Description

Summary and Overview
Biolase Technology, Inc. is a medical technology company involved in the design, manufacture, and marketing of surgical lasers for dentistry applications, as well as related products. The company maintains that its dental laser systems allow dentists and other specialists to perform various dental procedures, including cosmetic and complex surgical applications, in significantly less time and with less use of anesthesia that with traditional dental equipment such as drills and scalpels. Soft tissue dental lasers are not new and have been in use for over 15 years. However, single units with both soft and hard tissue capabilities such as Biolase’s WaterlaseMD product, are a relatively recent development. To become comfortable with a laser system purchase, a dentist has to believe that the laser offers far superior results, generates a unique revenue opportunity not currently captured by the existing practice, and/or facilitates strong patient loyalty to effectively offset the high upfront cost of the laser system itself. We believe that because a hard tissue laser can really only function as a complementary tool and not as a replacement for existing technology, it is harder for a dentist to get comfortable with its current value proposition.

Summary Financial metrics
EBITDA FCF
2004 -1.8 -3.0
2005 -16.2 -17.3
2006E -5.8 -6.5
2007E -4.9 -6.6
2008E -3.7 -7.6

Key Points to Investment Thesis

We believe Biolase (ticker: BLTI) is a compelling short investment with many interesting catalysts that should materialize over the next 12-18 months. We believe BLTI is likely worth approximately $1 per share, as we see value in only the company’s tangible assets, plus some value for its existing intellectual property. While the short interest in the stock is high at 26% of the float, we believe this is a case where the shorts are highlighting a great short candidate. Biolase has struggled operationally for the past 7 quarters to achieve operating profitability, and we believe it will continue to struggle going forward. We see the following key points to our investment thesis:

• We believe Biolase will continue to post net income losses and burn cash for the foreseeable future. Further, Biolase’s manufacturing process limits its ability to meaningfully cut pricing to levels where volume increases could cover operational costs, in our view;

• A recent class action lawsuit versus Biolase, containing allegations by 4 former employees, involves claims of intentional and rampant channel stuffing through affiliated distributors. Based on our due diligence, this practice appears to be continuing;

• Accounting issues involving inventory controls, as well as worrisome increases in both accounts payable and accounts receivable;

• Based on our channel checks, we believe that dentists have a difficult time understanding the WaterlaseMD ROIC proposition at a value much above $40k vs. the current $80k list price. At a price of $40k, the company has little hope of reducing losses;

• Competition and what we calculate as the demand curve for hard tissue lasers should inhibit Biolase’s ability to achieve meaningful pricing or sales volume increases needed to achieve break even sales;
• Recent management and sales force turnover (including the CEO and head of sales), introduces a higher degree of operational uncertainty to the Biolase story at a time when the company is struggling to achieve break even sales; and

• There are only two analysts following the stock, both of whom are bullish on Biolase’s prospects. We believe these analysts have unrealistic views of a turnaround and irrational price targets and we expect downward earnings revisions and ratings cuts over the next couple of quarters.

Financial Outlook Offers Little Hope of Turnaround

Rising Cost of Production Limits Profitability
Based on 2005 and 1Q’06 financial performance, we estimate the cost to produce each unit at roughly $29k, up from a cost of roughly $21k when the WaterlaseMD was first launched. We believe that a manual final assembly process limits operational efficiencies that higher volumes might bring to an automated process. It is this high cost of production that limits Biolase’s ability to sell its hard tissue lasers at a price point designed to reach mass market appeal. It should be noted that the company maintains that it has actually reduced its cost of production. However, to date, they have not been able to show us their calculation that renders our estimates invalid to its first 6 months of production. We expect the company to spend approximately $30,500 per WaterlaseMD unit in 2Q’06.


