate, from quarter to quarter due to a variety of factors. For example, we have historically experienced seasonality in our first and fourth quarters and have experienced adverse impacts on our revenue due to the COVID-19 pandemic and foreign currency exchange rates. In addition, in the three months ended September 30, 2023, we believe our revenue growth was adversely impacted by certain changes to our prior authorization support, as well as lack of ENT surgeon capacity. While we believe the impact of the prior authorizations support has improved, the ENT surgeon capacity challenges remain. If such impacts continue, our revenue growth may be further adversely impacted.

Our business has grown rapidly in recent years, resulting in substantially increased revenues, and we expect that our business will continue to grow. However, our revenue growth rate has generally declined recently, and it may continue to do so as a result of the difficulty of maintaining growth rates as our revenues increase to higher levels.

Cost of Goods Sold and Gross Margin

Cost of goods sold consists primarily of acquisition costs for the components of the Inspire system, overhead costs, scrap, and inventory obsolescence, warranty replacement costs, as well as distribution-related expenses such as logistics and shipping costs, net of shipping costs charged to customers. The overhead costs include the cost of material procurement, depreciation expense for production equipment, and operations supervision and management personnel, including employee compensation, stock-based compensation, supplies, and travel. We expect cost of goods sold to increase or decrease in absolute dollars primarily as, and to the extent, our revenue grows or declines, respectively.

We calculate gross margin as gross profit divided by revenue. Our gross margin has been and we expect it will continue to be affected by a variety of factors, including manufacturing costs, the average selling price of our Inspire system, the implementation of cost-reduction strategies, inventory obsolescence costs, which generally occur when new generations of our Inspire system are introduced, and to a lesser extent the sales mix between the U.S. and countries outside of the U.S., as our average selling price in the U.S. tends to be higher than in other countries. Our gross margin may increase slightly to the extent our production volumes increase and we receive discounts on the costs charged by our contract manufacturers, thereby reducing our per unit costs, and when we implement price increases on our products, thereby increasing our revenue. On the other hand, our gross margin may decrease slightly to the extent our yields decrease, or materials and labor prices increase due to supply chain issues and inflation, thereby increasing our per unit costs. However, our gross margin may also fluctuate from quarter to quarter due to seasonality and foreign currency exchange rates.

Our gross margin in the second half of 2022 was lower than in previous periods primarily due to inventory obsolescence charges associated with product introductions, additional costs associated with the transition of manufacturing lines to produce our new silicone-based leads, and higher costs of certain component parts which were impacted by inflation and supply chain issues. In 2023, we expect gross margins to be in the range of 83% to 85%.

Research and Development Expenses

Research and development expenses consist primarily of product development, engineering, clinical studies to develop and support our products, regulatory expenses, quality assurance, testing, consulting services, prelaunch inventory, and other costs associated with the next generation versions of the Inspire system. These expenses include employee compensation, including stock-based compensation, supplies, materials, consulting, and travel expenses related to research and development programs. Additionally, these expenses include clinical study management, payments to clinical investigators, data management and travel expenses for our various clinical studies.

We expense prelaunch inventory as research and development expense in the period incurred unless objective and persuasive evidence exists that regulatory approval and subsequent commercialization of a product candidate is probable and we also expect future economic benefit from the sales of the product candidate to be realized.

We expect research and development expenses to increase in the future as we develop next generation versions of our Inspire system and continue to expand our clinical studies to further expand positive coverage policies from private commercial payors in the U.S. and enter into new markets including additional European countries and the Asia Pacific region. We expect research and development expenses as a percentage of revenue to vary over time depending on the level and timing of initiating new product development efforts and new clinical development activities.

Selling, General and Administrative Expenses

Selling, general and administrative ("SG&A") expenses consist primarily of compensation for personnel, including base salaries, stock-based compensation expense and commissions related to our sales organization, finance, information technology, human resource, and legal functions, as well as spending related to marketing, sales operations, and training and reimbursement personnel. Other SG&A expenses include training physicians, travel expenses, advertising, direct-to-consumer promotional programs, conferences, trade shows and consulting services, professional services fees, audit fees, insurance costs and general corporate expenses, including facilities-related expenses.

