IRIX - Iridex Reimbursement Chaos Presents Buying Opportunity

2023-11-02 06:11:07 ET

Summary

• IRIDEX Corporation's shares rallied over the past several weeks on news it was conducting a strategic review.
• On November 1, the stock cratered as the company disclosed possible concerns with Medicare reimbursement for certain glaucoma procedures.
• The impact of this new ruling related to IRIX's business is limited, with only about 10% of revenue affected.
• The lost revenue can be more than offset by decreasing associated expenses.
• The new reimbursement concern does little to change the long-term value of the company, which is still nearly triple current trading levels.

IRIDEX Corporation (IRIX) is a global leader in ophthalmic medical technology for the treatment of retinal and glaucoma diseases, providing therapeutic based laser systems, delivery devices, and consumable instrumentation. Throughout most of 2023, IRIX shares have struggled as the company burned cash on its glaucoma business, and investors feared the potential of a dilutive capital raise. More recently, shares rebounded as the company announced a strategic review to "unlock shareholder value." In studying the company closely, I believed IRIX would, in fact, unlock significant shareholder value, even after the stock had moved over 100% higher since the strategic review announcement. I wrote about this in-depth just a month ago for Seeking Alpha. You can find the article here .

Since that article, we have seen one unexpected and material change. Specifically, on November 1, IRIX released an 8-K that led to a major selloff in the stock, as the company pulled its FY23 guidance, and investors worried about reimbursement concerns and their impact on the business. In this article, I wish to show why I believe the selloff was overblown and why I believe the dip in the share price provides a phenomenal opportunity for investors.

The article will focus on three key areas:

• The ruling of the relevant Medicare Administrative Contractor ("MAC")
• The ruling's impact on IRIX's business
• The value of IRIX's business in light of this decision

Ultimately, I will show why I believe the MAC's ruling does little in the way of impacting IRIX's value to an acquirer, and why I believe the company is still worth around $6.15/share (an approximately 185% premium from current prices) even after the recent news. For those who may have passed on buying IRIX last month because the stock moved up so quickly, this recent activity provides a second chance as the company continues its strategic review.

MAC Reimbursement Ruling

According to IRIX's 8-K, a MAC administering Medicare reimbursements for six states recently published new guidance. Under this guidance, the MAC indicates they will impose additional requirements for reimbursement for cyclophotocoagulation procedures conducted to relieve glaucoma symptoms (there are no cures for glaucoma; only treatments for symptoms and side effects). According to the MAC's decision, cyclophotocoagulation will be considered medically reasonable and necessary for patients with refractory glaucoma when patients:

1. Have failed trabeculectomy or tube shunt procedures AND
2. Have minimal useful vision and elevated intraocular pressure AND
3. Have no visual potential and need pain relief."

By default, then, glaucoma patients who do not meet these standards would not have their cyclophotocoagulation reimbursed by Medicare in the six states administered by this MAC.

On the surface, this ruling sounds bad because some of IRIX's glaucoma business may no longer be reimbursable under Medicare. That initial reaction is likely why the stock dropped by as much as 50% the morning the 8-K was released. But, is this news really that bad? What does it mean for IRIX?

Impact on IRIX's Business

IRIX operates two separate product lines: retina and glaucoma. Although both obviously deal with the eye and both use laser-based treatments, the two areas of focus are quite different. IRIX's retina solutions have been used for around 40 years. There is no controversy or concern with the reimbursement of IRIX's retina procedures.

In terms of glaucoma, IRIX offers two treatments based on the patient's need. One treatment, continuous wave cyclophotocoagulation, has been used for around 20 years. This treatment is only used when patients meet the three requirements outlined above in the MAC's ruling. In other words, IRIX's continuous wave treatment will continue to be reimbursed.

The only area of IRIX's business impacted by this MAC's decision is the micropulse cyclophotocoagulation, a treatment offering that is relatively new at IRIX. This treatment is specifically designed for patients who have not yet reached the end-stage of glaucoma. That is to say, micropulse aims to help relieve the patients' symptoms for 10-15 years before more serious and invasive procedures are needed.

Finally, it should be noted that this MAC's decision may eventually convince other MACs to go in the same direction; and it may even spur insurance companies to do the same-in fact, in my analysis here, I will just assume that is the case. Still, this impact will only be felt in the US, not internationally. With that in mind, I want to put this qualitative analysis of how the MAC's decision impacts IRIX into more quantitative terms.

Quantitative Impact of MAC's Decision

As I established above, only the domestic glaucoma micropulse business at IRIX is impacted by the MAC's decision. While IRIX does not break out its revenue or expenses to such a fine degree, we can arrive at some rough estimates.

Based upon my research, I estimate that $15M per year is the current annual run-rate for IRIX's entire glaucoma business. As the recent 8-K noted, of that glaucoma business, roughly 50% is international. Therefore, we can assume that IRIX's domestic glaucoma revenue is approximately $7.5M.

Of the domestic glaucoma business, according to the 8-K, slightly over 50% is attributable to micropulse procedures. For my estimation, and to be conservative, I will assume that IRIX's domestic micropulse glaucoma business is $5M in annual revenue. That is just under 10% of the company's total business. Now, in most cases, companies would not want to lose 10% of their revenue-and certainly that was not IRIX's preference in this case.

However, as the company noted in the 8-K:

"For the past several years, sales and marketing expenses relating to the Company's domestic glaucoma efforts have involved significantly larger expenditures compared to the Company's retina and international operations."

