volc 2011-0907initiation ben's edit - feltl and company · one of the only players in...

Healthcare- Diagnostic Imaging September 7, 2011

Please see important disclosures on pages 17 to 19.

Rev(mil) 2010A 2011E 2012E

Mar $66.6A $81.0A $94.0E June $73.5A $84.0A $103.4E Sep $72.9A $87.8E $106.4E Dec $81.2A $95.3E $113.7E

FY $294.1A $348.1E $417.5E P/Sales 5.1x 4.3x 3.6x

EPS 2010A 2011E 2012E

Mar ($0.08)A $0.02A $0.08E June $0.10A $0.09A $0.11E Sep $0.10A $0.05E $0.11E Dec ($0.03)A $0.07E $0.13E

FY $0.10A $0.23E $0.43E P/E 282.5x 122.8x 65.7x

Price: $28.2552-Week Range: $33.90 -$22.25Target: $37.05Rating: STRONG BUY

Shares Outstanding: 52.5 milMkt. Capitalization: $1,506 milAve. Volume: 600,000Instit. Ownership: 92%BV / Share: $5.67Debt / Tot. Cap.: 31%Est. LT EPS Growth: 30%

Feltl and Company Research Department 2100 LaSalle Plaza

800 LaSalle Avenue Minneapolis, MN 55402

1.866.655.3431 Ben Haynor, CFA

[email protected] | 612.492.8872

Company Description: Volcano Corporation develops and manufactures a number of intravascular ultrasound (IVUS) and functional measurement (FM) products for use in the diagnosis and treatment of vascular heart disease. The company sells its products worldwide for use by physicians and technicians who perform percutaneous coronary intervention (PCI) procedures.

Volcano Corporation

Race to the top, Volcano winning; initiating with STRONG BUY $37.05 PT (VOLC - $28.25) STRONG BUY

Key Points

Financial Summary

Rapidly growing, under-penetrated markets nearing adoption-accelerating inflection points.

Growing “Functional PCI” mindset driving adoption of Volcano’s products.

Widespread reimbursement still missing in the US, but Japanese experience points to massive penetration opportunity.

New product launches in the next few years will enable Volcano to address market opportunities totaling $3 billion annually, up from ~$700 million currently.

Dominant position in intravascular imaging makes Volcano an attractive acquisition candidate.

Initiating with STRONG BUY rating and $37.05 price target (4.5x FY2012 medical EV/sales plus Axsun industrial segment valued at acquisition price).

Volcano competes in rapidly growing, under-penetrated markets nearing inflection points. The IVUS (intravascular ultrasound) and FM (functional measurement) markets are growing at 12% and 25%, respectively. Both markets are still early in their growth curves – five of six markets Volcano competes in are less than 20% penetrated. The US IVUS and FM markets are both near the critical 16% penetration level – the inflection point where the early majority of adopters begins to use medical devices. Past examples, such as insulin pumps, show ~150% increases in volume over the three years after reaching the inflection level. “Functional PCI” concept driving adoption and, potentially, positive US reimbursement decisions. The “functional PCI” concept, using FM to make the treat-or-not-treat assessment and IVUS to guide the procedure in a percutaneous coronary intervention, is gaining traction. Studies show that the functional PCI methodology improves both patient outcomes and saves money, the “sweet spot” when it comes to gaining positive reimbursement decisions. Japan currently has reimbursement for IVUS and it is used in 75-85% of PCI procedures there. Should Volcano see positive reimbursement decisions for IVUS in the US, it has the potential to increase penetration fivefold. Volcano “owns” intravascular imaging (IVI), making the company an attractive acquisition candidate. The company holds leading market shares in both IVUS and FM and continues to take share from larger competitors. The company continues to assert its dominance, planning on launching seven new product lines over the next several years (from three currently) addressing markets totaling $3 billion (up from ~$700 million at present). Our analysis of acquisitions of companies holding solid market shares in rapidly growing sectors shows that private-market valuation multiples are 6-7x forward EV/sales.

September 7, 2011 rops Strong, Pricing Weak, Farm Profits Could Suffer

Feltl and Company Research Department Volcano Corporation (VOLC)

INVESTMENT THESIS We believe that Volcano’s multi-modality platform will enable them to become the de facto standard in the cath lab. Being one of the only players in precision-guided therapy to have a multi-modality console enables Volcano to continually take market share in their current markets (IVUS and FFR). New product introductions will likely lead the company to additional share gains. Further, we think that their large installed base and “enabling platform” approach makes the company an attractive acquisition candidate. We feel that such an asset deserves a premium multiple, but we have chosen to take a conservative approach and have set our $37.05 price target based upon sum-of-the-parts methodology incorporating a forward EV/sales multiple of 4.5x on their medical business plus the purchase price of their industrial segment. Therefore, we believe that Volcano is undervalued at present levels and have assigned the company a STRONG BUY rating. Opportunities Rapidly growing, under-penetrated markets. Of the major markets (US, Europe, and Japan) Volcano sells its current IVUS and FFR products into, half have single-digit penetration rates and only the Japanese IVUS market is near full penetration. In Japan, IVUS is fully reimbursed and should the US and Europe reached similar penetration rates upon positive reimbursement decisions, Volcano’s annual revenues would reach nearly $900 million. We estimate the IVUS market is growing at a low-teens rate and the FFR market to be growing at over 25%. Changes in reimbursement policies likely to increase usage. Currently, intravascular imaging and functional measurement are not well reimbursed by payors in the US despite an increasing number of clinical studies supporting their usage. However, certain carriers, notably Cigna, have begun reimbursing for IVUS under certain circumstances. Positive coverage decisions by other carriers would provide a boost to Volcano. Additionally, CMS is considering extending the readmission window to 90 days from 30 days whereby hospitals would face reimbursement penalties if they see higher than expected readmissions after certain procedures starting October 2012. Given that studies have shown lower readmissions when utilizing fractional flow reserve (FFR) and IVUS, we would expect hospitals to adopt these technologies in order to minimize readmissions (and the risk of a reimbursement reduction). “Functional PCI” procedure adoption. Utilization of “functional PCI”, using FFR to make the treat-or-not-treat decision and IVUS to guide stent placement, procedures has gained prominence over the past several years thanks to a number of clinical studies. We believe that functional PCI will eventually become the standard of care in the US and that changes in reimbursement will drive adoption. Multi-modality platform. Volcano’s s5 platform allows not only integration, but is the only console to do both FFR and IVUS. As the company continues to add new modalities, such as optical coherence tomography (OCT), the ability to house them all on a single platform should provide selling benefits (cath labs prefer fewer consoles). Volcano has been winning the “land grab”, adding 83% of IVUS installs versus Boston Scientific over the past two years and 78% of FFR installs versus St. Jude Medical over the past year. US IVUS adoption near inflection point. IVUS penetration in U.S. PCI procedures stands at approximately 16%, precisely the level where adoption accelerates as the “early majority” begins utilizing the technology. Costa Rica facility. Volcano has nearly completed the manufacturing facility in Costa Rica. Once complete and production begins, we believe they will see significant gross margin expansion (by ~5%) over the next several years and take advantage of lower tax rates. New products. Over the next two years, Volcano plans on launching a number of new products, including optical coherence tomography (OCT) catheters and system, additional VIBE products (Volcano’s balloon/IVUS entry into the ~$1.25 billion worldwide balloon market), FL.IVUS (forward-looking IVUS) catheters and system, and next generation versions of its current products. While these products may not immediately assert a meaningful contribution to the top line, we believe the stable of products launching in the near future will provide incremental growth for Volcano over and above the company’s stated 18-20% growth rate goal in the medical business. Risks FDA timeline slippage. The FDA approval process has been a difficult hurdle for many medical device firms to clear in the recent past, with many firms seeing their intended approval timelines pushed back, some for substantial amounts of time.



