Description

ENDO was presented by omar810 earlier this year. We are resubmitting the idea as we think the thesis has evolved significantly and in addition the stock has fallen over 40% since then. We beleive that ENDO is one of the most undervalued special situations in medical technology that we've seen in a long time.

Basic Thesis
- Institutionally abandoned equity due to accounting issues and former management team – problems almost entirely fixed now
- Clear leader in the fast growing space of curing prostate cancer with cryoablation (freezing of cancer)
- 2Q procedure growth was 22% sequentially and 55% YOY – running at less than 3% penetration of target market
- Cheap stock given the growth rate and earnings potential - Trades at low multiple to future revenues, has very solid gross margins, and will only require minor Capex going forward
- Opportunity to buy Endocare for 1/8 of the price that a large pharma/device company offered to acquire ENDO a few years ago before the accounting problems
- Approaching milestones in 2nd half of 2004 that create clear catalysts for stock price appreciation

Description
Endocare (Ticker: ENDO) is the leading company in the freezing of prostate cancer. Company has ~200 boxes in the field and generates revenue through the sale of disposable cryosurgical probes and through procedure fees for each cryosurgery performed.

Target Market
Last year about 220k thousand men were diagnosed with prostate cancer. Of these about 40k went into ‘watchful waiting’ (no procedure is performed while the progress of the cancer is monitored) and some die before a procedure is performed. Of the remaining patients about 40% (72K) got RP (radical prostatectomy = surgery = removal of the prostate) and 60% (108K) got some form of radiation therapy. It is this population of 180k patients that represent potential candidates for cryosurgery. In 2003 ENDO did 3584 procedures (2.2% penetration) and on a TTM basis they did 4308 procedures (2.4% penetration). Clearly cryosurgery of the prostate has significant growth potential as the benefits over other forms of treatment become understood by more doctors and patients.

Why Cryo? Efficacy
- Comparable efficacy to leading treatments (RP/radiation) with lower side effect profile (see www.endocare.com for complete efficacy data). “In the August 2002 peer-reviewed supplement of the journal Urology results of a seven year study of 590 cryo patients found that 92% of low-risk cancer patients, 89% of moderate-risk patients, and 87% of high-risk patients were disease free.” (Source: Endocare Website)
- Equal efficacy to surgery and radiation in low risk cases and likely better efficacy in high risk cases
- Endorsed by a number of top urologists including leaders at Mayo Clinic and Columbia Presbyterian

Why Cryo? Other Key Benefits
- Cryosurgery can be repeated. This is often not the case with radiation therapy because the body will have received too much radiation. Also, having radiation therapy limits a patient’s ability to employ radiation if needed for another indication further down the line.
- With focused ablation (partial freezing of the prostate) rates of impotency and urinary incontinence are much lower with cryosurgery. This is key since with improved PSA tests men are discovering younger and younger that they have prostate cancer. Quality of life (i.e. potency) is much more important to a younger patient. With older patients, RP related side effects are less of an issue as patients are less likely to be sexually active
- RP is not reversible (can’t put prostate back in!) and thus surgery is a permanent decision. Surgeons tend to have a ‘cut the whole thing out’ mentality. This was similar for a long time in breast cancer where the solution was to remove the breast. It took a long time to break that mentality and for doctors to look to lumpectomy to treat early stage breast cancer. Cryoablation is essentially the male lumpectomy and this thinking is beginning to take hold.
- Cryo is significantly cheaper than surgery
- Cryosurgery is minimally invasive and requires shorter recovery times

Thus, leading doctors are increasingly looking to cryosurgery as a front-line therapy. It can be tried first before needing to subject the patient to radiation or taking the irreversible step of surgery. Also, urologists like cryo because it keep patients within their fold. They do the cryo procedure themselves rather than referring their patient to an interventional radiologist or to surgery. Control over the patient and reimbursement stay with the urologist. (Reimbursement has been established for a number of years with government agencies and private payors. Cryo got its own code at the begging of 2004 - rates in 2005 look to be flat).

Procedure Growth and Trained Doctors

TTM at 2Q Annualized
2002 2003 30-Jun-04 30-Jun-04
Procedures 2,474 3,504 4,308 5,168
Total Trained Docs 275 536 682 n/a
Boxes in the Field 190 203 193 n/a

As seen above, procedure growth has been strong with Q2 2004 procedures running at a rate 55% higher than in Q2 2003. In addition, Endocare has been aggressive about continuing to train doctors (despite the substantial expense). This is essential as there will someday be more competition and ENDO must make sure that docs are trained, qualified, and comfortable on their system.

