Description

Iridex (IRIX)

Situation Overview

Iridex is an ophthalmological medical device company specializing in patented MicroPulse laser technology, historically for treatment of the retina but now expanding into the $5b glaucoma market. Since rollout of the glaucoma product in late 2015, the company has seen tremendous growth in this segment, which has quickly become 25% of total sales in 1.5 years and is poised to become >50% of the business in the next 2-3 years. While the legacy retina business was a capital equipment sale model, the glaucoma product is a razor/razor-blade recurring revenue model. At 2.0x EV/2017e sales, the market is severely undervaluing the business model transformation, as the high-margin recurring revenue glaucoma segment continues to become a larger piece of the company.  Using a blended 4.5x multiple on our 2019 sales estimate (2.0x for the legacy business and 6.0x for the high-growth glaucoma segment, in line with comps), the stock could be worth close to $30/share vs the current price of ~$10.

Business Description

The company makes laser systems and peripheral devices used to treat serious eye conditions, including macular degeneration, glaucoma, and diabetic retinopathy. The company markets its products under such brands as IQ and OcuLight through a direct sales staff in the US and through distributors in more than 100 countries worldwide. Its ophthalmic systems, including laser consoles, delivery devices, and disposable probes, are used by ophthalmologists in hospitals, surgery centers, and physician practice centers.

The company’s medical and surgical retina laser devices have a strong position with ~14% market share (according to estimates from Australian competitor Ellex). Though this write-up will focus predominantly on the glaucoma product, as this is the exciting part of the story, it is important to note that management has learned from their experience with the legacy products, in that such products relied heavily on capital equipment sales and thus the company was not fully able to capture the value created in treating over 1 million patients on an installed base of 700 systems (note that the company has impressively managed to increase the recurring revenue component of the existing business, such that it is now ~45% recurring content in the form of disposables, service and support).

In response, the company designed the glaucoma product, known as the Cyclo G6 system, to be a razor/razor-blade business model, with a relatively inexpensive laser console (ASP $14,500) tied to a consumable probe ($200/procedure). From a business model standpoint, this is very attractive as all the IP is built into the proprietary probe, preventing any competitors from trying to enter the market with a knock-off consumable. The company has a broad estate of patents (28 in the U.S., 20 international) extending through 2034.

From a medical standpoint, the G6 system is very promising, viewed by physicians and industry analysts as a much-needed addition to a currently weak glaucoma treatment paradigm. Glaucoma is a $5 billion global market, comprised of 80mm people with glaucoma, of which only 25mm are diagnosed (Market Scope 2016). There is significant unmet medical need. Glaucoma is a complex disease of the eye generally caused by increased pressure (called intraocular pressure IOP), which can ultimately cause vision loss. The current continuum of care spans from pharmaceutical eye drops to traditional laser therapies to MIGS (a hot new category, spearheaded by Glaukos) to invasive surgery. Each of these current treatments tries to reduce IOP, yet each has significant shortcomings. Most patients begin with prescription eye drops, which are effective yet have extremely low rates of compliance (50% of patients reportedly do not comply). In addition to complex dosing regimens, drops often have adverse side effects for those with allergies and also come with high, recurring costs to patients and the system.

Next, there are traditional laser technologies including argon-laser trabeculoplasty (ALT) and selective-laser trabeculoplasty (SLT), which deliver laser pulses to the eye to stimulate a release of cytokines that increase the permeability of the trabecular meshwork (TM) and reduce IOP. The problem with these treatments, however, is that they do not provide a lasting solution as the effects dissipate over time, with a high rate of failed IOP control after 12 months. Repeat procedures are less effective, and more importantly, these lasers cause structural damage to the ocular tissues.

A new category of alternative treatment is MIGS (minimally-invasive glaucoma surgery), pioneered by a Southern California company named Glaukos (GKOS), which went public in 2015 and now has a $1.4b valuation (8.8x 2017E sales of $165mm) and is growing >40% yoy. There has been tremendous excitement around the MIGS space and specifically Glaukos (seen in the valuation) as having the potential to revolutionize glaucoma treatment. GKOS’s iStent implantable devices lower IOP through a safe, micro-invasive procedure that has been shown to have little to no adverse effects, durable outcomes, and thus presents a compelling alternative to medical drops and their high rate of non-compliance. The stock has been on a tear as of late, coming in a little recently after Barron’s published a cautious piece highlighting the approval of similar MIGS devices by competitors like Alcon. While there is no denying that GKOS and the MIGS category as a whole is a compelling alternative treatment that will continue to grow rapidly, it is worth noting that MIGS devices are still limited to use in cataract surgery and require an incisional procedure with an implant left behind in the eye. Further, the MIGS segment is taking share predominantly from pharmaceutical eye drops and is not necessarily directly competitive with Iridex’s G6 (more on this below).

