Description

ARTC
Arthrocare is a name that has been submitted before. However the last time it was written on was in 2001. I would like to approach it from a different perspective. The basic thesis is that Arthrocare has a franchise in its core platform coblation technology. The intellectual property surrounding the technology has been defended successfully numerous times- most recently against Smith&Nephew. Sales growth, most of which has been internally driven, has not been less than 14% per year, and is currently in excess of 25%. Current operating margins do not reflect the high profit potential of this recurring revenue business. If sales continue to grow at 20%+, and I believe they will, operating margins can grow to reach or exceed 17% in 2005-which translates into EPS of $0.95 and $1.33, respectively. Over the longer term, I believe operating margins can exceed 20%.

Platform Technology- ARTC’s coblation technology is truly a platform technology. It uses in effect a cold heat- and is very effective in performing soft tissue surgeries. As opposed to cutting instruments or lasers, which can cause trauma to surrounding tissue, ARTC’s instrument effectively vaporizes tissue by splitting molecular bonds. The result is less pain, faster recovery times and better patient outcomes. ARTC’s surgical instruments are not reusable.

The primary markets in which Arthrocare operates in are Arthroscopy , Spinal and ENT. Arthroscopy, which consists of shoulder and knee surgery instruments, is relatively mature in terms of shoulder; 52% of shoulder procedures done today use the coblation technology. In knee it is less mature, as only 17% of procedures use coblation. ARTC’s market share within the penetrated portions of Arthroscopy is a leading 50%, with competitors J&J, Stryker and Smith&Nephew having the other 50%.

J&J and Stryker are both licensees of the coblation technology- they both pay royalties to ARTC. Smith&Nephew, estimated to have 15-20% arthroscopy (competing coblation) market share, recently lost a patent infringement case to ARTC and will most likely be taken off the market with a full injunction.

Spinal- ARTC’s spinal wand is used for spinal disc decompression. It is increasingly being viewed as the safest and most accurate means of decompressing the spinal disc. The most common method of treating contained herniated discs until the advent of Nucleoplasty (ARTC’s procedure) was the use of a laser. The problem with the laser is that it was not accurate and caused trama to surrounding tissue. Doctors I have spoken to that use the product have validated these qualitative differences.

ENT- ARTC’s instrument is used to remove patients’ tonsils. The use of coblation vs. cutting instruments or lasers results in faster recovery times and less pain. Doctors I have spoken to indicate the differences in outcome are most noticeable in children. 80% of all procedures are estimated to be performed on children.



Annual
Procedures ASP Potential Market % Unpenetrated
Arthrosc 2,600,000 $170 $442,000,000 65%
Spinal 500,000 $1,000 $500,000,000 99%
ENT 2,000,000 $170 $340,000,000 95%




2000 2001 2002 2003 2004 2005 2006
Atlantech 0 0 3 10 12 14 17
Arthroscopy 54 59 62 72 77 83 88
Spinal 4 4 9 14 21 32 45
ENT 3 7 10 17 25 38 53
Parallax 0 0 0 0 8 11 13
Other 6 8 5 1 0 0 0
Total Revenue 68 77 89 114 143 177 216

Revenue Growth 45% 14% 15% 28% 26% 24% 22%

Gross Margins 59% 61% 62% 70% 70% 72% 73%


As can be seen from the table above, the base Arthroscopy business (of shoulder and knee) represents the bulk of revenues but is not growing as fast as spine and tonsillectomy. Taken together, the slow growing arthroscopy businesses combined with the faster growing spinal and tonsillectomy businesses, can grow in excess of 20% internally for at least the next 3 years. (Atlantech, which is an international distributor was acquired in 2002.)

Track Record- While the company disappointed many in 2001 and 2002 as EPS went from $0.50 in 2000 to $0.43 in 2001 down to $0.05 in 2002, revenue growth and gross margins remained strong. The reason earnings declined, particularly in 2002, was that the company elected to build an infrastructure that could support a much larger sales base. ARTC switched to a direct sales model and hired separate sales forces for Arthroscopy, Spine and ENT. The company also undertook to perform clinical studies proving the benefits of coblation in the newer application areas.


Insider purchases: In May of 2002 aggregate purchases in excess of $700,000 were made by the CEO and the CFO of Arthrocare between $11.50 and $12.50. The company has repurchased nearly a million shares in the $16 range and the recent acquisition of Parallax
Medical was done for cash not stock.

Balance sheet: The balance sheet is currently debt free. Before the Parallax acquisition, cash was $33.9 million. The company will spend $28 million in cash (+a relatively modest earn-out) on the recent acquisition.

Valuation:There are 21.7 million fully diluted shares outstanding. The stock is trading at $23 giving it a market cap of $500 million. ARTC trades above most of its med tech peer group based on 2004 consensus EPS numbers and in line with the peer group when using my estimate for 2004. Consensus 2004 EPS is $0.52. My estimate is $0.70. It is only when one goes out to 2005 and 2006 that ARTC becomes a value. My estimates for 2005 and 2006 are $0.95 and $1.33, respectively. My estimates assume revenues improve by 25% per year on average ($143 million in 2004, $173 million in 2005 and $220 million in 2006) and that operating margins improve from 7.3% in 2003 to 20% in 2006. I believe ARTC should be able to continue to increase its top line beyond 2006 and therefore ARTC should command a premium multiple off of 2005-2006 numbers. 30x 2005 yield a price of $29 and 30x 2006 yields a target of $40. These targets could be reached as soon as the market gets better visibility that my numbers are correct.

Catalyst

Catalysts:
2004 should be a breakout year for ARTC in terms of profitability. Helping will be stability in operating expenses as fixed costs are leveraged, lower legal expenses from having the Smith&Nephew case largely over with and continued robust growth from Spine and ENT. If a permanent injunction were to be imposed upon Smith&Nephew in Arthroscopy, we would be that much more confident in our forecast for 2004. The key to my higher than consensus numbers materializing between 2004 and 2006 will be the continued 20%+ top line growth and continued strong gross margins. I do not believe these to be big leaps of faith considering the company’s successful historical track record on these measures.