Description

Introduction
I am a bit late to the show on this one as it bottomed a couple months ago at about $16. I don’t usually look at companies this small but have intermittently checked on LCAV due to a history with the company and a relationship with the new CEO, Steve Strauss. So when I happened to see a ticker tape roll by with a print of LCAV under $20 I suspected there was a nice opportunity in an undervalued name with good management that I know. The stock has gotten killed in the last 6 months dropping from $50 to a low of $15.30 as growth ‘investors’ dumped the shares following a revenue restatement and an earnings miss. I’m not worried about either of those things and believe the underlying business is in good shape. The primary negative factors are macro in nature, which are certainly real, but do not warrant the drop.

LCA Vision is the largest corporate provider of laser vision corrective surgery in the US with roughly 14% market share. LASIK and PRK surgeries for vision correction are the company’s sole business and source of revenue. PRK stands for photorefractive keratectomy, which is the old procedure performed with an actual blade. It has a long recovery time. LASIK is the more familiar excimer laser based procedure with a one or two day recovery period. LASIK makes up the majority of procedures. Historically there have been two prime inhibitors of mass vision correction adoption, fear and cost. I believe that both of these factors are being addressed by technological and financial innovation. The potential market for corrective procedures in the US is mind boggling and there are only two companies well positioned to take advantage if the tipping point on procedure penetration is reached, LCAV and TLCV. LCAV is the pure play and is much better capitalized and positioned to weather a rough environment, not to mention with management that I know and trust more.

LCAV is worth $30 a share versus the current price of $20. Importantly, this value does not factor in any real improvement in the market dynamics (increased penetration into the vast available market, etc) or capital allocation opportunities (big share buyback) that could move the value further north of $30.

Management
The management team is why LCAV caught my eye on the tape. I have known Steve Strauss, the new CEO for about 8 years and respect him. I have only spoken to him about the business once since he took the job and that was in June when the price was about $45. However he has a long history in the vision correction industry with a six year stint on the board of Laser Vision Centers, which was acquired by TLCV in 2001 where he stayed on for awhile. Steve’s entire career has been in the healthcare field, most recently as President of MSO Medical, an obesity products company, before taking the top spot at LCAV. Steve is ambitious and driven, his personality and character make me think he will do whatever it takes to address any issues and operate the company with excellence. His long experience in the industry and familiarity with his most serious competitor, TLCV, will aid in that process. Importantly, Steve personally bought 5000 shares on December 12^th at $18.55. This wasn’t an options exercise but an open market purchase. Over the last six months there have been six instances of insider buying and no sells, but this last example by the new CEO is the most telling in my mind. His total personal holdings are only 17k shares, but it is important to remember he has only been there a year and this is his first position at the top of a public company and this could be a substantial investment on his part.

Business
Corrective eye surgeries are LCAV’s only business. As mentioned they provide two procedures, PRK and LASIK. PRK actually involves the removal of the epithelium of the cornea, its protective covering, which necessitates a protective contact be worn and a long recovery. LASIK merely peals back the epithelium so the laser can adjust the surface of the eye. The epithelial flap is then folded back down which allows a much faster recovery. The development of laser based procedures with the quicker recovery time resulted in lower customer reluctance. This was partially responsible for the explosion in corrective procedures in the late ‘90’s. Until recently LASIK still required an actual blade, a microkeratome, to create the epithelial flap. AMO’s Intralase system addresses this ickiness factor by using a laser to cut the flap. Using an Intralase system for the flap and an excimer laser for the actual reshaping means nothing actually touches the physical eye providing both increased accuracy and less customer reluctance. It is estimated that LCAV has 75% of its centers with Intralase capability, I assume that the rest will catch up soon. A full laser operation with a quick recovery and a higher customization component will likely further reduce the fear factor that has traditionally been an inhibitor.

The potential market for corrective procedures in the US is enormous. There are roughly 150 million people who wear corrective lenses and theoretically would be candidates. It is estimated that the corrective laser surgery market is only 8% penetrated. Annual procedures have leveled off since about 2001 and industry growth has tracked commensurately. However hidden within this industry number is the fact that the corporate providers, LCAV and TLCV have continued to grow and prosper. Corporate operator numbers have been offset by the mom and pop outlets that far fewer procedures a month and which are, I believe, in an inevitable decline. A tick up in procedure growth would disproportionately benefit LCAV as it would add to the share gains at the expense of the mom and pops that I expect to continue. Currently the independent small shops have about 60% of the market. They are highly fragmented and average about 100 procedures per month per center. The corporates have about 39% of the market with LCAV at 14%. The rest is hospitals. LCAV averages between 200 and 350 procedures per center per month although the capacity of each center is much higher than this.

The second historical inhibitor, cost, is also being addressed. Costs per eye have dropped to a level that is more palatable to the average consumer. Even more importantly, financing options have evolved substantially. GE and Wells Fargo both provide third party financing through LCAV, there is also an in house financing vehicle for those that don’t qualify for third party financing. The result has been the migration of an eye procedure from a $5000 out of pocket expenditure 8 years ago to something more like a car purchase. The sticker price is still $1500 (roundabouts) per eye, but with the financing it translates into a $60 a month payment to add to the car and credit card. Not that I support this debt funded consumption style that fuels America’s macro issues, but it is a reality and LCAV will benefit from it.

