A 5-Star Small-Cap Stock

One of the small caps that currently has a 5-star Morningstar Rating for stocks is  FoxHollow Technologies . We estimate the fair value of the stock to be $45 per share, which compares to its current price of about $26. Below you'll find excerpts from the report by Morningstar analyst Julie Stralow.

Analyst Note (11/9/06)
FoxHollow Technologies shares fell Thursday after reporting excellent third-quarter results, in our opinion, but weak 2006 sales guidance. After adjusting our sales growth for this new guidance, we're keeping our fair value estimate at $45 per share, as the slower-growth expectation is offset by higher-than-expected profit generation.

FoxHollow delivered $54 million of sales in the third quarter, or 49% growth. We were impressed with the firm's ability to leverage that higher revenue into its second consecutive profitable quarter with an 11% operating margin. We weren't expecting such robust profit generation yet. However, growth appears to be slowing a bit, and the company reduced its full-year sales guidance to $202.5-$204.5 million from $210-$214 million. This guidance suggests that fourth-quarter revenue will not expand past third-quarter sales.

However, we don't think this spells out a long-term doomsday scenario, where FoxHollow sales never grow again sequentially. The company is working on several new versions of the SilverHawk plaque excision system. We think these new versions have the potential to increase units used primarily by expanding the types of vessels that can be accessed and, perhaps more importantly, expanding the physician population willing to use the SilverHawk. The MiniHawk is an example of a recently launched version that can expand vessels accessed, as it can be used in the lower legs and even the feet. We also remain especially excited about the NightHawk, which will add real-time imaging to the device. That imaging capability could significantly increase the pool of physicians willing to use this device. FoxHollow aims to launch the NightHawk in the second half of 2007. With a growing bottom line and a pipeline expected to bear fruit in 2007 and beyond, we think FoxHollow's long-term prospects remain bright.

Thesis (10/3/06)
FoxHollow Technologies aims to change the course of cardiovascular diseases, particularly peripheral artery disease. While we like the progress the firm's making on this front, we think its risk profile remains high.

FoxHollow sells SilverHawk, a catheter-based device used to cut plaque out of clogged arteries. The device is indicated only for peripheral (below the waist)--as opposed to coronary--arteries at this time. Peripheral artery disease represents a huge and growing market opportunity for FoxHollow. The American Diabetes Association estimates that about 12 million people throughout the United States are living with the disease. Since peripheral artery disease is driven by obesity, diabetes, and aging, trends suggest that it will only increase in prevalence. FoxHollow is attacking this market opportunity by rapidly expanding its salesforce to reach more patients with SilverHawk. As a result, more and more patients are beginning to benefit from this minimally invasive device, which we think provides a better option than stents and bypass surgeries for peripheral artery disease patients.

Even with the benefits of SilverHawk, patients with peripheral artery disease still have many unmet needs, and FoxHollow aims to introduce new versions of SilverHawk to address more of them. New versions could speed up plaque excision, be used in the lower legs and feet, and cut through difficult-to-treat calcified lesions. Perhaps the most exciting SilverHawk product in development is nicknamed NightHawk and is slated for a 2007 launch. This plaque-excision system includes on-device imaging, which will let physicians see their work in real time. This imaging feature could significantly increase the pool of physicians willing to perform the procedure, since some are not comfortable with the current X-ray-based technique. We expect new products like these and the continued uptake of existing SilverHawk offerings to fuel high growth rates at FoxHollow for the foreseeable future.

However, FoxHollow remains in its infancy, and it has not yet shown an ability to create economic value over the long term. Product concentration remains our key concern, since SilverHawk devices and related agreements remain the firm's only value driver. The firm is not immune to the competitive threats, third-party payer decisions, and legal suits that could significantly derail this product's success.

Despite its lack of an economic moat, we remain excited to see what develops next at FoxHollow. With its first taste of profits, an expanded  Merck (MRK) relationship, and new SilverHawk versions in development, FoxHollow's future looks bright.

Valuation
We're raising our fair value estimate for FoxHollow to $45 per share from $42 on the basis of the Merck collaboration extension. Given this new agreement, we now expect revenue to grow by 40% compounded annually from 2005 to 2010, rather than the 37% we assumed previously. FoxHollow remains heavily reliant on the growth of its SilverHawk devices, and, in turn, our estimate depends greatly on increasing penetration of the peripheral artery disease marketplace. We think SilverHawk will be used in at least 20% of procedures annually in the United States by 2010. We place only about $3 per share of value on the firm's coronary aspirations, but we would consider raising that figure if clinical trials progress successfully. Our fair value estimate also depends on FoxHollow's operating margins expanding toward 25% by the end of the decade, including stock compensation expenses. We expect capital expenditures as a percentage of sales to remain in the midsingle digits through 2010.

Risk
The risks surrounding FoxHollow are high. The firm faces single-product risk as the SilverHawk product line accounts for all product sales. Anything that disturbs it, like reimbursement rate declines, would severely hurt the firm. Even if SilverHawk is used widely, the risk that another company develops a better treatment always looms. Legal risks abound, and the firm might have to use significant resources to protect its intellectual property or defend against product-liability suits.