Description

OVERVIEW

I recommend Staar Surgical as a short recommendation – it has both an extreme valuation and a near-term catalyst that I believe will drive the stock 40% lower in the next 12 months. The company has suffered negative earnings in each of the last 3 years, and revenue has declined more than 4% each of those years. Within the last twelve months, the stock price quintupled from approximately $2.00 to $11.00 as investors became excited about a new product line in the U.S., which has very little chance of meeting the optimistic sell-side estimates and, even if it does, does not justify the excessive market capitalization.

Trading at $10.61, and with approximately 19 million diluted shares outstanding and negligible net cash, Staar’s market capitalization is a little less than $200 million. The company is on track to lose 18 cents per share in 2003, and analysts estimate the company will earn 10 cents in 2004.

Staar has two main products:

1) Intraocular lenses used in cataract surgery - $47 million of revenues

Staar’s primary business is the manufacturing of intraocular lenses, which replace the natural human lens during cataract surgery. Staar has 4% market share, competing against such industry leaders as Alcon, Bausch and Lomb, and Advanced Medical Optics, who together have about 75% of the market. Staar itself admits that this is a low growth business and says that the best case profitability for this business is $0.20 EPS, which I believe is optimistic. With such small market share and no other ocular products to sell to ophthalmologists, Staar has little value proposition to its surgeon customers. Even so, if we apply a generous 15x multiple, this would provide $3.00 of value per share for this business. A similar valuation is derived from a comparison of EV/revenue multiples of Staar’s competitors.

2) Implantable contact lenses used in elective refractive surgery - $3 million of revenues

Staar’s other meaningful business line is its implantable contact lens business. It is this business that has led to the inflated stock price. Staar’s implantable contact lenses are used in elective eye surgery, in which the doctor implants an adjunctive lens behind the iris and in front of the natural human lens, and this eliminates the need for glasses or contact lenses. This surgery is used for the same purpose as the LASIK laser procedure, with two major differences: 1) as a positive for Staar, the implantable lens can be used in the 2% of patients with extreme cases of myopia (nearsightedness), whereas LASIK is limited to 98% of the population, and 2) as a negative for Staar, the implantable lens surgery is more invasive, leading to potential complications such as cataracts. I believe that several years after FDA approval of Staar’s lens, expected in 2004, worldwide EPS potential for this product will be less than $0.18 per share, and the value of this business is less than $3.60 per share, in my opinion (details are below).

FURTHER DISCUSSION OF IMPLANTABLE CONTACT LENS BUSINESS

Staar’s implantable contact lenses compete with LASIK surgery; both are used in elective procedures to correct nearsightedness. LASIK is performed on the exterior of the cornea with pulses of a laser, whereas implantable contact lenses are surgically placed within the eye itself. The average retail price for LASIK procedure is approximately 50% of the average price for the implantable lens procedure.

Since beginning to market the lenses in 1995, Staar has only sold approximately 30,000 of these lenses worldwide; this excludes the U.S., where the product is not yet approved. Earlier this year, Staar was granted an expedited review process from the FDA for approval in the U.S. A panel convenes this Friday, October 3, with approval to occur most likely in early 2004. There are numerous competitors in the field, but the largest is Ophtec, which has 65% share in Europe. Ophtec’s FDA panel occurs in November, and so effectively both Staar and Ophtec will enter the U.S. market at the same time. I believe that both will be granted approval from the FDA.

The European market is a very good benchmark for what will happen in the United States. Implantable contact lenses have been approved in Europe for more than 5 years, and in that time they have reached approximately 2% penetration of the refractive surgery market. Put another way, for every 100 patients who chose to undergo refractive surgery, 98 chose laser surgery and 2 chose implanting a lens in their eye. In fact, it’s arguable that almost everyone with the choice would choose the laser, but it is limited to diopters between 0 and –8 (98% of the population), whereas the Staar lens can theoretically be used on patients with nearsightedness up to –24 diopters, which represents an additional 2% of the market.

As mentioned above, the implantable lens procedure is more invasive than LASIK and presents greater risks. This is one reason for its lack of popularity. Another reason is that the ease and profitability of LASIK surgery has created an entire industry of “LASIK Jockeys;” about one third of ophthalmologists make a living marketing and performing LASIK surgery. They are no longer proficient in intraocular surgery and could not easily perform the Staar surgery. Those ophthalmologists that can perform the Staar surgery are less marketing-oriented and more conservative, which will lead to a slower and smaller adoption rate than the optimists expect.

In the United States, there are approximately 1,100,000 LASIK procedures performed per year (that represents the number of eyes, not patients). It is a fair estimate to say that implantable lenses, such as those made by Staar and Ophtec, will achieve 2% of the refractive market, or approximately 22,500 lenses implanted per year. For my EPS calculation, I assume Staar gains 50% market share, but it is very possible they do not achieve such high share because their lens requires more technical precision to implant than Ophtec’s, and on top of that, there are other competitors that are contemplating entering the market. Staar’s 50% would represent 11,250 lenses per year, and at the $600 midpoint of the company’s ASP estimate, that equates to $6.75 million of revenue. Sell-side analysts estimate approximately 5,000 lenses sold by Staar in 2004 alone, and approximately 14,000 in 2005. These estimates seem very aggressive.

I think Staar’s entire 11,250 lens market potential translates to $1.7 million of EPS at a 25% net margin. Assuming the U.S. represents 50% of the worldwide opportunity, which is what authorities have stated, Staar will optimistically generate $3.4 million of net income in this business at its full penetration rate, or $0.18 per share in EPS. At a 20x multiple, this suggests a value of $3.60 for the business.

CONCLUSION

The Staar Surgical market capitalization is inexplicable given the known facts about the company and its businesses. The $6.60 of value I apply to the businesses is generous primarily because 1) the intraocular lens business will probably never generate the $0.20 EPS management says is possible, 2) Staar has only 20% market share in Europe, and arguably will not achieve 50% share in the implantable contact lens business in the U.S., 3) the ramp to adoption may take longer than expected or not occur at all, and 4) management has very little track record of success. This is one of the more straightforward short ideas I have seen in a while. I have additional notes and comments should anyone be interested.

Catalyst

The FDA panel review this Friday (October 3) might cause a temporary increase in the stock price if it approves the entire diopter range. If the stock rallies at all, I think it would be a good entry point for short sellers. I think this stock will typify “buy on the rumor, sell on the news,” and the stock will trade down over the next 12 months. As the company has to execute on its business, investors will quickly realize that revenues fall far short of expectations. Even 2004 sell-side estimates are aggressive.