Nephros
Conversation with the CEO
By Manuel Maurício
January 20, 2021
I’ve recently talked to Andy Astor, Nephros CEO and had the opportunity to ask him all the questions I had. Later in the same day I also talked to 2 head nurses of DaVita’s dialysis clinics here in Portugal to get a better understanding of the Hemodiafiltration opportunity.
Below I’m loosely transcribing the notes I took during the 3 conversations. At the end, there will be a conclusion.
BROAD UNDERSTANDING OF THE COMPANY:
What was the company doing prior to 2015 when Daron came in and what was the direction shift that you mentioned in one of your presentations?
The company was a wreck. It started out as a spinoff from the Columbia (?) University in 1997 to develop the HDF technology.
2003: The company went public.
2008: Wexford Capital, a Private Equity firm, bought a controlling stake hoping that the HDF machine would be approved soon.
2012: the HDF was approved by the FDA.
2013: Westford brought Daron (the previous CEO) as sort of a consultant to check from the inside what could be done to improve the operations.
2015: Daron became the CEO.
2016: Daron ran into Andy (current CEO) in an Airport, they talked for a few minutes and Andy came on board as CFO and COO.
ON THE COMMERCIAL SEGMENT:
Given that the carbon filters are the standard technology, why would the prospective end-clients switch to your filters and what prevents the big guys from keeping you away?
Andy has been involved with small software companies who have gained market share from big companies who aren’t that focused.
If Nephros wins $5M or $10M from a big company such as 3M, they will barely notice, while for Nephros that will double its business.
Because it’s an oligopoly, the two main players , 3M and Pentair, have very high margins in what is somewhat of a commodity-type product.
Last year, CUNO from 3M, came off of patent protection 6 months ago. Nephros is the first company to have the first CUNO compatible product. They’ve planned for that.
Now they have access to both halfs (because Pentair had already lost the patent?) and both halfs are $2Billion dollars.
They’re still trying to close the big deal.
You have 3 facilities. Wouldn’t it be better to have them all on the same place?
Yes.
Are there any plans for that to happen?
No
ON THE HEMODIAFILTRATION SEGMENT:
As far as I understand, Fresenius has its own HDF systems in Europe. Why would they partner with you if they could just bring their own machines from overseas?
They’re trying to do it right now. They’re waiting for Nephros to get FDA approval to advance with their own filing.
They will get approval eventual.
Fresenius is a full blown HDF machine.
Nephros is a machine that converts current Dialysis machines to HDF (it’s like an add on). This will allow to retro-fit thousands of machines without having to replace them and spend millions of dollars.
If Fresenius gets approval, and given the fact that it operates a significant percentage of all the dialysis clinics in the US, you may be losing that client, right?
I don’t know. If you go to them and tell them that you can convert a lot of their machines and they don’t have to throw them into the garbage, even Fresenius is a prospect. Unless they wish to kill us (laughter).
Once you get the approval, what happens?
Our asset of HDF goes from being valued by the marketplace at zero to something much greater than zero. Because now we have something valuable. Now we have strategic questions such as: should we call Fresenius and DaVita? Should we spinoff to another company? Should we take the subsidiary public? Should we combine it with another dialysis company?
These are questions we can not ask today because we don’t have an asset which has any value. We’ll call some clinics after the pandemic phases out to try to roll out in a few clinics and try to roll out in a few clinics to demonstrate what it is.
In 12 to 24 months from now, I don’t know what our world looks like in HDF.
Daron said that you guys would call the FDA prior to filling the special 510(k) to see if it would trigger the filings (?). Have you already done that approach? Because you have the device completed, right?
The device is built. We are done. There are a couple of documents that have to do with biocompatibility and validation that will be ready by the first part of this year, and we’ll simply submit as a special (510K). We won’t call them.
You don’t need clinical trials, you just need clinical experience.
Where will these systems be manufactured?
In the US by a contract manufacturer. Parts of it may be manufactured outside of the US. We haven’t really….