We expect SG&A expenses to continue to increase as we expand our commercial infrastructure to both drive and support our planned growth in revenue and as we increase our headcount and expand administrative personnel to support our growth and operations as a public company including finance personnel and information technology services. Additionally, we anticipate an increase in our stock-based compensation expense with grants of stock options, restricted stock units, performance stock units, and shares of our common stock purchased pursuant to our employee stock purchase plan.

Other (Income) Expense

Other (income) expense consists primarily of interest and dividend income, interest expense under our former credit facility, the impacts of foreign currency transactions and remeasurements, and gains and losses on investments.

Seasonality

Historically, we have experienced seasonality in our first and fourth fiscal quarters, and we expect this trend to continue. In the U.S., we have experienced, and may in the future experience, higher sales in the fourth quarter as a result of patients having paid their annual insurance deductibles in full, thereby reducing their out-of-pocket costs. Conversely, in the first quarter, many U.S. patients' insurance deductibles reset, requiring more out-of-pocket costs, which negatively impacts our sales during this period.

Results of Operations

(in thousands, except percentages)

Comparison of the Three Months Ended September 30, 2023 and 2022

Revenue

Revenue increased $44.1 million, or 40.4%, to $153.3 million for the three months ended September 30, 2023 compared to $109.2 million for the three months ended September 30, 2022. These results reflect an increase in sales of our Inspire system of $41.2 million in the U.S. and an increase of $2.9 million outside of the U.S. Overall revenue growth was primarily due to increased utilization, increased market penetration in existing territories, expansion into new territories, increased physician and patient awareness of our Inspire system, and to a lesser extent, a list price increase that began to impact some U.S. customers in May 2022, partially offset by the factors described under "Components of our Results of Operations - Revenue" above.

Revenue information by region is summarized as follows:

(in thousands, except percentages)

Revenue generated in the U.S. was $147.5 million for the three months ended September 30, 2023, an increase of $41.2 million, or 38.8%, compared to the three months ended September 30, 2022. Overall revenue growth was primarily due to increased utilization, increased market penetration in existing territories, expansion into new territories, increased physician and patient awareness of our Inspire system, and to a lesser extent, a list price increase that began to impact some U.S. customers in May 2022.

Revenue generated outside of the U.S. was $5.8 million in the three months ended September 30, 2023, an increase of $2.9 million, or 99.0%, compared to the three months ended September 30, 2022. Revenue growth was primarily due to increased market penetration in existing territories, the expansion of our European sales representatives into new territories, increased sales in the Asia Pacific region, and, we believe, increased physician and patient awareness of our Inspire system.

Cost of Goods Sold and Gross Margin

Cost of goods sold increased $4.6 million, or 23.2%, to $24.4 million for the three months ended September 30, 2023 compared to $19.8 million for the three months ended September 30, 2022. The increase was primarily due to product costs associated with higher sales volume of our Inspire system and additional costs associated with an isolated production issue at a supplier which has since been resolved.

Gross margin increased to 84.1% for the three months ended September 30, 2023 from 81.9% for the three months ended September 30, 2022. Gross margin for the three months ended September 30, 2023 was higher primarily due to $2.8 million of inventory obsolescence charges taken during the third quarter of 2022 associated with new product introductions, which lowered the gross margin during that period.

Research and Development Expenses

Research and development expenses increased $8.2 million, or 38.8%, to $29.1 million for the three months ended September 30, 2023 compared to $21.0 million for the three months ended September 30, 2022. This change was primarily due to an increase of $3.9 million of compensation and employee-related expenses, mainly as a result of increased headcount and stock-based compensation expense. The change also includes an increase of $4.6 million for incremental ongoing research and development costs, including ongoing development of the SleepSync™ platform, the next generation Inspire neurostimulator and physician programmer, and $1.7 million of prelaunch inventory related to our next generation Inspire neurostimulator. These increases were partially offset by a decrease of $0.3 million for clinical and regulatory submissions expenses.

