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Eargo Inc. (NASDAQ:EAR)
Q4 2020 Earnings Call
Feb 25, 2021, 4:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Eargo fourth-quarter 2020 earnings conference call. [Operator instructions] As a reminder, today's program may be recorded. I would now like to introduce your host for today's program, Nick Laudico, vice president of investor relations. Please go ahead.

Nick Laudico -- Vice President, Investor Relations

Good afternoon, everyone, and welcome to the Eargo fourth-quarter and full-year 2020 earnings conference call. The press release and slides to accompany this call are available under investor relations website at ir.eargo.com. As a reminder, both this live call and the 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.

Christian and Adam will provide prepared remarks, and then we will open the call to the Q&A. Before we begin, I'd like to remind you that some of the matters discussed in this conference call will contain forward-looking statements regarding future events as outlined in our slides. We wish to caution you that such statements are based on management's current expectations and beliefs and 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 materially include, but are not limited to, some factors referenced in our press release today follows our filings with the SEC.

We will also be discussing certain non-GAAP financial results on today's call. Please refer to today's press release and slide deck for a full GAAP to non-GAAP reconciliation. With that said, I will now turn the call over to Christian.

Christian Gormsen -- President and Chief Executive Officer

Thank you, Nick, and good afternoon, everyone. We're very pleased with our fourth-quarter and full-year 2020 performance, which caps off a truly incredible year for Eargo. On that note, I would like to thank all of my colleagues at Eargo for their focus and execution despite the challenging circumstances for everyone. Thank you.

Given that we preannounced our fourth-quarter 2020 net revenues and gross systems shipped, I will summarize the drivers of that performance and then turn it over t Adam, who will provide a more detailed review of our fourth-quarter financial performance and then provide full-year 2021 guidance. Starting on Slide 5. We delivered fourth-quarter net revenue growth of approximately 111%, gross systems shipped growth of approximately 68% and a return accrual rate of approximately 24%, down nearly 10 points year over year. Revenue and volume growth in the fourth quarter were driven by several factors.

First, and as expected, we saw increased consumer demand during the holiday buying season. The typical increase in interest around the holidays was magnified by our broader media reach, combined with the sheer scale of online shopping in the U.S. Our broader media reach was driven by strong performance of our national TV advertising, which we believe continues to succeed, at large, because of our differentiated focus on creativity and empowering messaging compared to others in the hearing aid space. As expected, TV advertising rates came down from their peaks during the presidential election.

As we saw the rates decline to more normalized levels, we ramped media spend accordingly. Combined with holiday promotions, their efforts drove high-quality needs and inbound calls. Increased national advertising also attracted an increased number of insurance customers, enabling continued penetration of a large, fast-growing and mostly untapped segment of the hearing aid market. As a reminder, we typically target insurance customers with call-outs on our national advertising, building awareness that consumers may be eligible for hearing aid at low or no cost.

However, the magnitude of insurance orders we received as a result of holiday advertising was ahead of our expectations, particularly in a quarter that is seasonally more cash pay-weighted. And lastly, the consumer adoption of hearing aids and receiving clinical support online continued to increase. If 2020 has taught us anything, it's that telecare is here to stay. We are excited to lead the hearing aid industry and the growing shift of consumer preferences.

We believe Eargo has the most established telecare support and service infrastructure in the hearing industry, built through over three years of interactions with the consumer and a real-time feedback loop that we constantly use to improve the user experience. We are committed to further investing in telecare clinical support to better help our customers solve for their hearing loss and further increase is important competitive advantage. Moving to Slide 6. As we've stated, we've developed the Eargo business model to grow at the lowest cost of customer acquisition possible.

We are incredibly pleased with the extent to which we diversified our customer base in 2020 from largely a cash pay business to one with a healthy mix of insurance and repeat customers, all largely driven by the same media. Insurance and repeat customers generally convert at higher rates and return at lower rates, which has the multiplying benefit of driving up net revenue growth while driving down our overall cost of customer acquisition. Looking specifically at our insurance opportunity, we believe there are approximately 12 million adults in the U.S. over 50, who have both hearing loss and access to hearing aid benefits under certain health insurance plans.

We are currently targeting approximately 1.3 million of that total and have only scratched the surface of that market opportunity. As of December 31, 2020, our insurance customer installed base represents approximately 1% of our current addressable insurance market, providing what we believe is a multiyear runway for continued efficient growth. Let me now turn it over to Adam for his review of our financial results.

