Cutera's Torrid Run Seems To Leave Little Room For More Upside
- CUTR has skyrocketed, gaining 169% in the last year and 390% in the last two.
- As one of the last independent energy-based aesthetics companies available, M&A speculation at least in part is fueling the gains.
- Performance has been better - but CUTR looks more than fully valued relative to recent growth and there are some concerns the market appears to be ignoring.
- CUTR looks like a dangerous short - but at some point, it would seem to be wise to take some money off the table here.
The energy-based aesthetics space saw a burst of M&A activity in early 2017 - but Cutera (NASDAQ:CUTR) stayed independent. Last February, ZELTIQ Aesthetics (ZLTQ) sold itself to Allergan (AGN), and the next day, Cynosure (CYNO) agreed to a takeover by Hologic (HOLX). Two months later, long-struggling Syneron went private.
That decision certainly looks pretty wise at the moment:
chart since January 1, 2017
CUTR has tripled since the start of 2017. A banner year has been a big driver. But the fact that Cutera is basically the last US-based energy-based aesthetics player left standing also helps. With CUTR trading at ~50x 2018 EPS and 46x EV/EBITDA (both multiples based on the midpoint of 2018 guidance), there seems to be at least some M&A premium built in here.
And at this point, I'd argue that there's likely too much premium. Cutera has a solid story, and is coming off a strong year. The space as a whole is benefiting from increased sales to non-specialty offices looking for cash sales. But valuation matters, and with growth solid but not spectacular, it's getting increasingly difficult to see much more in the way of upside for CUTR.
A Banner 2017
To be sure, Cutera had a phenomenal 2017. The company's original guidance for the year projected, at the midpoint, $137.5 million in revenue and $0.45-$0.50 in EPS. Cutera actually delivered $151.5 million in sales and $0.93 in adjusted EPS - even with a Q1 that missed consensus on the bottom line.
For the year, revenue rose 28% year-over-year. The launch of truSculpt 3D, the company's body-contouring product, was a major driver, per the 10-K and conference call commentary. But enlighten (used for tattoo removal and to treat pigmented lesions), excel HR (hair removal), and xeo (skin treatments) all grew sales year-over-year as well. (Cutera doesn't break out individual product sales or growth, which has been relatively standard in the space due to competitive concerns.)
The news was best in the U.S., where revenue rose 44%; in-country sales have nearly doubled in the last two years. The international business continues to lag, with revenue up just 8% as reported and likely in the mid-single digits in constant currency. (Cutera didn't break out exact benefits, but figures from the 10-K suggest the Euro and yen alone added 3-5 points.)
Overall, systems revenue rose 36% and a small distribution business in Japan (almost 3% of total sales) grew 14%. Service and hand piece refills both declined modestly, but Cutera is ramping up its emphasis on recurring revenue going forward, which should boost revenue in both categories.
Below the top line, the news looks pretty good as well. Gross margin did disappoint a bit, dropping to 57% even on a non-GAAP basis, down a point year-over-year. Cutera cited higher warranty costs and increased headcount. Operating expenses rose, thanks to investments in the salesforce (a count of 68 at year-end, per the Q4 call, against 58 the year before and just 40 at the end of 2015), higher R&D, and some G&A inflation. But the spend was leveraged across the board, and GAAP operating income tripled year-over-year (reversing what was a negative figure as recently as 2015).
All told, it's an impressive year; Cutera even repurchased 1 million shares at an average of $35, a ~one-third discount to Thursday's close. And it's the kind of year that drives a growth stock higher. 2017 performance would seem to set Cutera up for a strong couple of years ahead, with new products on the way and the installed base expanding. But behind the big headline numbers are some concerns, and a valuation that looks to price in an awful lot of success.
Tailwinds and Concerns In 2018 and Beyond
Initial guidance in the Q4 release projects 18-20% revenue growth year-over-year. That's a strong number given that comparisons toughen in Q2, as Cutera laps the launch of truSculpt 3D. Two new products will help, with the release of Juliet for vaginal health and Secret RF, a "micro-needling" skin treatment.
Longer-term, there are two potential drivers that can help revenue growth beyond systems. As noted, the international business has underperformed, as management admitted on the Q2 conference call. In response, Cutera has added new managers, and the head of international sales stepped down at the end of February. International performance did improve in the second half, per management commentary, and Cutera has argued that there's no reason to expect anything less than an acceleration to double-digit growth overseas.
The second driver is recurring revenue from service and consumables. The two new products both offer disposable tips. truSculpt 3D hand pieces have to be "refilled" (actually, refurbished) after a certain number of treatments. With the market as a whole projected to grow ~10% a year, per figures cited in the 10-K, and recurring revenue growing from new products and an expanding installed base, Cutera conceivably could keep double-digit growth intact for several years, particularly if it continues to take market share.
The question, however, is if even that type of revenue growth is enough. Valuation remains a concern (more on that in a moment). And there are some questions surrounding margins. The 57% gross margin figure in 2017 is a notable disappointment, given that Cutera long has targeted a 60% figure. EBITDA margins in 2017 were 8.7%; even the high end of guidance suggests only ~70 bps of expansion in 2018, and over half of that reported non-GAAP profit is coming from the exclusion of share-based compensation.