Selling, General and Administrative Expenses

SG&A expenses increased $27.6 million, or 32.3%, to $113.2 million for the three months ended September 30, 2023 compared to $85.6 million for the three months ended September 30, 2022. The primary driver of this change was an increase of $16.3 million in compensation, including salaries, commissions, stock-based compensation, and other employee-related expenses, mainly as a result of increased headcount. In addition, marketing expenses increased $7.0 million, primarily consisting of direct-to-consumer initiatives, including new national TV advertisements, which began airing in the first quarter of 2023, and the expansion of our ACP call center. Other drivers of the change to SG&A expenses included an increase in travel expenses of $1.4 million and an increase in general corporate costs of $2.9 million primarily due to consulting fees, legal fees, bank fees, and rent expense.

Other (Income) Expense

Other (income) expense changed by $4.7 million, or 788.9%, to $5.3 million of income, net for the three months ended September 30, 2023 compared to $0.6 million of expense, net for the three months ended September 30, 2022. The change was primarily due to an increase of $4.1 million in interest and dividend income due to higher interest rates on our higher cash, cash equivalents, and investment balances, a decrease of $0.7 million in interest expense due to the August 2022 early termination of our credit facility, and an increase of $0.1 million in foreign currency translation and remeasurement losses due to exchange rates.

Income Taxes

We recorded a provision for incomes taxes of approximately $0.3 million and $0.2 million for the three months ended September 30, 2023 and September 30, 2022, respectively.

Comparison of the Nine Months Ended September 30, 2023 and 2022

Revenue

Revenue increased $162.3 million, or 60.1%, to $432.3 million for the nine months ended September 30, 2023 compared to $270.0 million for the nine months ended September 30, 2022. The increase was attributable to a $156.2 million increase in sales of our Inspire system in the U.S and an increase of $6.2 million outside of the U.S. Overall revenue growth was primarily due to increased market penetration in existing territories, expansion into new territories, and increased physician and patient awareness of our Inspire system, and to a lesser extent, a list price increase that began to impact some customers in May 2022, partially offset by the factors described under "Components of our Results of Operations - Revenue" above.

Revenue information by region is summarized as follows:

(in thousands, except percentages)

Revenue generated in the U.S. was $416.7 million for the nine months ended September 30, 2023, an increase of $156.2 million, or 59.9%, compared to the nine months ended September 30, 2022. Revenue growth in the U.S. was primarily due to increased market penetration in existing territories, the expansion into new territories, and, we believe, increased physician and patient awareness of our Inspire system, and to a lesser extent, a list price increase that began to impact some U.S. customers in May 2022. As noted above, U.S. revenue during the three months ended March 31, 2022 was slightly negatively impacted by COVID-19.

Revenue generated outside of the U.S. was $15.5 million for the nine months ended September 30, 2023, an increase of $6.2 million, or 65.8%, compared to the nine months ended September 30, 2022. Revenue growth was primarily due to increased market penetration in existing territories, the expansion of our European sales representatives into new territories, increased sales in the Asia Pacific region, and, we believe, increased physician and patient awareness of our Inspire system. As noted above, revenue generated outside the U.S. during the three months ended March 31, 2022 was slightly negatively impacted by COVID-19.

Cost of Goods Sold and Gross Margin

Cost of goods sold increased $24.6 million, or 55.9%, to $68.5 million for the nine months ended September 30, 2023 compared to $44.0 million for the nine months ended September 30, 2022. The increase was primarily due to product costs associated with higher sales volume of our Inspire system, additional costs associated with the transition of manufacturing lines to produce our new silicone-based leads, and higher costs of certain component parts that were impacted by inflation and supply chain issues.

