MEMORANDUM
TO: Real-Client Managed Portfolio Class
FROM: Justin Gutcknech and Zachary Hensley
RE: VISX, Inc.
DATE: April 8, 2004
COMPANY OVERVIEW
V I S X, Inc. (EYE) is engaged in the development, manufacture, and distribution of technologies for laser vision correction (LVC). These activities are centered on the VISX StarTM Excimer Laser System product line and the associated VisionKey Cards. The VISX StarTM laser systems are used in LASIK procedures to correct a variety of vision problems. Currently, the FDA has approved their use for correcting myopia (nearsightedness), astigmatism, hyperopia (farsightedness), and several other less common vision problems.
We currently hold 1,000 shares of VISX, Inc. at $20.35, as of 1:16pm, April 7, 2004. These shares were purchased on October 18, 2000, at a price of $19.375 per share. As of April 7th, our position has appreciated 5.03% ($975.00).
Business Model
V I S X, Inc. has two major means of generating revenues: system sales and licensing fees. System sales as a percentage of total revenues have fluctuated between 27% and 35% from 1998 to 2003. This fluctuation has been due to the sales cycle of new product lines as the company comes out with new generations of systems.
Licensing fees comprise the bulk of the company’s revenues and represented 61% of total revenues in 2003. These fees are gathered through the use of VisionKey Cards which restrict the use of the lasers, and are purchased from the company on a per-procedure basis.
Economic Conditions
As of September, 2003, MarketScope estimated that 50 million Americans are candidates for LVC while only 5% of that market has undergone such procedures. Since the fees are charged on a per-eye basis, the market size for eligible procedures is 100 million. The price of LVC procedures has been declining steadily over the past several years and currently stands at around $1000 per procedure. While the proportion of candidates is similar in other parts of the world, two factors marginalize the prospects of international growth. First, the procedures are still expensive. Second, the procedure fee system is not present outside of the U.S., according to MarketScope.
At the same time, pricing pressures from doctors and competition from other laser manufacturers forced the company to reduce the licensing fee it charges from $250 per procedure to $100 in February of 2000.
Laser vision correction procedures are not subsidized by any major publicly or privately provided health care plans. Therefore, consumer spending on these procedures is purely discretionary. This can have a dramatic effect on licensing fee revenues as was the case in the 1999-2002 period when the number of procedures performed by V I S X systems declined from approximately 196,800 to 72,500.
Competitors
The major competitors with V I S X Inc. in the LVC market are Alcon and Bausch & Lomb. VISX has its systems in nearly 60% of the LASIK market while its rivals have been slow to compete. Even though the company holds a large market share, cross licensing with competitors will decrease their competitive advantage. Furthermore, many competitors exist in the LVC market and will continue to exert significant downward pressures on prices.
FINANCIAL POSITION & PROJECTIONS
Forecasts for the company were made for the five year period from 2004 through 2008, owing to the dynamic nature of the LVC industry and the difficulties in forecasting consumer spending.
Current Financial Position
Sales of VisxStar LVC systems, which represent roughly 30% of total revenues, have declined due to a weakened economic environment and competitive pricing pressures, particularly in Pacific Rim area. New products such as the WaveScan system are expected to offset these declines, although the company expects gross profit margins to remain low.
Licensing revenues, which represent 60% of total revenues, have declined 63% from 1999-2002. While licensing revenues experienced 20% growth during fiscal 2003, they still remain more than 50% below their all-time high in 1999.
The cost of equity position is our primary cause of concern on the balance sheet. In 2001 the company authorized the repurchase of 10 million shares of its common stock. Since that time, the company has repurchased 7 million shares. This aggressive repurchasing program has removed nearly $200 million from the company’s coffers. At this stage in the company’s life cycle, we believe that this money could have been better used to defray costs related to operations and to provide a buffer to declines in consumer spending.
Executive compensation further exacerbates the condition of the equity portion of the balance sheet. As of today, a little over 6 million shares of common stock may be reissued in the form of stock options. Exercising these options would further weaken the equity balance and dilute EPS.
Financial Projections
Financial projections were made over a five year period from 2004 through 2008 due to the difficulties in predicting consumer spending habits.
Cost of systems and services revenues were projected to decline 0.5% from their trend values (22.7% and 11.6%, respectively). This reflects gains in efficiency from production increases. Costs of licensing fees were projected to decline at a slower rate (0.25%) because the company has stated that it has already wrung most of the efficiencies out of licensing. R&D costs were projected to remain at 12.2% owing to the company’s strong position on maintaining technological advantages in the LVC market.
With the cost projections for operations in place, baseline, optimistic, and pessimistic projections were made for the company’s revenues. These projections took into account the following considerations. Sources of revenues remain roughly at their present percentages of total revenue. We projected system, service, and license revenues to comprise 25%, 15%, and 60%, respectively. System revenues were projected to increase by 10% over the 5-year period while service revenues were projected to increase at a constant 5%. This decision was partly for convenience, and partly due to the smaller effect these items would have on net revenue.
For the baseline projection, licensing revenues would grow by 40% for the next two years then decline 10% per year to 10% in 2008. This would result in a share price of $8.04.
Optimistically, licensing revenues were projected to grow 50% in 2004, 100% in 2005, and then taper of 25% per year to 25% in 2008. The resulting share price would be $14.25.
A pessimistic approach projected licensing revenues increasing 20%, 40%, and 20% in 2004-2006, respectively. They would then decline by 5% per year to 10% in 2008 resulting in a share price of $6.89.
Other Considerations
Several issues were not taken into account in the model, due to the difficulty in accurately predicting their monetary impact on the company. Chief among these is future litigation expenses. Over the years, VISX has been engaged in numerous legal battles concerning patent infringement. Although blanket settlements last year put an end to most of their legal problems, the absence of future litigation cannot be predicted with any reasonable amount of security. Also, our projections did not take into account the possibility that VISX may authorize more stock options for employee compensation. Such an action would further dilute shareholder earnings.
Conclusion
LVC is still a young and developing industry. The significant downward pressures on licensing fees from both competitors and doctors may have a material adverse impact on the future earnings of the company. Furthermore, since consumer spending drives revenues, the company’s earnings, and stock price, will be negatively affected by any declines in spending. Finally, the handling of stock repurchases and employee compensation raises concerns about the quality of managerial judgment.
For these reasons, we recommend selling all 1000 shares of VISX, Inc. at market.