GKOS - Iridex: The Whole Is Less Than The Sum Of The Parts

2023-10-04 05:04:03 ET

Summary

• IRIDEX Corporation is a leading provider of laser-based retinal treatments and is respected in the ophthalmic industry.
• IRIX stock has experienced a significant decline in value, but the primary reason for this (dilution concerns) is misguided.
• The company is undergoing a strategic review and may separate its two divisions, which could significantly benefit shareholders.

IRIDEX Corporation ( IRIX ) is a provider of innovative ophthalmic laser-based medical products for the treatment of glaucoma and retinal diseases. Despite its current small market cap status, the company is actually the leading provider worldwide of laser-based retinal treatments and is highly respected by physicians and experts in that space. I have previously written about IRIX for Seeking Alpha, but some important changes have happened since that time. One of those changes is that the stock is now down 67% since that last article over two years ago.

In this update article, I will talk briefly about why the stock has been punished so severely (as have many microcaps since that time), but will focus most of my time on discussing why I believe the stock is currently a screaming buy, even after shares have rallied around 100% from recent lows. This recent share price appreciation is clearly a result of the strategic review the company has undertaken to “unlock shareholder value.”

In this article, I will do my best to parse through the language of the linked press release, drawing upon my own research and knowledge of the company. In short, I will show why I believe IRIX’s whole is actually LESS valuable than the sum of its parts. Put differently, I will show why I believe the company is ultimately going to separate its two businesses—retina and glaucoma—and how this will significantly benefit current shareholders. In fact, I will make the argument that if IRIX chooses that route, the company should be worth at least $7.00/share, or nearly triple current values.

Why Did IRIX Shares Crash?

About two and a half years ago, when I first wrote on IRIX for Seeking Alpha, the company was fresh off a transaction with Topcon ( OTCPK:TOPCF ), a Japanese company that is a giant in the ophthalmological industry. To summarize the transaction, Topcon paid $6.18/share to acquire an approximately 10% ownership stake in IRIX. In total, IRIX ended up netting $19.5M from this transaction, which at the time, gave them $28M of cash on the books.

Now, just over two years later, IRIX is down to about $9M of cash on hand, with the glaucoma business not growing as much as the company and investors had hoped it would by now. Given this significant cash burn in just over two years, it’s no wonder that investors fear a dilutive capital raise, which in my estimation, is the primary reason for the precipitous stock price decline. However, I believe the market is missing several key aspects of IRIX’s recent cash burn and how that burn rate will soon be declining materially; not to mention the significance of this recently announced strategic review. What are they missing?

• Both during and after the global pandemic, IRIX wisely stocked up heavily on their inventory levels, fearing supply chain constraints. As those restraints have now eased, IRIX is selling down its inventory at a higher rate than it needs to replace/sustain it. This scenario means that IRIX was burning cash during the past two years stocking up on inventory, but will now be offsetting the inventory-related cash burn by selling down the inventory levels.
• Related to the Topcon transaction, and a primary reason Topcon gave IRIX so much cash, IRIX significantly ramped R&D expenses in order to integrate their own retina laser-based system with Topcon’s PASCAL system, so that now the two companies will be marketing one, unified solution throughout the world. IRIX just recently completed that integration (see the previously-linked press release on the strategic review) and will drastically slow down that related R&D.
• The glaucoma business has not picked up as quickly as the company planned, which is why the company will continue to burn cash in the near future—albeit at a much lower rate than the past two years, for the reasons I just mentioned. In addition, the company has identified concrete reasons why glaucoma sales have not picked up quickly, and they are in the midst of remedying that situation in order to attack a market with billions of dollars of opportunity.

Based upon my research and conversations with people familiar with IRIX, I believe the company’s burn rate—even with no material increase in sales in 2024—would come down to about $3M per year. This would mean the company has a several year runway before needing to raise capital at the projected burn rate, a runway that would obviously lengthen if the company sees increased sales.

