Description

A recent decision by a large stockholder to exit their sizable holdings in this name has depressed the price of Iomed’s stock to the point where it is an attractive opportunity for micro-cap investors. A purchase of Iomed stock offers the opportunity to invest in a Company with a strong balance sheet and net cash position while participating in the following key positives that I believe will create significant upside opportunity in the months and years to come:

- differentiated product with an attractive business model in a stable, niche market that produces an annuity cash flow stream
- clean balance sheet with a significant net cash position that supports a significant portion of the value
- very attractive valuation. This is compounded by hidden profitability related to a decision to report accelerated depreciation running through the income statement combined with a sizable NOL position that shelters substantially all future net income
- CEO who thinks like a value-oriented private investor and manages the Company with a balance of focus on profitability and research and development. This is evident through his actions as well as his manner when you speak with him.
- Some wild-cards attached to potential new products that serve to provide nothing but upside to the story.

Elan currently owns approximately 23.4% of the Company’s common stock. I would imagine that most of you are aware of Elan’s many problems and will not rehash them here. As part of Elan’s restructuring/business rationalization, they have planned to exit many non-core businesses and investments. On the back of this Elan publicly stated its intention to exit its investment in Iomed and recently sold about 110,000 shares between 6/28-7/14/04, a small portion of the position. This drove the stock down significantly as investors are frightened by the significant overhang on a security with limited liquidity. I believe this overhang has created the opportunity that is before us now. While in the short-term Elan may sell some or all of its position and create a downdraft in the stock price, I welcome a decline as it would further undervalue the Company and I will buy more.

In the following note I will address each of the aforementioned positive points to the investment case:

Stable, Niche Market and Attractive Business Model

The Company’s primary mission and product line is to manufacture and market drug delivery systems employing iontophoresis technology. Iontophoresis uses micro levels of electrical current to move water soluble ionic drug molecules across the skin and into the blood stream. Depending on the characteristics of the drug and how it is delivered, you will see systemic or localized effects. These systems are primarily sold to physical therapy clinics and occupational therapy clinics and are used to deliver anti-inflammatory treatments to treat tendon injuries and other local inflammatory conditions like carpal tunnel syndrome. The Company’s products are used when it is advisable to avoid the pain that may accompany needle insertion and drug injection, to minimize the infiltration of carrier fluids, and/or to avoid the damage caused by needle insertion when tissue is traumatized. The Company’s product offering is particularly useful when medical professionals are delivering dexamethasone, a potent and effective corticosteroid, to treat local inflammatory conditions. Because of the negative side effects often associated with the oral or injectable administration of dexamethasone, it is used only as a second or third line therapy. However, using the Company’s technology, the administration of this drug without the occurrence of these negative side effects is possible. Virtually every major sports franchise in the United States and many Olympians use the Company’s products, primarily in conjunction with a dexamethasone treatment, and demand is extremely stable.

I believe that the Company has locked up much of the market for iontophoresis treatment of tendons and muscles. I have spoken with about a half dozen end-users, including occupational therapists and doctors, each of whom has stated that the Company has a strong brand name and alternatives are few and far between. Additionally, the Company has over 80 patents in the United States and over 150 overseas defending the Company’s technology portfolio. Other companies have alternative iontophoresis technologies, including Alza (a division of Johnson & Johnson). Alza is focused on treating other indications (outside of muscle pain), primarily post-operative pain, which is more of a home run bet. The tendon and muscle market is far too mature and penetrated for it to be a viable target market for J&J relative to the investment required. In light of these market dynamics I have come to the conclusion that the iontophoresis tendon and muscle treatment market is a niche market with sizable barriers to entry. After one of my conversations with the CEO of Iomed, I came away with the impression that he agreed with my assessment. He explained it this way (I am paraphrasing): “It is a small, but very steady market, one in which Iomed has well over 50% market share, a solid reputation, a good, high quality product, a solid patent position and much of the brand name. Competitors see no reason to aggressively target this market due to its small size and our dominant position. This is not an easy area to penetrate. A substantial amount of knowledge is needed regarding electronics, human physiology and pharma chemistry to make it work without burning people.” The CEO sees no significant competitive threat at the current time, and “all has been quiet on the IP front”. He (and I) believes that the Company’s market share and end market is locked up for some time to come. The stability of this market and the lack of significant competition can be sized up by examining the following numbers (I will get to numbers below gross profit later in the write-up):

$'s in millions 1997 1998 1999 2000 2001 2002 2003 2004
Revenue 9.3 10.3 10.5 10.8 11.4 11.8 12.1 12.2
COGS* 3 3.6 3.7 3.3 3.1 3 3.4 3.7
Gross Profit 6.3 6.7 6.8 7.5 8.3 8.8 8.7 8.5
Gross Profit % 67.7% 65.0% 64.8% 69.4% 72.8% 74.6% 71.9%69.7%
* Note: I am excluding an accelerated depreciation expense the Company has been taking that hides true gross profit, discussed further down in the writeup.

