Syneron is a misunderstood stock and currently provides an opportunity to buy into a medical device company with great distribution and partnerships, #2 market share, and 26% of their market cap in cash. At current valuations, Syneron holds 125+% upside with only 15-20% downside.

 

 

 

Despite being a fast-growing company in an attractive industry with great demographic trends, Syneron trades at a 50% discount to its publicly-traded peers.

 

7/2/2007 Price 2007 P/E 2008 P/E 2007 Expected EPS Growth 2008 Expected EPS Growth 2007 EPS 2008 EPS CLZR $11.58 30.5x 25.2x -17% 21% $0.38 $0.46 CUTR $24.92 23.7x 16.5x -10% 44% $1.05 $1.51 CYNO $36.43 35.0x 26.9x 65% 30% $1.04 $1.35 PMTI $34.71 27.9x 22.1x -45% 26% $1.25 $1.57 THRM $8.34 333.6x 31.1x NM 972% $0.03 $0.27 ELOS $24.95 15.1x 12.6x 15% 19% $1.66 $1.98 Syneron discount to median -51% -50%

 

 While there are several qualitative reasons why Syneron’s stock has been weak, I believe that there are three financial reasons why Syneron has persistently traded where it has:

 

1)      Tax benefits are not believed:  Because Syneron is headquartered in a remote area of Israel, the company receives tax-free status on the products that are developed in that zone.  Therefore, Syneron currently has an effective tax rate of 4-5%, but over time, profits from legacy products will be hit with an Israeli tax rate of 25-27% as they roll out of their tax-protected status.  However, due to the development of new products with new tax protection, Syneron’s blended rate will unlikely exceed 10% for the foreseeable future.

 

2)      Concern that cash value cannot be realized:  With a free cash flow yield of 5.5%, which is high for a medical device company, Syneron has lots of cash, but they are limited in their flexibility due to the tax benefits they enjoy.  If they declared a dividend or did a buyback, their cash would be subject to the Israeli corporate tax (since the taxes are intended to be reinvested in Israeli enterprises, not returned to shareholders).  However, Syneron has gotten positive feedback from the Israeli tax authorities that they could use the proceeds from their IPO to effectuate a tax-free buyback of $54m, or about $2 per share, and management has hinted that they may do this.  In addition, Syneron continues discussions with the tax authorities regarding their alternatives with the remaining $125m in cash.

 

3)      Concern over sustainability of gross margins and cash flows:  Syneron’s gross margins are far higher than their competitors, which is a result of (a) the lower manufacturing cost of their combined laser/RF technology vs. laser alone; (b) lower repair costs due to the smaller size of their devices, which allows broken ones to be shipped overnight to a centralized depot vs. requiring field-based repair; and (c) tax free status of many of their suppliers near them in Israel.  Syneron’s gross margins have dropped slightly in the past 2 years, from 87% to 83% (vs. comps at an average and median of 63% and 70%, respectively), but this is a result of selling more devices that are laser-based (vs. light-based), which generally are priced higher and have lower gross margins.

 

On the cash flow front, Syneron’s DSOs are high, at 101 days.  This is not a concern because Syneron is using its balance sheet strength to expand its market share: Syneron has succeeded with many national and regional chains and well-established international distributors, which are granted better payment terms and are capable of paying their bills.

 

 

As can be seen in the charts below, Syneron has been one of the fastest growing companies in the aesthetic laser industry, and its growth has not slowed down.  Having already overtaken Lumenis, Syneron is on the cusp of having higher revenues than even Candela, which has led the market for the past several years.  Syneron has a strong presence in Europe, where its products are sold through distributors.

 

What makes Syneron’s products attractive are the following:

Certainly Syneron is not the only company with effective products, but the divergence of market share and discussions with many physicians leads me to conclude that there is no general consensus on whose product is the best.  Syneron’s overall market share and growth indicates that they do have an effective product and good word of mouth (25% of sales in Q1 in North America). 