Gross margin increased to 84.1% for the nine months ended September 30, 2023 from 83.7% for the nine months ended September 30, 2022. Gross margin for the nine months ended September 30, 2023 was higher primarily due to $2.8 million of inventory obsolescence charges taken during the third quarter of 2022 associated with new product introductions, which lowered the gross margin during that period. Gross margin for the nine months ended September 30, 2023 was negatively impacted by additional manufacturing costs of sensors and lower yields prior to process enhancements, additional costs associated with an isolated production issue at a supplier, and higher costs of certain component parts, partially offset by the price increase that began taking effect for some U.S. customers in May 2022.

Research and Development Expenses

Research and development expenses increased $38.1 million, or 80.4%, to $85.5 million for the nine months ended September 30, 2023 compared to $47.4 million for the nine months ended September 30, 2022. This change was primarily due to an increase of $21.0 million of incremental ongoing research and development costs, including ongoing development of the SleepSync™ platform, the next generation Inspire neurostimulator and physician programmer. The change also includes an increase of $17.1 million of compensation and employee-related expenses, mainly as a result of increased headcount and stock-based compensation expense, and $4.7 million of prelaunch inventory related to our next generation Inspire neurostimulator.

Selling, General and Administrative Expenses

SG&A expenses increased $102.0 million, or 45.2%, to $327.9 million for the nine months ended September 30, 2023 compared to $225.9 million for the nine months ended September 30, 2022. The primary driver of this change was an increase of $59.1 million in compensation, including salaries, commissions, stock-based compensation, and other employee-related expenses, mainly as a result of increased headcount. In addition, marketing expenses increased $28.5 million, primarily consisting of direct-to-consumer initiatives, including new national TV advertisements, which began airing in March 2023, and the expansion of our Advisor Care Program call center. Other drivers of the change to SG&A expenses included an increase in travel expenses of $6.3 million and an increase in general corporate costs of $8.1 million primarily due to bank fees, consulting fees, legal fees, computer equipment and software, and office rent expense.

Other (Income) Expense, Net

Other (income) expense, net changed by $14.7 million, to $14.4 million of income, net for the nine months ended September 30, 2023 compared to $0.3 million of expense for the nine months ended September 30, 2022. This change was primarily due to an increase of $13.0 million in interest and dividend income due to higher interest rates on our higher cash, cash equivalents and investment balances, somewhat offset by a decrease of $1.7 million in interest expense due to the early termination of our credit facility.

Income Taxes

We recorded a provision for income taxes of $0.8 million and $0.5 million for the nine months ended September 30, 2023 and September 30, 2022, respectively.

Liquidity and Capital Resources

As of September 30, 2023, we had cash, cash equivalents, and available-for-sale debt securities of $467.2 million, an increase of $15.8 million from $451.4 million as of December 31, 2022. Working capital totaled $499.6 million as of September 30, 2023, an increase of $30.8 million from December 31, 2022. We define working capital as current assets less current liabilities. The increase in working capital was primarily due to the following factors:

• an increase of $124.5 million in short-term investments;
• an increase of $14.2 million in inventory balances which increased as supply chain issues ease;
• an increase of $10.2 million in accounts receivable due to higher sales which occurred during the third quarter of 2023;
• a decrease of $4.4 million in accrued expenses which decreased primarily due to the payment of year-end bonuses and commissions; and
• an increase of $2.3 million in prepaid expense and other current assets which increased primarily due to prepaid insurance and other prepaid expenses.

The increase in working capital was partially offset by the following factors:

• a $111.7 million decrease in cash and cash equivalents, primarily due to the purchase of short- and long-term available for sale investments, offset somewhat by sales of the Inspire system and proceeds from the exercise of stock options; and
• a $13.2 million increase in accounts payable, generally due to our business volume and headcount growth from the prior year.

