Description

The aesthetic lasers companies are in play.

Link: Health Companies Think Fat-Freezing Is the New Botox

On Monday 2/13, AGN bought ZLTQ for $2.5b at 7x revs. The same day, a story ran that Apax was in talks to purchase ELOS. The next day, HOLX bought CYNO for $1.65b at 3.3x revs. It was a busy week!

The idea is that one main player remains, Syneron Medical (ELOS), and it trades at a significant discount to where its peers were taken out. I would expect ELOS to ultimately get acquired for a healthy premium. If it doesn’t get purchased, the net cash position and growing gross profit should provide downside support. Indeed, despite the flurry of speculative news, the stock is currently trading at the lower-end of its historic EV/gross profit range.

For those unacquainted with the industry, I would refer you to zipper’s short write-up on ZLTQ or elke528’s 2007 write-up on ELOS for some historical perspective.

In summary, these companies trace their roots back to selling lasers that remove unwanted hair. They sold these machines to dermatoligists and plastic surgeons, laser hair removal clinics and whoever else would pay the price. This was great for a period of time while the idea was new and these were certainly hot stocks back in 2005 and 2006 (the cast of characters included ELOS, CYNO, CUTR, PMTI and CLZR). However, there was no recurring component, just a capital equipment sale. So, as you would expect, the music eventually stopped, sales slowed and consolidation followed. Laser hair removal is now the legacy business.

Laser fat removal (“body contouring” in industry speak) was always the pipe dream that kept bulls excited. Yes, you read that right. I’ll set aside the debate on whether it actually works for now and leave that for the thread. The takeaway though is that it eventually happened and large industry players (Allergan and Galderma) partnered with these players, validating technology which once sounded outlandish. Unlike the laser hair removal product cycle, the companies smartened up this time around and made body contouring a razor, razor blade model.

The evolution of body contouring has been a recent phenomenon. While all of the companies had been talking about it for over 10 years, it was ZLTQ that truly pioneered the technology. Back in 2005 when CYNO, ELOS and others were stock market darlings, ZLTQ was just being started. It came public in 2011 and didn’t cross $100m in sales until 2013. ELOS introduced a competing product (UltraShape) in late 2014 and CYNO followed suit in late 2015. Indeed, it has really been the last few years that these procedures have taken off and done so in a big way. ZLTQ is expected to report $420m in sales this year, up from $111m in 2013.

It wasn’t until two years ago that the main aesthetic players started to take note. In December of 2014, Allergan launched a program to co-market ZLTQ’s device along with its own fillers. A year later, in December of 2015, ZLTQ moved on to working with Allergan’s competitor, Galderma. By March of 2016, ELOS joined the party and announced a collaboration with Allergan. Industry buy-in was a new and important development.

Now, I fully expect some skepticism. I get it. ELOS has burned more than a few investors. It’s based in Israel, there’s evidence of nepotism and the CEO position has been a revolving door. Moreover, it’s been a value trap for years that even showed up in Baupost’s portfolio for a while. To boot, yours truly once worked at a firm (many years ago) that was the largest shareholder. We lost money. Needless to say, I came at this idea eyes wide open. If it weren’t for a few significant developments, I would be skeptical myself.

Significant developments:

First, there were the aforementioned partnerships with the leading aesthetic players. This was interesting because it validated the technology. It was telling that Allergan and Galderma picked ZLTQ and ELOS, not CYNO. Allergan even talked about the promise of these new procedures at investors conferences, which was surprising (see the Goldman conference Q&A from June 2015).

In June of 2015, there was a rumor that Allergan may bid for ZLTQ.

In January of 2016, Todd Zavodnick joined ZLTQ as head of international. Todd was previously running Galderma North America, the company’s largest revenue segment (note that Galderma is fully-owned by Nestle). This was a surprising move.

