Description

Figures in this write-up are very rounded, as the big picture matters more to us for growth stocks than imaginary numerical precision. Also, this write-up was getting excessively convoluted w/ all the different angles around the story, so it has been cut back a lot. Happy to debate or discuss any missed points in discussion.

Overview

Zeltiq is a medical devices company that only makes one product for the aesthetics market, the CoolSculpting system. It is not the first company to deliver a non-surgical fat reduction/body contouring offering (ie. substitute for liposuction variants), but it has been the most successful by far and singlehandedly turned this neglected corner of the cosmetic procedures market into an actual category over the past six-ish years.

Although no longer trading at its post-IPO highs, with valuation in the range of 40-50x 2016 adjusted EBITDA and 3-4x 2016 sales (based on company guidance), the company’s shares still embed extraordinary growth expectations and have steadfast equity analyst support on Wall Street. We believe the company is already in the early stages of a major growth deceleration and that investor expectations will adjust accordingly over the next 1.5 years, likely taking shares to less than half of their current value. We might be early (or wrong), but if the downside catalysts below don’t come to pass in the near term, we still see capped upside in the stock price as investors realize that the market potential is nowhere as lofty as management projects.

Business Model

Zeltiq’s CoolSculpt machine destroys fat cells by freezing them to death (“cryolipolysis”). The procedure is non-invasive and involves the medical practitioner affixing the equivalent of a vacuum cleaner to your belly or thighs and turning the sandwiched flesh into an ice cube. The procedure is calibrated so that fat cells die, but skin and nerves survive. This may sound gimmicky and faddish (probably because it is!), but clinical results do show that it reduces fat cells in the ballpark of 20-25%. This does not translate into significant weight loss and cannot make a fat person skinny the way liposuction can. What it does is flatten fat rolls into smoother, more svelte body parts. There are enough positive reviews out there to conclude it works well enough, even if results are not consistent for everyone.

When introduced, the CoolSculpt alternative gave the patient a choice for non-diet/non-exercise based fat reduction that didn't exist before. Instead of going under the knife for radically better results but with non-zero perceived risk of injury/death, a person who was dissatisfied with their body image could try CoolSculpt to get a lower level of results but with negligible perceived risk of injury/death and at lower cost. CoolSculpt probably grew the fat reduction market rather than cannibalizing it, as the number of surgical procedures have grown in tandem with the rise of CoolSculpting.

Zeltiq operates a razor and razorblade model. It sells CoolSculpt systems for ~$85k each to aesthetics practices (doctors and non-doctors alike, high percentage of practitioners are dermatologists or plastic surgery practices) at an ~55% gross margin and then charges $125 or more per “cycle” of treatment at an ~85% gross margin. Management estimates that 55% of revenues in 2016 will come from recurring cycle sales in 2016.

Significant Deceleration in Unit Deployments

The recurring revenue aspect of the business should be very compelling, but the core equipment business is starting to slow down. Unit sales of CoolSculpt systems in North America have experienced two sequential quarters of MSD YoY declines for the first time, and international sales fell off a cliff in Q1 as well. Also note that a block sale of machines to the aesthetics chain, Ideal Image, accounted for 220 units (~25%) of NA sales over Q4 2014 – Q2 2015, which the company has yet to replace.

The company provides a cheatsheet of business metrics for your use here, which conveniently allows me to punt on trying to format excel tables and charts into VIC submission format. 

http://files.shareholder.com/downloads/AMDA-HFC01/1826053155x0x891174/5F97B8AE-133A-41AA-8D88-DC3085C5CB47/Q116_ZELTIQ_Supplemental_Disclosure.pdf

ZLQT reduced EBITDA guidance last year and again in Q1 2016. For the Q1 EBITDA guide-down, this was combined with a revenue guide-up, reflecting the company’s shift to upselling new attachments to its client base (CoolMini applicator for submental fat and CoolAdvantage applicator for halving of treatment time and greater comfort, with this 2nd product delivering lower margins). The company discloses that 60% of its existing accounts have already ordered a CoolMini and there likely won’t be substantially more penetration. CoolAdvantage will be delivered in the latter part of this year, so will provide a revenue boost to offset what we expect to be sagging system sales. The existential issue is, if they are no longer rapidly growing their practitioner base, the company will be caught on the treadmill of upselling its existing client base on ever-less-relevant upgrades in order to hit Wall Street expectations. 

