Summary of NEPHROS INC - Yahoo! Finance

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

This discussion should be read in conjunction with our consolidated financial statements included in this Quarterly Report on Form 10-Q and the notes thereto, as well as the other sections of this Quarterly Report on Form 10-Q, including the "Risk Factors" section hereof, and our Annual Report for the year ended December 31, 2008 on Form 10-K, including the "Certain Risks and Uncertainties" and "Description of Business" sections thereof. This discussion contains a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described in this Quarterly Report and our Annual Report for the year ended December 31, 2008 on Form 10-K. Our actual results may differ materially.

Financial Operations Overview

Revenue Recognition: Revenue is recognized in accordance with ASC 605. Four basic criteria must be met before revenue can be recognized: (i) persuasive evidence that an arrangement exists; (ii) delivery has occurred or services have been rendered; (iii) the fee is fixed and determinable; and (iv) collectability is reasonably assured.

Cost of Goods Sold: Cost of goods sold represents the acquisition cost for the products we purchase from our third party manufacturers as well as damaged and obsolete inventory written off.

Research and Development: Research and development expenses consist of costs incurred in identifying, developing and testing product candidates. These expenses consist primarily of salaries and related expenses for personnel, fees of our scientific and engineering consultants and subcontractors and related costs, clinical studies, machine and product parts and software and product testing. We expense research and development costs as incurred.

Selling, General and Administrative: Selling, general and administrative expenses consist primarily of sales and marketing expenses as well as personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, facilities and information systems expense.

Business Overview

Founded in 1997, we are a Delaware corporation that has been engaged primarily in the development of hemodiafiltration, or HDF, products and technologies for treating patients with End Stage Renal Disease, or ESRD. In January 2006, we introduced our new Dual Stage Ultrafilter (the "DSU") water filtration system, which represents a new and complementary product line to our existing ESRD therapy business.

We currently have three products in various stages of development in the HDF modality to deliver improved therapy to ESRD patients:

· OLpur MDHDF filter series (which we sell in various countries in Europe and currently consists of our MD190 and MD220 diafilters), which is to our knowledge, the only filter designed expressly for HDF therapy and employing our proprietary Mid-Dilution Diafiltration technology;

· OLpur H2H, our add-on module designed to allow the most common types of hemodialysis machines to be used for HDF therapy; and

· OLpur NS2000 system, our stand-alone HDF machine and associated filter technology.

We have also developed our OLpur HD 190 high-flux dialyzer cartridge, which incorporates the same materials as our OLpur MD series but does not employ our proprietary Mid-Dilution Diafiltration technology. Our OLpur HD190 was designed for use with either hemodialysis or hemodiafiltration machines, and received its approval from the U.S. Food and Drug Administration, or FDA, under Section 510(k) of the Food, Drug and Cosmetic Act, or the FDC Act, in June 2005.

OLpur and H2H are among our trademarks for which U.S. registrations are pending. H2H is a registered European Union trademark. We have assumed that the reader understands that these terms are source-indicating. Accordingly, such terms appear throughout the remainder of this Quarterly Report without trademark notices for convenience only and should not be construed as being used in a descriptive or generic sense.

We believe that products in our OLpur MDHDF filter series are more effective than any products currently available for ESRD therapy because they are better at removing certain larger toxins (known in the industry as "middle molecules" because of their heavier molecular weight) from blood. The accumulation of middle molecules in the blood has been related to such conditions as malnutrition, impaired cardiac function, carpal tunnel syndrome, and degenerative bone disease in the ESRD patient. We also believe that OLpur H2H will, upon introduction, expand the use of HDF as a cost-effective and attractive alternative for ESRD therapy, and that, if approved by the FDA in 2009, our OLpur H2H and MDHDF filters will be the first, and only, HDF therapy, approved by the FDA, available in the United States at that time.

We believe that our products will reduce hospitalization, medication and care costs as well as improve patient health (including reduced drug requirements and improved blood pressure profiles), and therefore, quality of life, by removing a broad range of toxins through a more patient-friendly, better-tolerated process. In addition, independent studies in Europe have indicated that, when compared with dialysis as it is currently offered in the United States, HDF can reduce the patient's mortality risk by up to 35%. We believe that the OLpur MDHDF filter series and the OLpur H2H will provide these benefits to ESRD patients at competitive costs and without the need for ESRD treatment providers to make significant capital expenditures in order to use our products. We also believe that the OLpur NS2000 system, if successfully developed, will be the most cost-effective stand-alone hemodiafiltration system available.