We believe Volcano will have an easier time than many in getting its new products through the FDA, however we also believe that timeline slippage is almost inevitable in the current FDA approval environment. Pending competition. A number of companies are developing intravascular imaging technologies that tout superior performance to Volcano’s currently marketed products. We believe a number of these will see market launch, including InfraReDx and SVMI’s coming IVUS products. However, we doubt that these companies will make a significant dent in Volcano’s sales thanks to the company’s large installed base. We do caution, though, that should one of these pending competitors be acquired by a “big iron” firm, such as GE, Philips, or Siemens, and their products integrated into their cath lab installs, Volcano may have a more difficult time competing. Single-source suppliers for some components. Volcano has a number of components that it currently purchases from single-source suppliers. The company has attempted to mitigate this risk over the past several years and has been successful in doing so. But, at present, the risk remains that the company could suffer supply constraints before it is able to find alternate sources for such single-sourced components. OCT legal risk and expenses. Volcano is currently engaged in litigation with St. Jude Medical (STJ – not rated) over the light source used in its upcoming OCT (optical coherence tomography) product. While the company believes that its HDSS (high definition swept source) does not violate St. Jude’s intellectual property rights and does have alternative light sources ready in the event of a courtroom loss, Volcano will likely be forced to spend $15-20 million in 2011-2012 to reach resolution. Axsun revenue volatility and lower gross margin. Revenues from Volcano’s Axsun industrial subsidiary can be volatile and carry a lower gross margin. This combination has the potential to create a double-edged sword perception issue. If Axsun revenues unexpectedly fall off and the company misses revenue estimates, the Street may view their performance negatively. Similarly, if the company beats revenue expectations due to the Axsun business performing well, it is likely to create lower-than-expected gross margin, which also has the potential to be perceived negatively. Street expectations. Volcano has exceeded consensus revenue estimates for 21 consecutive quarters, every quarter since their IPO. Should they fail to continue this impressive performance, they run the risk of being viewed as a “busted” growth story and see a lower multiple assigned to the stock. Thoughts on Valuation We believe Volcano occupies a relatively unique position within the medical technology area. The company has been consistently achieving revenue growth figures of 20%+ while competing with two much larger enterprises, St. Jude Medical and Boston Scientific. Granted, the market in which Volcano operates has been growing quickly, but the company has consistently taken share. In addition, in five of the six large markets in which the company competes, the tipping point of adoption (as seen in the graphic below) has not yet been reached; the markets have not yet seen their accelerating adoption phase. As such, we view Volcano as an attractive acquisition candidate that is deserving of a premium multiple, relative to other fast-growing medical technology companies.

The list of transactions in the table below represent acquisitions of companies that we feel occupied a similar market position as Volcano does in fast-growing market segments. Based upon these transactions, we believe Volcano would



deserve a 6-7x forward EV/sales multiple in an acquisition scenario. To set our price target, we have chosen to use a multiple of 4.5x forward EV/sales, or the midpoint of our acquisition multiple range less 2x to account for the non-control position that public investors hold. This would imply a 44% takeover premium from our valuation multiple to our estimated private-market valuation, which seems roughly inline with takeover premiums in the medical device arena. However, we believe it is only fair to assign this multiple to the medical portions of Volcano’s business, not the industrial segment.

Fast-Growing, Large Market Share Med Tech Acquisitions

Target Acquiror Closed EV Growth Rate TTM NTMSofamor Danek Group, Inc. (private) Medtronic (MDT) January 1999 3,300.0$ 30% 331.6$ A 400.0$ E 10.0 8.3

Advanced Neuromodulation Systems (ANSI) St. Jude Medical (STJ) November 2005 1,353.9$ 20% 142.7$ A 178.4$ E 9.5 7.6

TriPath Imaging (TPTH) Becton Dickinson (BDX) September 2006 350.0$ 20% 98.4$ A 118.0$ E 3.6 3.0

Digene (DIGN) QIAGEN N.V. (QGEN) July 2007 1,500.0$ 30% 159.7$ A 207.6$ E 9.4 7.2

FoxHollow (FOXH) ev3 (EVVV) October 2007 791.4$ 15% 198.1$ A 200.0$ E 4.0 4.0

Kyphon (KYPH) Medtronic (MDT) November 2007 4,200.0$ 20% 529.6$ A 600.0$ E 7.9 7.0

Ventana Medical Systems (VMSI) Roche Holdings (RHHBY) April 2008 3,400.0$ 20% 290.0$ E 348.0$ E 11.7 9.8

LifeCell Corporation (LIFC) Kinetic Concepts (KCI) May 2008 1,700.0$ 25% 202.5$ A 241.8$ E 8.4 7.0

Endologix (ELGX) Elliott Associates November 2008 93.6$ 40% 37.6$ A 52.4$ A 2.5 1.8

Radi Medical Systems AB (private) St. Jude Medical (STJ) December 2008 250.0$ 20% 80.0$ E 95.2$ E 3.1 2.6

ev3 (EVVV) Covidien (COV) July 2010 2,528.0$ 15% 472.5$ A 543.4$ E 5.4 4.7

Micrus Endovascular (MEND) Johnson & Johnson (JNJ) September 2010 480.0$ 15% 94.5$ A 105.0$ E 5.1 4.6

AGA Medical (AGAM) St. Jude Medical (STJ) November 2010 1,300.0$ 20% 209.7$ A 237.8$ E 6.2 5.5

Average $ 1,762.8 21% $ 234.1 $ 272.9 7.0 5.9 Median $ 1,427.0 20% $ 200.3 $ 222.7 7.1 6.2

Sales EV/Sales

LifeCell's AlloDerm was the first commercially available processed allograft dermal skin tissue used in skin grafts, hernia repairs, breast reconstructions and other applications. At the time of the acquisition it is estimated that LifeCell held 25% of the complex hernia repair and breast reconstruction markets.

TTM NTM

Medtronic's Kyphon acquisition came at a time when Medtronic had seen its market share in the $4 billion spinal market slip from 48% to 40%, largely at the hands of start-up spinal device companies. Kyphon was the leader in kyphoplasty and had the first approved minimally invasive device for the treatment of lumbar spinal stenosis, a potential $2 billion worldwide market. Medtronic struggled to integrate Kyphon and the deal was seen as somewhat of a disappointment a year and a half later.

Radi Medical Systems was the world leader in physiological assessment of coronary lesions (FFR) and manual compression-assist productsfor vascular closure at the time of acquisition. Radi's PressureWire Certus held a 70% market share in the $60 million FFR market growing at a strong double-digit rate. Their FemoStop and RadiStop closure product lines held a 60% share in a $45 million market growing at a mid-single digit rate. At the time, St. Jude estimated that the vascular closure market was ~27% penetrated.