We proactively manage our access to capital to support liquidity and continued growth. Our sources of capital include sales of our Inspire system and registered offerings of our common stock. In August 2022, we completed a follow-on offering that included our offer and sale of 1,150,000 shares of common stock at a public offering price of $215.00 per share. We received net proceeds of approximately $243.8 million after deducting underwriting discounts, commissions, and offering expenses. During the quarter ended September 30, 2022, we repaid all amounts outstanding under our former credit facility. See Note 4 in this Quarterly Report on Form 10-Q for additional information on our previous credit facility.

The primary objective of our investment activities is to preserve our capital for the purpose of funding operations while at the same time maximizing the income we receive from our investments without significantly increasing risk or decreasing availability. To achieve these objectives, our investment policy allows us to maintain a portfolio of certain types of debt securities issued by the U.S. government and its agencies, corporations with investment-grade credit ratings, or commercial paper and money market funds issued by the highest quality financial and non-financial companies. At September 30, 2023, we had $284.4 million in money market funds, $99.3 million in U.S. government securities, and $40.9 million in corporate debt securities, certificates of deposit, and asset-asset-backed securities. See Note 2 in this Quarterly Report on Form 10-Q for additional information on our investments.

In the nine months ended September 30, 2023, our R&D and SG&A expenditures increased significantly over the prior year levels, and we anticipate further increases during the remainder of 2023 and 2024. Our SG&A expenditures, primarily for increasing headcount and advertising, may exceed any associated increases in revenues, and therefore would reduce our cash flow from operations. We also anticipate R&D expenses will continue to be significant in 2023 and 2024, primarily related to the ongoing development of the SleepSync™ platform and the next generation Inspire neurostimulator.

We spent $15.6 million on purchases of property and equipment in the nine months ended September 30, 2023, mainly on testing systems and production equipment for our next generation Inspire system as well as our SleepSync™ platform. We anticipate further capital expenditures in 2023 and 2024, primarily for additional production equipment and, to a lesser extent, leasehold improvements on our corporate office buildings.

As of September 30, 2023, we did not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.

We believe that our existing cash and cash equivalents and investments, which totaled $467.2 million as of September 30, 2023, together with cash flow from operations, will provide liquidity sufficient to meet our cash needs and fund our operations and planned capital expenditures for at least the next 12 months. There can be no assurance, however, that our business will continue to generate cash flows at the same levels achieved in prior periods.

Beyond the next 12 months, our cash requirements will depend extensively on the timing of market introduction, and extent of market acceptance of, our Inspire system. Our long-term cash requirements also will be significantly impacted by the level of our investment in commercialization, entry and expansion into new markets such as Hong Kong and Australia, whether we make strategic acquisitions, and competition. We cannot accurately predict our long-term cash requirements at this time. An extended period of global supply chain and economic disruption could materially affect our business, results of operations, access to sources of liquidity, and financial condition. We may seek additional sources of liquidity and capital resources through additional securities offerings or through borrowings under a new credit facility. There can be no assurance that such transactions will be available to us on favorable terms, if at all.

Cash Flows

The following table presents a summary of our cash flow for the periods indicated:

(in thousands)

Operating Activities

The net cash provided by operating activities was $7.4 million for the nine months ended September 30, 2023 and consisted of a net loss of $35.9 million, non-cash charges of $64.2 million, and a decrease in net operating assets of $20.9 million. The non-cash charges consisted primarily of stock-based compensation, which increased mainly as a result of granting more stock options, restricted stock units, and performance stock units to a greater number of employees at a higher fair market value. The remainder of the non-cash charges included depreciation and amortization expense, non-cash lease expense, stock issued for services rendered, and other, net. Operating assets include inventories, which increased as supply chain constraints eased, and prepaid expenses and other current assets, which increased primarily due to prepaid insurance and other prepaid expenses. Operating assets also include accounts receivable, which increased due to higher sales volume. Operating liabilities include accounts payable, which increased generally due to our increased business volume year-over-year and the costs to support the growth of our operations, and accrued expenses, which decreased primarily due to the payment of year-end bonuses and commissions.

