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FoxHollow's SilverHawk Won't Soar
By Glenn Brandys
July 5, 2006

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.....
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Reply to Glen Brandy

“Foxhollow' Silver Hawk Won't Soar”

I read you submission with interest but disagree with almost everything you say. Let's start with your assertion about growth. You confuse revenue growth with unit sales growth in your assertion that the sales growth and the adoption of the product is slowing. In this instance this of crucial important. The growth in sales revenue has two components a) the growth in unit sales and b) the increase in price and gross margin.

The company introduced the product at a very low introductory price. It increased its price and gross margin steadily in Qtrs. 1through 4 of 2005. The increase in price from quarter to quarter slowed down from 7.1% in Qrt 1 2005 to just 2.3% in Qrt 4 2005. This decrease in gross margin expansion accounts for much of the perceived slow down in growth in Qrt 4 2005. If you strip out the price increase then yes unit sales did fall sharply in the Qrt 4 2005 to around 8% quarter on quarter growth compared with 13% in 3rd Quarter 2005. But unit sales growth accelerated to 18% again in Qrt 1 2006, based on the available data.

If you average out 4th Quarter 2005 and 1st Quarter 2006 the quarter on quarter sales growth was 13% per month - much the same as in 3rd Quarter 2005 – so where is the slow down? And we should also make allowance here for the component supply shortfall that did impact negatively the sales in 4th quarter 2005 and possibly to some extent 1st Quarter 2006.

The quarterly unit sales growth data (after adjustment for margin expansion) for 2005/6 consists of only 5 data points. These vary randomly and it is very heroic of you to deduce a declining trend from this data. You cannot get a statistically meaningful trend from this data. In fact to my view the conclusion is quite the contrary - the sales growth looks robust. The interesting fact is that in spite of a large increase in price over the period the company succeeded in increasing sales to existing customers, as well as the recruitment of new customers. This cannot all be due to channel stuffing as some commentators have suggested. Hospital managers are not that stupid. This all points to an increasing acceptance and usage of the product by clinicians. Indeed there have been a number of very supportive submissions to message boards and web logs by MD/clinicians who regularly use this product.

True we cannot expect the company to achieve massive quarter on quarter prices increase at the rate it achieved in the early months after launch. The product price is now probably very close to the price the market will bare and may only increase with inflation. But please also note that the unit cost of production has been declining along an 80% experience curve. The data scatter in this case is limited and the data is statistically significant. The reduction in costs can be seen most dramatically in the real terms data. This is a clear demonstration of tight management control of costs. All of this bodes well for the future prosperity of the company and for a further expansion of margin or at least an offset to any future price decline.

I did expect the growth in unit sales to slow somewhat in the 4th qtr 2005. The new sales force had to be integrated. You should note also that the first target of the company's marketing strategy would be to get acceptance of the product by the hospital clinicians. We must surely anticipate some slow down in the initial sales growth as the take-up by new clinicians matures. The next step is to increase the depth of usage by each clinician. There is now clear evidence that the growth in sales to existing customers is increasing, reflecting increased usage by the clinicians. The third stage should be to broaden the product range and increase the number of indications in which the product can be utilized.

We are all aware that this is currently a one product company. It is after all a relatively new company. It is developing new products which will hopefully expand the range of application of this technique, fulfilling stage three of the marketing strategy. And you should bear in mind that the company's sales have so far been limited to the USA. There is a market out here beyond the US shore.

As to the use of DCF techniques; I have an MBA and I have worked for more than 30 years on multi billion US$ projects for some of the worlds largest companies and a number of investment banks and venture capital funds. I fully accept the theoretical framework for DCF calculations. It is an essential conceptual frame work to have at the back of one's mind. It works tolerably well for in house projects where the variables are well understood and the time frame is bounded.

Your DCF based on the free cash flow for 15 years is meaningless. There is no theoretical justification for the use of free cash flow or for the 15 year time frame as a basis for valuing this stock. Surely a share is valued on the present value of all of the future dividends summed to infinite that will accrue to the share - the cash flow into your pocket- not EPS, and certainly not free cash flow, much of which in reality could be used to finance new product development. And just what assumptions are you going to make about future R&D and new products? What assumptions are you going to make about the dividend pay-out ratio over the time horizon you are using?

Also think on this. There are uncertainties implicit in your forecast of each of the variables you include: unit sales, prices, all of the cost elements, not to mention the rate of inflation over the fifteen year forecast horizon and the market interest rate. You have to combine these estimating uncertainties as you would errors in a scientific measurement. These uncertainties are essentially additive. My guess is that the uncertainties in the projections of each of these variables are at least of the order of +/- 5% each year of your projection. Given that you have upwards of ten variables to be included, the finally uncertainty in your calculation, before discounting, could be as high as +/- 50%. To put this into context if your DCF shows a value of $2 per share this could be as little as $1 or as big as $3. Heck I could estimate that on the back of an envelope based on best ball park guesstimates of next years earnings.

Then there is the little matter of the cost of capital you are to use in your DCF calculation. Are you going to use the company's cost of capital? How are you going to calculate the company's cost of capital? Perhaps you should use your own cost of capital as an investor? On what factors will you base your own cost of capital? Is your cost of capital the same as the cost of capital of the average investor, whatever that might be? Will this vary over the time horizon of your projection? You surely cannot use the market interest rate or bond rate.

