Solta Medical (NASDAQ:SLTM) is either going to make its investors a pretty respectable amount of money, or it's going to drive them most of the way to the asylum. For all of the things that should be so right about this business - a great high-margin disposables business, leverage to the best growth markets in aesthetics, solid IP - dicey execution, shareholder dilution, and turbulent end markets have made for a very rocky road so far.
Over the next three to five years, I expect the company's increased exposure to the body contouring/liposuction markets, as well as follow-on improvements to existing platforms, to build on improving end-markets to drive above-average revenue growth. I likewise look for a growing user base of the company's disposables/consumables and expanded direct sales efforts overseas to improve margins, such that the stock could rise 50% to 70% as the Street buys into the story again.
A Different Sort Of Player…
Solta has been around for a while. Founded in the mid-90s, Solta went public during the last great aesthetics bull market (2005-2007), but has yet to really execute on its initial promise. While a series of acquisitions have helped drive better than 20% compound annual revenue growth over the last decade and Solta's revenue stacks up well to its publicly-traded peers, the company remains a comparatively small player in the $35 billion-plus global aesthetics market.
Solta got its start with Thermage, an RF energy-based system designed to smooth, tighten, or contour skin. The real key to the story, though, has always been Solta's emphasis on a razor/razor blade model. Unlike most aesthetics companies which had previously focused on selling laser, ultrasound, or RF energy systems with expensive reusable handpieces, Solta has focused on designing (or acquiring) products that utilize very high-margin disposable tips. Combined with relatively low system costs, Solta's model allows users to avoid major upfront capital commitments, but still price their services on a very competitive per-procedure basis. What that means for Solta in terms of financial numbers is a nearly 90% gross margin on nearly half of the revenue.
...In An Insane Sector
Talk to any sell-side or buy-side healthcare analyst with a fair number of years' experience about the aesthetics market and you'll likely be treated to a pretty telling display of disgust and/or profanity. This sector has driven analysts and investors crazy over the years; while procedure volume growth over the last 20 years or so has been quite good (low teens, by most calculations) due to the introduction of a variety of less invasive, less painful technologies and procedures, it has proven difficult for any company to establish a real track record of growth, margin leverage, and overall performance.
Certainly the discretionary nature of the majority of procedures has something to do with it. Procedures like skin resurfacing, wrinkle reduction, or body contouring are seldom ever covered by health insurance, causing the industry to be sensitive to discretionary income and consumer access to credit. Likewise, this industry has attracted more than its fair share of shady operators running out of strip mall "clinics" and promising far more than the technologies could deliver.
Against that backdrop there have been a succession of new products and technologies, leading to brief stretches of glory for the companies behind them. Palomar Medical Technologies (NASDAQ:PMTI) had a tremendous run in the mid-90's, then an enormous collapse and respectable rally in the mid-00's (and then another partial collapse). Syneron (NASDAQ:ELOS) and Cutera (NASDAQ:CUTR), too, had their glory days in the mid-00's, with the stocks down nearly 80% from those highs. Last and not least, Cynosure (NASDAQ:CYNO) also enjoyed a significant move in the mid/late-00's, a near-collapse, and then a strong rebound from mid-to-late 2011 through early this year. Simply put, this is a sector where volatility has often been the norm.
Bulking Up On Slimming Down
One of the reasons I'm cautiously optimistic about Solta's future is that the company has made body contouring a priority. Solta acquired Liposonix from Medicis (since acquired by Valeant (NYSE:VRX)) for $35 million and earn-outs in 2011 and followed that up with a $30 million acquisition of Sound Surgical and its VASER liposuction and contouring products. All told, sales in this market should be more than one-third of Solta's revenue base in 2013.
That matters because body contouring (including liposuction) is estimated to be about one-quarter to 30% of the global aesthetics market, and has been one of the faster growing markets in recent years (in the high single digits). Solta's Liposonix uses high-intensity focused ultrasound (HIFU) to disrupt fat cells and reportedly a single one-hour session (at about $3,000) can lead to a one-size reduction in waist size. Sound Surgical is more oriented to the plastic surgeon community, where it's technology also uses ultrasound to essentially emulsify fatty tissue prior to minimally-invasive liposuction or non-invasive contouring.
All told, this should be a compelling combination. While the competition's (including Zeltiq (NASDAQ:ZLTQ), Syneron, and Cutera) alternatives to Liposonix are generally cheaper (or expected to be cheaper when released), they require multiple treatments to achieve their effects. With Sound Surgical, Solta has the opportunity to cross-sell into a customer base (plastic surgeons) that are typically better funded and thus far under-penetrated by the company.
Execution Is The Big Question...
The obvious fly in the ointment for prospective Solta shareholders is whether or not management will actually deliver upon the potential of the company. To that end, there have been some disturbing developments of late.
