Microsoft Investor
May 8, 1998
Optical Illusion -- or Opportunity?
Myopic patients and far-sighted investors both like Visx Inc., maker of eye-fixing lasers. But federal trustbusters have the company in their sights.
By George S. Mack
You can make out the gigantic E on line one -- and even the big letters on the next few lines. But after that, you have to squint. Almost in sync with your 40th birthday party, all of what used to be normal-size print is now blurred.
Mention the problem to your ophthalmologist, and she might tell you about a procedure called "laser vision correction." LVC is performed with an excimer laser, which uses a noble-gas halide to generate an ultraviolet beam. Aside from the eye-glazing definition, you'll probably find the pitch pretty interesting because you might be able to avoid glasses or contacts altogether. The news gets better: The procedure is bloodless, and it can be done with much less pain than going to the dentist and in less time than it takes to read the morning paper with your coffee.
The laser manufacturer that leads the field, controlling 70% of the market, is small-cap Visx Inc. (VISX). In addition to making the high-tech apparatus, the company also holds many patents on the actual LVC procedures performed with the device. Now starting to grow rapidly, Visx's first-quarter earnings set a record at 58 cents per share, stunning Wall Street analysts with a 100% earnings surprise. With $100 million in cash and no debt, Visx is selling at 35 times trailing and only 21 times next year's earnings, even though its stock has more than doubled since January.
So why do the shares trade so cheaply, considering that almost half of all Americans suffer from a correctable vision disorder? Before we answer the question, some background:
A Clear Revenue Stream
The Visx System works veritable magic by re-contouring the cornea, which is the outer surface of the eyeball. It corrects conditions like myopia -- better known as nearsightedness -- as well as astigmatism, which is a blurry vision problem caused by an irregularly shaped cornea. After measuring and mapping, the surgeon programs the "prescription" into the brand new Visx Star S2 SmoothScan, and a workstation-class computer calculates the pathway required to correctly reshape the cornea.
The contouring process is designed to properly bend or refract light rays entering the eyeball; thus, it is called PhotoRefractive Keratectomy, or PRK. Because of the patents on the procedure itself, each time a PRK is performed, a $260-per-eyeball fee is paid to Visx. On average, surgeons are charging about $2,000 per eye, and with the seven-spot beam emitted from the Visx System, the procedure can be performed in less than one minute -- sometime as little as 30 seconds.
Another LVC procedure being performed with the Visx System -- the LASIK, for Laser Assisted In-Situ Keratomilieusis -- is known in the trade as the "flap and zap." Although this procedure is not approved by the Food & Drug Administration, a 1995 joint letter from the FDA and the Federal Trade Commission calls it a "practice-of-medicine" issue. This is akin to your family doctor writing a prescription for a condition that's not listed in the drug's packet insert. Even though doctors assume a lot more liability in these "off label" uses, it has been determined that about 75% of LVC cases now being performed are LASIKs. And yes, Visx enjoys patents covering this procedure, again at $260 per pop.
Red Eye -- the Rub
To put it mildly, there are some issues blurring this field of vision. Visx and competitor Summit Technology Inc. (BEAM) are being investigated by the FTC for possible price-fixing mischief. It turns out that back in 1992, the two upstarts were at a stalemate due to the fact that both parties held patents needed to bring this new excimer technology to the marketplace. Neither company could move forward and raise money to get their respective projects moving. So, in a moment of negotiated brilliance, they decided to put their patents into a pool called Pillar Point Partners. This entity, in turn, licensed the patents back to the two companies -- as well as other companies who might want to use the know-how.
Now the FTC has taken an interest in Pillar Point Partners as an antitrust issue. Speaking of Pillar Point, Visx chairman and chief executive Mark Logan says, "It was an excellent idea, but it's outlived its usefulness." Indeed, he's being kind. The two companies have not gotten along well in recent times -- they've been trying to scratch each other's eyeballs out. Logan says there are newer technologies now, and his company has been trying to dissolve the patent-pool arrangement for quite some time; however, for its own reasons, micro-cap Summit wants to keep Pillar Point in place.
Even though the eye surgeon may own the machine -- having paid in excess of $500,000 for it -- he or she can't run it without first scanning an optical memory VisionKey Card to operate the system. That's how Visx gets its procedure fee -- by selling the cards. Human nature being what it is, some ophthalmologists have focused on that toll as a source of legal contention, wanting the fees back. Visx is also litigating -- suing some doctors and some renegade manufacturers for bypassing the fees. Moreover, Visx and patent partner Summit are also suing each other.