Finally, invasive surgery is the last treatment option for glaucoma, which not only sounds gruesome but is also rather ineffective due to a high complication rate, high failure rate, limited long-term efficacy and significant post-operation pain management issues.

Seen in light of these current treatment options, Iridex’s G6 product looks rather attractive, which is why it has been generating a lot of excitement at industry conferences and among physicians who have started using the products. G6 is safe, repeatable, non-incisional, titrateable, easy to perform in doctor’s offices and can be used across the current continuum of care. These are all highly-attractive qualities that make it very compelling to doctors and patients. In contrast to the laser treatments mentioned above, Iridex’s G6 system uses the company’s MicroPulse technology (which has been used safely and effectively for the past 10 years in the legacy products) to break a continuous laser beam into short, repetitive pulses that allow cooling between laser applications, thereby preventing thermal tissue damage. Instead of targeting the TM, G6 targets another area of the eye called the “Pars Plana” to improve uveoscleral outflow and thus lower IOP. Further, it is important to stress that unlike other treatment options, MicroPulse can be used alongside other treatment options, is repeatable, and does not rule out the potential for future options (unlike, MIGS, surgery, or existing laser technologies). This is crucial, as it means that MicroPulse can be positioned not as a competitor to these other options like MIGS, but as complementary. It is just another tool in the physician’s toolbox for treating glaucoma and reducing use of eye drops. To emphasize, the Glaukos iStent is labeled only for concomitant to cataract surgery procedures, while G6 can be used across the continuum of care. (From a business perspective, this means that IRIX can expect to treat the typical patient 4-6 times over the course of their glaucoma life @ $200 a shot, vs. GKOS’s one-time treatment @ $1000 for their device, so on a lifetime revenue/patient basis they are comparable).

Though MIGS has totally captured the limelight, Iridiex has quietly begun to build momentum with the G6 laser. The medical literature has been very positive, as has physician response at industry conferences and clinical studies at leading eye centers and research universities. As mentioned, the technology is built into the probes, not the laser console. The company currently has six probes, with the MP3 being their flagship product (3/6 probes are approved by the FDA, including MP3). The clinical evidence has been compelling, with a primary study at National University Hospital in Singapore showing 33% IOP reduction at 18 months, data which has since been corroborated in follow-up studies at Yale, UCSF, and the Willis Eye Hospital. At the annual American Academy of Ophthalmology conference, physicians have said that G6 is an ideal solution as it is effective, cost-effective, efficient, repeatable, has a strong safety-profile, gives physicians control of therapy compliance, and importantly leaves future treatment options open.

The FDA approved the product in February 2015 and since then the company has seen strong momentum in the commercial ramp. The company sold 113 systems in 2015 and 384 in 2016, bringing the total installed base to 497 at YE2016. 27,210 probes were sold in 2016, up from 7,590 in 2015. The company believes it will sell 400-450 systems and 45,000-50,000 probes in 2017 (guidance which we believe may prove conservative based on the momentum). Over 50 countries have purchased with pending approvals in China and Japan. The company finished 2016 with 17 direct sales reps in the US and has a stated goal of reaching 24 over the next few quarters. Reimbursement trends for the procedure have remained stable and management expects that to continue.

Management has been very successful so far at managing the commercial ramp (and has achieved results in line with what Glaukos had with their iStent at this stage of the roll-out). Importantly, the CEO William Moore is cautious, disciplined, and un-promotional, which is good to see and speaks to his long-term commitment to building this into a business multiples of the current size (he previously founded Natus in 1993; today it is a $1.2b medical device company). As Moore stated on the Q3 2016 earnings call: “I'll come back to what I've always said, sometimes on these products, you can get out and run really fast and end up having an adverse event that derails the product. I'll stand by my decision and say, I am going to be very conservative and make sure nothing happens. And at this point in time, now that we have roughly 30,000 probes used and roughly 400 customers, we're not going to get derailed by a single one or two type of adverse events if they come about.”

We view management’s strategy as very smart; they are focused on building out the installed base of laser consoles (selling them at a $14,500 breakeven level), which will drive long-term upside in the recurring revenue probe sales. This is a win-win strategy, as it offers physicians the potential for payback in less than two months on their investment, while giving Iridex visibility into a high-quality stream of recurring sales, while cementing the G6 platform as the standard of care to treat patients across the full continuum of glaucoma care, since the intelligence is designed into the probes. While the MP3 probe is primarily used to treat mid- to late-stage glaucoma, physicians have become more comfortable with the technology, safety and efficacy and have migrated to treating patients earlier in the continuum.