Another attractive point to the story is the Company’s business model. Iomed is a classic razor/razor blade story. The primary iontophoresis system is comprised of a reusable dose controller and single use, disposable active transdermal patch kits. The dose controller incorporates an advanced microprocessor to precisely control drug dosage through the Company’s proprietary, single use patch kits. The Company’s patch kits are regular orders for many occupational and physical therapy centers, creating a stable recurring revenue stream. Additionally, the Company often rolls out upgrades to its dose controller with reasonable uptake. These dynamics, along with the aforementioned niche market, patent portfolio and strong market position create the attractive and steady revenue and gross margin profile.

Clean Balance Sheet With Net Cash Position

Iomed’s balance sheet is attractive and supports a portion of the valuation and limits downside. Here are the numbers as of the most recent press release:

$ Millions
Cash 9.0
Other Current 1.7
L-T Assets 2.0
Total Assets 12.7

Current Lia. 1.1
Current Debt 0.6
L-T Debt 1.2
S. Equity 9.8

This amounts to a net cash position of approximately $0.95 per share and a tangible book value of $1.29 per share. Note that this balance sheet flexibility would allow Iomed to easily repurchase the current overhang of Elan stock and would leave the Company with more than sufficient liquidity.

Attractive Valuation and Hidden Assets

The stock’s current valuation is compelling. The Company has done a very good job of reining in expenses in recent years and I believe the CEO has done a good job of stabilizing the business and rationalizing the cost structure and future profitability will be maintained (I will address this further along in the note). EBITDA for the past 12 months amounts to $2.05 million. When viewed relative to enterprise value:

$’s in Millions
Market Cap. (fully diluted)*: $16.7
Net Cash: $7.2
TEV: $9.5
EBITDA: $2.0
TEV/EBITDA 4.6x
* Elan owns “preferred stock” you will see when researching Iomed. This is a very benign preferred and is effectively common stock with no voting rights. This was put in place to ensure that Elan would not be required to consolidate Iomed in its financial reporting.

On the surface this appears somewhat compelling but not a screaming bargain. However, there are other considerations that make this a great deal. First D&A is substantially in excess of capex at current levels (capex for last three months was virtually zero). The Company made a sizable investment in 2001 in a new facility and automated manufacturing equipment and built out new labs to get more capability in animal testing in anticipation of a successful clinical trial of a since failed project. The Company currently has a significant amount of excess capacity and no capex is in the works for the near to intermediate term. Capex will only be spent if a rapid payback is associated with it due to the current capacity situation, according to the CEO. Additionally, the Company has $19 million of NOL’s that will shelter any net income for “close to a decade”. As a result, any Operating Profit will drop directly to the bottom line. Finally, the cosmetics of the situation are improving as well. The Company has elected to recognize accelerated depreciation related to the 2001 purchases. The equipment will be fully depreciated within the next 18-24 months and D&A expense will gradually be reduced close to zero. With virtually zero capex, NOL’s that shelter all current and future net income, and depreciation going to zero, you can conclude that the EBITDA multiple must necessarily equal the free cash flow yield and, eventually, the P/E multiple. This leaves you with a 22% free cash flow yield and a 4.6x forward P/E when net cash is stripped out (interest expense has equaled interest income, so net to zero in pro forma for net income). I believe these multiples to be very attractive when viewed next to the business fundamentals/model and some of the upside potential I will discuss later in the note. One caveat: In the Company’s recent earnings announcement they cite lower sales for the upcoming fiscal second quarter due to one-time inventory adjustments by distributors. I talked to the CEO at length about this issue and he assured me that profitability and cash flow will be maintained and he feels this is a “one-time” issue as end-user demand remains unchanged while some distributors had “over-ordered” in previous periods. This bears watching but the CEO is fairly conservative.

