Under-followed by the Street and unknown to most investors, ophthalmology pure-play, Iridex Corp. (IRIX), is both a compelling short-term and long-term investment opportunity. Buttressed by its sterling reputation as a research-oriented firm for two decades within the ophthalmic laser space, Iridex has enjoyed a quiet inflection point in recent quarters. Iridex is now a more commercially-oriented company focused on ramping up its revenues and earnings - a focus we believe will boost its shares to $20+ in the next 12-18 months.
Already profitable and generating positive cash flow, Iridex's business momentum has only just begun to turn upward. After growing its revenues 8% year-over-year in its first two quarters of the year, in the third quarter, Iridex's revenues accelerated higher, growing 21% year-over-year. With a specific focus on the retina and burgeoning diabetic and glaucoma markets, Iridex's proprietary MicroPulse™ laser technology has a massive opportunity in front of it.
Numerous data points from the past six months support our bullish convictions that Iridex's recent inflection point will usher in a break-out Q4, along with a multi-year growth curve yet to be appreciated by the market. Moreover, with new CEO, William Moore, at the helm, who formerly founded Natus Medical Inc. (BABY), Iridex's growth pivot appears to be in its nascent stage. We believe the company can grow its revenues at a 25%-30% CAGR over the next three years, if not more.
In addition to an accelerating revenue line, Iridex's operating margins and underlying profitability appear poised to expand even further, positioning the company to grow its earnings to $0.40-$0.50 in 2014. While $0.80 in earnings may be a more realistic estimate for 2015, we believe that a $1 a share is certainly achievable, especially if Iridex is successful in expanding its product line late next year to address all phases of glaucoma.
As Iridex's top-line and bottom-line metrics improve, we believe new investors, along with new analyst coverage, will eventually propel shares to the mid-to-high teens by the end of 2014. In 2015, a move to the mid-$20s also seems within reach. Given that Iridex should grow its earnings at a CAGR of 50%-75% over the next three years, an eventual 25X forward estimate on $0.80-$1.00 in 2015 earnings will not be unwarranted if the company executes like we think it can.
Ultimately, we believe Iridex will become a logical acquisition target for either Alcon Inc. (ACL), with whom they already have a partnership, or Bausch & Lomb (a $2.8 billion division of Valeant Pharma International (VRX)), in two to three years. More on that later.
Taken as a whole, we see limited downside for Iridex and appreciable upside.
Iridex is one of our favorite names for 2014.
Company History
Iridex came public in 1996. While the company has done a great job of introducing innovative products, it has never been successful at sustainably growing its revenues and earnings during this time.
In 2007, the company made a fateful acquisition, spending $26 million for aesthetic assets it subsequently sold for just over $5 million in 2012. To say this was an untimely purchase is an understatement.
Note how the revenue line decreased by 40% from 2007 to 2012:
IRIX 2007-2012 Sales History
Due to its history of declining revenues and spotty record of profitability over the past five years, Iridex screens poorly for most investors. Their ambivalence presents a compelling opportunity for astute investors with a 12-24 month time horizon.
Enter William Moore
William Moore, a successful entrepreneur who founded Natus Medical, has been Iridex's chairman since 2007. Late last fall, Moore stepped in as Iridex's CEO.
Given that investing in microcaps can be like the "Wild West" at times, we are always comforted to find that a well-pedigreed CEO, with a history of success, has signed on to lead a company's turnaround. In our early rounds of due diligence, when we discovered Mr. Moore had taken on the day-to-day role of CEO at Iridex, it immediately prompted us to delve deeper into the story. We believe Moore saw a great opportunity at Iridex. Why else would an executive with his past achievements make such a commitment to an unknown laser company with only $35 million in revenues?
Listen to Mr. Moore's statement upon joining the company as CEO:
Iridex is in the unique and positive position of having both established [and] emerging products targeted at large and growing markets. The company has many assets, including technologies and intellectual property associated with a potential paradigm-changing means of treating serious eye conditions, a stable balance sheet and a talented team of employees. Having been a board member for more than 5 years, I am excited about this opportunity to serve as the President and CEO of Iridex. I am committed to representing the interests of all stakeholders as we work to build shareholder value.
