Syneron Medical (ELOS)- A Seth Klarman Pick

This report was originally written in March of 2007 for Marquette University's Applied Investment Management Program. I became interested in Syneron because it was listed as one of the Baupost Group's largest holdings. The company generates strong free cash flow, and is part of an aging baby boomer mega trend.Syneron (ELOS) sells medical products, which make use of their proprietary ELOS technology, to the cosmetic surgery industry. Demographics for this industry are favorable, allowing for strong potential growth opportunities. As the baby boomer generation ages, demand for Syneron’s products will likely increase as boomers seek to look younger.Moreover, Syneron is a highly profitable business that generates strong free cash flow. In fiscal 2005, the company generated nearly $30 million in owner’s earnings and had net margins of 27%. The main value driver behind Syneron is their low cost structure and extremely low tax rate on operating income of 2%, compared to the corporate tax rates of competitors of approximately 35%. I calculated a $42 stock price from my DCF model, and gave myself a 20% margin of safety to arrive at a conservative estimate of value at $34.00 per share, using a discount rate of 17%. If you would like to see my DCF model, it is available upon request via e-mail.BackgroundSyneron Medical Ltd. designs, develops and markets innovative aesthetic medical products based on their proprietary Electro-Optical Synergy, or ELOS technology, that uses the synergy between electrical energy and optical energy to provide effective, safe and affordable aesthetic medical treatments. Syneron’s products, which are sold primarily to physicians, target a wide array of non-invasive aesthetic medical procedures, including hair removal, wrinkle reduction and skin rejuvenation by treating superficial benign vascular and pigmented lesions.ELOS provides performance advantages over existing technologies that rely solely on optical energy, as using optical energy alone limits the safety and efficacy of many aesthetic medical procedures due to limited skin penetration and unwanted epidermal absorption. The ELOS combination of optical and electric energy enhances the user’s ability to accurately target the tissue to be treated and allows for real-time measurement of skin temperature, ensuing in increased patient safety and comfort and improved treatment results.Syneron Medical Ltd. sells its products in 46 countries through a direct sales force of 55 employees in North America and 42 distributors in Europe, the Middle East, Asia, Australia, New Zealand, Canada and South America. As of March 31, 2006, it had an installed base of over 4,500 products. The revenues from North America accounted for 60.2% of the Company's total revenues, while Asia-Pacific, Western Europe and Israel made up 20.4%, 18.3% and 0.4%, respectively, during the year ended December 31, 2005. Syneron’s main competitors consist of Candela Corporation, Laserscope, Lumenis Ltd., Cutera, Inc., Cynosure, Inc., Palomar Medical Technologies, Inc., Sciton, Inc., Radiancy Inc., Thermage, Inc., and Reliant Technologies, Inc.. Recently, Syneron entered into an agreement with Procter & Gamble (PG) to develop home use skin treatment devices.ELOS TechnologyAccording to Syneron’s 20-F filing, the ELOS technology offers many benefits that give it an advantage over competitors’ technologies. First, there is an enhanced control of treatment depth and selectivity. Epidermal pigmentation “limits the amount of optical energy a user can deliver without causing pain or skin damage” (Syneron 20-F). Because ELOS technology uses both optical and conducted RF energy, the products achieve “greater skin penetration with lower levels of optical energy and offer more control than conventional light-based systems” (Syneron 20-F). In addition to enhanced safety, the less powerful light-based energy source “increases patient comfort and reduces the need for anesthetics” (Syneron 20-F). Additionally, the use of bipolar RF energy “effectively controls the penetration depth and reduces impact on surrounding tissue” (Syneron 20-F). Syneron believes this provides more effective treatments and an increased array of applications. The ELOS technology overcomes limitations common to previous technologies, including more effective treatment of dark skin toned patients, light and gray hair, and large leg veins as well as the ability to penetrate into sub-dermal layers. (Syneron 20-F)Second, there is a continuous temperature measurement and automated parameter adjustment. Syneron believes that their products, with their proprietary dual-electrode RF hand piece, are “the only non-invasive aesthetic systems that enable continuous temperature measurement and feedback” (Syneron 20-F). The hand piece measures the temperature and resistance of the dermis every millisecond, unlike other technologies which do not provide continuous measurements. This measurement capability enables fine-tuning