In the first quarter of 2007, we received approval from the FDA for our Investigational Device Exemption ("IDE") application for the clinical evaluation of our OLp?r H2H module and OLp?r MD 220 filter. We completed the patient treatment phase of our clinical trial during the second quarter of 2008. We have submitted our data to the FDA with our 510(k) application on these products in November 2008. Following its review of the application, the FDA requested additional information from us. We replied to the FDA inquiries on March 13, 2009. The FDA has not provided us with any additional requests for information or rendered a decision on our application. We have made inquiries to the FDA about the status of our application and have been informed that our application is still under their review process.

In January 2006, we introduced our new Dual Stage Ultrafilter (the "DSU") water filtration system. Our DSU represents a new and complementary product line to our existing ESRD therapy business. The DSU incorporates our unique and proprietary dual stage filter architecture and is, to our knowledge, the only water filter that allows the user to sight-verify that the filter is properly performing its cleansing function. Our research and development work on the OLpur H2H and MD Mid-Dilution filter technologies for ESRD therapy provided the foundations for a proprietary multi-stage water filter that we believe is cost effective, extremely reliable, and long-lasting. We believe our DSU can offer a robust solution to a broad range of contaminated water and disease prevention issues. Hospitals are particularly stringent in their water quality requirements. Transplant patients and other individuals whose immune systems are compromised can face a substantial infection risk in drinking or bathing with standard tap water that would generally not present a danger to individuals with normal immune function. The DSU is designed to remove a broad range of bacteria, viral agents and toxic substances, including salmonella, hepatitis, cholera, HIV, Ebola virus, ricin toxin, legionella, fungi and e-coli. With over 5,000 registered hospitals in the United States (as reported by the American Hospital Association in Fast Facts of October 20, 2006), we believe the hospital shower and faucet market can offer us a valuable opportunity as a first step in water filtration.

Due to the ongoing concerns of maintaining water quality, on October 7, 2008, we filed a 510(k) application for approval to market our DSU to dialysis clinics for in-line purification of dialysate water. Following its review of the application, the FDA requested additional information from us. On February 24, 2009, we provided a formal response to the FDA. On July 1, 2009, we received FDA approval of the DSU to be used to filter biological contaminants from water and bicarbonate concentrate used in hemodialysis procedures.

During the nine months ended September 30, 2009, we were granted four new patents. In the U.S., the Company was issued patent #7,534,349 for a Dual Stage Ultrafilter with pump mechanism and/or shower feature. In Canada, the Company was issued patent #2,430,575 for a valve mechanism used in Infusion Fluid systems which is a feature used on our H 2 H TM module and patent #2,396,852 for an Ionic Enhanced Dialysis/Diafiltration system which is related to mid-dilution HDF. In China, the Company was issued patent #200510092067.3 for a Dual Stage Hemodiafiltration cartridge used in its OLp?r TM MD HDF Filter.

In 2006, the U.S. Defense Department budget included an appropriation for the U.S. Marine Corps for development of a dual stage water ultra filter. In connection with this Federal appropriation of approximately $1 million, we are developing a personal potable water purification system for use by warfighters. Work on this project was completed in August 2009 and we have billed approximately $900,000 during the twenty months ended August 2009. In August 2009, we were awarded a new $1.8 million research contract from the Office of Naval Research (ONR) for development of a potable dual-stage military water purifying filter. The research contract is an expansion of our current ONR contract which is being performed as part of the Marine Corps Advanced Technology Demonstration (ATD) project. The primary objective of this expanded research program is to select concepts and functional prototype filter/pump units which were developed during the first phase of the project, and further develop them into smaller field-testable devices that can be used for military evaluation purposes. An advantage of our ultrafilter is the removal of viruses which are not removed with commercially available off-the-shelf microfilter devices. Such devices generally rely on a secondary chemical disinfection step to make the water safe to drink. The expanded contract also includes research geared toward improving membrane performance, improving device durability, developing larger squad-level water purifier devices, and investigating desalination filter/pump devices for emergency-use purposes.

