Open Letter To The Board Of LCA-Vision On The Proposed PhotoMedex Transaction
By Samir S. Patel :
I am an LCA-Vision ( LCAV ) shareholder. After reviewing the details of the proposed transaction, I have concluded that the PhotoMedex ( PHMD ) offer materially undervalues the company. Thus, I am led to believe that your unanimous approval thereof is not in shareholders' best interests, and I respectfully request you to consider other alternatives. I was pleased to see that the company is engaging in a go-shop process. I encourage you to utilize that opportunity to its fullest potential.
While the offer certainly represents a sizable premium to the shares' previous market value, this is little consolation to your long-term shareholders, many of whom remain deeply underwater. To be completely clear, I understand that the majority of the decline over the past few years was driven by plummeting consumer confidence and discretionary income. In fact, I must commend your management team on their excellent work over the past few years in rationalizing the cost structure. As a result of their efforts, your company is now at cash flow breakeven, with many tailwinds starting to appear. This is exactly why I am disappointed by this announcement - we're finally starting to surface for air, but a potentially bright future is being taken away from us.
Let's review the pertinent details, starting with the massive, hidden assets that your company possesses. As you have highlighted in each of your investor presentations, you have a very strong balance sheet, with $29M of cash and short-term investments. But the nuances of GAAP accounting cause two other very important assets to be understated.
First, your PP&E is held on the balance sheet at a mere $7.8 million. However, at original cost, your facilities and equipment cost over $60 million, and many data points suggest that your lasers are far more valuable than their GAAP value. Your 2012 10-K filing notes three sales of equipment, one of which occurred at a 3.7x multiple of book value. On slide 6 of your January 2014 investor presentation, you also call your lasers "state-of-the-art" and note that your "leading-edge" technology is a key point of differentiation vis-à-vis competitors.
Further, you also hold over $100 million of federal and state net operating losses, which can be used to offset future profits for tax purposes. In your most recent 10-Q filing, you note that these are valued at zero on your balance sheet - "net deferred tax assets are offset by full valuation allowances because it is not more-likely-than-not that we will realize our deferred tax assets." Yet right above that line, you note that due to these same DTAs, your effective income tax rate for the quarter was negative 12.2%! It seems somewhat curious that your shareholders are deriving current value from assets that are held at zero. Given that your business has reached a cash flow breakeven point, and that future profits (which I will discuss momentarily) will take on a hockey-stick trajectory, it seems that the $26M valuation allowance offsetting the NOLs should be revisited.
Adding this all up, I come to a tangible asset value (net of the accrued liabilities discussed in your filings) ranging from $70M to $85M or so - $3.65 to $4.50 on a per-share basis. This means that the PhotoMedex offer assigns merely $20-$35M for your valuable LasikPlus brand, as well as the profit potential of your ongoing business. Only businesses in extreme distress are worth that little on top of their net tangible asset value, and as I believe we would both agree, your business is well past the days of extreme distress.
So now we move to the future of your business; understanding its potential is key to evaluating a fair and just value for shares. We all know that decreased consumer confidence post Great Recession has stymied your valiant efforts to create shareholder value. However, a corner has now been turned. For the past two quarters, your business has experienced year-over-year growth in procedure volume. Six weeks ago , your CEO noted your team was "very encouraged" by the strong fourth-quarter rebound, going on to say that you "expect to report a significant improvement in financial performance from our core LASIK business in 2013."
There are many reasons to believe this recovery will be rapid and robust. From a macro perspective, having reviewed dozens of conference calls, my impression is that most American executives are quite optimistic on the financial strength of the American consumer. Several major lenders noted for their conservative management have recently loosened credit standards for mortgages . Dallas Fed president Richard Fisher recently expressed his belief that the economy is moving in the right direction . Consumer confidence this month came in strong .
This macroeconomic recovery dovetails well with the secular demographic tailwinds. The combination of pent-up, deferred LASIK demand and the largest TAM for potential refractive correction eyes in LASIK history mean that a modest recovery to 100,000 procedures (roughly half of the 192,000 procedures in 2007) seems quite feasible over the next few years. The recovery's trajectory will likely resemble a hockey stick rather than a smooth curve - your filings note that procedure volume increased from 65,000 in 2003 to 142,000 in 2005, then to 192,000 in 2007. Given the larger TAM today, 100,000 should be easily achievable.
Putting this all together from a financial perspective: you are at cash flow breakeven and have substantial operating leverage. As noted in Slide 25 of your January 2013 investor presentation (and Slide 26 of your January 2014 investor presentation ), your business model would lead to $22-$30M EBITDA at a procedure volume of 100,000. Assuming this happens by year-end 2017 - approximately four years from today - and applying a conservative 5x EBITDA multiple to the low end of that estimate, we arrive at a terminal enterprise value of $118M. Discounting back at a high discount rate (15%) and adding back your valuable cash and NOLs, I arrive at a fair value of $6.39 per share, a 19% premium to the PhotoMedex offer. Since this model ignores all cash generated from now through 2017 - which could easily be in the $10-$20M range - $6.40 should be viewed as a floor, not a ceiling, for a transaction price that would represent a fair value for shareholders.
Further, if procedures recover to 120,000, your internal calculations (on the previously-mentioned slides) imply $37M in EBITDA. This value, with the same multiple, discounted back to the present, implies a current share price in the $8.35-$8.40 range (and a future share price well into the teens). Note that all of these scenarios ignore other potential avenues you may explore to increase your asset utilization.
So what should you do? Aggressively pursuing other potential acquirers during the go-shop process is a good start. Given that tapering will likely lead to interest rates rising off generational lows, the time for transactions is now - and your firm, with its demographic tailwinds and solid balance sheet, is a perfect target. There are also several strategic buyers who could extract significant synergies and cross-sell opportunities from a transaction.
Thank you for your time and continued efforts to maximize value for shareholders. As a shareholder, I would like to better understand why the Board has chosen to sell the company for a low multiple at a time when the long-term business prospects have never looked better. I look forward to hearing your thoughts on alternatives that will allow all parties involved to receive a fair return on investment.
Disclosure: I am long LCAV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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