But, will the company even be around in several years? Personally, I doubt it, based upon the company announcing the strategic review.

IRIX’s Two Divisions

In the press release, IRIX made clear the purpose of the strategic review is to “unlock shareholder value.” That sounds nice, but what does it mean with respect to IRIX? I think the press release gives us the answer. According to IRIX’s Board Chairman: “the Board of Directors believes this is an appropriate time to explore strategic options for the future of each of our product lines .” To an investor not intimately familiar with IRIX’s business, this line likely has little relevance. However, if you understand IRIX’s business and the differences between the two divisions, this sentence is key to understanding the likely outcome of the strategic review.

On the surface, the retina and glaucoma divisions no doubt seem quite similar. They both deal with eye diseases and both use laser-based systems and disposable probes to treat the respective diseases. In reality, these two divisions are quite different.

Retina is a well-established business at IRIX; one that, as I mentioned from the outset, has IRIX positioned as the global leader in laser-based retinal treatments, most especially with the recent integration of Topcon’s PASCAL. While the business is only growing at about 3-5% annually, it is a steady business that will not be going away anytime soon. People, unfortunately, continue to have retinal disease, and laser-based treatments are a proven way to treat the disease. I believe that IRIX’s retina business is, relatively-speaking, highly profitable (i.e. from a net margin perspective). However, this profitability is obscured by the glaucoma division.

Despite also using laser-based systems, IRIX’s approach to glaucoma treatment is relatively new and unique. Unlike in retina, where IRIX is a global leader, their glaucoma treatment has yet to see much market penetration. I will discuss the reasons for this, and IRIX’s plans to address that, shortly. In the meantime, I want to point out that IRIX has, in my opinion, been wise to burn cash in order to build the glaucoma business. Why? Because the glaucoma market is in the billions of dollars of opportunity .

Glaucoma is a debilitating disease that, ultimately, leads to blindness (unless the patient dies from other causes first). Sadly, there is currently no cure for glaucoma; only treatments to minimize its impact. A glaucoma patient simply hopes to extend glaucoma treatment benefits throughout their lifetime. Currently, there are several treatment options besides IRIX that can help patients. IRIX’s solution, it should be noted, seeks not to replace any of these options, but to complement them, which ultimately could lead to another 10-15 years of patient benefit.

In the United States and other wealthier countries, a common treatment for glaucoma is eye drops. Eye drops definitely help glaucoma patients, but they can become quite expensive and thus not an available option in many parts of the world. Moreover, while not technically “invasive,” they are burdensome because they must be used daily and they can often cause burning and noticeable irritation/redness in the eye. Unfortunately, their impact eventually dulls over, requiring additional prescriptions and compliance, with the effect that the patient will likely go blind without escalation to other, usually invasive, treatments.

Another, newer treatment is a procedure called MIGS (minimally/microinvasive glaucoma surgery). MIGS is often done in conjunction with cataract surgery since the physician has already created an opening into the patient’s eyes. As part of the most common MIGS procedure, a titanium instrument is placed in the eye to help relieve the pressure build-up, which is the cause of glaucoma. This procedure has worked quite well for patients; however, as with the eye drops, in many cases, the benefits quickly fade. Moreover, the procedure is usually only conducted in conjunction with cataract surgery, and not all glaucoma patients have cataracts. Like eye drops, the MIGS procedures are expensive, and thus not a great option in much of the world.

As I will discuss below in the Valuation section, MIGS companies have sold for extremely high valuations relative to their sales/profitability. The reason for this is that glaucoma is a global problem with no cure. Any treatment with the potential to safely and effectively reduce a patient’s symptoms for five, ten, fifteen years, can be a highly lucrative business. IRIX’s laser-based solution certainly seems to fit the bill, so why has it not seen a higher rate of adoption?