What the data above does not illustrate is that doctors who’ve been performing the procedure for a few years now do so on a far more regular basis – trained docs grow increasingly comfortable with performing the procedure and with patient outcomes. Thus, even if ENDO stopped training docs (which they have no intention of doing) we could expect to continue to see strong increases in procedure growth. We estimate that by mid 2005 ENDO will be annualizing at 10k procedures per year (represents only 5.6% penetration). This would require about 18.6% sequential growth each quarter for the next four quarters (last four quarters were 16.2%, 15.7%, 10.2%, 21.7%). At the very least we expect procedures to be running at 10k per year by 3Q 2005 (14.6% sequential quarterly growth from 2Q 2004).

Economics of Cryosurgery

For Cryo procedures, hospitals get reimbursement for about $6.5k to $14.0k primarily depending if cryo is done on an inpatient or outpatient basis. Cryo is a very viable outpatient procedure but hospitals still make better money if they do it on an inpatient basis. The hospitals must pay out about $5k related to cryo probes and procedure fees so the procedure is still reasonably profitable for them.

Endocare’s cryo division earns money in a number of ways
1. Of last years 1292 cases we estimate that about 500 were done on ENDO owned boxes. In this case ENDO earns the full $5k. We expect this number to be flat at 500 going forward.
2. For about 200 of the cases ENDO simply sells the probe kits directly to hospitals. We believe this is primarily in cases where kits are being sold to interventional radiologists for other forms of cancer treatment. There also may be some cases where the procedure will not be subject to traditional reimbursement and therefore the hospital buys the kits directly. In these cases ENDO simply charges $2.75k for the probe kits.
3. For the remaining cases, ENDO bills the 5k but the procedure is done on a box that is not owned by ENDO (built by Endocare but owned by a hospital or urology partnership). ENDO passes along $2.25K of the $5k procedure fee to the owner of the box. The net economic effect of this transaction type is the same as item #2 above (same gross profit) but it generates higher revs and a narrower gross margin because there is essentially pass-through income.

Going forward Endocare expects more procedures to be done without using ENDO owned boxes and thus blended gross margins will trend down over time. Having said that, they are in the process of successfully negotiating about $250 more per kit (thus they will get $3.0k per kit) and lowering mfg costs on probes which should mitigate this gross margin trend.

TIMM Medical

Endocare also has a division called TIMM Medical. This division was acquired a number of years back and is not integrated with the cryo business (i.e. separate sales force etc.). TIMM sells pump products for erectile dysfunction (patient population have conditions that Viagra and similar drugs do not work for). TIMM does about $9mm-$10mm per year with about 50% gross margins. We believe that at some point down the line TIMM will be sold to some strategic buyer with a sales force in urology. We would expect 1.0x to 2.0x sales or roughly 2.0x to 4.0x gross margin dollars (sales force could be eliminated so much of gross profit will drop to the operating line of acquiring company). For modeling purposes we have used a transaction price of $15mm less transaction costs of $1.0mm for a net of $14mm. ENDO should have no tax on this transaction since they will be taking a loss on the deal (ENDO also has $50mm in NOLs). (Note that the former management team paid about $37mm in cash and stock for TIMM Medical. Since that time the company has taken a ~$20mm write down on the transaction)

History

Endocare has a long and somewhat sordid history and previous management alienated a lot of investors. The stock fell from $23 at 10/24/01 to a low of $1.06 on 10/16/03 amidst mgt. fraud allegations and an accounting scandal. There is not sufficient time here to replay everything that happened except to say that old management’s accounting/reporting was aggressive and sloppy to say the least. Since this time ENDO has been in the ‘penalty box’ with investors, the SEC, the DOJ, plaintiffs’ attorneys, etc.

Recovery Process / Future Milestones

Relegated to the PINK sheets, ENDO needs to do a number of things to once again become an institutional quality security. These include:

- Settle their outstanding shareholder lawsuit: We predict this is the first thing investors will see. The liability should fall within the bounds of their $20mm D&O policy. ENDO’s insurance companies of course are making things a bit difficult in an attempt keep restitution low. In addition, despite not being liable, ENDO will likely have to pitch in a few million dollars as part of any settlement in order to keep the case from going to court and incurring more costs.
- Settle the SEC investigation: In spring 2004, ENDO finally filed a number of past due SEC filings (10Ks, 10Qs) and now is in compliance with Sarbanes Oxley. The SEC has started the process (Wells notices etc.) of pursuing judgment against ENDO. We suspect that the SEC will fine them $150k (this is the statutory maximum the SEC can charge per restated filings) per infraction for each of their seven cited infractions. Thus, ENDO would owe $1.05mm.
- Settle DOJ investigation: Since 2003 the DOJ has been investigating ENDO in connection with the accounting / reporting issues. The DOJ has not been in touch with ENDO regarding this matter in a while. Apparently they have no clear cut schedule in which they intend to pursue this case. Based on our discussions with management, it appears that the DOJ may be waiting to see how the above two items are resolved. Some past experience would suggest that as long as the former shareholders get some form of compensation, the SEC is satisfied, and former management are no longer involved with the company – then the DOJ is not likely to hit ENDO with any substantial penalties. The DOJ has bigger fish to fry and would be unlikely to do anything that would cripple a company that is in the business of curing cancer and has righted past wrongs.
- Relisting on a major exchange: Endocare has had discussions with both NASDAQ and AMEX both of whom showed interest in listing ENDO once some of the above matters are resolved. At present ENDO does not meet the NASDAQ $4/share listing requirement but does meet the requirements for AMEX listing. It is worth noting that the CEO has told us they’ve had significant interest from a number of money managers who are restricted from investing in Pink Sheet stocks. A relisting would of course allow this demand to come into the market.
- Refinance the balance sheet (discussed in detail below)

We think these milestones will be achieved roughly in the order presented above. From a strategic standpoint it makes more sense to settle the shareholder suit before improving the balance sheet – no sense in entering such negotiations with cash on hand. Also, the major exchanges will want to see progress on the shareholder lawsuit and the SEC investigation (and possibly the DOJ investigation) before considering ENDO for relisting.

Liquidity / Refinance of Balance Sheet

Endocare has about $11mm in cash and is burning cash at about $1mm per month. This rate would be somewhat lower if they were not dealing with trying to resolve all of the above mentioned items. We estimate that in 2003 there were over $12mm in extraordinary cash expenses. This year we think that number will be closer to $6mm. As part of the shareholder lawsuit they also may be expected to contribute some amount toward reaching an out of court settlement. Based on conversations we’ve had with the company and with lawyers we estimate this to be $2mm-$4mm.

The combination of cash burn and the potential need for money for a settlement makes the balance sheet seem somewhat undercapitalized. Our discussions with other potential shareholders suggest that the balance sheet is definitely one source of concern.

We believe that ENDO is well prepared to better capitalize the balance sheet once they resolve their shareholder lawsuit. They have hired a small investment bank to consider a number of options:

- One option is to simply sell equity. Craig Davenport (CEO) has made it very clear that he has no intention of raising equity at these prices. This decision is partly a function of the feedback he’s received from existing shareholders.
- They could simply borrow money against the boxes that are in the field. Since the company has no other debt one would think ENDO could get at least $5mm as long as this amount is secured by the assets of the company. This would be a decent solution at least until the stock price is somewhat higher and raising equity seems more reasonable.
- We think the most likely solution is the sale of TIMM Medical as mentioned above. This would put over $14mm of cash on the balance sheet. We believe this is the primary reason that ENDO hired the investment bank.
- Finally, the CEO has mentioned that they could form some type of strategic relationship with a key player in the urology/oncology channel. We think this is also a potential outcome although it is anyone’s guess what form such a deal could take. One possibility is that they could license the foreign rights to their technology since ENDO does not have the resources to take advantage of international opportunities. JNJ and BSX have recently made moves in heat ablation of cancer. We believe both would have a strong interest in cryoablation as well. In addition, we believe there are a number of other companies that would jump at the chance to ally with ENDO who is leading this cryo space. A partnership would typically include some form of upfront payment which would serve to provide needed working capital.

Competition

There is only one other competitor in prostate cryo which is Galil Medical (Israeli company). Of late, Galil has been absorbed in a number of M&A transactions and is now a division of Amersham which is a division of GE. Galil did a partial merger (domestic rights only) with Amersham where Galil owns 25% in the U.S. and Amersham owns 75%. Amersham was then purchased by GE.

Apparently the transitions that Galil went through caused them to lose focus although there is evidence that they are begging to wake up and get somewhat more proactive about pushing boxes. It is not known how many boxes Galil currently has in the field but ENDO management estimates that they only do 15% to 20% of the procedures that ENDO does. Our discussions with urologists suggest that ENDO has superior technology and that years of under funding have left Galil well behind in second place. They both share the same basic technology but ENDO has about 30 additional patents on key areas of the functionality and ease of use of their machine. (Galil technology creates small ice balls which then requires more probes – seen by some as a complicating factor)

Given the very low penetration rates of cryo in prostate treatment, we believe that there’s room for both players. We are encouraged by the fact that there are really only two players who, at least in the intermediate term, should be the only ones who’ll have any success in prostate cryo. Other companies attempting to get into the space will find themselves many years behind and will face significant barriers in technology, patent protection, process know-how, doctor training, etc.

