Description

PhotoMedex is $64 million market cap medical products company that has $2 million of net cash, trades at less than 2X last year’s revenues and is just turning the corner on profitability. They are in the 4th inning of rolling out their XTRAC laser for treating psoriasis, which will create a steady, recurring revenue stream. They also have a skin care products division that is profitable and provides some margin of safety.

There is a decent web cast that provides a good overview of the company (scroll to page 8):

http://hosted.mediasite.com/hosted4/Catalog/front.aspx?cid=4d07df7c-83c7-4bb8-a91e-34f236275149

Overview: PhotoMedex makes the XTRAC laser to treat psoriasis. There is no cure for psoriasis, which is a non-life threatening disease. It is mostly a life-style disease where the reddish, thick plaque builds up on the elbows, knees, face and other parts of the body. There are three categories of the disease: mild, moderate and severe. The XTRAC is currently approved to treat mild to moderate psoriasis, which represents 85% of the patient population, and the company is doing testing for severe cases of psoriasis. According to the National Psoriasis Foundation, 7.5 million Americans have psoriasis and worldwide, there are 80 million sufferers. Only about 20% of US people with psoriasis, however, are actively being treated. That stems from current treatments that are either less effective or difficult to maintain. The XTRAC is proving to be one of the best treatments, both in terms of medical response (89%) and in terms of cost ($2,000/yr per patient).

There are 11,000 dermatologists in the US. The company paid for a marketing database and knows that 3,200 dermatologists write 70% the prescriptions for the two leading psoriasis treatments, Dovonex and Tazorac. The average number of prescriptions written in that 3,200 subset is 300 per dermatologist.  The company has focused on those dermatologists with 300 or more psoriasis patients. They have found that of the 300 patients, 100 are very likely to switch to the XTRAC, so that is the goal that management has set for placing an XTRAC laser.

XTRAC Economics: PhotoMedex has adopted a system of placing an XTRAC laser with a dermatologist at no cost to the doctor, and they collect a per usage royalty fee. The cost of the XTRAC with capitalized R&D is about $40-$45,000 per machine. The laser is depreciated over five years and I estimate that they recoup the cost within about 12-15 months based on a comment from the CEO that they could, in theory, recoup it in six months. LEAF Financial provides a credit facility to fund the placement of the lasers. The business model is appealing to the dermatologist, as they invest no money in the machine and unlike a prescription that funnels all the treatment dollars to a pharmaceutical company, the XTRAC provides a revenue stream to the doctor. Management estimates that a practice treating 100 patients using the XTRAC will average four treatments per day and will generate $90,000 in royalty revenue. The physician can generate around $100,000 or more in net revenue. In most cases, the XTRAC can be used by an existing technician without physician involvement.

The company has placed 322 XTRAC lasers as of 6/30/07, and expects to add 30-40 lasers per quarter for the remainder of 2007. They expect to place 240 lasers in 2008. Management has indicated that revenues should grow 10-20% per linked quarter. Here is the XTRAC revenue trend over the last six quarters:

2006-Q1          $1.1 million

2006-Q2          $1.3 million

2006-Q3          $1.6 million

2006-Q4          $1.6 million

2007-Q1          $1.8 million

2007-Q2          $2.2 million

Using 10% to 15% growth per quarter for the next six quarters, the annualized revenue run-rate as of 4^th quarter 2008 would be $15.6 million to $20.4 million. Given that it takes 1-2 years to ramp up a newly placed machine, revenues should continue to grow in 2009 and 2010, even if they placed no additional lasers. If they hit their goal of $90K of royalty revenue on 600 placed machines, the annual revenue from the XTRAC would be $54 million. Medical device companies are typically valued at 4-5X revenues. Let’s say they only hit $50K per machine and value PHMD at 4X revenues, the domestic XTRAC division, alone, would be worth $120 million.

Customer Care: Management has not been shy to invest in the business. They recently hired 8 technicians to visit practices with the XTRAC and give assistance in using the XTRAC. The company does not have a lot of money to do advertising and they found that satisfied dermatologists and patients will generate good buzz about the XTRAC. In the 2^nd quarter, the technicians visited their top practices and revenues at those practices increased 120% over 1^st quarter. The company also realizes that they need to keep the physicians happy. They do that in several ways. One, the company provides good technical support with quick turnarounds.  Management also changed their sales rep bonuses, so that they are based on how revenues grow at the practices covered by each sales rep. Thus, the sales rep is incented to follow-up and doesn’t disappear after the placing a laser. Lastly, PHMD handles all reimbursement issues for the physicians. This not only creates goodwill with the practice, it also allows them to track reimbursement issues in a centralized manner. Let me explain why.

