Nephros, Inc. (NEPH) Earnings Call Transcript & Summary

Nephros is a water technology company that sells water purification filters, mainly to medical centers, dialysis clinics and health care facilities. The filters normally need to be replaced every 6 months, so it's a recurring revenue stream. Prior to COVID, the company was growing this recurring revenue stream at greater than 50% per year for the preceding 3 years. They hope to get back to those types of growth rates shortly. In addition to water filtration, the company recently launched the first-of-its-kind portable water pathogen detection system that allows on-site water pathogen testing and rapid results. We're honored to have CEO, Andy Astor, with us today. As a reminder, if you have any questions during Andy's presentation, click the Q&A button at the bottom of the Zoom screen, and we'll get to your questions after his formal presentation. Thank you, Andy.

Thank you, Ian. I am just going to get to my presentation here. And I believe -- please tell me that you can see this now.

I can see it.

Excellent. Great. Well, thanks, everybody, for coming. Once again, Nephros, NEPH on NASDAQ, market caps running around $85 million, $95 million these days, up about fourfold over the last 3.5 years or so. Covered by B. Riley FBR, Benchmark and Maxim in terms of our research and some very strong institutional holders. We're a pretty illiquid stock. Just so that you know, we only trade about 10,000 shares a day. Ian tells me that that's a good thing. I think it's not a terrible thing. It's -- we are -- we have a pretty low float, but patients, investors can come in and the returns have spoken for themselves over the last couple of years. And I think we're just getting started. Revenue-wise, the first half of this year is 20% greater than last year, but more importantly, it's 20% greater than the year before as well. 2020 was a cliff for us in Q2 when COVID hit in 2020. But we did $5 million in 2021 and only $4 million in the first half of the preceding 2 years, which I take is a very good sign. Pre-COVID, as Ian said, 15 consecutive quarters of growth over 60% -- averaging over 60%. And what I am calling post-COVID, although we're not really out of the woods yet, we've got 2 consecutive growth quarters, meaning Q1 and Q2 of 2021, averaging 25% between the 2 of them. Strong management team that I'll briefly touch on during the presentation. And we've been together, for the most part, for a fairly long time. It's none of our first rodeos. This is not a -- not a junior management team in any sense of the word, and I feel quite strong. As you'll see, the company, in terms of the market opportunity, is designed to have multiple growth engines and to be constantly innovating new product lines. And I'll explain how we think about that in just a minute. Cap structure-wise, very, very simple. We've got -- as of the end of June, we had almost $8.5 million in cash. That hasn't changed much over the last few quarters, partially because we watch our pennies carefully and partially because some warrants expired at the -- in Q2. And so we got a little bit of extra cash from that as they were exercised. We got about 10 million shares outstanding, 12 million fully diluted, and that's kind of a very high-level view of the company. The 3 business segments that we report on in our 10-Qs and 10-Ks; Water Filtration, Pathogen Detection and HDF Dialysis. And I apologize for the very busy slide. You're very welcome to read it. But what I'll do is really talk about what this slide represents and also let you know that we are -- we will be releasing an entirely new corporate deck starting in the early Q4. In Water Filtration, we really target 3 markets. All of them are what I call point-of-use filters. These are water filters -- ultra filters that protect patients. These are -- about 90% of what we sell are medical products. We protect patients from infections where they touch their water, so at sinks, at showers and ice machines. We are protecting patients from getting sick and, in some cases, from dying from water, particularly focused on immunocompromised patients. So in Water Filtration, the first target market is hospital infection control, where we have these point-of-use filters that I've described. That's about 70% of our business. About 20% of our business, meaning our revenue, is in dialysis clinics and in the portable and home dialysis products, the ultrafiltration that takes place inside the machine -- I'm sorry, in the water that's feeding to the machine to ensure that the dialysis machine is delivering ultra pure water to the patient. Again, the same medical filter technology that is in the infection control, but these filters are targeted at dialysis clinics. And that's about 20%. And then about 10% of our business comes from commercial water filtration, where we're not using the same medical technology. We're using more traditional, more cost-efficient, frankly, more commoditized carbon filters and some pretty innovative methods to prevent and remove scale and bacteria in certain circumstances from water. So 70%, 20%, 10% for those 3 areas, all in Water Filtration. In the Pathogen Detection, the second column, it's a brand-new area. The revenue is just beginning. It's -- I think we've done a little under $100,000 this year as opposed to $5 million in the first half of the year for Water Filtration. The Pathogen Detection area is pretty exciting for us. With filters, you know -- the customers you're serving are -- know they have a problem or know they could have a problem and so they put filters on to avoid the problem. With