Screaming Value at Syneron Medical

Today we see values in the market unlike any time since late 2002 and early 2003, when value investors could almost use a dart board. Among the many we see now, one stands out like the red-headed child. And yes, that child is screaming.

And yes, ahem, despite our image, value investors do scream, too.

Aesthetic laser company Syneron Medical (ELOS) today is priced at a level where the margin of safety is so great that the potential return is—as much as it is possible to say this at any time with a straight face—almost riskless. With enterprise value [EV] to free cash flow [FCF] or EBITDA multiples ranging from 5.5 to 8.7, a superb balance sheet, rising revenue, and a history of sound cash management, we have a company selling for a substantial discount to intrinsic value. A 50% gain in the next year or two would seem a reasonable expectation.

Why the low valuation, and why is it so lip-smacking?

Why the low price?
Almost all of the aesthetic laser companies were once market darlings and today have been thrown out with the trash, with the leading companies selling at or near 52-week lows and sometimes historical lows.

In most cases, they have been victims of retreats from once-torrid growth, so go-go growth and momentum investors have fled (they are so fickle!). Among Syneron, Palomar Medical Technologies (PMTI), Cutera (CUTR), Candela (CLZR), or Cynosure (CYNO), none has been spared. Yet in most cases, business is at least decent, financials strong, and the futures, if not blindingly bright, at least sunny. What the herd has left, value investors look to eat, and here there is plenty of meat on the bones. This is no value trap, “cigar butt” investment.

Yet the price drops are not entirely irrational. In most cases, sales competition is fierce, and these companies are all experiencing or facing price erosion. Gross and net margins remain high—practically at software industry levels—but shares have died through the collapse of investor expectations that margins would remain firm or expand. It simply costs more for companies to put their salespeople in the right places and shaves dollars off of margins. But where others see declining margins, value investors see still-superb margins that are stabilizing from effective cost management.

Another valid criticism is that the companies do not offer repeat business—there are no razor blades to sell or royalty payments per application. Or, if there are, they are not yet significant enough to bolster the ongoing businesses. I primarily know Syneron so am wary of making further observations, but repeat business helps you have more confidence in estimating future cash flows. And that, of course, is required to determine if today’s price offers safety or not. Yet if the expanding worldwide markets for aesthetic laser surgery are as we believe, there is plenty of value creation and intrinsic value left here to give us healthy profits soon enough—even with current business models.

Why is the valuation compelling?
One nearly foolproof investing strategy is to buy companies with neutral or rising free cash flow (FCF) for a single-digit multiple of enterprise value to FCF. Where EPS and FCF track each other, we keep in mind Benjamin Graham’s rule of thumb from The Intelligent Investor that any company that is consistently profitable, no matter if by a penny, is worth a P/E of 8—and thus an EV/FCF multiple of 8.

History shows us that this guideline is a very good predictor of both potential return and current risk. Buying according to the simple strategy in late 2002 through early 2003 was almost dart-board easy. Then it became difficult to find any candidates. Recently, we are awash again with at least potential opportunities, and Syneron is foremost among them. Syneron sells for EV/operating cash flow of 5, EV/true FCF of 5.5 (OCF minus cap ex), and EV/structural FCF (Buffett’s “owner’s earnings, excluding working capital but including interest) of 7.1. These are dirt cheap for any company, let alone one with Syneron’s quantitative and qualitative plusses.

Another finance guidelines that is surprisingly resilient is that buyers strive to pay as little as possible for a business, say 5-6 times EV/EBITDA. But as a seller, you try to get every last dime and if you can achieve 9-10 EV/EBITDA, you’ve done well. These are not applicable to all businesses—it depends on the industry and particular company aspects—but it’s amazing how often that range when you buy businesses valued at the former, you find yourself recipient of the premium in a buyout at the latter valuation.

For example, consider when Complete Growth Investor used to own deathcare provider Alderwoods. The business was predictable and we had seen the financials improve dramatically to those levels but saw little to no opportunity for further gains. We sold on a Friday with shares at 9 times EV/EBITDA for a 70% gain. So of course on the following Monday they were bought out by Service Corp. (SCI) for 10 times EV/EBITDA!

Rarely does it work out in such a charming textbook manner, but it’s still a great guide to value. In our case, Syneron has better growth prospects and finances than the staid, predictable deathcare industry, so its EV/EBITDA of 8.7 is not high, and might well invite a buyout at an EV/EBITDA multiple in the teens.

The brief case is this. Syneron today sells for over $17 a share. It’s debt free with $7.60 a diluted share in cash. Management has been using the cash to buy back shares, which is right where R&D funding is healthy and unaffected and shares have long been selling at such a discount to intrinsic value that ranges from the mid-upper $20s to the $30s.

We at CGI are not the only folks to see this value. Reclusive and brilliant active value investor Seth Klarman, whose Baupost Group has produced such remarkable long-term annualized returns, maintains Syneron as one of his top 5 positions. That’s company we’re happy to share.

 

Comments

[DaveinHacke...:]

I bought this one at $15.20 in April. At the time, it was trading at an EV/forward earnings multiple of about 5.7x. It still looks pretty cheap, if it can maintain earnings at this level. The company doesn't give earnings guidance, but it does guide for revenue. They expect a 10% increase in revenue this year.

2008 Jun 12 09:41 AM

[inagadadavi...:]

I notice you cite CYNO in your article. Better growth rate and prospects plus a US company. Unfortunate that ELOS is hdqt. in Israel. Major factor in their discounted stock price, and unlikely it will change soon.

2008 Jun 12 01:40 PM

[dlsrs:]

rearward looking analysis. without being exact, 14% growth in a part of the business (int'l) that is almost half of the business, and 5% in the total business, means the u.s. business was flat to down last quarter. of course, int'l sales were boosted by currency, so total company constant currency sales were likely up very little if at all.

with $4 gas, a million homes in foreclosure, etc sales in the u.s. should be headed down. you cannot look backward with a situation like this. based on q1 free cash flow, stock is at 14x, not the numbers you cite. where do you think the free cash flow trends are headed, anyway? up? not likely.

plus they played games last quarter by reversing a tax item, eps would have been -0.05 less otherwise. dso's jumped 16. mea culpa coming in the next qtr or so. do you do any analysis at all???

2008 Jun 13 05:52 PM