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Activist investor Glenn Welling and his fund Engaged Capital LLC today revealed a 5.1% stake in Volcano Corp. (VOLC), a maker of intravascular ultrasound medical devices.

In its 13D filing, Engaged Capital detailed its extensive thesis on VOLC:

The Reporting Persons acquired the Shares because, in their opinion, such Shares are undervalued and represent an attractive investment opportunity. The Reporting Persons believe that, at current prices, the Issuer's shares ascribe minimal value to (A) the potential for sustained revenue growth from the Issuer's fractional flow reserve ("FFR") and peripheral intra-vascular ultrasound ("IVUS") businesses as the penetration rates of these technologies increase, (B) the likelihood of material margin improvements and cash flow expansion as the Issuer begins to generate operating leverage, (C) the Issuer's opportunity to generate high rates of return through the disciplined allocation of its approximately $500 million cash balance, and (D) the Issuer's attractiveness as an acquisition target given the Issuer's advantaged and desirable position as the market leader in both FFR and IVUS.

The Reporting Persons believe investors are not appropriately valuing the aforementioned attributes of the Issuer due to the following factors:

  1. Several quarters of operating results that have missed management guidance and that have led to investor skepticism regarding management's forecasts, including the 2017 revenue, earnings before interest, taxes, depreciation and amortization ("EBITDA"), and free cash flow ("FCF") targets provided in the Issuer's long-run plan ("LRP") released on March 7, 2013.
  2. Fear of sub-optimal capital allocation via dilutive acquisitions following the convertible debt raise on December 3, 2012, which has resulted in an overcapitalized balance sheet possessing a total of $501 million in cash & equivalents and short- and long-term investments as of June 30, 2013.
  3. Concern that the Issuer may acquire a business, or businesses, that will make the Issuer a less attractive acquisition target in the future.
  4. An incentive compensation structure that fails to hold management accountable for achieving the LRP or multi-year performance targets, and include financial metrics that are closely aligned with shareholder value creation.

The Reporting Persons believe the Issuer has multiple, existing opportunities to enhance its valuation. Since their initial investment in June 2013, the Reporting Persons have maintained an ongoing dialogue with the Issuer's management team and members of its board of directors (the "Board") regarding the Issuer's (I) capital structure, (ii) capital allocation process, (III) investor communications, (iv) incentive compensation structure, and (V) long-term strategy. The Reporting Persons have recently intensified their communications with the Board regarding these topics and, based on discussions to date, the Reporting Persons believe the Issuer is committed to taking substantive actions to improve its share price.

Restoring Management Credibility

The Reporting Persons believe the Issuer's management team has done an outstanding job building market-leading franchises in both IVUS and FFR. Consistent operational execution led to the Issuer's meeting or exceeding consensus revenue expectations in 22 of the first 23 quarters that the Issuer was a publicly traded company. Additionally, the Issuer was able to capture market share in both its IVUS and FFR businesses from competitors with well-known brand names and significantly greater financial resources. Consequently, during the period from the Issuer's IPO until the most recent convertible debt raise on December 3, 2012, the Issuer's shares outperformed both its peers and broader equity indices. The Reporting Persons' research, including discussions with hospitals, doctors, academics, the Issuer's competitors, and sell-side analysts, has led the Reporting Persons to conclude that the Issuer has a highly differentiated product offering, especially in FFR, that is likely to generate significant revenue growth over the next five years. This anticipated growth is driven by the Issuer's installed base of over 7,700 consoles, (ii) highly supportive clinical data, improving physician awareness and acceptance, and (iv) the fact that FFR improves patient outcomes and lowers procedure cost.

However, the Reporting Persons note that recent operating results have failed to meet analyst expectations, as the Issuer has delivered quarterly revenues that have fallen short of consensus estimates in six of the past seven quarters. Further, the Reporting Persons note that management has reduced full-year constant currency revenue guidance in four of the past six quarters. As a result, investors have grown skeptical of management's assertions that the Issuer can deliver sustainable low-to-mid teens revenue growth. Additionally, the Reporting Persons believe that the convertible debt offering increased investor skepticism regarding the sustainability of revenue growth, and (ii) added the additional risk of suboptimal capital allocation via one or more large, dilutive transactions.

The Reporting Persons believe the keys to restoring credibility with investors include the Issuer setting and delivering on reasonable expectations, aligning management incentives with those expectations, deploying excess capital to its highest and best use, and executing a long-term strategy that optimizes the value of the Issuer for all shareholders.

Building Credibility Through Accountability

At the Issuer's 2013 Annual Meeting, more than 57% of the total shares of common stock represented at the meeting were voted against Proposal 6: "Approval, on an advisory (nonbinding) basis, of the compensation of our named executive officers." The Reporting Persons believe this strong negative vote is reflective of an executive compensation structure that is not aligned with shareholder interests. The Reporting Persons note, according to the Issuer's 2013 Proxy Statement, the only financial target included in the Issuer's long-term incentive compensation plan is current-year revenue. While organic revenue growth is a critical driver of the Company's valuation, the Reporting Persons believe the Issuer's incentive compensation targets should be revised to also include metrics that are more closely associated with shareholder value creation, such as EBITDA, free cash flow ("FCF"), return on invested capital ("ROIC"), and total shareholder return. Additionally, the Reporting Persons believe the targets used to determine both short- and long-term incentive compensation should be based on the Issuer's multi-year business plan. Consequently, the Reporting Persons have proposed the Issuer revise its incentive compensation plan to tie the vesting of long-term performance-based equity awards to the achievement of the Issuer's LRP targets, which include annual sales growth of approximately 13-15% from 2012-2017, $200 million of EBITDA, and $120 million of FCF in 2017. The Reporting Persons believe the achievement of these targets would materially increase the Issuer's share price.