Pathogen Detection, we're doing the water testing before they know they have a problem. So we're moving up in the thought process, up in the food chain of waterborne pathogens. And what we provide is something that, as Ian mentioned, is a unique offering. It is a portable real-time qPCR-based mechanism that not only tells you whether you have a particular bug such as Legionella, but actually 15 different bugs, meaning bacteria or viruses, all simultaneously in a product that we call PluraPath. There's a third business segment, which is a relaunch of, as you can see, it's called HDF Dialysis. And it's a relaunch of a technology that Nephros was founded to develop 25 years ago, which was commercially unsuccessful when it came out a number of years ago. And we are trying to relaunch that with a new next-generation product. Going back over this very busy slide, Water Filtration, close to 100% of our revenue; Pathogen Detection, new business, we expect it to grow quickly, and it's beginning to show signs of life right now; and HDF Dialysis, a new business that we will be launching late 2021, early 2022, as soon as we get 510(k) clearance from the FDA. Just a quick look at our revenues for the last 4 years. As you can see, we have year-on-year growth as we've talked about already, this is the second time of about -- of a little over 60% for 15 consecutive quarters, ending here in Q1 of 2020. Then there's the cliff that we saw from COVID -- sorry, the cliff that we saw from COVID. And really, the cliff from COVID was 2 things. It was the ability to get new customers, which are an important part of our growth. And it was also the elimination, frankly, of a whole category of our business in hospitals, which is called emergency response. I want to talk about that for just a second to make sure it's clear to everybody. 70% or so of our filter -- of our medical filter business is what I call proactive, which is, as Ian talked about, a recurring revenue model. Every 3 or 6 or sometimes 12 months, hospitals and dialysis clinics have to reorder these filters. They behave kind of like a subscription. But about 15% or 20% of our business is there's an outbreak of Legionella or there's an outbreak of pseudomonas. So there's an outbreak of some other bacteria. And on an emergency response basis, we are going to call them to close those -- to fix the water in a particular wing of a hospital or something like that. That business kind of went away last year. And it was interesting because we didn't understand why at first. But it turns out that the testing of water for Legionella and for other bacteria simply went away during the COVID world. Even though it's required, even though that testing is required, there was only one fire burning and it was COVID. And so that is the reason for the revenue downturn in Q2 of last year. You can see that we've steadily built back up. And even in Q2 of 2021, the last line here -- the last bar here, which is quarter-over-quarter shrink, it is actually a growth year-on-year, which is how we measure our growth and have consistently for a long time. Even with that reduction, our compounded annual growth rate in revenue is 35%. And we're very, very bullish on where we go from here. As I mentioned, I'm Andy Astor, the President and CEO. I come out of mostly the software technology background. I've been in Founder and CEO and President of several companies. One of them is the largest open source database company specializing in Postgres today. The other one was the second largest of that category and was acquired a couple of years ago by Amazon. But I bring with me to this -- to the fore, 3, frankly, world-class scientists/engineers. Daron Evans, who's the former CEO of Nephros, is now our Science Advisor and the CEO of that HDF Dialysis component that I talked about earlier. We have Mike Milman, the VP of Research and Development, trained at Stryker and is the longest tenured member of our leadership team. And Dr. Kimothy Smith, our newest member of the leadership team who runs our Pathogen Detection group. On the commercial side, we also are similarly quite strong with West Lobo, recently announced Chief Commercial Officer, very strong in the water business from both Watts Water and Xylem Water where he spent 20 years. Shane Sullivan, who is our second longest tenured. He's been with us for about 10 years, that number is updated in the box. And Greg Lucas, who is the President of our Commercial Water Systems. He was the founder and owner of Aether Water Systems, which we acquired at the end of 2018. And then Vashone Thomas, who runs our Quality and Regulatory organization, has also been around the block quite a bit on the medical product side and is driving our Quality and Regulatory. So I'll move pretty quickly through the details of the -- each of these 3 areas, but I do want to give you just a picture, particularly in the medical water filtration, what that looks like. The filters are in the back -- in the center in the back there. And these are actual filters that were removed from a hospital after 6 months. The water that was coming out of those filters is shown on the right. The water that is retained in the filters with simple back flush is shown on the left. So this is actually what tap water concentrated over a few months looks like, and it's what we do for a living. How we do it is with the smallest pore size in the world today for this purpose. We -- conventional filters from our competitors are typically of 0.2 micron or 200 nanometers pore size, which takes out most bacteria and lets -- but does let some through and doesn't -- and for the most part, lets