Nephros, Inc.

Good day, everyone, and welcome to the NEPROS Incorporated's third quarter 2022 financial results conference call. All participants will be in a listen-only mode should you need assistance. Please email a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star and then one using a touchtone telephone. To withdraw your questions, you may press star and two. Please also note today's event is being recorded. At this time, I'd like to turn the floor over to Kieran Smith with PCG Advisory, so please go ahead.

Thank you, Jamie. Good afternoon, everyone. This is Kieran Smith with PCG Advisory. Thank you all for participating in NEPROS' 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 NEPROS. I encourage you to review NEPROS's 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 effects of different materially than those described in the forward-looking statement. Factors that may affect the company's results include, but are not limited to, the impact of the COVID-19 pandemic, Necrosis' 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 Necrosis' business and other economic and competitive factors. The content of this conference call contains time-spent 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 the best of circumstances after the date of this conference call, except as required by law. I would now like to turn the call over to NEPOS's President and Chief Executive Officer, Andy Astor. Andy, please go ahead.

Thank You Karen 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%. At 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 Nefros products. These issues have since been resolved and the customer's 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 mid-year 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 30th. 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 nephro filter performance, evidence that often makes a compelling case for continued use of our infection control filters. We believe these collected 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 product 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 PDF 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 renewal products business segments will be found in our filing on form 10Q 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 Nafros 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 for questions.

Ladies and gentlemen, at this time we will begin the question and answer session. To ask a question, you may press star and then 1 and you're touching the telephones. If you are using a speaker phone, we do ask that you please pick up the handset prior to pressing the keys to ensure the best sound quality. To withdraw your questions, you may press star and 2. Once again, that is star and then 1 to join the question queue.

We'll pause momentarily to assemble the roster. Our first question today comes from Mark Weisenberger from B Riley Securities.

Please go ahead with your question.

Thank you. Good afternoon.

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 of this happening again in the next 12 months?

Thanks, Mark. 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 had excess inventory that wasn't moving as quickly as we would normally assume inventory is moving, and we had a formal policy in place for expiring items on the medical side, but not for you know, 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. we expect this to be a non-recurring item. Got it. Understood. Thank you. 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 kind of customers that could really move the needle? Yeah, 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 six-figure and perhaps even a seven-figure customer or two in the future. But there's also, you know, dozens of customers that might be $5,000 or $10,000 or $50,000 customers. 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, 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 of a, you know, 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 script in the call just now, which is also an increase in the number of evaluation 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 of the pathogens and other particles, the particulates, I should say, that we have retained in the filter, which we find is a terrific, is of benefit to our customers and also, therefore, is a terrific marketing mechanism that we have. And we expect that new customer growth along with evaluation kits growth will, you know, 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. Understood. And that kind of 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 NetPro 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? 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 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, BWFI, and NETROS. 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 two, but I do think there's a strong possibility that this will generate cash and benefit to net growth shareholders in the years following that.

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? Thank you.

Sure. Thanks, Mark. The trajectory of cash usage net will vary just because there are certain working capital natural variances that just happen, but are... If you separate working capital from operating expense, I would expect to see a narrowing of the gap or of operating income, I should say, or yeah, of operating income over the course of the next few quarters until we achieve cash flow breakeven in mid-2023.

Jamie? Once again, if you would like to ask a question, please press star and then one.

Our next question comes from Paul Resnick from Resnick Asset Management. Please go ahead with your question.

Hi, Andy. Hi, Paul. 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?

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... I will respectfully decline to make a suggestion or set guidance. No problem. I was curious. That's it? Yep. It's a fair question, though.

And once again, if you would like to ask a question, please press star and 1, star and then 2, and remove yourself from the question queue. Well, I'm looking at the queue. Oh, here comes one. Go ahead. And we do have a question from Rukon Google from Chandran. Please go ahead with your question.

Hey, Andy. How are you? I'm good, Rukon. How are you? I'm good. Andy, can you explain... sort of the business driver to taking that inventory reserve.

What makes a certain inventory slow moving? And is that sort of an accounting representation where you just have to classify inventory differently?

Or is that kind of a business justification where you ordered certain inventory and it was just moving less so than you expected?

and you're then taking, you know, what effectively looks like a reserve against it or, you know, just put it right there. Thanks.

