End-stage renal disease (ESRD) is a condition where the kidneys stop working well enough to effectively remove waste, toxins, and fluids from blood. Historically in the U.S., people with ESRD have been treated with hemodialysis (HD), a filtration method that utilizes a semipermeable membrane in a device called a dialyzer. In this device, blood flows along one side of the membrane, while clean fluid called dialysate flows on the other. Differing concentrations of toxins causes them migrate through the membrane from the blood to the dialysate, resulting in cleaner blood. This method is effective for small dissolved molecules like urea, but it is poorly suited for removal of larger toxins.
A newer system that is in widespread use in Europe is hemodiafiltration (HDF). HDF also employs diffusion, but it adds the mechanism of convection. During this process, fluid and toxins are moved across the membrane by both a concentration gradient and a pressure gradient. The result is that larger metabolic toxins are removed, including mid-sized molecules such as beta-2-microglobulin.
The primary benefits of HDF treatment are reduced mortality, and the simple fact that patients feel better after treatment. Typical hemodialysis treatment is accompanied by a number of side effects including fatigue, cramps, and nausea. In several studies, most recently a 900-patient clinical study in Spain, HDF, patients reported that they "feel better" following HDF than with HD. This is in addition to the study's primary endpoint, which showed a 30% reduction in mortality for all causes. Reasons cited were improved removal of larger toxins, and better control of blood pressure.
DaVita a Steadily Growing Part of U.S. Dialysis Duopoly
DaVita and Fresenius (NYSE:FMS) are the biggest renal care providers in the U.S. where together they serve about two-thirds of all dialysis patients. DaVita has grown dramatically over the past decade, beginning largely in 2004 when they bought the U.S. business of Gambro and doubled their patients to 96,000. Since then they have grown another 65%, mostly through acquisitions of smaller clinics, and through the overall growth of the dialysis market in the US, where patients increased from 301,000 in 2001 to 374,000 in 2013. DaVita now serves 157,000 patients in the U.S compared to Fresenius' 164,000. In the first quarter of 2014, DaVita performed 5,975,627 treatments, or 78,215 treatments per day, representing a per day increase of 6.3% over the first quarter of 2013.
DaVita has consistently expressed a focus on patients' quality of life, such as reduced mortality, hospitalizations and the patient experience. Their testing of HDF supports their stance of striving to improve care. In the internet age, where patients with chronic disease are far more likely to use the web and social media to explore better therapies, patient experience and outcome become pivotal to continued growth.
If the numerous studies concluding improved HDF outcomes are to be believed, DaVita's six month trial of the Nephros' HDF therapy should conclude with a positive assessment. This likelihood is supported by Fresenius' view on HDF, where their own study touts its benefits. In fact, in Fresenius' European dialysis centers, over 50% of patients already receive HDF treatment. But their system is not approved by the FDA for use in the U.S.
The size of the U.S. dialysis market ex DaVita is 217,000 patients. How many of these patients can be converted to DaVita customers through HDF is a critical unanswered question in the mind of Nephros investors.
Nephros' Position in the HDF Market
Nephros secured CE Marking for their HDF system in 2003 and by 2007 it was in use in over 50 European clinics. Further penetration into the European market has been driven by a licensing agreement with Bellco, a European distributor of ESRD equipment and supplies. In 2011, Nephros granted Bellco an exclusive license for its technology in Canada, Italy, France, Spain, and Belgium. Belco paid Nephros $2.6 million, plus a $6.00 royalty per unit beginning in 2015. Nephros has not disclosed information about Bellco sales, so investors have been left guessing with regard to potential royalty payments.
When they entered the into the deal with Bellco, Nephros stated that they were generating near-term capital to support their seeking of FDA approval in the United States. While they did finally secure FDA 510(k) clearance in 2012, they have had difficulty making inroads in the US market.
News of DaVita's six-month trial of Nephros' HDF therapy likely came as a surprise to many Nephros shareholders. Two years had elapsed since the FDA approval, and Nephros had been unable to make any progress toward commercialization. Specific details of the arrangement between DaVita and Nephros were not disclosed, but DaVita indicated that their interest in HDF is to evaluate if there are improved outcomes of treatment and quality of life with hemodiafiltration.
Investment Decision: Nephros or DaVita?
DaVita shares are up 6% YTD, and they have risen over 20% since November 2013 with reports of continued accumulation by Berkshire Hathaway. Berkshire now owns over 17% of DaVita. So with an endorsement by Berkshire, a commitment to patient outcome, and an under the radar foray into a treatment that will likely demonstrate better patient experience, DaVita would seem to be a good choice for a long-term investment.
Nephros, trading on the OTC market, is not as clear. Their near-term prospects hinge on the success of the DaVita trial. In the absence of a positive outcome, their longer term outlook is unclear, making this trial a significant binary event for the firm. Nephros is a tiny, undercapitalized firm, and they are in the midst of a transition from a developmental company to a commercial endeavor. They have made inroads in the mature European HDF market through a licensing deal, but they have struggled to gain adoption in the U.S. market.
Fortunately for Nephros investors, the firm is controlled by hedge fund manager Wexford Capital LP. To raise cash, Nephros has opted for shareholder rights offerings instead of other choices that would dilute minority shareholders. Dilutive actions, particularly those that would benefit Wexford, would be a clear violation of the fiduciary duty that a controlling shareholder owes to minority shareholders. Wexford's full participation in past rights offerings, as a quintessential insider, would seem to indicate a high degree of confidence in Nephros' potential.
Nephros is an opportunity that presents the possibility of extraordinary gains, albeit at significant risk. They are a microcap company, with a market capitalization of $20 million. The company traded on the AMEX until 2009 when they fell out of compliance with listing standards for shareholder equity. They have not generated a single profitable quarter since their IPO in 2004.
The SEC warns that while "all investments involve risk, microcap stocks are among the most risky." Many microcaps, like Nephros, have products that have not proven themselves to be commercially viable in their target market. They generally have low public float, and even small trades can cause wild price fluctuations. Nephros may be worth a look as a speculative choice, but proceed with caution.
Disclosure: I am long NEPH. I have plans to initiate a position in DVA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.