 

Annual Revenues 2004 2005 2006 LTM 2004-06 CAGR CLZR          112.4          139.1          154.5          150.9 17% ELOS            57.9            87.4          117.0          125.6 42% CUTR            52.6            75.6          100.7          103.2 38% PMTI (a)            45.8            65.8            92.2            99.2 42% LUME (b)            88.0          100.4            88.0  NA  0% CYNO            41.6            56.3            78.4            87.3 37% THRM            50.4            40.7            54.3            57.0 4% Total (c)          448.8          565.3          685.1 NA 24%

Latest Quarter 3/31/2006 3/31/2007 Y/Y Growth CLZR            42.3            38.7 -9% ELOS            23.7            32.3 36% CUTR            20.8            23.3 12% PMTI (a)            20.4            27.4 34% LUME (b)  NA   NA   NA  CYNO            17.1            26.1 52% THRM            12.4            15.2 22% Total (c) NA NA NA

 

Over the past 12 months, Syneron has invested heavily in a high-quality, highly-motivated, and adept management team.  Last year, the company’s sales stumbled as their growth was getting ahead of their infrastructure, especially in North America, and as a result, the president of North America was pushed out.  He was replaced by Doron Gerstel, who was the founder and CEO of a software company backed by such investors as Intel Ventures and Greylock.  Under Gerstel’s leadership, North America revenues increased by 28%, and he was just recently promoted to CEO of Syneron.

 

Gerstel helped build the infrastructure in both organizational structure and personnel.  His most impactful contribution has been the implementation in Q4 2006 of a low-cost inside sales group based in Toronto of 7 individuals that develop a pipeline for the field sales force as well as sell upgrades to existing customers.  In Q4, they experimented with how to approach this tactic, and in Q1 they reaped the benefits with 29% growth in North America.  Soon, the inside sales team will be up to 11.

 

On the personnel front, they ramped up the North American direct sales force from 42 at the end of 2005 to 60, and they hired a Chief Marketing Officer, an MD who joined from a competing laser company, and who has already placed Syneron’s products on TV (Rachael Ray, Today Show) and in popular magazines (People, Star).  In addition, the new president of North America is the former VP of Global Sales for VISX, a fast-growing ophthalmology laser company which was sold to Advanced Medical Optics in 2005.

 

Finally, the management team is also led by their chairman, Shimon Eckhouse, who helped develop the industry in the early 1990s (more on Eckhouse and his “lessons learned” later) and Michael Kreindel, their Chief Technology Officer, who invented the core of their technology and continues to develop new products and features. 

 

Management’s incentives are well-aligned with shareholders: Eckhouse and Kreindel own 9.6% and 5.2% of the company, respectively, and Gerstel has 150,000 options at a strike price of approximately $25.

 

 

The only guidance Syneron gives is top-line: they expect 20% growth in 2007.  In Q1, they grew 36%, which implies a need for only 16% growth for the rest of the year.  Considering the investments they’ve made in marketing programs, inside sales, and new products, hitting 20% growth for 2007 is conservative.  As can be seen below, North American sales force productivity has made steady progress even while adding new sales reps.  (Note that Q1 is seasonally slower in North America.)

 

Q4 05 Q1 06 Q2 06 Q3 06 Q4 06 Q1 07 Average N. Am. Sales Reps 41 49 55 55 58 60 Sales Productivity (U.S. revenues/Q) $350 $289 $250 $335 $359 $302

As productivity increases and the investments in infrastructure subsides, Syneron should see increased operating leverage.  Management pointed out their focus on operating leverage specifically in their Q1 financial results, pointing out that “our investments in marketing and sales, which peaked in the fourth quarter of 2006, have been reduced by approximately 7% [excluding non-cash options expense] compared to the prior quarter and are in line with our strategy to improve our cost structure.”  The smaller G&A expense was down 18% sequentially and flat with Q3 2006.  As the sales increase from the seasonally weak Q1, expenses as a percent of sales should be reduced.

 

 

On February 27, 2007, Syneron announced a marketing deal with P&G by which P&G will exclusively market and distribute Syneron’s home use devices for the treatment of fine lines, wrinkles, age and sun spots and cellulite.  This deal is important for three reasons:

 

1)      A partnership with P&G legitimizes Syneron’s product and technology.

2)      Once the product is launched, P&G’s involvement will speed global distribution faster than Syneron could have done itself.