We have also introduced the DSU to various government agencies as a solution to providing potable water in certain emergency response situations. We have also begun investigating a range of commercial, industrial and retail opportunities for our DSU technology.

NYSE Alternext US LLC (formerly, the American Stock Exchange or "AMEX") Issues

On January 8, 2009, we received a letter from the AMEX notifying us that it was rejecting our plan of compliance regarding the following listing standards to which we were in noncompliance of:

· Section 1003(a)(iii), which states AMEX will normally consider suspending dealings in, or removing from the list, securities of an issuer which has stockholders' equity of less than $6,000,000 if such issuer has sustained net losses in its five most recent fiscal years;

· Section 1003(a)(ii), which states AMEX will normally consider suspending dealings in, or removing from the list, securities of an issuer which has stockholders' equity of less than $4,000,000 if such issuer has sustained net losses in its three of its four most recent fiscal years; and

· Section 1003(f)(v), which states AMEX will normally consider suspending dealings in, or removing from the list, common stock that sells for a substantial period of time at a low price per share.

The AMEX further stated that the AMEX intended to strike our common stock from the AMEX by filing a delisting application with the SEC pursuant to Rule 1009(d) of the AMEX Company Guide. Given the turmoil in the capital markets, we decided not to seek an appeal of the AMEX's intention to delist our common stock.

On January 22, 2009, we were informed by the AMEX that the AMEX had suspended trading in our common stock effective immediately. Immediately following the notification, our common stock was no longer traded on the AMEX.

Effective February 4, 2009, our common stock was quoted on the Over the Counter Bulletin Board under the symbol "NEPH.OB".

In a letter dated April 13, 2009, we received a copy of the AMEX's application to strike our common stock from the AMEX.

Critical Accounting Policies

The discussion and analysis of our consolidated financial condition and results of operations are based upon our condensed financial statements. These condensed financial statements have been prepared following the requirements of accounting principles generally accepted in the United States ("GAAP") and Rule 8-03 of Regulation S-X for interim periods and require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to potential impairment of investments and share-based compensation expense. As these are condensed consolidated financial statements, you should also read expanded information about our critical accounting policies and estimates provided in "Management's Discussion and Analysis of Financial Condition and Results of Operations," included in our Form 10-K for the year ended December 31, 2008. There have been no material changes to our critical accounting policies and estimates from the information provided in our Form 10-K for the year ended December 31, 2008.

New Accounting Pronouncements

See Note 7 to our condensed consolidated financial statements set forth in Item 1 of this quarterly report for information regarding new accounting pronouncements.

Results of Operations

Fluctuations in Operating Results

Our results of operations have fluctuated significantly from period to period in the past and are likely to continue to do so in the future. We anticipate that our quarterly results of operations will be impacted for the foreseeable future by several factors including the progress and timing of expenditures related to our research and development efforts, as well as marketing expenses related to product launches. Due to these fluctuations, we believe that the period to period comparisons of our operating results are not a good indication of our future performance.

Three Months Ended September 30, 2009 Compared to the Three Months Ended September 30, 2008

Product Revenues

Net product revenues were approximately $711,000 for the three months ended September 30, 2009 compared to approximately $393,000 for the three months ended September 30, 2008, an increase of 81%. The $318,000 increase in net product revenues is due to: increased water filter sales of $98,000; increased military project revenue of $172,000 and increased blood filter sales in Europe of $48,000.

Cost of Goods Sold

Cost of goods sold ("COGS") was approximately $463,000 for the three months ended September 30, 2009 compared to approximately $254,000 for the three months ended September 30, 2008. The increase of approximately $209,000, or 82%, in cost of goods sold is primarily due to: increased water filter COGS of $32,000; increased military project COGS of $129,000 and increased blood filter COGS of $48,000. All increases were due to the increased sales or activities in these areas.

Research and Development

Research and development expenses were approximately $62,000 for the three months ended September 30, 2009 compared to approximately $191,000 for the three months ended September 30, 2008, a decrease of 68% due primarily to our planned reduction of activities to conserve our resources. This decrease of $129,000 is primarily due to: decreased salaries of $25,000; decreased supplies of $59,000; decreased machine development expense of $34,000; and decreased testing expenses of $11,000.