Yeah. It is more the former. Basically, upon a more detailed look, we made some decisions in the prior couple of years that brought in inventory for 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 was spent on that, and it's not something that we're going to pursue. There were excessive orders of certain parts and pieces of filters that were just, you know, weren't going to get used even with solid growth for more than the three years that we allow for inventory to be valued at. And so it was really more of a, a fresh look for an accounting treatment perspective than it was for, you know, it wasn't a situation where we bought a bunch of filters that we were sure we were going to sell and then business fell 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? Yes, it is. Great. Thank you so much. You're welcome. Thank you.

And our next question comes from Jeremy Perlman from Massim Group. Please go ahead with your question. Hi, this is Jeremy. I'm the line friend at Dave and Betty.

Just two quick questions. Number one, related to the HDF, you know, the initial limited commercial launch, you said you were planning on having one a commercial dialysis clinic is part of that by the end of 2022. Have you located that? Have you determined that clinic? 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.

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, you know, even assuming that we have somebody set up, it'll 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 hope that answers your question.

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

Yeah, I do think so. We're finding that our competitors have, you know, 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 there's a few that we have to build, which may take a week or two. 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, you know, 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 attributable to that, I wouldn't venture a guess.

Okay, and then actually just one last question. I noticed that you mentioned that you had about $300K and pulled through to the second quarter ahead of the price increase. Now that the price increase has gone into effect, have you seen any push? What is the market, the car market, aside from the ones that ordered early, has there been any sort of downturn in the ordering, or do you think that that's just really going to go through and you're not going to really test the bottom line going forward, the increased prices?

Yeah, we are not seeing, I mean, 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, 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. 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.

Okay, thank you.

And once again, that is star and then one to ask a question. Our next question comes from Larry Cassidy. Please go ahead with your question.

Thanks for taking my questions. Yes, as far as the pathogen detection business, is there no money exchange in hands on this deal? A nominal amount of money is in hand, but it is the bottom line is this is a deal that is being done to relieve a cash, a net cash burn from the company while still maintaining the potential value in the future for the next seven years of share growth profits. 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 then? No. 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-fifth 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. Okay. Well, it was my understanding. sales for this past quarter and gone down some, so that's why I asked the question.

Okay. Okay, thank you. You're welcome. Thank you.

And our next question comes from Nick Farwell from Arbor Group. Please go ahead with your question.

Andy, just a follow-up on the $600,000 inventory reserve. Was that in some measure precipitated by the move shutting down Las Vegas and moving the manufacturing, consolidating manufacturing in New Jersey and perhaps Greg's departure? Well, all of those are related. We did not move from Las Vegas to New Jersey, by the way, Nick. How do you move the commercial production, consolidate everything? That's not the case. 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 two 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 mechanisms and part of that analysis was inventory cleanup frankly. And was there a notable amount of emergency response business that was in the third quarter? It's actually an interesting question. I'm glad you asked it. We had a significantly lower than usual emergency response business in the third quarter. And for those of you on the call who don't know, I'll give just a quick primer 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. You know, we've seen it up over 30%, and we've seen it at close to zero. 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, you know, two or three 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're, you know, they are a benefit to the top line. So in this quarter in particular, Nick, it was a low emergency response quarter.

Thank you.

I appreciate it.

You're welcome.

And our next question comes from Ralph Wheel from Our Wheel Investment Management to help with your question.

Hello, Andy. 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 Donestar and Tractor Beverage Companies. and how that would work.

Sure. Thanks, Ralph. Good to hear from you. We are hard at work with Donna Star in to create a closer partnership. And I can tell you with great certainty that they and we are working hard together 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.

Our next question is a follow-up from

Rufin Dougal from Chandler. Please go ahead with your follow-up.

Yeah, I mean, just sort of two quick blocking and tapping type questions.

The PDS sale, is that still on track to be completed on the 18th of November in June? Yes. Okay.

And are there any anticipated sort of cash closing costs associated with that sale that you should expect for this next quarter?

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.

Okay, excellent. Thank you. Yep. 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.

I thank you, Jamie. 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.aster at nefros.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.

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