The net cash used in operating activities was $7.7 million for the nine months ended September 30, 2022 and consisted of a net loss of $48.0 million, non-cash charges of $38.7 million, and a decrease in net operating assets of $1.6 million. The non-cash charges consisted primarily of stock-based compensation, which increased mainly as a result of granting more stock options and restricted stock to a greater number of employees at a higher fair market value, as well as the introduction of performance stock unit grants. The remainder of the non-cash charges included depreciation and amortization, non-cash lease expense, stock issued for services rendered, and other, net. Operating assets include accounts receivable which increased due to higher sales, and prepaid expenses and other current assets which increased primarily due to prepaid insurance. Operating assets also include inventories, which decreased primarily due to sales demand. Operating liabilities include accounts payable, which increased generally due to our increased business volume year-over-year and the costs to support the growth of our operations, and accrued expenses, which increased primarily due to compensation and personnel-related costs and the accrual of R&D and inventory related costs.

Investing Activities

Net cash used in investing activities for the nine months ended September 30, 2023 was $143.1 million and consisted primarily of the purchase of investments of $137.3 million, the purchases of property and equipment of $15.6 million, and the purchase of strategic investments of $0.3 million, partially offset by the proceeds from sales or maturities of investments of $10.0 million.

Net cash used in investing activities for the nine months ended September 30, 2022 was $16.6 million and consisted of purchases of property and equipment of $6.1 million and the purchase of strategic investments of $10.5 million.

Financing Activities

Net cash provided by financing activities was $24.1 million for the nine months ended September 30, 2023 and consisted of $24.5 million in proceeds from the exercise of stock options and $2.8 million in proceeds from the issuance of common stock from our ESPP, somewhat offset by $3.2 million of taxes paid on net share settlement of RSUs.

Net cash provided by financing activities was $227.8 million for the nine months ended September 30, 2022 and consisted primarily of proceeds from the offering of common stock of $243.8 million, as well as proceeds from the exercise of stock options of $6.4 million, and proceeds from the issuance of common stock from our ESPP of $2.1 million, partially offset by $24.5 million in payments on our long-term debt obligation, which we prepaid in August 2022, and less than $0.1 million of taxes paid to net share settlement of RSUs.

Contractual Obligations and Commitments

There have been no material changes to our short-term and long-term anticipated cash requirements under contractual obligations, other than as described in Note 3 in this Quarterly Report on Form 10-Q, from those described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022.

Critical Accounting Policies and Estimates

Our critical accounting policies and estimates are described in "Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022. Other than the addition of prelaunch inventory described in Note 2 in this Quarterly Report on Form 10-Q and below, no material changes were made to our critical accounting policies from those disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022.

Prelaunch inventory

We capitalize prelaunch inventory prior to receiving regulatory approval if regulatory approval and subsequent commercialization of a product is probable and we also expect future economic benefit from the sales of the product to be realized. Prior to this, we expense prelaunch inventory as research and development expense in the period incurred. For prelaunch inventory that is capitalized, we consider a number of specific facts and circumstances, including the product’s historical shelf life, the product's current status in the development and regulatory approval process, results from related clinical trials, results from meetings with relevant regulatory agencies prior to the filing of regulatory applications, potential obstacles to the approval process, historical experience, viability of commercialization and market trends. If either the regulatory approval or market acceptance post-approval do not occur at all or on a timely basis prior to the inventory shelf-life expiration, we may be required to write-off some or all prelaunch inventory, which could affect our financial condition and financial results.

Recent Accounting Pronouncements

We have reviewed all recently issued standards and have determined that such standards will not have a significant impact on our consolidated financial statements or do not otherwise apply to our operations.

Interest Rate Risk

The risk associated with fluctuating interest rates is primarily limited to our cash equivalents which are carried at quoted market prices and our short-term investments. We do not currently use or plan to use financial derivatives in our investment portfolio. A hypothetical 1% increase in interest rates during the nine months ended September 30, 2023 would have impacted interest income on our consolidated financial statements by approximately $16.2 million.

