|Shares Out. (in M):||14||P/E||42.6||30.3|
|Market Cap (in $M):||286||P/FCF||119.0||43.9|
|Net Debt (in $M):||-48||EBIT||6||9|
|TEV (in $M):||237||TEV/EBIT||39.4||25.5|
|Borrow Cost:||General Collateral|
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Cutera, Inc. (NasdaqGS:CUTR)
Cutera (NasdaqGS: CUTR) is a Brisbane, California (San Francisco Bay Area) based manufacturer of aesthetic laser equipment used to conduct non-invasive dermatological procedures, such as tattoo or hair removal. In 2016, Cutera generated $118M in sales (55% US, 45% International) selling five major platforms: xeo, excel V, truSculpt, excel HR, and enlighten. The business primarily sells to its core physicians market of dermatologist and plastic surgeons as well as to non-core physicians, including podiatrists, OB/GYNs, family practitioners, and medspas.
Cutera is a hyped-up “takeout candidate” which has seen its share price increase 80% in the past year, driven by M&A speculation. An activist on the board, a deal-making CEO, M&A rumors, and recent acquisitions of peers have lured in the gamblers looking to make a quick buck on this potential buyout target. But at 57x earnings, Cutera remains an overvalued, low quality, historically unprofitable business with a stale product portfolio, presenting minimal takeout risk. As an acquisition fails to materialize, Cutera’s shares will eventually reflect its intrinsic value, which we estimate to be $13 per share, representing 35% downside.
Reason for Mispricing: Perception vs. Reality
Misconception 1: Viable Take-out Target
As far as the gamblers are concerned, all the signs point toward an imminent sale of the business:
The activist, Daniel Plants of Voce Capital Management, was elected Chairman of the Board, chairs the Strategic Transactions Committee, has a history of “creating shareholder value” in the healthcare equipment space, and is credited for both the Solta Medical and Obaji Medical sales to Valeant.
New CEO James Reinstein joined Cutera in January 2017, presumably for his deal-making experience. He previously held the CEO role at Aptus Endosystems before selling the firm to Medtronic in 2015.
In January 2017, Bloomberg published a piece citing peers Cynosure and Zeltiq, saying they would be attractive to larger health care companies1. Sure enough, both companies were acquired within the next few weeks: Zeltiq by Allergan and Cynosure by Hologic.
However, we believe that Cutera’s window of selling itself has closed, eliminating the largest risk to our short position:
According to its latest 13D filing, Voce has reduced its stake in Cutera by 34% from 727,031 (5.4% of shares outstanding) shares to 477,031 (3.4% of shares outstanding). Were a sale of the business on the horizon, there would be no rational economic reason for Voce to reduce its stake. In fact, Voce seems to have shifted its focus to its other activist campaign with Air Methods, which was sold last month to private equity firm American Securities.
Reinstein was not hired to sell the business; he was hired to build it. In fact, he has grand visions of tripling Cutera’s revenues and quadrupling its share price in five years via a plan he has dubbed the “3, 4, 5 Objective.” In his employment agreement, a change of control would only net Reinstein a year’s pay and bonus and accelerated vesting of his equity awards. Given his $500,000 base salary and $350,000 cash bonus target, Reinstein is incentivized to maintain an annual salary and attempt to grow the business for the next several years.
With their recent acquisitions, Allergan and Hologic are no longer potential buyers, as Cutera’s products would compete directly with Zeltiq’s and Cynosure’s. Given Voce’s past successes in selling businesses to Valeant, Valeant would appear to be a natural potential buyer, were it not for its ongoing issues. In fact, Valeant, is considering divesting both Solta and Obaji to reduce its debt load2. While there are plenty of other medical device companies out there, there is no strategic rationale behind purchasing Cutera, which not only has been historically unprofitable, it has essentially failed to grow sales in the past decade. Furthermore, Cutera’s product portfolio lacks innovation, with “new products” limited to add-ons to existing platforms.
Cutera’s lease for its global headquarters and manufacturing center expires at the end of 2017. Given rising San Francisco Bay Area lease rates, any acquirer of Cutera would have to incur related costs and capex.