and automatic adjustments for different areas of the body, reducing the risk of burns. Further, these products contain “sophisticated software which guides the adjustment of the treatment parameters to help ensure that the temperature of the skin does not exceed predetermined limits” (Syneron 20-F).Third, there is a wide rage of applications with ELOS in a single system. Syneron’s products permit users to perform multiple procedures with a single device. Syneron’s Galaxy system and Syneron’s newer eMax system allows users “to offer a wide variety of procedures, including hair removal, treatment of superficial benign vascular lesions and superficial benign pigmented lesions, and the treatment of acne, wrinkles and leg veins” (Syneron 20-F). Increasing the types and number of procedures that users can perform with a single system allows users to spread the fixed cost of the system over a greater number of procedures. This treatment versatility is an important feature for users “who have not yet established large aesthetic treatment practices or who have space limitations” (Syneron 20-F).Fourth, Syneron’s ELOS technology is “easy to upgrade”, because Syneron designs their products to allow users to cost-effectively upgrade their existing products to perform additional applications (Syneron 20-F). Users can purchase and easily install software plugs and hand pieces required to perform additional applications, providing Syneron with multiple sources of revenue from their installed base, while providing customers with the opportunity to own the latest technological innovations at a fraction of the cost of purchasing a new system. (Syneron 20-F)Fifth, Syneron’s ELOS technology is cost effective and reliable. Syneron’s products require minimal ongoing service and disposable expenses, providing customers with predictable costs of ownership. Also, because Syneron’s products utilize less optical energy than competing laser or light-based systems, their hand pieces “are able to deliver more pulses during the life of each hand piece, thereby requiring fewer replacements” over the life of a system (Syneron 20-F).Finally, Syneron’s ELOS technology is “user friendly” (Syneron 20-F). Syneron’s consoles are lightweight and have a small footprint, enabling the company to “ship replacement consoles overnight to customers” requiring system maintenance in North America (Syneron 20-F). The small console design maximizes the flexibility of limited space in the user’s offices, while ELOS hand pieces are “lightweight and ergonomically designed, enabling long-term use by customers” with minimal fatigue or discomfort (Syneron 20-F).DiscussionWhile the ELOS technology looks promising, and Syneron looks like an exciting company in a growing industry, an investment decision can only be made by analyzing the fundamental reality of the company’s stock through a conservative evaluation of Syneron’s future prospects. By analyzing Syneron’s growth, profitability, financial health, management team, and the bearish counter argument we can begin to get a better sense of Syneron’s true value. (a) Growth: Syneron is involved in selling medical products to the cosmetic surgery industry. According to the American Society for Aesthetic Plastic Surgery, nearly 11.5 million cosmetic surgical and non-surgical procedures were performed in the United States in 2005 (ASAPS). Compared to 2004, surgical procedures increased 1% to 2.1 million, while non-surgical procedures declined 4% to 9.3 million. The Aesthetic Society which has been collecting multi-specialty procedural statistics since 1997 says the overall number of cosmetic procedures has increased 444% since the collection of the statistics first began [ASAPS]. The most frequently performed procedure was Botox injections, as non-invasive procedures, such as Syneron’s various ELOS treatments, are becoming more and more popular [ASAPS]. The economics for non-invasive procedures are also attractive. They cost less than invasive procedures, but are only temporary and require repeat treatment every few months. The cosmetic surgery industry is also a fast growing area of the economy with strong demographics as baby boomer’s will want to continue to look young as they age. Baby boomers control approximately $2 trillion in spending power and 50% of all discretionary income. Moreover, cosmetic surgery candidates are willing to pay a premium for good looks, and the general market for cosmetic surgery consists of high income earners who are generally insensitive to price change. In addition, the safety and comfort of Syneron’s ELOS technology may allow for a competitive advantage, as patients generally seek to avoid discomfort, decreasing their recovery time for the procedure. Cosmetic surgeons will likely want to buy products that satisfy their patient’s wants and needs. These factors suggest that the company may be able to sell more of its products and increase product prices. Syneron’s historical growth figures confirm the strong upward industry