Note: I believe that Nephros doesn’t want to manufacture the HDF machines, but pursue a different way like licensing the technology, or selling the subsidiary.
On your 10K you mention that you estimate that there are over 100.000 dialysis machines in the USA, but then, on the Q4 2019 call, Daron mentioned that there are over 200.000. I know it’s hard to get an exact figure, but they’re very different numbers. Where does the difference come from?
I don’t know the answer. We’ve just been focused on keeping costs low and develop the product so we just don’t walk away from $100 million we spent developing the first machine.
What exactly can you sell?
The machine, we could even give it away for free. We won’t, but we could. The machine will have a cost of goods sold of many hundrends of dollars, but not thousands.
We will make money by selling the consumables, which include a very small filter from Medica and a tube set with a bunch of sensors. These two items will be sold together at a price between $30-$40.
Just to get an idea, how many filters will a machine need per year?
One filter and tube set lasts for one patient. They’re disposable.
A machine, if fully utilized can treat conservatively 5 patients per day. Let’s say that each clinic has 1 machine for HDF. One machine would generate $50.000 per patient per year.
NOTE: My cross checks tell me that one treatment is 4 hours long, so each machine can only treat 3 patients per day, possibly 4 if it’s working during the night. If Nephros machine is faster, I don’t know, but it’s better to be conservative and think about $30.000 a year per machine.
ON THE FILTRATION SEGMENT:
What’s the background on Medica and how did you come to partner with them?
Andy doesn’t know. They’ve been one of the 2 or 3 biggest customers for 10 years.
Regarding the licensing deal, is there reason to believe that the agreement might not be renewed in 2025?
If there was a lot of competition with Nephros to get those filters, maybe… We don’t believe that being squeezed is very likely at all. I would expect we would extend the agreement well past that.
NOTE: The more competition, the rougher Medica can be on the conditions of the renewal of the agreement.
Do the Minimum Purchase Commitments related to Medica still stand, even with the current pandemic?
They actually bought more than the minimum because of the pandemic. They’ve constantly pushed Medica to ship them more and more over the years. They bought a lot of filters last year.
That’s one of the two reasons their cash burn was so high. The other was HDF development. (will the R&D slow massively?).
NOTE: This is important. With the machine completely developed, R&D should come down massively.
Shouldn’t the Minimum Purchase Commitments be reflected on the balance sheet (as a form of debt, just like a lease agreement)?
Andy can’t answer if they should be on the balance sheet or not, but he is of the opinion that if the technical guy they are using to handle this stuff hasn’t said a thing, it’s because there’s no problem.
NOTE: Investigate this further.
You’ve mentioned previously that you could “triple our current size without any significant change in our supply chain”. Does this mean that the Italian factory is running at 33% capacity?
More or less, yes. And if we needed to grow beyond 3 times we’ve talked to Medica, There’s ways we can do it.
Is there (or was there prior to Bellco’ acquisition) any relationship between Bellco and Medica?
No. They wanted to use a filter, we licensed to them. It’s not a big deal.
Daron has mentioned that Care Mark is your largest distributor. Are we talking about CVS Care Mark?
No. They’re not our distributors.
NOTE: This may have been an error on the Transcript.
ON THE PATHOGEN DIAGNOSIS SEGMENT:
You’ve opted for an open source platform for the diagnosis segment. What exactly is proprietary?
Nephros the machine from Chai Bio. The machines can cost from from $5.000 to $200.000. Nephros buys the $5.000 one.
What Nephros makes are the strips of “micro-wells” that go inside that machine.
These “wells” have a water-based solution with proprietary compounds designed by the company called “assays” (which is more or less equivalent to “tests” in this case). In the early days, they bought some of those “assays”, but now they make them.
What customers must do is to mix in a small drop of the water they want tested with the solution, and then put the strip in the machine. It’s the assays that make it possible for the machine to detect the pathogens. The assays are the important stuff.
