Nephros
a fundamental analysis
By Manuel Maurício
January 15, 2021
Symbol: NEPH (NASDAQ)
Share Price: $7.98
Market Cap: $78.7 Million
Introduction
Once you look at the chart above, you lose interest, right? I know. But I believe that Nephros might be close to an inflection point. Just looking at the chart tells us very little about the business. One must dig deep to understand the opportunity here. In a way, investing in Nephros is like investing in a start up. It presents significantly higher risk than investing in more consolidated businesses, but the potential is also huge.
Business
Let me start by presenting the opportunity, then I’ll explain in detail the different parts of the business, then the financials, the management team, and finally the conclusion.
Nephros is a money losing microcap from the USA that sells some hard-core water filters for hospital and dialysis centers. It was growing by 80% annually before the pandemic broke out, and it’s expected to get back to those levels of growth when things go back to normal (the new normal).
On top of that, the company has two new segments that may become even larger than the filtration business: a quick testing kit for water pathogens (think Legionella) and a new, unique, dialysis machine.
Interested? Let’s dig deeper into each of those opportunities.
Segments
MEDICAL FILTRATION:
Every hospital needs some hard-core water filters to prevent infections from water-borne pathogens, especially in areas such as wound cleansing, surgery rooms and showers used by imunosupressed patients.
Also, every dialysis center needs filters to purify the water and bicarbonate used to purify the blood of people whose kidneys aren’t working properly.
Nephros filters are no regular filters, they are turbo charged filters that can filter everything and anything (very important in the case of imunosuppressed patients).
They filter up to 5nm (that’s nano-meters) versus the competition that filters up to 20nm (the lower the better). For the lay man (like myself) this says very little, but the difference is huge.
Whilst the regular 20nm doesn’t filter a whole bunch of bacteria and viruses, the 5nm filter can block virtually anything that is bad for our organism.
These filters last up to 3-6 months whilst the competitors’ filters last for about 1-2 months. On top of that, the flow rate is higher then the competitors’, even with much smaller pore size.
These are the three things you should look for when you buy medical water filters: size of the hole, flow rate, and duration. Here’s an image explaining all of this:
Because they last longer, customers change them less frequently, thus they present a lower overall cost. The fact that the filters must be replaced at the end of 3-6 months means that the bulk of the revenues are recurring (good).
Until recently, this was the whole business. But as I’ve mentioned previously, the company hasn’t been standing still.
COMMERCIAL FILTRATION:
This is the segment under which the company sells water filters to the restaurants, hotels and chain stores. All of these clients already use water filters in their ice machines and soft-drink dispensers. If you have a fridge with a water or ice dispenser, if you look in the back, you’ll see a filter.
These are carbon filters, which are much more common and easy to make than the medical filters. The differentiating factors between brands are the odor, taste and ability to block large sediments. Basically, which filter makes your coke taste better.
This is a market dominated by the big boys 3M and Pentair. Nephros is betting that its filters make water taste better. Let’s see. They’ve been close to landing a big deal (between $1M and $2M) for several quarters, and it should be inked anytime soon, but…
This is a big market so even with full penetration by the big boys, if the company can land a few big clients (small stuff for its competitors) it can really move the needle. The company has sales of $8.5M today (just the medical filter business), so a $2M contract would represent a 23% jump.
The CEO has mentioned that this is actually a high gross margin business (50-60%) and they don’t feel they’ll have to compete on price. The biggest barrier for such a small company is proving to its potential clients that it has the capacity to deliver 1000 or 2000 units.
The CEO has also said that he doesn’t know which of the filtration sub-segments (medical or commercial) will have the higher revenue in a few years from now. It goes to show the opportunity here.
PATHOGEN DIAGNOSIS:
This is the newest segment the management is betting on. They’re moving upstream from the water filtration to the water testing.
Every once in a while I hear someone on the news talking about a Legionella outbreak somewhere. Legionella is a water-borne pathogen that causes a pneumonia-type illness called Legionaires disease.
The traditional way to test if a source of water is contaminated is by taking a few samples and send them to a lab. This usually takes anywhere from 24 to 72 hours and there are reports that a great percentage of the Legionella dies in the meantime, so they’re not that effective.
Not to mention that a whole hospital might be waiting for a few days to know if the Legionella bacteria is located just in the pipes of the 5th floor or if it has spread throughout the whole building.
Nephros saw an opportunity there. They’ve been developing a portable detection system that not only tests for Legionella, but for a whole bunch of other bugs. And the results come out in less than 1 hour.
This has actually been “easy” to develop because they’re using the PCR open source technology (think about it like a smartphone that you can buy and put whatever software you’d like inside).
The company will not only sell the machine but also the cartridges (they call them strips) that must be inserted in the machine, so it will be a razor/razor blade model which means recurring revenues once again.