Valuation Summary

It would be hard to ascribe much value to Biolase as an on-going concern; we believe the company’s cost structure is way out of line with its cash flow generating potential. Thus, we believe Biolase’s only value is its existing cash, its hard assets, and some nominal incremental value for intellectual property, all net of liabilities. We believe that its patents are not worth much given 1) recent purchases of IP in the dental laser space, and 2) the company’s important patents expire by 2011. We believe, based on industry contacts, that Biolase receives a 1-2% royalty from its competitors for all US sales, which we do not believe to be a material source of cash flow to Biolase nor a significant competitive deterrent.

Valuation

Assets 44.0
Less
Intangibles (1.7)
Goodwill (2.9)
Liabilities (24.0)
Net Asset Value 15.4
Additional Value of IP 15.0
Total Value of BLTI 30.4
Shares outstanding 23.3
Value per Share $1.30

Financial Forecast – Income Statement

We expect the company to generate $60 million in sales during 2006, down 3% from 2005, as we believe sales force turnover among other things, during 2005 will likely weigh on productivity during 2006. It should be noted that the WaterlaseMD sales cycle can be up to 2 years or more. Additionally, we believe that the changes to Biolase’s marketing arm will further impact 2006 unit sales, as will lingering dentist concern over quality issues that affected warranty expense in 2005. The company should improve its revenue growth during 2007 and 2008, but not enough to achieve break even sales.

Gross margins should improve somewhat to 53% from 50%, as the closure of the German manufacturing plant should positively impact margins. However, the recent launch of new direct operations in New Zealand and Australia should limit the full impact of margin improvement during 2006. We expect gross margins to continue to show improvement during 2007 and 2008 on higher sales volume. EPS should be a loss of ($0.36) per share for the full year versus the consensus estimate of a positive $0.01 per share. We believe the current consensus EPS estimate for 2007 of $0.47 is unattainable; we expect a loss of ($0.30).

Financial Forecast – Cash Flow and Balance Sheet

The company has shown an inability to generate meaningful cash flow and during 1Q’06, Biolase burned roughly $2 mm from operations and exited the quarter with $15.8 million in cash. Cash flow included a material increase in accounts payable of $1.9 million (a source of cash) and was up 25% sequentially. We anticipate that Biolase will burn a total of just under $6 million during 2006 and should finish the year with $11.9 million of liquidity, although continued use of vendor financing (i.e. accounts payable) could soften this burn rate. Extended timing on accounts payable disbursements has been a source of $5.9 million in cash flow since the beginning of 2004 -- a trend we view as unsustainable. For 2007 and 2008, respectively, we expect an additional $6.6 million and $7.6 million in cash burn and ending cash balances of $5.3 million and ($2.3) million. Our forecast is driven by continued sales below break even levels, coupled by a lack of material increase in accounts payable. In short, with liquidity issues looming for Biolase, we would expect the company to seek to raise capital no later than early 2007. Further, we would not be surprised if Biolase was unable to raise financing (debt and/or equity) due to lack of demand or limitations on existing credit facilities.

Allegations of Improper Accounting Controls Leads Us To Question Management’s Assumptions

We Find Change of Auditors and Lax Accounting Controls Worrisome
On August 9th, 2005, Biolase announced that it had dismissed its auditors, PriceWaterhouseCoopers (PWC) and retained BDO Seidman (BDO) as its new outside auditors. PWC found in conjunction with its 2004 audit several, material weaknesses in Biolase’s financial systems. Alarmingly, PWC found that Biolase’s finance department did not have sufficient depth and skill in the application of GAAP to meet the objectives that should be expected of these roles, contributing to the ineffective controls. The litany of accounting issues highlighted from the audit are listed in the Company's 2004 10-k.

BDO’s audit work for 2005 revealed continued material weaknesses in Biolase’s internal control over the recording of inventory transactions and the valuation of inventory continued through year end. BDO cited the company’s ineffective controls over (i) recording of inventory transactions in a timely manner, (ii) ensuring inventory transactions were properly recorded in the relevant accounting systems, (iii) properly accounting for inventory at lower of cost or market, and (iv) properly applying overhead rates to finished inventory.

