TearLab: Blind Faith in a Risky Highflier with Forgotten Tear Stains

by Melissa Davis - 8/1/2013 11:05:44 AM

TearLab (Nasdaq: TEAR) might feel like crying if it contacted some of the doctors listed on its own website as providers of its diagnostic test for dry eye disease and listened to the feedback from those who no longer use its glorified machine.

Take Dr. Seaborn Hunt, for example. A Florida ophthalmologist, Dr. Hunt practices medicine in a popular retirement town crowded with seniors who qualify for coverage of the $50 TearLab test under the government-funded Medicare program. While TearLab specifically identifies his clinic as one of three local practices that utilize its device – generally provided by the company, free of charge, in exchange for a commitment to purchase a steady supply of the disposable cards that its system requires – Dr. Hunt has already returned his own machine and gladly resumed his use of an old-fashioned diagnostic test for DED instead.

“It was just a pain,” one of his employees bluntly explained. “We sent it back because we found it to be inaccurate.

“I know that a lot of people are advertising it. But if you have (DED), you have it. You don’t need a machine to tell you that.”

In neighboring Alabama, yet another ophthalmologist on that list must have reached a similar conclusion. Identified by TearLab as one of only four eye doctors who offer its test in the city of Birmingham, the largest metropolitan area in the entire state, Dr. Michael A. Callahan recently pulled the plug on that medical device – portrayed as an outright “lemon” by a member of his staff – and shipped the machine back to the company, too.

“I saw them boxing up this machine yesterday,” the receptionist volunteered when contacted by TheStreetSweeper a couple of weeks ago. “And sure enough, that was it! They sent it back; they found that it was not all that it was supposed to be.”

For its part, TearLab promotes its namesake device as a tremendous breakthrough so revolutionary that eye doctors will likely adopt the test as a new “standard of care” by screening their patients for DED as a matter of routine. While TearLab acknowledged that it has fielded a “small number of device returns” from doctors who effectively bailed on their multi-year contracts, when specifically questioned by TheStreetSweeper ahead of this story, the company pointed to low reimbursement from private insurers in certain areas – never hinting at any dissatisfaction with the machine itself – as the primary reason.

Regardless, TearLab has definitely sold Wall Street on its sexy story. After all, based on virtually any normal measurement tool, TearLab arguably should remain stuck (where it languished for years) deep in single-digit territory. All told, TearLab mustered less than $4 million in revenue last year -- easily dwarfed by the $12 million operating loss that it endured while pursuing that business – and recently closed the books on a “blockbuster” quarter by generating a modest $3.5 million in sales (likely eclipsed by yet another sizable loss) even after a powerful growth spurt.

A neglected $3 stock just one year ago, TearLab has nevertheless rocketed all the way past $14 a share since that time to achieve a lofty market valuation of $410 million – a staggering 70 times its prior-year sales – with the help of bullish calls from conflicted analysts who keep on urging investors to buy the pricey stock in spite of its nosebleed multiples.

An early TearLab fan who previously spent years managing a volatile small-cap fund for Kopp Investments – now the largest TearLab shareholder of them all – Craig Hallum analyst Steven Crowley has emerged as a particularly loyal cheerleader for the bleeding device company. Back when he first initiated his fawning research coverage of TearLab early last year, apparently overlooking a new study that challenged the reliability of its celebrated device along the way, Crowley pegged the future value of the stock (then languishing below the $2 mark) at just $5 a share. Later forced to scale back the revenue projections that he originally used to justify that $5 target, even though he had supposedly “taken a conservative approach” to estimating the potential demand for the only product that the company sells, Crowley has nevertheless gone on to repeatedly boost his price target on the wildly expensive stock, anyway.

At last count, Crowley had raised that target at least four different times to $16 a share – a figure almost bound to go higher with the stock now approaching that level -- since TearLab awarded his firm the first of two lucrative investment banking deals to manage stock offerings for the company. Yet based on his original formula, which valued TearLab at a generous multiple of five times its future sales, the stock would have actually realized its full value before it ever reached the $3 mark instead.