Depreciation Expense

Depreciation expense was approximately $53,000 for the three months ended September 30, 2009 compared to approximately $84,000 for the three months ended September 30, 2008, a decrease of 37%. The decrease of approximately $31,000 is primarily due to several assets having been fully depreciated as of year end 2008 resulting in no depreciation expense for those assets during the three months ended September 30, 2009. There was not a significant disposition of assets during the three months ended September 30, 2009 compared to the same period in 2008.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were approximately $676,000 for the three months ended September 30, 2009 compared to approximately $1,242,000 for the three months ended September 30, 2008, a decrease of $566,000 or 46%. The decrease reflects a reduction in: compensation and benefits of $389,000; recruiting fees of $55,000; marketing expenses of $50,000; insurance expense of $52,000 and legal expenses of $20,000 for the three months ended September 30, 2009 compared to the same period in 2008. The decreases were primarily due to our reduced headcount and operations to conserve our resources.

Interest Income

Interest income was approximately $2,000 for the three months ended September 30, 2009 compared to approximately $27,000 for the three months ended September 30, 2008. The decrease of approximately $25,000 is due to the decreased investments held during the three months ended September 30, 2009 compared to the three months ended September 30, 2008.

Interest Expense

There was no interest expense for the three months ended September 30, 2009 or September 30, 2008.

Other income and expenses

Other income in the amount of approximately $146,000 for the three months ended September 30, 2009 resulted primarily from receipt of 2007 New York State Qualified Emerging Technology Company ("QETC") tax refunds. Other income for the three months ended September 30, 2008 was approximately $5,000.

Nine Months Ended September 30, 2009 Compared to the Nine Months Ended September 30, 2008

Revenues

Total revenues for the nine months ended September 30, 2009 were approximately $1,869,000 compared to approximately $1,033,000 for the nine months ended September 30, 2008. Total revenues increased approximately $836,000 or 81%. The increase in net product revenues is due to increased water filter sales of $190,000; increased military project revenue of $684,000 and decreased blood filter sales in Europe of $38,000.

Cost of Goods Sold

Cost of goods sold was approximately $1,251,000 for the nine months ended September 30, 2009 compared to approximately $654,000 for the nine months ended September 30, 2008. The increase of approximately $597,000, or 91%, in cost of goods sold is primarily due to: increased water filter COGS of $43,000; increased military project COGS of $521,000 and increased blood filter COGS of $33,000. All increases were due to the increased sales and activities in these areas.

Research and Development

Research and development expenses were approximately $212,000 for the nine months ended September 30, 2009 compared to approximately $2,072,000 for the nine months ended September 30, 2008, a decrease of 90%, due primarily to our planned reduction of activities to conserve our resources. This decrease of $1,860,000 is primarily due to the fact that there was no clinical trial being conducted in the nine months ended September 30, 2009 compared to the same period in 2008. The decreased spending related to: decreased clinical trial expense of $1,060.000; decreased salaries of $567,000; decreased supplies of $102,000 decreased machine development expense of $92,000; decreased testing expenses of $26,000 and decreased computer software development expenses of $13,000.

Depreciation Expense

Depreciation expense was approximately $190,000 for the nine months ended September 30, 2009 compared to approximately $255,000 for the nine months ended September 30, 2008, a decrease of 25%. The decrease of approximately $65,000 is primarily due to several assets having been fully depreciated as of year end 2008 resulting in no depreciation expense for those assets during the nine months ended September 30, 2009.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were approximately $2,093,000 for the nine months ended September 30, 2009 compared to approximately $3,830,000 for the nine months ended September 30, 2008, a decrease of $1,737,000 or 45%. The decrease reflects a reduction in: compensation and benefits of $990,000; recruiting fees of $186,000; professional fees of $54,000; legal fees of $289,000; insurance expense of $110,000, and facilities expense of $108,000 for the nine months ended September 30, 2009 compared to the same period in 2008. The decreases were due primarily to our planned reduction in headcount and operations to conserve our resources.

Interest Income

Interest income was approximately $8,000 for the nine months ended September 30, 2009 compared to approximately $185,000 for the nine months ended September 30, 2008. The decrease of approximately $177,000 or 96% is due to the decrease in investments held during the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008. We had in excess of $4 million of investments generating interest income during the nine months ended September 30, 2008 compared to none in the comparable period of 2009.

Interest Expense

We incurred approximately $2,000 of interest expense for the nine months ended September 30, 2009. This interest relates primarily to financing of premiums for product liability insurance. There was no interest expense for the nine months ended September 30, 2008.