The reason for that is because IRIX's micropulse glaucoma therapy has enormous potential. Remember, the micropulse therapy can treat ALL glaucoma patients, whereas the continuous wave is only for end-stage patients. Therefore, IRIX believed it was worth investing in glaucoma micropulse treatment because finding commercial success in that area could have caused revenue to skyrocket.

The good news in this sage for current shareholders is that if IRIX were to shut down its domestic glaucoma micropulse business, the company would likely be breakeven to profitable since their sales and marketing expense this year is on pace for $17M, and the bulk of that is for glaucoma micropulse.

Now, to be clear, I doubt IRIX or an acquirer of its business would want to completely shut down this business. Somewhere along the way, it is highly likely that IRIX's procedure will be approved by this MAC and others as it proves itself out in a clinical trial which the 8-K mentions is about to start this current quarter.

In the meantime, I believe it is important we reiterate that only about 10% of IRIX's revenue is impacted by the MAC's decision. That alone should indicate a 33% selloff in the stock (as happened on November 1) is unwarranted; even more so when we learn the lost revenue is money-losing when you factor in its associated operating expenses!

Still, we are left with the question: what is IRIX now worth?

IRIX's Updated Valuation

Before diving into the valuation, let me explain my earlier thesis that IRIX was likely to sell its two product lines separately. Since retina is a well-established, profitable business, it would make sense to sell retina and use some of the funds from that sale to progress the glaucoma business. Such an approach might still make sense. Consequently, I want to show my valuation for each product separately.

That said, given the recent 8-K and the surrounding uncertainty, I now think it is more likely than before that IRIX will sell itself as one entity to one acquirer. Obviously, that remains to be seen, but for now, I want to highlight the separate valuations.

Retina

If you look at IRIX's financial statements you may notice that if you deduct the company's G&A expenses ($9M annually), they are at breakeven. This is important for two reasons. First, an acquirer of IRIX's retina business will likely be able to drastically reduce that expense because they can integrate IRIX's retina business into their current operations. Second, some of this G&A is obviously attributable to glaucoma, which further bolsters my point that an acquirer of retina can materially decrease IRIX's G&A expense.

Another point to highlight is the sales expense ($17M annually). As noted earlier, I believe we can assume the elimination of up to $10M of that expense based on IRIX's commentary in the 8-K. The final thing to note as it relates to teasing out retina's profitability is to look at the R&D expense line ($7M annually). A couple of things should be pointed out. First, IRIX's R&D will decrease drastically, even if the company were to continue to operate the full business. The reason is that IRIX just recently completed a major development project within their retina line, while also working to integrate Topcon's PASCAL product with their own. Because this work is now complete, R&D will drop materially. Second, a notable amount of this R&D line is attributable to glaucoma. A retina-only buyer obviously would not assume that expense.

Factoring in all these considerations, it seems likely an acquirer could operate IRIX's retina business at a minimum $10M annual net profit. At a 6-8x multiple, which would be beneficial to both IRIX and an acquirer, we are looking at a $60-80M buyout on retina alone. At the mid-point, that acquisition price represents $4.30/share, or 30% upside from current share prices (roughly $3.30/share) for retina only. That, of course, still leaves the glaucoma business.

Glaucoma

Glaucoma is more difficult to value, even before the MAC's reimbursement decision. The reason is that glaucoma is clearly not profitable. Regardless, glaucoma has enormous potential, and I have always viewed glaucoma's fullest potential to be recognized outside the US. In the US, IRIX's glaucoma treatment will compete with more expensive, but also more established, treatments like eye drops and MIGS (minimally/microinvasive glaucoma surgery).

Still, IRIX's glaucoma business has value to a potential acquirer, even one who may not be as interested in their retina business. The reason is that IRIX's glaucoma treatment could still become a billion dollar business worldwide. In my prior article, I cited my belief, based on some comps, that IRIX could sell glaucoma now for 2-3x sales. I recommend you refer to that article for the exact comps.

In any case, I am now factoring in the lost (estimated) $5M in glaucoma sales from the MAC's recent decision. With that amount eliminated, glaucoma sales should still be at roughly $10M annually. That would put the midpoint of my valuation (2-3x sales) at $25M, or $1.50/share.

Total Valuation

In addition to the underlying value of IRIX's retina and glaucoma businesses, as of last quarter, IRIX had $0.55/share of cash on hand. I will assume that between now and any sale, IRIX continues to burn some cash. Consequently, I will count cash on hand as only $0.35/share instead of $0.55/share. As such, here is my valuation.

Retina: $4.30/share

Glaucoma: $1.50/share

Cash: $0.35/share

Total IRIX Valuation: $6.15/share

Now, I must note that this valuation is remarkably similar to the one Topcon ( OTCPK:TOPCF ) arrived at when two years ago they acquired a 10% stake in IRIX for $6.18/share. Finally, I should note that at $6.15/share, I value IRIX shares at about 185% upside to current prices.

Conclusion

The selloff in IRIX on the news of a MAC no longer reimbursing certain of IRIX's procedures is overblown and completely overlooks the prior announcement that IRIX is engaged in a process likely to result in the sale of its two product lines. Investors sold first and asked questions later. When you ask the questions, you learn that only about 10% or less of IRIX's revenue is impacted by the MAC's determination; and it's cash-flow negative revenue at that! A potential buyer resulting from IRIX's strategic review will likely still see the significant value of the retina business, while also appreciating IRIX's progress in glaucoma to date. I believe that IRIX will likely not receive as much money now that there is this reimbursement uncertainty as they would have otherwise, but shares are still materially undervalued at current levels. Consequently, I used this selloff to increase my stake in IRIX, maintaining it now as an overweight position in my portfolio.

For further details see: