Can TearLab Stay On A Tear?
Mar 13 2013, 11:15 | about: TEAR, includes: AGN, COO, NVS
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
As I've lamented before, there just aren't many ways for investors to play the ophthalmology market. Aside from a few small biotech/pharma companies and Cooper (COO), the bulk of the industry is locked away within larger companies like Allergan (AGN) and Novartis (NVS). But it's not just scarcity value that makes TearLab (TEAR) interesting. TearLab has developed a quick test for dry eye disease that not only can be done in the doctor's office, but is actually profitable for the doctor to do. With an innovative test and a tried-and-true disposables-based model with a low breakeven level, TearLab could be an interesting small-cap speculation even here after a doubling in the stock.
TearLab Brings Quantitation To Dry Eye Disease
Dry eye disease (DED) is a somewhat unusual condition within ophthalmology. Doctors agree that it's a real condition, but it's difficult to accurately diagnose and there's only one prescription drug available to treat it (Allergan's Restasis) before it results in inflammation or infection. If caught early, though, over-the-counter eye drops can often keep the condition in check and relieve symptoms.
This is where TearLab comes into the picture. TearLab has developed the TearLab Osmolarity System - a compact diagnostic system that measures the osmolarity of tears to determine the presence and severity of DED. The TearLab system uses microfluidics technology ("lab on a chip") to measure osmolarity and can return results in about a minute. The system is simple to use at all levels (minimal sample prep or hands on time), and requires only a 50nl sample that is collected painlessly from the corner of the patient's eye.
Although approved by the FDA back in mid-2009, it has taken a while for the company to make this a viable system. The key catalyst in changing this was the receipt of a CLIA waiver in January of 2012, which allows the company to market this device to effectively all optometrists and ophthalmologists for in-office use. Now, though, the system is available and reimbursement is in place - reimbursement that actually encourages doctors to perform the test.
Better still, this test appears to be accurate and clinically valid. Tear osmolarity has been a gold standard diagnostic for some time, but doing the test on-site was effectively impossible - instead, testing was done off-site and required a sample volume some 500x to 1000x larger. In its place, then, most doctors used Schrimer strips to diagnose DED. While Schrimer strips are simple and easy to use, the test lacks specificity (ruling out false positives only about half of the time). What's more, Schrimer strip testing is not separately reimbursable - practices who perform the test have to absorb the cost themselves.
As it turns out, osmolarity testing has a positive predictive value (in other words, correct diagnoses) of about 87%, while Schrimer tests come in at 31%. Other methods, including staining and tear break-up time are just as bad as Schrimer strips or worse. That leaves TearLab's approach as not only accurate, but also fast, easy, painless, and profitable - a sweet spot of diagnostics, if there ever was one.
Now It's Time To Place The Boxes
Having an approved and apparently accurate test is all well and good, but it does shareholders no good unless those tests are actually performed. At this point, TearLab is still in the relatively early days of launching this system - system placements are still measured in the hundreds against the addressable market of over 50,000 U.S. practices. With the company due to report in about a week (as of this writing), we will get an update on the company's progress in getting more docs to sign on the dotted line and actual system placements.
A quick note on that last line - getting a doctor interested does not instantly translate into placement and revenue. Customers need to apply for CLIA waivers themselves and that's an unfamiliar process for most of them (there are very few CLIA-waived tests for the eye care market). The company seems to be helping where they can, but the company's small sales force and financial resources limit what they can do at this point.
That said, management has been pretty smart about the economic model for this system. While the system lists for $9,500, few practices will actually buy the system outright. Instead, the company will place the system for free in exchange for three-year purchase commitments. The two most common programs commit the purchaser to 3-year minimum purchases of 1,500 cards (the disposable part of the system) or 2,400 cards per year, at ASPs of $12.50 and $10, respectively - or $18,750 and $24,000 in annual purchases.
At those prices, this is a profitable test to offer. Medicare reimburses for this test at a price of $23.40 per eye, and while private insurance coverage is not universal yet, over three-quarters of claims are presently reimbursed. While the payments range from below $10 per eye to over $40, the average comes in just a little below the Medicare rate - meaning that doctors can collect about $20 per patient for a test that start-to-finish can be done in less than five or 10 minutes.
So why would a doctor not do this? Inertia is the first reason that comes to mind. While many investors have this image of doctors as forward-thinkers always looking for the next advancement in care, that's not the case - many are surprisingly stubborn and unwilling to adopt any procedure that wasn't taught to them in medical school or residency. Likewise, many optometrists and ophthalmologists have learned to build their practices around routine exams and the sale of glasses or contact lenses and not diagnostic testing.
