In November of 2011, I wrote an article arguing that as a result of the significant cash on their balance sheets and the amount of money spent on competing against one another, companies in the aesthetic laser light industry should merge. Today's merger of two of the largest players in the industry, Cynosure (CYNO) and Palomar Medical Technologies (PMTI), was the merger I had in mind, though I did not state as much as it would have been pure speculation. For the remainder of the article, I will refer to the combined company as "NewCo".
The combination of Cynosure and Palomar represents a combination of two of the best managed companies in the industry. In addition to the merger creating significant opportunities for the company to grow further, the valuation is reasonable when compared to Med-Tech peers.
To begin, both companies are based in the same town of Waltham, Massachusetts. This should make the integration of management, sales, back office operations and processes significantly easier than if the two were states apart. The merger is scheduled to close in the third quarter of 2013, so for the sake of comparability, we will look at the full year 2014.
|2014||Sales||EPS||Free Cash Flow||EV/Free Cash Flow|
CYNO Pre- Acquisition
|$185 million||$1.02||$20 million||12.9x|
|NewCo||$267 million||$1.36||$37 million||13.0x|
As you can see in the above table, while all of the company's financial metrics will improve after the merger, the EV/Free Cash Flow remains the same as the financial benefits are the deal are initially offset by dilution in the stock. As the company produces significant amounts of cash and reinvests it, we think the valuation will become more compelling.
On today's call, management cited that the combined company will be selling into a total of ten countries (including the U.S.) on a direct basis. We think that with the significant additional scale the merger brings, the company could enter additional markets with direct sales including Brazil & Argentina. On a worldwide basis, at least three of the company's markets overlap, creating an overlap for some cost savings, but more importantly, a more robust selling effort. In the United States, where NewCo will be attaining half of its sales, the combined sales force will be able to go into the doctor's office with a more significant offering. Additionally, territories can be re-assigned to maximize efficiency.
Turning to research and development, management indicated on today's call that there was at least some overlap in projects that the two companies were pursuing. While we see R&D in 2014 increasing from a previously expected $12 million to $19 million after the combination, we think the dollars will be much better spent on pursuing new indications instead of competing to sell similar products as had been the case before the merger. The key to success in this sector has proven to be developing new, meaningful indications. Not only do better products lend themselves to higher sales, but also greater pricing power and improved branding.
After the companies merge in 3Q of 2013, NewCo should have more than $100 million of cash on the balance sheet. When combined with the company's new annual run rate of free cash flow of over $35 million in 2014, and almost $40 million in net operating loss carryforwards that should lower NewCo's cash tax rate in the coming years, we think the company will have significant resources to pursue additional complimentary acquisitions. Over the past couple of years, CYNO's management has made disciplined acquisitions of businesses that they didn't have to leverage up to buy and that would benefit from the company's already expansive sales network. After completion of the Palomar acquisition, we anticipate the company will pursue acquisitions for new indications to enable greater scale and more consistent results.
Additional scale should also provide for less competition for customer acquisition, which should firm up pricing a bit in the sector. Additionally, greater scale may provide NewCo greater leverage with its vendors. Finally, to date, coverage of the aesthetic laser industry has been scant on Wall Street. With a post merger valuation of $600 million, and the increased share count from 15 million before the merger to 22 million after, the company should draw the attention of more analysts and institutional investors.
A call option on the company comes in the form of its first at home device later this year. While details are scant, Cynosure is expected to launch an at home aesthetic product with Unilver (UL) that works on the treatment of facial wrinkles. To date, at home devices that competitors have launched have been met with varying levels of success. While Palomar's high end Palovia device for the treatment of Crows' feet accumulated over $6 million in sales since it debuted in 2011, it has failed to reach profitability and is generally seen as a disappointment. That's not to say that it's not a good product, just that it did not catch on as quickly as hoped by some. Alternatively, PhotoMedx's (PHMD) consumer business has largely driven the company's results. So, while we can't know whether Cynosure's new consumer product will work out, it is one more event that can go right for the company.
Valuation Comparison Among Med-Tech Companies Based on 2014 Estimates
|Enterprise Value/Free Cash Flow||Enterprise Value/Sales|
|Solta Medical (SLTM)**||22.5x||0.9x|
The above comparisons are based on internally generated estimates.
* CYNO financials reflect NewCo
** SLTM Enterprise Value includes Contingent Liability for past acquisitions
Primary risks to Cynosure's ability to execute include the company's respective products cannibalizing one another and any economic headwinds the company might face. When the economy fell apart in 2008-2009, the industry suffered through significant sales declines (50% on average).
In conclusion, we think the merger of Cynosure and Palomar was the right deal at the right time. While CYNO's shares are down today, we think the additional scale the company was able to obtain with the acquisition should make results less volatile going forward in addition to breeding more innovation within the company.
Additional disclosure: Short SLTM, PODD, DXCM