Digene was the leader in HPV molecular diagnostics testing with the only FDA approved test. The HPV test market was estimated to be approximately $1 billion. They also had a leading presence in emerging cancer molecular diagnostics market in comparison to Qiagen's limited presence.

* Failed acquisition of Endologix not included in average or median numbers.

Endologix rejected Elliott Associates' takeover attempt, which came shortly after Endologix had secured two FDA approvals. Endologix produces a one-piece minimally invasive abdominal aortic aneurysm (AAA) treatment. At the time, many large medical device developers had experienced product failures in the same treatment area, including Boston Scientific, Johnson and Johnson, Edwards Lifesciences and Guidant. Endologix currently trades at an EV/Sales (ttm) of 4.4.

AGA Medical was the leading manufacturer and distributor of minimally invasive catheter-delivered devices for the repair of structural heart defects and vascular abnormalities at the time of acquisition. The acquisition gave St. Jude the leading position in four new cardiovascular markets.

The Sofamor Danek acquisition is considered one of Medtronic's most successful. Sofamor had over half of the $850 million spinal techologies market producing products to treat a variety of disorders of the spine and cranium.

Advanced Neuromodulation Systems (ANS) held a strong second in the $1 billion neuromodulation market which was growing at over 20% per year when acquired by St. Jude.

TriPaths' FocalPoint system was the only FDA-approved device for the automated primary screening of thin-layer and conventional Pap smear slides for cervical cancer screening. TriPath held ~20% of the cytology market with Cytyc being the market share leader. TriPath also had a relationship with Becton Dickinson at the time for genomic and proteomic-based assays for cancer screening.

Ventana was the leader in tissue-based diagnostics with a 40% market share in the advanced staining segment with a large pathology lab installed base in the US.

Johnson & Johnson announced its acquisition of Micrus Endovascular shortly after Covidien announced its acquisition of ev3. The acquisition came a year after J&J created a new business division, Codman Neurovascular, to target stroke-related problems in the brain. Micrus had been gaining share against Boston Scientific in the $500 million neurovascular coils market.

FoxHollow's SilverHawk plaque excision device pioneered the peripheral atherectomy market and was far and away the market leader at the time of acquisition. FoxHollow pushed sales hard in 2007 prior to several competitors' entrances in 2008, including Cardiovascular Systems, Pathways Medical, and Spectranetics. The 2008 peripheral atherectomy market was estimated at $230 million.

Covidien's announcement of their acquisition of ev3 came shortly before J&J announced their acquisition of Micrus Endovascular. Ev3 held the #2 position in the broadly defined $2 billion endovascular market.

The table below details past transactions in the intravascular imaging and functional measurement space. While we find the history of this industry interesting, the smaller size of the respective firms at time of acquisition makes it difficult to draw conclusions as to appropriate valuation metrics. To assign a multiple to the Axsun industrial portion of the company’s business, we have looked to Volcano’s acquisition of the company two years prior and assigned the value paid by Volcano in the transaction as the segment’s current worth ($23.8 million).

Intravascular Imaging and Functional Measurement Transactions Target Acquiror Closed EV Growth Rate TTM NTMCardiovascular Imaging Systems (CVIS) Boston Scientific (BSX) March 1995 82.0$ 25% 10.0$ A 12.5$ E 8.2 6.6

EndoSonics (ESON) Jomed August 2000 205.0$ 5% 48.2$ A 52.6$ E 4.3 3.9

Jomed (IVUS and FFR assets) Volcano Corporation (VOLC) July 2003 38.5$ 30% 47.0$ E 61.0$ A 0.8 0.6

EP Medsystems, Inc. (EPMD) St. Jude Medical (STJ) April 2008 95.7$ 25% 19.9$ E 24.9$ E 4.8 3.8

Radi Medical Systems AB (private) St. Jude Medical (STJ) December 2008 250.0$ 20% 80.0$ E 95.2$ E 3.1 2.6

Axsun Technologies (private) Volcano Corporation (VOLC) January 2009 23.8$ -5% 17.1$ E 16.2$ A 1.4 1.5

LightLab (private) St. Jude Medical (STJ) July 2010 90.0$ 25% 35.0$ E 43.8$ E 2.6 2.1 Axsun manufactures optical engines and lasers used in OCT technology and other industrial applications. Volcano purchased Axsun to accelerate their OCT development program.

LightLab was the only manufacturer to have an OCT product on the market at the time of the acquisition. St. Jude intended to combine the FFR technology it originally acquired in the Radi Medical Systems transaction with LightLab's OCT technology.

EV/SalesSales

Radi Medical Systems was the world leader in physiological assessment of coronary lesions (FFR) and manual compression-assist productsfor vascular closure at the time of acquisition. Radi's PressureWire Certus held a 70% market share in the $60 million FFR market growing at a strong double-digit rate. Their FemoStop and RadiStop closure product lines held a 60% share in a $45 million market growing at a mid-single digit rate. At the time, St. Jude estimated that the vascular closure market was ~27% penetrated.

EndoSonics controlled roughly 33% of $150 million cardiovascular diagnostic imaging (IVUS) market at the time of acquisition.

Boston Scientific had some anti-trust issues with this merger in the nascent days of IVUS. Upon completion of the merger, Boston Scientific controlled 75-80% of the $25-30 million cardiovascular diagnostic imaging (IVUS) market at the time with EndoSonics controlling the balance.

Volcano purchased the IVUS and FFR assets (essentially EndoSonics) from Jomed after Jomed was declared bankrupt in May 2003 to complement their internally developed virtual histology (VH) technology.

TTM NTM

EP Medsystems developed two intracardiac ultrasound echocardiography (ICE) catheters, one of which was scheduled for release in Q2 2008 when St. Jude made the acquisition. St. Jude utilized the acquisition to accelerate its entry into the fast-growing ICE and atrial fibrillation market (estimated at 25-30% at the time).

As a “gut check” on our derivation of an appropriate multiple for Volcano, we took a look at publicly traded med tech companies with mid- to high-teens growth rates and large market shares in their respective segments (shown in table below). If one looks at only the companies below that have a growth rate greater than 15%, the average EV/Sales multiple



on next year’s sales is ~4.6x. VOLC also trades below the mean and median EV/Sales multiple of the group below, despite being a faster-growing company. Therefore, we believe our 4.5x 2012 EV/sales multiple for Volcano is deserved.

Fast-Growing Publicly-Traded Med Tech Companies

Ticker EV TY NY Growth TY NY TY NY TY NYISRG 13,820 8.1 7.0 17% 1,701$ 1,986$ 19.5 16.7 32.9 27.8 EW 8,118 4.8 4.0 19% 1,702$ 2,033$ 21.1 15.6 35.7 26.3 THOR 1,605 3.7 3.5 7% 429$ 460$ 10.6 10.6 21.2 19.9 MASI 1,263 2.8 2.5 14% 450$ 513$ 12.0 9.6 19.8 16.3 NUVA 903 1.7 1.5 12% 536$ 600$ 7.4 6.7 19.4 16.8 NXTM 910 4.2 3.7 14% 214$ 245$ 112.6 37.0 NM NMTRNX 800 3.0 2.7 13% 263$ 298$ 34.8 19.2 NM 158.8 LMNX 930 5.1 4.3 17% 183$ 214$ 24.8 18.1 60.7 39.9 VIVO 729 4.5 3.9 15% 161$ 185$ 15.0 12.1 25.4 20.8 CYBX 683 3.2 2.8 13% 216$ 244$ 11.4 8.8 23.1 18.7 ABAX 475 3.0 2.6 16% 157$ 182$ 17.4 13.9 39.9 26.4

Mean 4.0 3.5 14% 26.0 15.3 30.9 37.2 Median 3.7 3.5 14% 17.4 13.9 25.4 23.5

VOLC 1,369 3.9 3.3 20% 347$ 414$ 31.2 20.3 130.8 64.0

EV/Sales Sales EV/EBITDA P/E

Based upon the above discussion we have set our price target for Volcano at $37.05 – the quantity of $400.6 million in medical sales multiplied by our 4.5x EV/sales multiple plus our assumed $23.8 million valuation for the Axsun industrial business and net cash of $112.3, divided by 52.3 million shares outstanding. Our target corresponds to 20.8x 2012 EV/EBITDA (pro forma), a discount to VOLC’s average quarterly high EV/EBITDA of 22.0 over the past eight quarters. Volcano’s average quarterly low EV/EBITDA multiple has been 16.3x over the same time period. At current prices, Volcano is trading in the lower third of its historical EV/EBITDA range (shown below). For reference sake, had we chosen the average quarterly high pro forma EV/EBITDA as our multiple when setting our price target, our price target would be $38.90 based on our 2012 pro forma EV/EBITDA estimates.

Pro Forma EV/EBITDA (ntm)

0.05.0

10.015.020.025.030.035.040.045.0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2007 2008 2009 2010 2011

High Low Current

Avg. High EV/EBITDA Avg. Low EV/EBITDA

Note: Historical pro forma EV/EBITDA values over 40 have been clipped at 40 for sake of chart readability. Key Model Assumptions We have attempted to take a base approach to modeling Volcano’s growth. Our model does not assume revenues from new product introductions. Further assumptions, with notes, are as follows:

• Assumed the company will place 200 new consoles per quarter, versus an average of 234 per quarter over the past two years and low quarterly placement level of 199 over the same time period.



• Modeled blended increases in IVUS penetration in the US, EU, and Japan of ~50bps per year and blended increases in FFR penetration by ~150bps per year in the same countries/regions. These model estimates are below the yearly growth rates experienced by each modality in the recent past.

• Assumed ASPs on consoles and catheters remain constant, although the company has been successful in increasing prices over the past several years and has higher-priced products entering the market soon.

• Assumed 26.5% tax rate for 2011 versus 26-27% guidance range. • Modeled $14.2 million for 2011 Axsun industrial revenues verus management’s guidance of $14-15 million on the

Q2 2011 call. • Estimated legal expenses of $5.5 million, split evenly between Q3 and Q4 2011, for the second half of this year

versus the company’s initial expectation of $7 million for the year. The company has already spent $4.5 million in the first half on the St. Jude lawsuit. Additionally, we have modeled $8 million in legal expenses in 2012.

“Functional PCI” – What is it and Why Does it Matter? Functional PCI Overview The term “functional PCI” has entered the medical lexicon relatively recently. Generally, the term refers to utilizing fractional flow reserve (FFR) technology to make the treat-or-not-treat decision then using FFR, IVUS, or OCR to guide stent placement decisions in a percutaneous coronary intervention (PCI) procedure. Physicians have traditionally used angiography to guide both decisions. However, angiography can be open to interpretation and depending on the judgment of the angiographer and which frame is picked a lesion could be categorized as having anywhere from 20% to 70% stenosis (or narrowing of a blood vessel). Thus, an angiographer could be biased to treat for safety’s sake in a situation where treatment may be unnecessary which may actually increase risks. The FAME study of 2009 focused on comparing FFR and angiography’s effectiveness when it came to placement of drug-eluting stents (DES) in patients with multi-vessel coronary artery disease. The results of the study showed that FFR improved patient outcomes in terms of death, heart attack, and repeat revascularization. Overall, FFR reduced the incidence of all types of adverse events by ~30%. The chart shown below depicts the relative performance of the two strategies over time in terms of major adverse cardiac events (MACE). In terms of economics, the FFR-guided strategy took the same amount of time to complete each procedure, used almost 30% fewer stents, and reduced the amount of contrast agent used by ~10%, resulting in material cost savings of $675 per procedure on average (11.2% savings).

Source: FAME data, 2009 TCT presentation by William F. Fearon, Pim A.L. Tonino, Bernard De Bruyne, Uwe Siebert and Nico H.J. Pijls.

Why Functional PCI Matters Clearly, functional PCI improves patient outcomes and saves money. As a result, the ACC, AHA, SCAI, and ESC all have guidelines supporting the use of FFR and rank the evidence supporting FFR usage as “A” (the highest rating). Additionally, using FFR to determine the extent of ischemia results in more vessels being ruled out as being diseased (see chart below), making it more likely that the treatment procedure will be of the PCI variety and not a coronary artery bypass graft (CABG). This benefits patients and physicians; patients benefit in that they have a less-invasive, less-risky procedure with a quicker recovery time, while physicians benefit in that they are able to do the PCI procedure themselves instead of being forced to refer the patient to a CABG specialist. Despite all the clinical and economic evidence, FFR is still in the early stages of its



adoption curve; in 2010, only 9% of PCI procedures used FFR in the US and it was used in even fewer procedures in other regions (5% Europe, 3% Japan).

Source: Company presentation.

Despite the relatively low current utilization, at least two additional catalysts exist beyond the economical and medical benefits already mentioned. First, “over-stenting” has come under much greater scrutiny recently, most notably gaining attention in the Abbott stenting scandal of late 2010, after several years in the background following the high-profile 2002 Tenet Healthcare case where the company paid out $485 million to settle their over-stenting case (as featured in “Coronary” by Stephen Klaidman). This has instilled a need to justify stent placement in the minds of many cardiologists who fear that they may be the subject of a lawsuit. Second, in May 2011, the Centers for Medicare and Medicaid Studies (CMS) published a draft proposal on readmission reimbursement changes scheduled to take place in October 2012. In their proposal, CMS proposes penalizing hospitals that have higher than expected readmission rates and singles out acute myocardial infarction and heart failure as “applicable conditions” for which the readmission rate will be tracked. CMS proposes tracking readmission rates over 90 days post-discharge. The graph above shows strong improvement in MACE for FFR versus angiography at 90 days and provides a powerful incentive for physicians and hospitals to adopt FFR in order to minimize adverse events that may require readmission and damage their reimbursement, potentially losing up to 3% of their regular Medicare payments. PCI Procedure Growth and IVI/FM Penetration Percutaneous coronary intervention (PCI) procedures have been relatively stagnant since the financial crisis, running at about 3.1 to 3.4 million procedures annually. Volumes in the US have been particularly flat over the past few years, but other regions have shown stronger performance with EMEA growing ~11%, Japan ~4%, and the rest of the world growing over 25% year-over-year in 2010. Based upon current run rates, we estimate that volumes in the US and Europe will be flat year-over-year and Japan volumes will be up in the low-single digits in the second half this year. The chart below shows the breakdown of PCIs by country/region in 2010.



