Description

Recommendation

We are recommending a long position in Lumenis Ltd.  (Nasdaq: LMNS), with a 1 year forward price target of $14.38/share or 50% upside relative to 7/7/14 trading price of $9.57.  Lumenis is an Israel-based global manufacturer and marketer of energy-based therapeutic applications (primarily surgical lasers) with exposure to three primary end markets: Surgical, Ophthalmic, and Aesthetic: 

• Surgical applications are for benign prostatic hyperplasia (BPH; or enlarged prostate) and ear, nose, and throat (ENT) surgery.
• Key ophthalmology indications include glaucoma and retinal diseases, as well as secondary cataract and refractive surgery.
• Primary indications in the aesthetics segment are for hair removal, skin rejuvenation (resurfacing, wrinkle reduction, scar and tattoo removal), vascular and pigmentation correction.

The shares currently trade at a 2015 year forward P/E of 12.3x (ex cash), EV/EBITDA of 9.8x (we note the company has minimal tax, working capital and capex requirements), and free cash flow yield of 9% (ex cash) based on our LTM June 2015 forecast (which is below consensus).  We believe the Company is well positioned to take share in the large and growing addressable markets (Est. $4B across current indications) were its products compete.  The Company has more than doubled EBITDA since 2011 and grown revenue at a 12% CAGR over the same period.   We believe the cadence of new product introductions over the 2013 – 2015 period, investments in sales and R&D, emerging market exposure, and superior positioning vs. alternative technologies will allow the company to continue to take share, sustain revenue growth, and potentially expand margins over the next 2 – 4 years.  Additionally, the Company’s diversity across end markets, products, and geographies should partially smooth volatility/mitigate earnings risk.

Investment Highlights

Large and Growing Addressable Markets:  Lumenis’ products participate in addressable markets aggregating to >$4B.  Primary drivers of these markets include:  a growing trend towards minimally invasive procedures, favorable global demographics from an aging patient population, and growing wealth in emerging markets leading to increasing surgical volumes and adoption of discretionary aesthetic procedures. Lumenis’ Surgical markets are over $1.8bn for lasers alone and the company is taking share from non-laser based therapies in key areas like BPH. The core BPH, ENT, and stones markets are all between $600-800mn annually. We believe the Company’s Surgical end markets are growing in the HSD% range.  The global Aesthetics market for device-based treatments is over $2 billion and growing in the HSD% range. The Ophthalmology capital equipment market is near $300mn (not including refractive lasers) and is growing in the LSD-MSD% range. These markets are highly fragmented and Lumenis has ample room to take share, as it only has about 5% share in Aesthetics and 20% share in key Ophthalmology segments.

New Product Introductions:  2013 and 2014 will be the most robust product development cycle in over a decade for the Company.  The Company had 6 product launches in 2013 and is expected to launch 1-2 new products in each of its major markets in 2014.  Additionally, there is speculation that the Company may enter the body countering segments of the aesthetics market in 2015.  We highlight some of the recent and prospective product launches below:    

• 120-watt holmium laser (Lumenis “Pulse”) on March 14, 2014 for general surgery. While the current VersaPulse platform is sold in several power ranges, the 100-watt device is the most popular. The new 120-watt device should be a source of further share gains and conversion from TURP (or Greenlight) to HoLEP as the device can likely treat larger prostate glands (>60g is a growing trend) and should allow for a pricing premium. The product launched in the U.S. in May and the EU in April.
• In the Aesthetics segment the Company launched the LightSheer INFINITY (Europe only, under FDA review) and LightSheer DESIRE laser hair removal in Q2 2014. INFINITY represents an important new opportunity within the LightSheer family as it features longer wavelengths and pulse widths that can safely and effectively treat darker skins. The availability of INFINITY should make laser hair removal more accessible to a broader range of people, especially those with dark and/or tanned skin that were previously ineligible for laser hair removal procedures.  DESIRE offers a value proposition by providing a portable and upgradable hair removal system.
• In the Opthalmic market the Company received 510(k) approval for its Array LaserLink scanning ophthalmic laser on November 1, 2013, for use in diabetic retinopathy, macular edema, neovascularization, and other therapies and the Accupulse Duo launched 2H 2013; which allows surgeons to switch between fiber and free beam modalities electronically.
• According to Jeffries equity research Lumenis is relying on two product releases to enter the body contouring segment of the Aesthetic market:  MARS Radio Frequency (RF) system for skin tightening (expected 2014/2015) and the MUST system for circumference reduction (expected 2015).  The company is aiming for share capture in a market that has strong acceptance of new technologies and is primed for growth given increasing global demand for body contouring and skin tightening.  Body contouring represents a $600mm niche within the broader $3bn+ aesthetic device market. Capturing 15% of this market could represent $90mm in incremental revenues.  Note we do not factor any incremental revenue from a potential entry into the body contouring segment. 