In October of 2016, Philippe Schaison announced he was joining ELOS as head of North America. He was previously in charge of AGN’s entire medical aesthetic business. This was a real head scratcher. Philippe was one of three division heads at AGN, a $90b company. He ran the $2b aesthetics segment, which is viewed as the crown jewel given its Botox franchise. And he left to join a $250m cap company with $300m in sales and wasn’t even going to be CEO. Even if he got pushed out of AGN, this seemed like a weird move. He also wasn’t unfamiliar with the company since AGN had announced a selling partnership with ELOS back in March so he’d had over 6 months to look under the hood. Not to mention, he brought along his colleague, Paul Little who was formerly VP, Finance and Head of Commercial operations at Allergan. Both Philippe and Paul got options (300k for Philippe, 100k for Paul). Philippe also got 100k RSUs. The exercise price for the options was set as the closing price on 11/10, which ended up being $7.35.    

The next day, October 18th, Craig Drill Capital filed a 13G showing a 5% position in ELOS. Craig runs a small fund and knows the aesthetic laser space better than anyone else. He holds a number patents in the industry, has invested in several private companies and, as you can guess, is a very shrewd investor when it comes to the public companies.

In January of 2017, ELOS announced that it had hired another AGN defector, Lisa Soderquist to be chief of HR. She got 100k options with an exercise price set at $9.85. This was probably just Philippe recruiting old colleagues but he must have had a decent story.

Finally, the M&A activity started.

On January 22nd, Bloomberg ran an article speculating that CYNO was eyeing strategic options, including a potential sale of the company. Allergan was noted in the article as a potential suitor. Stifel published a note and speculated that $65-$70 might be a takeover price. This would later prove to be a very perceptive estimate.

On February 4th, someone posted on cafepharma (a popular message board for medical device sales reps), “word on the street is that Galderma is purchasing Cynosure.” This person went on to explain, “My friend works there and…he said that Cynosure reps are NOT happy about this because they do not want to work for a drug company.” This will come in handy later.

One week later, $4b in M&A was announced. AGN kicked things off by buying ZLTQ on 2/13. HOLX then announced its intention to buy CYNO twenty four hours later. Sandwiched in between were rumors that Apax was looking at ELOS.

Since then it has been quiet. ELOS reported results in the middle of that week on 2/15 and simply said this:

In light of the aesthetic industry transactions around earlier this week, some reported press speculation on Syneron and questions we had received, I would like to quickly address these topics. Syneron Candela is a leading global player in a highly attractive market segment with substantial demonstrated growth. We are confident in our plan to leverage Syneron's unique strengths, both internationally and in North America, to continue to capture this growth opportunity. While we can't comment on others’ strategy, we nevertheless do think the transactions announced this week further validate the significant growth opportunities available in the aesthetic device market. Finally, as related to speculation on rumors on Syneron specifically, as a matter of policy, we do not and will not comment on such speculation and will not be taking any questions related to this activity.

Strangely enough, Syneron’s stock isn’t up that much since the deal frenzy started. It closed at $9.30 on 2/10 (the Friday before AGN announced its intention to buy ZLTQ). The last price of $9.95 is up only 7%. Furthermore, the article that ran in Calcalist, speculated that Apax Partners was in talks to purchase Syneron for $350-400M. Assuming that is an EV range, it suggests a stock price of $12.60-$14, +25-40%. Note that ELOS has net cash of $86m or $2.50/share.

Skeptics would argue that Calcalist, an Israeli newspaper, might not be the most reputable source. That may be true - I’m sure they’ve misfired in the past. The skeptic might also claim that $350-$400m referred to market cap. I’ve never heard a PE guy talk in market cap, but it’s possible. If so, that would imply a share price of $10-$11.50 and much more modest upside of 0-15%.

In truth, I’m not sure why ELOS isn’t up more. Maybe it’s because the stock is small and under the radar. There were only 3 analysts on the last earnings call, the only 3 analysts that cover the stock and all of whom work at small brokerages. None of these analysts got to ask a question on the AGN or HOLX calls despite the fact that they cover ZLTQ and CYNO as well.