Utilization Trends Positive, But Increasingly Advertising Driven

Other then selling more equipment, ZLTQ can make money by increasing the number of cycles that it sells. On this front, the trend is much better and you can read on the business metrics cheatsheet that revenue cycles have been increasing steadily, with a nice 26% YOY jump in Q1 2016.  We believe this Q1 result is a result of the nationwide direct to consumer (DTC) marketing effort launched in Q1 which will carry into Q2. Not surprisingly, web engagement has been very strong in Q1, but is plateauing at a lower level now and we believe will fall off when advertising spend trails off: https://www.google.com/trends/explore#q=coolsculpting.

Breaking this down further, holding system deployments flat, cycles can be increased by either selling new services to existing clients or attracting new clients. In terms of new services, the submental fat (under the chin) market is a new area with the new CoolMini applicator, as are the newly approved treatment areas of bra fat, back fat and banana rolls (buttocks fat, I did not make this term up). Feedback from dermatologists we have spoken to suggest that the submental market will be dominated by Kybella (injectable from the makers of Botox), which has already been extremely well received and does not require major upfront investment (lowers the startup and volume risk for doctors). We will have to wait and see how great demand for other body areas is. On new clients, it comes down to awareness and perception of the product. Success in this industry is based as much on marketing as on science, and because patients don't need to come back if the procedure works (and probably won't either if it doesn't), there is a need to constantly generate new patients. Advertising spend was a big factor in sending EBITDA negative in Q1, but it clearly helped juice cycles. Management has avoided the topic of discussing whether advertising generates persistent demand and claims that there is a tail effect on advertising investment. We will find out in Q3 when the DTC campaign runs off, but even analysts seem to think the benefits of advertising are short-term in nature.

Management has discussed that power users drive a disproportionate # of cycles, and thus has an active training/support program in place to turn machine owners into better sellers of the service. Office visits have made clear to us that doctors generally aren't actively working to draw in new patients for CoolSculpting, so much as trying to upsell their client traffic to use it. After the product has been on the market for as long as it has and with no major upgrades to the assistance programs, it is hard to see cycles increasing indefinitely except for awareness building practices using major advertising spend. 

Competition

The first real competitor, SculpSure (maker is Cynosure Ticke: CYNO), soft-launched in H2 2015 and is now in full commercial rollout. This alternative to CoolSculpt uses heating lasers rather than cold to kill fat cells.

The two core reasons why Zeltiq’s CoolSculpt succeeded where other products (LipoSonix, Zerona, other also-rans) have failed is 1.) efficacy (CoolSculpt is clinically shown to cut fat cells by 20-25+%, though results vary by patient) and 2.) pain factor (you won’t be napping during any of these procedures, but industry insiders point to the indescribable agony of LipoSonix as the primary reason it did not succeed).

SculpSure generates the same range of 20-25+% fat cell reduction as CoolSculpt, and requires half the time to treat. We’ve heard/read conflicting feedback on how painful the procedure is, but it is marketed as far more comfortable than CoolSculpt. It also boasts faster recovery, skin-tightening benefits and there is no ick factor of having a “butter stick” of frozen flesh protruding from your abdomen after the procedure. We’ve seen the SculpSure pitch and spoken to prospective buyers, and as far as offices that are considering buying a body contouring device, the pitch is heard as being superior, whether or not the product is better in actuality.

From the doctors’ office perspective, with a 2-year or less payback cycle (simplistically speaking - spend $85k per machine, earn $2k per 4 cycle patient regimen while paying $500 to ZLTQ = ~57 treatments to break even), there is less incentive toward product loyalty out of any misguided desire to amortize sunk investment costs. We’re not saying SculpSure will take over the market, but we're reasonably sure that if someone becomes the gold standard in this business, it won't be CoolSculpt. Even if we're not talking about a winner-take-all market, the introduction of real competition is going to dent CoolSculpt's grip on the market.

Interestingly, the release of the CoolAdvantage applicator is itself validation of SculpSure, as the applicator attempts to catch up with many of the advantages of SculpSure, especially comfort and treatment time. If you reverse engineer the 200 bp gross margin and EBITDA margin guide down in Q1 from 10% to 7-9% caused by ”the increased cost of the CoolAdvantage product configuration at the time of launch”, you get a result that suggests CoolAdvantage has less than half the gross margin of the base machine. This begs the question of “why sell this low margin product when we can sell more base units at 55% gross margins?” especially with an overtaxed sales force and a marketplace that is substantially underpenetrated. We suspect this is a defensive move because ZLTQ perceives a real threat, but of course it could just be that management goofed on forecasting or execution.

Another theoretically credible competitor is UltraShape, made by Syneron Candela, which utilizes ultrasound to achieve the same ends. UltraShape, SculSure and CoolSculpt all have excellent online reviews and similar efficacy stats, plus UltraShape is reputed to be the least painful of the treatments, but for some reason management at Syneron hasn’t to date gotten their act together to mount a real threat to CoolSculpt and the product ramp remains anemic.