Biolase’ poor accounting controls and its change of auditors, at the very best, indicates a lack of timely information flow from the operational and marketing units to senior leadership. For example, we found during our conversations with various sales contacts that the recent California Dental Association show laser sales were below expectations. Our research uncovered that Biolase sold approximately 5 units at the convention versus a typical 10 to 20 units. Now, our understanding of the units sold during the show may be incorrect, but we find it curious that Biolase management would indicate on it’s 1Q’06 conference call that unit sales from the show were UP 50%, implying 15 to 30 units sold. Our sources include both internal sales representatives and Biolase competitors. Dentists who are interested in a laser system usually speak with all three vendors to gauge price and product differences, so sales by Biolase will typically be detectable by Biolase’s competitors.

Summary of Current Litigation

Biolase was sued in US District Court Central District of California during 1Q’06. The plaintiffs, in the third amended complaint, now contend that the company made material and misleading statements in conjunction with its February 24th, 2004 secondary offering. The class action suit essentially contends that, in connection with its practice of intentionally stuffing its international distribution channel, the company made false statements regarding its revenue recognition and inventory levels. Among the allegations made, the suit specifically claims that,

“What Biolase failed to disclose was that the Company was (a) immediately booking revenue for questionable and highly unreliable purchase orders; (b) not selling laser units directly to dentists (as represented) but rather to a leasing company without a pre-approved lessee, thereby falsely representing demand and revenue stream; (c) stuffing international channels by shipping laser units to distributors and/or warehouses in Australia and elsewhere, where purchase orders and/or payment could not be confirmed and where the units would sit unsold for months upon months until a buyer could be found.”

We are also aware of a law suit filed in a foreign country contending that a dental distributor there received units that Biolase would not accept for return, despite the fact that the distributor did not even order the product. The distributor apparently has sued the company over this issue.

We Believe Dentists Have Difficultly Understanding WaterlaseMD ROIC Proposition

A key component to the WaterlaseMD sales pitch is that the product allows an individual dentist to run his practice more efficiently, capture revenue opportunities that are typically referred to specialists, and provide a better patient experience all at the same time. We believe the return profile for the WaterlaseMD is challenging for a dentist to quantify as productivity gains are tricky for even economists to measure and quantify, let alone dentists while new procedures offer subjective returns (many are cosmetic such as a crown lengthening, and thus are not covered by insurance). Also, improving the patient experience, while potentially worthwhile on its own merit, is similarly difficult to convert to a economic inflow. Thus, we believe that dental professionals in general are deterred from signing purchase agreements by the difficulty in measuring the WaterlaseMD’s ROIC. We also believe the relative cost of the laser unit to other dental equipment heightens discount rate used by potential purchasers, acting as a further deterrent to purchasers. At a minimum, we have observed a high level of post purchase regret from dentists we’ve spoken with, another indicator of “fuzzy math.”

WaterlaseMD Product doesn’t offer Material Value at Current Price

Based our research and field work, we believe that at an $80,000 list price, the WaterlaseMD does not offer a compelling value proposition to dentists versus competing lasers and traditional tools such as high speed drills. Essentially, we believe most dentists view the return on invested capital as unfavorable to their practice. One of the key selling points that Biolase uses to pitch its WaterlaseMD product is that the laser allows a dentist to perform a greater number of procedures without anesthesia. We have heard sales representatives and “commissioned” dentists claim that they can do 90% of their procedures without anesthesia. Based our channel checks, we believe dentists ultimately administer far more shots than they would otherwise expect given the emphasis placed on this point during the sales process. It is our belief that only 50% of hard tissue procedures can be executed without Novocain. Further, we believe claims for productivity gains highlighted by Biolase are overstated for a number of reasons, as most dentists we surveyed indicated that the use of local anesthesia does not materially slow down their workflow, and in fact, is necessary for many number of procedures in any case. Ultimately, we believe this shortfall can lead to disappointed customers, with buyers remorse affecting word of mouth sales.