Adam Laponis -- Chief Financial Officer

Thanks, Christian. Given Christian's thorough discussion of revenue drivers, I will start with gross systems shipped. As a reminder, we define a growth system as two hearing aids, a charging case and starter accessories shipped as a single unit. Fourth-quarter gross systems shipped were 12,096, up 67.7% year over year and 20% sequentially, driven by increased consumer demand during holiday buying season, strong performance of national advertising, increased penetration of insurance market and strong growth in repeat customers.

Fourth-quarter return accrual rate was 24.4% compared to 34% in the fourth quarter of 2019 and 25.2% in the third quarter of 2020. The the 9.6-point year-over-year reduction in our return rate was driven by the mix shift in volumes toward lower returning insurance and repeat customers. Moving to non-GAAP gross margin and operating expenses. Our discussion of financial metrics at the gross margin line and below will be on a non-GAAP basis, which excludes stock-based compensation expenses.

Please refer to our GAAP to non-GAAP reconciliation included in today's earnings release. Fourth quarter non-GAAP gross margin was 70.8%, compared to 55.3% in the fourth quarter of 2019 and 70.2% in the third quarter of 2020. The year-over-year gross margin expansion was primarily due to higher customer ASP driven by the mix shift to Neo HiFi, lower return accrual rates and lower COGS. Fourth-quarter non-GAAP sales and marketing expenses were $14.5 million, or 64.6% of net revenues compared, compared to $11 million or 100.3% of net revenues in the fourth quarter of 2019.

We continue to invest in sales and marketing to expand our teams and deploy new media while generating significant leverage, driven by a more efficient media spend and improved customer mix. Non-GAAP research and development expenses were $3.9 million, or 17.4% of net revenues compared, to $4.0 million or 37.8% of net revenues in the fourth quarter of 2019. We are rebuilding some of our long-term R&D capabilities and ramping personnel hiring after slowdowns these initiatives during the initial uncertainty related to the COVID-19 pandemic. We also had some Eargo 5 design verification build cost in Q4 that contributed to R&D costs.

We expect to continue to increase our R&D spend going forward to fuel long-term growth and ensure we stay ahead of the innovation curve. Non-GAAP general and administrative expenses were $4.7 million or 21% of net revenues, compared to $3.5 million or 32.7% of net revenues in the fourth quarter of 2019. We saw an increase in G&A expense due to higher costs associated with being a public company. Non-GAAP net operating loss for the fourth quarter of 2020 was negative 7.2 million compared to a non-GAAP net loss of negative 12.6 million in the fourth quarter of 2019.

Cash and cash equivalents as of December 31, 2020, were $212.2 million. This includes approximately 148 million in net proceeds from our IPO completed in October of 2020. We believe our cash on hand is sufficient to fund our current operating plan, as well as the investment initiatives across sales and marketing and R&D that we have outlined during our recent public offering. Now, turning to 2021 guidance.

We expect net revenue for the full year of 2021 to be in a range between $87 million and $93 million. This reflects our confidence in the continued customer adoption of Eargo, led by robust volume growth with stable customer ASPs and stable return accrual rates as compared to the full year of 2020. Given our better-than-expected revenues in the fourth quarter of 2020, we expect first quarter 2021 net revenues to be down sequentially. We remain on track to launch Eargo 5 in the second quarter of 2021, with material revenue contribution from Eargo 5 to begin ramping in the third quarter of 2021.

Moving to non-GAAP gross margin guidance. We expect our ability to refurbish returned Eargo 5 units will begin to drive gross margin expansion in the back half of the year. Therefore, we expect full-year 2021 non-GAAP gross margin to be between 70 and 72%. Specific operating expense guidance, we do anticipate full-year 2021 stock-based compensation expense of approximately 20 million to $25 million, up from approximately $5 million for the full year of 2020.

We plan to disclose the quarterly amount of stock-based compensation expense by line item in our quarterly earnings releases in 2021. I'd now like to turn it back to Christian for summary and closing remarks.

Christian Gormsen -- President and Chief Executive Officer

Thanks, Adam. I admit that I am proud of our execution on financial metrics, including the leverage that we are creating on our investments. On Slide 9, we take a step back and review our accomplishments in 2020, which was quite simply a record year for Eargo ago across all key performance measures. The one theme that underpins 2020 is innovation.