Percutaneous Coronary Interventions by Region 2010 (3.4 million procedures)

US30%

EMEA40%

Japan7%

Americas7%

Asia Pacific

16%

US EMEA Japan Americas Asia Pacific

Source: Company filings, Feltl and Company estimates. In contrast to PCI procedures, which are not growing rapidly in developed countries, the penetration rate of intravascular imaging (IVI) and functional measurement (FM) is growing quickly and only IVUS in Japan is close to full penetration. As can be seen in the chart below, half of the geographies (comprising 77% of all PCIs in 2010) featured have penetration rates for the various modality in the single digits. Based upon the standard market adoption curve (as featured in the “Thoughts on Valuation” section earlier), we estimate that once a ~16% penetration rate is achieved, it is rare not to see adoption accelerate. Fortunately for Volcano, IVUS penetration has reached that 16% threshold in the US recently, and we believe over the coming years that adoption will begin to accelerate.

IVUS and FFR Penetration Rate by Country/Region (2011)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

US EU Japan

FFR IVUS

Source: Company filings, Feltl and Company estimates.

The graph below shows the type of penetration rate increase a market can see once the tipping point is reached. Anecdotal evidence suggests that for medical advances targeted to the diabetes treatment market the tipping point happens sooner (somewhere between 8% and 10%) than in other markets. Nonetheless, the acceleration that occurs once that point is



reached can be clearly seen in the chart; prior to 1999, penetration had increased from 4% to 8%, and by 2002, penetration increased by 150% from the time the tipping point was triggered.

Penetration Rate of Insulin Pumps Amongst Type 1 Diabetics in the US 1996-2002

0%

5%

10%

15%

20%

25%

1996 1997 1998 1999 2000 2001 2002

Source: Various company filings, Feltl and Company estimates.

Company Overview Volcano’s core business develops, manufactures and sells intravascular imaging (IVI) and functional measurement (FM) consoles and disposable catheters. The company also has an industrial segment, known as Axsun Technologies, Inc., selling micro-optical spectrometers and optical channel monitors to telecommunications companies and accounting for less than 10% of revenues. Volcano’s main competitors are Boston Scientific (BSX – not rated) in intravascular ultrasound (IVUS) and St. Jude Medical (STJ – not rated) in FM. In fact, each market is effectively a duopoly if one excludes Terumo in the Japanese IVUS market. In addition, there are several private firms developing IVUS and OCT systems, including InfraReDx and Silicon Valley Medical Instruments (SVMI). The company sells its products direct and through distributors worldwide, with 46% of its sales coming in the US, 27% in Japan, and 20% in EMEA in 2010. Additionally, Volcano has marketing agreements with a number of companies including Medtronic (MDT – not rated), General Electric (GE – not rated), Johnson & Johnson (JNJ – not rated) and Philips (PHG – not rated). These agreements help coordinate marketing efforts while still being able to speak directly with the customer. Covidien (COV – not rated) recently signed an agreement with Volcano to integrate ev3’s plaque excision systems with Volcano’s IVUS “eyeballs”. We believe the company will continue to leverage its technology and platform in this fashion by entering into further image-guided-therapy-related OEM agreements with other firms. Volcano is headquartered in San Diego, California and is currently constructing a manufacturing facility in Costa Rica. This facility is on track to begin production in the first half of 2012. Management believes that this facility will allow the company to expand its gross margin by 2013 and take advantage of a lower tax rate. Product Overview Volcano’s products currently serve the $650-700 million worldwide market for intravascular imaging and precision-guided therapies. The company has a large installed base, with over 6,300 consoles placed worldwide, 4,000 of which are multi-modality (able to be used for more than one catheter or measurement type). Management envisions their three present product lines growing to ten in a variety of applications (new applications shown circled in blue in the graphic below), which



would give them access to market opportunities of approximately $3 billion. The subsections that follow describe their current and future products.


Current Products

Consoles We estimate that Volcano has approximately 4,000 multi-modality consoles, 900 FFR consoles, and 1,400 IVUS consoles placed as of the end of Q2 2011. Their s5 (shown below) and s5i (integrated version) consoles offer the ability to utilize both IVUS and FFR on the same platform. We estimate that integrated cath labs utilize between 20-30% more IVUS and FFR catheters than standalone consoles. The ability to offer multiple technologies on one platform sets Volcano apart from the competition and, as such, they have been able to win roughly 80% of all new installs over the past two years. Based on management commentary, we have the impression that Volcano will unveil additional functionality for the s5 platform, perhaps a major version software upgrade (to version 4.0 from 3.2.1), at the TCT conference in November 2011. Based on past releases, we speculate that this would include further streamlined FFR and IVUS workflows, support for future products (such as OCT, FL.IVUS, and FL.ICE), and a revised codebase geared toward “plug-and-play” functionality for third-party products operating on the s5 platform (such as the recent Covidien/ev3 agreement).



Source: Volcano sales literature.

Intravascular Ultrasound (IVUS) Volcano has the broadest IVUS product portfolio of any player in the industry, and this is reflected in its market share dominance (seen below). Last year the market amounted to $450 million worldwide, but is projected to reach $800 million by 2015 (12% CAGR). The company offers both digital (phased-array) and rotational IVUS catheters as well as varying frequencies, shaft sizes, lengths, guide wire compatibility, and distal tip lengths. In addition to the various technical specifications, their IVUS products incorporate value-added functionality on the console. Most notably, the company offers two proprietary technologies: ChromaFlo, which helps analyze stent placement by utilizing sequential IVUS frames to identify circulating blood, and VH IVUS which allows for categorization of plaque to stratify risk.


Functional Measurement (FM) Volcano offers a full line of pressure and flow guide wires, including a guide wire that can measure both pressure and flow. They launched the latest version of their pressure guide wire, the PrimeWire PRESTIGE in Q3 2010 and expect to introduce additional next generation FM wires in 2011. The fractional flow reserve market within functional measurement is growing very rapidly. In 2010, the total market represented $121 million worldwide, but the market is projected to grow to $300 million by 2015 (25% CAGR).

Future Products

Image-Guided Therapies (IGT)