So what will give the company the recurring revenue is actually the sale of those strips (they come in packs of 2).
NOTE: Andy mentioned that at some point they were buying the assays and I got the impression that they still buy some, which means that they can be bought by anyone. I forgot to ask for how much they will sell them.
How hard is it to replicate it? What will prevent the labs and players that are currently working on assays for COVID from turning to the water business once the pandemic is over?
No, because it’s not the machine that is proprietary, the intellectual property is what’s in the assays.
NOTE: Didn’t really answer my question.
Is it easy to copy it or develop something similar?
It can be done. It took Nephros two years and there’s still some work to do (I believe they still buy some of the assays, which means that it can be bought?). You need several high level scientists as well as computer scientists.
I’ve seen Spartan’s cube and I know that they only test for Legionella…
Most companies that I know won’t use them… (smile)
Quick notes from my conversation with DaVita's nurses
DaVita is the world leader in Dialysis clinics. They have 9 clinics here in Portugal so I called two of them to get a better understanding of the technology from their point of view. Here are some notes:
The HDF technology is better than the normal dialysis because it prevents joint and bone problems a few years down the road.
That’s why the young people will benefit most from it.
You don’t feel it right away. (it’s like eating healthy, you won’t feel a thing, but it’s better for you in the long run).
In Portugal the great percentage of DaVita’s patients use HDF (like 99%). The other 1% may have adverse reactions to the technology.
DaVita uses Fresenius machines that allow for regular dialysis or HDF.
More expensive than regular dialysis because it consumes more water.
The water management in a dialysis clinic is the most important thing.
One patient will do 3 sessions per week, each of 4 hours.
One machine will do 3 sessions per day, 4 if they do a night session. (This is different from the 5 that Andy mentioned).
One of the clinics had 22 machines. 2 are always free for redundancy reasons.
DaVita has 9 clinics in Portugal. If they all have 22 machines, that means roughly 200 machines. The 100.000 or 200.000 machines in the US don’t seem far fetched to me.
Conclusion
I like Nephros. There’s no real competitive advantage apart from being the first mover in a bunch of segments and being a highly focused company, but I like it. This is an $80 Million dollar company that can potentially be making multiples of its current value a few years from now without any big stretch of the imagination.
I don’t think that they want to manufacture the HDF machines themselves. They’ll probably be licensing the technology and collecting royalties or something of sorts.
But let’s just do a quick math to check the opportunity. At $30.000 of revenue per year from one machine, if they can sell one thousand machines, that’s $30 Million in sales. I believe that they can sell many more machines.
Regarding the other segments, I won’t even take them into consideration even though they are probably much bigger than the Medical Filtration segment. Let’s just look at the Medical Filtration segment:
If the company can grow 50% in the coming year (easy) and 30% there after until 2025, it will reach 2025 making around $12 Million in profits. Even if the company dilutes shareholders in the meantime, let’s say that the Earnings-per-Share would be $1.05. Let’s put a regular multiple of 15x on it. That would mean a share price of $16. Today’s share price is $7.8 so we would be talking about a double from here.
If the company is only able to grow by 20%, that would mean a share price of $8 in 2025, roughly where it is today. I don’t believe that’s the most likely scenario, but hey, I’m willing to take the risk.
Ok, now that we’ve identified that this may be a good opportunity, we’ve got to think about position sizing. Nephros is still a money losing company. It’s a story stock. It’s like a start-up. This means that the risk is high.
Because the reward can be big, I want to invest in it. But because the risk is high, I don’t want to put a lot of money at stake. What I’ll do instead is to buy it in 3 tranches. I will buy €1666 worth of stock tomorrow and as the company hits important milestones such as, for example, getting approval from the FDA for its machine, I will add to my position to make it a full position (€5.000).
I don’t mind leaving some money on the table right now and be adding to my position on the way up. If the potential is there and the company will actually be a success, there will be plenty of time to make money.
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