Making laser eye procedures less fear laden and more affordable is the key component of increased penetration. However, the industry still needs to let people know about the progress via effective advertising. Mom and pops have historically been unable to advertise well and have largely been cash flow junkies that spend in good times and pull back in bad. The corporate providers are the only operators with the scale to advertise effectively. LCAV’s superior balance sheet position affords them the flexibility to really advertise in a weak market environment and spread the word about the fear and price reductions. As they continue to grow it is increasingly feasible to leverage that scale with national advertising. Eventually there will be a tipping point where the scale of national advertising can quickly become a real competitive advantage in name recognition, especially with the message of lower fear and cost. TLCV has more centers at the moment, but LCAV has more potential and ability to grow as well as more inclination to leverage the scale edge. The mom and pops will the real losers in such a scheme. Even if top line procedure growth only tracks with population growth of 1.5-2% and penetration remains the same, market share capture from mom & pops will be good for a much higher level of top line growth. High single digits is all that I am modeling in to get to a $30 value, which I view as a high probability proposition. Playing with the penetration numbers and the potential national growth quickly moves the value close to recent peaks.  

Why Cheap?
LCAV showed consistent year over year growth and 20%+ ROICs for the ‘01 to ‘06 time frame attracting a growthy shareholder base. When the 06 slowdown came and a resurgent TLCV begin making headlines LCAV missed earnings and the stock was crushed. Then there was a restatement of Deferred Revenue and the departure of the management team, causing another big down draft. As I have said neither of these issues worry me. The income numbers are fine although they did miss a quarterly consensus estimate. The deferred revenue issue was a technical one where the SEC made the company restate prior revenue numbers to reflect how they recognized income from the sale of separately priced extended warranties. Historically LCAV had only been deferring revenue for patients that they believed would receive future treatment under the warranty. Granted this provides some wiggle room, which is why the SEC said they had to defer all of the revenue received from selling these warranties. The total restatements totaled $18 million for 2006. This revenue goes into a reserve and will be realized on a straight line basis over the life of the warranty. The cash flow has already been realized and the GAAP accounting convention is the only change. Steve has said that the company is planning on ceasing the sale of these warranties anyway. This is a non-issue going forward. The earnings miss and an immaterial accounting change have spooked the growth investors that loved the story but didn’t value the fundamentals providing a lovely opportunity.

Value
LCAV has no debt and a cash and investment balance that is 20% of the market cap. The company is very well positioned to ride out any near term market weakness and indeed to benefit from the resultant opportunity as weaker players are impacted. I believe LCAV shares are worth $30, more than 50% upside from current levels. This value is the middle of a multiples based value and a DCF value. This gives no credit for potential share buybacks or any aggressive assumptions on a shift in market fundamentals that allows for greatly increased penetration.

Comps for acquisition prices are hard to come by directly in this field as most of them are small and private. TLCV has largely been built on roll-ups, but mostly privately. In related fields and from what I can surmise in this one, take out multiples run about 11-14 times operating income which would be a high teens multiple on net income, about where these stocks have traded historically. Going at the low end of that range and using 11 x’s on 2007 or 2008’s operating income, which I expect to be in the $45-46 million range, and then adding back the non cash options expense of about $4 million, so call it $50 total at 11 x’s, is $550 million in value for the operations. Then add back in the cash and short term investments to get a total enterprise value of $626 million. On diluted shares of 19.3 million outstanding this give $32.44 per share.

From a discounted cash flow perspective (which is of course the yin to the multiples based value’s yang- two sides of the same coin) I use $1.50 in free cash flow generation on a normal basis and assume that it will grow in the 7-8% range for the next ten years with a 15 terminal multiple and a 10% discount rate to get $29 a share. I believe both of these values are fair to low (the recent high was over $50) so I’ll split the difference and go with $30 for a nice round number.

It is not necessary to factor in a working capital charge as I believe there is substantial room to reverse the WC trend of the last few years that has seen receivables turns drop from over 17 to 11 today. This is actually below TLCV for the first time and should remain flat to a source of cash going forward. If management were to take 75% of the cash balance and repurchase shares at today’s price than all else being equal the value would move up $5 to $35 a share. The company bought back $52 million in shares they retired in 2006, so there is a precedent. However, this was not under Steve and I am not sure he wouldn’t prefer to continue expansion as he has mentioned that the rates of returns on new stores are pretty hard to beat and is likely smarting at the repurchase of $50 million in stock at price well above where they are today, clearly a terrible capital allocation decision at the time with the shares above intrinsic value, although it would be a brilliant one today with the shares well below.

• The share price is cheap for macro reasons and a few internal reasons that were addressable and have been addressed, the underlying business is fine
• The company has a dominant co-position in a highly fragmented market with enormous theoretical potential
• There is a new, highly motivated management team, lead by a guy I trust who has been buying shares personally
• 20% of the market cap is in cash and the operations are currently selling for 5.5x’s adjusted 2008 operating income. I believe the shares are worth at least $30

Catalyst