Syneron Medical (ELOS) – Maintaining Bullish View

My last update on ELOS is almost a quarter old and with ELOS announcing its 2Q06 results today, it is time to revisit the investment thesis on this once again. A lot has transpired since the last update on May 20^th.

In brief, we had the following upcoming milestones for ELOS as of 5/20/06, as summarized by the top analyst in this field, Suraj Kalia:
1) Potential launch of home use skin rejuvenation product by year end ‘06.
2) Potential strategic partnership on the dermal filler / home use front – 2H-06.
3) Newer indications for the VelaSmooth 2H-06.
4) Dental laser product launch late 2H-06.
5) Non-Invasive Fat removal device – Potential launch late ’06 or 1H ‘07

To quickly recap the events of significance for ELOS from 5/20 to 8/6 before discussing the Q2 earnings today:

- On 6/5/06, Cutera settled patent infringement lawsuit with Polamor admitting to infringement and the CUTR stock soared up 40% as investors are happy that the lawsuit is behind them. Syneron opened up 6% in sympathy though it has absolutely nothing to do with the lawsuit, was never vulnerable to a lawsuit and doesn’t really gain anything from this settlement.

- On another story, also on 6/5/06, American Medical Systems announced that they will be buy Laserscope, LSCP for $31 a share a 45% premium to its closing price and LSCP shot up 45% in morning trading as a result. Though one should question the deep discount at which ELOS is trading compared to the bid LSCP received, ELOS did not react to the offer for more than a few hours of trading.

- On 6/5/06, I also lost my position as the only financial blogger on ELOS (there are plenty of medical blogs on ELOS) with “Average Joe Investor” highlighted ELOS as his stock of the week. Welcome aboard Average Joe! In his summary: “Syneron could be a good bet for someone with some risk tolerance. While there certainly is potential downside in the stock price if they miss analysts estimates in Q2, a lot of the downside has already been taken out of the stock through the relentless beating it’s taken the last two quarters. On the other hand, the potential upside is pretty nice.”

- On 6/14/06, CIBC reiterated their Outperform on ELOS, saying channel checks suggest that 2Q06 sales are on track, Vela will likely be up sequentially from 1Q06, and the new eLine Series seems to be doing well. Firm also noted that the stock currently trades at just 8x 2007 EPS (ex-options), while the peer group trades at an avg P/E of 21x. Given the product breadth and pipeline of new products, the firm believes that ELOS's current level represents an attractive valuation to start or add to a position. Hopefully their "channel checks" are as good as they were in Q405 when they killed the stock in the first place!

- On 6/15/06, Syneron presented at the Needham conference today - Dr. Eckhouse made an excellent presentation with numbers to support his vision for the company.
-138 mil in cash
-2006 - 2007 will be the turn to the future products of $250M company
-no taxes for another 8 years
-45-50% net margins going to our pile of cash or over 10 million per quarter
-growth average 45% a year
-sales 60% north America 40% the rest of the world
-no warnings today, stock stable at this point
-new products for dentistry + cosmetology gadgets
-home use wrinkle devices and improved ELOS line of products for doctors to make more money from aging population

- On 6/23/06, my son turned 1 and boy, is he cute!!! Well, back to ELOS, GroovyStocks joined the elite group of ELOS financial bloggers, though not as positive, with his note on ELOS – A Wildly Profitable Company and he has a couple of interesting comments on his post in his blog site

- On 6/26/06, Saul Sterman, of CrossProfit, put out his note that the revenue dip for Syneron should only be temporary

- On 7/12, Israel and Lebanon started engaging in a war that is feared by some to even be the start of WW III while others are optimistic will end soon. All Isreali stocks and their ADRs started taking a blood bath as the war induced uncertainty of the company’s future and potential damage to manufacturing and operations.

- On 7/13, Saul updated his note on 7/13/06 and we had a discussion on the impact the war may have on ELOS – he had initiated a position in the company at this time. Saul’s initial response to my question on the impact of the war – “The tense situation in Israel has no effect on ELOS. Manufacturing is done globally. Supply lines are secure. In the odd chance of an all out ground offensive into Lebanon, the IDF would call up only a small portion of the reserves. A few younger scientists in R&D might miss a month or two at work but that would be the extent of a worst case scenario. General Management is accustomed to doubling up whenever an employee goes off to do their annual reserve duty. A war situation is no different.”