3)      The deal will give Syneron access to a recurring revenue stream through royalty payments from P&G for consumables related to the devices (creams, lotions, etc.)

 

Unfortunately, P&G has not allowed Syneron to reveal much about their deal.  However, the CEO has hinted that their deal is better than the Gillette/PMTI deal for home use laser hair removal, which includes a 6% royalty payment.  Syneron was able to negotiate a better deal because they financed their own development and came to the table with a product that was nearly complete.  In fact, prior to the P&G deal, Syneron had mentioned publicly that they were going to launch their home use device in some unnamed country during 2007.

 

So with little revealed about the economics of the P&G deal, how should one evaluate what something like this could be worth?  By making some basic assumptions including:

 

1)      Only sold to women in the developed world (500m)

2)      Syneron price is $75, which leaves lots of margin for P&G and the retailer.  It has been suggested that the product would cost less than $300.  (There is a Radiancy home-use hair removal product sold on the Internet priced at $249 plus S&H.)

3)      Operating margin at 20% or lower, taking into account some competitive pricing pressures.

4)      Product adoption follows a traditional S-curve, with only 2% penetration by year 6 (5 years after launch).

5)      Syneron will pay taxes on their profits, even though this is unlikely for 10 years due to their special tax status in Israel.

6)      Discount rate of 12%

 

With assumptions like these, a discounted cash flow analysis arrives at a price per share of $50.  Even giving this whole analysis a huge haircut of 50%, I still arrive at a price per share equivalent to today’s price.

 

 

As will be addressed in more detail below, the use of lasers for aesthetic treatments is increasing around the world.  The market drivers are clear, as people become older, more affluent, and more vain.  Over the past 3 years, the publicly-traded competitors in this industry have grown collectively at an annual rate average of 24%.

 

I estimate that the whole industry has about 30,000 units installed and according to some market research, there are 495,000 global potential users (including physicians and medispas).  This represents a 6% penetration rate.  Given that the "market research" came from an industry consultant, it's likely high, but even if it's off three-fold, penetration rate is only 18%.  There is still plenty of room to grow for another couple of years without consolidation.

 

 

There are many misconceptions surrounding Syneron, some of which are exacerbated by sell-side analysts who have perpetuated rumors spread by Syneron’s competitors.  I will attempt to dispel the myths here.

 

 

One incorrect argument that the bears have made is that the management team is shady, which stems from a connection that the chairman has with ESC Medical, one of the pioneers in medical lasers.  For many years ESC was the pre-eminent provider of laser-based medical devices, but in 2003 it fell apart in an accounting scandal that eventually led to an SEC investigation into fraudulent sales and improper accounting.  The stock, which changed its name to Lumenis, was delisted in April 2006.

 

The Syneron chairman, Shimon Eckhouse, the CEO of Lumenis from 1992 to 1999, stepped down from the company in a proxy battle in 1999 by minority shareholders, led by Arie Genger.  The proxy battle was waged after a couple of disappointing quarters that were the result of some botched acquisitions from 1997 and 1998.  Eckhouse has admitted to me that “my ego played not an insignificant part in those acquisitions,” and that they didn’t do a good job of integrating salesforces.  As a result, they missed their sales targets.

 

Nonetheless, when Eckhouse stepped down at the beginning of July 1999, the stock was around $6, and the company had $62m in cash (about $3/share).  Eckhouse was long gone by the time the first fraudulent transaction took place in 2001, which was negotiated by the COO at the time, Sagi Genger, the son of the shareholder who fought Eckhouse.  The SEC’s civil fraud suit against Sagi Genger continues to this day.

 

For your reference, attached is the link to the SEC summary, which also contains a link to the entire complaint, which includes a timeline of the alleged fraud.  http://www.sec.gov/litigation/litreleases/2006/lr19675.htm

 

I view this entire experience as a good thing for Eckhouse, who owned 15% of ESC.  (As noted earlier, Eckhouse owns 9.6% of Syneron.)  Some lessons that he took away from the experience:

 

The competition’s salespeople make the claim that the product doesn’t work – that the radiofrequency is just a gimmick and that it’s just used for “marketing.”  Ignoring the fact that there are numerous physicians who have successfully conducted trials to evaluate the efficacy of the product (presumably the bears are not willing to accept this evidence due to the fact that Syneron sponsored the research), they cannot ignore the fact that in the past three years, Syneron has rocketed to the number two market position in the industry.  They cannot ignore the fact that the largest laser hair removal center in the country, American Laser Center, which grew 112% from 2005 to 2006 and is by far the largest chain of aesthetic laser centers, has chosen Syneron’s products for hair removal, skin tightening, and cellulite reduction.  Finally, they cannot ignore the fact that such a reputable company as P&G has chosen to partner with Syneron for every cosmetic laser application other than hair removal.

