Description

OrthoLogic’s main business line is the manufacture and sale of bone growth stimulators. OrthoLogic is also a biotech company. Its drug Chrysalin is currently in Phase III clinical trial.

What’s a bone growth stimulator? It’s an external device that uses electromagnetic fields to help bones heal. Yes, it sounds new-age, but the evidence shows that it can speed up the healing of fractures. Insurance companies are paying for their use on problem fractures that don’t heal, as well as their immediate use after spinal surgery.

Most bone growth stimulators are sold in the United States (which means the potential for significant international growth exists). According to consulting company Frost & Sullivan, the U.S. market is $300 million and growing. OrthoLogic had bone growth stimulation sales of $28.2 million for the first 9 months of 2002 and is on target for close to a $40 million sales year. Sales are up 27% so far over the previous year, and CEO Tom Trotter predicts another 25% sales growth next year. OrthoLogic’s sales are growing faster than the overall market. OrthoLogic’s product is superior to that of market share leader EBI because the EBI product has to be worn many more hours per day than the OrthoLogic product.

In the summer of 2001, OrthoLogic sold off its money losing CPM (Continuous Passive Motion machine) business. OrthoLogic acquired the CPM business several years back, and it was not a good match at all with the bone stim business. Bone stims are a high profit margin growth business, while the CPMs were a low profit margin non-growth business. The orthopedic doctors who set fractures are different than the orthopedic doctors who would prescribe CPM therapy, so there wasn’t any sales synergy between the two product lines.

After the sale of the CPM business, OrthoLogic was left with a big stockpile of cash. According to the latest quarterly statement, OrthoLogic has a net current asset value of $39.4 million ($1.23/share). With 32 million shares outstanding and a $3.88 stock price, OLGC is trading at 3.2 times its net current asset value. If you subtract the net current asset value from OLGC’s market capitalization of $124 million, and we assume OLGC will earn $5.2 million this year ($0.16/share), then OLGC has a PE ratio of 16. Not exactly the kind of value stock that Benjamin Graham would go gaga over, but value priced compared to a lot of companies in the market today. (Using the full market capitalization, the PE ratio is 24.) With projected 25% annual sales growth, one could easily justify the current price.

Just looking at OrthoLogic’s current operations ignores the huge potential future value of the company’s rights in a drug called Chrysalin. Chrysalin is a drug that will be injected into patients that have suffered bone fractures at the time that the orthopedic doctor sets the bone. Results from the Phase I/Phase II clinical trial show that patients heal 10 days faster when given a small dose of Chrysalin. The FDA has approved a Phase III clinical trial which OrthoLogic said would begin in the last quarter of 2002 (so presumably it has already started).

Tom Trotter says that Chrysalin has a market potential of over $1 billion. Where might such a huge sales figure come from? Imagine 2.5 million fractures a year, and in each case Chrysalin is used by the orthopedic doctor when he sets the bone. Suppose that a single dose of Chrysalin sells for $400. That’s where $1 billion might come from. (These numbers are educated guesses on my part. Some of the $1 billion might be coming from uses other than bone fractures, such as cartilage repair and spinal fusion surgery.) Insurance companies will pay up for Chrysalin because faster and better healing will mean fewer costly complications. It will be less expensive for the insurance company to pay in advance for Chrysalin than to pay later for problems related to the bone not healing. Chrysalin will also help the patient’s quality of life because the patient won’t have to wear the cast quite as long.

With OrthoLogic’s big stockpile of cash, there is plenty of money to fund the Phase III clinical trial, as well as a new Phase I/II clinical trial to study the use of Chrysalin for spinal fusion, and a planned clinical trial for cartilage defect repair.

CEO Tom Trotter drives around Phoenix in a black Porsche sporting the license plates OLGC-50. This reflects his belief that the stock will be worth $50/share one day. If OrthoLogic ever achieves that $1 billion sales figure, then $50/share is definitely a possibility.

Tom Trotter must be given credit for being focused on increasing shareholder value. A lot of CEOs wouldn’t have sold off the CPMs the way Tom Trotter did. Many CEOs want to build big empires and run big companies. Minus the CPMs, OrthoLogic is a much smaller company. There are even rumors floating that Tom Trotter wants to sell off bone growth stimulators as well and focus his efforts solely on Chrysalin. I guess his goal is to just make a killing on the millions of options he owns.

My take on OrthoLogic is that you're buying into the bone growth stimulator business for a fair price and getting Chrysalin for free.

Catalyst

If Chrysalin is approved by the FDA (won’t happen until 2005 if it happens), the stock price will obviously take off. Until then, preliminary news about Chrysalin, increasing profits and sales from bone growth stimulators, and possibly a sale of the bone growth stimulator business, could all drive up the stock price.