HEMODIAFILTRATION (HDF):
We’ve reached the last segment; the Hemodiafiltration. Yes, that’s a mouthful. Hemodiafiltration (or HDF) is just a better way of doing hemodyalisis. I’ll spare you the scientific details, but a short explanation is needed.
Hemodialysis is the process in which a machine and a special filter are used to filter the blood of those people whose kidneys stopped working properly. To go from regular hemodialysis to HDF, you need a secondary machine that you attach to the regular dialysis machine.
This is actually how the company started. Many years ago, it developed a new machine for HDF, but that machine was so complicated to use that it never gained any real traction. The company is back at it and it has been developing a new, much easier to use machine.
The HDF machines are quite common in Europe representing anywhere between 15-30% of all dialysis machines. But in the US, they’re not used. The only HDF machine that is approved by the FDA is Neprhos’ first model. Other companies tried to get approval for the machines they work with in Europe, but it seems that the FDA was never too keen to approve them.
After many delays they’ll be submitting their new highly-simplified machine to the FDA for a special 510(k) clearance. This special clearance is only available for modifications to a previously approved device which they have.
Two things might happen after they file: The FDA may accept that it is a special 510(k) after which the FDA will have 30 days to comment on it, if it doesn’t it’s approved; or the FDA may not accept that the device is just a modification of a previous approved device and the company will have to file a normal 510(k). When Nephros files this normal 510(k), the FDA has 90 days to comment (and it could last more due to the pandemic).
In January 4, 2020, the company has announced the completion of the machine (finally), but due to the pandemic they don’t feel it’s the right time to file for approval with the FDA (what?).
Instead, the company will be “scaling-up the supply chain and manufacturing capabilities to support future growth” before filing to the FDA. Following this announcement, I don’t believe we’ll be seeing Nephros rolling out the machine, at least, before the end of 2021.
This new machine has been developed under a subsidiary of the company (62.5% owned), most likely because they’ll be looking to sell it one day (it could fetch a hefty price).
Supply Chain
Each segment has its own supply chain and distribution model.
MEDICAL FILTRATION:
The vast majority of the medical filters are manufactured in Sardegna by a company named Medica Spa with which Nephros has signed a licensing agreement. Under this agreement Nephros is entitled to market the super filters and Medica is entitled to manufacture them. Nephros pays Medica a 3% royalty on its filtration sales. The agreement will expire in 2025.
The company has mentioned that they could triple production without any significant changes to the supply chain, which makes me wonder if the Medica facility in Sardegna is operating at one third of its capacity (?).
COMMERCIAL FILTRATION:
The commercial filters are manufactured in Las Vegas by the company. This is a new segment that was created with the acquisition of Biocon in 2019.
PATHOGEN DIAGNOSIS:
The strips will be manufactured in the company’s facilities in Reno, Nevada.
HEMODIAFILTRATION:
I don’t really know where the machines will be manufactured.
Disctribution
MEDICAL FILTRATION:
Hospitals are 80% of the revenue. The company currently goes to market through a network of distributors, some of them specialized in water management control in hospitals. This is both good and bad. Using distributors allows the company to work with a sales force of just 6 people. On the negative side, the company doesn’t get to deal with its end-customer every day.
I believe this will also be the model for the diagnosis segment.
COMMERCIAL FILTRATION:
The company will use a hybrid strategy; both dealing directly with big customers (national chains) as well as through distributors.
HEMODIAFILTRATION:
Here things are a bit different than the hospitals. The dialysis industry in the USA is a duopoly run by DaVita (Buffett owns 33%) and the Renal Research Institute which is owned by Fresenius. To negotiate the contracts, I would say that the company will go directly to both companies. They’ve worked together before (1 and 2), but Nephros machine was so lousy that things never really developed past the testing phase.
Because the decision making in the dialysis business is more centralized, I would expect the revenue coming from this segment to be much more bumpy than from the other segments at first. Then, as it matures, revenues will come not only from the sale of new machines, but also from the replacement of the filters and tube sets.
*Just as a side note, Fresenius manufactures its own HDF machines in Europe, but it has never brought them to the USA, mostly because of the FDA.
Size of the market
Regarding the medical filtration, there are 12.000 hospitals and dialysis centers in the US, and the company is estimated to have a penetration rate of about 5-10%. It can grow by selling to new hospitals as well as by replacing filters in already signed hospitals.
The former CEO says that the diagnosis has much higher potential than the filtration business. Legionella testing is over $8 billion globally. The commercial business is around $3-4 billion, and the medical business is smaller than that, around $500 million.
The company estimates that there are over 100.000 dialysis machines in the USA. it also estimates that for each of its own HDF machines, it could earn around $20.000 in revenue per year (with filters, parts, etc).
If they’re able to get a 10% penetration, which is not far fetched, that would represent annual revenue of $200 Million (!), or twenty times the current market cap.