The Reporting Persons have had discussions with the Issuer's Chief Executive Officer and independent Chairman on this topic. During these discussions, the Reporting Persons expressed their belief that the above changes would add much needed credibility to the LRP and, further, would address many of the concerns cited by Institutional Shareholder Services ("ISS") in its recommendation to vote against Proposal 6 at the Issuer's 2013 Annual Meeting. The Reporting Persons believe that the Issuer's management and Board will be receptive to changes that will better align the interests of management and the Issuer's shareholders. The Reporting Persons expect to continue this dialogue and extend this discussion to additional members of the Issuer's Compensation Committee.

Enhancing Value Through Disciplined Capital Allocation: Opportunity for $200m Share Repurchase

The Reporting Persons believe thoughtful capital allocation is an important component of equity value creation given the Issuer's significant cash balance and growing free cash flow. The Reporting Persons believe the significant underperformance in the Issuer's shares since the completion of the convertible debt raise on December 3, 2012 is attributable, in part, to investor concerns regarding the Issuer's capital allocation discipline. Specifically, the Reporting Persons believe investors are concerned that:

  1. The Issuer may pursue one or more large, dilutive acquisitions,
  2. Management has not communicated a rigorous capital allocation framework with which to evaluate the risk-adjusted returns of any potential acquisition or other deployment of capital, and
  3. The convertible debt raise and subsequent pursuit of sizable acquisition targets reflects management's lack of confidence in the growth prospects of the Issuer's core IVUS and FFR franchises.

After having had the opportunity to discuss these shareholder concerns with management and the Board, the Reporting Persons believe that such shareholder concerns may be misplaced. Following such discussions, the Reporting Persons are optimistic that management and the Board have a disciplined approach to capital deployment, (ii) understand the relationship between ROIC and value creation, are looking to focus on bolt-on acquisitions, (iv) are open to returning capital to shareholders, and are confident in the organic growth outlook for the core business. Accordingly, the Reporting Persons believe a more clearly articulated set of investor communications that reflect management's commitment to deploy capital to the highest risk-adjusted alternative, a preference for low-risk, bolt-on acquisitions, and confidence in the Issuer's core business prospects, will ease such understandable investor anxieties.

Importantly, the Reporting Persons have discussed with the Issuer's management team and independent Chairman additional, potential actions that the Issuer can take to create value for shareholders and further alleviate investor concerns. The Reporting Persons have suggested the Issuer repurchase $200 million of its shares to the extent the Issuer's stock remains undervalued. The Reporting Persons believe that this action would eliminate concerns regarding a large acquisition, show evidence of a disciplined capital allocation process, and objectively demonstrate management's confidence in the achievability of its LRP. Given the significant discount that exists between the Issuer's current share price and value of the Issuer's LRP, the Reporting Persons believe that such a substantial share repurchase would represent an attractive investment even if the Issuer's actual results were to fall short of the LRP's 2017 revenue, EBITDA, and FCF targets.

Highly Synergistic, Attractive Acquisition Target

The Reporting Persons believe the Issuer would be an attractive acquisition target for many large medical device companies, who, as acquirers, would be able to realize revenue and cost synergies that justify paying a significant premium to the Issuer's current share price. Notably, the Reporting Persons believe the Issuer's general and administrative ("G&A") expenses are approximately 20% of its current revenue base. A substantial portion of this expense would be eliminated if the Issuer were to be acquired by a large medical device company. Further, the Reporting Persons believe this is well understood by both the Issuer and potential suitors. The Reporting Persons believe that the Issuer may have been approached by potential acquirers on several occasions since the Issuer's IPO in 2006. Given the Reporting Persons belief that the Issuer's shares are currently undervalued, the Reporting Persons do not believe it is in the best interest of shareholders for the Issuer to pursue a sale of the Company at this time. However, the Reporting Persons do believe that, given the potential for sizable synergies that the Issuer would be unable to realize as an independent entity, an eventual sale of the business is likely and would represent the optimal outcome for shareholders. The potential to sell the business also mitigates downside risk in the event operating results disappoint, as the Reporting Persons believe the sizable cost synergies available in a transaction would be present under virtually any scenario.

The Reporting Persons do not have any present plan or proposal which would relate to or result in any of the matters set forth in subparagraphs - (j) of Item 4 of Schedule 13D except as set forth herein or such as would occur upon or in connection with completion of, or following, any of the actions discussed herein. The Reporting Persons intend to review their investment in the Issuer on a continuing basis. Depending on various factors including, without limitation, the Issuer's financial position and investment strategy, the price levels of the Shares, conditions in the securities markets and general economic and industry conditions, the Reporting Persons may in the future take such actions with respect to their investment in the Issuer as they deem appropriate including, without limitation, continuing to engage in communications with management and the Board of the Issuer, engaging in discussions with stockholders of the Issuer and others about the Issuer and the Reporting Persons' investment, making proposals to the Issuer concerning changes to the capitalization, capital allocation, communications with investors, ownership structure, board structure (including board composition) or operations of the Issuer, board representation, purchasing additional Shares, selling some or all of their Shares, engaging in short selling of or any hedging or similar transaction with respect to the Shares, or changing their intention with respect to any and all matters referred to in Item 4.

Shares of VOLC are +7.4% today.

Source: Volcano Corp.: "An Attractive Investment Opportunity"