Nephros, Inc. (NASDAQ:NEPH) Q3 2022 Earnings Conference Call November 2, 2022 4:30 PM ET
Company Participants
Kirin Smith – PCG Advisory
Andrew Astor – President and CEO
Conference Call Participants
Marc Wiesenberger – B. Riley Securities
Paul Resnik – Resnik Asset Management
Operator
Good day, everyone, and welcome to the Nephros, Inc. Third Quarter 2022 Financial Results Conference Call. [Operator Instructions].
At this time, I’d like to turn the floor over to Kirin Smith with PCG Advisory. Please go ahead.
Kirin Smith
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 networks. 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 metros’ ability to successfully timely and cost-effectively market its products and services 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
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 2 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 0. 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, bone-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 2 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 2 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 customers’ orders are now back to normal levels. If not for these 2 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 expense from continuing operations for the period ended September 30. This is an additional reduction following the 15% quarter-over-quarter decrease in operating expense 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 will expect — 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 1 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 June 30, 2020 — I’m sorry, 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 and 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.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question today comes from Marc Wiesenberger from B. Riley Securities.
Marc Wiesenberger
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
Thanks, Marc. Good to hear from you. The change in policy was, frankly, just a careful look mostly at our commercial business, which did have a management change earlier in the year. And we found that we have excess inventory that wasn’t moving as quickly as we would normally assume inventory is moving, and we decide — and we had a formal policy in place for expiring items on the medical side, but not for filter housings and things like that, that don’t formally expire, but if they’re moving very slowly, shouldn’t be kept on the books and so we implemented a policy immediately upon that recognition. And that is what brought that to bear. In answer to the second half of your question, no, there’s no expectation whatsoever that this would happen again this — we expect this to be a nonrecurring item.
Marc Wiesenberger
Got it. Understood. And I think you added about — maybe a little more than 200 new customer sites from the prior year period. Can you talk about how these new customers compare maybe relative to the existing customer base in terms of size, needs, and maybe potential revenue at scale, and highlight if there’s any customers that could really move the needle?
Andrew Astor
Yes, I can. My answer is that it’s a mix that I would consider a healthy mix. There are new large customers that have great potential to be 6-figure and perhaps even a 7-figure customer in the future. But there’s also dozens of customers that might be $5,000 or $10,000 or $50,000 customers. And it’s — I don’t — when I look at the list of old and new customers, if you will, I don’t really see a change. What I see is simply a growth in the number of active customers. And as many of you know, an active customer as the way we measure, which we’ve always done consistently is that they’ve purchased in the last 12 months. And so to have almost 1,400 customers that have purchased from us in the last 12 months is a heck — well, as we reported, it’s an 18% increase over what was there last year.
And we consider that a strong leading indicator. I’ll also highlight what I mentioned in the [ split ] in the call just now, which is also an increase in the number of the value rating kits, which evaluation kits are when we sell not only filters and the installation kits that go with them and the hardware and so forth. But also for free, we will do an evaluation of the water that we — of the pathogens and other particles, the particulates, I should say, that we have retained in the filter, which is — we find is a terrific — is a benefit to our customers and also, therefore, is a terrific marketing mechanism that we have. And we expect that new customer growth along with the valuation kit growth will always come before larger growth in the top line revenue, which it has traditionally in the past, and this is the highest we’ve ever seen it.
Marc Wiesenberger
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
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 7-year tail on that deal, which once a certain level of gross profit is achieved. There is a profit sharing between that partner, BWSI and Nephros. And 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 2. 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
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
Sure. Thanks, Marc. The trajectory of cash usage net will vary just because there are certain working capital natural variances that just happened. But our — if you separate working capital from operating expense, I would expect to see a narrowing of the gap or operating income, I should say yes, of operating income over the course of the next few quarters until we achieve cash flow breakeven in mid-2023.
Operator
[Operator Instructions] Our next question comes from Paul Resnik from Resnik Asset Management.
Paul Resnik
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
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 a direction or [ set ] guidance.
Operator
And we do have a question from [indiscernible].
Unidentified 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 so than you expected and you’re then taking what effectively looks like a reserve against that are anticipated write-down?
Andrew Astor
Yes. It is more of the former. Basically, upon a more detailed look, we made some decisions in the prior couple of years that brought in inventory for businesses and for parts of the business that we did not enter. And so for example, we looked at manufacturing our own carbon block as a savings mechanism and a fair amount of cash we spent was spent on that, and it’s not something that we’re going to pursue. And there were excessive orders on certain parts and pieces of filters that just weren’t going to get used even with solid growth for more than 3 years that we allow for inventory to be valued at.
And so it was really more of a fresh look for an accounting treatment perspective than it was for — it wasn’t a situation where we bought a bunch of filters that we were sure we were going to sell and then business sell away or anything like that. It was much more of a cleanup activity than it was of a business disappointment or anything like that. Is that clear?
Operator
And our next question comes from Jeremy Pearlman from Maxim Group.
Jeremy Pearlman
This is Jeremy on the line for Anthony and [ Betty ]. Just 2 quick questions. Number one, related to the HDF, the initial limited commercial launch. Have you — you said you would plan on having one commercial dialysis clinic is part of that by the end of 2022. Have you located that? Have you determined that clinic? And where are you in the progress of that? And then if you could talk more about how you see the official, the full commercial launch after that in 2023?
