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Few sectors of healthcare have been gutted to the same extent as aesthetics. Although large players with more of a pharmaceutical focus like Allergan (AGN) and Medicis (MRX) have held up reasonably well, that is in large part because a larger part of their business falls under the header of "medically necessary" and is eligible for insurance reimbursement.

For the device companies, particularly the energy-based device (colloquially called "lasers") companies, though, it has been a hard road indeed. While procedure volume has not yet picked up significantly, investors looking for to get in early may want to consider Palomar Medical Technologies (PMTI). If a recovery in aesthetics procedures really is a "sooner or later" event, the low valuation and strong IP could make this an interesting stock again.

The Easy Money Is Gone

Vanity has gone nowhere, but the easy money to pay for laser hair removal, skin rejuvenation, body sculpting and the like is long gone. Unfortunately, while the rich and vain are still happy (and able) to go spas and clinics for treatments, a nearly mass-market level of infrastructure and expectation was built up and is slowly withering away. Where once almost anybody could get high-cost financing for aesthetic procedures, much of that business has collapsed under the weight of uncollectable receivables.

Not surprisingly, sales have plunged for the equipment sellers. Palomar's recent revenue run-rates have been less than half of the 2006/2007 peak and competitors like Cutera (CUTR), Cynosure (CYNO), and Syneron (ELOS) have seen similar shortfalls over roughly similar time frames (though Syneron boosted reported revenue with the acquisition of Candela in 2010). Only Solta (SLTM) has fared relatively better, and here too acquisitions have played a role, though so have competitive product launches and a pricing/usage model better suited to the new economic realities of the market.

Still Innovating And Still Launching

Palomar has not just retreated to the bunker to wait for the bad times to blow over. The company continues to develop and release new products. The Icon updates the company's core professional aesthetic laser platform. The Acleara offers a light and suction-based system to treat mild-to-moderate acne and directly targets Solta's Isolaz system with a lower (almost 50% lower) price and faster treatment time. Palomar has also begun distributing the Adivive - a system that harvests fat, centrifuges it, and make it available for re-injection as a dermal filler.

Atop all of this is a home-based laser skin renewal system, the PaloVia, that is now on sale. Although Johnson & Johnson (JNJ) bailed on its partnership with Palomar to develop these at-home devices years ago, it seems like early sales efforts through channels like QVC are going reasonably well.

A Fierce IP Contender

Palomar arguably has some of the best IP in the energy-based aesthetics device sector and the company is absolutely fierce when it comes to enforcing it. It very nearly seems that everybody has to pay Palomar at some point - either licensing patents upfront or paying settlements after litigation that Palomar seems to win with regularity. It should be noted, in fact, that Palomar has long generated a fair portion of its revenue from royalties - from a low of 8% in 2009 to nearly 25% in 2006.

in fact, Syneron recently settled another case with Palomar and will be paying $31 million as a result - about $1.50 per share in cash.

A Recovery Play With Risks

Investors should note that Palomar is not the biggest player in this space by revenue, with or without those royalties and that companies like Solta and Syneron work diligently to engineer around those patents. It's also worth noting that patents on hair removal technology start expiring in 2015, while fractional laser technology patents start expiring in 2020. Although Palomar spends quite a lot on R&D through good times and bad, there is no guarantee that it can maintain that formidable IP estate.

If Palomar can regain 2007-era levels of free cash flow by 2015, this is definitely a company worth considering. While a forecast of a ten-year compound free cash flow growth of 20% may seem aggressive, keep in mind the low base from which this company is rebuilding. In fact, assuming that the company can achieve sustained profitability and free cash flow in 2014/2015 and thereafter, this stock could easily trade in the mid-teens without ever regaining peak free cash flow margins.

At the same time, shop around. The broad trends that could make Palomar a winner again largely apply to Syneron and Solta as well. Solta in particular has done a very laudable job of building a credible energy-based aesthetics business through a brutal downturn. Still, with attractive new products for both the professional and home-care markets, and a clean balance sheet, Palomar could be a winner-in-the-making for patient investors.

Source: Patience With Palomar Could Pay