As we continued with our due diligence this month, we felt it was paramount to understand what Moore referenced as the "potential paradigm-changing means of treating serious eye conditions." If we could fully comprehend Iridex's opportunity, sketching out a multi-year model for Iridex would become much easier. Afterwards, we would then be able to reverse engineer a road-map for where the stock could go during this multi-year inflection point.
Our conclusion is Iridex is in the right place at the right time.
Let's discuss.
What is MicroPulse and what makes it so paradigm-changing?
MicroPulse is a vision-preserving laser treatment that does not produce the retina tissue damage that is often associated with traditional laser therapies. By producing laser pulses in very short durations, MicroPulse creates a therapeutic response of lowering the intra-ocular pressure of a glaucoma patient without thermal damage. In layman's terms, this improves the doctor's ability to more precisely control the laser's effects on target tissues.
A major breakthrough occurred in 2012 when Iridex successfully incorporated the MicroPulse module into the IQ 532 laser system. This made the IQ 532 a valid laser treatment for a much broader patient population.
Iridex's IQ 532 system therefore offers ophthalmologists greater versatility and a high return on their capital investment because it can be used for a range of other conditions, including diabetic macular edema, proliferative diabetic retinopathy, and retinal tears.
MicroPulse does not burn and damage tissue
The easiest way to fully comprehend the differentiating aspects of MicroPulse over traditional lasers is to spend a minute examining the slide below:
MicroPulse vs. Traditional Laser Treatment of DME (Diabetic Macular Edema)
(click to enlarge)
Source: Iridex
While both traditional and MicroPulse lasers have demonstrated excellent efficacy for DME, only MicroPulse has been shown to be safer, with less side-effects, and no discernible retinal damage observed after ten years of treatment.
If you were an ophthalmologist, it seems pretty obvious you would choose the laser with the MicroPulse technology. Tack on ten-year data to review as proof that "MicroPulsed" eyes experience no retinal damage, and the choice is made even easier.
The following slide from IRIX's investor deck does a great job summarizing MicroPulse's positives:
(click to enlarge)
Source: Iridex
If the efficacy, 10-year safety data, and superior economics of MicroPulse over traditional lasers are not enough to spur adoption, a number of additional data points make a strong case for increased market adoption even stronger.
IRIX's inflection point intersects with many powerful mega-trends
The more data points an investor can assemble which are supportive of an emerging inflection point, the more powerful and longer-lasting that inflection point will be. As such, there are a multitude of data points concerning MicroPulse which suggest Iridex's inflection point is in the very early innings.
1. There are not enough ophthalmologists in the world to treat the alarming number of annual new cases of diabetic macular edema and glaucoma. Note the incredible rise in diabetes just in the U.S. from 1958-2010:
Growth in Americans with Diabetes from 1958-2010
(click to enlarge)
Source: CDC's Division of Diabetes Translation
2. The current standards of care for DME, anti-VEGF intravitreal injection therapies, are highly effective, yet each is extremely expensive and typically requires five to six injections into the eye annually, usually over a 15-20 year timeframe.
By combining the use of the MicroPulse laser in concert with anti-VEGF injections, the process provides a superior patient outcome, lowers the costs to the healthcare system, and increases the ophthalmologist's income.
3. Over the past six months, there have been dozens of clinical publications published as white papers by physicians around the world, detailing the wonderful results being observed in patients who have received treatments with lasers utilizing MicroPulse technology.
4. Standing room only and heavy foot traffic have been reported at MicroPulse presentations/booths at the top 3 annual ophthalmologist meetings over the past four months.
Let's delve into each of these data points.
A paucity of doctors to treat diabetes/glaucoma epidemics
The International Diabetic Federation recently disclosed there are 382 million diabetics in the world. By 2035, the organization predicts the number of cases will soar by 55% to 592 million diabetics. Here are some statistics, unearthed here:
- According to reports from the International Council of Ophthalmology (IOC), despite 200,000 ophthalmologists practicing worldwide, there is both a current and a future anticipated shortfall in the number of ophthalmologists in both developing and high-income countries.
- In developing countries, there is simply a lack of ophthalmologists.
- Ironically, in high-income countries, even though the number of ophthalmologists is increasing, the population of 60+ is growing twice as fast.
The math is simple. There is a serious scarcity of doctors to treat all these diabetic/glaucoma patients. Therefore, a tipping point seems close.