Reimbursements: Getting reimbursement from the medical payers has been a struggle and which has pre-occupied management’s efforts the past two years. Whoever coined the saying about build a better mouse trap and the world will beat a path to your door never dealt with Medicare and medical insurers. Better medical outcomes don’t mean much when the disease is not life-threatening. First, they had to work to obtain current procedural terminology (CPT) codes from the AMA and they received three CPT codes for XTRAC treatments.

Next, the company had to work with each health payer to get them to pay for XTRAC treatments. The payers were not in a rush to pay for another psoriasis treatment. Once PhotoMedex started showing cost-savings over conventional treatments, especially in moderate cases of psoriasis, they began to make in-roads with the Blues. The barriers began to fall. Over 80% of plans now cover their treatments and they hope to have that up to 90% by early 2008. Three key states that they are currently fighting are California, Texas and Illinois. The problem is that the insurance providers in those states have set reimbursement levels for the XTRAC below Medicare levels and PhotoMedex won’t do business at those levels. The company is working to get those reimbursement levels up.

Other Divisions: PhotoMedex has four other divisions. One is International, which sells lasers overseas, including the XTRAC. It is small and they are looking for an international partner for the XTRAC, which has to keep compete with cheaper therapies. It has current run-rate annualized revenues of $2.6 million. Next, there are two related divisions, Surgical Services and Surgical Products. These are lasers and related equipment used in hospital surgeries. Similar to the XTRAC, they place the machines at no charge and charge a per use royalty fee. Annualized run-rate on those two combined is $13 million. 4X revenues on these divisions equal the market cap of PHMD. Assume 2X revenues to be conservative, and the value is $31 million.

The last division is Skin Care, which includes their ProCyte business. Skin care generates around $13 million of revenues and $3 million of EBIT (with no corporate overhead). Since it is not a medical device company, let’s value it at 8X EBIT or $24 million. The other divisions combined are worth $55 million.

Skin Care: There are three things to understand about this division. One is that PHMD bought ProCyte in 2005 because it generated cash and more importantly, it had a commercial sales staff that dealt directly with dermatologists. ProCyte products are high-end and reputable, and are only sold by dermatologists. A number of these products are for before and after laser surgery and hair transplants. It was the perfect platform for rolling out the XTRAC. I think Skin Care could fetch a higher price based on its unique product distribution network. The other two factors relate to new product launches. One involves a product that promotes the appearance of longer, thicker eyelashes. The other appears to be more significant, a skin lightener using manganese peptide that will compete against hydroquinone products that have been under FDA scrutiny. A skin lightener helps reduce the color of age spots and reduce fine lines and wrinkles – perfect thing for aging baby boomers.

Management: Jeff O’Donnell is a very capable CEO. Having worked in cardio device sales at Guidant, Boston Scientific and J&J, he was brought into get the XTRAC launched. He is very focused on realizing shareholder value and is not here to build an empire. All of management’s stock options are currently under water. There are about 6.4 million stock options outstanding, about 10% of all shares, at a weighted average price of $2.00.

Capitalization: There are 62.9 million shares outstanding, $10.6 million of unrestricted cash, $4.3 million of long-term debt and $4.2 million of current debt that I assume was rolled, resulting in an EV of $60 million.

Valuation: Using $24 million for Skin Care and 2X revenues for everything else (or 4X revenues for 1^st Half of 2007), I get $60 million of value or about the current market cap. At 4X revenues on the medical devices, I get 50% upside, without any growth in XTRAC revenues. Assuming 4X revenues, 10% XTRAC revenue growth implies PHMD is a double, and close to a triple if revenues grow 15% and a possible 5-6 bagger if they hit $90K revenue per machine on 600 machines.

I suppose some of y’all might roll your eyes at using a metric like 4X revenues. It might work for JNJ, MDT and STJ, you say, but PHMD is not in their league. Okay, let’s talk dirty and see what EBITDA might look like. Excluding stock options, EBITDA was around ($350,000) for first half of 2007. Management has said that they intend to keep overhead expenses flat. The XTRAC’s gross margins were 52% in the last quarter. So every dollar of additional revenue from the XTRAC adds $0.52 to EBITDA. If the other divisions perform as they have, then PhotoMedex’ EBITDA could grow as follows, assuming NO gross margin improvement:

XTRAC Revs.             EBITDA

$8.8 million                 ($0.35 million)

$15 million                  $2.9 million

$20 million                  $5.5 million

$30 million                  $10.7 million

$40 million                  $15.9 million

$50 million                  $21.1 million

Given the high margins, I think a 10-12 EV/EBITDA multiple would be an appropriate valuation.

Gravy to the upside:

- they expand the sales force and drive laser placements to 900, or 20% of the targeted dermatologists

- the manganese peptide product takes off

- they get an international partner for the XTRAC

- they get positive results on the severe psoriasis study

- margins continue to improve

- technicians drive “same store” sales up

Risks:

- illiquid

- XTRAC placements slow

- credit facility gets pulled (not likely given the LEAF deal was signed in July and the $10.6 million in cash they have)

Catalyst