Escalon Medical (ESMC) is a micro-cap ($22 million) medical device manufacturer currently trading at $3.51 that is receiving patent royalties from publicly-traded Intralase (ILSE) with a present value of about $3 a share. Escalon has more cash than debt so an investor can essentially get Escalon’s operating businesses for about 50 cents.  Escalon’s high gross margin businesses have trailing twelve month sales of $4.63 a share and a book value of $5.14 per share.  The profitability and growth prospects of these businesses are hidden by large losses at one recently acquired turnaround situation (Drew Scientific), high costs for an emerging new business (Escalon Digital Solutions), and temporarily high legal expenses.  These problems should resolve entirely or at least improve dramatically in calendar year 2007 with Escalon likely returning to profitability.  Going forward, the rising royalty payments alone will increase Escalon’s reported earnings to $0.61 a share by fiscal 2009 (provided the operating businesses stop losing money) which should serve as a catalyst to the stock price.

 

COMPANY HISTORY

Escalon Medical originated as a laser technology development company incorporated in 1987 under the name Intelligent Surgical Lasers.  In 1996 the company made it’s first acquisition of a medical company and adopted the name Escalon Medical.  In 1998, Richard DePiano (the current CEO) became CEO with the stock price under $1.00 and began the move away from laser development to an operating company acquiring and developing niche medical companies.  Escalon licensed their laser patents to a venture capital firm partnered with the University of Michigan for an interest in the new company and future royalties.  The laser technology was successfully commercialized and an IPO consummated as Intralase (ticer ILSE) in 2003.  In the meantime, Escalon acquired and began to grow a stable of medical device businesses primarily marketing products to Opthalmologists.

 

Escalon’s businesses began to show increasing profitability in the early 2000’s.  This profitability was coming primarily from rapidly growing royalty payments from Bausch & Lomb for a silicone oil business Escalon sold them some years earlier.  These payments stopped in 2005 in accordance with the sales agreement (clearly spelled out in Escalon’s earlier SEC filings).  A 2^nd Escalon business, Sonomed, benefited from a short-term trend at the same time the silicone oil royalties were ramping up.  Demand for Sonomed’s pachymeter product spiked as a new glaucoma screening technique that used pachymeters was developed.  Optometrists, who traditionally didn’t use pachymeters, suddenly started buying them resulting in unusually high sales with unusually high margins.  Once the optometrists were done buying in 2005 demand dropped back to normal.  The effect of these two short-term but simultaneous increases in Escalon’s profitability drew the attention of Investor’s Business Daily.  Momentum investors bid the stock to an outrageously over-valued $27 in March of 2004.

 

Escalon’s management wished to take advantage of the overvalued stock.  They raised $10 million in a private placement at $13 a share in early 2004 and used the proceeds to retire all of their debt from earlier acquisitions.  In July 2004, they traded $7.5 million of their overpriced stock for Drew Scientific , a money-losing start-up businesses selling blood analysis equipment that was teetering on bankruptcy.  The business was short on cash and was having difficulty meeting orders as they couldn’t maintain an inventory of parts.  R&D spending of course was cut to the minimum.  Following the acquisition Escalon paid down Drew’s debt and infused the company with working capital and increased marketing expenditures. Fiscal 2006 sales for Drew rose 26.2% over 2005.  Having stabilized the company, Escalon increased spending on R&D with Drew-related expenditures of $1,734,000 in fiscal 2006 (12.2% of Drew’s sales).  Still flush with cash from the private placement and sales of Intralase stock, Escalon increased 2006 R&D and marketing expenditures in their remaining businesses and made a strategic acquisition (MRP Group) that had high integration costs.  Making things still worse for Escalon’s fiscal 2006 financials were high legal fees ($750,000 in 2006) from lawsuits instigated by Escalon against Intralase for underpayment of royalties.  The net effect of all this was that Escalon posted a $0.32 a share loss in 2006 and the momentum investors were getting out.  Things got worse for Drew in the 1^st quarter of 2007 as Drew’s sales dropped 32% from the prior year’s quarter while R&D expenditures continued to rise resulting in an $0.11 a share loss for Escalon.  Management cited the “aging of Drew’s product line” and delays in bringing new products to market as the cause for the revenue drop.  This isn’t surprising in view of the distressed financial situation of Drew under prior ownership and the resulting skimpy investment in R&D.  The stock promptly dropped further to today’s depressed level.

 

VALUATION SUMMARY

While Drew certainly has a problem, other Escalon businesses are showing positive results from all the investment.  Fiscal 2007 Q1 revenues at the Sonomed business were up 28% over the prior year’s quarter and the Medical/Trek/EMI segment revenues doubled.  A discussion of business conditions and a valuation estimate for each of Escalon’s business is included at the end of this report.  The valuation results are tabulated below and sum to about $6.10 a share, well more more than double the current trading price.  The valuation estimates are generally conservative with significant upside potential.

