RMTI - Rockwell Medical: A Cautiously Optimistic Path Forward (Rating Upgrade)

2023-08-17 08:35:46 ET

Summary

• Rockwell Medical's focus on the drug Triferic has led to neglect of its core operations in the hemodialysis concentrate business.
• The company is seeking to expand sales and improve profitability by focusing on the West states and its largest customer, DaVita.
• The recent acquisition of Evoqua Water Technologies' hemodialysis concentrate business could help improve revenue and net income for Rockwell Medical.

Author's Note: I have previously covered Rockwell Medical. Investors are urged to review that coverage for additional context before delving into this analysis.

Investment Thesis

Rockwell Medical Inc (RMTI) has experienced a dynamic journey within the renal care market. Once a promising market disruptor, the company's focus on developing Triferic drugs steered them away from their core dialysis concentrate business. While ambitious, this strategic bet on Triferic ultimately didn't yield the commercial success expected, causing significant challenges and raising questions about its past strategies.

However, recent developments hint at a potentially brighter horizon. Under new leadership, the company has pivoted to re-emphasize its core operations. The promising surge in Q2 margins and the strategic acquisition of what management describes as a modern, automated manufacturing facility signals a more focused and effective operational strategy. Furthermore, the company's expansion plans in Western states suggest the possibility of improved economies of scale.

Considering these positive strides and the recent price decline in RMTI's stock, the Risk/Reward profile appears more attractive now than in my previous article. As such, I'm upgrading my rating for RMTI from 'Sell' to 'Hold'.

Nevertheless, investors should remain vigilant. The road ahead is dotted with challenges, including the potential need to raise capital to modernize existing facilities, a necessary expense to enable RMTI to survive in a commodity-like sector characterized by razor-thin margins.

The Allure of Triferic

The promise of Triferic was compelling. The iron replacement therapy was tailored for hemodialysis patients. Its delivery method through the dialysis machine minimized the risk of overload while mimicking the body's natural iron absorption process, promising reduced side effects. It also presented potential cost savings due to the possibility of reducing the need for Erythropoiesis-stimulating-agents 'ESA,' which isn't clinically proven, but a statement pitched to investors, contributing to the allure of Triferic.

However, as mentioned in the previous article, the regulatory success of a new drug doesn't guarantee commercial success. This was the case for Triferic, which failed to convince the hearts and minds of the medical community. Earlier this year, management finally cut its marketing and R&D spending on Triferic.

Ignored Core Operations

Rockwell's fixation on Triferic for many years came at a significant expense. In hindsight, the company should have paid more attention to its foundation; the hemodialysis concentrate business.

Now the company has outdated manufacturing facilities in Texas, Michigan, and North Carolina, where it leases a total space of 176,000 square feet, the size of three soccer fields. Their facilities are below par, increasing production cost, which, combined with the commodity-like nature of dialysis chemicals and RMTI's small scale, is a recipe for challenging unit economics. To compete, RMTI will need to upgrade its facilities with new, automated production lines.

RMTI's focus on Triferic also increased its dependence on third-party outsourcing, notably involving marketing and distribution, with significant collaborations like the one with Baxter. Although these partnerships have since ended, RMTI must recalibrate its marketing strategies now and realign its products with previously overlooked market realities.

With its commodity-like nature, the hemodialysis concentrate market heavily favors entities with economies of scale, like Fresenius Medical Care AG & Co. KGaA (FMS) Their size and diversification allow them to produce cost-effectively and absorb market fluctuations. In contrast, RMTI, being smaller, struggles to maintain profitability due to intense price competition.

Current Initiatives

RMTI is undergoing a fundamental shift, with new management steering RMTI into an expanded presence in the hemodialysis concentrate market. The new CEO set clear priorities for the company in the coming twelve months that could potentially lead to capital returns to investors and potentially put the company in a position for future dividends for investors seeking to capitalize on the defensive nature of RMTI operations.

Gross margins improved considerably quarter-over-quarter, thanks to a newly renegotiated contract with DaVita (DVA), RMTI's largest customer. The recent acquisition of Evoqua Water Technologies' hemodialysis concentrate business comes with a modern facility with less production cost than RMTI's legacy facilities.

Evoqua will add about $18 million in annual sales this year, assuming a 100% customer retention rate. The facility currently runs at 50% capacity, with an EBITDA of around 20%. Taking straight-line depreciation for 20 years, a basic back-of-the-envelop calculation suggests that the new segment will generate a revenue of $38 million and an EBITDA of 7.4 million and a net income of roughly $6.5 million, assuming RMTI shifts some of its production to the new facility, increasing Evoqua manufacturing capacity to 100%.

Management guided for $85 million in revenue this year. Thus, more than half of the production will come from RMTI's low-margined old factories. Assuming a 5% net margin, the $47 million of revenue generated from these factories will generate about $2.5 million in net income. If things go as planned, RMTI's net income could reach $10 million.

Using some basic valuation metrics, if we align the best-case scenario above with the average PE ratio of the S&P 500, which is approximately 17x PE, this suggests a valuation for RMTI of around $170 million. This is about double its current market price. Factoring in the industry's modest growth rate of about 3% annually, this valuation seems plausible in an optimistic scenario.

Using an average PE of 17x on an average net income of $6.5 million, which is the projected capacity of the new facility alone and excluding any production from legacy facilities, we arrive at a valuation of $110 million, nearly 40% above the current price.

Thus, it is clear that the current price decline has improved the risk/reward fundamentals of RMTI.

Summary

Following a period of significant challenges, RMTI is showing tentative signs of recovery. The company's past overemphasis on their drug, Triferic, resulted in the unintended neglect of their foundational dialysis concentrate business. This led to outdated infrastructure and an increased reliance on third parties, compounded with intense competition from stalwarts like Fresenius. These factors contributed to a considerable decline in RMTI's stock.

Recent strategic shifts, most notably the acquisition of the dialysis concentrate division of Evoqua Water Technologies and notable margin improvements in the second quarter of 2023, hint at a positive momentum. Given these developments, and the stock's recent selloff, I am revising my rating for RMTI from 'Sell' to 'Hold'. This change signifies potential stability and growth in the company's future. However, investors should consider the challenges ahead, namely the need to invest in automating production to be able to compete. For this reason, investors should consider diversification and adjust market position accordingly.

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