 

 

Due to the explosion of hair removal centers and advertising, some investors are under the impression the market will grind to a halt in the near future.  Driven by the undisputable factors of an aging and increasingly-narcissistic world population, the market is still emerging in three areas: (a) domestically, (b) internationally, and (c) expansion of the types of treatments appropriate for laser devices. 

 

Domestically, while some parts of the country experience a glut of hair removal supply, this is not the case in most of the country.  In the past 9 months, American Laser Center has opened 30 new centers.  Another large chain, Ideal Image, has already opened 17 new centers in 2007.  These new centers are not confined to places typically perceived as “flashy” cities either.  These national chains now have locations in unlikely places such as Coralville, IA, Boise, ID, and Eugene, OR.

 

Internationally, the growth is just beginning as well.  At a trade show I attended, I observed physicians from Japan, South Korea, Russia, Colombia, and Brazil.  Many of the laser companies are now focused on China as well.  Syneron has a sales office in Hong Kong.

 

New treatments are constantly emerging to treat different cosmetic issues.  The past couple of years have seen an introduction of devices for cellulite, skin tightening, and skin rejuvenation.  As devices become more common, their presence has expanded beyond the traditional market of dermatologists and plastic surgeons into family practices, med-spas, and ob/gyn offices.  The cash-pay characteristics of these treatments are very attractive to physicians who look to supplement their income in the challenging managed care environment.

 

As for prices, my primary research indicates that treatment prices are holding steady for the providers, and a couple of discussions with laser financing companies indicate that prices are also holding steady for the laser manufacturers.

 

With better-than-expected revenue growth and a modest amount of operating leverage, I see Syneron with 2007 EPS of $1.70.  At that point, management’s credibility will be restored and it should be trading at a P/E of at least 20x (still a discount to the peers), or $34 per share.  And does not include any value from their very new dental laser or their home use device to be launched by P&G.  As mentioned above, the value of the P&G deal could be as high as $50 per share.

 

The table below summarizes the downside and upside cases for Syneron in 2007.

 

Downside Upside Comment 2007 EPS $1.50 $1.70 Difference between achieving some operating leverage or not "Credibility" P/E 14x 20x Takes into account concerns of mgmt, taxes, and cash situation Base Business Value/Share $21.00 $34.00 P&G DCF Analysis $50.00 $50.00 See summary of assumptions above "Skeptical" Discount 100% 50% Related to perception of likelihood of success (or my assumptions) P&G Value/Share $0.00 $25.00 Total Share Price $21.00 $59.00 Upside from Current -16% 136%

A.   Growth and/or leverage don’t occur

 

B.   Syneron makes a bad acquisition that doesn’t make any sense:  Even though Eckhouse should have learned his lesson, Syneron could still blow their cash balance on a dumb acquisition.

 

C.   Cash flow gets worse:  While it makes sense that Syneron extends better terms to larger clients, there’s a chance that they will become too loose with credit and end up with greater bad debt, which increased from 2005 to 2006.  (It had been too low in 2005.)

 

D.   Syneron could get sued by Palomar (PMTI) for patent infringement:  Syneron is the only major competitor that has not been sued by Palomar, which in theory holds the U.S. patent for light-based hair removal.  Palomar has sued and/or settled with Cutera, Cynosure, Alma, Laserscope, and is currently engaged in a larger suit with Candela.  Syneron claims that Palomar has not brought suit because they know that their technology is different.  Based on competitors’ settlements and royalty agreements, I would expect maximum exposure for Syneron to be a one-time payment of $15-20m ($0.55-$0.72/share) and $0.05/share per year.