 

Intralase patent royalties:          $17.1 million

Sonomed business:                   $12 million

Vascular business:                    $3.3 million

Medical/Trek/EMI business     $6 million

Drew business:                          $6 million

Unallocated Corporate  costs     ($6million)

 

Total:                                        $38.4 million = $6.10 per share

 

 

Catalyst: 

With no improvement in revenues from their current businesses, Escalon will post a profit in Fiscal Q1 2008 (beginning July 1, 2007).  This will be achieved by cost-cutting already being implemented at Drew, the elimination of legal fees related to the Intralase litigation, and rising Intralase royalties.  To see this note that Escalon posted a loss of ($714,777) in Q1 2007 primarily due to a ($753,000) loss at Drew and approximately $350,000 in Intralase litigation related legal and accounting fees.  Escalon is implementing cost cuts primarily at Drew that will save $1.9 million annually in fiscal 2008 and the Intralase litigation appears to be nearing an end.  Intralase royalties should increase 20% from $555,000 to $666,000 and the legal fees hopefully go away with the resolution of the trial.  Fiscal 2008 Q1 earnings should be higher by $936,000 resulting in a $221,000 profit for the quarter.  Actual results should be better as new product introductions at Drew and Escalon Digital Solutions should result in revenue improvement.  Annualizing the quarterly earnings results in Fiscal 2008 earnings of $0.14 per share.  Going forward profitability should rise steadily as the Intralase royalties rise (until patent expiration in 2014) and the operating businesses grow.  The steadily rising earnings will likely bring the momentum investors back.

 

RISKS & UPSIDE

1.  The CEO is a bit of a venture capitalist and in fact also serves as managing director of the Sandhurst Venture Fund.  The investments he is making in Drew Scientific and Escalon Digital may fail or pay off big.   Drew Scientific is a young company that has never made money even before Escalon acquired it.  Escalon Digital is investing in digital photography equipment for sale to opthalmologists which is a new market for the company.  Escalon is spending heavily on R&D for new products at these two divisions and these investments may pay off big or not at all.

2.  Intralase litigation costs could drag on without Escalon winning increased royalties.  Escalon has prevailed on almost every dispute that has been ruled on to date but one never knows.  The litigation represents upside to the valuation should Escalon continue to prevail as royalty payments appear to be just 1.72% of Intralase sales and could conceivably rise to as high as 2.5%.

3.  Escalon’s management and board of directors own only limited stock.  The CEO, Richard DePiano, owns just 2.27% of the company and all directors and officers together own just 2.51%.  Management shrewdly sold everything during the price run up and what they currently own is from recent option exercises.

4.  The CEO is 65 years old and continues to work.  There could be changes good or bad should he retire.

5.  Advanced Medical Optics (ticker EYE) recently announced the acquisition of royalty paying Intralase (ticker ILSE).  This will boost sales of Intralase lasers significantly and should increase the royalties to Escalon as discussed below. 

 

Discussion and Valuation of Escalon’s royalties and operating businesses.

 

Intralase Patent Royalties (value = $17.1 million):  Escalon’s license agreement with Intralase calls for payment to Escalon of a 2.5% royalty on all product sales related to their laser patents and a 1.5% royalty payment on sales unrelated to their patents.  The license agreement ends in 2014 when the last of the Escalon patents expire.  Intralase is publicly traded with 2006 estimated sales of $131 million.  This is up from $94.4, $60.0, and $25.4 million in 2005, 2004, and 2003 respectively.  Standard & Poor’s Analyst, Robert M. Gold, forecasts Intralase’s revenues to rise an average 20% annually over the next three years to $226 million in 2009 on market share gains and increased sales overseas.  I will estimate sales to continue to rise 10% a year from 2009 through 2013.  Escalon reported Intralase royalty payments of $555,000 in the most recent quarter.  This is approximately 1.72% of Intralase’s reported sales of $32.3 million (Hence the Escalon lawsuit for underpayment of royalties as Escalon claims Intralase is paying royalties on revenues less than their publicly stated revenues).  Assuming this same 1.72% royalty rate from now through 2013 and discounting the royalty revenues at 10% a year results in a present value of the royalty stream of $21.4 million before taxes. Escalon has net operating loss carryforwards of $12.8 million dollars to mitigate taxes on these royalty payments.  Assume an income tax rate of 20% and the royalties present value is $17.1 million.

    Mr. Gold's projection for Intralase sales growth of 20% a year over the next three years was made before the announcement of the acquisition of Intralase by Advanced Medical Optics (AMO).  Advanced Medical Optics is the leading laser eye surgery equipment provider with about 60% market share in the US currently.  Before reshaping the cornea with AMO's lasers, it is necessary to cut a flap in the cornea.  In about 70% of eye surgeries this is done with a microkeratome device which leads to complications requiring follow-up treatment in about 5% of patients.  In about 30% of eye surgeries, the flap is made using an Intralase laser with a complication rate of zero.  After acquiring Intralase, AMO will use an expensive advertising campaign to make the use of an Intralase laser the "standard of care" for laser eye surgery.  This advertising campaign along with AMO's larger sales force should speed the adoption of Intralase's lasers.  Intralase's market share should rise significantly to perhaps 50% or 60% in the US.  The royalty present value of $17.1 million is therefore likely conservative.  What effect the acquisition will have on Escalon's litigation isn't clear.

 

SonoMed (Value = $12 million):  Escalon acquired privately held SonoMed in 2000 for $12,250,000 financed by debt.  SonoMed has for over 25 years manufactured Opthalmic ultrasound equipment for imaging and measuring various parts of the eye.  Equipment is sold primarily to Opthalmologists and universities with sales increasingly overseas.  The company has leading market share and is a full-service equipment provider that has experienced staff to make 24 hour repairs and resolve technical problems.  They offer the full line of traditional ultrasonic equipment including A-Scans, B-Scans, and Pachymeters.  A new technology called Ultrasonic Bio-Microscopy has been recently developed in Canada and Escalon began offering a product in this category in fiscal 2006.  The Ultrasonic Bio-microscope uses much higher frequency sound to allow imaging of eye defects down to the microscopic level.  This product is being used  by Opthamologists for diagnosing eye problems, particularly problems related to phakic intraocular lens insertions (a growing medical treatment).  Research is also being done on how this tool can be used to diagnose other eye problems.  This product could have good potential for growth going forward as it may become a standard tool for Opthamologists.

     Escalon breaks out sales and operating profit for each of their segments.  Operating profit includes an allocation of corporate costs to the segment.  Corporate cost allocations are significant since Escalon is a rather small company. SonoMed’s history looks like this:

 

 Year ending June 30              Revenues                  Operating Profit      Gross Margin

2001                                       $5,988,000                                  

2002                                       $6,071,000                      $743,000                  55.5%

2003                                        $6,495,000                     $967,000                  61.1%

2004                                       $7,597,000                     $1,266,000                59.6%

2005                                       $7,663,000                     $955,000                   59.3%

2006                                       $7,737,000                     $104,000                   48.8%

2007 (Q1 annualized)              $9,172,000                     $888,000                   48.2%

 

International revenues have risen  as the company has expanded sales overseas by partnering with distributors in an increasing number of countries.  Domestic sales have generally been stagnant or have fallen.  In 2004 and somewhat in 2005, domestic sales were stronger as a new application for pachymeters for glaucoma screening arose.  Optometrists who traditionally did not use pachymeters needed to buy them resulting in unusually high and unusually profitable sales .   Year 2006 operating profit was affected by unusually high marketing costs related to the roll out of the new ultrasonic bio-microscope product as well as costs related to the expansion of overseas marketing efforts.  R&D spending related to the bio-microscope was also unusually high.  Sonomed’s sales are now more international than domestic.  Price realization on overseas sales is lower than domestic and overall gross margins have fallen from 55.5% in 2002 to 48.2% in the first quarter of 2007.  

   Sonomed’s revenue has grown at an annualized rate of 8.5% from 2002 to 2007 without the benefit of new products and with declining domestic sales.  International revenue now dominates sales and the new bio-microscope has good growth prospects so one might expect sales to rise at least 10% a year going forward.  Earnings should be leveraged somewhat so it might be reasonable to expect earnings growth of 15%.  Sonomed is debt-free and a dominant company in it’s niche so a 21 multiple of fully taxed 2007 earnings would result in a valuation of $12 million.  This is just 1.3 times sales of a company with 48% gross margins.  Escalon management apparently believes the company is worth at least this as the $9.5 million goodwill from the $12.25 million purchase hasn’t been judged to be impaired.  Sonomed’s profitability is hampered by corporate cost allocations from a small publicly-traded company.  An acquirer would likely be willing to pay more than $12 million.

 

Vascular (value = $3.3 million):  Escalon acquired their Vascular division in January 1999 for $2,104,000.  The Vascular segment manufacturers patent protected Doppler guided needles for locating arteries or veins.  They work using ultrasound and can distinguish veins from arteries.  They are one-time use needles that are expensive so they are generally used only in situations where access is difficult.  Vascular’s operating history follows:

 

Fiscal year                      Revenues                   Operating profit            Gross Margin

2000                                $2,345,000                 ($619,000)

2001                                $2,117,000                  ($70,000)                        52%

2002                               $2,634,000                  $57,000                           62.5%

2003                               $2,761,000                  $27,000                           56.7%

2004                               $3,055,000                  $12,000                           54.8%

2005                               $3,180,000                 $1000                               55%

2006                               $3,640,000                 ($7000)                            57.8%

2007 (Q1 annualized)      $3,268,000                 ($192,000)                        61.7%

 

While this high gross margin business has grown revenues it remains unprofitable after corporate cost allocations.  Escalon is attempting to boost sales by expanding into Latin America.  They’ve had some recent success in boosting gross margin by using their own sales force rather than distributors.  Value this business at just one times sales ($3.3 million) in view of its lack of profitability despite it’s high margin proprietary products.  Escalon has not written off the $941,218 goodwill associated with the acquisition.

 

Medical/Trek/EMI (Value = $6 million):  Escalon has put products from their Medical, Trek, and EMI lines into a common reporting segment.  They also dump miscellaneous expenses including legal fees not allocatable to other segments here.  This segment manufactures and distributes products used by Ophthalmic surgeons.  Recently, Escalon has formed Escalon Digital Solutions by combining their legacy digital imaging system with those of MRP Group acquired in January 2006.  They now have a complete high performance digital imaging product line that they have integrated with the image management software of ANKA systems.  Escalon is now marketing this complete system including ANKA’s software under a marketing agreement signed with ANKA in 2005.  The surgical tools business carries gross margins around 39% and sales haven’t grown in recent years.  The Escalon Digital solutions is a high margin business. Escalon’s major publicly traded competitor in this field, Ophthalmic Imaging Systems (ticker OISI on OTCBB) carries gross margins over 50% on $15.5 million in revenue and trades at 3 times sales.  Digital photography of the eye for diagnostic purposes is an emerging business.  Digital photography is getting cheaper and the ability to share photographs over the internet for expert diagnosis is now possible.Escalon’s history in this segment which I have adjusted to subtract out discontinued Silicon oil payments, Intralase patent royalties, and legal expenses associated with the Intralase patent royalties has been:

 

Fiscal Year                               Revenue                          Operating Profit             

2002                                         $1,588,000                          ($799,000)

2003                                          $1,935,000                         ($710,000)

2004                                          $1,696,000                         ($388,000)

2005                                          $1,727,000                         hard to figure

2006                                          $1,914,000                         hard to figure

2007 (Q1 annualized)                 $2,592,000                         (1,444,000)

Escalon spent heavily in 2006 and continues to spend at an annual rate of $604,000 in Q1 2007 to integrate the MRP acquisition and develop their digital imaging platform.  Escalon’s products and the MRP products appear to be high performance products that have traditionally been sold to large research institutions.  Escalon appears to be building a platform to reach the larger Ophthalmic practices and compete with Opthalmic Imaging Systems and TopCon (an Asian company).  To date there appears to be little sales of this new platform so it’s hard to guess a value but I will.  Escalon’s investment in the product consists of about $1.2 million for MRP, a million or so for their own product, and around a million in R&D and integration costs.  Add one times sales or 2.6  million for the current year product sales and the total is about $6 million.

 

Unallocated Corporate Costs (value = $-6 million):  The operating losses of the Medical/Trek/EMI segment sure makes it look like Escalon is dumping some miscellaneous costs on this segment.  They can be hidden here as Escalon traditionally reported Intralase Royalties and Silicon oil royalties in this category such that the segment reported profits.  Guess that $500,000 expenses are being dumped here based on the reported losses and value that at -12 times earnings or ($6 million).

 

Drew Scientific (Value=$6 million):  Escalon Acquired Drew on July 23, 2004 for $900,000 shares of stock valued at $7.4 million ($8.22 a share) and $1.3 million in investment banking and legal fees related to the transaction.  Since the acquisition, Escalon has loaned to Drew an additional $11.1 million to build up inventory, pay off Drew’s debt, expand sales and marketing, and fund research and development of new products.  Escalon’s total investment totals $19.8 million.  Drew is a young company manufacturing equipment for diagnosis and monitoring of medical disorders in the areas of diabetes, cardiovascular diseases, and hematology.  Drew competes in the niche of equipment for low volume testing in the doctors or veterinarians office.

 

Fiscal Year                                Revenues               Operating Profit          Gross Margin

2005                                         $11,294,000                ($1,231,000)               33.1%

2006                                         $14,253,000                ($2,430,000)               35.3%

2007 (1Q annualized)                $11,140,000                 ($2,980,000)              36.8%

 

Valuing Drew is guesswork as it’s losing money.  If the company were stable it would certainly be worth 1 times sales or $11 million.  Escalon’s total investment is nearly $20 million with $12.4 million of that cash.  To remain reasonably conservative, guess a value of half of Escalon’s cash investment or roughly $6 million.  This is just slightly above half of 2007 sales.  If Drew ultimately is shut down, working capital recovery would likely cover costs of closing and severance so it seems unlikely that Drew’s value is negative.