ZLTQ and CYNO have much greater coverage with 9-11 analysts following each company. It shouldn't be surprising then that when M&A speculation surfaced about CYNO, these same analysts suggested that ZLTQ (the other company on their coverage list) might also be in play. When ZLTQ was bought, they speculated that CYNO was next. ELOS seemed to get lost in the mix since the majority of the analysts simply don’t cover it.

Whatever the reason, the fact that ELOS isn’t up more is what makes this situation attractive.

One of the more interesting things to come out of the HOLX/CYNO call was this tidbit from HOLX’s CEO:

“We believe Cynosure received an unsolicited inbound offer from another company, which caused them to reach out to us. We were pleased to receive that call and were able to jump quickly into the process since we had studied the market and done much of the work previously.”

My guess is that the “unsolicited inbound” was Galderma. I suspect AGN wanted to own ZLTQ all along. It’s the premier player in the space and there were rumors dating back to 2015 that AGN was looking to buy ZLTQ. This also jives with the cafepharma post and explains why CYNO may have viewed an inbound from Galderman unfavorably and thus reached out to HOLX (i.e., CYNO reps don’t want to work for a drug company).

Also recall that Allergan and Galderma were partnered with ELOS and ZLTQ respectively. These are the two companies most interested in the space. With the ZLTQ deal, Galderma lost its partner.

Fast forward to today and ELOS trades at $10. As mentioned, it’s largely unchanged since the M&A started and up ~30% since Philippe joined, which was a significant development for the company in its own right.

There are now only two public players left: Syneron and Cutera (CUTR). Cutera though is tiny with only $118m in 2016 sales (ELOS did $300m). Further, the three main body contouring procedures are CoolSculpting (ZLTQ), SculpSure (CYNO) and UltraShape (ELOS). So I would argue that there’s really only 1 player remaining and that is Syneron. Nevertheless, CUTR for some reason trades at double the valuation of ELOS (1.6x forward sales vs. 0.8x for Syneron).

For this one remaining player there are a handful of potential parties that could be interested: Apax (already rumored in the press), German drugmaker Merz Pharma GmbH, and Shanghai Fosun Pharma (both rumored in a Bloomberg article). Finally, there’s Galderma, which remains the most logical suitor in my opinion.

Based on the preceding commentary, you might conclude that Syneron’s product is the dud of the group. Believe it or not, it’s quite the opposite. Again, I would refer you to zipper’s write-up as he devoted a lot of discussion to this topic. In fact, in his most recent post he stated, “everything I've come across regarding the UltraShape product suggests it is a technological winner.”

The problem for ELOS has been gaining traction in North America. This is why the hire of Philippe Schaison was such a big deal and should pay dividends for them moving forward.

While UltraShape was initially launched in Q4’14, a new and improved UltraShape Power device was introduced recently in Q3’16. Paired with new leadership, this is expected to accelerate growth.

Valuation:

At $9.95, ELOS’s market cap is $345m and the TEV is $259m or $7.46 per share. As can been seen in the chart below, sales and gross profit per share have been growing for the past few years. In fact, gross profit has been surprisingly consistent. If you go back to 2006, you’ll find that GP/share has been in excess of $3 in 9 of 11 years.

The issue for Syneron has been mismanagement of expenses, which is why new and reputable leadership is an important catalyst. At an Analyst Day in December of 2015, current management articulated a path to greater than 60% gross margins and double digit EBIT margins by FY18. This would suggest ~$1 in EBITA/share. While I don’t necessarily put much weight on this forecast, I also don’t think it’s wholly unrealistic. All of Syneron’s future growth should come from body contouring, which is much higher margin and benefits from a recurring revenue component.

In thinking about valuation, I tend to focus on gross profit since: a) as a standalone company, ELOS should be a turnaround story with improving mix shift, and b) as an acquisition target, ELOS should be able to eliminate much of its SG&A. With that in mind, it’s fascinating that ELOS is trading at the lower end of it historic EV/gross profit range, currently priced at 1.5x my estimate of current year gross profit (see chart above). This is despite the fact that the business model has improved, a new product cycle is in early innings and speculative interest is swirling around the industry. On current year EBITDA estimates, the stock trades at 7x.

