Earnings Call Transcript - NEPH Q3 2022

Operator, Operator

Good day, everyone, and welcome to the Nephros, Inc. Third Quarter 2022 Financial Results Conference Call. I would now like to hand it over to Kirin Smith with PCG Advisory. Please proceed.

Kirin Smith, PCG Advisory

Thank you, Jamie. Good afternoon, everyone. This is Kirin Smith with PCG Advisory. Thank you all for participating in Nephros’ Third Quarter 2022 Conference Call. Before we begin, I would like to caution that comments made during this conference call by management will contain forward-looking statements regarding the operations and future results of the company. I encourage you to review Nephros' filings with the Securities and Exchange Commission, including without limitation, the company's Forms 10-K and 10-Q, which identify specific factors that may cause actual results or events to differ materially from those described in the forward-looking statements. Factors that may affect the company's results include, but are not limited to, the impact of the COVID-19 pandemic, Nephros' ability to successfully, timely, and cost-effectively market its products and service offerings, the rate of adoption of its products and services by hospitals and other healthcare providers, the success of its commercialization efforts, and the effect of existing and new regulatory requirements on Nephros' business and other economic and competitive factors. Contents of this conference call contains time-sensitive information that is accurate only as of the date of the live call today, November 2nd, 2022. The company undertakes no obligation to revise or update any statements to reflect events or circumstances after the date of this conference call except as required by law. I would now like to turn the call over to Nephros' President and Chief Executive Officer, Andy Astor. Andy, please go ahead.

Andrew Astor, CEO

Thank you, Kirin, and good afternoon, everyone. Welcome to the call. I'm very pleased to be here to report and to comment on our third quarter results, which reflect positive trends in leading growth indicators and in cash usage. Before reviewing our results, though, I will first highlight two events that significantly influenced third-quarter financial results. First, on October 4, we agreed to sell our pathogen detection systems business, also known as PDS. Based on relevant accounting standards, we are reporting PDS as a discontinued operation, and all asset values have been written down to zero. PDS has also been removed from our results of continuing operations as well as comparisons to prior periods. PDS results are consolidated into summary line items titled discontinued operations. The impact of this accounting treatment was an increase in net loss of approximately $1.4 million. The second event is the implementation of a new slow-moving inventory reserve policy for items without expiration dates. As a result of the company's adoption of this new policy, slow-moving inventory is now reserved more aggressively, resulting in an increase in inventory reserves and net losses of approximately $600,000. The combination of these two events culminated in a total charge of approximately $2 million. It is important to note, however, that neither of these events impacted cash usage at all. I will now turn to reporting our detailed results. First, net revenue was $2.4 million, a decrease of 7% year-over-year and 16% over the previous quarter. Active customer sites or ACS increased 18% year-over-year to a record 1,391 sites, which is also 3% higher than the previous quarter. Customer retention rates remained steady at over 90%. A $2.4 million top-line growth was a bit disappointing. However, there are two mitigating factors to consider. First, certain customers pulled ahead approximately $300,000 of their third-quarter purchases into the second quarter to avoid a price increase that took effect on June 1, 2022. This increased second-quarter revenue and decreased third-quarter revenue. The second mitigating factor was a revenue reduction of approximately $200,000 from a large customer navigating regulatory issues that were unrelated to Nephros’ products. These issues have since been resolved, and the customer orders are now back to normal levels. If not for these two unusual circumstances, we believe revenue would have been approximately $2.9 million in the quarter. While revenue growth remains our top priority, we are also driving hard to achieve profitability with particular focus on establishing positive cash flow by midyear 2023. To this end, we remain committed to cost savings measures as evidenced by an 8% quarter-over-quarter decrease in total operating expenses from continuing operations for the period ended September 30. This is an additional reduction following the 15% quarter-over-quarter decrease in operating expenses from continuing operations during the period ended June 30. We expect that the sale of PDS will further reduce our expenses by more than $300,000 per quarter. To summarize our business performance, medical water filtration, or more specifically, hospital infection control and dialysis water purification was relatively strong this quarter, ending with record numbers of active customer sites. In addition, new customer sites were very strong as were sales of filter evaluation kits. Our evaluation kits provide customers with tangible evidence of Nephros filter performance, evidence that often makes a compelling case for continued use of our infection control filters. We believe these collective metrics are leading indicators for future growth in medical filtration revenue. In the commercial filtration space, we have significantly improved our operations with improved manufacturing methodologies and a new sales and marketing partnership, which we expect to discuss in more detail on our next earnings call. Finally, in our Specialty Renal Products segment, or SRP, the development of a commercial launch is ongoing with an anticipated rollout in at least one dialysis clinic around the end of 2022. I will now review our detailed financial results. We reported third-quarter net revenue of $2.4 million, a 7% decrease over prior year. Loss from continuing operations for the quarter was $1.3 million compared with $0.8 million in the third quarter or Q3 of 2021. This increase in loss from continuing operations was driven entirely by the previously mentioned change to our slow-moving inventory reserve policy and once again had no impact on cash. Loss from discontinued operations or PDS was $1.9 million compared to approximately $360,000 in Q3 of 2021. This increase was driven by the write-down of assets associated with the sale of the PDS business. Consolidated adjusted EBITDA in the quarter was negative $304,000 compared with negative $394,000 in Q3 of 2021. This significant improvement was driven by the cost-reduction efforts described earlier. Consolidated gross margins in the quarter was 32% compared with 53% in Q3 of 2021. This decrease reflects the impact of the aforementioned slow-moving inventory reserve policy implementation. Without this event, gross margins would have been in our target range of 55% to 60%. Consolidated research and development expenses or R&D in the quarter were $252,000 compared with $394,000 in Q3 of 2021. Consolidated sales, general and administrative expenses or SG&A in the quarter were $1.7 million, no change compared with Q3 2021. Net cash used in operating activities was negative $172,000 compared to $910,000 in Q3 2021, reflecting our focus on achieving cash flow breakeven by mid-2023. Our cash balance on September 30, 2022, was $3.9 million, and we reassert our belief that our current cash balances will suffice for the foreseeable future. Please refer to today's press release for more details about the calculation of adjusted EBITDA and its reconciliation to GAAP, net income or loss. Additional information about our results, including our water filtration and Specialty Renal Products business segments will be found in our filing on Form 10-Q, which we plan to file on or before November 15th. That concludes the financial discussion. We will open the call to questions in just a minute. But first, as always, I would like to thank each of our Nephros employees and our strategic partners for providing unsurpassed products and services to our customers, especially this year during some difficult times. And thanks also to our devoted investors for your continued confidence, patience, and support. We know these are challenging times for shareholders, and we believe that our ability to navigate short-term results will be to our ultimate benefit as we maintain our commitment to investments in scalable commercial and operational infrastructures as a path toward long-term sustainable growth. This concludes our formal presentation remarks. We will now take questions from the audience. Operator, please open the call to questions.

