Medical companies today abound with innovative products and captivating promises of changing the way medicine is practiced worldwide. And with the wonderfully entertaining animations on these companies' websites depicting their new products as being able to work miracles before your very eyes, it's easy to get caught up in the flash and the fascinating technology. Yet most of the companies that pledge us these products will fail.
I recently went through an experience like this with FoxHollow Technologies (NASDAQ:FOXH), after reading about how its SilverHawk system works and viewing the nifty CGI movies of the gadget in action. But after taking a deeper look at the company, I think the SilverHawk, a device used in treating peripheral artery disease, is destined for mediocrity as a niche product that will never surpass modest sales.
Not growing the customer base
One cause for concern is the source of growth. With a new product, you would want to see an increasing user base -- in this case, doctors using this device over alternative treatments for peripheral artery disease. If you look at the SilverHawk, though, the growth has come primarily from a hefty 20% increase in price and an increase in sales per account, while the base of new users expanded by only about 5% from last quarter. Some may be thinking this situation is perfectly fine, but in medicine, prices hit a ceiling quickly because of flat Medicare reimbursement rates, which won't allow for significant price increases in the future.
The slowdown in new user growth -- even despite an investment from heavy hitter Merck (NYSE:MRK) -- is a trend that doesn't seem likely to change, because the company has announced expectations of having a smaller sales force than originally expected. That's a further hint that customer growth is diminishing. This leaves us with a company that's beginning to exhaust the amount of sales to doctors already adopting the product and failing to expand the user base.
The numbers
|
Qtr. |
Rev. |
Seq. Growth |
Merck Rev. |
Total Rev. |
Seq. Growth |
|---|---|---|---|---|---|
|
Q1 2005 |
$21.5 |
46.3% |
-- |
$21.5 |
46.3% |
|
Q2 2005 |
$28.7 |
33.5% |
-- |
$28.7 |
33.5% |
|
Q3 2005 |
$35.6 |
24% |
$0.4 |
$36.1 |
25.8% |
|
Q4 2005 |
$39.5 |
11% |
$2.4 |
$41.9 |
16.1% |
|
Q1 2006 |
$44.6 |
12.9% |
$2.1 |
$46.6 |
11.2% |
|
Q2 2006 (proj.) |
$48.3 |
8.3% |
$0.2 |
$48.5 |
4.1% |
|
Q3 2006 (proj.) |
$51.8 |
7.2% |
$3.5 |
$55.3 |
14% |
|
Q4 2006 (proj.) |
$55.4 |
6.9% |
$3.5 |
$58.9 |
6.5% |
|
2005 |
$125.4 |
225% |
$2.8 |
$128.2 |
232.1% |
|
2006 (proj.) |
$200 |
59.5% |
$9.3 |
$209.3 |
63.3% |
At first glance, things look great. First-quarter revenue has more than doubled and the gross margin improved by more than 15% from a year ago. Expected revenue for this year exceeds $200 million, compared with $128 million in 2005 and $38.6 million in 2004. These figures are sure to cause bullish reactions, especially now that the stock is trading at half of its former $55 price.
Well I'm afraid that even at its newly deflated price, the company remains overvalued, given that growth is screeching to a halt.
Yes, year over year, things look great, but quarterly growth trends induce images of a skydiver who didn't take enough care packing his parachute. Just look at the sequential revenue increases for the past four quarters: 33.5%, 25.8%, 16.1%, and 11.2%. SilverHawk sales growth for this past quarter will continue its slide, falling to 8%, while overall revenue increases by a meager 4%. It should be noted that revenue from the collaboration with Merck is expected to be between $8 million and $10 million, with $2.1 million in the first quarter of 2006. The remainder will come primarily in the third and fourth quarter. So although we'll see an increase in quarterly growth from the second to third quarter of the year on the income statement, it will be unrelated to SilverHawk sales.
What's more, a discounted cash flow analysis of the company shows the stock to be quite overvalued. I used the revenue estimate for 2006 and analyst numbers for 2007 ($270 million) with growth decaying at a rate slower than the current trend. I also modeled sales peaking at $433 million in 2013 and then gradually declining over the remainder of the next decade.