With image-guided therapy, Volcano is attempting to capitalize on the trend of procedures to become more minimally invasive, or PCI-based. The company reasons that developing IGT products, including stents and balloons, will differentiate their products and expand the market. The company has gained CE Mark and Japanese regulatory approval for its VIBE RX catheter which includes a balloon and anticipates launching the product in the US next year. Optical Coherence Tomography (OCT) While many seem to think of OCT as a competing technology to IVUS due to its higher resolution, we believe that it will prove to be a complementary technology. Volcano had been in the process of developing an OCT system, but chose to acquire Axsun in 2008 to accelerate their development program. However, since the acquisition, it has run into legal issues with St. Jude Medical (STJ – not rated) and their LightLab acquisition. The case centers around a novel non-laser light source developed by its Axsun subsidiary known as high definition swept source (HDSS). The outcome of the litigation will determine the light source that Volcano uses in its OCT product, but the company believes it has alternatives to HDSS, but would prefer to use the HDSS light source as it promises to enable high resolution at speeds of 200kHz, which is unprecedented in the medical industry, approximately four to ten times faster than currently available OCT systems. Forward-Looking Intravascular Ultrasound (FL.IVUS) The FL.IVUS development program is based upon imaging technology gained in Volcano’s acquisition of Novelis. “Forward-looking” in this context means exactly what one would think, that it looks forward down a vessel as opposed to perpendicular to the catheter as in other intravascular imaging technologies. The company plans to commercialize two types of devices using this technology. The first application is planned to be used with interventional guide wires to cross lesions and the second pairs the technology with a radiofrequency (RF) ablation device to tunnel through lesions. The main target markets of FL.IVUS will be chronic total occlusions as well as other coronary, peripheral and structural heart applications. We believe that Volcano is the only company developing forward-looking intravascular imaging technologies at present. Forward-Looking Intracardiac Echocardiography (FL.ICE) Volcano’s FL.ICE technology came from the acquisition of FLUID Medical in 2010. The FL.ICE product will be focused on target markets of septal crossing and structural heart applications such as mitral valve replacement and repair, atrial fibrillation, and percutaneous LAA closure. Volcano views the potential FL.ICE market as over $530 million by 2015 assuming a $1,500 ASP and is targeting 2013 as a release date for its product. OEM Image-Guided Therapies The company announced an agreement with Covidien (COV – not rated) to provide their IVUS “eyeballs” for use on ev3’s plaque excision systems. Although the agreement had a number of milestones with regard to development, there were no payments associated with them. Volcano has indicated that the OEM arrangement will be on a cost-plus basis. The signing of OEM agreements such as this should solidify the Volcano platform’s dominance in the cath lab, akin to the way the Apple iPhone became such a force in the mobile phone market as a result of the AppStore; it becomes a self-perpetuating cycle whereby the platform that has the most “apps” generates greater sales and, in turn, more “apps”. Volcano has indicated that investors should expect at least a couple more OEM agreements in the next 12-18 months. While it is unlikely that these agreements will carry gross margin at the same level as Volcano’s disposable catheter sales, they should further entrench the Volcano platform in the cath lab, giving the company a solid competitive positing and make the company more attractive to potential suitors. These types of agreements will also require little in the way of operating expenses and may impact operating margin positively.



Image-Guided Therapy/Diagnostics Potential Applications


Ongoing Clinical Studies Volcano has a number of ongoing clinical studies seeking to validate use of the company’s products in various diagnostic and therapy settings. In most cases, the studies are post-marketing studies regarding effectiveness and treatment outcomes. The company has mentioned that it plans to present data on at least a couple of its studies in November 2011 at the Transcatheter Cardiovascular Therapeutics (TCT) Conference. Brief descriptions of several of Volcano’s ongoing studies (complete with clever acronyms for names) follow in the subsections below. VERDICT – Vascular Evaluation for Revascularization: Defining the Indications for Coronary Therapy VERDICT is designed to build on the PROSPECT trial and evaluate the correlation between FFR and VH IVUS in patients with intermediate coronary lesions. The company expects to complete enrollment in Q4 2011 and follow patients for three years afterwards. Volcano had expected to present data from VERDICT at the TCT 2011 conference, but we are unsure whether this will occur as the company had initially planned to complete enrollment by Q2 2011. FIRST – Fractional Flow Reserve and Intravascular Ultrasound Relationship Study The FIRST study’s objective is to evaluate the relationship between angiography, IVUS, VH, and FFR measurements. Management noted on the Q2 2011 call that they were very close to completing enrollment in the study. Volcano expects to present data from FIRST at the TCT 2011 conference. ADAPT-DES – Assessment of Dual Anti-Platelet Therapy with Drug-Eluting Stents ADAPT-DES consists of two studies; one designed to evaluate the frequency and timing of DES thrombosis that has over 9,000 patients enrolled and one to determine whether one or more IVUS parameters are independent predictors of stent thrombosis which has 1,900 patients enrolled. VOILA – Volcano OCT Image Lesion Analysis Using Intravascular Optical Coherence Tomography The VOILA study’s objective is to evaluate the efficacy of Volcano’s OCT system in the observation of coronary arteries. The company had expected enrollment to commence in Q2 2011, but no note of it was made on the latest earnings call (Q2 2011).



VIBE Study Volcano has begun a study to support their FDA regulatory submission of their VIBE catheter. Management noted they had received word that the first patient had enrolled on their Q2 2011 conference call. The study is expected to enroll around 275 patients in approximately 20 centers in the US and Europe. Management Scott Huennekens, President and Chief Executive Officer Scott Huennekens has served as President and Chief Executive Officer since April 2002. From January 2000 to March 2002, he served as the President and Chief Executive Officer of Digirad Corporation, a medical imaging company. Mr. Huennekens is a member of the Board of Directors for Volcano Corporation, the Medical Device Manufacturers Association (MDMA), and BIOCOM. He received a B.S. in Business Administration from the University of Southern California and an M.B.A. from Harvard Business School. John Dahldorf, Chief Financial Officer and Secretary John Dahldorf has served as Chief Financial Officer and Secretary since July 2003. From November 2001 to March 2002, he served as Chief Financial Officer of Digirad Corporation, a medical imaging company. He received a B.B. in Finance and an M.B.A. from Western Illinois University. David Sheehan, President of Operations, IVUS and Systems David Sheehan has served as President of the IVUS and FM Business Units since March 2010. From June 2008 to March 2010, he served as an Executive Vice President, and had Volcano’s wholly-owned subsidiary, Volcano Japan KK, reporting to him since June 2008. From May 2005 to May 2008, Mr. Sheehan was a consultant or CEO for various start-up companies in the San Diego area. From September 2000 to April 2005, Mr. Sheehan held positions at Digirad Corporation, a venture backed medical imaging company he took public, where he most recently served as the President and Chief Executive Officer, and previously as President, Digirad Imaging Solutions. Prior to September 2000, he held jobs in Sales, Marketing, Business Development and Operations Management at Baxter and Haemonetics. Mr. Sheehan received a B.S. in Mechanical Engineering from Worcester Polytechnic Institute and an M.B.A. from the Tuck School at Dartmouth College. Joseph Burnett, Executive Vice President & General Manager of Functional Measurement and IGT Joseph Burnett has served as Executive Vice President of Marketing since March 2010. Prior to this role, he was Vice President of Global Marketing, and the Business Unit leader for both the Image Guided Therapy and the Functional Measurement Businesses. Mr. Burnett joined Volcano in November 2004 and has held numerous Product Development, Marketing, Training and Education roles over the past six years. Prior to joining Volcano, he was an engineer and marketing manager at Guidant from September 1999 to November 2004. Mr. Burnett received a B.S.E. in Biomedical Engineering from Duke University and an M.B.A. from the Fuqua School of Business at Duke University. Physiology and Intravascular Imaging (IVI) Overview Fractional Flow Reserve (FFR) Fractional flow reserve provides a physiological measure of coronary stenosis, in contrast to the anatomical measurement provided by angiography, which is the most common method of identifying stenosis currently. The information provided by FFR is similar to that obtained through myocardial perfusion studies, but has better spatial resolution and is more specific. FFR in normal coronary artery equals 1.0, while a cutoff of 0.80 is used to indicate ischemia-causing stenosis with a greater than 90% accuracy. This makes it very accurate in the treat-or-not-treat decision. However, stenting when the FFR measurement exceeds 0.80 increases the risk of an adverse event due to thrombosis (formation of a blood clot in a vessel) and restenosis (reoccurrence of stenosis, or narrowing of a blood vessel) associated with the placement of the stent. This is the reason why stenting all stenoses identified via angiography raises the MACE risk rather than lowering it and further illustrates how FFR’s measurement of collateral flow is beneficial in identifying functionally unimportant blockages which require no treatment. The following chart shows FFR compared with angiography in terms of cost and quality adjusted life years (QALY) from the FAME study.



