Description

VNUS has 4.75/share of cash, dominant market share and rapid revenue growth, yet trades at 10x ttm earnings (ex-cash). VNUS shares have fallen over 50% since the October 2004 IPO.

SUMMARY DATA (in millions)
Market cap 112
Cash/eqivs 72
TEV 40
2005 Revs 49
2005 Op Inc 4
2005 ROIC 100%
5 year CAGR 60%

2006 Revs 57
2006 Op Inc 0 (excl one-timers, see below)

COMPANY DESCRIPTION
The company's primary product is the VNUS Closure system, a minimally invasive treatment for varicose veins. It consists of a radio-frequency, or RF, generator and disposable catheters. The RF generator heats the tip of the catheter, closing the vein along it's entire length as the catheter is gradually withdrawn. The procedure is performed under local anesthesia on an outpatient basis, originally in hospitals but increasingly in a doctor's office or surgicenter. Vascular surgeons using VNUS Closure treated 55k patients in 2005 and over 135k patients since 1999.

COMPETITION
The two other treatments for varicose veins are vein stripping and endovenous laster ablation (EVL). Traditional vein stripping surgery is a somewhat gruesome procedure requiring general anesthetic and days or weeks of recovery time. Understandably it is quickly losing market share to minimally invasive treatments. EVL came along about five years ago and is taking share at about the same pace as VNUS. EVL disposables are a little cheaper, though this is not really significant for a $2000+ procedure. EVL is also a little faster (e.g. 40 minutes vs. 50) which can be significant to vascular surgeons. VNUS claims the Closure system is superior to EVL because it provides feedback to the operator, but test data indicates both systems work well.

Significantly, there are half a dozen EVL providers competing viciously and compressing margins for everyone. EVL pioneer and market leader Diomed (DIO) has less than half of VNUS's market share and is massively unprofitable, yet sports an TEV almost as high as VNUS. While DIO is the only EVL pure play, ANGO and VASC sell EVL systems as a small part of their vascular device business. These guys all trade at much higher multiples than VNUS (e.g. P/S ratios of 5x vs. <1x).

Last year VNUS sued DIO, ANGO and VASC for patent infringement. I have no opinion on the merits of the suit, but VNUS will spend a few million on it this year so they must think they have something.

2006 OUTLOOK
In March VNUS guided to $58m revenue (+18%) and -3m net income for 2006. Without 3m of patent suit costs and 1m of lease cancellation expense earnings would be slightly positive. Still, the drop in operating margins from 10%+ to slightly negative is a big part of the stock's trouble. Competition from EVL is part of the problem, but there's more to the story. VNUS is ramping sales and marketing in Europe, where varicose vein treatment is 3x more common than the US. VNUS is also ramping R&D on several projects which have yet to be formally announced. Management arguably should have stretched some of these discretionary expenses out to smooth earnings, but these guys are basically just entrepreneurs and somewhat tone-deaf to the ways of public markets.

The core business is still profitable and justifies the current valuation. The increased sales/marketing spend should produce mid-term growth, and the R&D projects should produce both positive buzz and longer term growth. More importantly, the R&D projects should move VNUS out of the one-trick-pony penalty box. VNUS has hinted they'll discuss these projects in the Q1 earnings call.

VALUATION
As noted, VNUS trades at cash plus 10x ttm opinc. This provides downside protection while waiting for VNUS to bring margins back up and introduce new products. 18 months from now VNUS could easily hit ANGO's current projections of 78m revenue and 10% margins. Whether this will translate into ANGO's $340m EV and an equivalent VNUS share price of $26 remains to be seen, but there's clearly plenty of upside.

RISKS
1. Management blows cash on new projects that don't pan out
2. A new treatment or vastly improved EVL makes VNUS obselete

Catalyst

1. VNUS discusses new projects in Q1 call

2. Margin outlook improves late this year as one-time expenses go away and new marketing initiatives either produce results or are ended