PhotoMedex Inc. (PHMD)
November 2, 2012 per share price of $13.18; short target price of sub-$7.00

Company Overview / Background:  On December 13, 2011, Radiancy Inc., an Israeli-based marketer of consumer and professional aesthetic and dermatological devices, reversed-merged in an all-stock transaction into PhotoMedex Inc. (Nasdaq: PHMD), at the time a $30MM nanocap business that was unprofitable (retained losses of $135MM since inception) and under duress.  Following the merger, Radiancy shareholders owned approximately 75% of PHMD stock.  While each of the pre-merged PHMD and Radiancy offer an array of professional lasers and devices, almost 80% of sales and greater than 100% of the profits of the merged company are derived from the sale of an at-home consumer hair-removal device marketed under the no!no! brand name.  The no!no! device is marketed as producing laser-like results for hair removal through its “Thermicon” technology, which consists merely of a heated wire that melts or chars the surface hairs with which it comes into contact (see www.trynono.com).  PHMD markets the no!no! primarily via infomercial (both 28-minute long format and increasingly 30- and 60-second short format) and on cable home-shopping on HSN.

Short Thesis:

1)      Inherent risk in direct-response-television-driven businesses; current financial performance likely unsustainable.  The no!no! product is sold primarily via direct-response television, retails at a high price-point ($270.00) and represents a one-time, non-consumable-purchase item.  The company has already sold a reported 2.5MM no!no! units to date, primarily in theU.S. andJapan, which implies approximately 4% penetration of the addressable target market of women aged 30 to 55.  While such penetration levels could indicate further runway, most infomercial stories are challenged to grow beyond $75MM to $100MM in annual domestic sales (no!no! reported DRTV sales of $76MM in 2011), and moreover follow a finite lifecycle (usually no more than three to four years; no!no! has been marketed heavily since late 2009, so it may be near or past the peak of its lifecycle/earnings power).  Because of the fad-like/finite lifecycle of DRTV products, there is usually very little durable equity value in infomercial businesses and accordingly there are no examples of public market DRTV companies with sustained success (see previous demise of Salton (maker of George Foreman grills), Ronco, etc.).  no!no! is also unlikely to find success in traditional bricks-and-mortar retail, given the product’s high pricepoint and challenging selling proposition without the assistance of demonstration/education from DRTV commercial.  Moreover, the no!no! was previously sold at Sephora but is no longer carried there, perhaps indicating the product had run its course in traditional retail or did not sell through at sufficient velocity to consumers.

2)      High level of consumer dissatisfaction; questions regarding efficacy of no!no! product.  Another major problem facing PHMD is that consumers simply do not like the no!no! product.  The sampling of online customer reviews from AMZN, HSN and QVCUK are not favorable, with average rating of less than 2.0 out of 5.0 stars (see links below).  A number of other online blogs question the product efficacy, with some accusing Radiancy of false claims/advertising.  There have also been a number of formal complaints to the BBB (see link below).  At a minimum, such consumer reviews do not bode well for the long-term viability of the no!no! product and could open the company up to further claims.  On a related note, the company recently settled litigation related to trademark infringement and false advertising with competitor Tria Beauty, Inc.; the terms of the settlement were undisclosed but the dispute dated back to November 2010 and required Radiancy/PHMD to spend approximately $10MM to defend.

3)      Returns as percentage of reported net sales increasing; signs of weakness in Japan.  Provisions for sales returns as a percentage of consumer segment sales increased 150 basis points to 24.0% over the first six months of 2012 from 22.5% in 2011.  Actual sales returns as a percentage of consumer segment sales increased 80 basis points from 17.1% to 17.9% over the corresponding period.  This is another indication of consumer dissatisfaction with the no!no! product and is a metric to monitor over time.  Additionally, sales to the Japanese distributor have decreased from $29.5MM in FY2010 to $25.9MM in FY2011 to $20.5MM over LTM 6/30/2012.  While Japan represents only 12% of total sales, this point is worth noting because Japan is the world’s second-largest cosmetics market behind the U.S. and the no!no! ramped up more quickly inJapan relative to theU.S. back in 2009.  Softness In the Japanese market could foretell pending weakness in theU.S. market.

4)      Operating margin eroding rapidly despite top-line growth.  Despite growing Consumer segment sales 40% over the first six months of 2012 relative to the corresponding period in 2011 ($92.7MM versus $66.1MM), PHMD has seen its pre-corporate Consumer segment operating margin decrease 900 basis points from 38.9% in first half 2011 to 29.7% in 2012.  This is a result of lower bang for the buck on higher spending on television advertising.  Overall, adjusted Ebitda has essentially remained flat ($22.4MM over first six months 2012 versus $22.7MM in 2011), resulting in a decrease in adjusted Ebitda margin from 33.1% to 20.5%.