Positioned to Gain Share:  We believe the Company’s premium positioning, strong brand recognition, recent initiatives, and competitive advantages vs. existing treatments should enable the company to gain share over the long term: 

• The Company has been executing on a number of initiatives that we believe will help sustain and potentially accelerate revenue growth in the near term.  For example the company added 136 sales people between 2009 and 2013 in APAC alone (now totaling 210 at 12/31/13).  The Company has also been focusing on increasing the number physician training programs to help drive adoption of its products. The company is sponsoring a number of training courses in 2014 and our understanding is that classes are full and demand is growing.  Lumenis has also increased its investment in R&D and Sales and marketing going from 6.5% and 29.8% of revenue in 2009 to 8.4% and 30.6% of revenue in 2013.  In aggregate dollars R&D spend has increased from $14.6M annually in 2009 to $22.2M in 2013 and sales and marketing has increased from $67.4M in 2009 to $81.3M in 2013.  Despite this increased rate of investment the Company has expanded margins and tripled EBITDA during the period. 
• We believe Lumenis’ HoLEP (Holmium Laser enucleation) technology with 8% share of BHP laser based treatment market is superior to the GreenLight Laser PVP (Photoselective Vaporization of the Prostate) with 30% market share.  Lumenis’ enucleation product is not ablating like the GreeLight laser, but involves precise cutting to remove the prostate.  The holmium laser allows for more control, less blood loss, and greater efficacy vs. PVP.  Additionally, HoLEP has lower reoperative and conversion rates than PVP or TURP (the current standard of care, which is more invasive than PVP or HoLEP).  We estimate every 2% of incremental BHP share adds 15% to 30% to the value of Lumenis (assuming $30M - $60M in current BHP related sales, 60% gross margins, 15% tax rate, and 15x multiple).  We believe the Company’s technology should be able to gain meaningful share vs. the GreenLight Laser over the long term.  However; there are hurdles to HoLEP’s broader adoption, principally among them is longer procedure times. A HoLEP procedure can take an hour or more while vaporization can be done in 30–40 minutes. Vaporization is time dependent so that smaller prostates are optimal for the therapy relative to HoLEP and as prostate size grows, the benefits for vaporization start to moderate. Importantly, reimbursement for each procedure to the clinician is roughly the same in the US and this has thus far slowed adoption. Notably in countries where physician payment is not such an important issue, like the UK, HoLEP has become the standard of care. We note that the company has also recently launched a higher powered laser, the Lumenis Pulse 120H Holmium Laser Platform. The system is the most powerful and versatile laser system launched by the company. The 120 watt output improves on the 100 watts in the previous version. The additional power can reduce procedure time for enucleation and also allows for vaporization with the system— effectively lessening the major shortcoming of enucleation while allowing clinicians to still vaporize should they desire to.
• We believe Lumenis is also well positioned to gain share in the market for the treatment of  Urologic stones.  Stones are crystalized deposits of calcium, uric acid, or other minerals found in the urinary tract and can form in the kidneys, bladder, or other areas of the urinary tract (i.e. ureters) and primarily occur in men (>80% of cases). Lumenis estimates that there are more than 1 million stone procedures performed annually in the US and approximately 4 million performed worldwide. The urologic stone market is highly fragmented (low barriers to entry) and very competitive. While there are a number of therapeutic approaches, non-invasive ultrasound / extracorporeal shock wave lithotripsy (ESWL; sound waves), is the leading non-invasive therapy in this segment.  Lumenis also markets its holmium laser platform (VersaPulse + SlimLine fibers) for treatment of stones (“lithotripsy”), in what management believes is in excess of a $400mn device therapy market growing in the +2-3% CAGR range. Lumenis has about 8-9% market share and analysts estimate is growing at more than a 15% CAGR. While the market leading ESWL therapy typically involves 2.5 procedures on average, has a 20-60% single treatment success rate, and only reduces stone size (smaller, fractured stones still have to be passed), Lumenis’ holmium laser offers 90-100% single treatment success rates and completely destroys stones. Beyond stones, the VersaPulse platform is cleared for a number of other urology indications (bladder tumors, ureteral strictures), as well as other surgical disciplines, including gastroenterology / general surgery (appendectomy, cholecystectomy), orthopaedics, gynecology, thoracic/pulmonary, and podiatry.