We believe we have proven we can innovate the entire hearing aid experience for consumers through every facet of their journey. From a product perspective, we launched the highest quality, best sounding hearing aid in our history with our fourth generation Eargo Neo HiFi. In awareness generation, we launched innovative new creative and national TV that speaks to the consumer in their language. In clinical support, we further invested in telecare and added new tools for consumers to engage with us digitally, further distancing our competitive need in telecare support for hearing loss.

In distribution, we opened a new channel for consumers to acquire hearing aids at low or no cost through insurance, driving down our return rates and improving the efficiency of our business. And lastly, we raised significant capital to support the execution of our business plan and the opportunity to help even more people hear better. Our accomplishments in 2020 give us high confidence in our ability to deliver our 2021 business plan and financial objectives. We believe our improved customer mix, sophisticated demand generation capabilities, continued scale-up of national advertising and the launch of Eargo 5 will result in another year of robust consumer adoption.

More importantly, the cross-functional innovation we saw in 2020 gives us confidence we will continue to innovate this large, underpenetrated hearing aid market over the next several years. In summary, we could not be more excited about what the future holds for Eargo as we remain focused on our mission of helping more people hear better. That concludes my prepared remarks. And I would like to turn the call back to the operator for Q&A.

Questions & Answers:

Operator

Certainly. [Operator instructions] Our first question comes from the line of Robbie Marcus from J.P. Morgan. Your question, please.

Sarin Murlidar -- J.P. Morgan -- Analyst

Hi everyone. This is Sarin on for Robbie. Congrats on the great quarter. So you gave some commentary here on the guidance.

But, can you just help me understand what's built into your assumptions here in terms of your base case for 2021 guidance and the quarterly -- first-quarter revenue sequential decline. I can understand that benefits in use cases pick up and the benefit in use cases come down. So it's sort of a win-win. But just what's involved sort of in your base case here?

Christian Gormsen -- President and Chief Executive Officer

OK. Again, thank you for the question here. And let me start overall what our guidance is built on, and Adam is going to give the details for Q1. But overall, I think we've been pretty clear in our communication that all our guidance is based on what we have already done.

So it's really driven off what we know we can do in terms of driving awareness and driving demand through advertising. That's point No. 1. How we can continue to penetrate the federal insurance opportunity that's driving a big part of our growth.

The product launches that we have been doing historically and that we know are coming are, of course, also included in our guidance. And then really, how -- and especially coming into '21, this level of repeat customers. So that's what's in the model. We're not modeling any of the additional opportunities that we see in this marketplace.

So that's not included in our guidance. So further expansion of insurance, international, etc., that physical retail experiences, none of those factors are included in our guidance. So Adam, do you want to --

Adam Laponis -- Chief Financial Officer

Yeah, sure. Thanks, Chris. To add a bit more color, comment, the idea here is, in Q1, we actually have a pretty big sequential ramp up. If you look at where we are versus prior year, we had -- it was our first big quarter of insurance volume in Q1 2020.

And really, we see that growth in Q1 2020 grow almost a sequential 140%. So we obviously know there's a difficult comp there as well. The other thing to keep in mind is we did, in last year, we did have sequential growth Q4 to Q1 of '19 to '20, but we also had the launch of the Eargo HiFi, we'll be launching, the Eargo 5 here in Q2 of 2021. If you look at the full year, as you kind of think about the sequential performance, we expect sequential improvements each quarter going forward after Q1.

So I'd expect to be about a 47% to 53% on back half split in terms of the full event.

Christian Gormsen -- President and Chief Executive Officer

And of course, I would entail a significant year-over-year growth in Q1. So although sequentially down from our record quarter, it's still a very strong year-over-year growth.

Sarin Murlidar -- J.P. Morgan -- Analyst

Great. Thank you. And just one follow-up on the Eargo 5 launch. With that coming around just around the corner here, what kind of impact do you think that's sort of going to have on the P&L? Could we expect any fluctuations in return rates as some people upgrade from their existing systems to the 5.

Christian Gormsen -- President and Chief Executive Officer

Yes. Yes. And very far over, our focus is really is how are we going to drive the best user experience. And this is what makes us so excited about Eargo 5 that we truly believe has a lot of revolutionary benefits.

That's not the main emphasis here. So we're really focused on how we're going to bring this to market in the best possible way. Will there be some short-term movements on our KPIs for sure. And I know Adam has, basically, a rundown of those.

But long term, Eargo 5 is a new platform that will enable further improvements on operating metrics. But that's more on a long-term basis. And I think more short-term variations here, Adam?

