VISX: A Hard Look Found the Flaws

Editor's note: With this column we introduce Whitney Tilson, the founder of Tilson Capital Partners, a New York City-based money management firm. Tilson uses the principles of traditional fundamental analysis to analyze companies in both technology and nontechnology industries. As always, tell us what you think.

Last Thursday, the stock of VISX (VISX) plunged 29%, and has continued to fall. It is now more than 70% off its 52-week high reached only a few months ago. Why did this happen and what can we learn from it?

I had LASIK surgery done on my eyes last September and the results were outstanding (click here to read about my experience). I believe that there will be tremendous growth in the number of people who choose to have this surgery done, so I decided to take a look at the many companies that could benefit from this growth.

To make a long story short, I carefully analyzed VISX but decided not to invest because, while I believe the company will grow quickly, I was not persuaded that its competitive advantages would prove to be enduring -- the most important factor I consider when deciding whether to buy a stock. (Lest you think I am applying 20/20 hindsight to this analysis -- no pun intended -- I posted my reasoning on the VISX message board at Fool.com last September, when the stock was at 94.)

VISX has mouthwatering economic characteristics. It is growing extremely rapidly, has extraordinary margins, lots of cash and no debt. It has the industry's largest installed base of lasers, hundreds more than its closest competitor. Its laser was the first to receive FDA approval to treat higher myopia with or without astigmatism, and was the first laser the FDA approved for the correction of hyperopia, or farsightedness. Summit Technologies' (BEAM) laser last October also received FDA approval for the treatment of hyperopia.

Finally, according the company's 10-K:

VISX has 140 existing and 70 pending U.S. and foreign patents to protect its technology. The company expects that other excimer laser [gas lasers that emit radiation pulses] products that come through the patent process will infringe on the company's patents and thus require a license. Thus, the company's patents create a formidable barrier to any would-be competitors. In addition, the company earns revenue not only for laser systems sales, but also for each performed procedure through 'VisionKey card' sales . . . Because a unique VisionKey card must be used with each procedure performed, the company earns guaranteed royalties for each operation.

That's a heck of an economic model if it's sustainable, which it appeared to be, based on all the patents, the first-mover advantages, installed base, etc.

I decided to do a little digging. In the course of my research on whether to have the LASIK surgery done, I met many doctors in the industry so I called them and asked questions about VISX, competitors' machines and so on. One of the doctors, who runs a LASIK center that is part of a larger chain, said that the entire chain had standardized on VISX machines and paid VISX $24 million in the previous year in royalties, plus large amounts for machine maintenance.

I could hardly wait to buy VISX stock until he said that the founder of the chain had been testing a new machine made by another company, and he loved it because it was more precise than a VISX machine -- and much cheaper because there was no royalty charged. I asked what the chain was planning to do. Not surprisingly, he said they would switch as fast as they could to the better, cheaper machines (though he said this would take some time).

My enthusiasm for VISX went out the window. Those "140 existing and 70 pending U.S. and foreign patents" had sounded very impressive, but they obviously hadn't prevented another company from developing what might be a better machine. I concluded that there was a high degree of risk that VISX might face serious competitive encroachments, which could trigger a damaging price war. That wasn't a risk I was willing to take with the stock trading then at 86 times trailing earnings.

So, what happened? For a few months after I completed my analysis, nothing. Then on Dec. 7, the stock plunged 41% after the U.S. International Trade Commission ruled that technology marketed by a Japanese competitor, Nidek, did not infringe on a VISX patent and was not subject to VISX's patent fees. (My surgery was done with a Nidek laser, though this was not the new laser discussed above.) Then the stock stabilized until Thursday, when it fell another 29% after VISX reported revenue growth that was far slower than the overall growth in vision-correcting lasers.

Could the selling be overdone? Perhaps. While trailing the market's growth, revenue last quarter still grew 79.2% year-over-year, net margins were a fabulous 34.3% vs. 28.7% a year ago (normalized for full taxation), VISX has $258 million in cash (more than 12% of its market cap) and the stock is now trading at approximately 20 times trailing earnings. But those who buy the stock will have to become comfortable with declining market share and competitive advantages that appear to be modest and shrinking.

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