A Real Market, But Maybe Not As Large As You Think
Due to a lack of good testing options, the prevalence of DED is an open question, with estimates historically ranging from about 12% to 35% of the population. A prevalence study done by Dr. Eric Donnenfeld has turned up some interesting data in this regard. In a study of 1,019 adults, samples tested with the TearLab system indicated a prevalence of 43%.
Interestingly, there is a lack of correlation between traditional symptoms and actual DED - more than half of patients with classic DED symptoms actually have a different type of inflammation, while 40% of patients who are asymptomatic do have it. As undiagnosed DED can ultimately lead to inflammation, infections, and damage to the eye, that could argue for routine DED screening as a part of normal eye care check-ups.
If everybody in the U.S. got an annual eye exam (which is never going to happen), that would mean an annual potential market opportunity of $6 billion for TearLab, assuming a $10 per-eye ASP. Even if the test was only used in those diagnosed with DED, about 4 million people, that's still $80 million in annual revenue opportunity - a level of revenue where the company could likely be profitable.
Obviously the gap between $80 million and $6 billion in revenue is enormous. The data is sketchy, but surveys indicate that about 30% to 40% of Americans get an eye exam every two years. If that's accurate, that works out to a real addressable market of about 55 million patients each year, or about $1.1 billion in addressable revenue opportunity for the company. Even that number is too ambitious for now, though, as the company doesn't even have 2% of the clinical practice base signed up. As a result, I'd say 10% of that market (5.5 million patients, or $110 million) is likely the real addressable market for the next five years or so.
As far as competition, there's not much out there. Apart from going with what's already available (even with its low positive predictive value) like Schrimer strips, there is the InflammaDry from RPS. This system measures MMP-9, an inflammatory marker, and is about as accurate as TearLab's system but takes longer (about 10 minutes). Currently approved in Europe and Canada, this approach could emerge as a rival in the U.S. in the coming years.
I do think one other note of caution is worth mentioning. While it is possible for a person to have DED in just one eye, it's not very common. That makes me wonder if there's any risk that insurance companies push clinical practice in such a way that only one eye is tested (with a test for the other eye being eligible for reimbursement if the first test is positive). For now, there's no reason for doctors to embrace that approach (as I said, they get paid decently for this test), but it's not an unthinkable long-term outcome.
It's also worth mentioning that this test could find use outside of routine testing and monitoring of diagnosed DED patients. There are correlations between the presence of DED and poor outcomes in LASIK surgery, and DED can likewise impact the choice of contact lenses and management of glaucoma. As recognition and familiarity with the system grow, these could be worthwhile markets down the line.
A Profitable Model, If The Company Can Grow The Placements
TearLab has outsourced its manufacturing needs for at least the next few years - Sparton (SPA) manufactures the readers and collection pens, while MiniFAB manufactures the cards under a take-or-pay agreement. In conjunction with a target market that is relatively "dense," that suggests that TearLab could be profitable at a revenue base as low as $50 million - half the typical breakeven revenue level for med-tech companies on a historical basis.
That said, I've been following med-tech for over 15 years now, and that has taught me a few universal truths. Namely, driving adoption of a new technology always takes more cash and more sales and marketing spending than management projects. So while I do believe in the basic story here and the inherent profitability, I want to point out the risks that not only might the adoption curve be less steep than hoped, the path to profitability may be a little longer.
All of that said, I think the company could be cash flow positive in 2015 (though just barely), and could have a double-digit free cash flow margin in 2017. That said, I wouldn't be even slightly surprised if good adoption of the system ultimately led management to consider insourcing manufacturing and/or expand the sales force even more - compromising margins and free cash flow in the short term in exchange for more revenue and profits down the line.
As it stands now, though, I believe this company could have over $300 million in revenue by 2022, with a free cash flow margin in the mid-teens. I will also observe that my numbers are much lower than others - management has talked of $1.8 billion revenue opportunity, while most sell-side analysts are projecting long-term opportunities of $300 million to over $600 million.
The Bottom Line
Given the relative scarcity of eye care diagnostics, I wouldn't be stunned if a drug company like Allergan or a diagnostic equipment company like Zeiss went after TearLab if the company can prove a real clinical interest in the systems. Independent of M&A, though, I believe that these shares are undervalued. Even my admittedly low projections (at least relative to the company and sell-siders) suggest a fair value above $7 today.
There are ample risks to this story, including both market adoption and the company's ability to execute, and investors should not ignore them. That said, this looks like an interesting small-cap speculation with the technology of a truly better mousetrap.
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.... waited for a pullback... didn't quite make my target. Does it pull back or are the shorts in for a world of hurt and up she continues? 
- just based on the shorts climbing all over each other.
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