Other

ENDO is also researching the use of cryoablation in kidney cancer, lung cancer, and bone pain. These are all very large markets and ENDO has some early indications that cryo has efficacy in all these areas. Although these are certainly large markets, we do not at present assign any value to these indications although they has certainly been significant interest from leading oncology doctors. It is worth noting that in 2003 ENDO sold the rights for cryoablation in cardiac related conditions (primarily cardiac arrhythmias) for $10mm and a small declining royalty stream.

Valuation

It is commonly understood that before all of the accounting issues and management turnover, an acquisition offer was made by a large company for ENDO. The rumor is that JNJ offered $20 per share. Current management will not say what company made the offer or the specific price but they do confirm there was a clear offer and that the price was, “well into the double digits.” This offer was a few years ago when the number of procedures performed was less than half what it is today. We take great comfort in the belief that ENDO could quickly turn around and sell the company for what we believe would be many multiples of today’s share price. We do not see a sale as imminent though. Craig Davenport has a good sense of what his company could be worth (he has 1.0mm options at over $4 per share) and is committed getting the company beyond it its current problems and to growing the share price before contemplating a transaction. He’s right to think this way considering that ENDO was once a $20+ stock when in institutional favor.

Our valuation of ENDO is based on the assumption that TIMM Medical will be sold sometime in the next six months. We think this is the easiest and more obvious course for management to finance the balance sheet. With that in mind the valuation looks like:

~25mm Diluted Share x current share price of $2.30 = a market cap of $57.5mm

We calculate the enterprise value as $57.5 less $14mm from the TIMM Medical sales = EV of $43.5mm. We could include $11mm cash on the balance sheet to reach an EV of $32.5mm but we choose not to as we believe this is the amount of burn necessary to reach breakeven sometime middle of 2005. Thus we have a market cap of $57.5mm and an enterprise value of $43.5mm

Our valuation is based on the previously demonstrated procedure growth rate. We assume that by mid or perhaps late 2005 ENDO will be annualizing at 10k procedures per year. At an average revenue rate of $4.5k per procedure (number is comprises of three revenue types explained previously – management has guided to this number) this will represent $45mm in cryosurgery revenues. Thus, ENDO is trading less than 1.0x mid-2005 run-rate procedure revenues. By any measure this is cheap for a fast-growing medical device company with a razor / razor blade strategy, strong gross margins, and very limited Capex requirements.

Also, we expect by mid-2005 that blended gross margins should be better than 50%. At that rate (after all the current reorganization expenses and TIMM medical related expenses are gone) ENDO should be better than breakeven by mid to late 2005. Management has mentioned the back half of 2005 as a reasonable breakeven date. They also said they could be breakeven tomorrow if they needed to but that would require them to stop growing the business. We are more than happy to delay breakeven as they continue to train doctors ($20k-$25k per doc) and spread the word about cryo for prostate cancer as well as explore applications in other cancers.

Although 2006 is somewhat difficult to forecast at this time – we would expect at least a 50% increase in procedures over 2005. Revenue per procedure should be somewhat lower as more and more procedures are done boxes not owned by Endocare – we figure around $4200. At this point Endocare will be profitable although we’d be guilty of false accuracy if we tried to forecast costs and income. We imagine that ENDO will eventually sell itself. Craig Davenport came out of semi-retirement to fix this company but we do not suspect he wants to run it for five years. We’ll not try to speculate on what it might be worth in a transaction other than to say that other high growth, procedure based, medical device companies with 50%+ gross margins often get revenue multiples of 3x to 6x.

Risks
- ENDO tends to be a pretty volatile stock and frequently changes by 5%-10% in a single day
- Continued delay in reaching milestones will likely further alienate investors
- Some investors will continue to be wary of the stock until the balance sheet is better financed

Conclusion / Catalysts

We think that investors who buy today will in 12-15 months own a company that:
- Has rid itself of a shareholder lawsuit, an SEC investigation, and a DOJ investigation
- Is relisted on a major exchange (means large institutions can buy again)
- Is financially very healthy with a solid balance sheet and generating positive free cash flow
- Continues to grow at rapid rates as the far-ahead leader in curing prostate cancer with cryoablation. Even at this growth rate and when in ~12 months they are running at 10k procedures per year, they’ll have less than 6% penetration in their target market
- Will have even more leading urologists trained on Endocare systems
- Large urology / cancer treatment / device companies including JNJ and BSX would want to own ENDO (and for which someone offered $20 per share a few years back).
- Currently trades for less than 1x mid-2005 procedure revs with great gross margins very limited Capex required going forward

Catalyst