Dark History

To be fair, other TearLab bulls have made some rather bold calls on the highflying stock as well. Look at celebrity stock picker Jim Cramer, host of the popular “Mad Money” television show, just for starters.

Perhaps unaware that he had previously touted an earlier version of the same company – with disastrous results for those who acted on his bullish call – Cramer recommended TearLab to a national audience earlier this summer, even though the stock had by then already doubled since the beginning of the year. Once Cramer threw his weighty support behind the company, with Crowley dutifully resurfacing to boost his price target on the stock yet again (resorting to the steep multiples generally reserved for actual buyout candidates at that point), TearLab immediately blew past its former highs and – despite a dilutive secondary offering – has largely remained on fire ever since.

Of course, back when the company still operated as OccuLogix years ago, its stock posted similar gains on a Cramer endorsement only to go on and lose two-thirds of its value in a single day. While the company has long since reinvented itself with the help of a new name and a different business strategy, Cramer has effectively placed his faith in the same leadership team that failed him so miserably the last time that he banked on its imminent success.

Back then, with OccuLogix tanking on a major setback that would almost destroy the entire company, critics rushed to not only blast Cramer for making “one of his worst calls” on record at the time but also warn others against piling into his future stock picks on down the road.

“In his own book,” one investor astutely reminded, “he mentions that people can’t follow too many stocks at one time. You have to spend about an hour a week keeping up with each stock you own.”

Yet “Cramer makes snap-judgment calls on hundreds of stocks every month,” that same investor grumbled. “He doesn’t do his homework on every stock, (because) there’s not enough time to be that informed.”

To be sure, when Cramer recommended TearLab to his loyal fans as a promising speculative play this June, he never mentioned that prior travesty or hinted that he even remembered the fiasco himself. While Cramer recently decided to take a fresh look at TearLab after the latest surge in its share price – and actually directed his followers to cut their positions in the highflying stock by “a third (or) maybe even half” about a couple of weeks ago – he stopped well short of sounding any legitimate alarms about the company. Indeed, by simply presenting TearLab as a massive winner with reduced potential for explosive gains, Cramer seemed more like an outright bull than a cautious skeptic who – already burned by the company once in the past – felt compelled to at least question its future prospects.

In fairness, TearLab has managed to convince plenty of traditional analysts (including all of those employed by the four investment banking firms hired to manage its latest stock offering) that the company boasts a proven leadership team and a revolutionary device that – while largely ignored by eye doctors for years – will soon take the entire vision market by storm. After skyrocketing on a powerful combination of hype from its cheerleaders and hope from its growing base of fans, TearLab has emerged with such a hefty market capitalization that the company almost needs to deliver a remarkable homerun and avoid even minor errors along the way. Although TearLab has traded like a surefire winner over the course of the past year, however, the company arguably looks a whole lot more like a true underdog instead.

Lousy Vision?

Talk about blind faith. One of the most relentless promoters of TearLab by far, Crowley somehow looks at the company – a bleeding firm with a long history of failure – and always manages to see a rising star that’s “on the brink of blossoming financially” by “capturing a large and very lucrative market” to emerge as a dominant player in the space.

Since TearLab obviously still needs to prove itself, Crowley has largely based his bullish outlook for the company (and his rising expectations for its stock) on the glorified record of its top executives and the overblown promise of its only device. By presenting TearLab as a company with a “proven senior management team” and its device as a superior diagnostic test with “no directly competitive products,” however, Crowley has overlooked some rather compelling evidence to the contrary.