Operator, Operator

Our first question today comes from Marc Wiesenberger from B. Riley Securities.

Marc Wiesenberger, Analyst

The charge related to the slow-moving inventory, can you just explain that further? What prompted the change in policy? And is there any risk that is happening again in the next 12 months?

Andrew Astor, CEO

Thanks, Marc. Good to hear from you. The policy change was primarily a result of a thorough review of our commercial business, which experienced a management change earlier this year. We discovered that we had excess inventory that was not moving as quickly as we typically expect. While we already had a formal policy for expiring items on the medical side, we did not have one for filter housings and similar products that do not have an official expiration but should not be kept if they are moving slowly. We acted quickly to implement a new policy based on this realization. Regarding the second part of your question, there is no expectation that this will occur again; we anticipate this to be a one-time event.

Marc Wiesenberger, Analyst

I understand. You have added over 200 new customer sites compared to the same period last year. Can you discuss how these new customers compare to the existing ones in terms of size, needs, and potential revenue at scale, and mention if there are any customers that could significantly impact our results?

Andrew Astor, CEO

Yes, I can. My answer is that it's a healthy mix. We have new large customers with the potential to become six-figure or even seven-figure customers in the future. However, we also have dozens of customers who may contribute $5,000, $10,000, or $50,000. When I review the list of both old and new customers, I don't see much change; rather, I see growth in the number of active customers. As you know, we define an active customer as one who has purchased in the last 12 months. Having nearly 1,400 customers who have made a purchase in that timeframe is a strong sign. This represents an 18% increase compared to last year, which we view as a solid leading indicator. I'll also note the increase in our value rating kits. These evaluation kits involve not only filters and installation kits but also a free evaluation of the water for pathogens and particulates retained in the filter, which we believe provides significant benefits to our customers and serves as an effective marketing tool. We anticipate that growth in new customers and evaluation kit usage will precede larger growth in top-line revenue, as has been the case historically, and this is the highest level we’ve ever observed.

Marc Wiesenberger, Analyst

Understood. And that segues to my next question since you talked about evaluation of water pathogens. Maybe if you could lay out how the sale of the PDS segment and the new owner will create value for Nephros’ shareholders? And maybe if you could just really paint a picture in terms of the potential trajectory of how this business could evolve under the new owner and the profit-sharing provisions there?