Credit Risk, Foreign Currency Risk, and Inflation Risk

For market risks related to changes in credit, foreign currency, and inflation, reference is made to Item 7A “Quantitative and Qualitative Disclosures About Market Risk” contained in Part II of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022. Our exposure to these risks has not materially changed from those disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022, other than as described below.

As of September 30, 2023 and December 31, 2022, our cash, cash equivalents, and investments were maintained with financial institutions which we believe have sufficient assets and liquidity to conduct their operations in the ordinary course of business with little or no credit risk to us, however our cash balances were in excess of insured limits. Market conditions can impact the viability of where our cash is held. In the event of failure of any of the financial institutions where we maintain our cash and cash equivalents, there can be no assurance that we will be able to access uninsured funds in a timely manner or at all.

Evaluation of disclosure controls and procedures

The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, refers to controls and other procedures that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and our management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our management, with the participation of our chief executive officer and our chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our chief executive officer and our chief financial officer concluded that our disclosure controls and procedures were effective, at the reasonable assurance level, as of the end of the period covered by this Quarterly Report on Form 10-Q.

Changes in internal control over financial reporting.

There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

For a discussion of our potential risks and uncertainties, see the information in "Part I, Item IA. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022. There have been no material changes to the risk factors disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022, other than the following:

We may not receive the necessary approvals or certifications for our future products or expanded indications, and failure to timely obtain necessary approvals or certifications for our future products or expanded indications would adversely affect our ability to grow our business.

An element of our strategy is to continue to upgrade our products, add new features and expand the indications and uses for our current products. In the U.S., before we can market a new medical device, or a new use of, or claim for, or significant modification to, an existing product, we must first receive PMA from the FDA. In the process of obtaining PMA, which was required for our Inspire system, the FDA must determine that a proposed device is safe and effective for its intended use based, in part, on extensive data, including, but not limited to, technical, pre-clinical, clinical study, manufacturing and labeling data. The PMA process is typically required for devices that are deemed to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices.

Modifications to products that are approved through a PMA application generally require FDA approval. PMA can be expensive, lengthy and uncertain. The process of obtaining a PMA is costly and more uncertain than the 510(k) clearance process used for lower risk devices. Despite the time, effort and cost, a device may not be approved by the FDA. Any delay or failure to obtain necessary regulatory approvals could harm our business. Furthermore, even if we are granted regulatory approval, it may include significant limitations on the indicated uses for the device, which may limit the market for the device.

The FDA and other regulatory authorities or notified bodies outside the U.S. can delay, limit or deny approval or certification of a device for many reasons, including:

• our inability to demonstrate to the satisfaction of the FDA or the applicable foreign regulatory entity or notified body that our products are safe or effective for their intended uses;
• the disagreement of the FDA or the applicable foreign regulatory authority or notified body with the design or implementation of our clinical studies or the interpretation of data from pre-clinical studies or clinical studies;
• serious and unexpected adverse device effects experienced by participants in our clinical studies;
• the data from our pre-clinical studies and clinical studies may be insufficient to support approval or certification, where required;
• our inability to demonstrate that the clinical and other benefits of the device outweigh the risks;
• the manufacturing process or facilities we use may not meet applicable requirements; and
• the potential for approval policies or regulations of the FDA or applicable foreign regulatory authorities to change significantly in a manner rendering our clinical data or regulatory filings insufficient for clearance, approval or certification.

In addition, the FDA or other regulatory authorities or notified bodies outside the U.S. may change their approval or certification policies, adopt additional regulations or revise existing regulations, or take other actions, which may prevent or delay approval or certification of our future products under development or impact our ability to modify our currently cleared or certified products on a timely basis. Such policy or regulatory changes could impose additional requirements or time delays upon us that could delay our ability to obtain new approvals or certifications, increase the costs of compliance, adversely impact our revenues or inventory forecasting or restrict our ability to maintain our current approval or certification.

