Syneron Medical at a Discount

Syneron Medical (ELOS) is a company in the aesthetic application industry that should be able to maintain a competitive advantage in the home-used devices with its Procter & Gamble (PG) distribution deal. It is now largely undervalued, with an enterprise value that is only slightly higher than its average free cash flow as well as a very strong balance sheet.

One industry that has been hit considerably is the field of light and laser-based aesthetic applications. Many players compete in the industry and in order for a company to climb and stay at the top, it must either protect its patents aggressively or develop a strong distribution network. While most devices are currently sold to physicians or chiropractors, the next step for the industry will be to expand into the sizeable home-used devices market.

Two companies have struck important deals in order to start commercializing and distributing these devices. Syneron has signed a 10-year mutually exclusive agreement with Procter & Gamble for devices that treat fine lines, wrinkles, age and sun spots and cellulite. Meanwhile, Palomar (PMTI) has a deal with P&G for hair removal devices and a deal with Johnson & Johnson (JNJ) for all other treatments. As a result, it should be expected that these two companies will be in a very advantageous position a few years from now.

Israel-based Syneron presents an interesting investing opportunity for many other reasons. First of all, it has been able to conserve a higher gross margin than its competitors by manufacturing products that combine electrical and optical energy as opposed to laser-alone based devices like its competitors. Its costs of production are therefore cheaper. In addition, most of its suppliers offer better prices since they are located in Israel where many companies are under a tax-free status.

Thanks to strong margins and an improved sales force in North America, ELOS has been able to collect excellent free cash flows since its inception.

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In addition, the company has a pristine balance sheet with a very large cash position and no debt. It has to be noted that if the company was to redistribute all its cash, $48M of its $219M would have to be given back in taxes since the tax exemption they have obtained requires them to re-invest in their own country. Still, with a market cap of approximately $220M (November 12, 2008), an adjusted enterprise value of $49M, just above their 3-yr average FCF of $38M. Moreover, its market cap is slightly higher than their adjusted NCAV of $197M.

Possible reasons why this stock has been hit so badly are:

• Aesthetic treatments are a highly discretionary service and in this economy, spending in this area will be reduced.
• The company’s tax-free status requirements are a disincentive to redistribute the cash to shareholders.
• What was once considered a high-flying “growth company” has seen a slowdown in its growth rate which has led to a sell off by growth investors.
• Palomar has sued many of its competitors for patent infringement of its hair removal devices, creating a certain instability and uncertainty in the sector.

I believe Syneron will be able to build a moat to protect itself with its P&G distribution deal, its consumer contract with American Laser Centers (the largest laser treatment chain in America), as well as with its recent Syneron China joint venture with EverCare Medical Group, the largest aesthetic hospital chain in China. The fact that these large reputable companies have selected Syneron as their partner shows that ELOS has quickly become one of the most trusted companies in its industry.

It can also be added that many positive long-term trends provide a tailwind to the industry in general. These include the aging of the population, the increasing awareness of laser/light treatments as an option for skin rejuvenation as well as the society becoming vainer.

Another positive factor is the fact that the management has launched a $50M share repurchase program on November 8 2007 and has since bought back $9.1M in shares at an average price of $15.45. According to the CEO, the company “[is] currently in a process where [it is] evaluating the potential impact of additional shares being bought in the open market on [its] future tax exposure”. In the current environment, the company may look at ways of reinvesting its money in Israel rather than redistribute it to shareholders and pay taxes at the same time.

Possible catalysts

• P&G begins distributing Syneron’s home-used devices at the end of 2009
• Company accelerates buybacks at the current price level
• Sales gain traction after a few difficult quarters as the economy gets back on track

Disclosure: Author holds a long position in ELOS

Comments

[Directoy:]

The Israel Syneron Medical Company developed a very strong distribution network in US and around the world, I hope that can help on this Day,s

2008 Dec 31 09:29 AM

[zagrebzagreb:]

Although there are some fine points in here, as of today, the fact is ELOS is down about 50% since this article was published. Yes, the worry about discretionary spending on laser treatments, etc. in this economy is probably the biggest factor.

Mar 10 09:33 PM