CFO Ron Santilli, who served for 16 years, including a brief stint as interim CEO, announced his resignation (not retirement—he’s only 57) in April. It is unlikely that Cutera, or any publicly traded business, can properly execute a sale process without a CFO. Were an imminent sale pending, it would have made sense for Santilli to simply resign following the sale of the company—not before. And were an imminent sale pending, Santilli would have likely stayed on to receive his change of control payments of 150% of base salary and targeted bonus as well as 18 months of COBRA payments, which amounts to $764,036.
Misconception 2: Fast Growing “Med Tech” Company
Cutera is perceived as this fast growing, Silicon Valley based company in the burgeoning “med-tech” industry. After all, sales have grown at an impressive 23% CAGR organically over the past three years, and the business has finally turned the corner, achieving profitability in 2016.
Source: Cutera, Inc. at Sidoti & Company Spring 2017 Presentation, March 2017
The story here is that Cutera will grow sales indefinitely at a double digit organic rate, with CEO James Reinstein setting a goal of tripling Cutera’s revenues and quadrupling its share price in five years.
But the truth is, Cutera’s recent growth is unsustainable and is the result of recent product launches, a growing sales force, and reliance on equipment lease financing. Over longer periods of time, Cutera has not demonstrated an ability to grow consistently. In fact, Cutera has grown revenues at a mere 1.6% CAGR over the past decade, and that includes acquisitions:
Source: SEC Filings
Source: Cutera, Inc. at Sidoti & Company Spring 2017 Presentation, March 2017
First, as expected, recent sales growth has corresponded with new product launches. Except for its xeo platform, the bulk of Cutera’s main product lines has debuted from 2011: excel V in 2011, truSculpt in 2012, excel HR in 2014, and enlighten in 2014. With the vast majority of nonsurgical cosmetic/dermatological procedures addressed through its existing product lines, new product growth will be bound by the limits of laser technology use cases. The newest innovation in laser procedures seems to be vaginal rejuvenation (yes, that is a real thing), yet Cutera has given no indications on entering this market. Even if it did, Cutera would have difficulties competing against a bevy of incumbents such as Cynosure (MonaLisa Touch), Alma Lasers (FemiLift), Fotono (IntimaLase), and Thermi (ThermiVa).
Second, recent sales growth accelerated following the hiring of Larry Laber, a former Cynosure executive, as EVP of North American Sales in late 2014. Since his hiring, Laber has expanded Cutera’s North American field sales force from roughly 40 in late 2014 to 58 to end 2016, hiring many ex-Cynosure Area Sales Managers, and sales have grown accordingly. According to Linkedin, Cutera currently has 77 sales employees, nine of which recently worked for Cynosure. With a limited base of sales managers left to poach, Cutera’s future hires will likely rely on building relationships with core and non-core physicians from the ground up, resulting in longer conversion cycles.
Cutera is already losing momentum on the hiring front. In its most recent Q1 2017 update, Cutera’s North American field sales force was down by four to 54 employees, which management attributed to a “year-end performance assessment,” implying that these four employees were dismissed for performance reasons. Yet if you screen Linkedin for the four Cutera area sales managers who were let go in Q1 2017, they weren’t let go—they left for other jobs:
This is indicative of turnover issues facing the company. Management has publicly stated its intentions to grow its North American field sales force to 70 by the end of 2017, an increase of 16 from its March 31, 2017 count. But with 18 sales roles listed on its Linkedin page, Cutera has a long way to go to achieve its 70-person target by the end of year. It appears management has been trying to alleviate its turnover issues and lure in new hires by posting phony, promotional Glassdoor reviews3.
Third, recent sales growth has benefited from revenues via equipment loan financing schemes. A piece of Cutera’s laser equipment can exceed $100,000, an amount far too large for a small business owner who may lack access to bank financing. So in order to secure a sale, Cutera refers customers to equipment lease financing companies like Balboa Capital. A quick Google search of Balboa reveals a multitude of shady practices, including luring in customer with seemingly attractive APRs and equipment buyout clauses only to switch them down the road4.
Growth through these schemes are unsustainable. With rising interest rates, Cutera’s sales growth will be hampered by higher borrowing costs as well as customers’ lack of credit financing. Secondarily, a recent rise in leases has contributed to increased supply in the used-equipment market. As customers look to maximize their ROI and minimize payback periods, they will wind find a much easier time justifying a purchase of used—as opposed to brand new—equipment, pressuring Cutera’s sales. The set up here is analogous to the current auto loan bubble, where the industry has seen auto sales plateau.