Financials
Bear in mind that the only segment that has generated meaningful revenue so far has been the medical filtration business.
The revenue has been going up consistently and fast. Disregarding 2020 for a second, the company was able to grow its revenue by 82% in 2019.
Then, of course, the virus messed everything up, and in a business where the salesmen have to actually go to the hospitals to sell, it’s easy to understand why the revenue has come down.
But it hasn’t come down as much as one could imagine. An 18% fall shows that most of the revenue is indeed recurring.
A good way to know if the company is being forced to lower its prices due to the competition is by checking the gross margin.
The CEO says that he expects an overall gross margin in between 55-60%, which is very sound. I’m actually surprised that the commercial segment, which is a commodity-like product can get such high margins. HDF could be much higher than that given the monopolistic position that the company may achieve.
And when we look at the bottom line (the profits) is when we see that we’re looking at a quasi-start-up. The company has been losing money for all of its life (except for 2013).
This, by itself, should be enough to get me disinterested right away. But it isn’t.
The CEO believes that with annual revenue of $15M to $20M the company can be profitable. If the virus hadn’t appeared, I think we should be there by now. As usual in microcapland, things always take longer than expected.
He also says that a few of those bets pay off, he sees no reason for the company not to be a $100M revenue company in the next few years. That’s 10 times today’s revenue.
Balance Sheet
The first thing that stands out is the fact that, due to the lack of profits, Nephros has been funding itself through repeated and consistent issuance of stock (diluting existing shareholders). The good part is that insiders and major shareholders have been buying into these raises.
The company has been burning about $1.8M per quarter, and ended 2020 with $8.3M in cash. That should be enough for about 4 quarters. The company will very likely be issuing new shares in 2021. This is one of the biggest risks when investing in microcaps, but the opportunity is big here.
Regarding debt, the company has a few maturities coming, but I expect it to be able to pay them with the cash on hand and new cash coming from future equity raises.
Management
The current CEO, Andy, was the CFO and COO until a few months ago when the previous CEO Daron Evans left the company due to Covid related issues (someone in his family I believe).
I’ve watched and listened to a bunch of interviews with both and they come across as honest guys who show their faces when things don’t go according to plan. This is important, especially in a money losing company that needs to constantly tap the stock market to keep going.
By the way, Daron is no longer the CEO of Nephros, but he’s the CEO of the subsidiary that is developing the HDF machines.
On the image below I compare the CEO’s compensation to other microcaps (not directly related). Needless to say that I find the compensation too high for a company doing $10M in revenue.
But hey, if they deliver, I don’t care.
Competition
For each segment, there are different competitors:
Medical Filtration: Pall Medical, big subsidiary of Danaher ($170 billion dollar company) is the main competitor in the medical filters. Nephros is number 2 and there a few other smaller competitors.
Commercial Filtration: Pentair under the brand name Everpure® and 3M under the brand name Cuno®.
Pathogen Diagnosis: Portable tests are a new market with not a lot of competitors right now. The largest competitors are the labs. There are other companies developing portable tests such as Spartan Biosciences, who has a beatiful cube shaped machine that looks like it was design by Jony Ive.
DHF: Fresenius e Baxter are the two leading names on HDF filtration. These are big boys and Nephros should watch out for them. Asahi Kasei Medical, Nipro Medical, and Terumo Medical are smaller players in the dialysis industry.
Risks
- Every microcap risk
- Customer concentration. 17%, 16%, and 8%
- License may not be renewed.
- Market acceptance. There is no market yet for the new products
- Risk of product failure or harm caused by the products.
- Dependency on the suppliers
- Regulatory
- Financial risks. It can take a long time to get approval and do trials.
- Dilution
Conclusion
I like the fact that this company has several opportunities that may explode in the next few years. Having said that, I still need to get answers to many questions before trying to estimate future profits, and before making a decision.
One of those questions was brought up by my girlfriend: If Spartan Biosciences can quickly develop a COVID test because it’s already using the PCR technology to test for pathogens in water, it seems “easy” to develop tests for new stuff (legionella, covid19…).
When the pandemic is over, won’t all of those companies that are now focused on the COVID19 tests shift their focus to the water pathogen diagnosis?
I’ve sent an email to Andy, the CEO, with all of my questions. You can check them in the link below. He replied saying that he’ll be available to chat next week. I gave him two dates to choose from, Monday and Tuesday, and I’m still waiting for a confirmation.
I’m sure we won’t be able to go through the whole list of questions, but if you have any questions for him, please let me know.
DISCLAIMER
The material contained on this web-page is intended for informational purposes only and is neither an offer nor a recommendation to buy or sell any security. We disclaim any liability for loss, damage, cost or other expense which you might incur as a result of any information provided on this website. Always consult with a registered investment advisor or licensed stockbroker before investing. Please read All in Stock full Disclaimer.