Subject to the transitional provisions, in order to sell our products in EU member states, our products must comply with the general safety and performance requirements of the EU Medical Devices Regulation, which repeals and replaces EU Medical Devices Directive and the AIMDD. Compliance with these requirements is a prerequisite to be able to affix the European Conformity (“CE”) mark to our products, without which they cannot be sold or marketed in the EU. To demonstrate compliance with the general safety and performance requirements, we must undergo a conformity assessment procedure, which varies according to the type of medical device and its (risk) classification. Except for low risk medical devices (Class I), where the manufacturer can self-assess the conformity of its products with the general safety and performance requirements (except for any parts which relate to sterility, metrology or reuse aspects), a conformity assessment procedure requires the intervention of a notified body. The notified body would typically audit and examine the technical file and the quality system for the manufacture, design and final inspection of our devices. If satisfied that the relevant product conforms to the relevant general safety and performance requirements, the notified body issues a certificate of conformity, which the manufacturer uses as a basis for its own declaration of conformity. The manufacturer may then apply the CE mark to the device, which allows the device to be placed on the market throughout the EU. If we fail to comply with applicable laws and regulations, we would be unable to affix the CE mark to our products, which would prevent us from selling them within the EU. The aforementioned EU rules are generally applicable in the EEA, and non-compliance with the above requirements would also prevent us from selling our products in these three countries.

Once devices are certified under the EU Medical Devices Regulation, we must inform the notified body that carried out the conformity assessment of the medical devices that we market or sell in the EU and the EEA of any planned substantial changes to our quality system or substantial changes to our medical devices that could affect compliance with the general safety and performance requirements laid down in Annex I to the EU Medical Devices Regulation or cause a substantial change to the intended use for which the device has been CE marked. The notified body will then assess the planned changes and verify whether they affect the products’ ongoing conformity with the EU Medical Devices Regulation. If the assessment is favorable, the notified body will issue a new certificate of conformity or an addendum to the existing certificate attesting compliance with the general safety and performance requirements and quality system requirements laid down in the Annexes to the EU Medical Devices Regulation. The notified body may disagree with our proposed changes or take more time than anticipated to review and assess applications resulting in regulatory delays (See Part I., "Item 1A. Risk Factors — Risks Related to Government Regulation” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022 for additional information regarding disruptions faced by notified bodies). As a consequence, product introductions or modifications could be delayed or canceled, which could adversely affect our ability to grow our business. For example, we applied for certification of silicone-based leads under the EU Medical Devices Regulation in December 2021 in order to replace the polyurethane-based leads, two components of the Inspire system currently used only in the European market. However, designated notified bodies currently have severe capacity constraints, and review times have lengthened significantly, including for our certification application. We forecasted our polyurethane-based leads inventory based on our notified body’s original lead-time for certification of the silicone-based leads, and we now expect to obtain certification of our silicone-based leads in the first quarter of 2024. Because of these unanticipated delays, we began experiencing an inventory issue related to our polyurethane-based stimulation leads during the third quarter of 2023. In the interim, we received a derogation from the Dutch national competent authority allowing us to place the silicone-based leads on the market until April 1, 2024 or until we receive certification under the EU Medical Devices Regulation, whichever occurs first. We are also pursuing similar derogations in several other EU member states. However, such derogations are only granted at the national level, and we cannot be certain that national competent authorities of the other EU member states will grant a derogation similar to the Dutch authority. Until we obtain certification under the EU Medical Devices Regulation or these derogations are received, we may only sell our polyurethane-based leads in the EU where the stimulation lead is in low supply. During the fourth quarter of 2023 and possibly extending into early 2024, we expect that the delay in certification and the shortage of polyurethane-based stimulation leads may cause delays to implant procedures which may adversely affect our business in the EU, including a reduction in our European and, thereby, our consolidated revenue.