Fractional Flow Reserve (FFR) versus Angiography

Source: FAME data, 2009 TCT presentation by William F. Fearon, Pim A.L. Tonino, Bernard De Bruyne, Uwe Siebert and Nico H.J. Pijls.

Intravascular Ultrasound (IVUS) Intravascular ultrasound provides an inside-out view of the arteries which helps reveal plaque volume or the degree of stenosis (narrowing) of the artery lumen. This visualization of plaque cannot be seen by angiography. Further, angiography may not capture plaque growth that is uneven and results in an eccentric-shaped lumen; the two-dimensional nature of angiography could capture an angle where stenosis is not evident but where an image captured at an angle rotated 90 degrees from the initial image would show significant stenosis (think of an oval captured from two different angles). IVUS is most often used to aid in stent sizing, determine stent placement, and monitoring vascular response to coronary stenting post procedure. Initially, IVUS was only able to classify plaque as fibrofatty, calcified, or “soft”, but new applications, such as virtual histology, are able to classify plaques as lipid, fibrous tissue, calcification, or necrotic core with high accuracy. Clinical evidence currently supports IVUS usage in left main, bifurcation, and superficial femoral artery procedures. Combined these represent ~1.1 million annual procedures worldwide. Optical Coherence Tomography (OCT) Optical coherence tomography is similar to IVUS in its application, but it uses near-infrared light instead of ultrasound. Because it uses light (shorter wavelength than ultrasound), OCT has a much higher resolution, 5 to 20 microns, than the 50 to 200 microns typically seen with IVUS. However, for the same reason, OCT cannot penetrate tissue as deeply, ~1.5mm versus over 5mm for IVUS; OCT may not be able to visualize the entire vessel wall in the presence of a heavy plaque burden as a result, whereas IVUS would have no trouble doing so. Further, certain OCT technology requires flushing in order to reduce interference from the blood, which IVUS does not. Many view OCT as having benefits in percutaneous structural heart treatments such as atrial fibrillation ablations and mitral valve repair/replacement. Additionally, OCT is considered better at measuring thin-cap fibroatheromas (TCFA), which are significant predictors of major adverse cardiac events.

September 7, 2011


Volcano Corporation (VOLC) Ben Haynor, CFA

[email protected]

Income Statement 2009 Q1 Q2 Q3 Q4 2010 Q1 Q2 Q3E Q4E 2011E Q1E Q2E Q3E Q4E 2012E 2013ERevenues 227.9 66.6 73.5 72.9 81.2 294.1 81.0 84.0 87.8 95.3 348.1 94.0 103.4 106.4 113.7 417.5 505.0

COGS 91.5 26.6 27.1 26.0 29.2 108.9 27.9 26.8 29.0 31.7 115.4 32.4 35.8 37.1 39.8 145.1 164.6

Gross Profit 137.2 40.1 46.6 47.1 52.2 186.0 53.3 57.3 59.0 63.8 233.3 61.8 67.8 69.6 74.1 273.3 341.4 Gross margin 60.2% 60.3% 63.4% 64.6% 64.3% 63.2% 65.8% 68.1% 67.2% 66.9% 67.0% 65.7% 65.6% 65.4% 65.2% 65.5% 67.6%

Operating expensesSG&A (GAAP) 111.6 33.1 30.1 29.6 40.4 133.2 35.5 35.5 37.7 39.6 148.3 38.0 40.8 41.4 43.3 163.5 187.3

% of sales 49.0% 49.7% 41.0% 40.6% 49.8% 45.3% 43.8% 42.2% 43.0% 41.5% 42.6% 40.4% 39.5% 38.9% 38.1% 39.2% 37.1%R&D (GAAP) 37.4 9.9 9.6 10.2 12.9 42.5 13.1 13.3 14.1 15.3 55.9 14.6 16.0 16.5 17.6 64.7 72.7

% of sales 16.4% 14.8% 13.1% 14.0% 15.9% 14.5% 16.2% 15.9% 16.1% 16.1% 16.1% 15.5% 15.5% 15.5% 15.5% 15.5% 14.4%Amortization of intangibles 4.2 0.6 0.6 0.6 0.7 2.6 0.9 0.9 0.9 0.9 3.4 0.9 0.9 0.9 0.9 3.4 3.4

Total operating expenses (GAAP) 153.2 43.5 40.3 40.4 54.1 178.3 49.4 49.7 52.7 55.8 207.6 53.4 57.7 58.8 61.8 231.7 263.5 % of sales 67.2% 65.4% 54.9% 55.4% 66.6% 60.6% 61.0% 59.1% 60.1% 58.5% 59.6% 56.8% 55.8% 55.2% 54.4% 55.5% 52.2%

Operating income (GAAP) (30.8) (3.6) 6.0 6.6 1.0 10.0 3.7 7.6 6.0 7.8 25.1 8.2 9.9 10.6 12.0 40.7 76.9

EBITDA (GAAP) (14.7) 0.7 10.5 11.3 6.2 28.7 9.3 13.3 11.8 13.6 48.0 14.0 15.7 16.4 17.8 63.9 100.1

Other income, net 3.1 (0.1) (0.4) (0.2) (2.0) (2.6) (2.2) (2.1) (2.0) (2.0) (8.2) (1.8) (1.8) (1.8) (1.8) (7.3) (7.1)

Income before taxes (GAAP) (27.8) (3.7) 5.7 6.3 (1.0) 7.3 1.6 5.5 4.1 5.8 16.9 6.4 8.1 8.7 10.2 33.4 69.8 Taxes 1.2 0.4 0.3 0.7 0.7 2.1 0.4 0.6 1.4 2.1 4.5 1.7 2.1 2.3 2.7 8.8 18.5

Tax rate -4.3% -10.2% 4.5% 11.6% -72.3% 28.5% 26.3% 11.0% 35.5% 35.5% 26.7% 26.5% 26.5% 26.5% 26.5% 26.5% 26.5%

Net income (GAAP) (29.0) (4.0) 5.4 5.6 (1.7) 5.2 1.2 4.9 2.6 3.7 12.4 4.7 5.9 6.4 7.5 24.5 51.3

EPS (GAAP) (0.60)$ (0.08)$ 0.10$ 0.10$ (0.03)$ 0.10$ 0.02$ 0.09$ 0.05$ 0.07$ 0.23$ 0.08$ 0.11$ 0.11$ 0.13$ 0.43$ 0.89$

EPS (pro forma) (0.01)$ (0.02)$ 0.16$ 0.16$ 0.06$ 0.37$ 0.08$ 0.15$ 0.16$ 0.18$ 0.58$ 0.19$ 0.21$ 0.22$ 0.24$ 0.86$ 1.22$

Shares outstandingBasic 48.4 49.7 50.5 50.8 51.2 50.6 51.8 52.3 52.9 53.5 52.6 53.8 54.1 54.4 54.7 54.2 55.4 Diluted 48.4 49.7 53.1 53.3 53.9 53.3 54.2 54.5 55.1 55.7 54.9 56.0 56.3 56.6 56.9 56.5 57.7