viruses and endotoxins, which can cause illness, get through without stopping. Nephros' filters have a 5-nanometer as opposed to 200-nanometer pore size. They stop all bacteria, viruses, endotoxins. It's very simple, our pore size is 40x smaller than conventional filters. Now what you'd expect with pore size that's small is that the flow rate of the filter would be worse then the flow rate through a larger pore size. If you've got a colander, the water flows through faster than it does if you've got a tea strainer, for example. But because of the design of our filters, we actually present much more surface area to the water and therefore, have the same or even better flow rates. And because of the design as well of the hollow fibers in our filters, our filter life is 2 to 3x better than other products on the market. And hospitals measure the cost of their filters and dialysis clinics measure the cost of their filters in terms of cost per month. And our cost per month is the same as the products that I would argue are less strong competitors on the market today. So that's the story of the medical filters. In the commercial filters, we have here the carbon block filter, which reduces chlorine and improves taste and odor. But we also have more sophisticated filters such as the scale control filter which uses a proprietary technology to drastically reduce and sometimes eliminate the scale and that we've all seen, particularly in coffee machines. These are filters that are focused on the food and beverage and hospitality industries and improve the taste and odor and improve the scale control and the bacteria control of water in these settings. On the pathogen detection front, I mentioned that we have a portable system. This -- what you're looking at is a pelican case -- a rollaboard pelican case that can be checked on an airplane. And everything that you need to do the testing is in that pelican case. And that is something that we sell, but the money, the recurring revenue in this business is really in the sample strips, which perform 15 separate qPCR assays, looking at the DNA and the RNA in a water sample in about an hour. And the -- sorry, the gross margin of this area was about the same as the water filter area, which is about 55% to 60%. But in July, just a couple of months ago, we announced the acquisition of a very small company called GenArraytion. And GenArraytion is, as I said, a very small company that we acquired for $1.2 million that makes -- that has the formulas for the assays that we were using. In other words, they were our supplier. And while we were also developing our own assays, we've now bought the supply chain of these assays. We have vertically integrated them and driven our gross margin significantly higher, i.e., our cost of goods sold significantly lower. So PluraPath is our primary product here. It is, as I said, it gives the ability to do many assays as opposed to just one assay for Legionella in real time, less than an hour, on-site, using a rollaboard suitcase, and it's getting a lot of interest in the marketplace. We also have 2 additional products, one of which is now available as a service called SequaPath, which answers a different question. The question that PluraPath answers, the one that you saw just a moment ago is do I have any of these bacteria in the water? What SequaPath does is processes 96 samples at once and answers the question, what's in the water? It is able to recognize over 20,000 different bacteria and very useful, not just in medical facilities, but in commercial facilities of -- how is the water quality to an office park, for example. This is a newer product than PluraPath. It is emergent at best but it is something that we think has some real potential for legs. And then our newest product, the DialyPath product, is for dialysis clinics to test for what's called gram-negative bacteria in water, which can make particularly dialysis patients sick. And it is -- we think it will have the ability to replace the limulus amebocyte lysate test, which, a, is more expensive, but also requires the destruction of the horseshoe crab population of the planet. And we're hoping that we are able to replace that test with the DialyPath test over time and remove that serious threat, by the way, to the horseshoe crab species. I mentioned that we also have a -- sort of a legacy business. We call it Specialty Renal Products. I listed it earlier as HDF Dialysis. And in a nutshell, Nephros was originally founded 25 years ago to build this product. It took, frankly, over $100 million, and it took -- was lost. And it took about 15 years to get it approved by the FDA. And even though it was approved, it -- the way that the company at that time built it was not a strong -- was not a successful implementation. We put it on the back burner. We pivoted the company to the Water Filtration and Pathogen Detection businesses that I've talked about and are now relaunching Specialty Renal Products with the same technology but a dramatically simplified version of it that we think will be an interesting strategic asset for us. We didn't want to just let it die, frankly. We have put it into a private entity called Specialty Renal Products inside the public entity and raised money for it separately, and it will have to stand on its own two feet. It's not -- it's considered to be a stand-alone offshoot of Nephros. So once again, that's pretty much our story. We've -- this slide is nothing more than a copy of the one at the beginning, so I won't read it to you. But again, the symbol is NEPH. And I will open it up for questions from the audience. Thank you.

