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Shares of Cynosure (NASDAQ:CYNO) have taken a beating. The developer and marketer of aesthetic treatment systems which are used to perform non-invasive procedures announced that it has agreed to acquire Palomar Medical Technologies (NASDAQ:PMTI). Shares ended the day with losses of 5%, while shares of Palomar rose more than 4%.

The Deal

Cynosure announced that it has agreed to acquire Palomar Medical Technologies in an attempt to create a world-leading aesthetic laser and light-based company. Cynosure will acquire the company for a total of $284 million in cash and stock.

Shareholders in Palomar stand to receive $6.825 worth of Cynosure's common stock and a similar amount in cash. The deal values the company at approximately $294 million. The deal represents an 8% premium compared to Friday's closing price.

Combined, both firms have an installed basis of over 20,000 aesthetic laser systems. The company has a distribution network in more than 100 countries and will have its revenues approximately evenly split between North America and international markets.

CEO and Chairman Michael Davin commented on the deal: "We believe the acquisition of Palomar creates a substantial opportunity to generate profitable, long-term growth for our Company and drive value for our stockholders. Combining with Palomar complements our product portfolio and customer base, adding new product and service revenues, strengthening our global distribution network, creating new cross-selling opportunities and enhancing our intellectual property position with the addition of more than 40 patents."

Palomar generated $80.6 million in annual revenues for the year of 2012 on which the company lost $6.2 million. The company operates with $88.2 million in cash and operates without the assumption of debt. As such the net "cash" value of the deal is only $206 million which values the company at 2.6 times annual revenues.

Cynosure expects that the deal will be accretive to earnings in the calendar year of 2014, based on expected annual synergies of $8 to $10 million. The deal has been unanimously approved by the board of directors and is expected to close in the third quarter of this year.

The deal is subject to normal closing conditions including shareholder and regulatory approval. Upon completion of the deal, shareholders of Palomar will hold approximately 23% of the shares in the combined company.

Valuation

Cynosure ended its fiscal year of 2012 with $126.7 million in cash, equivalents and short term investments. The company operates with merely $0.4 million in total debt. As a result, financing the deal will be no issue at all given the strong financial position, the large cash position of Palomar, and the fact that 50% of the deal will be financed with the issuance of new shares.

For the full year of 2012, Cynosure generated annual revenues of $153.5 million, up 39% on the year before. The company reported a net income of $11.0 million compared to a modest loss the year before.

Factoring in the 5% correction on Monday, the market values Cynosure around $360 million. This values operating assets around $225 million. As such, operating assets are valued around 1.5 times annual revenues and 20-21 times annual earnings.

Cynosure does not pay a dividend at the moment.

Some Historical Perspective

Shares of Cynosure rose from lows around $10 in 2006 to peak at $40 a year later. Shares fell hard during the recession towards $5 in 2009 after which they started a steady recovery. Despite the correction, shares have already returned 12% so far in 2013, currently exchanging hands at $27 per share.

Between 2009 and 2012, the company more than doubled its annual revenues from $73 million to $153 million. The company reported a sizable $23 million loss in 2009, but steadily increased profitability to $11 million over the past year.

Investment Thesis

Investors are not applauding the deal with the greatest enthusiasm. Cynosure has lost roughly $20 million of its market capitalization despite the sizable synergy estimates, while the market capitalization of Palomar increased by roughly $10 million.

Fact is that Cynosure is willing to pay a significant premium for Palomar, valuing assets around 2.6 times annual revenues despite a decline in the revenue base compared to 2011. Its own operating assets are merely valued at 1.5 times annual revenues despite the strong growth rates and the superior profitability of the firm.

While the premium seems unjustified based on revenue, earnings and growth multiples, investors should comfort themselves based on the sizable synergy estimates. Annual synergies of $8-$10 million could be worth a $100 million, bringing the net incremental expense of the deal to little over $100 million. Factoring in the synergies, the multiples become more acceptable.

Combined both firms generate pro-forma revenues of $234 million and earnings of roughly $5 million. Yet annual synergies could drive annual earnings towards $15 million per year.

Cynosure will pay half of the $284 million price tag, or $142 million in cash. Given Palomar's net cash position of $88 million, the net investment will only be $54 million. As a result, the net cash position of Cynosure will only fall back to $72 million. Yet there will be some dilution to the share base. The market capitalization will expand from a current $360 million towards $500 million.

The new combination will as such be valued around $500 million, and its operating assets around $430 million. This values operating assets around 1.8 times annual pro-forma revenues and 28-29 times annual earnings.

Overall the deal makes strategic sense as the company adds to its current portfolio at a time when the market for cosmetic procedures is recovering. Shareholders act reserved and I think the price is a bit rich as well, despite the sizable synergies estimates. The company would need to achieve better sales leverage through its own marketing and distribution network to make the deal really worthwhile for Cynosure's shareholders.

Despite the modest premium, shareholders of Palomar appear to have gotten the better deal. I refrain from investing in Cynosure at the moment, despite the sizable deal.

Source: Cynosure: Price Tag Of Palomar Deal A Bit Steep