According to filings with the Securities and Exchange Commission, Deerfield Management now owns 5.8 million shares of NxStage Medical (NXTM), a medical-device company whose primary product, the NxStage System One, is used for hemodialysis treatment. Along with a number of warrants, Deerfield controls 5.9 million shares, giving it just under 10% of the shares outstanding. Deerfield is a health-care-focused fund managed by James Flynn; it had owned 5.3 million shares of the stock at the beginning of October.
NxStage's revenue climbed 9% in the third quarter of 2012, compared with the same period in 2011, roughly in line with its growth rate on the top line in the first half of the year. Net losses, which had been slightly lower earlier in the year than in the same periods last year, were cut in half in the most recent quarter. For what it's worth, NxStage lost $2.6 million ($0.04 per share), compared with $4.3 million invested in research and development (and R&D was up 26% from the third quarter of 2011). The company also reported that its cash flow from operations had been positive for the first nine months of 2012 (unlike a year ago), meaning that it should not need to dip into its balance sheet cash of $100 million to keep the company going.
The System One, according to NxStage, has the advantages of being both portable and easy to use, so it can be used by people with little training as well as health care professionals, and in patients' homes as well as health care facilities. This product is responsible for about two-third of the company's sales, and it has been the source of most of its growth. With margins improving considerably, the System One segment experienced a 68% increase in operating profit in the third quarter compared with the third quarter of 2011. NxStage also sells some hemodialysis products to dialysis centers; this segment saw lower revenue growth, but operating profit was up significantly here as well.
Of course, NxStage is still unprofitable, and while we can see that its business is improving, the analyst consensus is that it will lose money in 2013 as well. The market capitalization is about $670 million (with about 400,000 shares traded daily, and a current price of $11.30), and as we've mentioned, a considerable portion of that is cash. Orbimed Advisors, another large health-care-focused fund, had a smaller position in the stock at the end of the quarter. One of NxStage's largest customers, DaVita HealthCare Partners (DVA), is well known as a stock that Warren Buffett has been buying recently on the expected strength of the dialysis market.
As such, we would expect continued increases in revenue for NxStage in 2013. The question is, can NxStage continue to increase its margins to the point where the company can show positive net income and continued growth that would justify the current valuation? The company says in its 10-Q that it expects continued increases in R&D, which could of course be a positive sign for future revenue growth but makes it less likely that we will see profits next year. In addition, NxStage will be hit by a medical-device excise tax starting in 2013. As a result, improved operating margins would likely have to come from continued improvement in gross margins, to such a degree that these headwinds are overcome.
We're interested in seeing health-care-focused funds get into NxStage, and Buffett's interest in DaVita might be taken as a good long-term sign for companies that are tied to dialysis. While we can't really evaluate it from a value perspective at this point, it might be worth coming back in a quarter or two to check on its progress.