On top of the Pillar Point challenge, the FTC has also made an unkind suggestion that Visx has fraudulently acquired a crucial patent and therefore feels that such patent is not enforceable. Declares Logan: "We're going to prevail on this." He says Visx shareholders spent $100 million to develop the equipment and bring it to market. Without the patents and procedure fees, "there would be no industry." Logan is emphatic that the PRK and LASIK procedures are "brand new" and are not replacing any old systems or techniques.
PaineWebber analyst Charles Olsziewski likes the company. His estimates going forward are based on the royalty stream from individual procedures. "We see Visx's equipment sales going down each of the coming three years. There are only a finite number of sites that can buy a laser; that's why the royalty stream is so important in the decision to own this stock." Olsziewski's target price for Visx is $55 by the end of 1998, and he expects the company to earn $1.75 this year and $2.20 next year.
He is discounting the threat of new competitors coming into the market, as well, noting that unless important patents are invalidated, even future competitors will be beaming royalty fees to Visx's bottom line with each laser sold.
Eyes on the Prize
Indeed, the Paine Webber analyst is bullish on the industry as a whole. There are companies that provide facilities and lasers for surgeons, one of which is TLC The Laser Center Inc. (LZRCF), a Canadian firm that is the largest provider of LVC services in North America. Though he doesn't follow Laser Vision Center Inc. (LVCI), Olsziewski says both companies are doing well and approaching profitability. Rating TLC a "buy," he says the company will lose 34 cents per share in 1998 and will turn the corner next year, making 16 cents. After that, things look very good for TLC with 76 cents in 2000 and $1.40 per share in 2001. His target price is $21 to $22 over the next 12 months.
Michael Lachman of Hambrecht & Quist says he believes the price-fixing case will eventually have a straightforward resolution: Pillar Point will be dissolved, which is what both Visx and the FTC want to see happen. The patent issue is more complicated, and therein lies the danger. "I think the risk is already reflected in the stock price," says Lachman.
If these issues are resolved favorably for Visx, then there's a huge amount of upside to the stock price. "Part of the reason I have a `strong buy' on the stock is that I think we'll see several more quarters of excellent earnings numbers before there's any resolution to the FTC patent matter," explains Lachman. Though he has no target price currently, his EPS estimates are $1.80 this year, $2.20 next year followed by $2.69 in the year 2000.
Competition Gearing Up
Certainly, Summit is competing with Visx on a small scale, but on the horizon are some others: Autonomous Technologies Corporation (ATCI) got a nod from an FDA advisory panel in mid-February, and the company now expects approval of its excimer-laser device sometime in the second or third quarter. Now owned by Bausch & Lomb (BOL), Chiron Vision Corp. has a device that will probably receive approval sometimes in 1999. Again, Chiron and others must be licensed under Visx's patents and pay a royalty. Logan says he's "absolutely" prepared for any competition and that he will compete "on any level" he has to.
Logan, at least, is voting with his personal wealth. Each of the past three years, including this year, CEO Logan says he's sold a rather scant 40,000 shares of company stock. "It has nothing to do with the stock price -- it's dangerous to have all your assets tied up in one company -- salary, bonus and pension plan. I'm a bit more diversified now." He says that when he came to the company in 1994, the board granted him 300,000 shares. Today, after all sales of stock, he owns 520,000 shares, which works out to 3.4% ownership -- worth in excess of $23 million.
Institutional shareholders include Dresdner Bank AG of Frankfurt, Germany, with 13.8%, and Dresdner RCM Global Investors LLC of San Francisco with 13.7%. Money managers Chancellor LGT Asset Management and Merrill Lynch & Co. hold 12.0% and 13.4% respectively. With only 15.4 million shares outstanding, it wouldn't take much bad news to give the company a laser-sharp haircut.
Clearing the Bar
The risks of owning Visx are real. Laser sales are going down and will level off -- that's just a plain fact. Analysts have predicated their strong earnings estimates on a per-procedure royalty stream, and so from now on the primary risk factor is going to be the company's ability to live up to those expectations.
Plainly, the company has shown its willingness to compete in a marketplace of aging baby boomers. It will be the legal and regulatory elements that ultimately either show daylight to Visx shareholders, or blindside them.
Links
The American Academy of Opthalmology offers information and perspectives on PRK procedures on its Web site. A Radial Keratotomy Web site includes answers to frequently asked questions. And Tommy's Home Page offers a personal account of the procedure.
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