NEPH

Business Context and Reporting Period

Company: Nephros, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2010
Business Overview: Nephros develops hemodiafiltration (HDF) products for End Stage Renal Disease (ESRD) and water filtration systems (Dual Stage Ultrafilter or DSU). The company operates in European and Canadian markets for medical filters and pursues U.S. government contracts for military water purification.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue: For the nine months ended September 30, 2010, revenue increased 30% to $2.42 million compared to $1.87 million in the prior year. This was driven by a $260,000 increase in U.S. DSU sales and a $324,000 increase in European MD filter sales. Conversely, quarterly revenue for the three months ended September 30, 2010, decreased 13% to $622,000 due to lower billings from the Office of Naval Research contract.
• Profitability: The net loss for the nine months ended September 30, 2010, improved to $(1.27) million from $(1.54) million in the prior year. The quarterly net loss narrowed slightly to $(0.38) million from $(0.40) million.
• Operating Expenses: Selling, general, and administrative (SG&A) expenses decreased 9% year-over-year for the nine-month period, primarily due to reduced personnel costs. Research and development expenses increased 22% for the nine-month period.
• Liquidity: Cash balances declined from $1.00 million at December 31, 2009, to $421,000 at September 30, 2010. Net cash used in operating activities improved significantly to $(0.64) million for the nine months ended September 30, 2010, compared to $(1.87) million in the prior year.

Guidance, Outlook, Risks, and Unusual Items

• Going Concern: The filing explicitly states that recurring losses and negative cash flows raise substantial doubt about the company's ability to continue as a going concern. Management indicates a need to raise additional funds through licensing, asset sales, or equity/debt offerings.
• Subsequent Financing: On October 1, 2010, the company issued a $500,000 senior secured note to Lambda Investors LLC (its largest stockholder, owning ~44%). The note bears 12% interest, matures April 1, 2011, and is secured by a first-priority lien on all company assets, including intellectual property. Proceeds are expected to fund operations through February 2011.
• Capital Raising: The company filed a Form S-1 on October 1, 2010, for a proposed rights offering to raise up to $3.5 million from existing stockholders.
• Regulatory Status: On June 30, 2010, the FDA issued a final decision letter stating it could not reach a substantial equivalence determination for the company's HDF system. The company is evaluating future actions, though this does not impact sales outside the U.S.
• Supply Chain: A fiber supplier notified the company of termination of a supply agreement effective July 18, 2010, though sales continued during negotiations for a new agreement.

Investor Verification Checklist

• Cash Runway: Verify the sufficiency of the $421,000 cash balance plus the $500,000 note proceeds to sustain operations until the proposed rights offering is completed.
• Debt Covenants: Review the restrictive covenants of the October 1, 2010, note with Lambda Investors, which limit mergers, asset sales, and additional indebtedness.
• FDA Approval: Monitor the status of the FDA 510(k) application for the HDF system, as the June 2010 rejection poses a significant risk to U.S. market expansion.
• Customer Concentration: Note that two customers (A and B) accounted for 80% of sales and 69% of accounts receivable for the nine months ended September 30, 2010.
• Rights Offering: Confirm the status and terms of the proposed $3.5 million rights offering filed in October 2010.