IRIDEX Corporation (IRIX) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by, and welcome to IRIDEX Business Update Conference Call. [Operator Instructions] I would now like to hand the conference over to your speaker today, Dave Bruce, CEO of IRIDEX. Thank you. Please go ahead, sir.

Thank you, Justin, and welcome, everyone. Thanks for joining our call on short notice. We're very excited to announce a strategic collaboration today, and I'd like to take a few minutes and go through the highlights with you. For those of you with access to the slide deck, we'll cover a number of deal-related and strategic points and then have a question-and-answer period at the end. Next slide, please. Can you advance the slide? Yes. Operator, I don't see the slide advancing. Is that me? There we go. Just to remind everyone that we will be giving forward-looking statements during this conversation, and all of the safe harbor provisions apply. I won't go through it line by line today. This is also in the press release that's available online. Next slide, please. Yes. Operator, next slide, please. Just to recap very briefly before we get into the specific collaboration elements. We've been working for a little over 1.5 years, actually almost 2 years now, to rebuild the growth trajectory for IRIDEX. We have a new leadership team and a shift strategically and tactically of how IRIDEX intends to grow. We've released several new products, including second version of our flagship glaucoma probe. We have received and announced clearance but are yet to launch a new system platform that we will roll out through the course of 2021. And we've released several updates to our delivery devices for laser energy, the laser indirect ophthalmoscope, that's the headset that an ophthalmologist would wear to deliver laser energy; and our TxCell scanner product, which is a laser delivery device that allows an array of spots to be placed instead of single spot. We've also worked very hard on improving our cost-effectiveness. And particularly during the COVID period, we were able to really minimize expenses in spite of a reduction in our revenues related to COVID impacts and were able to burn only about $1 million in the course of 2020. That includes, as you may recall, a PPP loan of $2.5 million. Our revenue breakdown is shown on the right. We're about 50-50 in the U.S. and outside the U.S. of revenue, and we have passed the 50% point of recurring revenue, which is made up of disposable probes, service and royalties. And we finished 2020 fiscal year with $11.6 million in cash. And just to highlight our shifting revenue mix as glaucoma probes become a bigger percentage of our total revenue. Next slide, please. Operator, next slide, please. So today, we're announcing a strategic collaboration with Topcon Corporation, and I'll tell you a little bit more about Topcon here in a second. But the benefits of this to combine 2 leaders in retina and glaucoma treatment, deliver a significant increase in capital to IRIDEX to drive our growth initiatives, leverage the global distribution network that Topcon and IRIDEX can bring together and improve the scale of design and manufacturing of our laser systems through combining the PASCAL business currently under Topcon. Next slide, please. Operator, next slide, please. So Topcon is a Japanese-based corporation headquartered in Tokyo with about $1.3 billion in revenue, most of that from outside of Japan. So truly a global company. Their primary businesses are positioning systems and smart infrastructure. And a large component of that revenue is the eye care division at about $430 million in sales in 2019, a broad footprint across the globe and #1 in OCT, which is a diagnostic exam that gives a snapshot of the rear of the eye, a cross-section of the retina area. It's important in both retina and glaucoma disease. You can see the array of products: OCT, vision testers, topography, refractometry and lensometers, running the gamut of examinations, treatment and a networking solution among various components that allows for communication between physicians, optometrists and patients. Next slide, please. Operator, next slide, please. So the rationale for this collaboration is multifold. First of all, it generates $19.5 million of additional capital for IRIDEX, and we plan to use that to accelerate our glaucoma product growth. Part of that is a $10 million equity investment by Topcon for approximately 10.4% stake in IRIDEX after the transaction. And we feel this is a significant endorsement of the opportunity and the ability to execute together. It delivers a comprehensive distribution network where Topcon has strengths in Asia Pacific and in Europe, Middle East, Africa, where we'll combine IRIDEX distribution into Topcon's network. And IRIDEX will take distribution in the United States, the Americas and other select countries around the world. It's going to generate efficiencies through 2 parts: market consolidation, 2 competitors in the high-end scanner segment combining. Plus, with IRIDEX absorbing the PASCAL product line, we will have greater scale in design and manufacturing efficiencies. And finally, unique in this transaction that minimizes the dilution is that as a part of the deal, we've sold the distribution rights that I just described to Topcon, a major partner in the industry. Next slide, please. Operator, next slide, please. Just briefly, so you can understand, so on the left is the organizational structure block diagram of what IRIDEX and Topcon look like IRIDEX has its manufacturing business and then distributors, which distribution is being purchased by Topcon. So in the next graph over, you'll see that revenue will go into Topcon's portfolio. Before this collaboration, Topcon had a unit that designed and manufactured the PASCAL scanning product. That will fold into IRIDEX, and IRIDEX will sell that product and other IRIDEX products to Topcon. On the right, IRIDEX revenue