While the WaterlaseMD product is good at some procedures, particularly those involving soft tissue, it does not replace the dentist’s traditional tools in totality. We believe most dentists view the WaterlaseMD as a supplement to their existing equipment rather than as a core component of their capital equipment. However, at $80k, we believe the cost of the machine materially reduces real purchase interest.

WaterlaseMD Inappropriate Tool for Many Common Procedures

The Biolase sales process stresses that its WaterlaseMD system is an effective replacement for the drill, but, in reality, we believe dentists find that the drill remains a necessary tool. We believe that for many common procedures such as polishing, cutting metal fillings, and grinding, the drill remains the most effective tool. Additionally, there are operational system issues with hard tissue lasers such as an inability to cut amalgam (silver fillings) that limit the usefulness of the product. Our survey work also revealed that one of the biggest complains dentists have about hard tissue lasers is that they are not effective for preparing crown posts. The average increase cited by dentists surveyed indicated that it takes about 4 to 5 times as long with a laser than with a drill, or approximately a full hour. Crown post prep work involves grinding down the tooth (usually a molar) to a very small stub; the crown is then attached to the stub.

Recent research indicates lasers may not be as effective for root canal procedures as previously thought, or more importantly, as marketed by Biolase. A recent article in the Journal of American Dentistry JADA from the January 2006 issue indicated that lasers "Do not sterilize hard tissue past the first 5 layers of hard tissue.” We understand this essentially requires that root canal procedures continue to need the traditional sterilization methodology currently in use. Our understanding is that one productivity gain Biolase promotes to dentists is the shortened sterilization process needed in a root canal procedure. When asked about the article, Biolase indicated that they refute the methodology of the study, but did not rebut the article formally.

A dentist purchasing a hard tissue laser must understand that it is a complementary product to existing drills and not a replacement product. We believe this lower practical utility is reflected in our survey where dentists expressed a real interest in the product at the $40k price level and lower, as opposed to the current $80k list price. We believe that above a price point of above $40k, product demand is limited and as a result, hard/soft tissue dental lasers will likely be slow in achieving meaningful market penetration.

Potential New Market Entrant Could be Disruptive to Biolase’s Market Position

On Syneron Medical’s expected entry into the dental laser market, one of our sources confirmed that the company will launch a soft and hard tissue laser product in the coming months set at a $40,000 price point. We believe this could be very disruptive to Biolase and at a minimum, necessitate a reduction in list price on the WaterlaseMD product from the current $80,000. We expect a year end 2006 launch, although we are uncertain if Syneron has approached Biolase to discuss licensing of its IP. More importantly, we also believe that many dentists who are interested in purchasing a hard and soft tissue laser system are aware of the potential entry by Syneron, and may be delaying purchase decisions for further price clarity. The market rumor is that the Syneron system gets around Biolase IP by placing the laser mechanism in the handset, although those people we surveyed with a technical understanding of hard tissue lasers thought this would be very difficult to engineer. In any case, we estimate, based on industry sources, that the current royalty payment is between 1% to 2% of sales, or between $400 and $800 an unit would not be a material deterrent to entry.

Pricing Appears to be Softer Than Stated List Price

At a recent sales presentation, we noted a Biolase sales representative stating, “Unlike other technologies, the price of our product is NOT going down; in fact, it is going up…so you should think about buying sooner rather than later.” Biolase did announce during 1Q’06 that is was raising its list price to $80,000 per machine, up from $75,000. However, on the company’s conference call, management noted that the average selling price was under 70k for the WaterlaseMD systems. We calculate that the average selling price is closer to $60k, and that significant discounting is taking place. Biolase has indicated that pricing in the international markets is below domestic markets. The company’s competitors have similar products priced in between $55k and $65k. Additionally, our conversations competing sales reps revealed that a typical sales practice is to include a $10k diode laser with the purchase of a larger, hard/soft tissue system.