Andrew Astor, CEO

Sure. Thanks for the question. We decided to sell PDS really for the simple reason that we still believe in it, but it is costing more and taking longer to grow than we had anticipated, and I think all of us on this call have experienced that. And at a gross expense rate of about $350,000 a quarter or net expenses of about $300,000 a quarter, it just wasn't a tenable or a prudent investment to maintain. So what we did was we sold it to a partner that we have a lot of confidence in, and there is a seven-year tail on that deal, which once a certain level of gross profit is achieved. There is a profit sharing between that partner and Nephros. While we're not disclosing the particulars of the deal, I don't expect to see anything significant out of that in the next year or two. But I do think there's a strong possibility that this will generate cash and benefit to Nephros shareholders in the years following that.

Marc Wiesenberger, Analyst

Okay. And that dovetails nicely into my final question. Can you talk about the expectations for the trajectory of cash usage until you get to positive cash flow in mid-2023?

Andrew Astor, CEO

The trajectory of cash usage will vary due to natural working capital fluctuations. However, if we separate working capital from operating expenses, I expect to see the gap in operating income narrow over the next few quarters until we reach cash flow breakeven in mid-2023.

Operator, Operator

Our next question comes from Paul Resnik from Resnik Asset Management. Sure. Thanks, Marc. The trajectory of cash usage will vary due to certain natural variances in working capital that occur. However, if you separate working capital from operating expenses, I expect to see a reduction in the gap of operating income over the next few quarters until we reach cash flow breakeven in mid-2023.

Paul Resnik, Analyst

The quarter's revenues were held back and you said they would have been $2.9 million without these unusual events. Going to the current quarter, would you say $2.9 million is a reasonable or conservative expectation for revenues?

Andrew Astor, CEO

It's a fair question, Paul, but I won't answer it. And the reason is simply that we haven't given guidance and there's too much variability. We're only a month into the new quarter, and so I will respectfully decline to provide direction or set guidance.

Operator, Operator

And we do have a question from an unidentified speaker.

Unidentified Analyst, Analyst

Andy, can you explain the business driver to taking that inventory reserve? What makes certain inventory slow-moving? And is that an accounting representation where you just have to classify inventory differently? Or is that a business justification where you ordered certain inventory and we're just moving less than you expected and you're then taking what effectively looks like a reserve against that anticipated write-down?

Andrew Astor, CEO

Yes. It is more of the former. Upon closer examination, we made decisions in the past couple of years that resulted in inventory for parts of the business we did not enter. For instance, we considered manufacturing our own carbon block to save costs and spent a significant amount of cash on that, which we will not pursue. Additionally, there were excessive orders for certain parts and filter components that would not be used, even with solid growth projected over more than three years. Therefore, it was really more of a reassessment from an accounting perspective rather than a situation where we purchased filters we were confident we would sell and then saw the business decline. It was more of a cleanup activity than a business disappointment. Is that clear?

Operator, Operator

And our next question comes from Jeremy Pearlman from Maxim Group.

Jeremy Pearlman, Analyst

This is Jeremy on the line for Anthony and Betty. I have two quick questions. First, regarding the HDF and the initial limited commercial launch, you mentioned planning to have one commercial dialysis clinic by the end of 2022. Have you identified that clinic? What is the status of that progress? Secondly, could you discuss how you envision the official full commercial launch for 2023?

Andrew Astor, CEO

Sure. Thanks, Jeremy. We are in discussions with clinics, and I won't go further than that. If we had something to announce, we would say it. In terms of the commercial launch and how that might roll out, I would expect that even if we have someone set up, it will take some time to implement. However, we anticipate seeing a clinic using it with patients early in the year, early in '23, followed by additional clinics and a rollout from there. I hope that answers the question.

Jeremy Pearlman, Analyst

Yes. And then just one last question. I know on the last call, you mentioned that some of your competitors are facing supply chain issues you have and you were not. Has that dynamic continued this quarter? Is that where maybe some of the additional market share you've been gaining the active customers? Can we attribute some of that to that?

Andrew Astor, CEO

Yes, I believe so. We have noticed that our competitors experience longer lead times for many of their products, while around 98% of ours are ready for purchase on the shelf. I haven't tracked that precisely, so don't hold me to that figure, but it seems fairly accurate. Most of our products are available immediately, with only a few that require a week or two to build. We invest significantly in ensuring we have adequate inventory for our customers, driven by our commitment to customer support and the urgency of responding to emergency disease outbreaks where every minute counts for patient safety. I think this situation in the marketplace persists, but I'm not certain how much of our market share growth can be directly linked to that.

Jeremy Pearlman, Analyst

Okay. And then I have just one last question. You mentioned having about $300,000 in pull-through to the second quarter before the price increase. Now that the increase has taken effect, have you noticed any changes in the car market, apart from the early orders? Has there been any decline in ordering, or do you believe that the situation will stabilize and not significantly impact the bottom line moving forward with the price increase?