trend. Syneron grew its net income from fiscal 2003 to fiscal 2004 by 224%, and from fiscal 2004 to fiscal 2005 grew its net income by 50%. Wall Street analysts estimate an annual growth rate in income of 20% over the next 5 years. (finance.yahoo.com). Next quarter, analysts forecast a 28.1% growth in income, and a 20.1% growth rate for the entire year, outpacing the S&P’s forecasted growth rate of 6.2%. While Syneron appears to have good growth prospects, the high expectations placed on the company by Wall Street analysts may make it difficult to meet these near term targets every quarter. Any earnings surprise may cause selling in the market place for reasons not based on the investment merits of Syneron, which will give the AIM Fund a chance to purchase Syneron Medical at an attractive price, assuming fundamentals have not deteriorated. (b) Profitability: Syneron is a highly profitable company. In fiscal 2005, Syneron had a gross margin of 86%, an operating margin of 44%, and a net margin of 47% with a net income of $41 million. Total revenue for Syneron in this period was $87.4 million. Syneron had an asset turnover ratio of .51, and a return on assets of 24%, with financial leverage of 1.14, as the company does not carry a large amount of debt. Syneron’s return on equity for fiscal 2005 was 27%, while Syneron’s return on invested capital in 2005 was 29%, with net operating profit after taxes of $41.75 million and invested capital of $145 million. With excellent margins, Syneron may be able to increase profitability even more by turning over its inventory more efficiently, as well as by taking on a modest amount of debt to increase its financial leverage and create an optimal capital structure for shareholders to increase the price of its shares. Fat margins and low tax rates have helped Syneron generate strong free cash flow, which is the best measure of profitability. Operating cash flow in 2005 was $31.3 million, while capital expenditures were only $645 thousand, generating an operating cash flow of $30.35 million. Syneron’s free cash flow to sales for fiscal 2005 was 35%, telling us that the company is doing an excellent job of generating cash for shareholders. Not many companies have the favorable profitability characteristics of Syneron, and the company’s high return on equity, high return on invested capital and strong free cash flow make Syneron an extremely attractive investment prospect. Still, Syneron’s cash flows and profitability numbers seem too good to be true, and their low tax rate of 2% must be questioned. Syneron’s main value driver, besides their margins, is their extremely low tax rate, implemented under the Israeli corporate tax law known as the Inflationary Adjustments Act, which was passed in 2003 to help stem the high inflation in Israel. In fiscal 2005, they paid a mere 2% in taxes on their operating profits, while competitors faced much higher tax rates. According to Syneron’s 20-F filing, the Inflationary Adjustment Acts comprises the following rulings: 1. Where a company’s equity, as calculated under the Inflationary Adjustments Law, exceeds the depreciated cost of its Fixed Assets (as defined in the Inflationary Adjustments Law), a deduction from taxable income is permitted equal to the excess multiplied by the applicable annual rate of inflation. The maximum deduction permitted in any single tax year is 70% of taxable income, with the unused portion permitted to be carried forward, linked to the Israeli consumer price index. The unused portion that was carried forward may be deductible in full in the following year. (Syneron 20-F) 2. The Company has been granted the status of “Approved Enterprises”, under the Law, in two investment programs (the “Programs”). The second program was approved in January 23, 2005. In accordance with the Law, Syneron Ltd. has chosen to enjoy an “Alternative benefits program” status. Accordingly, Syneron's income attributed to the “Approved Enterprise” is tax exempt from taxes on income derived there from for a period of ten years starting in the year in which the Company first generates taxable income. (Syneron 20-F) Competitors, such as Cutera and Candela, for example, face tax rates of approximately 35%. This gives Syneron a powerful strategic advantage over competitors, helps drive free cash flow, and creates value for shareholders. At the same token, if Syneron’s tax circumstances were to change, this could seriously impact free cash flows and the price we would be willing to pay to buy this stock. (c) Financial health: Syneron has very little debt, plenty of cash, and therefore is in excellent financial health. Total debt to equity for fiscal 2005 was zero, as the firm carries no long-term debt. Due to strong cash flow, management has chosen to finance projects with cash. Still, Syneron’s strong cash flows are mainly driven by and are highly dependent on the low tax rate of 2%. If the tax rate was to change, the company would likely rely more on debt to finance