Emerging Markets Exposure Enhances Growth Prospects: LMNS is well positioned in APAC, where its revenue has doubled over the past five years and now accounts for more than one-third of total revenue. Rapid growth in APAC has been driven by strong growth in emerging markets like India and China. The latter is now LMNS’s second-largest single market by sales. APAC revenue has been the key source of LMNS’s overall top-line growth in the past two years, growing 23% in 2012 and 15% in 2013 constant currency. While growth in APAC can be volatile, we see LMNS’s strong foothold in APAC as a boost to its overall growth potential.

Geographic and Product Diversity:  As of December 31, 2013, the Company had 87 Lumenis medical laser product families and associated accessories registered in over 50 countries. Lumenis owns more than 300 cleared 510(k) pre- market notification submissions, and more than 950 active international product registrations (including 50 in Japan and more than 140 in APAC).  The Company generates ~40% of its revenue from its Surgical segment, 38% from its Aesthetic segment, and 23% from its Opthalmic segment.  Lumenis also benefits from a diverse global footprint with 2013 sales by geography as follows: the Americas (35%); Asia Pacific (32%); Europe, Middle East, and Africa; (18%), and Japan (15%). In total, emerging markets accounted for around 40% of sales last year, the majority of which stemmed from China.  Additionally, sales of our consumables represented ~15% of 2013 revenue, and services represented ~20% of 2013 revenue. The Company estimates recurring revenues accounted for 31%, 32% and 33% of our total revenues for the years ended December 31, 2011, 2012 and 2013, respectively.

Key Risks

Relatively new management team: The majority of LMNS’s senior executives, including the CEO and CFO, joined the company in 2012, and do not have a long history in running the company. While the new management has demonstrated a commitment and ability to improve execution in this short time, it will take time for them build credibility.

Company has provided limited visibility on pipeline: While LMNS plans to launch 1-2 new products or applications per business segment in 2014, the company has provided limited detail into the nature of its product pipeline. Additionally, from a business perspective, with the majority of its revenue stemming from capital equipment, the preview of new equipment will likely discourage sales reps from promoting and customers from purchasing existing products.

Dependency on capital equipment and elective procedure volumes:  Nearly 70% of LMNS revenue is from capital equipment, which is a higher price tag purchase made by hospitals and physicians. Demand for devices, which typically carry higher average selling price (ASP) can be lumpy and usually slows in an uncertain macro environment.  Additionally, the Aesthetics segment represents 39% of sales and tends to follow consumer discretionary spending patterns.  On the Surgical and Opthalmic portions of the business, many of the Company’s procedures are not urgent (though many are necessary) and can be deferred, and are thus classified as “elective.” Certain macro trends like higher deductible insurance plans in the US can cause weaker 1H volumes before deductibles are used up and people go to the doctor. Also, factors like unemployment can have a meaningful impact on non-urgent procedures.

Limited liquidity and IPO lock-up expiration:  Prior to the IPO, Lumenis had a dual class share structure, comprised of both “Ordinary shares” and “B shares.” During the IPO, 6.25mn new B shares were issued, but approximately 25.8mn Ordinary shares and 3.2mn other B shares (issued to selling stockholders as a dividend prior to IPO) will be locked up for 180 days. Upon expiration of the lockup period, all Ordinary shares will convert to the new B share class (only B shares will remain), and a total of ~29mn shares will become unlocked. We estimate that 60-65% of B shares will still be controlled by financial sponsors upon lock-up expiration, which could ultimately decide to sell shares. The timing and/or magnitude of potential sales by financial sponsors are unknown.  Additionally, while the Company has a $363M fully diluted market cap the current float is extremely limited and in line with a sub $100M company. 

Valuation and Financials

We value the company using a DCF approach with the following assumptions:  9% unlevered cost of capital, 3% perpetual growth, and no debt in the terminal year.  Our target price implies a 6% FCF yield in the terminal year.  Note that our forecasts are generally lower than consensus ($37M of 2017 Net Income and $1.03 of 2017 EPS) as we forecast lower growth and provide for minimal margin expansion (we also do not add back SBC).  Our revenue growth forecast is lower than consensus as we do not have enough visbility into the nature and cadence of new product introductions to quantify share gain or give the company to much credit beyond market growth.  Our margins are lower as we believe the Company's investments in sales and R&D will limit operating leverage.  However, we believe consensus estimates are credible given the Company's recent track record of generating growth, cadence of management initiatives, and track record of expanding margins.  We provide a summary of financial model below:

Catalyst