Andrew Astor, CEO

Yes, nobody enjoys a price increase, myself included, but we're not experiencing a decline in demand. In this current environment with supply chain challenges and inflation, people are anticipating price hikes. We approach our price increases fairly, considering both our needs and costs. I want to emphasize that, from an investor's perspective, our gross margins were in the mid-50s again, which is significant for our investors who have been looking for this improvement since early in the pandemic. I'm happy to report that the price increases have returned us to where we need to be, and I expect to see strong gross margins again, hopefully starting in Q4.

Operator, Operator

Our next question comes from an indiscernible source.

Unidentified Analyst, Analyst

Yes, as far as the pathogen detection business, is there no money exchanged in hands on this deal?

Andrew Astor, CEO

A nominal amount of money is being exchanged. However, the key point is that this deal is intended to reduce the company's cash burn while still preserving potential value over the next seven years in terms of share of gross profits.

Unidentified Analyst, Analyst

Okay. And the second question is, with the increase in your customer base, would that indicate your older customers aren't ordering as much as what they had been?

Andrew Astor, CEO

No. Well, I'm not sure I understand the question. We monitor our average order value or average orders per quarter, and we have not seen a dip in that. But when a new customer comes on, their purchases are typically about one-sixth of what they average once they are a mature customer. So the first sale to a customer averages about $2,000, and follow-on sales to customers average $10,000.

Operator, Operator

And our next question comes from Nick Farwell from Arbor Group.

Nick Farwell, Analyst

Andy, just a follow-up on the $600,000 inventory reserve. Was that in some issue precipitated by the move, shutting down Las Vegas and moving the consolidating manufacturing in New Jersey and perhaps Greg's departure?

Andrew Astor, CEO

Well, all of those are related. We did not move from Las Vegas to New Jersey, by the way, Nick.

Nick Farwell, Analyst

I thought you moved to the commercial production, consolidating everything. That's not the case.

Andrew Astor, CEO

We discussed the possibility of doing that but haven't acted on it yet. It became clear that the decision is more complex than anticipated. While I believe we could save some money, I don't think the amount would significantly impact us. I would prefer to see the two businesses located together, but we talked about that earlier this year and never moved forward due to the extensive cleanup required for product rationalization and production processes, which included inventory management.

Nick Farwell, Analyst

And was there a notable amount of emergency response business that was in the third quarter?

Andrew Astor, CEO

It’s actually an interesting question. I'm glad you asked it. We had significantly lower than usual response business in the third quarter. For those of you on the call who don't know, I'll give just a quick overview on emergency response. If you just look at us over the last five years, about 15% of our sales are for emergency response events where there's an outbreak of legionella or pseudomonas or what have you. But that number is extremely variable, and it goes up. We've seen it up over 30%, and we've seen it at close to 0. But again, the average is about 15%. This quarter, it was in the single digits. And that's just something that we can't predict. And frankly, we have become less dependent on it than I think we were 2 or 3 years ago. And I think that the business is healthier to just expect our business to be 100% programmatic. And then as emergencies happen, they are a benefit to the top line. So in this quarter, in particular, Nick, it was a low emergency response quarter.

Operator, Operator

And our next question comes from Ralph Weil from R. Weil Investment Management.

Ralph Weil, Analyst

And I got on the call a bit late, so you may have already talked about this. But I'm just wondering if you could comment a bit on the commercial order pipeline, following your sale to Chipotle and elaborate a little more on the significance of your partnership that was announced with Donastar and Tractor Beverage Company and how that will work.

Andrew Astor, CEO

Sure. Thanks, Ralph. Good to hear from you. We are hard at work with Donastar to create a closer partnership. I can assure you that we are both diligently working together to finalize our documents and related matters. Ultimately, I believe we will see further growth in the commercial business supported by our partners, and I hope to provide more updates on that in the coming quarters.

Operator, Operator

Our next question is a follow-up.

Unidentified Analyst, Analyst

Andy, I have two quick questions. Is the PDS sale still on track to be completed on the 18th of November?

Andrew Astor, CEO

Yes.

Unidentified Analyst, Analyst

Okay. And are there any anticipated cash closing costs associated with that sale that we should expect for this next quarter?

Andrew Astor, CEO

There are no anticipated significant additional costs in Q4 as we have already accrued for what we think the closing costs will be.

Operator, Operator

And with that, we'll be concluding today's question-and-answer session. I'd like to turn the floor back over to management for any closing remarks.

Andrew Astor, CEO

Thank you, Ajay. You orchestrated the call well. And I thank you all for the active questioning and for your patience, both your long-term patience and your patience with me on the call. It's good to hear from you all. And of course, you can always reach me at andy.astor@nephros.com, and many of you have my number, and I look forward to talking to you all soon. Thanks, and have a great evening. I wish you all the best. Take care.

Operator, Operator

And with that, ladies and gentlemen, we will conclude today's conference call and presentation. We thank you for joining. You may now disconnect your lines.