First and perhaps foremost, TearLab relies on a CEO who spent much of his career overseeing a laser-vision surgery chain that ultimately spiraled into bankruptcy after he abandoned his position to lead a spin-off company that – steered by other future TearLab officers as well -- barely managed to survive a messy disaster of its own. The immediate predecessor to TearLab itself, OccuLogix wasted an outright fortune pursuing an overhyped cure for a leading cause of blindness – with its stock exploding to double-digit highs on that ill-timed recommendation from Cramer along the way – only to suffer a devastating blow after the U.S. Food and Drug Administration rejected its worthless treatment and left the company scrambling for a reason to exist. Even after OccuLogix purchased the technology behind the TearLab system in a last-ditch effort to reinvent itself, offering the equivalent of $8 million for an asset that the market now values at more than $400 million instead, its stock wound up plummeting all the way to just 10 cents a share and threatened to disappear entirely.

Thanks to a series of related-party deals that left current TearLab CEO Elias Vamvakas with a mountain of cheap stock, however, the company raised enough cash to stay afloat until it secured approval of its diagnostic test by simply establishing that its device worked at least as well as existing tools already utilized to detect the same disease. While TearLab now likes to portray such old-fashioned DED tests as inferior, however, the company itself has produced some rather important evidence that clearly suggests otherwise. According to the very data that TearLab collected for regulators when seeking FDA clearance to market its DED test, that device mustered so-called “specificity” and “sensitivity” rates of just 71% and 64% respectively that – when compared to the corresponding rates of 92% and 69% recorded by traditional procedures – failed to even match the accuracy levels provided by the long-established tests that the company now hopes to replace.

Moreover, when subjected to an independent test designed to determine whether the device could in fact prove useful as a new standard of care, the TearLab system fared poorly enough to almost rule out that alluring possibility. The conclusion of that overlooked study: Unless eye doctors performed the test multiple times and then averaged the results – potentially tripling the cost of the procedure well beyond levels covered by Medicare and private insurers in the process – physicians could not rely on TearLab to diagnose the milder forms of DED that most often elude detection based upon the presence of mere symptoms alone.

In fact, a more recent study has since revealed, TearLab cannot even identify one of the most serious types of DED on its own. After trying the test out to determine whether it could accurately catch DED cases related to Sjogren’s Syndromea nasty disorder of the immune system that can dry out multiple bodily fluids – that study bluntly proclaimed that “the TearLab system disclosed no ability to distinguish between healthy individuals and patients with dry eye” at all.

No wonder TearLab has resorted to giving a whopping 95% of its machines away for free. Even TearLab itself has admitted that it sometimes encounters doctors who initially agree to install one of its free devices in their offices only to find little use for the diagnostic test and – breaking their promise to order the multi-year supply of disposable cards that Wall Street banks on when the company announces new orders – wind up abandoning the idle machine.

“What happens if somebody doesn’t really buy into the TearLab story, and it’s just sitting on a shelf somewhere?” the company mused earlier this year. “We just take it back. We’re like, ‘Look, if you’re not going to do it, we don’t need to babysit you. You don’t need to worry about fulfilling the contract.’

“There are doctors that don’t get it,” the company acknowledged. “That’s fine … They’ll come visit us later, when we are the standard of care.”

TearLab better not count on the likes of Dr. Chris Gurley to install its machine in his busy practice, though. A veteran optometrist based in an Oklahoma market saturated with competition, Dr. Gurley practices in a state that TearLab actually regards as quite accomodating – since doctors can secure the special waivers required to utilize its machines in a matter of days – and he generally welcomes breakthrough technology that will allow him to better attract and treat the local patients in his area. When Dr. Gurley researched the TearLab system, however, he saw very little appeal beyond its free price tag.

 “What does it actually tell me that I don’t already know based on patient complaints alone?” he wondered. “The trick to dry eye disease is figuring out the underlying cause. This test might tell me whether a patient has dry eye, but it doesn’t tell me what to do about it.

“To really know what the problem is – and understand how I should treat it -- I would still have to look further,” he emphasized. “This is just one piece of that puzzle.”

Blind Spot

While TearLab likes to present its device as a rare breakthrough poised to corner the market as the new DED diagnostic tool of choice, a rival player recently introduced an entire system powerful enough to not only identify the root cause behind the overwhelming majority of all dry-eye cases but also relieve the underlying disease.

