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Friday, July 21, 2006

'No Place Like Home' in Biotech Stocks, Part 3: Cutera (CUTR)

From Crossprofit

Saul Sterman submits:

The first installment of this five part analysis covered Syneron Medical (ELOS).

The second part covered Candela Corp. (CLZR). In this third article I cover Cutera (CUTR).

First, here's a quick synopsis of the series in its entirety:

Syneron Medical (ELOS) – designs, develops and markets aesthetic medical products currently relying heavily on FotoFacial RF skin treatment and developing a dental laser line of products.

Candela Corp. (CLZR) – designs, develops and manufactures aesthetic laser systems currently replacing the VBeam system with the more advanced Pulsed Dye Laser (PDL) Platform.

Cutera (CUTR) - designs, develops and manufactures aesthetic laser systems and other light-based equipment.

Laserscope (LSCP) – designs, develops and manufactures surgical and aesthetic laser systems and related surgical equipment.

Palomar Medical Technologies (PMTI) – researches and develops laser systems primarily for hair removal and to a lesser extent other cosmetic applications.

Our (CrossProfit) outlook on the medical equipment sector is for the most part neutral with the notable exception being the cosmetic surgery stocks. Contrary to the over supply situation that prevails in the cardiology, orthopedics and drug-eluting coronary stents categories, robust demand for cosmetic surgery – primarily facial aesthetics and breast enhancement – should yield excellent returns well into 2007.

And now for the feature presentation...

It is high time I stated what this industry is all about. Essentially laser aesthetics is a “look good feel good” business. Cosmetic treatments generate the bulk of revenue though there are some nifty niche medical applications.

The basic principle is a well accepted and proven procedure. For example in Cuteras’ skin tightening application the three step process is as follows;

1) Pre-cooling of epidermis to protect the outer skin layer from excessive heat related redness and irritation.
2) Laser treatment penetrates the dermis to 2.5mm. Heating the collagen causes it to tighten (contract).
3) Post-cooling protects the epidermis and relieves temporary discomfort.
In plain English: tightening the under layers of the skin removes wrinkles appearing on the outer layer so that you can say your 21+ again.

The various competitors use differing technology each claiming to have definitive advantages over the competition. For instance, Syneron (ELOS) claims that its patented technology is less abrasive and causes less temporary discomfort because it combines two separate methods of penetration. Of course Cutera will send you a booklet with 20 questions to ask… explaining why their technology is superior. Amusingly (or not) during the patent infringement hearings brought by Palomar (PMTI) against Cutera, Cutera inadvertently admitted that its technology was inferior
to that of Palomar, as part of its defense!

The types of lasers used for hair removal are; Candela/alexandrite, Cutera/ND:YAG, Laserscope/ND:YAG, Palomar/ruby or diode and Syneron/Aurora. Each type has its pro’s and con’s. For instance the ruby laser is considered to be the safest overall, alexandrite is preferred on dark skin patients and ND:YAG for treating pseudofolliculitis barbae (shaving bumps). Aurora as previously mentioned is a combination technology.

After the patent settlement in June 2006 with Palomar, wherein Cutera agreed to pay $22 million in back fees, Cutera lowered its guidance going forward. The ongoing royalty rates were not disclosed. The market took this as a positive sign and some analysts upgraded the stock immediately.

Most notably Lazard Capital Markets analyst Alexander K. Arrow upgraded the stock to "Buy" from "Hold" and set a target price at $42. Earnestly, $42 is a bit rich for my blood (skin).

Cutera is trading at roughly 20 x forward PE prior to reducing 2006 EPS from a profit of 93-95 cents per share to a loss of 33 cents per share. Q2 results are to be announced on August 7th; the same day that competitor Syneron announces results. It will be interesting to compare the two.

In general this is a fast growing market with plenty of room for more than two top players. Now that the patent issue has been put to rest and even if Cuteras’ tech is inferior, the upcoming two quarters will reveal the potential of this player. Until then a wait until proven doctrine is prudent.

Concerns about a possible slowdown in the U.S. economy have some fretting over future discretionary spending. I find this of little concern for several reasons.
1) Home treatment devices have the potential to spur tremendous growth. Hair removal has always been a big business. What can not be done safely at home will feed into professional clinics.
2) The industry derives more than half its revenue (and future growth prospects) from outside the United States.
3) There are some major cultural differences between East and West. For instance in China if a woman looses her job it is culturally accepted to spend a whole month’s salary to improve ones image (aura) before seeking new employment. Interestingly enough men are not included.
4) South Americans are extremely ‘skin conscious’ even when compared to what is termed the ‘vanity of the American baby boom generation’. Personally I don’t think that the vanity of the baby boom generation is any different than the vanity of other generations, but that is a totally separate issue.
5) If there is a recession in the U.S. then more costly cosmetic surgery may be substituted with less costly laser procedures. (Some laser procedures are not permanent and need to be repeated every six months.)
6) Discretionary Spending:
Not all discretionary spending (DS) is recession sensitive. In fact some DS actually improves in a recession. There are three primary categories of DS.

Functional purchases: DS for items that are purpose oriented and provide a function but are not necessarily needed by the consumer. (i.e. a new and better computer, new skirt, another pair of shoes.)

Indulgence purchases: DS for items that bring consumers emotional gratification that can be justified without creating a sense of guilt. (i.e. flowers, candy bars, beauty parlor, computer games.)

Extravagant purchases: DS for items that are definitely more than needed and usually imply a status symbol. (i.e. Tiffany, BMW, Starbucks – just kidding.)

Recession creates uncertainty, uncertainty creates crisis and crisis creates stress. It is well documented that during recessions and true for depressions as well that the consumers psyche shifts when under stress.

For functional and extravagant items times get tough. The sale has to address the psychological barrier of guilt as well as convincing the consumer that it’s not really totally discretionary as the product has an inherent value of its own and will also improve the owner’s quality of life.

Indulgence purchases tend to pick up during a recession as people want to feel good about themselves without guilt. Hair removal is an indulgence and skin tightening would be considered by many as an indulgence as well.

Disclosure: Author is long shares of ELOS as of 7/13/06. This is the consensus of the CrossProfit – IL analysis team.

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