Mid-double-digit growth is going to drive some type of margin expansion going forward, to be sure. But a major expansion in the near term is going to be tough. Refill revenue should be higher-margin, and should grow. But it's also a tiny fraction of overall sales - just 1.7% in 2017. Service revenue has a lower gross margin than do products, per Cutera's recent presentation. The two new products are third-party sourced, which per the Q4 call implies lower margins (as the import price is accounted for as COGS). Salesforce headcount is expected to rise another 15% in 2018. And analysts have mentioned more intense price competition in the space, with CEO James Reinstein saying on the Q4 call that enlighten pricing had "eroded a bit", even with that product maintaining a premium over rivals.
If gross margin is relatively capped, it puts a lot of pressure on opex leverage to drive EBIT margin expansion. And, again, there's a clear path for Cutera to grow the top line enough to drive that expansion, particularly assuming salesforce investments level off in 2019. But even that path requires more success overseas, sharp growth in recurring revenue, and continued success against tough competition.
truSculpt 3D is going against ZELTIQ's CoolSculpting, Cynosure's SculpSure, and myriad other products. A 'hands-free' option in the category is due in the second half of 2018, later than originally planned, and should help further - but Cutera isn't first to market there. Juliet is going up against Mona Lisa Touch, manufactured by El. En. SpA (OTC:ELEAF) and distributed by Cynosure. The tattoo removal space is crowded as well (though it's likely to be a growing market for the next 40-50 years, at least based on my personal experience).
For CUTR to drive significant margin expansion and earnings growth, it's going to have to run on all cylinders. And as impressive as headline numbers of late look, that actually hasn't quite been the case in 2017. International sales are somewhat disappointing. Recurring revenue is relatively minimal - and declined last year. Gross margin targets have been missed. That's a double-edged sword, of course: those areas all offer room for improvement, and thus the potential to augment core growth in North American systems installation. But as a standalone, Cutera really needs to hit pretty much all of its targets to get profits to a point that support the current valuation.
All that said, there's an argument that margins aren't necessarily that material since Cutera appears to be a very likely takeover target. Folding Cutera into a larger product portfolio would allow for synergies that could quickly expand those ~9% margins even without organic improvement.
But there's two catches with the takeout thesis here. The first is that I'm not sure there's a logical acquirer left. I long thought a ZELTIQ-Cutera tie-up made sense, given ZELTIQ's single-product portfolio. Cutera has had success with 'bundling' sales - about 20% of North America revenue, according to the Q4 call - and adding its portfolio to ZELTIQ's would allow for similar cross-selling.
The problem there is that Allergan is being pressed to break itself up, not add to its portfolio. And with truSculpt 3D the largest contributor to revenue in Q4 (again, per the call), the overlap between that product and CoolSculpting is larger than it would have been even a year or two ago. As far as other rivals go, whether it's Valeant Pharmaceuticals' (VRX) Solta or Hologic, there's far too much redundancy in the respective portfolios.
That leaves basically a go-private or another medical giant looking to enter the aesthetics space. The latter certainly is possible. Cutera continues to move beyond the 'core' dermatology and plastic surgery spaces (just 38% of orders at this point) as other practices look for cash sales that avoid insurers and cost controls. That same rationale could drive larger firms interested in similar diversification. But at the moment, there's no logical or speculated acquirer that I know of, while Allergan's interest had been rumored for some time.
There's also the valuation problem. Even assuming substantial synergies, CUTR isn't cheap. Adding 10 points to EBITDA margins still values CUTR at over 20x forward EBITDA. Taxes conceivably could rise in a takeout scenario, given guidance for an effective tax rate of 10-12% in 2018. (Cutera does have ~$35 million in federal NOLs and ~$21 million at the state level, which could offset that impact slightly, subject to Section 382 limitations.)
Even on a revenue basis, the other deals in the industry suggest CUTR is somewhere close to fully valued. Cutera stock trades at 4.1x the high end of 2018 top-line guidance. ZELTIQ was sold for 6.8x revenue. But its sales grew 39% in 2016, roughly double Cutera's projected 2018 growth rate. And CoolSculpting was the unquestioned leader in the fat reduction space at the time, with revenue from that product alone triple that of Cutera as a whole.
Cynosure, whose growth was more in line with what Cutera is posting at the moment, went for 3.3x revenue. That multiple, even at the high end of 2018 guidance, would value CUTR at $44, about 17% downside. Syneron sold for barely 1x sales (though its growth and execution both were much weaker).
Cutera's turnaround has been impressive. Admittedly, I was skeptical for quite a while before turning bullish last year. Revenue is likely to grow for some time (though in a discretionary space, an investor can't ignore macro risk). I expect margins to continue to expand as well.
But as a standalone, Cutera needs something like 400-500 bps of EBIT margin expansion - possibly with little help from COGS - and 3-4 years of double-digit growth simply to get the EV/EBITDA multiple down to ~20x. A takeover makes sense in theory, particularly with Cutera basically the only option left (unless Valeant decides to sell Solta). But even there, valuation is a question mark and patience likely is advised given the lack of a natural suitor at this stage.
I'm not interested in shorting CUTR. A fast-growing, low-float, potential takeout target is a sub-optimal short target, to say the least. But I question just how much upside is left after the torrid run of the last two years. It really looks like Cutera has to be close to perfect to keep CUTR shares moving higher. And as impressive as the company has been of late, that's a lot to ask.
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