Recent Management and Sales Representative Turnover Heightens Execution Risk

Effective May 9th, Robert Grant, the company’s President and CEO, and who also was appointed Acting Chairman of the Board on March 30, 2006, announced his resignation from Biolase to accept a position at Allergen. Biolase reappointed Jeffrey W. Jones to the post of President and CEO; Jones had held these positions previously before being replaced (and accepting the role as CTO) by Grant from 1994 to 2004. While we’ve heard it is possible that Grant could take key personal, nonetheless, the change highlights current management disarray. We being somewhat cynical, believe the leadership change is more a reflection of Biolase’s forward prospects.

Further on May 17th, 2006, the then current EVP of Marketing, James M. Haefner, resigned from Biolase to pursue other opportunities. Keith G. Bateman, who previously served as Biolase’s EVP of Marketing from 1999 to 2004, was renamed to the post of Executive Vice President, Global Sales and Marketing. We also understand that as of May 19th, 3 other sales representatives were released as well. We believe this additional turnover should impact sales for the remainder of 2006.

High Sales Turnover and Limited Initiation Periods Aligns Representative’s Interests Away from the Client

As a part of our due diligence, we held numerous discussions with former Biolase sales representatives. It is our understanding from both these conversations and though our industry contacts, that the Biolase sales force turned over almost 70% during 2005 and that current reps have a $2 mm minimal sales target. This equates, at list, to roughly 25 WaterlaseMD units a year. We further understand that sales reps are given a very short initiation period, sometimes as low as 3 months, to demonstrate meaningful progress towards their quota. We believe this aligns the sales rep not with the customer, who is making a long term purchase of a capital good, but with his/her own, very short term self interests, and can lead to very hard selling tactics.

Hard Sell Tactics not Aligned with Long Term Client Satisfaction

During our survey work, we were amazed at the hard selling techniques utilized by Biolase’s sales force. We had the opportunity to observe a sales meeting which, in our view, seemed strangely familiar to various fraternity initiation rites and pre-game football locker rooms pep talks. Biolase is changing its marketing strategy, launching a national road show and reduces its conferences presence. Our internal sources indicated that the company believes it can generate more “peer pressure” at bigger road show events. It is our belief that “hard sell” tactics alone are not commensurate with sustainable long-term returns; if economic benefits to ownership were obvious to the prospective client, hard sell techniques and emotional appeals wouldn’t be necessary.

Sell Side Analysts Have Overly Optimistic Expectations, We Believe Downgrade Risk is Likely

Two analysts currently follow BLTI and we believe these analysts have unrealistic views of a turnaround and irrational price targets. In light of very poor 1Q’06 results, both analysts reaffirmed their respective Buy ratings, while one analyst actually increased his price target from $11 to $13. We believe that as the story erodes, these analysts will ultimately cut price targets and downgrade the stock, putting further pressure on the shares.

Risks to Our Call

We have identified the following risks to our short call on Biolase:

•Insider stock purchases
•The announcement of a distribution agreement could be seen as a positive in the short term, although we believe such an agreement will negatively impact margins and disintermediate the company’s direct distribution channel.
•Small increase in absolute unit sales can materially improve results in a given quarter
•Delays of Syneron Medical laser or poor market receptivity to its offering
•Acquisition by distributor or competitor, which we believe is highly unlikely
•Biolase owns the significant hard tissue laser IP, although the major patents expire by 2011
•Application of technology to eye applications could be a new source of cash flow
•Expense rationalization - closing of German facilities should help expenses in 2006, although this cost savings should be offset by new costs associated with opening of direct distribution channels in New Zealand and Australia

Catalyst

• Liquidity issues looming which is likely to necessitate capital raise that we would expect no later than early 2007. We would not be surprised if Biolase was unable to raise capital (debt and/or equity) due to lack of demand or limitations on existing credit facilities;
• News flow from a class action lawsuit filed against the company in US Federal Court;
• Potential additional lawsuits;
• Introduction of additional competitive products, expected during 3Q’06;
• 2Q’06 and full year 2006 results, which, based on our channel checks, should continue to produce losses, disappoint street estimates and miss on cash flow generation; and
• Downward revision of forward growth expectations, resulting in valuation multiple contraction and thus, stock price declines.