Adam Laponis -- Chief Financial Officer

Yes. And I think we've talked about it a fair amount. But obviously, one of the things we're really excited about with Eargo 5 is the ability to become refurbished and use refurbished product. And when there are returns, that will help drive a tailwind to gross margin.

That will take a number of months to ramp up. So we expect that impact to really be more felt toward the fourth quarter. So in the short term, we do expect modest gross profit headwinds in terms of the Ergo 5 launch and the kind of ramping and using up of some of the initial inventory of prototype parts before we actually turn on the refurbishment capabilities as we progress throughout the year. In terms of the revenue implications, right now, we're modeling it to be -- obviously, we're going to have -- there's going to be some benefit from repeat customers buying more of the Eargo 5, and we expect that to continue to ramp throughout the year.

But we haven't modeled in a change in return rate specifically around Eargo 5. Obviously, we expect to see a benefit there, but we have not guided to that.

Sarin Murlidar -- J.P. Morgan -- Analyst

Alright. Thank you.

Operator

Thank you. Our next question comes from the line of Bob Hopkins from Bank of America. Bob, you might have your phone on mute. It looks like he might have disconnected.

Larry Biegelsen from Wells Fargo, your question please.

Unknown speaker

Hi. It's Lei calling in for Larry, and thanks for taking my question. Just on the revenue guidance for 2021, can you give any color around relative growth of the three segments, insurance, cash pay and the BP business? And I have a follow-up to that.

Christian Gormsen -- President and Chief Executive Officer

I think we've spoken about, we see an opportunity to grow all our customer types here, so that's really the emphasis, and that's also inherently. I think in terms of more and more detailed guidance, Adam, what are we comfortable sharing here?

Adam Laponis -- Chief Financial Officer

Yeah. No, absolutely. I think the way we saw it, we actually, in the back half of 2020, have roughly 45% of the volume came from insurance, a little bit more than that in Q3, a little bit less in Q4. The way we're modeling 2021 is basically a continuation of that similar behavior in terms of the insurance to that mixed percentage of the business.

So we expect it to continue to grow, and as Christian said, and we expect the mix to be kind of weighted toward about 45% insurance throughout the year.

Unknown speaker

OK. That's helpful. And then just on the rest of P&L, you mentioned gross margin impact from refurbishment will be later in the year. So it sounds like, should we expect a tick down in the gross margin kind of in the early part of the year and then return to the higher end of the range toward the latter part? And also, any commentary around spending cadence this year given the launch that you have? Thanks.

Christian Gormsen -- President and Chief Executive Officer

That's great. I can provide the commentary. I think, look, I mean, obviously, we felt really good about the gross margins in Q4. And I'd expect Q1, in the beginning part of Q2, to be in line with kind of where we've been trending in the middle of the range.

I expect the dip to come -- launches are always one week in effect the quarter in launch timing, but expect a slight dip in Q2 and into Q3 as we had the prototype parts and on the refurbishment. And then exiting Q4 at the upper end or community in slightly a tick above the range for Q4 versus the full year in terms of gross margin. Looking down the P&L, I mean, our big focus, as Christian's always said. So we're going to be responsible about our growth, but we don't want to do any -- our main focus is making sure that we drive growth we are also seeing contribution improvements.

So we don't want to see any of our metrics as a percent of revenue growth, the opposite direction year-on-year. So we're mindful of that, but we're also mindful that the primary focus is driving the growth. And we just want to make sure we continue to keep an eye on in increasing the flow of responsibility in the long term.

And just a minor addition to Adam's commentary here around prototypes, around launch. Of course, we're not launching on prototypes, but we are spending, obviously, dollars currently on prototypes to really do detailed user testing. We will be expensing those as part of the launch, right? So that's more where it's coming from. Of course, all the products are going to be on volume production parts.

And we feel great about that, but we need to flush this through the P&L right around the exact launch timing.

Unknown speaker

Great. Thanks, guys.

Operator

Thank you. Our next question comes from the line of Margaret Kaczor from William Blair. Your question, please.

Margaret Kaczor -- William Blair & Company -- Analyst

Thanks for taking the time today. I wanted to follow-up on insurance. Obviously, it's been a huge success since launch, and it only seems to get better. So I was hoping to get some color around whether that scale is associated with ramp in advertising versus better awareness versus better targeting? And then if you guys can also give us a comment on kind of the broader trend in hearing aid coverage, my understanding is that kind of coverage is starting to improve broadly nationally, but you tell me.