Thanks, Andy. [Operator Instructions] First question is, what's the market opportunity by segment?

Well, the Water Filtration segment is one that we understand pretty well. And I'll tell you that the -- I mentioned that there are 3 markets there. There's the hospital, infection control, dialysis and commercial. Infection control is somewhere around $0.5 billion and -- the TAM, the total addressable market. Today, the market is probably only half of that or maybe even smaller. And there is a leader in that area, which is Pall Medical, subsidiary of Danaher. We are the #2 there, but the market itself is growing very quickly. So that's $0.5 billion. The dialysis clinic and portable market is somewhere between $50 million and $100 million. It's smaller, but we think we have a stronger ability to dominate overall that market since no one else is really addressing it head on the way we are. And then the commercial market, frankly, is billions of dollars, but that's -- I don't like it when other companies tell me that their market is unlimited. It's billions of dollars. We have to find a very narrow area. There's probably a $4 billion or $5 billion market just in hospitality and quick service restaurants for water filtration. I want to -- as we mature that business, I want to understand it more deeply and shrink the addressable market so that we can actually have a meaningful part of it. It's philosophically -- it doesn't make sense for a microcap company to go after a $5 billion or $10 billion market because you've got no chance. On the Pathogen Detection, in a similar situation, there's an $8 billion water testing global market. But once again, if that's too big for us to say we're going to go after an $8 billion market, we don't know yet how big the on-site PCR-based market is but it's a significant size. It's certainly in the hundreds of millions of dollars, and it is potentially in the low billions. And then finally, on the HDF, another multi-hundred million dollar business. What the HDF product does that is interesting and different than anyone else is it converts existing dialysis machines, HD machines to do HDF dialysis, which is, some would argue, a better modality of dialysis where patients feel better. And for a very small investment and just recurring disposables, you can convert an HD machine, which costs tens of thousands dollars, to be an HDF machine without replacing the whole machine. So $0.5 billion to $1 billion on that one.

So who are your customers for the pathogen detection system?

There's a couple of categories. First of all -- and these are the ones that we've been talking about for a couple of years now. There are hospitals. There are senior living facilities. There are rehab centers. All the places where patients live need to have their water tested and that they need to have water management plans that is driven by CMS and implemented by the Joint Commission, and we're a very important part, I think, of that world. In addition, we think we can go after the centralized laboratories, which are currently where water samples from hospitals are sent to for a spread culture plate analysis, basically a petri dish analysis, because increasingly PCR technology is used as -- it used to be that culture plates were the gold standard, that is no longer true. It is now culture plates and PCR as well. So that's an additional market that we haven't talked about much, but that we're feeling pretty strongly about.

So when you sell your medical filtering systems, I assume that they're basically installed at the point of delivery, so like a sink or something like that?

Yes, that's correct. The infection control filters are -- pretty much 100% of them are either at sinks, showers or ice machines.

And how many points of delivery or how many systems could you potentially sell into like a hospital? Do they like -- the hospital try to like put one on every delivery point? Or are they focused on certain areas of the hospital or...

Yes, some do, but most don't. Most -- these filters are expensive. It's $50 a month to have these filters on for each filter or $2 a day. And so it's -- I mean Legionella is not dangerous. Pseudomonas is not dangerous for most of us. But it is very dangerous for immunocompromised patients. So figure that's 25%, 30% of the beds in a hospital. And that's really -- if you want to quantify the number of beds that we can service, think of it as about 25% of the beds in a hospital. But there we have hospitals, I mean in Chicago. We have hospitals here that -- where we've got hundreds of filters and thousands on an emergency basis when there's outbreaks. And that's -- we have that all over the country. We're in some of the -- it happens that the best hospitals also are the biggest users of our filters because they are very proactive in all -- in every aspect of health care delivery. And so we're in many hospitals that are -- that have hundreds of filters.