These sentiments were echoed by Mr. Moore on the Q3 call:
What I'm convinced of is that the logistics of doing injections on the emerging population of diabetic patients will become overwhelming to the physician base. If you simply take the number of doctors practicing versus the numbers of doctors retiring versus the number of doctors that are coming into the business and look at the diabetic population, they can't treat them. It's just mathematically impossible to do it with drugs.
In Europe, Brazil, and India, people are looking at the huge number of diabetic patients and realizing they can't afford their current mode of repeated drug treatments for DME. It's too expensive and not financially sustainable, let alone the logistics of having millions of patients repeatedly visiting their physicians to receive costly injections every 6 to 8 weeks.
Anti-VEGF therapy, in conjunction with MicroPulse, improves time efficiencies while lowering the cost to the healthcare system
In addition to requiring 5-6 repetitive injections a year, anti-VEGF therapies are disruptive to the lives of both patients and their extended families, with the need for multiple visits to the doctor's office.
However, by combining the use of the MicroPulse laser with anti-VEGF injections, not only does it provide a superior patient outcome, but it also lowers the costs to the healthcare system, while simultaneously increasing the ophthalmologist's income.
We found this quote from Retina Today particularly revealing:
Dr. Mansour stated that the goal of DME therapy is to achieve the greatest reduction in macular thickness in the shortest amount of time with the least amount of side effects and with the greatest duration. I am able to achieve that by combining micropulse laser therapy and pharmacologic VEGF inhibitors.
As for the economics of combining treatments, they are actually more beneficial to the ophthalmologists:
(click to enlarge)
Source: Iridex
While all patients will not necessarily be able combine therapies, for those that are eligible, it seems like a great option for an ophthalmologist to choose on many levels.
Surge in White Papers supports our accelerated adoption thesis
One of the more compelling reasons for why the accelerated adoption of MicroPulse has already begun, is the multitude of complimentary white papers published by independent ophthalmologists from around the world over the past six months. These papers extol the virtues of the MicroPulse technology.
Think about that for a moment. What better way for a product to sell itself than to have glowing word-of-mouth reviews by actual users in the form of documented white papers. We believe these independent white papers spurred sales in Q3 and they will act as an important lever to quicken sales growth in both Q4 and throughout 2014 and beyond.
For those who would like to peruse these white papers first-hand, they can be found on Iridex's site here.
We thought the following quote by Dr. Jonathan D. Walker, from a white paper published earlier this year, was representative testimony to the prevailing sentiment on MicroPulse that can be found throughout these various case studies:
I have found combination therapy to be most effective for DME. I tend to utilize whichever treatments are necessary for each patient, including topical NSAIDs, anti-VEGF agents, traditional focal laser when the anatomy calls for it and MPLT - particularly when edema involves the fovea.
Logistically speaking, it is an advantage to be able to use the IQ 577 laser for several types of traditional treatments as well as MicroPulse. Although I have used the Iridex IQ 810 laser with good results and the 810 nm wavelength allows safe treatments at higher duty cycles, the IQ 577 seems to be more comfortable for my patients.
If I had to summarize my experience with MPKT in just one sentence, I would say that I would find it difficult to treat my diabetic patients without it.
Standing room only and heavy foot traffic at the most important eye conferences
With so many positive endorsements, such as Dr. Walker's above, published throughout this year, it is not surprising that reported interest in Iridex has surged amongst ophthalmologists at the most important eye conferences.
Here are some data points provided during the Q3 call by Mr. Moore:
1. Physicians come up to our booth in conferences and without prompting or asking about it.
2. At a recent conference in Hamburg, physicians actually paid a fee to see presentations from four MicroPulse-practicing physicians.
3. In Amsterdam, we sponsored a workshop, and more than 100 physicians gathered to learn how it could benefit their patients.
4. With more than 1,400 global views of Iridex's most recent webinar, we are seeing strong interest from physicians in MicroPulse Laser Therapy as a durable and economically appealing medical solution for both the glaucoma and retina markets.
Note that the MicroPulse presentation in Hamburg was not sponsored by Iridex. Instead, the European Society of Retina Specialists sponsored the presentation - something which has never happened until this year.
At the largest annual conference for ophthalmologists, known as the AAO conference, a medical journal reported that Iridex's booth was one of the busiest of the meeting. This timely data point for investors was only reported as of last Friday.