Impairment Loss of Auction Rate Securities

Effective January 1, 2008, we adopted fair value measurements under ASC Topic 820, which applied to our financial assets such as available-for-sale marketable securities (included as part of investments in the Unaudited Condensed Consolidated Balance Sheet). These items were to be marked-to-market at each reporting period; however, the definition of fair value used for these mark-to-markets is now applied using ASC Topic 820. Our available-for-sale marketable securities consisted of auction rate securities (ARS) at September 30, 2008.

During the first three months of 2008, our ARS failed at auction due to sell orders exceeding buy orders in the entire ARS market. Based upon an analysis of other-than-temporary impairment factors, ARS with an original par value of approximately $4.4 million were written-down to an estimated fair value of $4.3 million as of March 31, 2008. We reviewed impairments associated with the above in accordance with ASC Topic 320 to determine the classification of the impairment as "temporary" or "other-than-temporary."

An impairment loss of approximately $114,000 on ARS was charged to our results of operations for the nine months ended September 30, 2008. Approximately $300,000 of ARS were redeemed at par during the three months ended June 30, 2008 thereby reducing the total par value from $4.4 million to $4.1 million as of June 30, 2008.

We sold, at par value, our remaining ARS to a third party on July 22, 2008 for $4.1 million. We recorded an Unrealized Holding Gain in the second quarter of 2008 of approximately $114,000 when we adjusted such investment to fair value, as a result of our reclassification of such investment from Available-for-Sale to Trading Securities. We subsequently reversed the Unrealized Holding Gain and recorded a Realized Gain on Sale of Investments of approximately $114,000 in the third quarter of 2008 when the sale transaction was executed.

There was no impact on our operations for the nine month period ended September 30, 2009 because the ARS investment was sold in 2008.

Other income and expenses

Other income in the amount of approximately $328,000 and $163,000 for the nine months ended September 30, 2009 and September 30, 2008, respectively, resulted primarily from receipt of New York State Qualified Emerging Technology Company ("QETC") tax refunds in each of these periods. Tax credits for the years 2006 and 2007 were received during the nine months ended September 30, 2009. The tax credit for the year 2005 was received during the nine months ended September 30, 2008.

Liquidity and Capital Resources

Net cash used in operating activities was approximately $1,870,000 for the nine months ended September 30, 2009 compared to approximately $4,329,000 for the nine months ended September 30, 2008. The $2,459,000 decrease in cash used in operating activities was primarily due to:

· During the 2009 period, our net loss decreased by approximately $3,887,000;

· During the 2009 period, our stock-based compensation expense decreased by approximately $29,000;

· Our accounts receivable increased by approximately $114,000 during the 2009 period compared to a decrease of approximately $93,000 during the 2008 period;

· Our inventory decreased by approximately $118,000 during the 2009 period compared to an increase of approximately $1,000 during the 2008 period;

· Our prepaid expenses and other assets decreased by approximately $49,000 in the 2009 period compared to a decrease of approximately $48,000 in the 2008 period; and

· Our accounts payable and accrued expenses decreased by approximately $638,000 in the aggregate in the 2009 period compared to an increase of approximately $594,000 in the 2008 period.

Net cash provided by investing activities was approximately $7,000 for the nine months ended September 30, 2009, compared to net cash provided by investing activities of approximately $4,630,000 for the nine months ended September 30, 2008. Our net cash provided by investing activities for the nine months ended September 30, 2008 reflects the proceeds from the sales of auction rate securities of approximately $4,100,000 plus maturities of short-term investments net of purchases in the amount of approximately $593,000 partially offset by approximately $63,000 for purchases of computer equipment.

On July 24, 2009, the Company raised gross proceeds of $1,251,000 through the private placement to eight accredited investors of an aggregate of 1,345,161 shares of its common stock and warrants to purchase an aggregate of 672,581 shares of its common stock, representing 50% of the shares of common stock purchased by each investor. The Company sold the shares to investors at a price per share equal to $0.93. The warrants have an exercise price of $1.12, are exercisable immediately and will terminate on July 24, 2014.

Off-Balance Sheet Arrangements

We did not engage in any off-balance sheet arrangements during the nine month periods ended September 30, 2009 and 2008.

Certain Risks and Uncertainties

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