We believe that sales distribution is a key differentiator in this business, and getting product out is not as easy as cold-calling doctors when there is no name recognition. This suggests real challenges to CoolSculpt will take time, although it is encouraging for the short that CynoSure had a great Q1 on the back of SculpSure, as it was able to use its installed base to sell through a lot of systems. Anecdotally, based on conferences and marketing events we track (some of which we attend), it is clear to us that the cadence of SculpSure marketing is ramping rapidly.

Valuation

Growth businesses are difficult to value, but several diversified aesthetics medical device companies provide excellent reference points on where things could land. Cutera (CUTR), Cynosure (CYNO) and ELOS (Syneron) trade inside a range of 0.5x – 2.5x 2016 revenues and 11x – 16x 2016 EBITDA. CYNO may actually have a very attractive growth path ahead of it if SculpSure turns into a hit, but even with 20% topline and 40% EBITDA growth (based on consensus) ahead of it, it still trades at 1/2 to 1/3 the multiples of ZLTQ. Prospects for the other comps are debatable, but serve to highlight the severe overvaluation of ZLQT if you are of the mind they are not the next coming of Allergen.

What is clear to us from our study of the industry is that product differentiation drops off quickly, regulation is far less onerous for this class of medical devices, and you have a very fickle consumer/provider base to whom sales are driven by marketing as much as by results. The market is still pricing ZLTQ as if it were an explosive medical devices company with extremely strong product/regulatory barriers (which it was once), versus the reality today, which is that growth is slowing and barriers to entry are eroding quickly. There is every possibility that CoolSculpting will be either long forgotten or a very marginalized (or commoditized) product five years from now, if they follow the historical baseline for healthcare treatments with ambiguous medical benefits.

Conclusions

Big picture, this is a 1-2 year thesis based on the following: 

- Core equipment sales are slowing, likely due to domestic saturation, even before considering the effects of competition.

- Credible competitors have finally emerged in a market which ZLQT had to itself for the last half-decade.

- In terms of recurring revenue, this is not like botox or tanning booths, where patients keep coming back. After the initial battery of treatments, there are no “maintenance”-type visits for a long time. The business needs to keep finding new customers or applying procedures to new body parts, so is this really a razorblade business at all?

- The market for cosmetic procedures is fickle, and practitioners have no embedded incentive not to switch if a competing solution becomes more popular

- Valuation is well out of line with business results and market potential

Other resources

Please also see this presentation from an independent research shop for some thoughtful ideas on market sizing, technology differentiation and other good points I’m not going to take credit for here.

http://www.compoundinsight.com/2016/01/08/zeltiq-aesthetics-inc-zltq-sample-issue/

Links to ASDS and ASAPS statistics.

https://www.asds.net/_Media.aspx?id=8963

http://www.surgery.org/media/statistics

Links to product reviews on all of the aforementioned aesthetic procedures:

http://realself.com

Catalysts

Short term: Deceleration in system sales due to saturation and aggressive competition, conclusion of DTC advertising causes utilization trends to revert.

Long term: Inability to generate consistent profitability and to hit long-term margin targets, possible this product eventually lands in the dustbin with other forgotten fad healthcare products.

Risks

Zeltiq may have good topline figure in upcoming quarters if management executes on international sales, CoolAdvantage sell-through is strong, or they land another franchise-type customer like Ideal Image. Their recent distribution deal with Galderma has not produced results yet, but may click in upcoming quarters.

All of our research has been on the US market, and international sales is an area that is much harder to grasp. According to management, Q1 sales suffered as a new sales head deferred urgency on closings.

Competitor solutions may take longer to penetrate, given the inefficient sales/distribution channels in the industry.

Utilization may also increase in the short term as returning/new patients try CoolSculpting on freshly approved areas: under chin, bra fat, back fat, and banana rolls. Also, the advertising blitz may bring in more patients in the short term.

It is possible the company will debut new innovations, including in discussed areas such as cellulite and acne, but based on R&D spending levels and the lack of visible progress, we do not think this is likely nor likely to justify valuation.

M&A risk seems diminished at current valuation levels and with declining growth, although a buyer might think they could leverage their distribution to reinvigorate sales.

Catalyst

Short term: Deceleration in system sales due to saturation and aggressive competition, conclusion of DTC advertising causes utilization trends to revert.

Long term: Inability to generate consistent profitability and to hit long-term margin targets, possible this product eventually lands in the dustbin with other forgotten fad healthcare products.