First quarter revenue was underwhelming (flat overall on an organic basis and down 19% in the U.S.) due to manufacturing issues with Liposonix and significant sales turnover at Sound Surgical. The Liposonix issue was arguably not management's fault (a defective third-party component), but the turnover at Sound Surgical is more troubling. Solta intended to maintain two sales forces after the deal (keeping Sound Surgical's sales force for the plastic surgery market), but apparently about 20% of the reps chose to jump ship in the first quarter. Given the commission-heavy structure of most sales reps' pay, it wasn't exactly a ringing endorsement of their faith in Solta.
It's also worth noting that the founder of the company recently resigned from the board of directors, though there was no known disagreement between him and the company. Last and not least, a relatively small owner of Solta shares recently challenged the board's proposal to double the outstanding share authorization, claiming that the company has significantly diluted shareholders through stock-based deals in the past and shouldn't be abetted in doing so again in the future.
The issue of M&A is relevant. Over its corporate history, Solta has done five significant deals that brought it the Fraxel skin resurfacing system, the Isolaz acne system, the Claro home-use system, Liposonix, and Sound Surgical's VASER technology. Over the last six years, shares outstanding have swelled from about 25 million to 80 million on a fully diluted basis. While it can be argued that it takes money to make money, the company's free cash flow and stock price performance argue that the "make money" side of that bargain has yet to be kept.
… And Maybe The Answer Is Coming
Another big part of my bullish thesis on Solta is that I believe there is at least the opportunity for execution to significantly improve.
First, I think the company's focus on dermatologists and plastic surgeons is the right one for the long term. These are actual medical doctors and their practices tend to be better-capitalized (or have access to capital) and more stable through the economic cycle. Likewise, I agree with the company's focus on higher-growth areas like skin resurfacing and contouring (versus markets like hair removal).
Second, I believe there is a case to be made for meaningful operating leverage. Solta continues to do a good job of getting systems out into the field, and recent product development initiatives ought to help. A new tip for Thermage will double the bulk heating volume, while a new iteration of Fraxel (Fraxel SST) includes a larger handpiece that will reduce treatment times. These improvements ought to help utilization and system placements, which means more growth in those high-margin tips and consumables (where revenue was up 13% in the otherwise disappointing first quarter).
I also believe the company's overseas strategy will fuel margin improvements. Solta gets close to half of its sales from overseas, but dealing through distributors forces the company to discount its products by as much as 40%. Expanding direct operations in Europe and Asia is costing the company money today (particularly in under-leveraged SG&A), but over time I believe the company will not only see better foreign sales growth (a direct sales effort is almost always more effective than a distributor), but significantly better margins on those sales.
Well-Placed To Compete
There is fierce competition in the aesthetic device space, but I like Solta's competitive position. While markets like skin resurfacing and tightening often see battles of leapfrog as companies develop and launch new systems, Solta has generally established a solid reputation for technology and products that allows for shorter treatment times, solid per-procedure profitability for the doctor/clinic, and longer duration for the patient.
Of course, not every plastic surgeon, dermatologist, or aesthetic physician will agree with those statements, and that is part of why this industry has always been volatile (every company has its fans and its detractors). That makes it vital that Solta engage the physician community and remain responsive to the market.
Significant Potential To Do Better
I am modeling around 10% revenue growth (OTCPK:CAGR) for Solta over the next decade, which is higher than the expected growth rate in the underlying market as I expect the company to gain share in body contouring and skin treatments (in part through cross-selling to, and expanding, Sound Surgical's 1,500-client customer base).
I also expect to see meaningful margin improvements as the company better leverages its operating costs. While I expect minimal free cash flow over the next two years, I am modeling a free cash flow margin of 10% in 2017 and 12% in 2022. This is lower than the typical mid-teens margin of a quality med-tech company, but I believe it is appropriate given the volatility and cyclicality of the aesthetics industry. All told, that works out to a fair value of about $3.50 today.
It's also worth noting that there have been several M&A transactions in the aesthetics/dermatology space recently, including the acquisition of Palomar by Cynosure. While many larger companies have been avoiding the aesthetics space, Solta would nevertheless be an attractive option for a company that wanted to enter the market (particularly if they have the sales infrastructure to accelerate operating leverage). Were Solta to get the same sort of valuation as these recent deals, a price of $4.00 would not be out of line.
The Bottom Line
Solta has a lot to prove, and the Street is notoriously skeptical about this entire industry. Nevertheless, past runs in the sector have shown that these stocks can move up significantly when investor (and customer) interest returns, making Solta something of a stealth play on better consumer confidence/disposable income in the coming years.
The company's disappointing first quarter is a good reminder that they are not out of the woods yet from an operational perspective, but then it's hard to find bargains when everything's going well. For investors who can stomach the risk that rivals like Zeltiq, Syneron, and Cynosure will capture more market share and marginalize Solta and/or that management will fail to improve its execution, the potential returns of a Solta success story are quite interesting today.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.