Description

RMTI – An opportunistic short-term and long-term small cap investment

• Current Price:  $4.19
• Enterprise value: $77 million
  • ($119 million market cap – $15 million cash + $10 million debt - $37 million present value of tax assets)
• Price Target (Base): $10.99 +162%
• Price Target (Bull): $13.02 +211%
• 52w high/low:  $6.24 / $0.84

Rockwell Medical is the #2 provider of dialysate (fluid that is used to pull toxins from the blood during dialysis treatment for people with end-stage renal disease) in the country and is down -46% in two days last week after doing one of the smartest acquisitions that I have seen in public markets. I think the stock is worth $11 to $13 today, or 200% upside in net present value. Under new CEO, Dr. Mark Strobeck, the Company has been executing a turnaround for the past year. They have deprioritized legacy R&D projects and refocused the entire company on its commercial dialysis business. Despite its small market capitalization, the Company has guided to $82-86 million of sales this year, with pro-forma revenues approaching $100 million. From this base, we expect pricing to go up, costs to go down, margins to expand dramatically, and cash flows to materialize. The Company may be bad at communicating, but the new CEO seems like he’s pretty darn good at executing. Just look at what the stock was doing prior to the deal-induced panic selling last week.

Why did the stock sell off?

The company announced a deal to acquire the dialysate business of Evoqua water. Evoqua was recently acquired by Xylem to create the world’s largest water purification company and RMTI opportunistically pounced on a marquee non-core asset that Evoqua had acquired as part of a previous acquisition. 

RMTI purchased Evoqua for $11 million cash upfront, with $5 million of future milestone payments. Standalone Evoqua had approximately $18 million of revenue and $3.3 million of EBITDA. The Company financed the deal via the exercise of preexisting in-the-money warrants providing $13.8 million of cash. They effectively cleaned up their cap structure and transformed their business without having to access the capital markets. 

Management noted that the Evoqua manufacturing plant had superior EBITDA margins (18% v. RMTI’s aspirational break-even to slightly profitable target in 2024).  On the July 11^th conference call, Dr. Strobeck stated, “…it also enhances our manufacturing capabilities, and particularly a fully automated manufacturing process, which will ultimately improve the cost for us to manufacture our products, and therefore, the margins we’re going to be able to achieve upon selling products. So this is, as I said, a transformational opportunity for us…”

But rather than spoon feed the market guidance, Strobeck went on to say, “[W]e expect to see an improvement in gross profit. However, we are going to hold off issuing updated gross profit guidance for 2023 until we further assess the synergies between Evoqua and Rockwell's concentrates business and fully integrate Evoqua's concentrates business into Rockwell.” In addition, the Company disclosed that its second quarter revenues were $1 million light of consensus estimates due to the timing of shipments.

Consequently, the market has been HATE selling the stock assuming the company may just have been trying to cover up a potential revenue hole on an enlarged share count. I bet Dr. Strobeck regrets not giving the market an estimate of the actual good news...

What’s so epic about this deal? 

Evoqua and RMTI make the same product. Evoqua was, in fact, the number three player in the dialysate market behind RMTI. Management has indicated that the Evoqua plant has excess capacity and as a fully automated facility runs with just two employees versus RMTI’s three plants which we estimate employ close to 200 people. Management has commented previously about their struggles to handle inflation and the highly manual process that takes place in its facilities. Machines, on the other hand, do not demand increased wages when the cost of living rises nor do they need to sleep or get paid overtime. To put a finer point on it, if we assume that RMTI acquired Evoqua prior to the beginning of 2023 and could optimally allocate this year’s production between Evoqua’s state of the art facility and RMTI’s three manual plants, I estimate the pro-forma gross margin for the combined Company would be 19.7%—nearly double managements 2023 guidance of 10%. RMTI is expected to grow 15% topline over the next 5 year (more color on this after the margin math), so by the time 2028 rolls around, in a scenario where RMTI is able to deploy Evoqua’s technology on its growth, EBITDA margins expand from (10%) in 23E standalone to 17% in 28E pro-forma.

Okay, prove it then. (Note, I’ve colored coded some cells so you can follow the math).

Here is what F23 looks like for standalone RMTI.  This is based on company guidance and a sell-side model. Note, that all sell side models ignore RMTI’s $311 million of net operating loss carryforwards.

Now we need to figure out what gross margins look like at Evoqua’s automated plant. We know its standalone EBITDA margin is 18.3% per RMTI’s 8-K. What we don’t know is the SG&A burden Evoqua had. RMTI’s SG&A as a percent of revenue Is 21.3% at the mid- point. If we assume $2 million of that SG&A is public company costs, then we would estimate SG&A, ex corporate costs is 18.8% as a percentage of revenue. This would imply that the Evoqua automated plant has gross margins of 36.4%. Recall, this is the exact same product as RMTI!

If we assume that Evoqua is operating at 50% capacity, we can take $18 million of production out of RMTI’s manual plants and move it into Evoqua’s automated plant, we get 19.68% pro forma gross margin as our starting point for future years. Then, I assume the incremental gross margin on additional capacity expansions at Evoqua is 500 basis points higher than current gross margin due to better fixed cost leverage and throughput and, similarly, I assume the decremental gross margin on the $18M of revenue that is no longer being produced in RMTI’s manual plant is also 500 basis points higher for the inverse reason (less cost leverage/throughput).

