In Fine Fettle

Opto Circuits (Opto) is a Bangalore-based company that manufactures and develops medical equipment that is both invasive and non-invasive in nature.
Earlier, the company manufactured and supplied electronic medical sensors used in patient monitoring systems. Later on, with the acquisition of Palco Labs, USA in 2003, it graduated to manufacturing patient monitoring systems. In the non-invasive segment the company offers patient monitors, diagnostic and therapeutic cardiology devices, and PAD (peripheral arterial disease) diagnostic equipment. Altogether this segment contributes 78 per cent of the company’s total sales (FY11). About 61 per cent of the revenue of this segment comes from the US market. Recently Opto acquired Cardiac Science (CS) of the US, which is expected to boost the revenue of its non-invasive segment further.
The company forayed into the invasive segment in 2006 with the acquisition of EuroCor. Now, Opto manufactures bare metal stents (BMS), drug-eluting stents (DES), coated balloons, and other invasive equipment required in cardiac treatment. Overall this segment contributes 20 per cent (FY11) of the company’s total sales. This segment’s biggest client is Europe: it contributes 52 per cent of its total sales.

Industry outlook
The medical electronics industry is highly capital intensive in nature. A lot of capital has to be deployed for sustaining constant innovation. The installation and use of most of the equipment is mandated by government regulation, so medical service providers have to install them. Hence, this industry’s growth is closely intertwined with that of the overall healthcare sector.
Non-invasive. According to Opto’s management, the non-invasive part of the medical electronics industry (patient monitoring equipment) is expected to grow at an increasing rate in developing countries. The international market is expected to grow at a compounded annual growth rate (CAGR) of 29.08 per cent between CY10-CY15. The Indian market, on the other hand, is expected to clock a growth rate of 15 per cent next fiscal.
Invasive. Invasive treatments are increasingly gaining favour over full-fledged surgery. Over the past decade, cardiac stents have undergone rapid innovation. Angioplasty, which began with the use of dilatation balloons to clear cardiac blockage, is now being carried out using drug-coated balloon catheters. The size of the vascular intervention market exceeds $6 billion internationally.

Strengths
Product range. As we mentioned earlier, the medical electronic equipment business thrives on innovation. For the past three years, Opto has been launching two new products every year — one in the invasive segment and the other in the non-invasive segment.
Opto’s invasive business, primarily the business of Eurocor, has clocked a revenue growth rate of approximately 50 per cent between FY08 and FY11. Its invasive business has maintained its growth momentum by launching products like Taxcor Plus, Dior, Freeway and Magical (incidentally, the last product only recently got approval for being launched in India).
Distribution strength. The company conducts its US market operations through its subsidiary Mediaid. Opto has a distribution network of 1,300 plus dealers worldwide. More than 90 per cent of the company’s revenue comes from abroad, a testimony to its strong global distribution capabilities. The recent acquisition of CS will allow Opto to tap the former’s large client network of US hospitals for cross-selling its non-invasive products.
High-quality management. Opto has chosen to grow the inorganic way. The management has taken this route both to acquire technology and to gain entry into key markets. In the last 10 years, it has acquired nine companies. In FY10 it took charge of NS Remedies, India (manufacturer of stainless steel and cobalt chromium stents) and Unetixs Vascular, US (manufacturer of equipment for measurement of peripheral arterial disease, having 14 patents worldwide). It has acquired companies in India, US and Germany. Getting all these disparate companies to work towards the same objective despite cultural and geographic differences attests to the high capabilities of its management.
Its recent acquisition, CS, is a high-end cardiac diagnostic and therapeutic equipment company. But before being bought by Opto it was a loss-making company with several product-related issues that led to massive product recalls. Therefore, when Opto decided to buy CS, its investors were concerned. But in the very first month CS became EBIDTA positive. In Q4FY11, CS posted sales of Rs 171 crore with a profit margin of 9 per cent. Opto’s management expects CS to post sales of $140-150 million in FY12. CS has also seen new orders for its Power hear AED’s from Tyco Flow Control and US Postal Inspections Service.
Earlier, in FY09, when Opto acquired Criticare, its management showed similar skill in turning that company around. As a result, Opto has been able to maintain an enviable five-year return on capital employed (RoCE) of 32.8 per cent.

Weaknesses and concerns
Litigation risk. Since Opto belongs to a sector that prides itself on innovation and has a substantial patent portfolio, it cannot insulate itself entirely from litigation. Hence, it has to provision for protecting itself against the risk of patent infringement by rivals, while at the same time defending itself against claims of infringement against it made by them. Its invasive business is particularly susceptible to litigation risk.
Technological obsolescence. This is an industry where products have to be upgraded constantly. The threat that some other company might develop a new patented product and steal market share from it will always loom over the company.
Foreign exchange risk. About 90-95 per cent of Opto’s sales comes from exports. Therefore, the company has to guard against the risk of currency fluctuation. For example, in FY09, it made a gain of Rs 25.4 crore due to currency fluctuation, while the following year it lost Rs 11 crore on this account.

Opportunities
The company derives only a very small part of its revenue from the domestic market, even though it has products of international quality. The company’s management is also of the view that future growth in both invasive and non-invasive segments will come from the emerging economies, especially India. The Indian market is approximately `400-500 crore in size. With its international experience and its low-cost production centres in India and Malaysia, Opto stands a strong chance of gaining market share vis-a-vis rivals in the Indian market. It has begun its foray into the Indian market: it plans to shortly launch Magical in India.
In China, it is awaiting approval from Chinese SFDA to sell Dior there. It has opted to take the joint-venture route in China. Thus, it is only a matter of time before it starts selling its products in that country.

Financials
Opto has shown stellar performance over the past five years. Its topline has grown at a CAGR of 63 per cent while its bottomline has grown even faster at 57 per cent over the past five years. The fast pace hasn’t prevented the company from generating free cash flow: it has consistently been free cash flow positive over the past five years. The company had a debt-equity ratio of 0.65 at the end of FY10. This is considerably higher than its lowest figure of 0.33 in FY08. In the past three years, the company has borrowed heavily: this has pushed its outstanding debt from Rs 101 crore in FY08 to Rs 232 crore in FY10. But overall the company’s fundamentals look strong owing to the healthy margins that it enjoys.

Valuation
Currently the stock is trading at a price-earnings ratio (P/E) of 18.91, with earnings per share (EPS) of Rs 13.11. This is 27.23 per cent lower than its five-year median P/E of 27.69. Moreover, its five-year EPS growth rate gives it a price-earnings to growth (PEG) ratio of 0.5.
According to estimates by analysts at IIFL Institutional Equities, Opto is likely to grow its EPS at an average rate of 25 per cent annually between FY12-13. Hence, taking both its growth prospects and its fundamentals into account, investors may take a position in this stock in the mid-small cap space.