Good day, everyone, and welcome to the Nephros Incorporated Q3 2022 Financial Results Conference Call. All participants will be in a listen-only mode. Should you need assistance, please signal 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 touch-tone 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 Kirin Smith with PCG Advisory. Please go ahead.
Thank you, Jamie. Good afternoon, everyone. This is Kirin Smith with PCG Advisory Group. Thank you all for participating in Nephros' Q3 2022 Conference C all. 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 Nephros. 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 impacts of the COVID-19 pandemic, Nephros' 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 2, 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.
Thank you, Kieran, and good afternoon, everyone. Welcome to the call. I'm very pleased to be here to report and to comment on our Q3 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 Q3 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 in 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 remain 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 Q3 purchases into the Q2 to avoid a price increase that took effect on June 1, 2022. This increased Q2 revenue and decreased Q3 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'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-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 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 Q3 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 Q3 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 -$304,000, compared with -$394,000 in Q3 of 2021. This significant improvement was driven by the cost reduction efforts described earlier.
Consolidated gross margins in the quarter were 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%-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 -$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, 2022.
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 15. 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.
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 one on your touchtone telephones. If you are using a speakerphone, 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 two. Once again, that is star and then one 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? 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. We found that we had excess inventory that wasn't moving as quickly as we would normally assume inventory is moving. 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 don't formally expire, but if they're moving very slowly, shouldn't be kept on the books. 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 week. We expect this to be a non-recurring item.
Got it. Understood. Thank you. I think you added about two, 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. 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.
To have almost 1,400 customers that have purchased from us in the last 12 months is a heck of a, you know, it's a. 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 script in the call just now, which is also an increase in the number of evaluation kits.
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 pathogens and other particles, the particulates I should say, that we have retained in the filter, which we find is of benefit to our customers and also therefore is a terrific marketing mechanism that we have. We expect that new customer growth along with evaluation kit growth will you know always comes before larger growth in the top line revenue, which it has traditionally in the past. This is the highest we've ever seen it.
Understood. That kinda 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. 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. 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. 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, BWSI 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's shareholders in the years following that.
Okay. 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 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, over the course of the next few quarters until we achieve cash flow break even in mid-2023. Jamie, next question, please.
Once again, if you would like to ask a question, please press star and then one. Our next question comes from Paul Resnik from Resnik Asset Management. Please go ahead with your question.
Hi, Andy.
Hi, Paul.
Yeah. 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 respectfully decline to
Okay.
Make a projection or set guidance.
No problem. I was curious. That's it.
Yep. It's a fair question though.
Once again, if you would like to ask a question, please press star and one. Star and then two will remove yourself from the question queue.
Well, I'm looking at the queue. Oh, here comes one. Go ahead.
We do have a question from Rukun Duggal from Chandern. Please go ahead with your question.
Hey, Andy. How are you?
I'm good, Rukun. 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 know, 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 that or, you know, an anticipated write-down? Thanks.
Yeah. 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 that and for parts of the business that we did not enter. 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 gonna pursue. There were excessive orders of certain parts and pieces of filters that were just, you know, weren't gonna get used even with solid growth for more than the three years that we allow for inventory to be valued at.
It was really more of 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.
Our next question comes from Jeremy Perlman from Maxim Group. Please go ahead with your question.
Hi, this is Jeremy on the line for Anthony Vendetti. Just two quick questions. Number one related to the HDF, you know, the initial limited commercial launch. You said you plan on having one commercial dialysis clinic as 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 could you, if you could talk more about how you see the official 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. 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. We would expect to see a clinic using it with patients early in the year, early in 2023, followed by additional clinics and a rollout from there. I hope that answers the question.
Yes. Yeah, that does. Thank you very much. Just one last question. I know that on the last call you mentioned that some of your competitors were facing supply chain issues. You have, and you were not. Has that dynamic continued this quarter? Is that where maybe some of the, you know, the additional, the market share you've been gaining the active 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. 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. There's a few that we have to build, which may take a week or two.
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. I think that situation is continuing in the marketplace and exactly how much of our market share growth is attributable to that, I wouldn't venture a guess.
Okay. Actually just one last question. I know so you mentioned that you had about $300K in pull through to the Q2 ahead of the price increase. Now that the price increase has gone into effect, have you seen any pushback? What is the, you know, the market, the commercial market aside from the ones that are ordered early, has there been any sort of, you know, downturn in the ordering, or do you think that that's just really it's gonna go through and you're not gonna really affect 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 costs. I will say from an investor standpoint that I did say this in the call earlier, and 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 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 you know, I expect to see solid gross margins again starting hopefully in Q4.
Okay. That's really encouraging to hear. I'll hop back in the queue. Thanks a lot.
Okay. Thank you.
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 question. Yes, as far as the Pathogen Detection Systems, is there no money exchanging hands on this deal?
A nominal amount of money is exchanging hands, but the bottom line is this is a deal that is being done to relieve a net cash burn from the company while still maintaining the potential value in the future for the next seven years of our share of gross profits.
Okay. 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?
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. When a new customer comes on, their purchases are typically about one-fifth of what they average once they are a mature customer. 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 had gone down some, so that's why I asked the question.
Okay.
Okay. Thank you.
You're welcome. Thank you.
Our next question comes from Nick Farwell from Barbour Group. Please go ahead with your question.
Andy, just to follow up on the $600,000 inventory reserve, was that in some measure precipitated by the move shutting down Las Vegas and moving, 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.
I thought you moved the commercial production, consolidated 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. 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. Question. I'm glad you asked it. We had significantly lower than usual in response business in the Q3. 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. That number is extremely variable, and it goes up. It can, 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. That's just something that we can't predict. Frankly, we have become less dependent on it than I think we were, you know, two or three years ago.
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, a benefit to the top line. In this quarter, in particular, Nick, it was a low emergency response quarter.
Thank you. I appreciate it.
You're welcome.
Our next question comes from Ralph Weil from R. Weil Investment Management. Go ahead with your question.
Hello, Andy. I got on the call a bit late, so you may have already talked about this. 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.
Sure. Thanks, Ralph. Good to hear from you. We are hard at work with Donastar to create a closer partnership. I can tell you know, with great certainty that they and we are working hard together to get our documents in place and so forth. 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 Rukun Duggal from Chandern. Please go ahead with your follow-up.
Hey, Andy. Just a sort of two quick blocking and tackling type questions. The PDS sale, is that still on track to be completed on the eighteenth of November in two weeks?
Yes.
Okay. Are there any anticipated sort of cash closing costs associated with that sale that we 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.
Yeah.
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. Of course, you can always reach me at andy.astor@nephros.com. 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.
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.