IRIX’s Glaucoma Hurdles

As with any new medical procedure, it takes time and education before market uptake. This has certainly been true with IRIX’s laser-based glaucoma treatment. Here, I will briefly explain the two key elements for IRIX’s treatment to be effective, followed by my assessment of why some physicians have not seen success with the product, and then concluding with IRIX’s approach to address this gap.

IRIX’s laser-based treatment is the most non-invasive of all glaucoma medical treatments of which I am aware. Unlike drops, the patient does not need to use it every day. Unlike MIGS, there is no surgery or cutting into the eye. And also unlike MIGS, the IRIX treatment can often be repeated several times before its impact dulls, meaning that patients can see anywhere from 10-15 years of benefit even after undergoing eye drop and/or MIGS treatment.

For IRIX’s solution to be effective, however, the patient must receive the correct “dosage.” I put dosage in quotation marks because by this I mean that not only must the patient receive the correct amount of energy delivered to the eye from the laser, but the “sweeping time”—the time that the specific energy is delivered to a precise location of the eye—must also be correct. Therefore, the dosage is not as simple as a pharmaceutical solution. The correct dosage includes both the amount of energy and the sweeping time. IRIX has shown in a clinical study that the correct dosage results in a highly effective treatment for glaucoma patients. Moreover, IRIX provides numerous physician testimonials by highly-esteemed experts in the field who use IRIX’s solution.

The problem with uptake of IRIX’s solution seems to be primarily related to the difficulties of physicians applying the correct dosage. Most specifically, IRIX has discovered issues related to the sweeping time aspect of the correct dosage. This should come as little surprise to anyone familiar with cataract surgery (the same physicians treating cataracts are often the same physicians treating glaucoma). Cataracts are treated in what can best be described as a conveyor-belt-style. Patients are lined up and the physician goes quickly from one to the next, with little time needed to fix the eye. While IRIX’s glaucoma procedure does not take much time, it absolutely cannot be something hurried. The sweeping time needs to be precise and cannot be shortened if optimal results are desired.

This disconnect has caused some physicians to see minimal effect from IRIX’s laser-based treatment, and seems to be the number one reason IRIX market share has not picked up as significantly as desired. Fortunately, IRIX is in the process of addressing this issue in two important ways.

1. IRIX is working on an entirely automated procedure, one that will simply require physician oversight, and will not rely upon the physician to manually sweep the eye. This automation should eliminate the problem of improper dosage/sweeping time. IRIX already made some improvements in the area of assisting physicians with the sweeping time requirement, which is why they have seen an increase in glaucoma sales, but the company now realizes that broader adoption is unlikely until the process is fully automated.
2. IRIX is currently recruiting patients for a multi-center clinical study that will focus on patients who received MIGS treatment, but who have again suffered from the progression of glaucoma symptoms. The study is important for a couple of reasons. First of all, the study will include multiple centers, which is important to show it can succeed in the hands of numerous physicians. Second, the focus on post-MIGS patients is key because it will show physicians they can keep the MIGS patients as part of their practice for a much greater period of time. By that, I mean that currently, once the MIGS procedure fails, there is really nothing much a physician who is not a glaucoma specialist can do for the patient. With IRIX’s solution, the physician will now be able to keep the patient for another decade or more, with the physician profiting from the patient and, most importantly, the patient benefiting significantly from IRIX’s treatment solution.

Of course, for IRIX to accomplish these two tasks—the automation and the clinical study—it is going to take some time and money. And that is where I believe the strategic review comes back into play, and makes sense of its timing.

Unlocking Shareholder Value

As noted, I believe IRIX’s retina business, on its own, is a steady, slightly-growing, but most importantly, profitable business. Glaucoma, on the other hand, is cash-burning, but has lucrative potential—its valuation could someday dwarf retina. That said, I highly doubt IRIX, a small company, can take the glaucoma treatment to the promised land. But what IRIX can possibly do is to progress the glaucoma business to the point that it is of much higher value than the current enterprise value of IRIX as a whole. How can that be accomplished? Well, what makes the most sense to me is to separate the two divisions to “unlock shareholder value.” And while I do not think even IRIX knows for sure that is what will happen, they certainly seem open to the possibility based upon the Chairman’s statement that they will “explore strategic options for the future of each of [their] product lines.”