Valuation

Despite the positive momentum outlined above, the company’s valuation is rather undemanding at 2.0x EV/2017e sales, while the story is not well-known in the investor community, with only a single analyst covering the name (coverage began Dec. 2016). We think the appropriate way to value the business is on a sales multiple, as the company is not yet profitable and is in land-grab mode for ramping the install base. In 2016, the company reported $46.2mm of sales, split roughly 75/25 between the legacy business and glaucoma platform. Glaucoma did $11.0mm in sales (+250% yoy), split 50/50 between console and consumable sales with the attach rate hovering at 8-10 procedures/system/month. Based on management probe/console sales estimates for the year, and guidance that the legacy business should be “flat-to-down,” we model $16mm in glaucoma platform sales in 2017 (+47% yoy) and a 5% decline in the legacy business, leading to $50mm total sales (in the middle of guidance range). Going forward, we assume a 10% annual growth in systems sold, leading to an installed base of just over 1,900 systems in 2019. Management has said there are somewhere around 5,000 offices in the addressable market, though each office might average 1.5 systems, so the TAM is somewhere around 7,500 from a console perspective, implying that the company would remain relatively underpenetrated even in our base case. (Thought of another way, the TAM can be measured on a per patient basis. The company estimates there are 5 million addressable patients worldwide, each of whom could be treated 4-6 times, implying a $5bn total consumable revenue opportunity. Obviously the product is nowhere near penetrated enough to do this kind of volume anytime soon, but the point is that at $10mm of 2017e consumable revenue the company is only scratching the surface of the opportunity.) We also assume the utilization rate of 8-10 probes/month remains flat, though the company views this as another upside lever.

Using these assumptions, we forecast ~$50mm of glaucoma segment revenue in 2019 alone (62% ’16-’19 CAGR), which is roughly equivalent to total company revenues today (and only ~1% of the total glaucoma market). The revenue split would be around 40/60 between legacy retina and glaucoma at this point. Management believes the company should be profitable by this point, with probe consumables contributing 80% incremental margins. Applying a 2.0x multiple to legacy sales (which recall is now ~45% recurring) and a 6.0x multiple to glaucoma (a 30% discount to GKOS and other high-growth med tech names, which trade at >9x sales but are much larger), the business is worth close to $28/share. Even if one wants to be more punitive on the multiple, and assume a blended 3.5x sales which is where medical aesthetics company CYNO was taken out (the laser based fat-removal business has similar growth and recurring revenue profile as IRIX), the stock is still worth >$20/share. Put another way, given the durability of the legacy retina business, it is hard to see how one could lose money at this valuation, while you are getting all the upside from the glaucoma platform. We believe this mispricing is due to lack of investor attention and a failure to understand the shift to a recurring revenue business model. Specifically, the unexplained selloff over the past month to the $10 level has created an excellent entry point.

The situation has largely been de-risked due to the FDA approval for the main MP3 device, coupled with the strong clinical data and initial physician adoption around the world. However, given that this is a high-growth, unprofitable micro-cap medical device company, there are still risks associated with the investment, most significantly executional risk surrounding the G6 commercial ramp and also patent infringement risk (less worrisome in our mind due to the company’s proven ability to defend its IP). As mentioned, management has proven disciplined and capable surrounding the rollout, but were some averse event to occur halting the growth rate, the multiple would likely not re-rate and the stock would not outperform. However, downside is rather limited again due to the resilience of the legacy business and the current installed base of the glaucoma platform that will continue to drive recurring sales. Another risk relates to competition in the market from other alternative therapies such as MIGS. IRIX has a strong patent portfolio and is years ahead of any competition trying to develop a similar laser technology. Ophthalmology is a conservative space, and a potential competitor cannot replicate IRIX’s 6 years of clinical data on G6 overnight. Though we feel strongly that MicroPulse is a complementary (rather than competitive) solution to current MIGS alternatives for the reasons outlined above, a player such as GKOS could conceivably try to take outsized share of the market by innovating a new product that is more effective than laser technology. We believe the chances of this are low and mitigated by IRIX’s proven success as a safe and effective treatment, with a rapidly growing installed base.

In conclusion, IRIX presents a compelling investment opportunity as the company is in the very early innings of a transformation to a high-margin recurring revenue business model that is being undervalued by the market. The G6 product has strong runway with a large target market of glaucoma with significant unmet medical need. The company’s broad patent portfolio, differentiated technology, strong brand (MicroPulse is trademarked and used in the medical literature), and global commercialization infrastructure create a solid moat. We believe that the company is positioned to grow to multiples of its current size in the years to come.

Catalyst

Continued sales ramp of G6 glaucoma product

More positive data presented at conferences

More analyst coverage

Increased utilization of consumable probes

GKOS success/more entrants into MIGS space, drawing attention to alternative glaucoma therapies

M&A (IRIX is a ~$100mm company and would be easy for larger ophthalmological players to swallow, looking to enter the high-growth alternative glaucoma therapy space)