Of course, the more interesting upside case is if ELOS gets acquired. Both ZLTQ and CYNO got taken out at multiples far in excess of where ELOS is currently trading.

The push back would be that ELOS is no Zeltiq and is merely a poor man’s Cynosure. It’s growing slower than peers and has less exposure to the desirable body shaping market. Sure, there’s some truth to this critique, but the valuation multiples more than reflect this sentiment. ELOS grew sales 7% in 2016, clearly below that of peers but still nothing to sneeze at. As for CYNO, much of its growth over the past few years came via acquisition. Organic sales growth for Cynosure was closer to mid-teens – still better than ELOS but not as different as you might think.

In terms of body shaping, let’s try to get the facts straight. We know that all of ZLTQ’s $350m in 2016 sales were tied to body contouring. CYNO doesn’t disclose a comparable number but we know that SculpSure was soft launched in September 2015 and released in earnest during Q1’16. Since sales for CYNO increased by $94m in 2016, it seems safe to assume that SculpSure represents something less than $100m in revenue. Syneron discloses “emerging product” sales, which totaled $83m in 2016, up 42%. This represented $100m in run-rate sales as of Q4’16. It also implies that the legacy business ($216m in sales) was flat y/y. The majority of what Syneron classifies as emerging products is UltraShape and that piece totaled $53m in 2016, up 36%.

To recap, LTM body contouring revenue per company would seem to be as follows:

• ZLTQ = ~$350m

• CYNO = ~$100m ($333m in legacy)

• ELOS = ~$50m ($250m in legacy/emerging)

For all 3 players, body shaping revs are growing in excess of 30%. For CYNO and ELOS, their legacy segments appear to be flattish. If you apply the same 7x revs to CYNO’s $100m in body shaping sales, it implies that HOLX paid 2.2x for Cynosure’s remaining legacy business. Interestingly enough, CYNO paid 2.5x revs for Palomar (all legacy business) back in 2013.

The 2x sales multiple makes some sense. These businesses should earn low double digit EBITA margins stand-alone (CYNO was 13% in 2016, ELOS is targeting double digits). HOLX guided to $25m in synergies with CYNO, implying that they would get margins up to ~20%. I tend to think this is more reflective of the legacy segments since body shaping is still subscale and in investment mode. That means 2x sales would equate to ~10x EBITA for the legacy business - a reasonable no-growth multiple in my opinion. In addition, Lumenis, another cosmetic laser company heavy in legacy business, was acquired in 2015 for 1.5x sales. As noted previously, CUTR currently trades at 1.6x sales.     

If we use the same logic for Syneron (7x $50m in body shaping revs and 2.2x for the rest), it would yield an EV of $900m and a stock price of $28. Now, I don’t think ELOS will get sold for that much but the point is that it’s not hard to envision a materially higher price. Certainly, a strategic transaction could occur at a price significantly above 1x sales.

Personally, I put 3x on Syneron’s body shaping business that is growing in excess of 30% and 1x on its legacy business that is flattish. That yields an EV of $400m (the same figure quoted in the news article) and suggests a stock price of $14.  

Conclusion:

In summary, ELOS has historically been mismanaged and thus slower to participate in the growth of the new body shaping market. That said, its technology is good and its brands are well recognized. The prospect of qualified new management, let alone someone who ran Botox, cannot be overstated. More importantly, ELOS is the only remaining player in an industry that is drawing amplified strategic interest. If a deal materializes, the company could fetch a materially higher price than $10. If a deal doesn’t materialize, ELOS trades at a historically attractive multiple of 1.5x gross profit for a business that is growing nicely with improved prospects and a positive mix shift going forward.

Catalyst

Acquisition by a strategic or financial buyer