A private company led by an impressive roster of industry veterans and backed by $150 million in venture-capital funds – about twice as much as TearLab itself has managed to raise (under its current name) through private placements and public stock offerings combined -- TearScience secured FDA approval for its next-generation DED system last year and now offers its product in key markets all over the globe. Although TearScience charges six figures for its DED diagnostic/treatment system – and has yet to even bother with seeking insurance coverage for its expensive test – the company has still managed to win over a growing crowd of doctors by providing them with a lucrative, new specialty. Since the TearScience system generally pays for itself within a matter of months, doctors can then go on to make a bundle by collecting thousands of dollars from DED patients who gladly pay those steep prices in exchange for relief from their disease.

Just weeks ago, in fact, TearScience fielded a big order from a prominent Japanese vision chain – a firm that has literally performed more laser-vision surgeries than any other ophthalmic business on the planet – after it tried out the DED system at its world-renowned practice in Tokyo and decided to begin offering that service at every clinic that it operates. Despite the hefty upfront cost of its hardware and the current lack of insurance coverage for both its diagnostic test and its actual treatment for the disease, TearScience fully expects that trend to continue until eye doctors adopt its own system as a standard of care in countries all over the globe.

“We are creating a market – truly creating a market – and that takes a while,” TearScience CEO Tim Will told TheStreetSweeper in a recent interview. “But in seven to 10 years, this will be in every ophthalmologist office – and most optometrist offices – I’m sure. This will be there … We have a $10 billion market opportunity.”

Even though TearLab aims to target many of those same doctors itself, the company has basically chosen to dismiss that rival DED player as a potential threat altogether. When asked by TheStreetSweeper for its views on this particular matter, TearLab selectively noted that TearScience markets “a new treatment option for one of two predominant forms of dry eye disease” – completely ignoring the diagnostic test included with that powerful system – and boldly declared that it does not regard TearScience as a competitor at all.  

Granted, by giving its machines away for free and securing insurance coverage for its diagnostic test, TearLab has understandably convinced more doctors to utilize its own device in its home country (where they can clear about $25 on each patient they screen) at least. While TearLab has also secured regulatory clearance to market its device in other countries, however, the company has actually seen foreign demand for its machines start to collapse. Despite incentives offered to a firm heavily backed by its own CEO for sales in his native country of Canada and yet another lucrative deal struck with a boardroom director to drum up business in Japan – where rival TearScience has enjoyed so much recent success -- TearLab weathered a steep plunge in foreign orders for its machines last year that literally chopped its international sales in half.

TearLab can hardly afford to dismiss those long-distance orders as a mere luxury, either. After all, as the company itself routinely admits in its corporate filings, “our near-term success is highly dependent on increasing our international sales.”

Second Glance

In reality, TearLab introduced its diagnostic test to the market well before Wall Street suddenly “discovered” the company and started celebrating its device as an important breakthrough destined to reshape the vision industry. Back when TearLab originally secured FDA approval of its device three years ago, however, even its own CEO displayed little faith in its future prospects. Although he had spent years guiding the device through the regulatory process – and owned a large stake in TearLab that stood to appreciate in value if its diagnostic test proved to be a hit – then-CEO Eric Donsky promptly resigned from his post the month after the company won clearance to sell its machine so that he could “pursue other opportunities” instead.

Initially restricted to targeting only those rare vision facilities classified as “high or moderate complex” by government standards – and finding relatively few takers among the certified specialists at those selective eye clinics -- TearLab mustered less than $4 million in total revenue (a big chunk of that generated by international sales that have since plunged to record lows), while losing roughly four times that amount in the process, during the first two years that the company tried to woo doctors with its device. Clearly incapable of supporting itself, TearLab resorted to selling a mountain of cheap stock (including a pile of free warrants that remain available for exercise) to corporate insiders and other investors at less than $2 a share as recently as a couple of years ago. While that stock actually went on to lose half of its value in the months that followed, bottoming out at just 78 cents a share in the fourth quarter of 2011, TearLab soon reversed course and exploded past its original price after Craig Hallum and Canaccord Genuity – the very firms since hired to lead its latest stock offeringdutifully stepped in and helped ignite the powerful rally that carried TearLab all the way to its recent $15 high