Below that I lay out a bull case where any new growth comes on at the Evoqua automated gross margins and a base case where any new growth comes on at incremental gross margins that are 500bps better than the previous year’s gross margin. 

 Bull case: NPV $13.02 (+211%) – New Revenue comes on at automated plant gross margins.

  Base case: NPV $10.99 (+162%) – New Revenue comes on at prior year gross margin +500 bps.

This seems too good to be true . . .

To some degree, you’re probably right. It’s always easier to show margin expansion in excel than the real world, but in my opinion it’s a matter of timing, not degree. We know the Evoqua plant is a way more efficient operator than RMTI’s manual plant. Maybe it takes until 2025 to optimize production. It doesn’t matter. The upside is too enormous to quibble over a $1 or $2 dollars of NPV. Under any reasonable timing scenario, the stock is at least 150% undervalued in my opinion.

Can the business really grow 15% a year on the topline?

Sure can.  So the market for dialysate is expected to grow at a 9.6% CAGR from 2023 through 2026 per third party analysis that RMTI has published in some of its filings (slide 7, here). Yes 9.6% is less than 15%. Glad you’re still paying attention. But RMTI has two unique drivers for above market growth. The first is simple, pricing.  The second is slightly more nuanced, but I expect RMTI to take share as the industry moves away from sole source suppliers due to changes in dialysis center economics and supply chain issues that arose during the pandemic aftermath in 2022. 

On the pricing point, there are two major pieces of recent news: (1) RMTI recently signed a new deal with their biggest customer (Davita (46%) of sales) which gives them better pricing and (2) RMTI cancelled its distribution deal with Baxter and signed new distribution deals with Cardinal Health and Medline.  Regarding DaVita, the new deal gives RMTI much better pricing and, in exchange for a multi-year supply commitment, DaVita also invested $15M in the company via a one-off preferred stock deal to share in the upside from RMTI’s future margin expansion. Regarding Baxter, Baxter used to sell dialysis machines and products that it manufactures and it used RMTI’s dialysate as a loss leader to drive better uptake of its machines and ancillary products. Baxter recently announced it is spinning off this business, but I digress.  Cancelling that deal with Baxter has given RMTI pricing power for the first time in recent history, a major change in business prospects. Both these dynamics beg the question, how did RMTI end up in these bad deals with DaVita and Baxter in the first place. The simple answer is the old CEO had a different strategic vision for the company and was focused on developing new products where he might have pricing power instead of running the core dialysate business profitably. The new CEO came in with a novel idea – run the business profitably. He subsequently scuttled the legacy science projects, notably the US NDA application for RMTI’s Triferic product for which there was never going to be any market demand or reimbursement anyway. You can read about all of this in RMTI’s 2022 10-K here.

On the industry move away from sole source supply, some context would probably be helpful. The number one player in the dialysate market is Fresenius Medical.  Fresenius also happens to be the other member of the US duopoly in-center (and home) dialysis market with DaVita.

In 2022, Fresenius had supply issues that led to dialysis centers having to ration the amount of dialysate they used when treating patients (not a great look, read here). A jaded person might think: Why would the dialysis center industry care – more output from less input expands margins? Well, one these are peoples’ lives, not widgets. But two, there has been a shift in the industry towards value-based care where dialysis providers get paid for keeping their patients healthier, not just for providing dialysis services (read about some of the programs here). Patients with End-stage renal disease cost about 7x more to insure than a normal beneficiary and a lot of the excess cost comes from patients being hospitalized as a result of missed dialysis treatments (dialysis requires three 3-5 hour treatments per week) or an unplanned transition to dialysis from chronic kidney disease (the diagnosis prior to developing end-stage renal disease). The way it works is basically the insurance companies and government will pay the dialysis providers a bonus if they can lower the cost of care for a person with end stage renal disease below the costs that the insurance company or government would normally expect to pay. As a result, ensuring supply of critical inputs and compliance with nephrologist treatment prescriptions becomes of the utmost importance. Couple these new economic incentives with the supply shortages experienced during Covid due to labor scarcity, it makes sense you would want to have more than one potential supplier of dialysate. This, in my opinion, will benefit RMTI and enable them to take share as the number two player. Particularly now that their production is automated.  Further, as noted by management on the deal call, the location of the new Evoqua plant (Minnesota) will enable RMTI to ship to the west coast of the US for the first time and assume a larger market share of the growing hemodialysis concentrate market.

Disclaimer: This research report expresses the author’s opinions. Use of the research produced by the author is at your own risk. This is a long-biased report and you should assume the author of this report and its clients and/or investors hold a long position the securities of RMTI and/or their derivatives that will benefit from an increase in the price of those securities. Following publication of the report, the author (including members, partners, affiliates, employees, and/or consultants) along with its clients and/or investors intend to continue transacting in the securities covered therein, and may be long, short, or neutral at any time hereafter regardless of the initial recommendation.  The information in this report is presented “as is,” without warranty of any kind– whether express or implied. The author of this report makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. Forward looking statement and projections are inherently susceptible to uncertainty and involve many risks (known and unknown) that could cause actual results to differ materially from expected results. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any of the information contained herein. The author is not a broker/dealer or your financial advisor and nothing contained herein should be construed as an offer or solicitation to buy or sell any investment or security mentioned in this report. You should do your own research and due diligence before making any investment decision with respect to securities covered herein, including, but not limited to, the suitability of any transaction to your risk tolerance and investment objectives and consult your own tax, financial and legal experts as warranted.

Catalyst

-execution on synergies

-earnings