Small Cap Stocks

Introduction
LifeCore Biomedial (LCBM) is an interesting stock to put on your watch list. Even though the company is no longer in true turnaround mode, we think the company is ripe for a major corporate makeover given recent private equity interest in the dental implant industry. As such, it could make for a nice trade and/or investment should the stock decline because of overall market conditions and/or non-fundamental factors.

The Business
Lifecore Biomedical, Inc. manufactures biomaterials and medical devices for use in various surgical markets. It has two divisions, Hyaluronan and Oral Restorative. Dental implants and related oral restorative products comprise nearly 70% ($43 million) of LifeCore’s total annual revenue of $63 million. The other 30% of LifeCore’s revenue comes from the sale of hyaluronan, a polysaccharide used primarily in cataract surgery and various orthopedic applications.

The Problem
There is clearly no synergy between LifeCore’s two businesses, and in fact the uncertainty related to the hyaluronan division seems to distract investors, as well as management, away from the significant and, in our view, less risky, growth opportunities presented by the dental implant subsidiary.

In fact, troubles in the Hyaluronan business pummeled LifeCore’s stock in 2003 when FeHA, (formerly labeled as GYNECARE INTERGEL Adhesion Prevention Solution) was voluntarily withdrawn from the market by ETHICON (a division of J&J) in March 2003 in order to assess information obtained from postmarketing experience with the product, including allegations of adverse events associated with off-label use in non-conservative surgical procedures.

The real trouble with the Hyaluronan division, though, is that Lifecore has absolutely no control over this business. They sell the Hyaluronan Division products through long-term strategic alliances with corporate partners, like Alcan. As such, the Company has limited direct sales capabilities in the Hyaluronan Division and generally relies upon its corporate partners for marketing and distribution to end-users. Without much in the way of end customer relationships the company is always at the mercy of its partners.

As for dental implants, the total worldwide dental implant market is estimated at over $1.4 billion and the potential size of the market is nearly $20 billion given the estimated replacement of 100 million teeth in the adult population in the US, coupled with the growing acceptance by the medical profession of implants over traditional dentures.

Overall, the dental implant market remains one of the fastest growing segments of the medical device industry and this coupled with the direct sales nature of the business makes it attractive from an investor viewpoint. The problem though is that LifeCore is still a small fish in a market dominated by much larger competitors, such as Nobel Biocare and Straumann, two foreign companies. As such, the company’s growth is somewhat limited unless it can get additional financing or engage in some form of M&A activity.

Recent Changes and Their Significance

In recent months, HealthPoint Capital, a private equity group out of New York City, has gobbled up two smaller dental implant companies: BioLok and BioHorizons. BioHorizons valuation is not known, as the company is private, but BioLok’s valuation is public. The price: $35 million for $9 million in annual sales, for a valuation of 3.8X sales. Notably, the other major public dental implant companies, such as Straumann and Nobel Biocare, trade at significantly higher price/sales valuations.

With private equity now in the picture, it seems obvious that smaller dental implant companies are in play. The strategy for private equity is clear: Acquire more dental implant companies, in an effort to create marketing scale to compete with the larger competitors in the industry. This situation is clearly beneficial for LifeCore investors for two primary reasons:

• Downside Risk in the Stock Is Minimized
Takeout Valuations of BioLok and others allow for a more certain valuation for LifeCore’s implant business, thereby placing a theoretical floor to the stock price and limiting downside for investors, despite uncertainties related to the Hyaluronan business.

• The Potential for Additional Upside Based on M&A Deals Has Increased

Given the valuations of dental implant companies, shareholders of LifeCore are probably itching to separate the company’s two businesses in order to extract value. In theory, a stand alone implant company could be more aggressive in pursuing growth strategies. With LifeCore, shareholders could either push for a split-up of the company or they could persuade management to pursue a sale of one or more of the divisions.

The Price: Risk/Reward

• Financial Condition is Solid and Business Risk is Limited

Before getting to some basic valuation considerations, it is important to note that there is almost no financial risk for LifeCore. The company is currently profitable and sitting on $28 million in cash, with only about $5 million in debt, for a net cash position of $1.70 per share.

In addition, since the dental implant division is primarily a direct sales business, with LifeCore’s relationships with doctors going back many years, we see little risk in anything going dramatically wrong with that business. The hyaluronan division is of course another story and investors are well aware of how a screw up there can lead to a significant decline in LCBM’s stock price.

However, despite troubles with FeHA, as mentioned above, and the other risks associated with the business, the Hyaluronan division remains profitable for LifeCore to the tune of $5.2 million in operating income in 2006. The division also has interesting growth opportunities. In fact, management estimates a $350 million annual market for hyaluronan in the cataract surgery market alone. In addition, the company’s wholly-owned 110,000 square foot building in Chaska, Minnesota, is designed to permit the production of hyaluronan at levels exceeding current levels of production, suggesting a valuable manufacturing asset for a competitor. Taken together it therefore appears that there is at least some decent value in the hyaluronan business to limit downside for investors.

• The Upside and Downside for The Stock Price

Ultimately, it would seem that based on HealthPoint’s purchases of smaller competitors that Lifecore’s dental implant business alone would be worth at least 3.8X sales or about $160 million ($11.70 per LCBM share) and perhaps as much 5X Sales or $200 million ($15.50 per share). The hyaluronan division is much more difficult to value given a lack of M&A data. But based on various EBITDA multiples off of the division’s $5.2 million in OI in 2006, we value the division at about $75 million, or about $5.50 per share. We consider this a low valuation, as it does not take really take into consideration the value of the company’s manufacturing facilities which has value on the books at $23 million, but cost upwards of $50 million or $3.65 per share.

Taking the above valuation scenarios for the dental implant business plus the hyaluronan estimate, it seems that LCBM, based on relative valuations, is worth between $17.50 per share and $21 per share on the upside. On the downside, the closer LifeCore’s stock price gets to $11.70 the greater your chances are of picking up the hyaluronan division for free. Therefore, we’d be aggressive buyers at sub-$15 levels, where the potential upside could exceed 50%, with limited downside.

The People
LCBM’s current CEO Dennis J. Allingham was appointed President, Chief Executive Officer and Secretary and to the Board of Directors in February 2004. Mr. Allingham previously served as Executive Vice President of the Company from November 1997 to February 2004. He served as Chief Financial Officer of the Company from January 1996 to March 2004.

Mr. Allingham was appointed CEO following the FeHA debacle. He has done an incredible job of turning around the company. Under his watch sales have increased from $47 million to $63 million and more importantly cash has grown to $28 million from only $8.5 million. The stock has also performed well under watch. Mr. Allingham currently owns 345,000 shares of LifeCore and would clearly benefit from a sale or other transaction at the company.

What’s even more interesting with LifeCore, though, is the increasing presence of funds taking significant stakes in the stock. Just this past week, Gamco Advisors filed an updated 13-D, showing purchases of the stock from $13.80 to $15. Gamco is well known for buying into stocks with M&A potential.

As such, we would not be surprised if an activist investor and/or private equity buyer begins to pressure LifeCore management to split the company up or pursue a sale of one or more divisions in order to enhance shareholder value.

How To Trade This Stock

As in other small-cap situations, LCBM’s stock is thinly-traded and quite volatile, presenting opportunities for investors to pick up shares on temporary liquidity drops. We would be buyers at the sub $15 level and/or on any potential bad news related to the hyaluronan division, given that the long-term value of the company is clearly in the implant business. We think the downside is at most $12 per share.