TearLab actually hit that peak on the very day that it priced its recent secondary offering at $13.50 a share, successfully avoiding the sharp discount that often accompanies fresh dilution -- and zooming right past that level to record double-digit gains -- after the company preannounced that it had given away far more of its free machines during the busy second-quarter season than Wall Street had previously anticipated. While TearLab obviously delighted its loyal fans with that recent surge in orders for its device, however, the company forgot to remind them about potential risks to its upcoming results and the corresponding forward guidance that tends to matter even more. Notably, without the handy exposure provided by industry conferences and the ready access to eye doctors (many of them closed for vacation) that it enjoys throughout the rest of the year, TearLab has previously spent the summer months sweating to generate new business and has at least hinted at the potential for a repeat of that slump.

“We haven’t gone through the summer,” TearLab cautioned earlier this year. “I don’t know how slow summer gets. We have only had one year of summer, and that’s been very slow … It’s not as if we have a lot of experience.”

With TearLab set to host its next quarterly update less than two weeks from now, the company understandably declined to share any clues about its recent performance with TheStreetSweeper and its audience in advance. Instead, TearLab merely noted that it does not comment on “current sales activity” – or even provide future guidance for that matter – so the company obviously refused to speculate about whether it expects to satisfy Wall Street when it hosts that looming conference call.

Still, if its momentum has in fact stalled over the summer, TearLab cannot necessarily count on the same kind of break that Wall Street sometimes affords other companies hindered by seasonal dips in their business. With TearLab trading at such extreme multiples to its anticipated sales, the stock looks practically doomed to suffer a hit – and a potentially nasty one at that – at the first signs of any slowdown.

Indeed, even when TearLab briefly slipped back toward the $10 mark this summer after the so-called “Cramer effect” began to fade, one of its followers – who regretted his reluctance to buy the stock earlier – still felt too nervous to place an actual bet on the company. A certified financial analyst who actually highlighted TearLab as a promising speculative play months before Cramer followed suit at much loftier prices, Stephen Simpson ultimately decided to remain on the sidelines after concluding that the stock already traded at rich multiples “by almost any rational med-tech standards” and looked “due for a breather” after their powerful run. 

With TearLab instead showing early signs of the powerful rally that would send the stock to a series of record-breaking highs, however, another Cramer follower soon stepped forward to declare his newfound allegiance to the celebrity stock picker. In a bullish review of TearLab published by TheStreet.com, the financial news site that Cramer himself co-founded and continues to preside over as chairman of the board, special contributor Richard Saintvilus pointed directly at the recent surge in that highflying stock as a clear reason to follow the advice of the “Mad Money” host when he shares his future picks on down the road.

As an investor who had yet to risk any money on TearLab himself – let alone lose on such a speculative call -- that Cramer fan sure expressed a whole lot more confidence in the influential TV host than those who actually followed his advice back when he recommended the predecessor to that same company so many years ago. A double-digit stock itself after Cramer promoted the company on his popular television show as “the greatest medical stock you’ve never heard” of, OccuLogix sank all the way from $12.75 to $3.78 a share at the opening bell the very next month, rendering the stop losses that he had recommended as protection from excessive downside virtually worthless in the process.

 “That is terrible for those that went long,” one critic observed at the time. “Hopefully, those people that bought didn’t lose too much.

“Hopefully, they also learned a lesson,” he then emphasized, “as painful as it may be.”

* Important Disclosure: The owners of TheStreetSweeper hold a short position in TEAR and stand to profit on any future declines in the stock price.

* Editor's Note: As a matter of policy, TheStreetSweeper prohibits members of its editorial team from taking financial positions in the companies that they cover. To contact Melissa Davis, the senior editor of this website and the author of this story, please send an email to [email protected] 

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