The evidence is overwhelmingly clear to us. Ophthalmologists' interest in Iridex's lasers is at an important inflection point, one that should translate into accelerating sales growth for the company in both Q4 and throughout the next 2-3 years.
Sales growth begins to accelerate
Taken together, we tend to view Iridex's 21% sales increase Q3 as no fluke. Instead, we firmly believe it is just the start of an accelerated multi-year growth curve.
While MicroPulse is the primary driver for Iridex there are additional levers to spur growth. The company recently introduced four new niche products at the AAO conference. Moreover, internal initiatives, potential tuck-in acquisitions, and an important new consumable product for early stage glaucoma late next year are all future catalysts to spur growth. Consequently, we are quite comfortable in our belief that Iridex can grow its sales at a 25-30% CAGR over the next three years.
Presently, coverage on Iridex is limited to one analyst. As such, most investors do not realize how much leverage there is going to be in Iridex's model. At the Craig Hallum Conference in September, Iridex stated their long-term operating model would consist of 55% gross margins, along with 15%+ operating margins. Although it will take a few quarters before the leverage truly manifests itself, we believe Iridex could accelerate its operating margins quickly on a realistic rate of 25-30% sales growth. Let's take a look at our model.
IPI IRIX Model
We believe our model is both realistic and highly achievable for the next two years. Should top-line growth accelerate even faster than we are modeling, 2015's operating margins could a pleasant surprise. Here are our projections for Iridex's next two years:
IPI's 2013-2015 IRIX Model
(click to enlarge)
Source: Inflection Point Investing LLC
Risks: As with any investment there are a number of risks that investors should consider.
First, Iridex has a limited supply of stock. While we think this is a positive, some investors may be turned off by the company's 9.8 million shares outstanding. To this end, although average daily volume has improved dramatically since Iridex reported its break-out Q3 earnings, there is no guarantee that the stock will continue to trade actively in the future. Investors in Iridex should therefore be mindful of the liquidity risk when sizing their positions. Also use limit orders when entering or exiting a position in the name.
A private equity fund owns 25% of the stock. Given that this fund initially placed Mr. Moore on IRIX's board in 2007, we believe they are shareholder-friendly and will slowly dispose of their position in a controlled manner via a secondary offering in 2014. Nonetheless, there is no guarantee that such an offering would be greeted warmly by the market.
There is also the risk that accelerated adoption may not occur as quickly as we anticipate. Our model could be too aggressive.
Having noted these risks, even if we are wrong about Iridex's sales trajectory, its business will still accelerate and earnings growth will follow. In this scenario, shares would still have meaningful upside, just not the substantial gains we are predicting.
Conclusion
Although Iridex has recently had a big move, we believe the stock has meaningful upside in 2014 and beyond. This is a story that will resonate very well with new investors, even at current levels.
Just yesterday Briefing.com added Iridex to their Emerging Growth Stocks list, stating:
Iridex's MicroPulse will begin to take share due to its non-invasive nature, favorable economics, and lack of side effects. The Q3 report was a big catalyst. The company not only beat guidance but provided commentary MicroPulse was gaining traction.
In addition to ourselves and Briefing.com, we expect new positive viewpoints to emerge on IRIX's stock. New analyst coverage is therefore another catalyst investors should anticipate during 2014.
As for the ultimate endgame, we believe Mr. Moore sees a big runway ahead for Iridex over the next few years. Because he is 64 years old, however, we believe Mr. Moore's plan is to scale Iridex to a $75-$100 million revenue run rate by 2016 and then put the company up for sale.
Multi-billion dollar companies such as either an Alcon or a Bausch & Lomb could easily turn a company like Iridex and $75-$100 million in sales, into a $200-$300 million company pretty quickly with their vast distribution channels. If we are right, a takeover of Iridex would most likely be valued at 3-4X forward sales, implying a potential valuation upside to as much as $225-$300 million.
Let's not get too ahead of ourselves, however. For now, we will be very happy to see the stock simply advance to the mid-to-high teens next year. Such a move would provide investors with 50-75% upside from current levels.
With tremendous support in the $8-$9 range, we see minimal downside and strong upside. Iridex is therefore one of our high-conviction names entering 2014.
Disclosure: I am long IRIX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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