Christian Gormsen -- President and Chief Executive Officer

Alright, Margaret. Thank you. No. Clearly, the highlight of Q4 in terms of the pretty significant beat came out the outperformance of insurance.

We went out in Q4, as we spoke about on our early guidance. But we went out with pretty aggressive added media given the holiday promotions, focused on the cash pay. And we saw a nice sequential growth on cash pay. As expected, but what really positively surprised us was the impact of insurance.

We saw insurance follow. And we actually saw nice sequential growth. Remember, Q3 was a very strong insurance quarter that we were very pleased with, but also uncertain on whether we would maintain that momentum. And we managed to accelerate that momentum.

So I think the key thing behind the insurance that we're looking at right now with federal employees is awareness. So when we are on more national media, we see it's driving awareness. It's basically having people call in and contact us to understand their potential eligibility. So it's really about driving awareness.

So how do we tip the scales? This is, of course, something that we're looking very, very carefully at, looking into this year and forward. We know from an overall penetration point of view, as I covered in the prepared remarks, we have barely scratched the surface. We have approximately 1% penetration of that specific opportunity. So we know that a lot.

But we also know that it is an awareness game, so how are we going to be driving this efficiently. So that's why we're absolutely being conservative around how fast we can ramp it and grow it. We feel very good with the guidance that we're getting. But of course, it's a key area for us to work on.

So that was under scaling. In terms of trends on coverage, there's a lot of talk about it. I think there's also a lot of enrollment that's been happening. Concretely, we're not really seeing any specific added benefits to specific health plans.

It is an area that we're starting to look into. But also remember, right now, we're not selling to general healthcare plans or Medicare Advantage plans. So it's an area we're looking into. But we're not necessarily seeing increased coverage.

I think we're seeing more focus and attention on hearing as a category, and we believe that there's potential, but we haven't seen anything that indicates that coverage is necessarily going up.

Margaret Kaczor -- William Blair & Company -- Analyst

OK. Useful. And then I wanted to talk about return rates as well. I understand majority of the decrease in return rates in 2020 was attributed to mix.

But are you seeing return rates within the individual segment categories fall as well? And I guess more specifically, what did you see here out of that in 2020? And what are you assuming in '21?

Adam Laponis -- Chief Financial Officer

Yes, Margaret, that's a great question. And just to kind of provide color on that. I mean, the majority of the movement by far, the vast majority, is that mix shift. And so we did see modest improvements in cash pay and even in churn throughout the year as we continue to refine, but that would be major -- in a fraction of the total improvement.

We haven't modeled the business in 2021 to see improvements in any one of the customer types, and we tell them it's relatively stable. So most of our revenue growth is really attributable to volume growth in 2021 model.

Margaret Kaczor -- William Blair & Company -- Analyst

OK. Got it. And just kind of longer term, where do you guys expect that return rate to end up, realizing that mix is one factor, but maybe you guys can do other segments in terms of close rates and so on to improve it. Thanks guys.

Christian Gormsen -- President and Chief Executive Officer

Yes. No. I think back to how we built the model, I think we have been tracking ahead of where we believe we were almost at the level where we can see ourselves ending up. It doesn't mean that we think there's no more opportunity, because this is ultimately a user experience, and the lower the return rate goes, it's a better user experience.

So it's something we will -- that will always be a tough priority for us. So we are at that level. Obviously, this is going to be impacted as we expand on our channel structure and focus more on omnichannel. We know repeat is going to come in that's going to help us give us more tailwind to driving it down.

But also looking longer term, hopefully, getting more into retail opportunities and other areas, that's going to be changing sort of the nature of it. But right now, we are essentially -- we're already leading the hearing industry in terms of return rates. So we're doing really well. But it's going to be a continued focus, but we're not guiding any further improvements on return rates.

Margaret Kaczor -- William Blair & Company -- Analyst

Perfect. Thanks, guys.

Operator

Thank you. This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Nick Laudico for any further remarks.

Nick Laudico -- Vice President, Investor Relations

Thanks, operator, and thank you, everyone, that joined us on the call today. This concludes the Eargo fourth-quarter and full-year 2020 earnings conference call.

Operator

[Operator signoff]

Duration: 33 minutes

Call participants:

Nick Laudico -- Vice President, Investor Relations

Christian Gormsen -- President and Chief Executive Officer

Adam Laponis -- Chief Financial Officer

Sarin Murlidar -- J.P. Morgan -- Analyst

Unknown speaker

Margaret Kaczor -- William Blair & Company -- Analyst

All earnings call transcripts

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