What about inflation? Are you going to use real terms (net of inflation) or are you going to base your cash flow on current money values? What value of inflation are you going to project over the time horizon of your projection?

Your DCF calculation is fraught with difficulties and uncertainties. I know business schools love DCF but we have to deal with reality. I may be wrong but I seem to recall the JM Keynes was a little scathing about DCF calculations and I believe he developed the concept originally. And finally there is no conclusive evidence that individual investors or the market in general actually bases valuations on DCF projections of the company's EPS or dividends. Until you can conclusively prove otherwise DCF calculations remain merely a theoretical concept, useful for concentrating the mind, but of little use in the real world.

Clinical trials: It seems to me that surgical procedures are not normally evaluated using the double blind randomised test protocols used with pharmaceuticals. In the pharmaceutical industry, in which I worked for some years, clinical trails are designed to test the efficacy and safety of a product and not to compare one product with another. Just how are you going to set up the placebo in the trials of Silver Hawk? The best you can do is to use follow up data on patients who have been treated with each of the competing techniques. There must surely be sufficient data available for an independent adjudicator to make this assessment. But the most important test in this case, however, must be the appraisal of the product by the clinicians who have used the technique and the confidence they have in the product. From the feedback I have read the future is bright - the future is Silver Hawk.

In conclusion
My view is that this is an excellent company with a very interesting product which by all the accounts that I have read is well accepted. There is evidence that the product is gaining increased usage by existing customers at the expense of competing techniques as evidenced by the increased sales to existing customers. I agree the market is currently somewhat limited by the parameters of the device. New models are in final stages of development to extend the usage of the technique and these products will be launched in the next two quarters of this year.

It has to be said that the major problem with the share price at the moment is the stock market's and analyst's fixation on quarterly performance. In the case of a relatively new small company such as this the data will fluctuate randomly from one quarter to the next. A delay in the component supply chain or in the timing of a contract can have a major impact on the quarterly results

The company has tight control of costs and is achieving economies of scale in production. The sales force is large for this level of sales by comparison with competitors. But then the sales volume is growing strongly, and who is to say that the competitors have got it right, after all they do not seem to be performing all that well.

As to the valuation, forget DCF fights of fantasy. My best conservative estimate is $45 to $50 by year end based on standard valuation metrics.
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Excellent discussion of FOXH's business and wonderful counterpoint to Glen Brady. As far as My best conservative estimate is $45 to $50 by year end based on standard valuation metrics..., could you elaborate on your standard and how you came up with your estimates?


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I just thought I would say a few words here. I am glad to see the article spawned some discussion. In reply to some of the issues, here are some thoughts.

It seems most of the issues above deal with the general idea of using a DCF analysis. I agree 100% that it is only as strong as the assumptions that you make given the nature of the beast.

The reason I wrote the article was that I was using quite positive figures in every aspect when evaluating FoxHollow and kept getting low valuations for the company. In the numbers used for the article I had the COGS dropping to 15% at a rapid pace, which is optimistic, revenues meeting analyst expectations for the next 2 years, and having the company's R&D as well as SG&A expenses being on the low end of guidance. You mentioned the 15 year time frame as meaningless, and again I used this as an optimistic outlook of the timeframe in which the SilverHawk could have meaningful sales. This article was to show that the SilverHawk was not going to have blockbuster status, so if FoxHollow invents a new and improved device, this period should be extended for valuing the firm, but as a product in a quickly evolving medical industry, I think the long 15 year period only adds to my point. Even with all of the assumptions favoring FOXH's outlook, I continued to get numbers that showed the company to be overvalued. It would take very drastic inputs to have the company as having huge growth potential from its current stock price.

I also think it is worth mentioning that using multiples has huge assumptions embedded into the analysis and a reliance on the quality of the valuations conducted for the peer firms. Further they become less viable for valuing companies with negative cash flows.

About the clinical trials, it is obviously impossible to do a double-blind study as we are dealing with procedures in which the patient and doctor would inherently be aware of which treatment is being performed. I was saying there needs to be a thorough, large-scale study that shows increased efficacy in using the SilverHawk as compared to the alternatives such as the standard of care (the bypass) as well as the currently avaiable minimally-invasive options such as stents, angioplasty, and Spectranetics laser.

I also thing it is important not to overlook the issues with management. I find it hard to be excited about a company's prospects with the turnover at key positions FoxHollow has experienced and especially the appointment of Simpson as permanent CEO after they publically announced an extensive search for a qualified replacement.

I think there is a definite future for the removal of plaque from arteries using a catheter, but it is an imperfected science. From what I have heard from vascular surgeons who have used the device, they have told me the device is neat but not where it needs to be to develop a widespread adoption that extends into the common hospital. This definitely has the potential to change in the future, but the device still has a ways to go.

The SilverHawk has achieved strong sales and FoxHollow will be profitable very soon, but everything I have seen hints at it beginning to plateau. Unless annual growth continues as it has the past two years, which would require a rerversal of quarterly growth trends, this is not going to be a multibagger.

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