Cynosure Still Looks Attractive After A Bull Run

| About: Cynosure, Inc. (CYNO)

Summary

CYNO's shares are up 160%+ since late 2014, but I still see more upside.

SculpSure clearly is garnering exceptional demand, making it a legitimate number two competitor to ZELTIQ's CoolSculpting.

Valuation is a bit of a concern, but the story looks rock-solid, and CYNO should be considered for the growth part of a portfolio.

I was a bit late in coming around to the story at Cynosure (NASDAQ:CYNO), but the company's second-quarter earnings report on Tuesday strengthened that story. It seems clear that SculpSure's roll-out has been a success, and as penetration grows, it appears to be benefiting Cynosure's legacy products.

With SculpSure now looking like a legitimate competitor to ZELTIQ's (NASDAQ:ZLTQ) CoolSculpting - a product that alone has driven an enterprise value over $1 billion - the risk in CYNO now moves from its portfolio to its admittedly still-high valuation. But with enough leverage in the future to support that valuation - and margins outperforming already - CYNO still looks to have upside.

SculpSure

One of the difficulties in trying to value Cynosure is that the company - like its peers - doesn't break out sales by product (No matter how hard analysts try to get that information out of management, as witnessed on earnings calls). But Q1 results appeared to imply a very strong start for body-shaping product SculpSure; Q2 seemed to support that thesis. North American product revenue increased 46% year over year, with SculpSure apparently the key driver. Given a ~$19 million absolute increase, it seems likely that SculpSure again cleared at least $10 million in product revenue, after an estimated $10-15 million in Q1.

Notably, service revenue spiked as well, increasing 47%, a gain that "primarily" came from so-called PAC keys for SculpSure. And that increase seems to imply that SculpSure units are seeing impressive utilization. Parts and service revenue overall increased $6.3 million year over year; we'll assume that PAC key sales accounted for $4.5-5 million of that increase (Service revenue rose ~$1.3 million the year before, or about 10%; $4.5 million-5 million seems a reasonable estimate for SculpSure's contribution). In this scenario, Cynosure sold 90,000-100,000 applicators (100 per PAC key) at a list price of $50.

Cynosure has said in the past that "it is not uncommon" for customers to buy three PAC keys with installation; assuming an average then of 250 treatments going with each sale, and 100 Q1 installations ($13.5 million in revenue), Cynosure likely sold 65-75 thousand applicators against an existing base likely in the range of 250. That's ~300 per installed unit, which seems to imply utilization over 1 per day.

Intuitively, that seems too high - but if it is, then SculpSure product sales are higher than I've modeled. CoolSculpting is seeing North American utilization of about 1.46x per day; Syneron Medical's (NASDAQ:ELOS) UltraShape is hitting rates of about two per week. Early numbers then appear to show that not only is Cynosure showing early success installing its base, but also that practitioners are having early success selling procedures to customers.

Meanwhile, reviews for SculpSure still seem solid, and roughly in line with those of CoolSculpting. SculpSure gets an 80% "worth it" rating on RealSelf; CoolSculpting's figure is 83%. SculpSure has some inherent advantages as well: a 25-minute treatment time is 10 minutes shorter than CoolSculpting, even after ZELTIQ managed to bring its figure down to 35 minutes from an hour. CoolSculpting uses suction, which makes patients feel a "pinch" and can lead to bruising; reviews seem to suggest that SculpSure has an advantage in recovery time and post-procedure pain. SculpSure appears to have more flexibility than CoolSculpting as well.

At the least, SculpSure seems to have room to coexist with CoolSculpting. Both companies have rolled out DTC marketing campaigns of late (they have competing billboards less than a mile apart on I-94 north of Chicago), and they are targeting roughly the same space. But on the Q2 conference call, CEO Michael Davin said Cynosure still wasn't running into ZELTIQ and Syneron to the extent it had originally thought.

That seems bullish for the space as a whole, particularly given that the three companies (along with other competitors) are targeting both "core" (plastic surgery and dermatology) practices along with "non-core" (general practitioners, OB/GYN, etc.) practices looking to drive cash sales in a tougher climate for providers. For now, there still seems to be room for everyone to grow. The fact that pricing has held after some early discounting - according to both Cynosure and Syneron - supports that conclusion, particularly given that UltraShape and SculpSure hit the U.S. market around the same time.

