Candy, Babies, Hospitals and IPOs

Tim Mullaney

In the IPO market, there's lots of candy and darn few babies to take it away from. But this week, you may get to come close.

That's a fancy way of saying look out for this week's IPO of Visicu (NASDAQ: EICU), a Baltimore-based e-health startup whose software is used to document and calibrate the care people get in intensive care units. Plus, Visicu staffers use technology to remotely monitor the care provided in ICUs, working from 27 EICU centers, and help on-site staff tailor treatments to the latest medical research. Regular readers know that e-health, pun intended, is an issue close to my gut: A bout with stomach cancer (I finished treatment a year ago last week) will do that. . Better process control in hospitals is the key to controlling a truly scandalous rate of in-hospital deaths from medical errors and other poor or badly coordinated care. By some estimates, that's the nation's third-leading cause of death, and it came uncomfortably close to nabbing me.

Another thing that's close to my gut: An instinctive affection for startups that grow sales 3x in a year, and whose operating cash flow flirts with 60% of sales. Visicu, with $18.4 million in 2005 sales (up from $5.5 million in 2004) and $10.9 million in operating cash flow last year, fits the bill. They have a $70 million backlog of business that customers have ordered but not yet taken delivery of, about 40% of which is expected to turn into 2006 revenue. So revenue this year is $28 million (40% of $70 million) even before they sell anything new, with cash flow likely to be at least $17 million (60% of $28 million, rounded up, though the real calculation is a little more complicated than that.) And headroom. Baby. They're only in 97 hospitals so far, out of about 6,000 in the U.S. "They've taken a medical specialty that hadn't been thought of as leveragable, and they're addressing a major medical cost center," says Linda Killian, who runs the IPO Plus Aftermarket fund for Renaissance Capital.

OK, so why does this deal look so solid?

* Pretty reasonable valuation. The indicated range points to a market cap around $413 million. That's a lot for a company that had $18 million in sales last year, granted, but not so much for a company with a $70 million backlog and 60% operating cash flow margins. Cash flow is actually way better than reported income at this company because people pay for $2 million software packages up front, but the revenue is recognized over a three-year contract term. Killian cites valuation as a concern. I see her point, and in a worried market I might agree. But in recent years, Wall Street has been very intelligent about when to pay up for growth in IPOs and when to reject companies that are just story stocks. My gut says investors will see Visicu as a tipping point story worth taking the chance on, much like VistaPrint (VPRT) last year or (CRM) in 2004. Neither was exactly cheap, but they've more than justified early bets.

* Huge secular trends at its back. Hospitals have been slow to implement infotech to improve care, but there's no doubt that the tipping point is coming if it isn't already here. The federal government is coordinating the setting of industry standards for a national health info network to let providers share data to improve care. Anticipating the national network, and big hospitals are embracing IT in a way that lets them redesign care and gives them a competitive advantage over laggards. (See our March 2005 cover The Digital Hospital). Plus, Medicare is moving toward tying reimbursement rates to the quality of care. In all, hospitals have a lot of reasons to buy products like this.

* Modest competition and loads of potential acquirers. The single most unusual thing in the S-1, to me, is that it lists only two direct competitors for Visicu now, and two more that make products that include some form of Visicu's ICU-management functions in broader software packages. But in a passage meant to be scary, or at least cautious, it mentions seven companies that make enterprise software for hospitals that could decide, sometime in the future, to compete with Visicu. It's a much better bet that both Visicu and its direct rival Picis get to choose up sides some time down the line, as those seven companies (including giants like Siemens and McKesson) buy ICU functionality rather than build it. Look for maybe Cerner to grab one and Siemens or McKesson the other. That's how the e-health software business has been going. It's a roll-up game as a handful of big players build out capabilities.

* Not least, the product seems to work. Granted, I'm relying here on research done by Visicu's own consultants, as reported in the SEC filing I'm about to quote, although a version of their work was published in a peer reviewed journal. The data say "the use of our eICU Program by one of our customers reduced mortality risks in that customer’s ICUs by approximately 27% and reduced the average length of stay in the ICUs by approximately 16%. In the study, these improvements were shown to reduce average costs per case by approximately 25% and increase the hospital’s average ... margin per case by approximately 56%." (Over the next couple of days, I'll try to get that customer on the phone and I'll post the results). Needless to say, if your software can do that you're likely to sell some of it.

* Risks. Competition, for sure. Cerner is challenging Visicu's patent in court. It takes an average of nine months to sell each new client, so there could be lumpy earnings now and again. Customer concentration is pretty significant, with two hospital groups accounting for 25% of revenue. And all those services agreements for monitoring ICUs from Visicu's remote centers have to be renewed every three years. All these factors are reminders of why IPO investing can be tricky, but no major red flags jump out.

So keep an eye out. At a market cap of just over $400 million, Visicu looks like pretty cheap candy, baby.

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