With a discount rate of 15%, a cost of goods at 23% quickly decreasing down to 15% in 2010, and all of the $68.7 million of tax credits figured in, we should get a fairly optimistic view of the future for FoxHollow. But running the numbers until 2020, the net present value was $462 million, giving an intrinsic value per share of roughly $19.
| Metric | 2006 | 2011 | 2016 | 2020 |
|---|---|---|---|---|
Revenue | $209.3 | $424.0 | $323.1 | $7.4 |
Free Cash Flow | $5.9 | $111.6 | $129.5 | $0.7 |
Present Value | $5.1 | $48.2 | $27.8 | $0.08 |
Total Net Present Value | $462.2 | |||
Value Per Share | $18.97 |
It was surprising to find such a drastically lower share value using a fairly optimistic outlook. For the DCF critics out there, a relative valuation looking at multiples such as forward price-to-earnings, price-to-sales, and price-to-book for competitor and peer firms in the medical supply industry still has FoxHollow valued at roughly only $20 a share.
Where's everyone going?
Looking at management also sounds plenty of alarms. With the CEO, COO, and VP of sales rounding out a trifecta of departures, high-level executives seem to be running away from this party faster than teenagers from a high school kegger when the cops show up. Former CEO Robert Thomas' departure from the company certainly raised questions about FoxHollow's direction, and the concern was only worsened by the company's inability to find a permanent replacement. Founder John Simpson stepped in as the interim executive in January, and after six months, with the search to find a permanent CEO apparently having turned up empty, Simpson was enthusiastically named as the permanent solution. Not to be a downer, but looking for a new CEO for six months and coming to the conclusion that the guy filling in is the best option is no way to instill a lot of confidence. It's becoming hard to still believe that FoxHollow is headed for greatness when insiders are bailing ship and the company can't find replacements.
Why is this happening?
It's not a complete mystery why the SilverHawk's growth is slowing and why FoxHollow's stock is falling. First of all, FoxHollow is a one-product company; its success is completely dependent on the SilverHawk. Furthermore, the technology is not a completely new idea -- there have been several atherectomy devices that never achieved high levels of success. Part of the problem with past devices was the potential that their spinning blades could rupture arterial walls. The SilverHawk was designed to reduce this risk, but the major problem slowing down its market penetration seems to be the lack of evidence showing an improvement over other minimally invasive procedures.
Additionally, the SilverHawk costs somewhere in the ballpark of $2,000 per device. That makes it a very expensive alternative, and without a definitive clinical trial proving this device has long-term benefits over the use of balloons or stents, most hospitals are going to have a hard time justifying that kind of outlay. Doctors have new devices thrown at them constantly, so they depend on thorough clinical trials to decide which technologies are worth trying. FoxHollow just initiated a new non-randomized, multicenter study, but it is not comparative -- rather, it's another registry similar to its study already in existence. I wouldn't expect this to have a large impact on sales in the future. One step in the right direction, however, is an upcoming study that will compare SilverHawk with surgical bypasses. This is the type of direct head-to-head comparison that I think SilverHawk needs to gain additional market penetration.
Using the SilverHawk is also time-consuming. The procedure takes several hours in some cases, typically because the nose cone collecting the plaque in an artery fills up too quickly. The catheter thus has to be completely removed, emptied, and reinserted several times for a single procedure. And doctors are not going to adopt a new technology if it takes substantially longer than existing options, unless there is conclusive proof that it is dramatically better for the patient. The cost and lengthy procedure time are thus combining to label SilverHawk as a niche product only to be used for below-knee procedures, where stents and other alternatives are not as viable.
Foolish conclusion
The SilverHawk isn't a failure, but don't be surprised if sales peak well below expectations. Unless quarterly growth trends reverse quickly, it seems the device is in danger of never overcoming niche status to become a mainstream product. An improved marketing effort toward new customers, product modifications to reduce procedure time, and, most importantly, a conclusive comparative study showing long-term benefits versus competitors would help to make the SilverHawk take flight once again. Until these factors occur, don't expect FoxHollow to do anything but disappoint.
Rule Breakerssummer intern Glenn Brandys, hailing from the University of North Carolina -- Chapel Hill, does not own shares of any company mentioned in this article. The Motley Fool has a disclosure policy.