Supplemental DataConsoles installed 5,000 5,200 5,400 5,600 5,900 5,900 6,100 6,300 6,500 6,700 6,700 6,900 7,100 7,300 7,500 7,500 8,300 IVUS sales 131.4 38.6 40.9 42.6 44.9 167.0 47.6 50.0 51.5 53.0 202.1 54.9 58.6 60.1 61.7 235.4 272.0 FFR sales 31.1 10.6 10.8 11.3 13.9 46.5 14.7 16.6 17.3 19.0 67.6 19.1 23.4 24.3 26.6 93.3 124.4

Working capital 158.7 172.3 180.7 264.6 264.9 264.9 266.2 266.2 254.1 243.2 243.2 250.1 258.5 267.6 277.7 277.7 354.4 Net debt (122.1) (128.6) (127.5) (121.4) (127.6) (127.6) (114.0) (112.3) (96.3) (92.4) (92.4) (91.1) (93.7) (105.1) (124.5) (124.5) (192.6)

Free cash flow (27.8) 3.2 (1.1) 5.2 13.5 20.9 (6.5) 5.6 (4.0) 8.0 3.2 2.3 6.1 14.9 22.9 46.2 76.1

September 7, 2011


Analyst Certification I, Ben Haynor, CFA, certify that the views expressed in this research report accurately reflect my personal views about the subject company and its securities. I also certify that I have not been, am not, and will not be receiving direct or indirect compensation related to the specific recommendations expressed in this report.

Important Disclosures: The analyst or a member of his/her household does not hold a long or short position, options, warrants, rights or futures of this security in their personal account(s). As of the end of the month preceding the date of publication of this report, Feltl and Company did not beneficially own 1% or more of any class of common equity securities of the subject company. There is not any actual material conflict of interest that either the analyst or Feltl and Company is aware of. The analyst has not received any compensation for any investment banking business with this company in the past twelve months and does not expect to receive any in the next three months. Feltl and Company has not been engaged for investment banking services with the subject company during the past twelve months and does not anticipate receiving compensation for such services in the next three months. Feltl and Company has not served as a broker, either as agent or principal, buying back stock for the subject company’s account as part of the company’s authorized stock buy-back program in the last twelve months. No director, officer or employee of Feltl and Company serves as a director, officer or advisory board member to the subject company. Feltl and Company Rating System: Feltl and Company utilizes a four tier rating system for potential total returns over the next 12 months.

Strong Buy: The stock is expected to have total return potential of at least 30%. Catalysts exist to generate higher valuations, and positions should be initiated at current levels. Buy: The stock is expected to have total return potential of at least 15%. Near term catalysts may not exist and the common stock needs further time to develop. Investors requiring time to build positions may consider current levels attractive. Hold: The stock is expected to have total return potential of less than 15%. Fundamental events are not present to make it either a Buy or a Sell. The stock is an acceptable longer-term holding. Sell: Expect a negative total return. Current positions may be used as a source of funds.

9/7/2011Ratings Distribution for Feltl and Company

------ Investment Banking ------ Number of Percent Number of Percent of

Rating Stocks of Total Stocks Rating categorySB/Buy 41 68% 3 7%Hold 18 30% 0 0%Sell 1 2% 0 0%

60 100% 3 5%

The above represents our ratings distribution on the stocks in the Feltl and Company research universe, together with the number in (and percentage of) each category for which Feltl and Company provided investment-banking services in the previous twelve months.

September 7, 2011


Date Nature of Report Rating Price Target

09/07/11 Initiation@$28.25 StrongBuy $37.05

Feltl and Company does make a market in the subject security at the date of publication of this report. As a market maker, Feltl and Company could act as principal or agent with respect to the purchase or sale of those securities. Valuation and Price Target Methodology: We have set our price target for Volcano at $37.05 based upon a sum-of-the-parts methodology – the quantity of $400.6 million in medical sales multiplied by our 4.5x EV/sales multiple plus our assumed $23.8 million valuation for the Axsun industrial business and net cash of $112.3, divided by 52.3 million shares outstanding. Our target corresponds to 20.8x 2012 EV/EBITDA (pro forma), a discount to VOLC’s average quarterly high EV/EBITDA of 22.0 over the past eight quarters. Volcano’s average quarterly low EV/EBITDA multiple has been 16.3x over the same time period.

Risks to Achievement of Estimates and Price Target:

• FDA timeline slippage. The FDA approval process has been a difficult hurdle for many medical device firms to clear in the recent past, with many firms seeing their intended approval timelines pushed back, some for substantial amounts of time. We believe Volcano will have an easier time than many in getting its new products through the FDA, however we also believe that timeline slippage is almost inevitable in the current FDA approval environment.

09/07/11 SB Target: $37.05

September 7, 2011


• Pending competition. A number of companies are developing intravascular imaging technologies that tout superior performance to Volcano’s currently marketed products. We believe a number of these will see market launch, including InfraReDx and SVMI’s coming IVUS products. However, we doubt that these companies will make a significant dent in Volcano’s sales thanks to the company’s large installed base. We do caution, though, that should one of these pending competitors be acquired by a “big iron” firm, such as GE, Philips, or Siemens, and their products integrated into their cath lab installs, Volcano may have a more difficult time competing.

• Single-source suppliers for some components. Volcano has a number of components that it currently purchases from single-source suppliers.

The company has attempted to mitigate this risk over the past several years and has been successfully in doing so. But, at present, the risk remains that the company could suffer supply constraints before it is able to find alternate sources for such single-sourced components.

• OCT legal risk and expenses. Volcano is currently engaged in litigation with St. Jude Medical (STJ – not rated) over the light source used in its

upcoming OCT (optical coherence tomography) product. While the company believes that its HDSS (high definition swept source) does not violate St. Jude’s intellectual property rights and does have alternative light sources ready in the event of a courtroom loss, Volcano will likely be forced to spend $15-20 million in 2011-2012 to reach resolution.

• Axsun revenue volatility and lower gross margin. Revenues from Volcano’s Axsun industrial subsidiary can be volatile and carry a lower gross

margin. This combination has the potential to create a double-edged sword perception issue. If Axsun revenues unexpectedly fall off and the company misses revenue estimates, the Street may view their performance negatively. Similarly, if the company beats revenue expectations due to the Axsun business performing well, it is likely to create lower-than-expected gross margin, which also has the potential to be perceived negatively.

• Street expectations. Volcano has exceeded consensus revenue estimates for 21 consecutive quarters, every quarter since their IPO. Should

they fail to continue this impressive performance, they run the risk of being viewed as a “busted” growth story and see a lower multiple assigned to the stock.

Other Disclosures: The information contained in this report is based on sources considered to be reliable, but not guaranteed, to be accurate or complete. Any opinions or estimates expressed herein reflect a judgment made as of this date, and are subject to change without notice. This report has been prepared solely for informative purposes and is not a solicitation or an offer to buy or sell any security. The securities described may not be qualified for purchase in all jurisdictions. Because of individual requirements, advice regarding securities mentioned in this report should not be construed as suitable for all accounts. This report does not take into account the investment objectives, financial situation and needs of any particular client of Feltl and Company. Some securities mentioned herein relate to small speculative companies that may not be suitable for some accounts. Feltl and Company suggests that prior to acting on any of the recommendations herein, the recipient should consider whether such a recommendation is appropriate given their investment objectives and current financial circumstances. Past performance does not guarantee future results. Additional information is available upon request.

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