How are the health care filters currently being sold? Is it direct or through distributors, partners?

Thanks for asking. It's about 85%, 90% through partners. We partner with water treatment companies that take care of the water quality in hospitals. And we have -- we wholesale through them, and they've got a new revenue stream by partnering with us, which, by the way, is not available from Pall. They pretty much only sell direct and keep all that margin.

So does that mean you're pretty much the only solution that those companies can sell? Or are there other competitors or...

There's competitors, but we're by far the largest of the competitors after. And we're -- we don't have any competitors with the technology, with the specifications that I talked about earlier.

Okay. So it sounds like your solution is technically better in terms of filtering than your competition, correct?

If I owned a hospital, I would buy Nephros.

Just looking for your questions. So one of the questioners or listeners asked, it's kind of surprise to see the low head count in the company. And I was wondering if Nephros is trying to do too much. It would be possible to grow faster if you're targeting fewer markets. Maybe talk about why you're targeting all the markets you are?

Yes. It's a fair question. Our thesis, if you will, is to build a company that can have a few, not many. But a few $50 million bets, minimum $50 million revenue bets. And I've told you today about the 5 that we've chosen. I don't plan on adding a sixth or an eighth or a twelfth. I think we've got -- we've been pursuing these 5 since we started the company. Not all of them are going to pan out the way we expect them to. Some of them we're going to overachieve, some of them maybe will underachieve. Some of them will grow faster, some will grow slower. And the structure of this company has -- from the turnaround that we put in place 4 or 5 years ago, it has always been to have a small handful of markets that we can pursue so that we don't have all our eggs in one basket, but don't -- aren't trying to do too many things either.

Is there any potential legislation requiring water testing that could positively impact your business?

Yes. It doesn't require water testing. I want to be clear. I don't want to mislead anybody. But there is a guideline that first came out in 2015 and then was adopted into hospital requirements from CMS in 2017, that is being updated right now and will go into effect with an updated version in 2022. And what this requirement, it's all based on ASHRAE 188, if you want to look it up. And what this requires is that every hospital, every health care facility that services patients in the United States, which is about 20,000, must have a water management plant. The water management plant must -- it must have a logical design for protecting patients and for keeping the bacterial count of pathogens low -- acceptably low and may be validated with testing. So that's the language of the regulation. In practice, that means everybody tests. So it's not a required but testing is part of the validation. And so the short answer is we think those requirements from the CMS guidelines are very much driving the need for testing and will increase the size of the market.

How do you think about the rate of revenue growth versus getting the profitability?

I'm glad you asked the question. Thank you for asking it. I think that it differs depending on which of the 3 business segments you're talking about. I think the Water Filtration business, which is close to 100% of our revenue, we now owe the shareholders profitability there, and we need to work on that. Is that next quarter, next year, we're not talking about that, but it's soon we recognize our responsibility to get that profitable. We have, by the way, had one profitable quarter, fully loaded every -- all the costs included. We did have a profitable quarter in Q4 of 2019. And then, of course, the pandemic hit in Q1 of 2020. So we're shooting at that. We're not shooting for profitability right now for Pathogen Detection. And we're not shooting for profitability right now for HDF. And what will that mean to the consolidated profitability? I don't know. But for a sophisticated investor, looking at Nephros, I think the way to think about profitability is by business segment and the first place you should be looking is Water Filtration.

A lot of companies are having issues with supply chain. Can you talk about your supply chain and how it might be challenging right now?

I can, and I'm very pleased to say that we have no challenges. When the pandemic hit, we saw the potential for supply chain constriction. And in February of 2020, we said pedal to the metal, make as much as you can. And let's just put a lot of stock on our shelves. And I think our inventory went up 30%, while our sales went down. And that was just fine because it made sure that we had plenty. It turns out that we don't have any supply chain challenges at all. And our back orders are well under 1%, probably under 0.5%.

Okay. Thank you, Andy. I appreciate this time.

You're welcome. Thank you, Ian. Great questions. Thank you, everybody, and have a good day.

Thank you.