for 2019 was approximately $13 million from glaucoma, $30 million from retina for about a 30% to 70% ratio. Pro forma, the PASCAL business into IRIDEX 2019 would be approximately $52 million, still the $13 million in glaucoma and rising to almost $39 million or 75% of the revenue base. Next slide, please. I understand there's a 5-second delay as we try to move the slides forward. I apologize for my impatience. In terms of the overall economics of the transaction, I mentioned the equity investment by Topcon into IRIDEX. That is at the 5-day closing average ending yesterday, which works out to about $16.18 a share and equates to about 1.6 million shares or approximately 10.4% of the outstanding shares post-closing, and we'll have registration rights after a 6-month lockup. The combination of Topcon purchasing distribution rights and IRIDEX purchasing the PASCAL product line nets out to $9.5 million to IRIDEX. Topcon distribution will now cover about 60% of what our international product revenue was. And then IRIDEX will take on the development and manufacturing of the PASCAL product line, which is actually local here in the Bay Area to our headquarters and manufacturing operations, for a net proceeds to IRIDEX of $19.5 million excluding the transaction-related costs. Next slide. A couple of points on the glaucoma marketplace and then the retina marketplace. So it was very important for IRIDEX to increase funding, really drive sales promotion and market development activities, in addition to expanding our sales force. So in the U.S. where we're direct, we'll have 12 dedicated territories on glaucoma and 6 dedicated on the retina business. In the U.S., we'll sell the IRIDEX line plus the PASCAL product. In Asia Pacific and key markets of EMEA, we will leverage Topcon's large sales organization and promotional scale and create an opportunity to bundle with the breadth of product offerings they have to glaucoma customers. We're very happy with the growth that we've been able to achieve. And on the right, you see glaucoma probe units annually. And as we released in prior announcements, we did achieve growth, albeit small, in the second half of 2020 despite COVID compared to the 2019 second half. But as you can see, we took a substantial hit in the first half due to significant reduction in procedures during the COVID lockdowns at that time. Next slide, please. At the bottom is the slide -- a picture of the -- what we call the Rev 2 MP3 probe. That's the handheld disposable piece that delivers laser energy to the eye. On the retina side, we see this as a strategic boost. The wheel on the right shows the variety of products we have on -- at the 11:00 position, you can see we've added PASCAL to that. PASCAL and TxCell are currently competing products. But we plan to consolidate those 2 product areas into 1 leading scanning product. But together, currently generates over 50% global market share. It shifts to competitors to become collaborators and, as I've mentioned, gives us greater scale in design and manufacturing, consolidating our OUS distribution. And that will, as I mentioned, be about 60% of our outside the U.S. sales and about 1/3 of total IRIDEX sales. And we look forward to being part of Topcon's broader portfolio and the package of offerings that they can bring to the marketplace, and we will be working together to launch those combined packages. Next slide, please. I wanted to share some of the financial considerations under this series of transactions. First of all, part of the proceeds will likely be recognized as revenue, the nonrecurring revenue by the nature of accounting rules in the U.S., subject to fair market valuations that will start now that we have signed agreements. The nonrecurring revenue may require some extra explanation as we go forward, and we'll be working on those details and announce them as we go forward. We've identified approximately $1 million of transaction and initial integration expenses that will occur during the course of 2021. And given the nature of shifting distribution channels with current distributors with inventory and commitments with customers, we are anticipating there could be some temporary volatility in our revenue reporting, and we'll do our best to explain that. But we do believe over a couple of quarter period, we should see some normalization. We also expect that there will be some gross margin compression in the first half of the year due to transition and operation costs and see 2021 really as a transition year to consolidate, establish our joint distribution networks and launch into fiscal 2022 with significant benefits in manufacturing scale and fully onboarded distribution partners. On the right, $19.5 million in cash. If you add that to our end-of-year balance of $11.6 million, you'll pro forma begin this year at $31 million of cash. And that's -- going forward, we will absorb a wholesale revenue stream that was approximately $8.5 million in 2019. Next slide. So finally, the next steps. We anticipate closing this in early March. We believe we're -- we've covered most of the issues in reaching agreements. And we have several steps to go for closing but don't anticipate that taking an extended period of time. Immediately upon integration -- sorry, immediately upon closing, we'll integrate the PASCAL production and distribution -- or sorry, production and product development into IRIDEX' business in the Bay Area. And beginning in April, we'll start transitioning distribution rights as we shift from current distributors to the new Topcon distributor network around the world and do the transitions smoothly with the existing distributor base. That's a highlight of the transaction that we are announcing today. And we're very excited to join in partnership with Topcon eye care business around the world, and looking forward to launching into working together. With that, I'll stop and turn it back to the operator for questions.