Given Cutera’s stale product portfolio, sales force turnover, and reliance on third party equipment lease and financing, revenue growth will face increasingly tough compares going forward.
Misconception 3: Scalable Business Model with Untapped Earnings Power
New CEO James Reinstein thinks he can triple sales in five years (that’s a 25% CAGR!) and consensus has sales growing at a double digit CAGR indefinitely. Having just turned its first annual profit since 2007, investors believe Cutera will scale its revenue growth and leverage fix costs to generate increasing levels of profitability for shareholders.
Even if Cutera can achieve this pie in the sky, double digit top line growth rate (which we don’t think they can), we doubt Cutera can successfully scale the business for the following reasons: unattainable gross margin targets and the expiration of a very attractive lease.
Management has often cited a normalized gross margin of 60% for the business, which is their target for Q4 2017. Management has been on record saying 60% gross margins were achievable at a $20M+ quarterly sales run rate. Cutera has generated $20M+ in revenues in nine of the past 10 quarters, yet it has not once achieved a 60% gross margin. We see a similar trend when viewed over longer periods of time.
Source: SEC Filings, S&P CapIQ
Candela acquired by Syneron, Lumenis acquired by XIO Group, Solta acquired by Valeant
Cutera last achieved 60% gross margins on an annualized basis back in 2008. Even Cynosure, with sales 3.5x larger than Cutera, doesn’t generate 60% gross margins. If Cynosure can’t achieve gross margins in the 60%+ range at $400M+ in sales, we doubt Cutera will be able to.
Secondarily, Cutera’s current cost structure benefits from a very attractive lease for its Brisbane, California headquarters, where Cutera manufactures, warehouses, test, and develops equipment in addition to housing its sales, marketing, regulatory, and administrative activities.
Source: SEC Filings, LoopNet
The current lease rate for this 66,000 sq. ft. facility is $20.4 per sq. ft. At current market rates of $43.0 per sq. ft, lease expense will more than double from $1.35M to $2.84M annually. For a business that generated $2.4M in operating income last year ($3.6M adjusted for a $1.2 legal settlement with Kendall Jenner), this $1.5M in incremental lease expense presents a significant increase.
We believe Cutera will ultimately have to relocate, as it makes very little sense to manufacture its products in the Bay Area. The relocation, associated costs, potential loss of employees, etc. will be disruptive and continue to pressure margins.
What is Cutera Worth?
At $20.0/share Cutera trades at 57x earnings (P/E) and 44x EBITDA (EV/EBITDA), which is far too high for a business that is marginally profitable and has only grown sales at sub 2% CAGR over the past decade. Even if we assume Cutera can grow revenues as a high single digit CAGR (5 year CAGR through 2021: 8.6%) for next several years (which is unlikely given the case we outlined above) and also scale the business model, we believe shares are worth $13-14/share at best, representing 33% decline at the midpoint. Our DCF is summarized below:
Our DCF assumptions are quite conservative and assumes EBIT margins expand to 7.7% by 2021. As a reference point, Cynosure achieved comparable EBIT margins in 2015 but at $339.5M in sales, which is nearly double our projections for Cutera at the terminal year.
Alternatively, if Cutera is acquired for the same multiple as Cynosure—which has greater market share, is faster growing, and possesses superior economics—we get a similar share valuation of $12.9 per share, representing 35.6% downside:
The most significant risk to a short position in Cutera is buyout risk. Given the recent share price increase, reduced stake by activist investor Voce Capital, pro-growth visions of the new CEO, insider selling, management turnover, and an upcoming lease expiration, we believe the window for a Cutera buyout has closed. No reasonable strategic or financial buyer would pay a reasonable premium over the current elevated share price.
A secondary risk is that Cuter will eventually grow into its valuation. However, given its historically weak growth profile and inability to grow margins, as well as the potential disruption from a likely move of its headquarters and manufacturing facility, we think this is unlikely.
Phony Glass Door Reviews
Reliance on shady equipment lease financing companies (Balboa Capital)
Unrealistic CEO targets
Lack of incentives for management to sell business
1. Buyout fails to materialize, investors hoping for a takeover exit, stock traces back to intrinsic value
2. Lease expiration hurts 2018 earnings power relative to consensus
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