Andrew Astor
Sure. Thanks, Jeremy. We are in discussions with clinics, and so I won’t go further than that. If we had something to announce, we would say it. And then in terms of the commercial launch and how that might roll out, I would expect, frankly, that even assuming that we have somebody set up, it will take some time to roll it out. But we would expect to see a clinic using it with patients early in the year, early in ’23, followed by additional clinics and a rollout from there. I’m not — I hope that answers the question.
Jeremy Pearlman
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
Yes, I do think so. We’ve — we’re finding that our competitors have long lead times for many of their products. And our products are probably 98%, give or take on the shelf ready for purchase. I haven’t measured that, so don’t quote me on that. But I would say that’s probably pretty close. The vast majority of our product is on the shelf and ready to go and some — there’s a few that we have to build, which will take a week or 2.
But we actually spend a lot of money, time, and energy on making sure that we have sufficient inventory for our customers, partially because it’s in our DNA in terms of our customer support, but also partially because part of our business is responding to emergency outbreaks of disease where minutes and hours and certainly days matter to patient safety. So we are — I do think that situation is continuing in the marketplace and exactly how much of our market share growth is attributable to that, I wouldn’t [ be sure on that ].
Jeremy Pearlman
Okay. And then actually just one last question. So you mentioned that you had about $300,000 in pull-through to the second quarter ahead of the price increase. Now that the price increase has gone into effect, have you seen any push as — what is the market, the car market at aside from the ones that are ordered early, has there been any downturn in the ordering? Or do you think that’s just really — it’s going to go through and you’re not going to really affect the bottom line going forward, to increase prices?
Andrew Astor
Yes. We are not seeing — nobody likes a price increase, myself included, but we are not seeing a decrease in demand. I think that in this world that we are all living in the — with supply chain issues and inflation and so forth, People expect price increases. We are fair about our price increases, and we take what we can and also what we should, based on our cost. But I will say from an investor standpoint that — and I did say this in the call earlier, this is an important point that without the slow-moving inventory policy change, our gross margins were actually up in the mid-50s again, which I know our investors have been waiting for, for some time. It hasn’t — that hasn’t happened since early in the pandemic. And I’m pleased to say that the price increases have gotten us back to where we should be, and I expect to see solid gross margins, again, starting hopefully in Q4.
Operator
[Operator Instructions] Our next question comes from [indiscernible].
Unidentified Analyst
Yes, as far as the pathogen detection business, is there no money exchange in hands on this deal?
Andrew Astor
A nominal amount of money is exchanging hands. But it is the — the bottom line is this is a deal that is being done to relieve a cash — net cash burn from the company while still maintaining the potential value in the future for the next 7 years of share of gross profits.
Unidentified 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
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 1 sift 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.
Unidentified Analyst
Okay. Well, it was my understanding sales for this past quarter and on down some. That’s why I ask the question.
Operator
And our next question comes from Nick Farwell from Arbor Group.
Nick Farwell
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
Well, all of those are related. We did not move from Las Vegas to New Jersey, by the way, Nick.
Nick Farwell
I thought you moved to the commercial production, consolidated everything. That’s not the case.
Andrew Astor
We had talked about doing that. We have not pulled that trigger yet. It turned out that it’s a more complicated decision. And while I do think we can save some money. I don’t think it’s going to be — I don’t think that the cash save will move the needle. I would like to see the 2 businesses co-located, but we had talked about that earlier in the year, but never got to it basically because there was a lot of cleanup work to do in terms of product rationalization and production mechanism and part of that analysis was inventory cleanup, frankly.
Nick Farwell
And was there a notable amount of emergency response business that was in the third quarter?
Andrew Astor
It’s actually an interesting question. I’m glad you asked it. We had significantly lower than usual in response business in the third quarter. And for those of you on the call who don’t know, I’ll give just a quick firmer on emergency response. If you just look at us over the last 5 years, about 15% of our sales are for emergency response events where there’s an outbreak of [ lugene ] 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 benefit to the top line. So in this quarter, in particular, Nick, it was a low emergency response quarter.
Operator
And our next question comes from Ralph Weil from R. Weil Investment Management.
Ralph Weil
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
Sure. Thanks, Ralph. Good to hear from you. We are — we are hard at work with Donastar to create a closer partnership. And I can tell you with certain — with great certainty that they and we are working hard together to get our documents in place and so forth. But the bottom line is, yes, I do think that we will see additional growth in the commercial business aided by our partners, and I hope to have more to say about that in the coming couple of quarters.
Operator
Our next question is a follow-up from [indiscernible].
Unidentified Analyst
Andy, just two quick blocking-tackling type questions. The PDS sale, is that still on track to be completed on the 18th of November and [ 2 ]?
Andrew Astor
Yes.
Unidentified Analyst
Okay. And are there any anticipated cash closing costs associated with that sale that we should expect for this next quarter?
Andrew Astor
There are — no. They’re already — we’ve accrued for what we think the closing costs will be. So we don’t expect any significant additional costs in Q4.
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
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 patients 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
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.
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