For its part, SculpSure certainly has room to grow. Only 10% of product sales in the quarter were from international markets; the figure overall was 34%, as SculpSure continues to get approval in new markets (recently Canada, Australia, and South Korea). 70% of sales so far have been to new customers, and 25% bundled with other products, which implies that SculpSure growth can have a "halo effect" on product lines such as ICON and PicoSure.

The worry I had last year, and even into Q1, was that CYNO's shares might have gotten ahead of SculpSure's growth. And it's worth pointing out that UltraShape sales from Syneron started strong before seeming to fall off in the back half of 2015 (though SculpSure may have had something to do with that). Even Davin seemed to try and tap the brakes on sentiment a bit, pointing out that growth rates would slow down in Q4 as Cynosure anniversaried the full launch of SculpSure. At 39x trailing earnings plus ~$9 per share in net cash, some caution is advised. But Cynosure at the least has established that SculpSure is a legitimate competitor in its space, and that opens up opportunities going forward.

Leverage

Cynosure beat consensus (more accurately, crushed consensus) for the quarter, with 20% non-GAAP EPS growth (CYNO doesn't exclude stock-based compensation from non-GAAP figures, just acquisition and amortization costs plus non-cash forex gains and losses). That's impressive enough on its own, but analysts actually had forecast an earnings decline in the quarter even while projecting revenue growth in excess of 20%.

The beat comes from revenue and associated leverage, obviously, but those projections show how much impact SculpSure's launch has had on opex. Operating expenses increased over 37% year over year, due almost solely to the spend around SculpSure. Sales and marketing spend rose 35%, as Cynosure builds out its sales force to support the new product, and as it targets spend to DTC initiatives and now incremental personnel in the field.

A lot of this spend obviously isn't coming off the books; it's not as if Cynosure has some $75 million TV ad campaign that won't be repeated next year. But spend came in at 35% of revenue against post-Q1 guidance of 35-37%, and commentary implies the delta came from sales growth that exceeded Cynosure's expectations, not higher-than-expected spend. Cynosure said after Q1 that spend would come down in the back half, and it's targeted sales and marketing spend of 32-33% in 2017. CFO Timothy Baker said on the Q2 call that gross margin would continue to improve - disposable revenues are helping, with a typical margin of 80-90% - and that R&D and G&A leverage was expected as well. That's in addition to 300-400 bps improvement in operating margin from lower sales and marketing spend.

Q2's results seem to imply that operating margin could improve more than expected, given that Cynosure's sales and marketing (as a percentage of revenue) has come in at the lower end of its range in both Q1 and Q2. Again, that doesn't seem to come from the company spending less than it planned; in fact, it appears to have accelerated investment in SculpSure, in particular. It's because sales are growing faster than expected, and that should imply better-than-expected performance going forward.

Valuation

I'm surprised CYNO's shares didn't see a bigger gain coming out of earnings; it opened strong on Tuesday, faded, gained, then declined modestly on Wednesday. To be sure, there might be some sentiment that even the quarter's outperformance is priced in, and perhaps some investors took Davin's cautionary words about the top-line impact of anniversarying SculpSure to heart.

But it struck me as a very strong quarter; while commentary on the portfolio ex-SculpSure was limited, it does seem that Icon, PicoSure, and MonaLisa Touch (which Cynosure distributes for former minority owner El. En SpA (OTC:ELEAF)) grew in the quarter. PicoSure appears to have had strong demand after a Q4 release in China, and El. En's Q1 report implies strong performance for MonaLisa Touch (that company hasn't released its Q2).

I argued after Q1 that 2017 consensus of $1.89 looked conservative, and the Q2 report certainly supports that argument. Even at $54, CYNO still is trading around 22x forward EPS (if it can get to $2) plus cash, and Q2 seems to have minimized some of the growth risk relative to SculpSure in particular. A new product line is coming out in 2H 2017, and Cynosure's excess cash can go to either share repurchases or a potential acquisition. A mid-20s multiple in 2017 doesn't look particularly excessive given SculpSure opportunities, and that still implies upside to the mid-$60s.

All told, Q2 looked highly supportive of the bull case, even if valuation is a bit high; the combination of growth going forward and margin expansion should narrow that multiple considerably. More broadly, the growth story heading into the quarter looked good; it looks even better coming out.

Disclosure: I am/we are long ELOS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.