5)      Capital markets actions / capital allocation raise questions.  To put it mildly, PHMD’s capital markets actions and capital allocation decisions have been questionable following the reverse merger.  Here are some of the most head-scratching examples:

• On April 27, PHMD sold 3.0MM primary shares or 16% of the sharecount at the time, resulting in gross proceeds of $40MM.  Canaccord Genuity led the offering, which announced six (6) days after a Canaccord analyst initiated coverage with a ‘Buy’ rating at $22.00 price target.  The decision to sell primary stock may point to lack of conviction in the sustainability of the business model, particularly since the company had a material cash position and was profitable at the time of the offering. 
• Next, on May 1, PHMD announced it was dual-listing on the Tel Aviv stock exchange.  While Radiancy is an Israeli-based company, a dual-listing may be an unnecessary distraction for the company and its management since it is already listed on Nasdaq with access to the one of the largest and deepest pools of capital in the world.
• PHMD touts a report supporting the efficacy of the no!no! technology by “independent” research firm Crystal Research Associates.  PHMD issued Crystal Research Associates 25,000 warrants on March 1 as consideration for issuing the report.
• And perhaps the biggest head-scratcher of all: On August 18—less than four months from the April sale of $40MM of primary equity at a share price of $13.23—the board of PHMD announced a share buyback of up to $25MM.  (Why did the company ever sell primary equity in the first place?)

High-Level Valuation (Figures in million, except per share price data):

PHMD’s market capitalization is currently $283MM with an enterprise value of $230MM (6.3x LTM adjusted Ebitda), which on the surface may not seem overly valued.  However, given there is not likely any long-term sustainable equity value in the no!no! business, it would not be reasonable to apply a multiple against current earnings.  Instead, the business should be valued based on expected cash flow generation.  The following analysis attempts to value PHMD based on a reasonably conservative sum-of-the-parts of balance sheet cash , expected cash flow from the no!no! business (undiscounted) before it eventually hits the wall, and the value of the pre-merged PHMD business/non-no!no! Radiancy business (figures in millions, except per share data):

Historical Financial Summary (figures in millions): 

(1) Physician Recurring segment represents pre-merged PHMD business; results not included prior to partial year 2011.

 
Online Customer Reviews:

• HSN: http://www.hsn.com/beauty/no-no-8800-face-and-bikini-professional-hair-removal-kit_p-6440389_xp.aspx
• AMZN (32 out of 57 reviewers rate 1.0 out of 5.0 stars): http://www.amazon.com/8800-Series-Deluxe-Hair-Removal/product-reviews/B003U8GIB4/ref=dp_top_cm_cr_acr_txt?ie=UTF8&showViewpoints=1
• QVC U.K.(75 out of 129 rate 1.0 out of 5.0 stars): http://reviews.qvcuk.com/1690/400063/no-no-no-no-face-body-hair-removal-system-with-travel-case-accessories-400063-reviews/reviews.htm
• Sephora (cache page showing mediocre reviews; also indicates “This product is no longer available”): http://reviews.sephora.com/8723/P194264/reviews.htm)
• BBB customer complaints: http://ourbbbproxy.bbb.org/new-york-city/Business-Reviews/beauty-supplies-and-equipment/radiancy-inc-in-orangeburg-ny-96795/complaints

Potential Risks to Going Short:

• The no!no! hair-removal infomercial could continue to perform for the next few reporting periods; infomercial reporting service Jordan Whitney (www.jwgreensheet.com) has consistently listed no!no! among the top-10-performing short-form products throughout Q3 2012.  (Note: It is possible that margins will suffer if management chases top-line growth to meet public market expectations, however, as media spend increases along with higher return rates / bad debt expense)
• Company could introduce new hit products or successfully market existing pre-merged PHMD products via direct-response television (Note: It is extremely difficult to successfully market products via direct-response television with any sort of predictability)
• The company could be a takeover target in an M&A event at a premium to the current valuation (Note: Hopefully any potential buyer would share concerns outlined in short thesis; also, based on ‘Background of the Merger’ section of the merger proxy it appears as though each of Radiancy and pre-merged PHMD had been actively exploring M&A opportunities for some time)
• Balance sheet is essentially debt-free, with approximately $2.50 of net cash per share

The short thesis is based primarily on the expectation that sustained sales of the no!no! hair-removal product are not viable over the long term, resulting in a decrease in sales and breakdown of operating margin/earnings.  Another catalyst could be a wave of selling by insiders who own approximately 7.7MM shares (approximately 35% of outstanding shares).  These shareholders were locked up through early June 2012 and have not sold a material number of shares since that date; the CEO, Dolev Rafaeli, and company President, Dennis McGrath, recently sold a modest number of shares (approximately 40,000 in the aggregate) at a purchase price at or above $15.00 through their respective 10b5-1 trading plans.