projects. Nonetheless, Syneron’s times interest earned ratio for fiscal 2005 was 493, which means that the company could repay this expense 493 times. Syneron’s current ratio for fiscal 2005 was 7.85, while its quick ratio for this period was 7.69. These ratios tell us that Syneron should be able to meet all of its operating needs right now without much difficulty, and also suggest that the company is not likely to suffer much if it were to miss earnings. Syneron’s considerable amount of cash on the balance sheet will offer investors a margin of safety if things were not to go as optimistically as planned. (d) Management: Syneron Medical Ltd. has management with both business experience, as well as medical expertise, which is critically important in this highly technical field. Additionally, Syneron conducts a conservative direct compensation policy, and has performed very well. The Chairman of the board, Dr. Shimon Eckhouse, has served in this role since May 2004. Dr. Eckhouse is the chairman of OrSense Ltd., CardioDex Ltd., NanoCyte Ltd. and Edge Medical Devices Ltd. and a director of WideMed Ltd., ColorChip Ltd., Ventor Medical Technologies Ltd. and Matteris Ltd. Dr. Eckhouse was a co-founder of ColorChip and served as its active chairman from 2003 to January 2004 and as its chief executive officer from 2001 to 2003. Dr. Eckhouse was the chairman and chief executive officer of ESC Medical Systems from its inception in 1992 until 1999. Prior to founding ESC Medical Systems, Dr. Eckhouse was head of product development and technical director at Maxwell Technologies in San Diego, California. Before that, Dr. Eckhouse was a scientist, team leader and head of a department in Rafael, Armament Development Authority of Israel and was active in various areas of research and development, including lasers and electro-optics. Dr. Eckhouse holds a B.Sc. in physics from the Technion Israeli Institute of Technology and a Ph.D. in physics from the University of California at Irvine. He has more than 20 registered patents and has published more than 50 papers in leading reference journals and conferences, and also is also a member of the Board of Directors of the Technion Israeli Institute of Technology. Dr. Michael Kreindel has served as chief technology officer and a member of the board of directors since inception in July 2000. From 1994 to 2000, Dr. Kreindel was first a senior scientist and then project and program manager in ESC Sharplan. Dr. Kreindel was leader of a scientific group in the Institute of Electrophysics in Russia. Dr. Kreindel has an M.A. in experimental and plasma physics from the Ural Politechnical Institute in Russia and a Ph.D. in pulsed power, gas discharge and plasma physics from the Institute of Electrophysics in Russia. David Schlachet has served as chief executive officer since November 2005 and has a wealth of business experience. From July 2004 to November 2005, Mr. Schlachet served as the company’s chief financial officer. From 2000 to June 2004, Mr. Schlachet served as Managing Partner of Biocom, a venture capital fund specializing in the life sciences area, while from 1995 to 2000, Mr. Schlachet served as a senior Vice President and Chief Financial Officer of Strauss Elite Holdings, a packaged food group. From June 1997 to June 2000 David Schlachet also served as an active chairman of Elite Industries, a chocolate and confectionery company which is a subsidiary of Strauss Elite Holdings, in addition to his position in Straus Elite Holdings. From 1990 to 1995, Mr. Schlachet served as Vice President of Finance and Administration of the Weizmann Institute of Science. Mr. Schlachet serves as a director for Nasdaq listed companies Pharmos Inc., LanOptics Ltd and Compugen Ltd.. In addition, Mr. Schlachet serves as a director for Tel-Aviv Stock Exchange listed companies Taya Investments Ltd. and Edgar Investments and Developments Ltd., as well as director of several privately owned Israeli companies. Mr. Schlachet holds a B.Sc. degree in chemical engineering and an M.B.A. from the Tel-Aviv University. David Seligman has served as chief financial officer since February 2006. Prior to that Mr. Seligman served as the chief financial officer of NUR Macroprinters Ltd. (NURM) from October 2003 to October 2005. Prior to joining NUR Macroprinters, Mr. Seligman served as chief financial officer of RADVISION Ltd., a Nasdaq listed company under the ticker symbol RDSV, from November 1999 until August 2003. Prior to that, he was chief financial officer for LanOptics Ltd. (LNOP), a senior financial analyst for Fidelity Investment Systems Company in Boston, Massachusetts, and served as a controller and financial analyst for several hi-tech companies. Mr. Seligman holds a B.A. degree in political science and geography, and an M.B.A. degree in accounting and finance, both from Tel-Aviv University. (e) Bear Case: Although Syneron Medical Ltd. has a unique technology, good growth prospects, is extremely profitable, is financially healthy, and has a good management