To me, what makes the most sense for IRIX, short of the unlikely event of one company stepping in to pay a fair value for the entire business, is to sell the retina business in the relatively near future. This should give IRIX the opportunity to pocket well beyond enough cash to finish automating the glaucoma procedure and to finish the clinical trial—or at least to see it through the six month and/or one-year readouts, after which time a buyer might pay a fair value. With that in mind, I will turn to my valuation of IRIX based upon separate valuations for retina and glaucoma. I think you can see from this how IRIX could be a homerun to investors entering the stock at current levels.

Valuation

Retina

Based upon IRIX’s financial statements and my conversations with people familiar with the company, I believe that the retina business is profitable for IRIX, and that the reason the company is losing money is due to funding the glaucoma business. This seems to make sense because IRIX has a rather small sales force for retina. Moreover, the business operates according to a razor-razor blade model. Specifically, IRIX sells laser systems (the razor) which then use probes (the razor blades) for individual cases. The probes, then, are essentially “disposables.” As one might expect under such a model, the laser systems have a much lower margin than the probes. I will discuss the importance of this in minute.

Before that, I want to back up and look at IRIX’s financials . Note that if you back out G&A expenses, the company is essentially operating at breakeven. That is important because an acquirer will likely be able to drop a significant chunk of G&A, integrating IRIX's retina business into its current infrastructure. Moreover, note that if you extend that reduction to SG&A, you are becoming quite profitable. By my estimate, IRIX has about twice as many salespeople in glaucoma as in retina, so sales are more weighted towards glaucoma than retina. Finally, in looking at expenses, you can also see that by eliminating G&A and then also eliminating R&D, IRIX would be nicely profitable. As noted, retina R&D expenses are expected to decline materially since the PASCAL product has now been integrated with IRIX’s original retina system.

Now, to be clear, no acquirer can eliminate 100% of R&D and 100% of Sales and 100% of G&A expenses. That should be fairly obvious. However, an acquirer should spend significantly less on retina G&A and R&D than IRIX has recently spent, and would not have the sales expense associated with glaucoma if they only acquire the retina division. Based upon this, I estimate it would not take much for an acquirer to see $10M of net profit from IRIX’s retina division. This is my base case scenario.

However, it should also be noted that the possibility exists for an acquirer to purchase IRIX’s retina division and to essentially shut down the sales force and to coast on selling the high-margin probes. IRIX has tens of thousands of retina systems in service and over 70 distributors worldwide and could, theoretically, rely upon them for future sales and simply continue to service the existing systems by providing the probes. Because IRIX is a market leader, I doubt this type of buyer will materialize and outbid someone who hopes to expand IRIX’s retina reach, but it is possible. If that happens, the acquirer could earn more than the $10M net profit I estimate as my base case scenario.

Still, as I noted, my base case is that IRIX’s retina business could quite feasibly produce $10M of net income for an acquirer who wants to operate and expand it. Based on that, I believe IRIX could sell its retina division alone for $60-80M, a 6-8x multiple. Actually, it is possible if my assessment is accurate that retina could sell for more; however, I am trying to be conservative in case my net income estimate is slightly high; or if the current market does not support a higher multiple as we might have seen 2-3 years ago. Also, retina is not fast-growing, so a more conservative multiple is in order.

The midpoint of my estimate ($70M) equates to roughly $4.30/share, or roughly 70% higher than the current share price. And, remember, that is for retina only and does not include the current roughly $0.55/share IRIX has in cash on hand.