Strong CEO Working for Shareholders

I can’t stress enough that I believe Robert Lollini, to be a capable CEO, and most importantly, very interested in managing the Company in the interests of shareholders. Lollini owns 3.7% of the Company including stock options. Lollini’s background is in accounting. He worked for Arthur Anderson through much of the ‘70’s auditing manufacturing clients. In the early ‘80’s he joined RP Shearer, a public drug delivery company (soft gelatin capsules) with 20 facilities worldwide. Lollini was in charge of financial planning and acquisitions for Shearer. In the late ‘80’s he was promoted to CFO. Lollini left Shearer in ’93 to become CFO of Iomed. He led the Company through the IPO in ’98. The Company failed in a big clinical trial in 2001 and the CEO and VP of Operations left. Lollini was promoted to CEO and immediately began running the Company in a fashion a value investor would appreciate. Lollini recognized that he had a good core product and market and that he could reduce excess expenses to push Iomed to profitability while continuing to explore growth opportunities and research and development. He reduced overhead and cut any non-core R&D. All R&D is now directed to potentially commercially viable opportunities with identifiable ROI’s. I have spoken with Lollini on several occasions and always come away impressed. He has stated to me that “profitability comes before all else”. He has communicated to me that he is managing the Company’s opportunity to grow through leveraging its core technology (I will discuss later in the note) in a fashion that will minimize capital and R&D investment by working with strategic partners. They will not pursue any opportunities without most of the capital coming from a partner that is committed to a project. These are comments I like to hear from the CEO of a company in which I have invested, and I have become comfortable that the “annuity cash flow stream” I outlined above is not in jeopardy of being hijacked by a management hell bent on growth at any cost. Additionally, I have been pushing Lollini to use the Company’s cash hoard to buy back Elan’s shareholding in Iomed. I believe he is actively considering this and while it is certainly not a done deal, I wouldn’t be surprised if they were to do so. This would reduce the share count by about 20% if executed (assuming current prices).

Wild Cards That Provide Upside

While not necessary to see a sizable return from this position (given the valuation and core product), I believe Iomed has some opportunities to significantly add to the upside here. In 2001, the Company had a clinical trial in Phase III go badly. The trial related to treating acute local inflammation using dexamethasone. This would have allowed the Company to establish an NDA and have the system approved for home use with dexamethasone, for patient home use application; a successful outcome would have substantially enhanced the Company’s market opportunity, and expanded the products use from solely off-label as a medical device under 510(k) to an approved product that could be used without professional supervision. Lollini believes that efficacy is obvious, as represented by the fact that elite athletes use the Company’s products. He represented to me that the clinical trial design and execution was the issue, not the efficacy of the product. In fact the Company’s Phase I, II and the first half of the Company’s Phase III trial all met with success, but the second left ambiguity. Lollini fingered previous operating management as the problem in the trial and their relationship with the Company was severed after the failure. After Lollini was brought in, he decided to rein in expenses and stabilize the business. He has been so focused on this that he has not spent a lot of time attempting to resurrect this opportunity. He now plans to resurrect it, but only in small steps. The key to success here would be a partnership with a larger company. He has noted the need to demonstrate to a partner with clinical evidence that the trial design was the issue. Much of recent R&D has been focused on establishing this and a partnership with a larger company could substantially add to the story and the Company’s market opportunity. Lollini is comfortable that a new trial would be successful and add value, but he will not fund the trial out of his own coffers.

Another interesting product is the Company’s Ocuphor line, which allows drug delivery to the back of the eye. The Company continues to spend R&D on this product and Lollini believes this is a potentially “huge” market opportunity. Application of this technology has sizable economic potential and a medical and therapeutic benefit. The problem is that the Company’s solution is for a problem that does not yet exist. Drugs being considered for treating the back of the eye (usually in conjunction with macular degeneration) are still in early stages of development. Before a drug delivery system can be completed, the system manufacturer must know the compound, pharmokinetics, delivery quantities, delivery frequencies, etc. The Company is taking a dual approach to this potential product, making sure they have enough data to show that they have tested a broad range of compounds that they can deliver in dose ranges that are safe for humans, so drug developers have proof that they have a safe alternative. Lollini believes the Ocuphor system is the only one of its kind and would be extremely well positioned if a drug were developed to be administered in the back of the eye (difficult to reach by needle).

Conclusion

I believe Iomed offers the opportunity to invest in a company that is undervalued, with an annuity cash flow stream, strong balance sheet, catalysts to unlock value, and some nice upside surprises that may arise down the road related to the potential for new products. In thinking about a reasonable value for the Company, I would expect, given stability in the business and the potential for upside, to see a free cash flow yield of 7-10%. This would result in a value range of:

10% FCF Yield
$2.046 (free cash flow)/.1=20.5 million+7.2 million (net cash)=27.7 mm/7.75 mm shares=$3.57 (66% Return from Current Levels)

7% FCF Yield
$2.046 (free cash flow)/.07=29.2 million+7.2 million (net cash)=36.4 mm/7.75 mm shares=$4.70 (119% Return from Current Levels).

Catalyst

- Market recognition of undervaluation
- Earnings approaching EBITDA as accelerated depreciation goes off the book and NOL’s continue to shield earnings from taxation
- Resolution of Elan overhang
- Use of cash hoard to repurchase stock (potentially Elan overhang) or pay out sizable dividend
- Partnerships with larger pharmas or biotechs to complete clinical trials related to the Company’s core product which would expand market opportunity.