[Operator Instructions] And our first question comes from Jon Block from Stifel.

Congrats on the deal. Seems like it makes a lot of sense in a lot of different ways. So I'll start with -- you mentioned -- as you mentioned, you've done a really good job with the spend throughout 2020 and preserving cash. But I mean this is a material announcement. It gives you a good amount of flexibility. I think you actually mentioned the $31 million pro forma year-end cash balance. So maybe if you could talk to what changes with IRIDEX' strategy with the cash from the deal? I saw the 12 reps focused on glaucoma. I think you mentioned the 6 focused on retina. Is that where you want to be? Or how do we think about an accelerated pace of investment with reps over the next 12-plus months?

Yes. Thank you for the question. Yes, we're looking at an expansion there. We had 12 territories that were combined. We covered both glaucoma and retina. So we're going up about 50% in reps and then splitting that team to focus specifically in the disciplines of glaucoma and retina. And so we'll operate at that level. We are constantly trying to balance the increased spend associated with bringing on new reps and expanding the spend against the rate that we can grow the business. So we will continue to expand our distribution and drive growth and keep an eye on the investment phase that we go into as we add reps. The -- we're also going to increase our spending in the market development side of the equation in driving clinical studies, key opinion leader, participation in webinars, seminars and advisory panels, expand our support of customers in the areas of, for example, reimbursement and other things. So we are increasing our investments, and we will gradually increase those investments along with growth so that we aren't significantly cutting into that cash position in the short term. That said, we will have investment mode by the expansion of the reps in the short term as well as the market development spending and the integration. So we will share more in the future, but we do expect to spend a decent chunk of that cash as we progress through '21 and then up our investments as we grow in the future.

Got it. Perfect. Very helpful. And maybe just sort of some -- a question with some specifics. I don't know if it's going to be disclosed in filings. But are there minimums associated with the Topcon deal in APAC and EMEA, that the length of exclusivity, if those minimums build over time? If you're able to comment on any of that.

Yes. So the 8-K will have reference to the agreements. There are actually 3 separate agreements. One is the distribution agreement, another is an asset purchase agreement, and the third is equity investment agreement with a registration rights agreement behind that. And yes, there are some minimums for baseline targets. We are going to collaborate on what the forecasts are, but we do expect that those targets will grow each year as we work together going forward. And we intend to significantly exceed the baseline numbers together. But yes, there are some baseline elements. Okay. You asked about something else as well. Oh, the duration, the duration, yes. So the way it's structured is it's a 10-year exclusive distribution rights deal, with -- yes, with some baseline targets to retain that exclusivity. It also contains some right to exit that distribution arrangement if there was a change of control.

Okay. Perfect. And maybe just 2 more for me. I'll ask a specific and then a high-level one. Just on the PASCAL product line, the $9 million-ish, $9.5 million that it seemed to be doing, I believe that's just capital, if I'm correct, Dave. I don't think it's recurring, but maybe I'm wrong. And then is there just -- sort of 20% of pro forma sales, so is there a gross margin profile associated with PASCAL that we can think about? And then I'll ask my last one.