teams, there are many things that could go wrong with the stock. To begin with, the low tax rate that Syneron currently enjoys may change without notice as it is subject to the jurisdiction of the Israeli government. Syneron was granted a tax exemption by Israel under the Inflationary Adjustment Act, which was designed to combat inflation in Israel, and was also given “Approved Enterprise Status” for the next 10 years. If conditions change, and Syneron is taxed at the traditional Israeli corporate tax rate of approximately 34%, this would hurt future free cash flows and shareholder value. In addition, there is no guarantee that Syneron’s technology will remain cutting edge. Though ELOS is patented by Syneron, intellectual property law has begun to face many problems, as these laws are not necessarily being observed. China, for example, produces many pirated products for lower costs with the same quality. It is also not inconceivable that in the near future engineers will figure out how to reverse engineer Syneron’s products and tweak them slightly to get around patent laws. Larger manufacturers of medical devices, with bigger research and development departments may also be able to develop an even better technology than ELOS, rendering Syneron’s competitive advantage obsolete. Finally, consumer’s taste may change, and investors have no control over this. Though plastic surgery has become more and more socially acceptable, evidenced by hit television shows such as Nip/Tuck, consumers may change their opinion and deem plastic surgery as undesirable. Still, this trend does not look to reverse soon, as boomers, who are willing and able to pay for plastic surgery, want to look more youthful. In general, people will continue to pay a premium to indulge in vanity if they can afford it. (f) Analysis of Ownership: It is important to look at who the major owners of a stock are because it can offer clues to how insiders, as well as smart money, such as mutual funds and hedge funds with excellent track records, value the stock. It is a positive sign when many insiders are buying stock because management has greater knowledge of the company than the public. This may signal that management feels the stock is undervalued. Syneron has 10% insider ownership, and has 53% institutional investor and mutual fund ownership. Unfortunately, however, data for insider share purchases was currently unavailable as Syneron is an Israeli company and is not required to disclose insider share purchases. At the same time, there is some ownership information that may be useful for our purposes. The Baupost Group, a deep value investing hedge fund that is founded on the principles laid out by Benjamin Graham, is the largest institutional shareholder. The founder of the Baupost Group, Seth Klarman, is highly regarded amongst value investors for his 6,133% return net of fees for his fund since 1982, which comes out to an annual compound rate of approximately 20% a year (www.stockpickr.com). Klarman also wrote one of the best investing books of all time which is titled Margin of Safety. Klarman looks for situations in which “their has been irrational selling the market place for reasons other than investment merit that offer downside protection and significant upside potential” (Margin of Safety). The Baupost Group owns 1.5 million shares that are worth $40.695 million. This works out to an average price of $27.13 per share. This tells us that an exceptional value investor views the price of $27.13 as a significant discount to their projections of Syneron’s intrinsic value.ConclusionSyneron’s common shares look like an attractive investment opportunity. First, Syneron is in a fast growing industry that will continue to grow in size as boomers age and demand more treatments to continue to look young. Second, the business has a unique technology known as ELOS that will give Syneron an economic moat in the cosmetic surgery products industry. Third, Syneron’s low cost structure and favorable tax rate helps Syneron achieve strong margins and a large amount of free cash flow, which creates shareholder value. Fourth, the large amount of cash on Syneron’s balance sheet gives the company strong financial health, and offers us a margin of safety if Syneron does not meet Wall Street analyst’s high expectations as the company will be able to remain solvent and continue to conduct its business operations as usual in the event it misses earnings. Fifth, Syneron has a good management team that has both business expertise as well as medical expertise, which is important for a company that is in a highly technical industry. Finally, there is a decent amount of insider ownership, as management owns 10% of outstanding shares. Even more, an exceptional value investor, Seth Klarman of the Baupost Group, is the largest institutional shareholder, who, evidenced by his transactions, believes that a price of $27.13 a share is a fair price to pay for Syneron.Disclosure: Author has a long position in ELOS.