Glaucoma

Glaucoma is obviously harder to value because it is currently a money loser (as, to my knowledge, are all MIGS-based companies/divisions at this time). However, I think it is clear glaucoma could become a highly lucrative business for an acquirer. My current expectation is that IRIX understands it is on the brink of making glaucoma more valuable by automating the sweeping process and undertaking the multi-center clinical trial. Consequently, my best guess is that IRIX pockets the $60-80M from the sale of retina and stewards it to finish these tasks of unlocking value from glaucoma. I will get back to that in a minute.

Before that, let’s assume that IRIX’s Board and management is simply tired of dealing with glaucoma, and so decides to sell it sooner than later. I believe that glaucoma currently has revenue of around $15M annually. Would that not be worth 2-3x sales to an acquirer who could possibly move the needle? Someone like Topcon, who already was interested in IRIX’s glaucoma business and made the previous transaction with them a few years ago at $6.18/share? Certainly, one could justify that type of valuation if you look at comps like Glaukos Corporation ( GKOS ), with sales of roughly $305M and an enterprise value of $3.5B!

Or, take a look at Alcon acquiring Ivantis, Inc. for $475M two years ago. The company’s estimated revenue was no higher than $60M, and likely lower. So, again, probably about 8-10x sales. Now, granted, IRIX’s glaucoma solution is not in the current hot space of glaucoma treatment (i.e. MIGS), but selling for a minimum $30-45M (2-3x sales) does not seem unreasonable. At the midpoint ($37.5M), that represents roughly $2.30/share.

However, note that $30-45M is my estimate for how much IRIX’s glaucoma business would be worth to an acquirer now . I believe in a year to 18 months, the glaucoma business will be worth much more, possibly as much as the $60-80M at which I value retina, once the sweeping process is automated and, presumably, IRIX sees positive readouts from the clinical study.

Retina + Glaucoma

Putting together retina ($4.30/share) and glaucoma ($2.30/share) plus the $0.55/share of cash on hand, I currently value IRIX at $7.15/share. This does not even factor in the approximately $25M of tax assets on the books. I am not 100% sure how those would be split between the businesses and will simply use it as a form of buffer if my valuations for retina and/or glaucoma are slightly high, which I do not believe they are. Still, better to err on the side of conservatism.

In any case, while I believe glaucoma could become significantly more valuable in the next 12-18 months (perhaps twice as valuable as it is now), even so, I presently value IRIX at $7.15/share, which represents roughly 160% upside from the current share price.

Risks

There is no guarantee that IRIX will find a buyer for either business or for the business in its entirety. Currently, the market is the least favorable market for selling a business in quite some time. So, even if IRIX finds a buyer(s), they may end up settling for less than what they and I estimate as fair value. Regardless, I believe my Valuation section above shows that IRIX is undervalued at present levels and, thus, provides little downside from here.

Nevertheless, in the rather unlikely event IRIX finds no buyer(s) within the next 18 months, it is quite possible the company would need to dilute shareholders to raise capital to continue the business. Again, I find this to be highly unlikely, but it is a risk to keep in mind.

Conclusion

IRIX shares plummeted earlier this year, likely because the market expected the company to need to issue shares in order to stay afloat. However, as I outlined, the company is drastically cutting its burn rate and should not need funding anytime soon. Moreover, the company recently began a strategic review that I believe will lead to the sale of each of its two divisions. Because of the unique circumstances surrounding each of the business units, I believe that IRIX’s whole is actually less valuable than the sum of its parts, and that each business unit will be acquired by a different entity.

In the hands of the correct acquirer(s) for each unit, retina can be a steady, profitable business and glaucoma could turn into a multi-billion dollar enterprise over the next decade. While I believe IRIX can sell retina and then use some of that cash to further progress the glaucoma business over the next 12-18 months, I am currently valuing the company based on what I believe a buyer(s) would pay now. As a result, I value IRIX at $7.15/share, which includes the current cash on hand, but does not factor in the approximately $25M of tax assets, which I leave out of the equation to serve as a buffer. Based on this valuation, I believe IRIX shares are worth about 160% as much as their current levels, with low relative risk. As such, IRIX is currently a pillar in my portfolio.

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