I had to object to that, since I knew that all 3 manufacturing plants are indeed in Israel and Syneron’s manufacturing is not done globally, to which Saul was quick to provide a detailed response and more clarification:

“At CrossProfit when compiling data on nearly 1000 U.S. listed companies we analyze their BCP – Business Continuity Program. Truth be told, with most Israeli companies we don’t bother. Willy-nilly most Israeli companies had a BCP in place long before 9/11. Syneron is no exception. Syneron subcontracts all manufacturing. This is one of its strengths on an ongoing basis and provides the basic structure of its BCP. The way Syneron has structured its BCP is typical Israeli style i.e. a three prong approach.

1) Primary protocol: Manufacturing is outsourced to three Israeli companies.

2) Secondary protocol: The three sites are located in three different geographical locations within Israel. Any two out of the three have the ability to manufacture the complete product line. Syneron will confirm this.

3) Backup protocol: Syneron maintains all production files at a location other than the three Primary sites. At the drop of a hat production can be transferred to several other predetermined locations/subcontractors (in or) out of Israel. Syneron will confirm the existence of the production files but will not disclose details of its backup protocol.

In the case of a general call up of all reserves (unlikely) Syneron could activate its Secondary protocol and combine manufacturing to two sites. There are other options as well. In the case of: nuclear (Iran?)/chemical (Syria)/biological (?) attack (not on the table now) Syneron could turnkey its Backup protocol. Sorry for the doomsday prognosis but you did want to know if there was any added risk due to the Middle East situation. The answer is none. Very few Fortune 500 companies have this type of a global production capability. The Primary/ Secondary/Backup structure is the best known/cost effective BCP method available. The backup protocol is confidential. Hence, we do not know where the production lines would popup should the occasion arise. I should have said ‘can be done globally’ and not ‘done globally’. Thank you for noticing.”

Encouraging interaction but haven’t had the time to check into the credibility of Saul’s comment on Syneron’s “BCP” but haven’t found a reason not to trust as of today.

- On 7/18/06, Andrew T. Gillies, an Associate Editor at Forbes, wrote up an article on stocks with Israel’s War Discount highlighting ITRN as his top pick but bringing attention to ELOS also.

On to Q206 earnings:

Syneron released 2Q earnings at 6:30 am on August 7^th – reporting sales slightly ahead of consensus at $27.5M in sales but earnings of 32 cents versus the 39 cents estimate.

- Revenues: Q206 revenues grew 37% Q205 from $20.1 million to an all time high of $27.5 million. The consensus estimate from analysts was for $27.3M - so in line.
- Expenses: Incurred additional expenses associated with the introduction of new eFamily products and increased sales force.
- EPS: On a GAAP basis, $0.32 (which includes stock-based compensation expense of $2.4 million, or $0.09 per diluted share) versus consensus of $0.39 - so need to wait and see what the reaction will be for a "7 cent miss" - the question will be answered based on whether value is attached to the growth of the company than the bottom-line. EPS grew from $0.25 in Q205.
- Cash balance: Increased to $148.5 M or $5.53 per share with no debt. Considering acquisitions and buy backs with the cash in hand and the discounted multiple that the stock is trading at now.
- Gross Margins: Ended at 84%, their internal target - 85%. The small slip is being attributed to revenues from Europe, Asia and Latin America rising to 50% of total revenues, compared with a historical level of 40% to 45% and they anticipate margins to be back up as the return to historic geo mix.
- DSO: Trade receivables were $29.7 million on 6/30, representing a decrease of DSO by eight days to 98 days on an end of quarter basis and 95 days on an average balance basis. Expects DSO to remain in the mid-90s going forward.
- Geo performance: Sales in Europe and Asia grew Q/Q and Y/Y. In North America, sales grew 17% Y/Y and flat Q/Q in spite of mgmt transitions.
- Guidance: Given the benefits from marketing and sales initiatives worldwide, as well as cost management initiatives, ELOS continues to expect to meet previously announced guidance of $114-120M for 2006. The new products are still on target for a Q107 release.

Initial reaction from the retail investors has been positive with Syneron trading up as much as 10% pre-market – though on insignificant volume. I will be watching for the analysts’ reactions to Syneron’s Q2 earnings. In my books, Syneron is clearly a company that is focusing on growth and striving to achieve top line revenue guidance without worrying about bottom line profits. Kudos and maintaining my bullish view on this company.

Disclosure: I continue to maintain my “very” long position in ELOS

Last Updated: Aug 7^th 2006