Sunday, June 10, 2007

Advanced Medical Optics (EYE)- In Need of Focus

It's been quite some time since I have last posted and I apologize for the disruption. But rather than create random drivel, I prefer to post when I believe I have something interesting to discuss.

Advanced Medical Optics (EYE) is such an idea. Clearly, the company is terribly out of favor, with the stock down about 26% over the last year, having suffered two fairly significant problems in this period of time.

The company announced on May 25th that it was recalling its Complete MoisturePlus contact lens solution globally because of health concerns. The voluntary recall was initiated because of concerns over eye infections from Acanthamoeba, a naturally occurring water-borne organism which can contribute to serious corneal infections potentially leading to blindness or more likely, a corneal transplant. The company responded quickly and conscientiously to data from the U.S. Center for Disease Control and Prevention (CD) that showed that it had interviewed 46 patients who had developed Acanthmeoba keratitis (AK) infections reported since January 2005. A total of 39 of these patients were soft contact lens wearers, 21 of whom reported using complete MoisturePlus products. AK infections are usually found among individuals who improperly store or disinfect their lenses, swim/use hot tubs/shower while wearing lenses, etc. The CDC has received reports of 138 cases of confirmed AK infections but only 46 have provided complete patient data. There are many types of keratitis and consequently the diagnosis of AK requires a significant effort on the part of the treating eye care professional to isolate organisms from corneal cultures or to detect cysts on the histopathology.

The bottom line is that no one can explain what caused the higher incidence of AK cases among the people who reported to the CDC and there are a wide variety of potential factors that relate to the general increase in the number of AK cases and the apparently higher incidence of cases related to MoisturePlus.

The product generated sales of about 10% of the firm's total revenue. The costs of recalling the product will be high, as well as the settling of potential product liability lawsuits. The company will also face costs of advertising and marketing as it attempts to re-establish the brand with new formulations.

The fact of the matter (at least according to a recent Bear Stearns conference call) is that there does not appear to be an effective multipurpose no rub contact lens solution for killing AK. Older technologies of "rub" products and hydrogen peroxide products seem to work better. Strangely, EYE could benefit from a move back to older technologies, as it is a major player in the hydrogen peroxide space.

The "other" problem that I refer to is a manufacturing problem from November that resulted in a recall but with no adverse health reactions reported. The problem facility has cleared inspections and is currently on stream. This created the initial break in the stock price and in my opinion, lowered expectations dramatically.

So much for the bad news...what does the company do right? EYE sells a full range of cataract products to surgeons. Some 76% of surgeons who use the company's lens-removal system will use an EYE Intraocular lens implant. The company is readying a new multi-focal IOL to compete with market leader Alcon (ACL.)

EYE acquired VISX which gives it market leadership in LASIK surgery. The company has a unique franchise in selling both LASIK and refractive intra ocular lens, an ability for the eye surgeon to cross-sell. LASIK equipment is sold to surgeons but EYE receives an additional licensing fee that is calculated per procedure. Custom LASIK procedures which are gaining share provide about twice the licensing fee of standard LASIK.

The company acquired a major competitor in microkeratomes, the cutting device that creates the corneal flap in LASIK surgery with the purchase of IntraLase, the leading manufacturer of a laser keratome.

In summary, EYE is the largest player in refractive surgery, it is #2 in cataract surgery, and is #3 in contact lens solutions. This company has made several transformative acquisitions since its spin off from Allergan (AGN) in 2002. The balance sheet is somewhat leveraged with $1.6 billion in total debt. However, EBITDA/Interest paid is about 6.5 times based on trailing twelve months of EBITDA.

Operating margins could well expand from TTM levels of about 11% to levels approaching 20% plus as the LASIK market expands and refractive Intraocular lens replacement grows. Some reports suggest that custom LASIK could represent over 80% of the total LASIK market versus its current roughly 50%, another significant boost to profitability.

The company, just prior to its AK recall news had announced that it was potentially interested in purchasing Bausch & Lomb (BOL) a company that is the target of a $3.7 billion takeover by Warburg Pincus. EYE needs to focus on its own issues at the moment and continue the integration of prior businesses rather than build itself some new obstacles. I suspect that management will back away from its BOL dreams, at least for now.

BOL's current valuation (at a premium to the Warburg Pincus bid) is about 16 times EV/EBITDA. EYE is valued at about 10.3 times on this basis.

Return on equity is about 11%, a function of high leverage rather than great asset or capital management. ROIC is an embarrassingly low 5%, an issue that will no doubt be addressed by some activist shareholder involvement.

I am encouraged by a 13-D filing by ValueAct Capital Management, a highly regarded activist firm who have built their ownership position in this company to a current 9.86% as of their most recent May 29th filing. ValueAct has a long history of responsible activist investing which has focused on healthcare and technology companies, a track record I greatly admire.

There is no cheery consensus here...of 8 analysts that follow, there is one sell, six holds, and one lonely buy. Management has a long strong of acquisitions that have built a significant market position business with three easily fungible parts but below WACC returns.

Insiders own about 0.6% of the stock (which goes a long way to explaining some of the acquisition history) but about 4% on a fully diluted basis (through options.)

Dare I speak of a lack of focus or an inability to keep the eye on the ball? All punning aside, I am comfortable with the stock at current valuation. Expectations are nil and the Street wants to wait and see (sorry.) Smart outside ownership is coming in for the cure.

Disclosure: I, my family, or clients have a current position in EYE.


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