Yes, that's wholesale revenue. So that would have been as if IRIDEX was selling it to an end distributor as opposed to end customer. And it is a capital equipment business in the laser space. And as I've talked about before, it's mature, it's competitive, and the margins are more challenging. But we do believe that with scale and with product development efforts, we can significantly improve the margins on the whole portfolio. But in the short term, you could probably think of it more in line with our current margins on wholesale capital sales.

Yes. Okay. And last one for me, sorry. I'm just -- maybe to sort of zoom out, why now for the deal? I mean you are 2 leaders in the space. I'm guessing you guys have known each other for some time. What was the impetus of the deal? What made it come together? Or maybe if you're able to comment anything on the timing.

Yes. It's interesting. Where is the right time? Because as an industry, the players are in different degrees of conversation almost all the time. And the timing is right when the opportunities match up for both parties. And we believe that the benefits of consolidation, the benefits of joint distribution and broader portfolio and the idea that a capital investment really gives IRIDEX the significant resources to drive harder. We wanted to get out of the COVID period, and we wanted some confidence that the adoption of the glaucoma products could be driven through a sales process, and we just keep gaining confidence in all those areas. So it was the right time for us and turned out to be the right time for Topcon as well.

Perfect. Congrats.

And our next question comes from Scott Henry from Roth Capital.

Congratulations. Just a couple of questions. First, being this is a deal between competitors, are there any regulatory approvals necessary for the transaction?

There are not anything associated with the companies. Of course, when you shift distributors in certain parts of the world, you need government approvals, regulatory approvals. And so we'll go through some of that, but there's nothing at the corporate level that we're aware of.

Okay. Great. And then I think you mentioned that the PASCAL sales were to a wholesaler. Now would you go to the end customer? So should we expect that number to move higher? Is that how we should think about that?

Yes. Yes, so what -- the way we characterize the PASCAL revenue was as if it was manufactured by IRIDEX. In this case, it's a captive manufacturer within Topcon that produces and sells primarily to other Topcon entities. So it generated a wholesale revenue amount that then went to end customers. We have kind of split up the world in terms of distributors. So we will be the distributor in the U.S. and significant parts of Latin America and other parts of the world. About 40% of our old network of distribution remains with IRIDEX. So some of that will be wholesale, but where we're direct in the U.S., in Germany, we would end up with, call it, end-user prices. So we'll exceed -- would exceed that number on an apples-to-apples comparison in IRIDEX' hands.

Okay. Great. And then the 60% of OUS sales you will be losing, a couple of questions on that. Is that mostly retina? I don't recall what percent of that is glaucoma. And were those sales less profitable, I would think, than your domestic business? Just trying to get a sense of the profit magnitude of those.

Yes. So that is a representative mix of our overall. So it's about 70% capital, 30% glaucoma -- or 70% capital and other and 30% glaucoma. But it really isn't a loss of revenue. It's just a shift. We may have been selling to one distributor in our current portfolio of distribution, and now we will sell to a different distributor being Topcon. So none of that revenue goes away from IRIDEX is what I was trying to highlight on the slide that's kind of showed the pro forma structure going forward. We retain the revenue. We will just sell it to a different distributor. We will add the PASCAL revenue. And that PASCAL revenue primarily will go to Topcon, the 60 -- call it the 60-40 ratio. But also, we will sell it in the U.S., and we will sell it to other distributors in our parts of the world where we continue with the distribution network.

Okay. That's helpful. And so given that dynamic, can I assume there are no royalties in either direction? Or I guess it will just be a sale versus a manufacturing revenue. I don't know if we'll get some new lines in the income statement.

Yes. We'll sell a wholesale product, say, a PASCAL system, IRIDEX, glaucoma system, probes, to -- Topcon's got several distribution entities generally by geography around the world. And we will sell to those entities, and they will sell to the end customers. And that's the same as a current relationship. There's not royalty stream going back and forth under this deal. We've purchased the assets, and so part of that has some intellectual property and some know-how that reverts now to IRIDEX upon close.

I would now like to turn the call back over to Dave Bruce for closing remarks.

Okay. Thank you. So this was a brief overview of our new exciting collaboration. We're energized going forward, and we thank you for your interest. We'll go to work executing on this and continuing to grow the company. Thank you, everyone, for participating.

Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.